Illustrative of a suspicious issue is that if you take an ounce of gold and continually loan it out at about 5% interest, then after about 1200 years, you would be owed an amount of gold equal to the Earth’s mass:
Of course, 1200 years is a long time, but one ounce is not a lot of gold. In any case, does it make any sense to have an ongoing activity that is physically impossible to sustain over a long term? As any engineer will tell you, no real system can sustain a positive exponential character; something has to break down.
So perhaps we can easily imagine why inflation and economic “bubbles” are endemic to our economic system. Since the possibility of consistent return on investment is physically impossible, we will inexorably have bubbles that pop and property foreclosed on (taken by banks to be resold at inflated prices later), and/or a continuously inflated currency. Like a game of musical chairs, a system like this must inevitably create winners and losers.
Austrian economists complain about the continual drop of the value of the dollar versus gold, and if you look at that curve going back to 1913, it looks roughly like a negative exponential curve – precisely the shape that would counteract the wishful thinking embodied in the positive exponential of interest. Supposing that the virtue of assigning guaranteed positive interest to all loans is a highly destructive myth, then the Federal Reserve incompetently balances this myth with reality by constantly devaluing the dollar, thus at least partially counteracting the negative impacts of interest (but of course, insiders unjustly exploit their being first in line for low interest money as they hand it out to non-insiders at increased rates of interest).
The basis put forth in an attempt to justify the notion that it is a borrower’s inherent duty to pay interest is an obvious fact: that the borrower is getting value from the loan. Does this premise really lead to the conclusion that the borrower should therefore pay “rent” on the money for as long as he is “using” it? Theories of “time preference” (e.g., see Ludwig von Mises’ Human Action) declare that we are all essentially animals who fixate on short-term desires, who want what we want now, and must be bribed with interest in order to delay “consumption” until later. This has some plausibility given the behavior of many people, but is it really true that the value of exchanging a loan for repayment later flows only one way, from lender to borrower? If so, then interest would make perfect sense: each day the lender is prevented from hedonistically spending his money is, on the theory of time preference, some measure of personal suffering, and in return for his suffering, he must be paid an amount relating to the time of his suffering and the amount of loan principal.
In order to best understand why the theory of time preference is false, one must first mentally set aside the highly contrived fiat money system in which we are all forcibly ensnared. On our fiat-money system, money is only created when new loans are created, and loans are virtually always forcibly created with interest. This behavior doesn’t emerge from bottom-up market-driven choices; no alternatives to interest on money creation are legally permitted – anyone attempting to trade in truly non-dollar-denominated terms will eventually find themselves on the receiving end of a SWAT team. These facts about fiat money cause many secondary effects, including the effect that it may make perfect logical and moral sense to charge interest on constantly inflated fiat money one was forced to use. It is impossible to derive truth from a violently manipulated reality; we need to temporarily ignore the fiat money system (whether the fiat money is made of gold or paper is beside the point) and consider the marketplace in terms of true units of economic meaning: wealth.
What is the nature of wealth? Human beings do not create the substance of wealth, which is matter. Rather, they rearrange matter that already exists using time, effort, and purposeful intelligence. In rough terms, real wealth is the multiplication of these three factors.
Another aspect of wealth is that all things being equal, it decays over time. A home falls into disrepair; a basket of tomatoes goes rotten; an innovative product becomes outdated and worth relatively less than a newer version. This is an economic law related to The Second Law of Thermodynamics, which states that the entropy of a system always either increases or remains constant over time. Things generally get old and fall apart, and when you have human beings engaged in normal self-improving activities, old ideas make way for new ones (ideas don’t per se “fall apart”, but assuming humans keep innovating they do become less economically valued over time). The Law of Wealth is that wealth decays over time.
Different forms of wealth will of course decay at different rates, depending on three factors: 1) The “shelf life” of the unit of wealth in question; 2) Obsolescence; 3) loss, theft, or confiscation and the cost of securing wealth against the risk of these. The first factor happens when tomatoes rot. The second factor happens when the new version of the iPhone comes to market (it might be argued that the second factor isn’t always in play, but we hope it is otherwise the human race is either stagnant or regressing). The third factor is involved in both obvious and subtle ways with every kind of wealth. It is obvious that any criminal might break into your house and steal your gold and hence it is wise to take steps to secure and insure against that outcome. It is a bit less obvious that the government might declare gold to be illegal to own, which is itself a form of legalized theft (see the US in 1933). And less obvious than that are the costs and consequences of government legislation, which ultimately result in an ongoing tax on wealth (it does not matter what kind of government one supports or even whether one advocates for no government – implementation of any system or “non-system” that protects one’s wealth has real ongoing costs). There is no escape from The Law of Wealth: one’s wealth always decays.
