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The question of interest
has occupied thinkers for more than two thousand years. Aristotle came to the
conclusion that interest is illegitimate and cannot be justified, since
“money cannot beget money”, unlike all living things which
reproduce themselves. Since “money cannot beget money”, Aristotle
argued that it is unreasonable and impossible to demand that money lent
should be repaid with a greater amount than the amount of the original loan.
The thinking of Aristotle
influenced the Catholic Church, which for centuries banned the taking of
interest. Loans with interest were made by Jews, not subject to the laws of
the Catholic Church, and by Christians who sinned in doing so, and
circumvented the prohibition on interest by schemes which hid the interest
under other labels. It was at least partly due to a sense of having sinned,
and in atonement for it, that the heads of the great financial dynasty of the
Medici of Florence contributed so heavily to the building of the Renaissance
temples of that city, and paid splendidly for the beautiful religious art of
that period.
There is still, today, a
minority who agree with Aristotle. And of course, there is the Islamic ban on
the taking of interest, which is substituted in Islamic law or sharia,
by having the lender participate, according to a set of rules, in the profits
expected by the borrower as a result of obtaining a loan. (Note: I am not
endorsing all modern Islamic banking, because it seems to me that the Islamic
bankers may be evading their religious law by various schemes, just as the
Medici did in their time; one important Islamic scholar and leader has told
me that Islam is flatly against all payment of interest whatsoever.)
A popular argument against
the Western banking system is frequently expressed as “the banks make
loans and in doing so, create money; but they do not create the money to pay
the interest. Therefore, the system is unsound and must collapse eventually.”
This would appear to be a variant of the Aristotelian objection.
The argument that
“banks make loans and thus create money, but do not create the money to
pay the interest on the loan” is a specious and confusing argument
because, on the one hand the power which modern banking systems have to
create money out of nothing by granting credit is an anti-social power based
on fraud, since real money can only be gold and silver and these cannot be
created out of nothing. And on the other hand, the idea that “there is
not enough money in existence at any moment to pay the interest due on
loans” is fallacious, because all interest does not come due at any
given moment; the payment of interest takes place over time as debts mature
and become payable.
The Western banking system
has undergone great development, because it has separated the concept of
profits from the concept of interest. The prudent banker will want to
understand the borrower’s business plan, and how the borrower will use
the funds loaned in a way that will produce a profit, but more importantly,
he takes care to insure that his loan is given a right of precedence in
payment over other obligations of the borrower, and besides that, he may
insist on specific guarantees (collateral), and perhaps co-signers as well,
on behalf of the borrower. This is done, so that regardless of the
profitability of the venture undertaken by the entrepreneur, the banker can
be reasonably sure that he will collect his loan and the interest payments on
it.
This separation between a)
the concept of the profitability of the endeavor for which the loan is
granted and b) the concept of the legal right to collect the interest, must
date to ancient times; but earlier still, at its very birth, Interest arose
out of profit-sharing: the merchant who wished to send his quinquereme across
the Mediterranean "with a cargo of ivory, and apes and peacocks,
sandalwood, cedarwood and sweet white wine" required an investment to
make his enterprise possible. He went to the trapezai - the local
bankers - and found one willing to risk his money in return for a portion of
the profits of the venture. Over time, this profit was reduced by
market practice to various standard percentages and became known as Interest.
In the course of its evolution as a financial concept, the origin of Interest
as a participation in Profits was forgotten.
It seems to me that the
connection between Interest and Profit has been rediscovered by NASOE, the
New Austrian School of Economics (see www.professorfekete.com), which
points out that the lower bound of interest rates is determined by the Time
Preference of the marginal investor, who will keep his gold if the rate of
interest on an investment - let us call it a Bond - is insufficient to
satisfy his Time Preference, and the upper bound of interest rates is
determined by the marginal producer, who will sell his productive enterprise
and purchase the Bond if the Bond yields more than his enterprise. Purchasing
the Bond raises its price and thus caps the rise in the interest rate. In
this way, NASOE is once again linking the upper bound of interest rates to
the profitability of industry and commerce - as occurred when Interest
first made its appearance in human affairs.
Interest has been regarded
as a phenomenon in itself; perhaps as if sunlight could be studied separately
from the existence of the Sun. The separation between a) the concept of the
profitability of the endeavor for which the loan is granted and b) the
concept of the legal right to collect the interest, has allowed
specialization in the activity of Western finance and its consequent growth.
