Economy without interest: Myth or reality?
Friday, 29 June 2007
Zahid Zamir
In modern economic systems interest plays a very important role. In fact, in the Western world as well as some eastern countries people cannot think of any economic system without interest. From a theoretical standpoint, interest has been a debatable subject among economic and political theorists. Interest as we all know, is the excess of money paid to the lender by the borrower over and above the principal for the use of the lender's money for and over a certain period of time. Economists have presented different interpretations of interest. Samuelson states that "Interest is the price of rental for the use of money". Don Patinkin gives the following definition: "Interest is one of the forms of income from property, the other forms being dividends, rent and profit". However, J.M. Keynes did not define interest but mentioned the rate of interest as "The percentage of excess of a sum of units of money contracted for forward units of time over the spot or cash price of the sum thus contracted for forward delivery".
However, some Muslim, socialist and a number of capitalist economists have questioned these explanations on both theoretical and technical grounds. They often stress the point that money capital cannot be treated as capital goods on the same basis as productive factors. It is pertinent to remark here that lending of money for interest was abhorred and, in most cases, prohibited by all the monotheistic religions. An eminent Western economist, Roy Harrod in his famous book Towards a Dynamic Economics, regards the abolition of interest is the only way to avert a collapse of capitalism. Not only this, but he speaks with great admiration for an interest-less society. Harrod clearly recognises that, "It is not the profit itself, earned by services, by assiduity, by imagination, or by courage, but the continued interest accruing from the accumulation that makes that profit taker eventually appear parasitical…" and he further states that an interest-less society which will be a totally new kind of society would be the correct and final answer to all that is justly advanced by the critics of capitalism.
There are at least four characteristics that define the interest rate.
1. It is positive and fixed ex-ante,
2. It is tied to the time period,
3.Its payment is guaranteed regardless of the outcome or the purposes for which the principal was borrowed,
4. The state's apparatus sanctions and enforces its collection.
Saving and investment: Saving and investment are two of the most important determinants of economic growth and development. The classical belief that saving is determined by the interest rate is refuted by Keynes. According to Keynes, aggregate saving is governed by the aggregate income. The empirical evidence does not show any significant relationship between saving and interest rates, the results have at best been inconclusive. In fact, interest puts a limit to the marginal efficiency of capital. Interest is inversely related to the marginal efficiency of capital. In the presence of Interest the marginal efficiency of capital does not rise to its optimum level. As a result, all the resources available cannot be fully utilised. This causes a fall in investment.
Interest rate, in fact, limits investments. Interest is also considered as a cost of production and hence the price of the product is adjusted to it so that consumers are affected because of the higher prices of goods and services. Interest dampens investment activity because it adds to the cost of investment. However, if interest rate is raised to contain monetary demand in situation where excessive fiscal deficits are fuelling inflation, private investment receives a severe setback leading to stagflation. This has actually been the experience of a number of developed countries in recent years. So, interest-less economy is unlikely to reduce the volume of savings. In fact, in an interest -free economic system savings are likely to be promoted. First of all, in the profit sharing arrangement the return to capital will include "reward for both savings and risk-taking" which means a high return to financiers than in an interest-based system. This means if higher returns or higher income determine the level of savings, people will save more in a share economy than in an interest-based economic system. Secondly, profit-sharing in mass production between employer and employees will, on the average, give higher income to the employees who constitute the majority of the population.
On the other hand, in an interest-free scheme, where both the financiers and the investors have a stake in the return of their investments, low returns may not deter them from investing, as neither the investors nor the financiers will be better off or worse off, one at the cost of the other. In fact, both can be worse off by not investing. In the profit sharing system, it is innovative enterprises that are likely to set constraints to investment rather than finance. This is because capital does not impose a limit to investment such as in the interest based system. Thus innovative entrepreneurs who are ready to develop new profitable investments will always raise funds for such ventures.
