As Australians patiently wait for the leading economists of the RBA to announce whether or not interest rates will change, a curious mind cannot help but think about why we even have interest rates.
Interest rates are an integral part of our economy. Lower interest rates mean that it is cheaper to borrow money which entices people and businesses to spend more. This can spur economic growth as well as inflation. Needless to say, falling interest rates will do the exact opposite and as such are a good way for the RBA to stop the economy from overheating.
For most ordinary people, the most obvious effect of interest rates is felt when they make mortgage repayments. With house prices in Australia at record highs, mortgages have become an assumed part of life for the average Australian (unless you have a cool half a million dollars stashed away underneath your bed, in which case please mail me your address). When you borrow money from the bank, you have to repay that money as well as a fee for borrowing it. This fee is known as interest and it recognises that a dollar today is worth more than a dollar tomorrow (the time value of money).
Say you wanted to buy the average house in Dandenong which costs $427,000, you would most likely need to borrow money from the bank to do so. Assuming you take out a 30 year variable loan from Westpac at the going interest rate of 5.7%, you will be paying the bank $2,478.31 monthly. Over the life of the loan this means that you will have paid the bank $465,191 in interest on top of the $427,000 you borrowed. Yep, you paid $892,191 for a $427,000 house (and this doesn’t even include all of the other associated fees and costs).
Now I know what you’re thinking, ‘these guys are criminals!’ but let me play the devil’s advocate for a moment; would you have been able to afford the home in the first place were it not for the loan that the bank offered? What incentive would the bank have to lend you money if they did not make a profit from it?
Paying interest has become a widely accepted part of the global financial system but this wasn’t always the case. How would you feel if you borrowed $5 from your friend for lunch money one day and the following week he asked you to return the $5 with an additional $1 of interest? Ripped off? Used? Well that’s how the people of Venice felt when they first came across the concept of interest being charged on borrowed money. Although the Jewish Torah forbade charging interest to a ‘brother’ or fellow Jew it didn’t prevent them from charging interest to non-Jews. When the Jews charged interest on money borrowed by Catholics in Venice, the outraged Catholics felt betrayed and angry at the Jews who they labelled money hungry and greedy for such doings. They forced them into a part of town which they called the ‘ghetto’ where they were persecuted for centuries. Although this occurred in the 16th century, those characteristics form part of a negative stereotype given Jewish people even to this day, and the concept of ghettos was used to isolate and persecute Jews in places like Nazi Germany.
While the Catholic Church initially called it ‘usury’ and labelled it illegal. The sheer amount of money and influence that came from effectively charging interest meant that the wealthy and powerful Christians of the time began to commonly practise it and in turn the church softened its stance on the matter.
While interest is still forbidden in the Islamic faith, the Islamic banking system has found different methods of ensuring that banks can earn a profit from loans. This is done mainly through the charging of other fees and going into a joint venture with the investor in which the bank is entitled to a share of the investor’s profits.
While each of these Abrahamic faiths has clearly shown a great deal of apprehension towards the idea of interest over the centuries, it has become a commonly accepted part of our money centred financial system. I guess that’s part of what makes interest so interesting!
What are your thoughts on the matter?
Welcome to my first economics blog. You would think that writing a blog would be a rather simple task given that I have recently written and published an economics textbook and yet I still find myself indecisively trying to filter through the endless possibilities of topics that could appeal to readers. As we look around there are so many issues that can only be understood through the eyes of an economist that it is hard to know where to start. Should I write about the cause and widespread effects of low petrol prices? Or about the volatile economic situation in Europe with Greek and Spanish people fiercely resisting the austerity measures imposed on them in recent years? Perhaps it would be interesting to explore the economics behind the conflict in Ukraine, or the tons of other ongoing economic issues surrounding sustainability, poverty etc.
The world as we know it revolves around economic principles, and there will always be interesting and often controversial issues to explore. That is why I love economics, understanding its most basic and core principles opens up a new way of looking at the world. As economists we question the things around us by looking at all of the factors, possible outcomes, and make decisions in a rational and thought out way. Right now you are probably thinking, these economist guys sound pretty smart, pity I’m not one of them; but the economists I’m talking about aren't just those with a fancy piece of paper from a university labeling them qualified economists, I’m talking about all of us who think with an open mind and take a rational approach to the problems faced in our day to day lives, as both individuals and members of a society.
The study of Economics is about how we use our limited resources to make us better off. This means that economists look at far more than GDP, Interest rates, and business cycles; it means that every day you wake up you make a countless number of economic decisions. Should you walk to school and save your money, or take the bus and save time? What should you purchase when you are at the canteen? Should you spend your lunch time walking around, playing sport, or doing your homework? An economist doesn't just trust their intuition when answering these questions; they think about all of the costs and benefits of each alternative and make a rational decision that is likely to lead to the most favorable outcome.
‘But hang on a second, I kind of do that already!’
Yes my friend, you have been an undercover economist all along; and the more you wear your economic thinking hat, the better off you will be.