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 Riba?’ 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.1
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.2 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.3
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.4
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.5
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.6
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.7
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.8
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.9
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TABLE
Interest and Fiscal Deficit
Case of High Indebted Countries
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|
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.10
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.11
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.12
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.13
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 1980.14 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.15
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.16 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 Riba are not
based on strong premises. This paper has argued that Riba
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@
h@asanah. 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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