The belief that inflation is mathematically necessary to avoid default on previous loans is fallacy.
This widespread belief is referred to as the paradox of interest. The argument goes like this. Every dollar in circulation represents a debt to the bank. If all the money in existence was pulled together and the collective debt was repaid, interest would still be owed and there would be no money to cover the added expense. Therefore, in a system where interest is permitted, it is inevitable that someone will default unless the money supply is increased to cover the additional debt.
The Roman Catholic Church, Muslims, and even some veins of economics consider interest as evil or less than ideal for society. These beliefs are largely based on a misunderstanding of how interest works and the function it serves in a free society. The real evil lies in the the legal tender laws which force a money system on the people and the monopoly power government grants to the central bank to create government money out of thin air and manipulate the interest rates at which it lends to it’s member banks.
Yes, interest serves a useful purpose. Of course, as is the case in our current state of affairs, the banks artificially control interest rates and create money out of nothing. Any social benefit that interest could confer is undoubtedly nullified in such a scenario. However, in a truly free market economy, the rate of interest is established through market forces, which are controlled entirely by the personal, subjective preferences of free individuals. Interest in such a world would rise and fall based on individuals preference to save or spend. If the majority of the market participants desired saving or delaying their purchases to a future date, the interest rate would fall. If immediate spending was preferred, interest rates would rise. The reason is pretty simple really. If you were a capitalist who made a living by making loans and there wasn’t that many people interested in borrowing, you’d lower you rate of interest to entice more individuals to take a loan. If there were people banging down your door to get loans, given the fact that your resources are scarce and the money for lending is not unlimited, you would raise your rate of interest to maximize profit and limit the number of applicants. This economic law allows the business man to properly allocate resources to best meet the needs of his consumer base. Interference in this most crucial market gauge distorts market signals and encourages malinvestment.
What if a society did not allow interest to be charged on loans? Wouldn’t we all be better off even if the paradox of interest is not true? Isn’t it just the decent thing to do, if a fellow human being needs a loan and you believe that the loan will be repaid, to give it without the string of interest attached?
The truth, I believe, is that without interest there would be little or no incentive to loan money at all. Those who have the money would be much more likely to hold onto it for themselves than risk their capital in some business venture where, at best, they’d break even. In a market with little to no capital available to the entrepreneur, society would no doubt be much worse off.