T P W I

The simple scenario described below is based on an idea by Michael Lipton at the University of Sussex in 1992. Imagine a farmer who wishes to buy a plot of land and farm it. His purchase and operating costs are to be financed entirely on borrowed funds. The land is capable of supporting a highly intensive technique which is forecast to produce £150 per year of net profit for fifteen years, and which results in the land’s desertification. An alternative production technique produces only £100 per year of net profit, but allows the land to regenerate and maintain its productive potential indefinitely.

Discounted cash-flow analysis allows the modern farmer to compare these two sets of cash-flows and select the most profitable. For each interest rate, the present value of the related set of cash-flows is calculated according to a standard present value formula. For example, £110 to be received in one year’s time is worth £100 today if one assumes an interest rate of 10%. It is the farming approach that provides the highest total present value that is then recommended. The tables below show the relevant calculations where ‘t1’ represents year 1, ‘t2’ year 2, and so on.

Year	Profit	PV of profit at 5%	PV of profit at 10%
t1	150	143	136
t2	150	136	124
t3	150	130	113
t4	150	123	102
t5	150	118	93
t6	150	112	85
t7	150	107	77
t8	150	102	70
t9	150	97	64
t10	150	92	58
t11	150	88	53
t12	150	84	48
t13	150	80	43
t14	150	76	39
t15	150	72	36
t16 to t ∞	0	0	0
Totals	2,250	1,560	1,140

High intensity farming produces £150 of profit per year for 15 years followed by desertification

Year	Profit	PV at 5%	PV at 10%
t1	100	95	91
t2	100	91	83
t3	100	86	75
t4	100	82	68
t5	100	78	62
t6	100	75	56
t7	100	71	51
t8	100	68	47
t9	100	64	42
t10	100	61	39
t11	100	58	35
t12	100	56	32
t13	100	53	29
t14	100	51	26
t15	100	48	24
t16 to t ∞	100	falls to 0	falls to 0
Totals		2,000	1,000

Low intensity farming produces £100 of profit per year for ever

The calculations show clearly that with interest rates at 5% the highest present value (£2,000) resides in the low intensity farming approach, whilst with rates at 10% the highest present value (£1,140) resides in the high intensity option, and the incentive towards intensive farming, and thus desertification, increases as the interest rate increases. This unfortunate result is entirely due to the familiar way in which the discounting process progressively reduces the present value of the land’s output in future years toward zero. £100 of net profit earned in year fifty has a present value of approximately £0.85 if the interest rate is 10% per year. No wonder then that the analyst who relies on discounted cash-flow analysis has little care for what the land can produce in year fifty. Whether the land at that time is desertified or not is of little relevance, since its contribution to present value is negligible. Lipton argued that:

Dramatically rising interest rates in 1977-79, sustained ever since, have increased the incentives – to families, businesses and governments – to use up natural resources now, and to ignore the consequences later … for third world governments that wanted to provide resources or subsidies for conservation, rising interest rates drained their ability to do so.  In 1972, interest payments – at home as well as abroad – comprised 5.6% of spending, including net lending, by governments in non‑oil developing nations; by 1988, they had reached 18.7%. … Participants at Rio warned of impending famine, dearth, and depletion. The rate of interest is our spectre at their fast (Michael Lipton, The Spectre at the Fast, Financial Times, 24 June 1992).

Despite the mathematical recommendations, one can be excused for believing that the bankrupting of land for the sake of increased short term returns does not make intuitive sense.  An immortal goose that lays one golden egg per week should not have its immortality traded in for the sake of two golden eggs per week in the meantime.  It appears however that some natural assets can be sacrificed at the behest of discounted cash-flow analysis. Whether such sacrifice takes the form of desertification, the extinction of a species or the immensely long-lived pollution of a nuclear power plant, the principle remains the same. Compound interest values the distant consequences of current actions at next to nothing and the resulting problems are often deferred to a future generation that had no say in their creation.

It is surely part of every decent philosophy that man should do his best to maintain the Earth for succeeding generations. But since our valuation of the rights of future generations is tied so very closely to the practice of discounting, and thus in practical terms to the institution of interest, no discussion on a society’s duty to its offspring can be isolated from an examination of its position on interest.