Unemployment and inflation: Interest rate causes unemployment and inflation in several ways. When interest rate is high it makes cost of production also high, causing a decline in investment and in some cases closure of production units, resulting in retrenchment of workers by employers to reduce cost. Alternatively, producers increase the prices of goods and services to cover the increased cost, thereby causing inflation. On the other hand, when interest rate is low the tendency is to switch to capital intensive method of production, thereby causing technical unemployment due to the replacement of labour by machinery. On the consumer side, low interest rate encourages borrowing for consumption which usually increases the demand for goods and services, hence resulting in demand-pull inflation. It was believed by most economists until the early 1970's that there is a trade-off between unemployment and inflation. However, subsequent findings have shown that both high unemployment and inflation can co-exist. This gives rise to a new phenomenon known as stagflation. That is a situation where high unemployment and inflation are positively related. This phenomenon has caused many economic problems in the industrialised countries. Weitzman, Martin in his article on " Profit Sharing as Macro Economic Policy" published in the American Economic Review, Vol 10, No.4, 1985 stated that all the mechanisms attempted so far in solving the problem of stagflation have failed. He proposed that profit-sharing and not the Interest is the best form of policy for combating unemployment and inflation. He further mentioned that profit-sharing represents a way of building into the system, the kind of natural resistance to unemployment and inflation that could really disarm stagflation at its source.
Interest and entrepreneurship: According to Schumpeter, economic growth is determined by the dynamic function of entrepreneurship and this dynamic function is an innovation which leads to technological changes. So, the entrepreneurs are the real pillars of economic edifice. The interest-based system discourages innovation, particularly on the part of small scale enterprises. Large industrial firms and big landholders can afford to experiment with new techniques of production as they have reserves of their own to fall back upon in case the adoption of new practices does not yield a good dividend. Small scale enterprises hesitate to go in for new methods of production with the help of money borrowed form banks as the liability of the banks for the principal sum and interest has to be met irrespective of the results while they have very little reserves of their own. In this way economic development is hindered.
Interest and stability: It may, in fact, be asserted that interest is one of the most destabilising factors in the capitalist economy. Milton Friedman, posing the question, "What accounts for this unprecedented erratic behaviour of the US economy?", responds by saying, "The answer that leaps to mind is the corresponding erratic behaviour of interest rate". The erratic fluctuation of the rate of interest creates erratic shifts in financial resources between users, sectors of the economy and countries, causing erratic movements in the loan based investments, commodity and stock prices and exchange rates. They also bring about shifts in short and long term commitment of funds and between equity and loan financing. The high degree of interest rate volatility has injected great uncertainty into the investment market which has had the effect of driving borrowers and lenders alike form the longer end of the debt market into the shorted end, thus fundamentally altering the investment decisions of businessmen.
Profitability and productivity: Some people think that profit-sharing (which is the Islamic alternative to interest) will not be profitable to the financiers compared to traditional interest based system. This contention has been refuted. It has been argued that for the financiers as a group, profit-sharing is more profitable than traditional interest based system.
A PLS (Profit and Loss Sharing) system is likely to be more attractive for both the firms and the financiers. This is because PLS system promises leverage benefits to the firms free of risk and a return higher than the rate of interest to the financiers. Fluctuations in the rate of profit on equity under PLS finance are likely to be smaller than the rate of profit on equity under the interest finance and that PLS operations may have a smaller destabilising potential for the economy as a whole compared to financing on interest. Another factor that makes profit-sharing more profitable than interest-based system is that the burden of the risks on the part of the investors has been reduced. This encourages entrepreneurs to be more innovative and venture into high risk projects which are usually characterised by high profitability. Furthermore, the spirit of mutual co-operatives and sense of ownership and responsibility promoted by profit-sharing results in efficient use of resources and increased output, in turn, increases profit.