All men are mortal, and all wealth is mortal. But that doesn’t stop men from wishful thinking. Just as they foolishly pursue a “Fountain of Youth”, they also pursue an escape from The Law of Wealth. But unlike the ever-elusive Fountain of Youth, an escape from the mortality of wealth can seemingly be had by some, for a price – a moral price.
Suppose one owns a home, and through one’s productive efforts, builds yet another home. As any homeowner knows, maintaining the wealth that is the home is an ofttimes troublesome activity. Weeds need to be pulled, pipes need to be fixed, shingles blow off the roof, and on and on and on. Also, security and insurance needs to be in place in case thieves break in and steal things, or in case of natural disaster such as a lightning strike or a fire. So, moving to a second home and leaving the first empty, expecting to be able to regard one’s idle house as a kind of “bank account” which can be “withdrawn” from through later trade is not going to work. Someone is going to have to put in quite a lot of effort to maintain the home’s value. If you can find a means to effortlessly secure, insure, and maintain the value of the home for thirty years, when over the same time the value of the home would have dropped dramatically from lack of maintenance, then you’ve seemingly hit on a very good plan. But what if you can at the same time multiply the wealth threefold? Well, you will have not only cheated The Law of Wealth, but have spat on the Grim Reaper of Wealth as well! What a deal! There’s only one problem: where to find the poor sucker who will spend thirty years not only maintaining a banker’s wealth, but tripling it? And herein lies the key: The Fountain of Youth for wealth is the youth. To defeat The Law of Wealth, you eat the young, by manipulating the economic, political, and intellectual climate such that their efforts to not only maintain your home but to triple its value is as natural to them as death and taxes and working 40 hours every week with two weeks of vacation a year.
It is a fact of human life that, generally speaking, we are unproductive before our 20’s; we are highly productive through our 40’s, and then our productivity diminishes after our 50’s. Being aware of this, most people put away for retirement (more would be put away if not for government social programs). In other words, their actual “time preference” is to consume some of their wealth now and some of it later. They don’t actually prefer to spend it all now; they have plans for the future. So clearly, if a middle aged man “loans” the wealth of his second home to a younger man who has no home, then assuming there is low risk of default, even simply getting the same well-maintained home back years later is of great value to the older man, for if he had left it unmaintained for 30 years, he could well have no home. Clearly then, the theory of time preference does not apply to real people and their wealth (it may apply to hedonistic lab rats and their cheese).
So what is a reasonable trade between the lender of a home and the borrower of a home? Unforeseeable market dynamics preclude one from making a definitive statement, but there cannot be a continuing stable and just system of real interest on wealth – basic physics precludes it. If a lender continually receives three homes in return for one at every 30-year interval, eventually the market must collapse. The Federal Reserve can, literally speaking, “paper” over this problem by inflating the value of money, thereby turning three homes back into two, or even into one or less, but that “solution” converts one systemic lie into another systemic lie. A system based on lies is not a system for a virtuous people nor for a healthy economy, since manipulation leads to distrust and unpredictability, which leads to apathy and a consequent general reduction in ambition and productivity.
According to The Law of Wealth, a man who leaves his wealth untended will lose it over time. So he benefits overall when his wealth is merely maintained (such maintenance includes a reasonable guarantee of its return). On an actually honest economy, how would the younger man’s need of a home sooner relate to the older man’s need for its return later? I speculate that over time, the free market would find that the older man is getting the better deal when the younger man returns the home in equal condition to when he first obtained it. The reason is that the young can through strength easily get by on meager wealth, which would cause a downward pressure on the price the old man gets for loaning his home, but the older man becomes utterly dependent on the wealth they created before (or on others’ wealth). The older man needs stored wealth more than the young man does. All things being equal, this imbalance implies a greater value going to the older man if the condition of the wealth is guaranteed by the young man upon its return – which is the reverse of what the theory of time preference argues for.
But this is not a question for me or anyone else to decide. It is between the young man and the old man trading value for value as they see it in an actually honest economy. The only thing that can be said for certain is that one’s being entitled to interest for loans is a myth and is only sustained in the long term and generally through government fiat. It flouts The Law of Wealth, inexorably leading to incessant boom and bust cycles as the positive exponential leads to inherent economic system instability. And any engineer could have told you that.
Closely related to The Law of Wealth is The Principle of Symmetry of Wealth, which is always tacitly denied when furthering economic myths about interest. The Principle of Symmetry of Wealth is a corollary to The Law of Identity: just as A is A, Wealth is Wealth, and no form of wealth has any special economic status relative to any other unit except to the individuals involved in a particular act of wealth creation or exchange, and only in accordance to their particular individual values and uncoerced choices.