The questioning of interest on theoretical grounds is not a recent development. Plato regarded it as a means whereby the rich could exploit the poor, and Aristotle believed that money was to be ‘used in exchange and not to increase at interest’. In Greece, during the sixth century BC, Solon waived the debts of the poor and imposed an upper limit of 10% on the rate of interest. Among the Romans, Seneca and Cicero argued against usury, and among the early Christians, Nysennas, Augustinus and Acquinas were similarly opposed.

Prohibitions on usury appear in both the Old Testament (including Exodus 22:25, Deuteronomy 23:19, Nehemiah 5:7 and Ezekiel 18:8, 18:13, 18:17)and the New Testament (Matthew 25:26-27 and Luke 19:23). However,many in the Jewish community have interpreted the Old Testament prohibitions as applying only to loans made between Jew and Jew, not between Jew and Gentile. Deuteronomy 23:20 does indeed substantiate that claim, although Muslim scholars will question its authenticity as a piece of Divine revelation:

If you advance money to any poor man amongst my people, you are not to act like a money lender; you must not exact interest from him (Revised English Bible, Exodus, 22:25).

You are not to exact interest on anything you lend to a fellow countryman, whether money or food or anything else on which interest can be charged (Revised English Bible, Deuteronomy, 23:19).

You may exact interest on a loan to a foreigner but not on a loan to a fellow countryman, and then the Lord your God will bless you in all you undertake in the land which you are entering to occupy (Revised English Bible, Deuteronomy, 23:20).

That debt frequently became burdensome in ancient times is evidenced by the existence of a ‘Jubilee’ year in which the debts of the poor were cancelled. Deuteronomy 31:10 requires such cancellation every seven years and Leviticus 25:10 requires it every fiftieth year. Commenting on these practices, Michael Hudson writes:

Clean-slate proclamations date from almost as early as the first interest-bearing debt, starting in Sumer around 2400 years BCE. Eventually, the tradition became known as the Jubilee Year, but by that time it was taken out of the hands of kings and placed at the core of Mosaic law. Radical as the idea of the Jubilee seems to modern eyes, these “restorations of order” were a conservative tradition in Bronze Age Mesopotamia for 2,000 years. What was conserved was self-sufficiency for the rural family-heads who made up the infantry as well as the productive base of Near Eastern economies. Conversely, what was radically disturbing in archaic times was the idea of unrestrained wealth-seeking. It took thousands of years for the idea of progress to become inverted, to connote irreversible freedom for the wealthy to deprive the peasantry of their lands and personal liberty (Hudson, M., It Shall Be a Jubilee Unto You, Yes, USA, Autumn 2002).

At the Council of Nicea in 325 CE, where some theological principles seem to have been compromised under pressure from King Constantine, the Church’s representatives stood firm on the topic of usury. Usury among the clergy was banned. For many centuries a consensus ruled against the practice. O’Brien quotes the decree of the Lateran Council of 1179:

Since almost in every place the crime of usury has become so prevalent that many people give up all other business and become usurers, as if it were lawful, regarding not its prohibition in both Testaments, we ordain that manifest usurers shall not be admitted to communion, nor, if they die in their sins, be admitted to Christian burial, and that no priest shall accept their alms (O’Brien, G., An Essay on Mediaeval Economic Teaching, Ch. 3.2, 1920).

During these times, the willingness of Jews to advance money under usury saved many a Christian exchequer from financial embarrassment. But as time progressed, the debts of the common folk to the Jewish community also began to escalate and attitudes towards them hardened. Cleary writes:

The charters of Henry III and Edward I, granted to town after town at the request of the citizens, prohibited Jews from settling in them that the community might be safeguarded from their ravages. Edward I indeed made some attempt to get all the Jews to give up their usurious practices. He forbade them to take usury on money and to enable them to secure a livelihood he permitted them to work with Christian masters, to buy and sell without payment of toll and even to take leases of land for a term not exceeding ten years (Cleary, Rev. P., The Church and Usury, 1914, p. 71).

The King’s efforts did not resolve matters. Cleary continues:

The people clamoured for their expulsion, and at length in 1290 Edward, yielding to their importunities, ordered all Jews to quit the kingdom with their goods and chattels under penalty of death. To the number of 16,511 they assembled at the Cinq Ports and left the kingdom amidst universal rejoicing – the clergy granting the king one-tenth, the people one-fifteenth in token of their gratitude. They were not allowed to return until the time of Cromwell (Cleary, Rev. P., The Church and Usury, 1914, p. 72).

