Adverse effects of bank interest in simple economics

Let's try to understand the economic implications of bank interest in day to day life in layman's language. I like to put aside all the economic jargons and technicalities to avoid complexities. This post is not intended towards economists who believe in hypothetical derivatives formed by assumptions to predicate outcomes by renowned economists of the past. 

The matter

The clientele deposits the money in banks for security reasons and to receive income by means of interest. The interest rate may vary bank to bank depending on the interest rates speculated by the country’s Central Bank. In Sri Lanka interest rate for money deposits ranges between 8%-15% time to time depending on the kind of deposit the customer makes. This money got from the depositors is re-circulated into the society for higher interest rates in various forms of lending with the interest rates up to 20%. 

Example: housing loans, agricultural loans, vehicle lease, medical loan etc.

Exceptionally interest rate for pawning  service is between 1.2%-2.5% in Sri Lanka for reasons jewellery is pledged by the client and the liquidity for gold is comparatively high.

Simplification 1

If simplified to understand, the banks get the money from the clients for low interest rate and lend to the client for higher interest rates.

 i.e your money is lent to you for more interest.

 i.e the banks earn from you by investing your own money in you.

What happens when the customer receives the bank loan with interest;

To pay back the interest other than loans (in most of the situation banks calculate compound interest ) the client has to do an increment (adjustment) in the pricing of his/her products or services. Which in turn will increase the market prices of goods and services available for consumption. This mechanism has many chain reactions and creates instability in the market. As we know there is no stringent mechanism to regulate the prices for all the goods and services by the authorities the market prices increase time to time out of control. And the economists bestow the responsibilities simply on the ‘market forces’ and console the contempt saying all depends on the ‘supply and demand’.

Japan and its ultra low interest rates.

After the Tokugawa period (1603) and the successive Meiji restoration (1868) in Japan it’s economic growth sky rocketed. Even after the Hiroshima and Nagasaki nuclear bombs and the 2011 tsunami Japan seems to be economically stable and progressing well.

In June this year Japan’s interest rates hit zero (http://www.tradingeconomics.com/country-list/interest-rate). Japan is famous for its Zero interest rate policy for decades and the nation of 127 million people has been living with zero rates for so long that they seem, well and normal. Japan maintains an interest rate below 1% though mentioned as zero interest rate. The country has accumulated a very good savings and its foreign reserves are well high than the average.

In USA

‘’After the September 11 the American Federal reserve lowered its interest rates. Why did America do that. The Federal Reserve lowered key interest rates by one half a percentage point on September 17 and on October 2: the one-point drop in rates left the federal funds rate at 2.5 % and the bank discount rate at 2.0%, the lowest those rates had been since 1962. The drop in rates on September 17 was followed by other central banks, including the European Central Bank, the Bank of Canada, and the Swedish central bank’’ – Report  for Congress The Economic Effects of 9/11: A Retrospective Assessment (September 2002)

Simplification 2

Forget about Adam Smith’s Absolute Advantage and Ricardo’s Comparative Advantage theories for the moment. Let us take the liberty to assume as the aforesaid used assumption as well to better understand.

Let’s assume 100% of a country’s population is investing in the banks to receive interest money for survival without engaging in any economic activities. Imagine a scenario where there will be no one to receive loans from the banks. What will happen to the bank operations. How will the people eat and lodge. The human race of that particular country will be erased. Although this will not happen in any situation let’s see the underlying factors in simple terms.

No work will be done in that country – no farming, no agriculture and no work at all will be done. Because all will become lazy to do work and they will engage in leisure because all of them have an income source by means of interest from the bank. They do not have to worry of doing any work because the bank will take care of them. Ultimately banks will not be able to provide interest to depositors. This is an imagination. But it is the underlying reality in fixed deposit schemes in banks. It deprives a country from economic growth. People tend to become lethargic and engage in lesser efforts where the borrowers from the bank struggle to pay the interest for their loans. You may pose the question of pensioners and elders who can not work due to aging – a different topic needs to be discussed in detail. They can have social security through interest free investments which will not burden the loan receiver/entrepreneur and will not increase the market prices which will counter affect the investor.  

To end 

• How did the Japanese banks cope for decades with such a low interest rate. How is Japan progressing with zero interest rate policy.
• Why did the US Fed lowered the interest rates in the  aftermath of September 11.
• Aren’t we made to believe in the interest based banking system which reaps less benefit in long term when compared to interest free banking system.

There underlies an untold truth which the conscience of every thinking human being will understand.

Zero interest rate can be associated with slow economic growth but definitely it leads to a steady economic growth.