In the
following part of an article by Muhammad Akram Khan, Chief Accounts Officer in
the Ministry for Foreign Affairs, the writer explains that, at macroeconomic
level, interest can never be accepted as a benevolent institution and urges
those who support interest to consider its far reaching implications in an
economy and its effects on the lives of common people. Khan is a profound
scholar of Islamic economics and a prolific writer on that subject. The
complete article was published in ‘Pakistan Banker’ (January-December 1996)
under the title ‘Is Commercial Interest Ribā?’ Here, part of the original
article is being published with the kind permission of and with thanks to the
Editor, Pakistan Banker. (Pakistan Banker is a magazine of The Bank of Punjab)
-- Editor
Interest and
Unemployment
Modern
capitalist societies have markedly failed to solve problem of unemployment.
Even rich countries face a certain level of involuntary unemployment.
Economists accepted it as a fact of life. They now talk of natural rate of a
unemployment. The unemployment exists along with idle physical and
technological resources as the finance to mobilize these resources is not
available. The scarcity of finance is not natural. It is not like the scarcity
of land which man cannot create. It is contrived by human beings. The finance
is there but does not become available except at a certain rate of interest.
Until that rate of interest is committed the finance remains waiting in the
coffers of banks and finance houses. There are, at all times, some investment
proposals which cannot generate return sufficient to meet contractual
obligation of interest besides leaving something for the enterprise. These
investment proposals which could otherwise employ people and physical
resources remain unfulfilled. Interest thus becomes the foremost deterrent to
investment.
Keynsian
economists have now established it beyond doubt (and classical economists also
did not disagree) that interest and investment are inversely related. The
higher the rate of interest, the lower will be level of investment and thus of
employment. The unemployment can be reduced to a bare minimum of frictional
level if the rate of interest is reduced to zero.
The
real-life evidence for this phenomenon is now available in case of miraculous
development of Japanese economy. Since 1950, Japan’s average rate of interest
on capital for investment has been less than 5%. [Peter Drucker has recently
argued that this low cost of capital is the only factor which explains Japan’s
success. It is neither culture nor structure -- which people often invoke to
explain Japanese wonderful performance.] As compared to Japan, the cost of
capital in America and other Western European countries has been between 10%
-- 15% during this period. No wonder, the rate of unemployment in these
countries has also been much higher than the rate of unemployment in Japan.
The question
arises as to why capitalists societies do not eliminate interest to achieve
full employment despite their understanding of the inverse relationship
between interest and employment? The answer lies in the fact that the wealthy
class which owns finance is unwilling to part with its interest income. The
political power lies with this class. The economists also rely on financial
help from the rich class for obtaining degrees, keeping their research
institutions going, and publishing their research. Many economists themselves
are beneficiaries of the interest income since they have invested their
savings in securities and bonds. Thus all the influential people in the world
of politics, economics and power have some vested interest in retaining the
institution of interest in the society. They pay a lot of lip service to the
agony of the unemployed. They have even devised elaborate systems of social
security to sustain the poor and the needy. But they are unwilling to uproot
the real cause of unemployment, namely interest.
The solution
of poverty through an elaborate system of social security has also backfired.
It first led to high tax rates to finance social security benefits for the
unemployed. When it became impossible (at least politically) to raise taxes
further, governments started incurring public debt. Thus financiers started
getting interest income from governments as well and therefore lent strong
support to the social security system. The social security system became a
channel to enrich the already wealthy class. In some cases the governments
also resorted to printing of more currency to meet their fiscal deficits. The
result was an endemic curse of inflation. When inflation became painful, it
was tempered with various schemes of indexation and monetary policy. Despite
best efforts of nations, no enduring solution of the twin problems of
unemployment and inflation has been found so far. The topsy turvey solution of
fighting unemployment through social security schemes while retaining
interest, the root-cause of unemployment, has created more problems than it
has solved. Social security schemes could have provided good solution if they
had been implemented with zero rate of interest. In such a case social
security cover had been necessary for only those who were unable to make a
living because of some physical or mental disability.
Interest and
Inflation
Although
conventional economics pleads an inverse relationship between interest and
inflation there is now ample evidence available which shows that price level
and interest move in the same direction.
