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What is the Purpose Of Interest?

Cullen Roche -

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.

16 comments
  1. jswede

    the interest rate is the mechanism by which people choose to consume now and forgo consumption into the future, or vice versa.

  2. Frederick

    Isn’t it strange that the government has given the banks an oligopolistic type control over this entire industry?

  3. Geoff

    What is the purpose of interest?

    Wow, that is a huge question that has been debated for thousands of years, and has often had religious undertones. I’m still not sure there is any agreement. See Murray Rothbard’s “An Austrian Perspective on the History Economic Thought”.

  5. theta1

    It seems to me you are describing and effectively defining interest as credit risk. If this is the case, can you then explain why this “fee” is lower the current environment than the higher growth/arguably better macro environment of the 90’s? Or in other words, why has the “fee” dropped for the risk free economic agent (the government) several hundred basis points since then?

  6. mike

    Interest exists to allow for the control of other parties…no different than when the mafia charges a “vig” to one of its businesses for “protection”. Those that need something from another are always at disadvantage.

  7. Cullen Roche

    Interest rates have declined primarily because the rate of inflation has declined. So you’ve had the Central Bank in the USA dropping interest rates thinking this would spark inflation. When the economy is weak as it is now then the banks are essentially charging less to interact in the system. They are actually trying to entice people to interact more. The overall structure of interest rates at present really just reflects a weak economy and environment of low inflation.

  8. 1Don_Levit1

    Interest is simply the time value of money.
    It is the price one pays (plus loan principal) to access others’ money principal now.
    What I would like to know, is, why has the principal been forsaken in the loans the government accesses thru Treasuriers?
    Don Levit

  9. Suvy

    I look at things a bit differently. I view banks as effectively taking a risk spread (for a conventional bank, they’re making the long-short interest rate spread). They create assets and liabilities simultaneously wherein they create loans by issuing deposits. Deposits are short term debt and loans are long term debt.

  10. Cowpoke

    “When a bank lends you money they are essentially allowing you to use their payment system for a fee”

    So Interest is the extra labor you have to expend to mediators who work with in a system of finance that converts your “Physical/Mental” labor/actions into book entry credits, then values them accordingly to the marketplace of Ideas and exstrapolates it’s fees accordingly?

  11. Ralph Musgrave

    A distinction really needs to be made between what might be called “genuine interest” and administration fees charged by banks. Genuine interest is a charge that any lender (bank or non-bank) makes for the pain or inconvenience of forgoing consumption, so that someone else (a borrower) CAN CONSUME.

    If some commercial banks set up in what had hitherto been a barter economy, and supplied everyone with just enough day to day transaction money to enable them to replace barter with money transactions, the banks would not charge any genuine interest. But those banks WOULD CHARGE administration fees, e.g. for the cost of checking up on the value of collateral.

  12. Dinero

    There is also an economic quantitative value that the bank lends . Its capital. The bank lends the borrower the power of its balance sheet. The pooling of IOUs made to
    the bank, it assets, make an IOU written by the bank, drawn against that pool, more
    tradable than an IOU written by one single person. As they have more value of assets than the deposits written against them, they can absorb the loss in the possible event of the borrower defaulting on their loan contract. And so the bank is lending its Financial credibility to the borrower. In that way a party accepting money, more readily accepts a bank deposit, written against an IOU made to a bank, than they would accept that same IOU if it were issued by the borrower directly to themselves.

  14. Ralph Musgrave

    I’m suggesting there is a difference between, 1, “genuine interest”, which is where a borrower pays a lender to abstain from consuming wealth or resources so that the borrower CAN CONSUME those resources, and 2, the costs for a bank of administrative items like checking up on the value of collateral.

  15. Robert Buttons

    Interest can and does occur outside of a banking system.

    Interest is simply the premium for the time preference of money. People would rather have money today than at some unspecified point in the future, therefore it is more expensive today.

    Of course there is a risk premium, but interest still would exist on a risk free loan.

  16. theta1

    In that case you may want to amend your answer to the original question, by mentioning that the interest represents two things, a) compensation for time value of money a.k.a. inflation and b) credit/duration risk premium.

Comments are closed.