In due course Charles VI of France ordered the expulsion of the Jews and during the fifteenth century several German states followed suit. In many cases, the Jews thus expelled found new homes in the Muslim world on honourable terms. However, the Muslims, both elites and commoners, were much less willing to engage in usurious practices with the Jews and the absence of a substantial debtor-creditor relationship at the state level must to some extent have stunted the political influence of the Jewish community during this period. While Jews in Holland encouraged Cromwell to undo Edward’s expulsion order with offers of loans and financial assistance (see for example Guizot, M., Life of Oliver Cromwell, Richard Bentley, London, 1868, p. 307), the Muslim caliphs afforded few such fulcrums for lobbying, at least until the later Ottoman period.

In the theological debate surrounding usury in Christendom, the arguments of the Christian scholastic Thomas Acquinas stand tall. In Section 2.2 Question 78 of his Summa Theologica, Acquinas argues against those who see the rental of money at interest as being akin to the rental of an asset of some kind. In the rental of food, the use of the food is in the eating of it. Since food cannot be eaten without also being destroyed, food cannot be rented. Rather, it must be sold. And since this is the case, a price cannot be charged for the food as well as for the use of the food. He who buys food automatically owns the right to use the food.

What then of the rental of a horse? Here is an asset which is not destroyed in the act of being used. Once again the scholastics argue on grounds of legal title. If the horse dies while in the possession of the one to whom it is rented, it is the owner of the horse who suffers the loss. But in a money loan, if the money is lost or stolen, it is the borrower who suffers the loss. Hence, a loan of money cannot be a rental, but rather a sale of money now in return for money later. And if this is the case, then it is unjust for one unit of money to be exchanged for anything other than one unit of money. A loan of £100 should be repaid with £100, not £110.

Theological opposition of a rationalistic nature such as this is perhaps evidence of an increasingly bitter struggle between the Church and the merchants of Europe on the subject of usury. During the centuries that followed, a variety of legal devices were invented to circumvent the Church ban on interest. Chown describes one of the later inventions, the contractum trinius. The investor would simultaneously enter into three contracts with an entrepreneur; to invest money as a sleeping partner; to insure himself against any loss; and to sell any profits over and above a given level back to the entrepreneur in return for a fixed amount of money per year.

All three [contracts], taken separately, bypass the usury provisions, but the overall effect is simply a loan for interest (Chown, J. F., A History of Money, 1994, p. 121).

In The Scholastic Inquiry into Usury, John Noonan discusses the changing position in Christendom with respect to usury.  Some time before 1220 CE, the canonist Hispanus identified a charge that would be paid by a borrower who was late in repaying a usury-free loan. This charge would compensate the lender for the loss of use of his money in between the time that repayment should have been made and the time when it was actually made. It would be called “interesse”, derived from the Latin for “in between”, and was to give rise to the modern term “interest”.

Soon there came a crucial innovation in thinking. It was argued that a charge could be made for a loan from the outset, not simply where a borrower was late in making repayment. The justification for this was on two counts. “Lucrum cessans” (literally “profit ceasing”) was the profit that a lender had forsaken by lending his money, and “damnum emergens” (literally “loss occurring”) was an actual loss incurred by a lender as a result of having loaned his money.

Though proposing different linguistic origins, other writers also view interest as something that compensates the lender for an assumed loss as a result of lending money:

The Latin noun usura means the “use” of anything, in this case the use of borrowed capital; hence, usury was the price paid for the use of money. The Latin verb intereo means “to be lost”; a substantive form interisse developed into the modern term “interest”. Interest was not profit but loss (Homer, S., & Sylla, R., A History of Interest Rates, 1996, p. 73).

In 1545, under Henry VIII, English law permitted the charging of interesse up to a maximum defined rate of 10%, although any amount in excess of this was regarded as being usury. Soon, the pro-interest lobby began to find its intellectual champions in the unlikeliest of places:

The Christian reformers, both Luther and Zwingli, condemned usury, but the reformer Jean Calvin was the first to raise his voice in favour of usury; one century later his disciple Claude Saumairc [Saumaise], in his book “Concerning Usury” (1638) argued that the taking of interest was necessary to achieve salvation (Vadillo, U., The End of Economics, 1991, p. 17).