Interest is not only related to price level, it is also a cause of inflation
in the following manner:
First,
interest enters into the prices through cost of production. Therefore, any
increase in the rate of interest leads to a proportionate increase in the
price level. This point is not conceded by the neoclassical economists who
emphasize the need to raise rate of interest to control inflation. But the
fact is that some economists in the past have argued forcefully about a direct
positive relationship between rate of interest and price level. This point of
view has not received due attention from the economic profession. For example,
Carlo Panico, in a recent study has stated:
In these
volumes (That is, volumes of A History of Prices published in 1838), Tooke
claimed that a permanent variation in the interest rates causes a variation in
the same direction in the prices of commodities by affecting their cost of
production.
Similarly,
he has stated about J.M. Keynes as follows:
The
conclusion of this analysis is that persistent changes in the interest rates
affect distribution and price formation. A raise in the interest rates tends
to raise the rates of profit and prices, while a fall in the interest rates
tends to lower the rates of profit and prices.
Second, in a
more subtle manner, increase in the rate of interest leads to decline in
investment (as less funds are available) which results in contraction in the
economy. It leads to a rise in the price level as fewer goods and services are
available than would be if there had been no restriction on investment due to
interest rate.
Third,
interest determines a floor for the prices of other factors of production. It
creates a stickiness in the market operations of rates of rents and profits
leading to a general rise in prices. This can be seen from the following
example. Suppose a person has some savings on which he can earn an interest of
15%. Now suppose that he plans to buy a property with his savings for hiring.
He will not invest in the property if the expected rate of rent is likely to
bring a return less than 15% on his capital. In fact, the rent must be
substantially higher than 15% to persuade him to buy the property and rent it
out. Otherwise, why should he bother to maintain a property and receive an
income which is less than the interest income that he could get without any
effort and any risk? Thus the existence of interest in the economy creates a
floor for rents. Same is the case of profits. A person who plans to invest his
capital must get a higher return than the interest which he can earn while
sitting at home. In this way, interest does not permit the profit level to
fall below the interest level. These two variables cause an increase in the
general price level which in turn leads to demand for higher wages. Once wages
are increased, a new cycle of higher prices sets in.
Now think of
any economy where interest has been abolished. A person who aims at earning a
return on his capital must either work or at least take some risk. Otherwise,
his capital will remain unproductive. In such an economy, rents and profits
will not be determined with reference to interest. There will be no floor for
rates of rents and profits. There will be some income either through rents or
profits or no income at all. The channel to earn a return on capital by
interest in not open any more. The rents and profits will be determined by
their natural flows of supply and demand. The greater the competition the
lower shall be the level of these returns. In a capitalist economy, interest
is also a restriction on free competition as it does not make capital
available except at a certain rate of interest and firms which cannot pay that
interest can not enter the market. If we abolish interest an important
obstacle to free competition will be removed. At the same time rents, profits
and wages will not be guided by any floor. Free competition will determine
these remunerations and there will be no other compulsion to hold prices at a
level higher than the one determined by free flows of supply and demand.
Fourth, by
far the greatest current source of inflation is the fiscal deficit of
governments. The major reason for this deficit is a very low ratio of tax
revenue to GDP. The narrowness of tax base itself is due to the problem of
external debt. Governments are under pressure to generate current account
surplus so that they can service their debt. As a result, they curtail
non-interest domestic expenditure, which in turn leads to recession in the
private sector, causing a decline in wages, profits, and imports. The tax base
is eroded. Governments then borrow to supplement their meager tax receipts.
Interest
payments on debt are themselves a direct cause of fiscal deficit leading to
further debt. For example, data on the fourteen highly indebted countries
listed in the table shows that out of eleven years only in three years fiscal
deficit was larger than interest payments. Otherwise in each year interest
payments were larger than the fiscal deficit. If there was no burden of
interest payments there would have been no fiscal deficit and it would have
reduced the rate of inflation in these countries. It is not claimed that
there are no other reasons for fiscal deficit. The table simply shows that
interest is one of the main contributing factors towards fiscal deficit which
in turn leads to inflation.
Fifth,
sometimes a vicious circle of interest, inflation, debt, fiscal deficit and
interest may also take place. When public anticipates that inflation will
persist, nominal interest rates rise since bond holders demand higher premium
for parting with their money. As a result, nominal debt increases which
further increases fiscal deficit. This, in turn, accelerates inflation and the
whole cycle starts all over again.
Sixth, the
conventional policy of fighting inflation by raising rates of interest does
not always yield the expected results especially if a country has large public
debt and people have little trust in the government’s solvency. An increase in
interest rates may be effective over a short period but over the long run it
leads to outbursts of inflation. Increase in interest rates leads to increase
in stock of nominal debt. It induces the public to expect more inflation. Note
the following argument of Guidotti and Kumar:
As
inflationary expectations worsen, nominal interest rates rise pari passu, and,
if inflation remains unchanged, real interest rates increase, weakening the
government’s credibility even more. Thus a policy of high interest rates which
was initially implemented with the objective of reducing inflation, may end up
forcing abandonment of the stabilization program.
