Money grows on tree?

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When I was growing up my parents often told me that money doesn't grow on tree. I sort of disagreed in my head but never had the courage to confront them - In my head I used to think, if you have mango tree then it gives you mangoes which you can sell for money and hence money DOES GROW on tree!

As I grew up, I learnt the concept of interest rate - Money magically grew with time. If you deposit $100 today with the bank it would give you more than $100 in a year's time. This was so strongly etched in my head that it became a gospel almost as true as Sun rises from the East until it got challenged recently - Why should interest rate be positive at all? How does money automatically multiply as we sleep?

Although the notion of "Negative Bank Interest Rates" until recently was a completely theoretical conception, the fact is that idea of taking "Positive Interest Rates" for granted itself is quite a recent phenomenon! For large part of human existence, civilizations have primarily been agrarian and traded barter. In general agricultural harvest or commodity used as money (such as gold) do not simply grow with time. If anything they decay. If you have five apples today, you do not suddenly have six after a week. In fact one may rot and you will be left with only four. This spur people to consume rather than save. So negative interest did for large part of human existence effect household decisions - consume before it perishes. In general, usury defined as the lending of money at high interest rates, is frowned upon by many religion. The three Abrahamic faiths - Judaism, Christianity and Islam - take a very firm stance against it. Several Islamic nations prohibits it as haraam or prohibited till this date.

The proliferation of the notion of "time value of money" grew in tandem with the growth of central banks (which did not exist before 1609). Central Banks are entities such as the Reserve Bank of India or Federal Reserve Bank which practice top heavy financial macro management by controlling the interest rate. Prior to the 17th century most money was commodity money, typically gold or silver except in China. And commodity does not have a natural "time value of money". The stock of gold or silver increases only when more is mined and not when time simply passes.

In the 21st century we became very comfortable with fiat currency (Paper Money) and it became easier for Central Banks to ingrain the concept of "Time value of money" (Positive Interest Rate) as they could simply roll the press and benefit from seigniorage. Governments started issuing papers called bonds against which they promised to pay more paper (Currency) than you put in. This could simply be achieved by printing more paper. Tied to this is the concept of inflation. Since "money" (paper currency) in circulation keeps increasing while the real economy usually does not grow at the same rate at which money is being printed, inflation creeps in. Things get more expensive than they were a year ago and hence anyone lending money expects to be compensated for this loss in value of paper currency.

In many countries today the Bank interest rate is negative particularly in Europe. The idea is that by lowering interest (to the point of making it even negative) central banks gives to commercial banks, the commercial banks will be spurred to lend out more to the general public rather than have money locked in cellars. Nothing can be further from the truth. Commercial Banks do not lend because they have stacks of money lying in their coffers earning negative interests. This "macro transmission" view is flawed. Commercial Banks lend to individuals and corporations on a "micro level" not on "macro economic" climate. If banks feel that the money they lend will not be returned back by individuals or corporations they will happily take the risk of losing 1% in value every year in form of negative interest rates rather than suffer defaults which can potentially totally wipe out up to 100% of the money loaned (Case in point Vijay Mallya and Anil Ambani). This is what needs to be fixed "bottom up" - the micro environment needs to boasted enticing banks to lend to businesses and individuals. This is outside the purview of central banks (assuming independence of central banks) and is something that governments need to take charge of. So in conclusion, money can grow on tree provided the tree is well watered and fertilised.

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[…] have one dollar today or two dollars in a year? The idea is that money (magically? – Read more here Money grows on tree) multiplies with time. The speed at which it multiplies is called interest rate when looked ahead […]