If a money lender from the time of Christ had loaned an ounce of gold at 5% annual compound interest, it would today require an amount of bullion weighing several planet Earths in repayment. Early bankers knew the profound implications of this fact: a system in which commodity money is loaned out at interest is physically unsustainable in the long term.
With paper money things are different. When the exponents begin their inevitable work, the issuer of such money can simply print a larger face value on his banknotes. In acquiring the legal privilege to create money in this way, the early banks side-stepped a critical failsafe in the financial processes that drive economic activity, though the consequences were slow to emerge.
Other problems with interest could not be resolved so easily. In the real world things experience compound decrement, which is to say they rot and become useless. Meanwhile, interest allows money to grow at compound increment towards infinity. Herein lies the fundamental conflict between interest-based finance and the environment. Money loaned at interest does not obey the same laws as the physical assets that money buys.
Hence Michael Lipton’s example of a hypothetical plantation farmer who faces a choice of land use. He can farm his trees on a sustainable basis and produce 1000 units in profit annually for ever. Or he can move to intensive farming and produce 1250 units of profit annually for twenty years, after which his land turns to desert. With interest rates of more than 9% per annum, a standard discounted cash flow analysis recommends that the farmer chooses the intensive option. Unfortunately, this ‘killing of the golden goose’ is not confined to theory. The world’s top deforesting nations are among its most indebted partly because saving trees is less of a priority than servicing international debt.
Lord Hanson once said that his job was to “appropriate tomorrow’s value today” and although such business logic may be familiar to an MBA student, future generations are unlikely to thank us for it. The great monuments of the world were built because their progenitors took precisely the opposite attitude. They cared more about creating value for the future than the present. But when infrastructure is financed with loans at interest, caring about the future becomes a rather expensive habit. One reason that we find it so difficult to build the likes of St. Paul’s Cathedral nowadays, or even the London Underground, is that we have forgotten how to fund projects without resorting to bank loans.
Unfortunately, a powerful commercial logic called financial leverage is preventing change in these matters. The business model of most modern corporations is to borrow money at a rate of interest that is below the rate of return earned when investing that money. For example, by borrowing 100 at 5% and investing it in a one year project that yields 20%, the executive manager can earn 15 for his firm. And the banker will earn 5 of interest on his newly created money. It is a rather cosy symbiosis, but its logical consequence is that firms will grow increasingly large over time. Instead of borrowing 100 in order to make 15 of profit, why not borrow 100 million and make 15 million of profit instead?
In this manner, financial leverage has enabled a relatively small number of corporations to achieve market dominance, while their bankers collect interest on an ever-growing pile of debt. And because the commercial banking system has the ability to create new money almost without limit, there is correspondingly nothing to restrict the extent of financial leverage. The result is that economic growth of a highly aggressive kind is being forced upon humanity.
Nowhere is this better illustrated than in the changing face of Britain today. A charming landscape of ages past is gradually being scarred by the characterless housing estates that financial leverage imposes on us. Large corporations are beginning to monopolise business and cultural activity, removing decision-making power from local communities and passing it in increasing measure to distant centres of control. This is the system that put the butcher, the baker and the candlestick-maker out of business, and then employed them at a nearby supermarket on the minimum wage. And if you think that Top Shop, Burton, Miss Selfridge, Dorothy Perkins, Wallis, Richard Shops and BHS represent healthy competition in the fashion sector, think again. All these companies are controlled by one businessman, obligingly empowered with bank debt. Is this what passes for market competition in the twenty-first century?
Given the amount of profit at stake, it is understandable that the connection between interest-based leverage and matters of environment is rarely mentioned in political discourse. Mr. Stern’s voluminous report on global warming and Al Gore’s documentary barely touch upon it. But there is another way, and that is the way of equity in both its financial and social sense.
Imagine a world in which holders of surplus wealth invested with entrepreneurs only on a profit and loss sharing basis. Here the investor gains or loses according to the entrepreneur’s business fortunes. Under this kind of finance, the interests of both parties are closely aligned. The investor will be more careful when examining the entrepreneur’s project plan and personal history before investing. This contrasts with the attitude of many interest-based lenders who attach greater importance to the borrower’s collateral than to his business plan. This is because collateral can be repossessed and sold on the market in order to repay the original loan plus interest. Bank loans therefore tend to be directed towards those members of society who already have wealth, not necessarily to those with the best projects. A poor man may have a good business idea but, without collateral, few banks will finance him. Interest-based finance therefore tends to increase wealth inequality, whereas pure profit and loss sharing tends to reduce it.
In Islam, any benefit accruing to a lender of money is regarded as a form of usury and is prohibited. There is no such thing as a “usurious” rate of interest in Islamic law, because all rates of interest are usurious. And although the prohibition of usury is not a cure-all for the maladies of modern life, where it has been implemented as part of a wider regime of Islamic regulation the historical precedents are excellent. The universities, hospitals, welfare systems and infrastructure of Iraq, Spain and the Ottoman Empire were funded without resort to interest-bearing loans. Within twenty years of the institution of Islamic law, the Arabian peninsula was transformed from a scene of poverty to one in which deserving recipients for welfare payments could not be found. The lesson is clear. Interest-based finance is not a pre-requisite for society’s material advancement.
In today’s context, the prohibition of interest would yield immediate benefits to the majority of the world’s poor. If the developing countries were to cease their debt service repayments today, they would find themselves richer by more that a billion dollars a day. That would make a very real difference in a world where as many as three billion people are each living on less than two dollars a day. Their hunger is our luxury, and usury makes it so.
1400 years ago the Prophet Muhammad (peace be upon him) told his followers, “though usury be much, it always leads to utter poverty”. When such words are uttered by a Prophet, they carry the force of an economic law. They warn us that even the wealthy nations of the world are in a race against time. If we do not defeat usury, usury will defeat us too.
Tarek El Diwany is a writer and consultant in Islamic banking and finance. He is the author of The Problem With Interest and founder of http://www.islamic-finance.com. He holds a BA Hons in Accounting & Finance from the University of Lancaster in the UK and is a founding partner of Zest Advisory LLP.