Seventh, at
the global level, many countries face extraordinary debt burdens only because
they had contracted debts at variable rates of interest. For example, any rise
in the rate of interest due to high demand for loanable funds in a large
country like USA causes the interest burden of these countries to rise by
billions of dollars. To service this debt these countries incur further debt
which, in turn, causes inflation.
Uneven
Income Distribution
Interest
redistributes wealth in favour of the wealthy class. Governments borrow large
sums of money for defence, social security, general administration and social
infrastructure. They borrow capital for these purposes on interest from their
own citizens. The repayment of these loans is done either by taxes or by
further borrowing. In the former case, taxes collected from the entire
population flow to the coffers of the wealthy rentiers. And the process is
cumulative. Rising load of public debt keeps on intensifying the entire
process. It is natural that interest on these loans plays a significant role
in concentration of wealth in a few hands as the rates of interest are usually
compound which multiply to astronomical figures over a long period.
TABLE
Interest and
Fiscal Deficit
Case of High
Indebted Countries
| Years |
Fiscal Deficit |
Interest Payments |
| 1978 |
-2.6 |
2.2 |
| 1979 |
-1.6 |
2.0 |
|
1980 |
-2.1 |
2.2 |
|
1981 |
-5.4 |
3.2 |
|
1982 |
-7.4 |
6.5 |
|
1983 |
-4.2 |
6.8 |
| 1984 |
-2.7 |
5.8 |
| 1985 |
-2.8 |
6.0 |
| 1986 |
-4.0 |
6.6 |
| 1987 |
-5.0 |
7.3 |
| 1988 |
-3.8 |
7.3 |
Source:
Guidotti & Kumar, Domestic Public Debt of Externally Indebted Countries
(Occasional Paper No. 80) Washington, D.C.: IMF, 1991 p. 27.
Note:
Figures relate to the following high indebted fourteen countries: Argentina,
Bolivia, Brazil, Chile, Colombia, Cote d’Ivoire, Ecuador, Mexico, Morocco,
Nigeria, Peru, The Philippines, Uruguay, and Yugoslavia.
Financial
Imperialism
Over the
last two decades the world has seen an explosion of public debt. This is true
for rich as well poor countries. In 1988, average indebtedness of industrially
advanced countries had increased from 44.2% of GDP in 1981 to 58.6%. In the
case of Italy, Belgium, Ireland, Netherlands and Japan. These ratios were 95,
134, 133, 77, and 73 percent respectively.
The position of low-income countries was even worse. The total external debt
of low-income countries was $ 111.855 billion in 1980. It rose to $ 489.297
billion in 1994, an increase of 337% in 14 years.
This was the state of external debt. Domestic public debt was beside this. Let
us look at interest payments. In 1970, all countries paid $ 1.643 billion as
interest to their foreign creditors. In 1990, total interest payments of all
countries was $ 45.441 billions - an increase of 1.3 times. Such colossal
amounts of money were flowing from debtor countries to creditor countries.
Creditor
countries also feel that something must be done to reduce the transfer of
capital from the poor to the rich countries. One such technique is
rescheduling of debt. But it also adds to the agony of the poor world. For
example. Willy Brandt writes:
To take the
case of Mexico: the second debt rescheduling, for a period of 14 years, will
amount to one and a half times the original debt, i.e. $130 billion. At a
meeting with government representatives in Mexico city I asked if it was true
that parts of the first rescheduling had cost 30% in interest and fees. Yes, I
was told, that might well be so.
Public debt
has become a tool of modern imperialism and exploitation. Third World
countries have gone under heavy debts. They are finding it extremely difficult
to pay back the debts along with interest. The debt servicing ratio as a
percentage of exports in the case of 20 countries had exceeded 30% in 1994
while the same ratio was only 10 in 1980.
The result is that they have to borrow more capital just to pay back interest
and principal of the existing debt. In a large number of cases the net inflow
of foreign capital has, in fact, become negative, which means that capital,
instead of flowing to poor countries, in flowing towards rich countries. For
example according to World Development Report 1990, 27 countries had a
negative net transfer of funds from debtor countries to creditor countries.
The quantum of this negative flow was $ 22 billions. The corresponding figure
in 1970 was mere $ 2.31 billions. During 20 years, net negative transfer had
increased 10 times.