The banker’s business is simply to make loans and collect both the
loans and the interest, and no more. The banker in effect says:
“Whether you make a profit or not, I want my interest, and I want my
loan paid back.” This specialization of the function of the banker and
this limitation of his interest and responsibility has produced high
efficiency in Western banking; at the same time it has introduced into society
an anti-social element, for the banker has been granted a legal right to
demand payment of the interest due on his loan; if not forthcoming, the
banker is legally entitled to carve up the debtor’s substance, in
effect getting his “pound of flesh”, in order to recover his loan
and accrued Interest.
In my view, the answer to
both the old Aristotelian objection and the modern objection is that payment
of interest cannot be anything else than a name given to a distribution of
profit, in other words, another name for “dividends”. It seems to
me that the distinction between “interest payment” and
“dividend payment” is merely a legal distinction, not a real
distinction.
This is why the modern
concept of “EBITDA” is so important to financiers. The letters stand
for “Earnings Before Interest, Taxes,
Depreciation and Amortization”. The importance of
“Earnings” is primordial for a very good reason: if there are no
Earnings (profits) the payment of Interest is in jeopardy, as well as
Dividends.
Successful entrepreneurial
activity leads to the creation of profit. There is such a thing as profit,
and no one disputes its legitimacy. If the creation of profit is a reality,
then the distribution of profit to the equity owners of an enterprise is also
legitimate and certainly possible. Conversely, if there is no profit, there
is no substance which can be distributed either for interest payment or for
dividend payment. In actual reality, it is the creation of profit that makes
payments of both Interest and Dividends possible.
This is the approach to
lending of the Islamic banking system: the lender is entitled to a share in
the profits of an enterprise which he finances, subject to the existence of
those profits. This share may be negotiated, but the fundamental question is
that there must be a profit to share, for the lender to obtain what we
call interest. (The sharia law that governs Islamic banking
includes provisions for the recovery of the lender’s capital, which are
not pertinent to the present discussion of the subject of interest payments.
Again, I must emphasize that not all Islamics agree regarding the religious
legitimacy of "Islamic banking").
This approach to the
question of Interest, by those who favor Islamic banking, eliminates the
objections of both the Aristotelians and the modern day critics who say that
at any given moment there is not enough money in existence to pay the accrued
interest: the payment of “interest” is another name for a
distribution of profit. Under Islamic banking, a loan and interest are
substituted by a sort of transitory equity agreement; the loan takes the form
of an equity participation in the enterprise, which ends when the equity
investment plus the profit it produced is returned to the investor.
Islamic banking is in this
respect quite unwieldy when compared to Western banking, but in my view, it
is just and realistic. It also makes for more prudent banking, for a slower
expansion of credit. It is a just system, because it unites the interest of
the entrepreneur in obtaining a profit, with the interest of the lender in
the same objective.
The specialization of the
Western system of banking, which divorces the objective of the entrepreneur
from the objective of the lender, has allowed the great growth of finance in
the West but at the cost of justice; for if interest is only another name for
a distribution of profit, how can payment of interest be justly demanded if
there is no profit to distribute?
Western banking rides
roughshod over this reality – the fundamental requirement of the
existence of a profit that can be distributed – and allows the banker
to liquidate the operations of the borrower and pay himself a non-existent
profit when he collects both the loan and accrued interest in a bankruptcy
court.
We, who operate under the
Western banking system, have seen to what depths of injustice it has
descended as illustrated in the predatory lending practices described by John
Perkins in his book, “Confessions of an Economic Hit Man”
(Berrett-Koehler Publishers, Inc.) This lending, as documented by Perkins, is
done with the ulterior criminal object of taking possession of the
borrower’s assets, whether the borrower is a corporation or a sovereign
nation, and not, as most of us assume, with the intention of providing funds
to further the borrower’s productive activity, with the simple
objective of collecting interest and eventually, the capital loaned.
Critical remarks have been
expressed with regard to the outrageous behavior of certain bankers named by
Perkins, but what is really necessary is an evaluation of the general
constitution of Western banking, which is conceptually structured in such a
way that it makes such outrages possible.
The relatively unwieldy
Islamic system has the virtue of being realistic, in that it obligates the
lender to be much more careful in his approval of a loan, since the failure
of the borrower to make a profit implies no return of “interest”
(which they call a “share of the profits”) upon the loan. Both
lender and borrower are partners in any venture.
The divorce between the
interest of the borrower in taking a loan and the interest of the banker in
granting it is to a degree responsible for the condition of excess which
prevails in Western finance, currently enjoying a boom gone out of control.
We are all going to pay a costly price for this divorce which in the last
analysis is a divorce from economic reality.
A final note: I have no interest in promoting Islam. If I
refer to Islamic Banking, it is because it provides an alternative approach
to the question of Interest in the realm of finance.
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