When confronted with the seemingly unstoppable spread of interest‑based practices in the world of business, the Church authorities became increasingly silent on the issue. Eventually, in 1917, the Catholic Church formally accepted the practice of paying and receiving interest. The Codex Iuris Canonici issued in that year replaced earlier statements of Canon Law, and its position on usury is quoted by Noonan as follows:

… in lending a fungible thing it is not itself illicit to contract for the payment of the profit allocated by law, unless it is clear that this is excessive, or even for a higher profit, if a just and adequate title be present (Codex Iuris Canonici, Rome, 1920, c. 1735).

Occasional attempts by secularists to reintroduce a usury law of some kind are met with stiff opposition from the banking sector and have in most cases failed despite occasional backing from powerful quarters:

It began on Nov. 12, 1991, at a $1,000-a-plate fundraising luncheon in New York for President Bush. At the last minute, an aide made a quick addition to a list of stimulus policies the president wanted to propose during his speech. “I’d frankly like to see credit cards rates down,” he said. “I believe that would help stimulate the consumer and get consumer confidence moving again.” Those two sentences had a powerful and immediate impact. As it happened, one of the luncheon guests was Alfonse M. D’Amato, then a senator from New York who had been critical of the 10-point gap between the prime rate and the interest rate typically charged to cardholders. The very next day, Sen. D’Amato proposed national legislation to cap credit card interest rates at 14 percent. After some 30 minutes of debate, the Senate voted 74-19 to approve the measure. Panic swept through the banking industry. By Friday, economists were speculating about huge bank failures and the stock market plunged. The fervor for reform quickly cooled. In a television interview that weekend, Vice President Dan Quayle said if the proposed cap survived a House vote, it would likely be vetoed. By Monday, the tough talk about a national usury law became a call for a study of industry pricing practices (Stein, R., Frontline, USA, 2006).

It is worth noting at this stage the rather remarkable similarities that exist between the stories of the usury prohibition in Christendom and the world of Islam. While Muslim scholars have always condemned the practice of usury without equivocation, in recent times commercial forces have begun to eat away at the foundations of their reasoning in a way that is highly reminiscent of the Christian experience. Hence, where the Qur’an sternly prohibits, some modern commentators identify critical ambiguities:

O you who believe, fear God and give up what remains of your claims of usury if you are truly believers. If you do not, then take notice of war from God and His apostle (Qur’ān 2:278).

The Qur’an … prohibits the charging of interest, although various methods have been devised in order to circumvent the prohibition. For instance, a higher price may be charged for goods when payment is deferred than is charged if payment is made in advance or upon delivery (Encyclopaedia Britannica 1996).

It is important to recognise that the public attitude towards usury in the West is not what it was five centuries ago. Injunctions against usury from religious quarters are nowadays seen as little more than an embarrassing appendage of backwardness, motivated perhaps by simple-minded distaste for the money-lenders of old. Often, religious pronouncements seem unscientific and weak when placed before the articulate economists of the pro-interest camp. The latter have produced a wide variety of arguments in the effort to justify and explain the level of interest rates at almost every level of society. As a result, usury has ceased to be an issue in the public mind, at least in the Western world.

Among the arguments that seek to justify interest, expected inflation, positive time preference, anticipated risk and diminishing marginal utility feature prominently. These justifications all propose the superiority of the present over the future, and thereafter that interest exists to compensate those who give up money now in return for money later. Meanwhile, in arguments of explanation, modern theorists tend to propose that the interest rate is the price of money as determined by supply and demand in the marketplace for funds. What we are concerned with here are the justifications for interest rather than explanations of the mechanisms that determine its level. Some detail is required before proceeding.

The idea that an element of interest is somehow justified as a compensation for the effect of inflation is a common one. It is said that the lender of money includes a certain amount of interest, commensurate with expected inflation, in order to maintain the purchasing power of his initial investment. The desire to protect one’s savings from inflation is quite understandable and is not criticised here, however the inflation argument does not attempt to explain the existence of a rate of interest in excess of expected inflation (a “real” rate of interest).  Elsewhere, I question those arguments that assume inflation to be a cause of interest charges and argue that precisely the opposite is often true.