The
phenomenon has been pertinently termed as ‘financial hemorrhage’. The poor
countries are toiling hard to pay back the debts. The situation is approaching
a point where perhaps poor countries will be working only for rich countries.
This will be the worst form of exploitation. The rich countries, with the
instrument of compound interest on their loans, have been successful in
keeping an effective hold on the poor countries without bothering to govern
and administer them. They have been able to replace territorial imperialism by
financial imperialism.
Interest and
Trade Barriers
Interest is
instrumental in restricting international trade in a subtle and intricate
manner. Developed countries have raised tariff and non-tariff barriers against
products of developing countries. Willy Brandt laments:
There is no
doubt that the developing countries’ access to the markets of the industrial
countries is obstructed by the same groups that like to talk of the free
market economy and free world trade. Sixty percent of world trade is
transacted under ‘non-free conditions’. Of the total industrial products
consumed in the USA and the EEC, over 30% are now affected by protectionist
measures; a few years ago, it was about 20%. In the first half of the
eighties, the developing countries were affected more than anyone by an
increase in protectionist measures, particularly in textiles and clothing,
steel, and agricultural products. UNCTAD registered no less than 21000 cases
in which ‘non-tariff’ barriers (i.e. barriers other than custom duties) had
been employed.
Industrially
advanced countries do not feel compulsion to reduce trade barriers since they
can expand their own exports to developing countries by providing suppliers’
credit. Suppose the world as a whole is able to abolish interest, developed
countries will not be willing to sell their products on credit. Instead they
will be inclined to enable the developing countries to expand their exports to
their countries so that a reciprocal trade relation is established. At
present, the compulsion to reduce trade barriers is minimal. The developed
countries can sell their products on credit to developing countries and earn
interest too. If the interest-bearing credit is not available and developed
countries are also not willing to reduce trade barriers, developing countries
will review their own import policies and will cut down unnecessary imports
such as luxuries. In brief, interest-bearing credit is playing a tacit role in
perpetuating the status quo in which the developed countries have been able to
keep developing countries out of the international market. The abolition of
interest from global economy will have a positive effect on world trade.
Direct
Foreign Investment
The
alternative to interest-bearing foreign finance is direct foreign investment (DFI).
The developing countries resort to interest-bearing loans on the plea that
sufficient funds are not available as DFI. The reason for the non-availability
of DFI is not that it is unprofitable. In fact, the rate of return on DFI is
usually higher than the rate of interest. For example, the rate of return on
DFI in a number of developing countries was 35% per annum during 1984-89
according to IFC Emerging Markets Composite Index. This compares favourably
with the rate of return of 20.3% on the US Benchmark Standard and Poor’s Index
of 500 stocks.
To the extent governments are borrowing for their consumption needs there may
not be an immediate answer except that should review their financial policies
to cut down on this type of borrowing. But for productive projects the need
for encouraging DFI is imminent. Despite this realization, developing
countries are unable to create a congenial atmosphere for DFI. The DFI needs a
peaceful social life, irrevocable guarantees against nationalization, removal
of bureaucratic hurdles in approval of projects, and simple regulations for
repatriation of earnings. But developing countries have not paid proper heed
to these factors. One reason is that they do not feel compelled to create such
a climate since they can get interest-bearing loans from international
financial market and other developed countries. Suppose that interest-bearing
loans are not available. Developing countries will then make a serious effort
to improve conditions for encouraging DFI. Interest acts as an indirect
stimulus to keep the status quo in which DIF is discouraged.
Need for
Further Research
Interest
cannot be accepted as a beneficial institution for humanity. The intellectual
efforts to distinguish it from Ribā are not based on strong premises. This
paper has argued that Ribā and interest are one and the same thing but in our
search for an alternative we have come across some nagging problems which need
to be solved. For example, in case of inter-personal transactions, we still do
not have any plausible answer for the protection of money value in view of the
creeping inflation, assuming that we do not accept indexaction of financial
claims. Similarly, there is need for the institutionalization of qard hasanah.
We still have numerous difficulties in applying the concept of profit-loss
sharing for short term credit. Also, as yet we do not have any mechanism for
interest-free credit to the government. The Islamic banks have not been able
to find a solution to delayed repayment of principal sums. No doubt these are
yet unresolved issues. A moderate statement will be that we need further
research and thinking for finding answers to these problems. Sweeping aside
the entire progress made in the areas of Islamic finance and going back to
justify interest as a legitimate institution is an unbalanced approach.
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