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Pragmatic Capitalism

Practical Views on Money, Finance & Life

What is the Purpose Of Interest?

Good question here from the forum:

“Can you explain what actually is the reason/purpose of interest in our modern day monetary system?”

Money is endogenous in the modern monetary system.  That means it can be created by any user within the system and can be created from what is really nothing more than an agreement between parties.  The primary form of money in our system is bank deposits and they are created by banks when banks make loans.  Private banks essentially control the primary payment system that we all use and so they create the primary form of money and maintain the system in which it is used.  If you want to participate in the US economy to purchase goods and services then you need a bank account.

Banks make money by charging you a fee to use their system and to use the money they create within this system.  Because the system is privately controlled there is an element of risk management in everything that a bank does.  That is, if a bank doesn’t properly manage its risks it can end up like Washington Mutual or Northern Rock.  Because banks are private profit maximizing entities they have to balance how they generate a profit and how much risk they take in the process of doing this.

The privately controlled element of this system creates competition which makes banks operate more efficiently and makes them accountable for how they operate their businesses.  But since this payment system is so central to the health of the economy the payment system has a unique relationship within the economy.  And as we’ve all discovered over the last 5 years when the payment system doesn’t work properly the whole economy stops working properly.  And so you get this inherent and tricky mix between government intervention in the banking system and the way banks try to operate within their “free market” to compete.  It’s all a bit messy because the banks are profit maximizing and risk taking entities who can, at times, threaten the health of the entire economy through their ability (or inability) to manage their risks in the pursuit of profit.

When a bank lends you money they are essentially allowing you to use their payment system for a fee.  And they will assess this fee based on the duration in which you want to use that money and the risks you pose to using that system.  So, a borrower with bad credit could be rejected from being allowed to use the payment system that banks operate.  Or the banks could just choose to charge that person a very high fee (interest rate) to use the system.  So, in its simplest form interest is just the fee that banks charge users of the payment system.

Of course, there are lots of instruments which convey a similar temporal relationship like stocks or corporate debt.  These instruments convey a similar type of relationship where one party is again creating a financial instrument to obtain money and thereby paying someone a fee to use that money.  So, for instance, a corporate bond is an agreement by a corporation to obtain bank deposits for a certain period of time at a certain interest rate.  In the process of creating this instrument with lower moneyness than the bank deposit they will pay the lender a fee for the specific period.  They are, in essence, convincing the bank deposit user to forgo using their bank deposits in exchange for a fee.  So you can see how this process of financial asset creation can be thought of within the spectrum of moneyness with different entities creating different forms of money within that system….

I hope that helps answer the question.

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