An empirical study conducted by Jones and Svejnar on Italian producer co-operatives, have come out with the interesting conclusion that, for producer co-operative, profit-sharing participation and individual worker ownership of assets have a positive, or at least a non-negative, effect on productivity, and that collectively owned reserves have a negative effect on productivity. In fact, these findings support the proposition that profit-sharing encourages co-operation, greater sense of belonging and responsibility among the partners. Consequently, greater productivity and profitability is achieved.
Interest and concentration of wealth: There seems to be a near consensus of opinion among the advocates of interest free economic systems that one of the causes of high concentration of wealth in the capitalist economies is that institution of Interest. Interest creates a big source of inequalities of income. Income inequalities bring social inequality, that is inequality of opportunity for the disadvantaged to earn their livelihood. In the modern world, industrialists borrow capital from the banks and make a large profit but pay only a small part to the depositors through the banking system. This is an indirect transfer of income form the masses of depositor to a few industrialists. This leads to the concentration of wealth in the society. Thurs, in the interest based capitalist economy, the flow of wealth is from the 'many' to the 'few', and in most of the cases the 'many' are poor people.
Misallocation of resources: In the conventional economies, there is no theoretical justification for the existence of a rate of interest so far as allocation of resources is concerned. Interest rate can only theoretically efficiently allocate resources if money and capital market are perfectly competitive and if the environment is certain and static. But in the world of imperfection, and uncertainty, the rate of interest cannot allocate resources efficiently. It is, in fact, true that in the old days production could not be extended owing to lack of capital, but now in a number of rich countries, there is a super-abundance of savings and large sums of money which are simply lying idle. We find simultaneously with this super-abundance of capital a very large class of unemployed people. People are unemployed because the capitalists do not find it worthwhile to invest their funds in the fields where the rate of return is less than the current rate of interest. For instance, if the current rate of interest is 4.0% and money is invested in irrigation works which directly yield only 3.0%, then, according to capitalist view, irrigation is unproductive. The money will not be invested in irrigation works, however useful these may be for society. The result is that the capital remains idle while resources remain undeveloped. All public works, however conducive they may be for the benefit of society, remain undone in an interest based economy if the yield from such works is less than the current rate of interest.
Justice and equity: In an interest based system the entrepreneur is, on one hand, discriminated against when he has to pay the fixed interest, even in case of losses, and the contributor of capital is, on the other hand, discriminated against when the entrepreneur makes a large profit but only a nominal interest is paid for the capital. Such discrimination is clear injustice. Charging a uniform rate of interest from different economic circumstances does not seem to be socially correct or just. A particular person may be borrowing for education of his children, treatment of prolonged diseases of certain family members, or marriage of his children. He would be charged almost the same rate of interest as would be perhaps charged from one of the richest businessmen who may be earning a large profit. Naturally, this is neither economically just nor socially desirable. In fact, interest-based lending/borrowing is based on collateral which means the poor without collateral have no access to credit/capital lying with financial institutions. Since loan is collateralised, it is not in the interest of any interest-based financial institution to consider the factors responsible of the business failure. The profit has been pre-fixed through legal contracts with no bearing to market risks confronted by normal production activities.
Transactions based on interest violate the equity aspect of economic organisation. The borrower is obliged to pay a pre-determined rate of interest on the sum borrowed even through he may have incurred loss. So, this predetermined rate of return, independent or irrespective of the actual productivity, profitability or utility, is not reasonable from the point of view of justice. The predetermined rate of return is, by definition, usually the same for more efficient and less efficient, richer and poorer people as well as more honest and less honest parties.
In conclusion it can safely be said that interest is one of the most destabilising factors in the modern-day economy. Cooperation between man and man deteriorates and there arises a man who flourishes on material relationship rather than brotherly feelings. Justice, humanity and altruism do not play any role in the society where Interest is prevailing. Whereas Interest free profit and loss sharing system help obtain a sustainable economic growth, innovation as well as promoting cooperation and man to man brotherly relationship.