In his 1836 work Outline of the Science of Political Economy, the English economist Nassau Senior proposed that interest is charged because by lending money the lender has to abstain from consumption. Interest is the reward for the lender’s abstinence. Mr. Senior’s critics observed that lenders of money were usually rather wealthy people who didn’t have to abstain from very much at all as a result of lending their money. Life in the country house remained much the same after the loan as it was before, and so the question returned: what justifies the charging of interest?

Alfred Marshall in due course proposed an improvement to Senior’s theory. It was not the lender’s abstinence that gave him the right to charge interest, rather it was the fact of ‘waiting’ to get one’s money back. Under this theoretical improvement, the obvious lack of abstinence among the rich no longer presented a problem. However, since many individuals wait (save) when interest rates are zero, Marshall’s explanation still failed to satisfy the enquiring mind.

In 1893, Eugene Böhm-Bawerk discussed the subject of interest in Positive Theorie des Kapitalzinses. He proposed that human beings prefer to have pleasurable experiences sooner and painful experiences later, in other words that they have positive time preference. This was widely seen as a breakthrough among justifications for interest. Money allows its holder to satisfy needs now rather than later, so money now must surely be better than money later.

It is nevertheless apparent that in many cases individuals prefer pleasure in the future to pleasure today. For example, most individuals would prefer one breakfast per day for the next week, rather than a week’s worth of breakfasts today. In the physical sense, the preference for breakfast does not accord with assumptions about the preference for money. If an individual does not necessarily prefer current consumption to future consumption, why should he prefer the money that can finance such consumption now as opposed to later? Even more contentious is Böhm-Bawerk’s argument that, once needs are satisfied, surplus money can be invested to generate profit sooner rather than later. Here we are told that ‘money now’ is superior because it can produce ‘money now’!

An element of any given interest rate is usually held to act as a compensation for risk. For instance, a lender may believe that he will not be alive to enjoy repayment, hence an older person may require far more reward for delaying consumption than a younger person. Lenders also discriminate between borrowers by lending to those of higher risk at a higher rate of interest. The more uncertain the future repayment, the higher the returns demanded in the meantime. Hence one often encounters the term ‘risk premium’ in reference to the extra amount of interest charged on higher risk loans. It is not too early in this discussion to point out that by charging a borrower a higher rate of interest, the lender can make that borrower’s commercial life more difficult and hence increase the chance of a loan default. The financial industry’s presumptions therefore need to be reconsidered on this issue. Higher interest rates produce higher risk, not the other way around.

Advanced statistical analysis is often applied by financial specialists when estimating risk levels. For example, credit rating agencies such as Standard & Poor’s and Moody’s will analyse the financial history, balance sheet structure and trading prospects of a corporation before assigning a ‘credit rating’ to its debt obligations. The interest rate charged to a borrower by lenders will tend to reflect this credit rating. Yet if credit analysis draws too heavily upon past data, then the interest rate charged by lenders will in turn reflect past risk more than estimates of future risk. This is one essential problem in the analysis of credit risk. The time when reliable analysis is needed most is the time when future performance diverges sharply from past performance. If sub-prime mortgage assets have provided healthy returns in every year of their history this does not mean that the investment risk looking one year forward is small. The most important part of credit risk analysis involves an educated guess as to the future, and it could well be argued that financial specialists are often too close to the action to make such guesses.

Despite the fact that the future is so unpredictable, modern lenders have little hesitation in varying risk premiums by the smallest of fractions according to the presumed risk of the borrower in question. Is it reasonable to be so precise about a future that is so unknowable? Price points out that the incorporation of a fixed interest premium into a loan implies an unchanging level of risk over the time horizon under consideration. It is far from clear that this is justified. For instance, over time, a given borrower may become more established in the marketplace, and therefore less risky.

A discussion of risk cannot be complete without paying at least some attention to the existence of the ‘risk-free rate of interest’. If it is clear that an amount of physical wealth cannot often be maintained without cost, it seems clearer still that such wealth can never be maintained without some degree of risk. Because many events can act to reduce the value of physical assets, theft and fire for example, nothing in the physical world is risk-free. Indeed, the most that a financier in a barter economy can do is to minimise the risks involved in holding his wealth. The expected net rate of return derived from a securely stored physical asset will usually be negative due to the various costs incurred in storing and, or, maintaining it. One might term this rate the risk‑minimised rate of return.

