Why should money earn interest simply because somebody owns it? We usually treat interest as a natural and inevitable part of the economy, but in this Understanding Economics video, I question whether that assumption is justified.

Commercial banks do not need to collect deposits before making loans. When a bank lends, it creates new money through its accounting records. The process of creating that money itself costs very little, so why are interest rates often so high, even after allowing for the fact that lending does involve administration and the risk that borrowers will not repay?

That question is especially appropriate when much lending is now virtually risk-free. Interest should not be confused with an investment return. Investment involves taking a genuine risk in the hope of making a profit. Interest, by contrast, is a payment for allowing somebody else to use money for a period of time.

I argue that we should separate the different costs currently bundled together as interest. Borrowers could instead see a basic charge for using money, an administrative charge and a separate premium reflecting the genuine credit risk involved.

This matters because interest rates have significant economic consequences. Higher rates redistribute income towards people who own financial wealth while increasing mortgages, rents and borrowing costs. They can also discourage productive investment and spending on priorities such as the green transition.

I am not arguing that interest should be abolished. I am arguing that the basic interest rate on low-risk money should be close to zero in real terms, while genuine costs and risks should be identified and charged transparently.

Understanding what we are actually paying for would make borrowing clearer, improve competition and help us understand who gains and who loses from the interest rates that shape our economy.