Central to the tacit denial of The Principle of Symmetry are various forms of propaganda that purvey the notion that money is special. Just as most political myths result in legislation that supports the myths, “legal tender” laws legislate that money is special in various ways, but most centrally: 1) taxes must be paid in legal tender; 2) all reportable economic activity must be denominated in terms of legal tender; 3) legal tender is the only unit of wealth that is exempt from “investment”-related taxes (i.e., when, through deflation, the dollar increases in real value, unlike other wealth holdings, this increase is not taxed). The buttress of legal tender laws, upheld with the threat of imprisonment or death to anyone who defies them, is a very strong psychological impediment for understanding the truth about money, but the truth is: the purpose of creating a dichotomy between money and wealth is to facilitate both taxation and the potential for insiders to centrally manipulate an economy.
Some self-styled defenders of the free-market claim that even without threats of attack by government for the sin of not using government approved money, a dichotomy between money and wealth would still exist. But in fact, all that would exist would be individuals trading value for value in whatever medium and denominations they preferred. The fact that at a given time and locale a given unit of trade emerges as popular is utterly irrelevant – the fact would remain that two individuals would still be free to defy the popular convention and create their own private terms of transaction. The popularity of a given unit of exchange is of no more relevance to the issue of what counts as money as is the popularity of a given book to the issue of what counts as a book. Money is nothing more nor less than what units of wealth two consenting parties decide to denominate their trades in. This decision should not be coercively enforced, nor is it a communal “standard” – on the contrary, what counts as money is decided on by each individual when they transact. When many people happen to make the same choice for many of their transactions and have the same monetary habits, then that may be convenient for them, but nothing new has happened that didn’t already happen when there was only a pair of individuals who first decided to transact using a particular medium of exchange. Money is wealth used in a particular way in a particular transaction; its status as money is solely determined by the particular transaction, not by the happenstance of many similar transactions taking place.
To put it more egoistically: My trading partner and I will decide what constitutes money; we don’t need someone else presuming the authority to tell us whether something is or is not money. It is our prerogative and ours alone to make such decisions. It is arrogant presumption to butt into another’s financial business and tell them what units of wealth or what rights-respecting economic activity is more preferred than others. One would think that proponents of liberty would be the last people who need to be told this, and yet for some reason, it has become the current fashion to obsessively associate liberty with a gold “standard” and with other sundry economic notions. To truly advocate liberty is to put the principles of equal liberty on a pedestal, to be reverently worshiped and respected in and by all human beings. Yet many self-styled defenders of liberty spend far more energy putting gold and other economic trinkets on that pedestal, displacing true liberty with economics. What do people need with economic jargon if they don’t have their liberty? After all, with true liberty, one can collect whatever trinkets suits one’s desire. One can trade value for value without interference. Who needs an intricate economic theory to tell them what they want? And what good will economic theory do them when they don’t have their liberty? An actually free market has no use for complex economic theory; humans who are free will do what they want, and that’s that. Economic “science” and metal trinkets are thus false idols that distract people from the proper object of worship: true human liberty.
Anyone who has been convinced by my arguments might wonder: Why would such insidiously destructive ideas be used as the legal basis of our financial systems? Since the myth of exponential return was institutionalized long ago, it is not as important to know the motives of those who instituted it as it is to know why this myth would persist. But the answer to that question is fairly obvious. The majority of people do not care to engage in rational political or economic thought, and the minority who are part of the political/financial apparatus seemingly have little to gain and much to lose by overturning widely-held myths (the political class in particular thrives on contrived crises). So the question is really: Why are so many people willing to “become as little children,” to submit themselves to the unscrutinized authority of another? The reader will have to answer that question for himself.
It is natural to wonder precisely how society would function economically if the choice of what counted as “money” was driven bottom-up (in accordance with what natural rights demands) as opposed to coercively driven top-down. While it is interesting to ask this question, it is (as has been said) arrogant presumption for us to specify what free, independent, creative people should choose. Also, one person can barely begin to imagine the creative ways in which society would be transformed for the better once human beings were free to create improved ways to trade value for value in accord with their own free choices rather than being unjustly bound by the arbitrary and simplistic strictures of a centralized money dictatorship.
But to speculate, I think a strong theme would emerge out of free market choices, namely that the stock market would evolve into something much more instrumental than it now is. People who didn’t want to think much about what store of value was best could simply use a kind of stock index, denominated not in arbitrary fiat dollars but in terms of something useful, for example, some basket of resources actually used day in and day out by the average person, where, say, one unit approximates the daily resource requirement for an average person. People who were a little more adept would own specific commodities and stocks that related to their future pursuits. E.g., saving to build a home would mean saving lumber, iron, gypsum, and other related commodities, and when you had enough claims to material saved up, then you could “cash out” to build your home. The fact that everything would be computerized would mean one could quickly trade one form of wealth store for another, so one could own stock in gold if one wanted, and then convert to whatever the grocery store wanted right there on the spot. Trading would be instant and you could trade wealth “stored” in the general stock market for wealth on the grocery shelf. Computer technology would make this very simple and effective.
A version of this article was originally published in 2012 under the title “The Fallacy of Compound Interest versus The Law of Wealth.”
For historical context see Trust Issues, by Paul Collins.