In contrast, modern financial theory has us believe that the risk-free rate of interest is a positive rate of return that an investor derives from investing in a financial asset that is free of risk. An amount of money lent to a government, and the interest amount charged, is assumed to be risk‑free because it is in turn assumed that a government can tax, borrow or print further amounts of money to repay its debt. These three options are indeed available to a modern government, but because the government has no access to risk‑free rates of return when investing the borrowed money, such options are merely a means of passing on the bill to others when the fact of a non‑risk‑free physical system eventually reasserts itself.

The very existence of a risk-free interest rate does however have a pervasive effect upon the financial economy. Given that government is prepared to pay a specified rate of interest and is a risk-free borrower, lenders will inevitably have little appetite for lending at rates that are below this risk-free rate. With a few aid-related exceptions, the risk-free rate becomes the lowest interest rate at which borrowers may obtain loan funding. As we shall see, it is a rate that is often set with little regard to returns available in the real economy.

An alternative, and widely applauded, justification for interest begins by proposing that the ‘marginal utility’ of consumption is declining, in other words that the next unit of consumption is of less use value to a consumer than the previous one. If one assumes that real incomes grow over time, then future consumption should be greater than current consumption. And if it is true that marginal utility is declining, then an extra unit of consumption in the future must be of lower utility than an extra unit of consumption in the present. Hence, interest arises as a result of the comparison between present and future utilities that can be obtained by the spending of a given amount of money.

An immediate response to the marginal utility argument is that incomes may not increase in future periods and therefore that marginal utility will not necessarily be lower in future periods. Discounting would, under these circumstances, be quite inappropriate as an analytical tool. Indeed there have been long episodes of human experience in which real income has declined. For example, Nordhaus and Tobin’s analysis of economic performance in the United States using their ‘Measure of Economic Welfare’, rather than the more traditional yardstick of ‘Gross Domestic Product’, showed real income to be declining.

Even where statistics show that real income is increasing, there are many kinds of utility that cannot necessarily be enjoyed simply by spending money. An unpolluted environment is one of them. Who is to say that an extra unit of clean environment in the future will be of less utility to a consumer than an extra unit of clean environment today? One could argue that the opposite will be the case.

If we take the assumption of continued growth in real income as valid, the marginal utility approach now requires us to properly identify which incomes to analyse when calculating income growth. Should one look at the incomes of the poor, the rich, or the national average? As Price points out:

Thus a social discount rate based on mean income growth rate overemphasises income growth of the affluent, and underemphasises the changing importance of consumption by the poor. Where the rich are getting richer and the poor poorer, the social discount rate will be much too high; it may even have the wrong sign (Price, C., Time Discounting and Value, 1994, p. 236).

Of those arguments that seek to explain the level of interest rates in a modern economy, the simplest is that which views interest as the ‘price’ of money. This approach portrays money as an item that can be bought and sold like other goods or services. Here, the rate of interest is that which equates saving with borrowing. According to the UK Budget Red Book of 1990:

… interest rates are the price of money and credit. Changing the price is the best method of influencing the degree of monetary tightness.

In Chapter Two, the Red Book’s view is refuted in detail. Here, we should remind ourselves both of Acquinas’ argument and the entropy principle. Why, if money is indeed ‘sold’, must it then be returned to the seller at the end of the sale transaction? Of course, money is not so much sold as lent and interest cannot therefore be the price of money. Rather, most will regard interest as a ‘rent’ on money. But if interest is a rental charge, then money is unlike any other rented item since it does not depreciate through usage, and rental payments on money do not relate to the utility gained by the borrower since money borrowed might not be invested profitably. In contrast, a rented physical item, the ox of the earlier example perhaps, wears out with usage and provides a known utility in the meantime.

Keynes proposed three reasons that individuals might prefer to hold their assets in the form of money, the ultimate form of liquidity. These were the need to transact, the need to hold money as a precaution for unforeseen events, and the opportunity to speculate that money gives to the one who holds it. Keynes proposed that when a loan of money is made, liquidity is lost and that an element of interest will therefore be charged by the lender for foregoing the advantages of that liquidity. These ideas were encapsulated in the ‘liquidity preference theory’, a short run model for determining the rate of interest according to the supply of money in the economy and the demand to hold it.