The writer teaches at York College of the City University of New York and a research fellow of IERF.
In modern economic systems interest plays a very important role. In fact, in the Western world as well as some eastern countries people cannot think of any economic system without interest. From a theoretical standpoint, interest has been a debatable subject among economic and political theorists. Interest as we all know, is the excess of money paid to the lender by the borrower over and above the principal for the use of the lender's money for and over a certain period of time. Economists have presented different interpretations of interest. Samuelson states that "Interest is the price of rental for the use of money". Don Patinkin gives the following definition: "Interest is one of the forms of income from property, the other forms being dividends, rent and profit". However, J.M. Keynes did not define interest but mentioned the rate of interest as "The percentage of excess of a sum of units of money contracted for forward units of time over the spot or cash price of the sum thus contracted for forward delivery".
However, some Muslim, socialist and a number of capitalist economists have questioned these explanations on both theoretical and technical grounds. They often stress the point that money capital cannot be treated as capital goods on the same basis as productive factors. It is pertinent to remark here that lending of money for interest was abhorred and, in most cases, prohibited by all the monotheistic religions. An eminent Western economist, Roy Harrod in his famous book Towards a Dynamic Economics, regards the abolition of interest is the only way to avert a collapse of capitalism. Not only this, but he speaks with great admiration for an interest-less society. Harrod clearly recognises that, "It is not the profit itself, earned by services, by assiduity, by imagination, or by courage, but the continued interest accruing from the accumulation that makes that profit taker eventually appear parasitical…" and he further states that an interest-less society which will be a totally new kind of society would be the correct and final answer to all that is justly advanced by the critics of capitalism.
There are at least four characteristics that define the interest rate.
1. It is positive and fixed ex-ante,
2. It is tied to the time period,
3.Its payment is guaranteed regardless of the outcome or the purposes for which the principal was borrowed,
4. The state's apparatus sanctions and enforces its collection.
Saving and investment: Saving and investment are two of the most important determinants of economic growth and development. The classical belief that saving is determined by the interest rate is refuted by Keynes. According to Keynes, aggregate saving is governed by the aggregate income. The empirical evidence does not show any significant relationship between saving and interest rates, the results have at best been inconclusive. In fact, interest puts a limit to the marginal efficiency of capital. Interest is inversely related to the marginal efficiency of capital. In the presence of Interest the marginal efficiency of capital does not rise to its optimum level. As a result, all the resources available cannot be fully utilised. This causes a fall in investment.
Interest rate, in fact, limits investments. Interest is also considered as a cost of production and hence the price of the product is adjusted to it so that consumers are affected because of the higher prices of goods and services. Interest dampens investment activity because it adds to the cost of investment. However, if interest rate is raised to contain monetary demand in situation where excessive fiscal deficits are fuelling inflation, private investment receives a severe setback leading to stagflation. This has actually been the experience of a number of developed countries in recent years. So, interest-less economy is unlikely to reduce the volume of savings. In fact, in an interest -free economic system savings are likely to be promoted. First of all, in the profit sharing arrangement the return to capital will include "reward for both savings and risk-taking" which means a high return to financiers than in an interest-based system. This means if higher returns or higher income determine the level of savings, people will save more in a share economy than in an interest-based economic system. Secondly, profit-sharing in mass production between employer and employees will, on the average, give higher income to the employees who constitute the majority of the population.
On the other hand, in an interest-free scheme, where both the financiers and the investors have a stake in the return of their investments, low returns may not deter them from investing, as neither the investors nor the financiers will be better off or worse off, one at the cost of the other. In fact, both can be worse off by not investing. In the profit sharing system, it is innovative enterprises that are likely to set constraints to investment rather than finance. This is because capital does not impose a limit to investment such as in the interest based system. Thus innovative entrepreneurs who are ready to develop new profitable investments will always raise funds for such ventures.