Price questions the various liquidity arguments :

Nor is it clear, in a time preference sense, that anyone would be better off eventually for having liquidity now, if taking advantage of that liquidity (for transactions, precautionary or speculative motives) meant sacrificing equal liquidity next year. Indeed it could be argued that early liquidity simply offers early opportunities to commit funds – that is to establish early loss of liquidity. It is of course advantageous to be able to acquire resources at the most propitious time – the time of lowest price, or the time when their quality meets some particular requirement. But exercising this advantage early denies it in future periods. The liquidity premium element in rates of return does not represent the betterness of earliness (Price, C., Time Discounting and Value, 1994, p. 209).

It is worth noting that in the long run, according to Keynes, a very different set of factors could determine the impact of interest rate changes upon the economy. Where the Classical theory proposed that saving would increase if interest rates increased, Keynes argued that if people’s saving increased then their consumption spending would inevitably fall. With less being spent on goods and services, businessmen would lay off their staff. The total amount of income earned in the economy would therefore fall, and with it the amount saved. A rise in interest rates could therefore reduce the aggregate amount of money saved, the opposite of what the Classical theorists had proposed.

Irrespective of the level of interest rates there remain distinctions between the conventions of the money lender and the reality of the activity that he seeks to finance. For instance, revenues realised on a project financed with borrowed money will usually vary in both amount and timing during the life of the loan. But if profits are not received on a regular and predictable basis, how can the borrower have the opportunity to reinvest those profits in the regular manner assumed by the compounding process? Even if clockwork reliability to cash-flows is attainable, in assuming reinvestment of profits at a fixed rate of return, the financial mathematics assumes that there is no such thing as diminishing marginal returns on capital employed. Compound fixed interest simplifies real world processes by assuming that, throughout the life of a loan, the rate of return on those real world processes remains unchanged.

Whilst flows of cash can be reinvested, as we have already seen, a flow of utility, the enjoyment of a hot shower for example, cannot be. If at any stage one wishes to enjoy part or all of the output of a productive process, that output must be enjoyed as a flow. Compound interest assumes the full reinvestment of yields and inevitably implies that, on the physical level, consumption of those yields cannot occur. This, as Soddy put it, is a process that forever sees bulb issuing in bulb, never in flower. What precisely is the point of such a process from the human perspective?

It was suggested earlier that compounding of interest does not accommodate a physical world in which capacity constraints exist and that, in order to meet the high real rates of interest occasionally thrust upon it, enterprise attempts to increase the rate of resource extraction or energy consumption, or both, by boosting the productivity of physical capital. It seems to me that advances in technology since the Industrial Revolution have allowed many societies to resolve this problem by making ever greater degrees of productivity and energy output possible. Yet such advances only delay the day of reckoning with mathematical inevitability. However long this delay proves to be, and it may be a very long delay indeed, our earlier argument foretells the dire consequences that productivity increases can have upon the entropic Earth-bound system. Polluted rivers, festering rubbish tips and resource-depleted seas may be just the first installment of the price that is paid for entering into a race with compound interest. By determining production in the physical world according to the mathematics of interest, progressively greater increases in entropy are encouraged over time.

In setting course for a more appealing future, we will first need to complete our description of the deficiencies of the present. In the meantime, if the arguments employed so far draw criticism, then it will most likely be on the grounds that they rely too heavily on physical reductionism. Analogy with the physical world has indeed been frequent in this section, and for this I make no apology. Finance should be the servant of industry and real world processes, not their master. The theory of our financial conventions must address this fact and, unless corrected by reasoned argument, I shall continue to believe that we survive by virtue of processes in the physical world. Herman Daly, in an excellent review of Soddy’s work, comments:

If debt and money are the units of measure by which we account for and keep track of the production and distribution of physical wealth, then surely the units of measure and the reality being measured cannot be governed by different laws … If [physical] wealth cannot grow at compound interest, then debt should not either (H. Daly in G. B. Kaufman: Frederick Soddy 1877-1956, 1986).

When industrialists and environmentalists complain about the attitudes of bankers, maybe they too are sensing a conflict between finance and the reality of the world in which they operate.