Unemployment and inflation: Interest rate causes unemployment and inflation in several ways. When interest rate is high it makes cost of production also high, causing a decline in investment and in some cases closure of production units, resulting in retrenchment of workers by employers to reduce cost. Alternatively, producers increase the prices of goods and services to cover the increased cost, thereby causing inflation. On the other hand, when interest rate is low the tendency is to switch to capital intensive method of production, thereby causing technical unemployment due to the replacement of labour by machinery. On the consumer side, low interest rate encourages borrowing for consumption which usually increases the demand for goods and services, hence resulting in demand-pull inflation. It was believed by most economists until the early 1970's that there is a trade-off between unemployment and inflation. However, subsequent findings have shown that both high unemployment and inflation can co-exist. This gives rise to a new phenomenon known as stagflation. That is a situation where high unemployment and inflation are positively related. This phenomenon has caused many economic problems in the industrialised countries. Weitzman, Martin in his article on " Profit Sharing as Macro Economic Policy" published in the American Economic Review, Vol 10, No.4, 1985 stated that all the mechanisms attempted so far in solving the problem of stagflation have failed. He proposed that profit-sharing and not the Interest is the best form of policy for combating unemployment and inflation. He further mentioned that profit-sharing represents a way of building into the system, the kind of natural resistance to unemployment and inflation that could really disarm stagflation at its source.
Interest and entrepreneurship: According to Schumpeter, economic growth is determined by the dynamic function of entrepreneurship and this dynamic function is an innovation which leads to technological changes. So, the entrepreneurs are the real pillars of economic edifice. The interest-based system discourages innovation, particularly on the part of small scale enterprises. Large industrial firms and big landholders can afford to experiment with new techniques of production as they have reserves of their own to fall back upon in case the adoption of new practices does not yield a good dividend. Small scale enterprises hesitate to go in for new methods of production with the help of money borrowed form banks as the liability of the banks for the principal sum and interest has to be met irrespective of the results while they have very little reserves of their own. In this way economic development is hindered.
Interest and stability: It may, in fact, be asserted that interest is one of the most destabilising factors in the capitalist economy. Milton Friedman, posing the question, "What accounts for this unprecedented erratic behaviour of the US economy?", responds by saying, "The answer that leaps to mind is the corresponding erratic behaviour of interest rate". The erratic fluctuation of the rate of interest creates erratic shifts in financial resources between users, sectors of the economy and countries, causing erratic movements in the loan based investments, commodity and stock prices and exchange rates. They also bring about shifts in short and long term commitment of funds and between equity and loan financing. The high degree of interest rate volatility has injected great uncertainty into the investment market which has had the effect of driving borrowers and lenders alike form the longer end of the debt market into the shorted end, thus fundamentally altering the investment decisions of businessmen.
Profitability and productivity: Some people think that profit-sharing (which is the Islamic alternative to interest) will not be profitable to the financiers compared to traditional interest based system. This contention has been refuted. It has been argued that for the financiers as a group, profit-sharing is more profitable than traditional interest based system.
A PLS (Profit and Loss Sharing) system is likely to be more attractive for both the firms and the financiers. This is because PLS system promises leverage benefits to the firms free of risk and a return higher than the rate of interest to the financiers. Fluctuations in the rate of profit on equity under PLS finance are likely to be smaller than the rate of profit on equity under the interest finance and that PLS operations may have a smaller destabilising potential for the economy as a whole compared to financing on interest. Another factor that makes profit-sharing more profitable than interest-based system is that the burden of the risks on the part of the investors has been reduced. This encourages entrepreneurs to be more innovative and venture into high risk projects which are usually characterised by high profitability. Furthermore, the spirit of mutual co-operatives and sense of ownership and responsibility promoted by profit-sharing results in efficient use of resources and increased output, in turn, increases profit.
An empirical study conducted by Jones and Svejnar on Italian producer co-operatives, have come out with the interesting conclusion that, for producer co-operative, profit-sharing participation and individual worker ownership of assets have a positive, or at least a non-negative, effect on productivity, and that collectively owned reserves have a negative effect on productivity. In fact, these findings support the proposition that profit-sharing encourages co-operation, greater sense of belonging and responsibility among the partners. Consequently, greater productivity and profitability is achieved.
Interest and concentration of wealth: There seems to be a near consensus of opinion among the advocates of interest free economic systems that one of the causes of high concentration of wealth in the capitalist economies is that institution of Interest. Interest creates a big source of inequalities of income. Income inequalities bring social inequality, that is inequality of opportunity for the disadvantaged to earn their livelihood. In the modern world, industrialists borrow capital from the banks and make a large profit but pay only a small part to the depositors through the banking system. This is an indirect transfer of income form the masses of depositor to a few industrialists. This leads to the concentration of wealth in the society. Thurs, in the interest based capitalist economy, the flow of wealth is from the 'many' to the 'few', and in most of the cases the 'many' are poor people.
Misallocation of resources: In the conventional economies, there is no theoretical justification for the existence of a rate of interest so far as allocation of resources is concerned. Interest rate can only theoretically efficiently allocate resources if money and capital market are perfectly competitive and if the environment is certain and static. But in the world of imperfection, and uncertainty, the rate of interest cannot allocate resources efficiently. It is, in fact, true that in the old days production could not be extended owing to lack of capital, but now in a number of rich countries, there is a super-abundance of savings and large sums of money which are simply lying idle. We find simultaneously with this super-abundance of capital a very large class of unemployed people. People are unemployed because the capitalists do not find it worthwhile to invest their funds in the fields where the rate of return is less than the current rate of interest. For instance, if the current rate of interest is 4.0% and money is invested in irrigation works which directly yield only 3.0%, then, according to capitalist view, irrigation is unproductive. The money will not be invested in irrigation works, however useful these may be for society. The result is that the capital remains idle while resources remain undeveloped. All public works, however conducive they may be for the benefit of society, remain undone in an interest based economy if the yield from such works is less than the current rate of interest.
Justice and equity: In an interest based system the entrepreneur is, on one hand, discriminated against when he has to pay the fixed interest, even in case of losses, and the contributor of capital is, on the other hand, discriminated against when the entrepreneur makes a large profit but only a nominal interest is paid for the capital. Such discrimination is clear injustice. Charging a uniform rate of interest from different economic circumstances does not seem to be socially correct or just. A particular person may be borrowing for education of his children, treatment of prolonged diseases of certain family members, or marriage of his children. He would be charged almost the same rate of interest as would be perhaps charged from one of the richest businessmen who may be earning a large profit. Naturally, this is neither economically just nor socially desirable. In fact, interest-based lending/borrowing is based on collateral which means the poor without collateral have no access to credit/capital lying with financial institutions. Since loan is collateralised, it is not in the interest of any interest-based financial institution to consider the factors responsible of the business failure. The profit has been pre-fixed through legal contracts with no bearing to market risks confronted by normal production activities.
Transactions based on interest violate the equity aspect of economic organisation. The borrower is obliged to pay a pre-determined rate of interest on the sum borrowed even through he may have incurred loss. So, this predetermined rate of return, independent or irrespective of the actual productivity, profitability or utility, is not reasonable from the point of view of justice. The predetermined rate of return is, by definition, usually the same for more efficient and less efficient, richer and poorer people as well as more honest and less honest parties.
In conclusion it can safely be said that interest is one of the most destabilising factors in the modern-day economy. Cooperation between man and man deteriorates and there arises a man who flourishes on material relationship rather than brotherly feelings. Justice, humanity and altruism do not play any role in the society where Interest is prevailing. Whereas Interest free profit and loss sharing system help obtain a sustainable economic growth, innovation as well as promoting cooperation and man to man brotherly relationship.
The writer teaches at York College of the City University of New York and a research fellow of IERF.