Interest: A Bane for the Society


By

Najmul Hoda
Senior Lecturer
NIILM Centre for Management Studies
New Delhi
 


Evolution of Interest

The concept of "usury" has a long historical life, throughout most of which it has been understood to refer to the practice of charging financial interest in excess of the principle amount of a loan, although in some instances and more especially in more recent times, it has been interpreted as interest above the legal or socially acceptable rate. The practice of usury i.e, lending money and accumulating interest on the loan- can be traced back 4,000 years(Jain, L.C. (1929) Indigenous Banking in India, London: MacMillian & Co.),. With the expansion of trade in the 13th century, the demand for credit increased, necessitating a modification in the definition of the term. In 1545, England fixed a legal maximum interest, a practice later followed by other Western nations. Economically, the interest rate is the cost of capital and is subject to the laws of supply and demand of the money supply. But it has always been despised, condemned, restricted or banned by moral, ethical, legal or religious entities. and during its subsequent history it has been repeatedly condemned, prohibited, scorned and restricted, mainly on moral, ethical, religious and legal grounds. The first attempt to control interest rates through manipulation of the money supply was made by the French Central Bank until 1847.

Prohibition of Usury in Various Religions

Hinduism

The earliest such record derives from the Vedic texts of Ancient India (2,000-1,400 BC) in which the "usurer" (kusidin) is mentioned several times and interpreted as any lender at interest.  More frequent and detailed references to interest payment are to be found in the later Sutra texts (700-100 BC), as well as the Buddhist Jatakas (600-400 BC).  It is during this latter period that the first sentiments of contempt for usury are expressed.  For example, Vasishtha, a well known Hindu law-maker of that time, made a special law which forbade the higher castes of Brahmanas (priests) and Kshatriyas (warriors) from being usurers or lenders at interest.  Also, in the Jatakas, usury is referred to in a demeaning manner: "hypocritical ascetics are accused of practising it".

Christianity

Usury has always been viewed negatively by the Roman Catholic Church. The Second Lateran Council condemned any repayment of a debt with more money than was originally loaned, the Council of Vienna explicitly prohibited usury and declared any legislation tolerant of usury to be heretical, and the first scholastics reproved the charging of interest. In the medieval economy, loans were entirely a consequence of necessity (bad harvests, fire in a workplace) and, under those conditions, it was considered morally reproachable to charge interest.Therefore, to charge interest was considered to commerce with God's property. Also, St. Thomas Aquinas, the leading theologian of the Catholic Church, argued that the charging of interest is wrong because it amounts to "double charging", charging for both the thing and the use of the thing.

Judaism

Criticism of usury in Judaism has its roots in several Biblical passages in which the taking of interest is either forbidden, discouraged or scorned.  The Hebrew word for interest is neshekh, literally meaning "a bite" and is believed to refer to the exaction of interest from the point of view of the debtor.  In the associated Exodus and Leviticus texts, the word almost certainly applies only to lending to the poor and destitute, while in Deuteronomy, the prohibition is extended to include all moneylending, excluding only business dealings with foreigners.  In the levitical text, the words tarbit or marbit are also used to refer to the recovery of interest by the creditor.

Prohibition of Interest in Islam

Islam is the only religion that categorically forbids any transaction based on interest. The criticism of usury in Islam was well established during the Prophet Mohammed's life and reinforced by various of his teachings in the Holy Quran dating back to around 600 AD.  The original word used for usury in this text was riba which literally means "excess or addition".  The Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production but it does not allow the factor to make a prior or pre-determined claim on the productive surplus in the form of interest.

Rationale for the Prohibition of Interest

1. Effect on Monetary System

It has been argued, for instance, that interest, being a pre- determined cost of production, tends to prevent full employment. It has also been contended that international monetary crises are largely due to the institution of interest (Khan, n.d),

2. Improper Allocation of Funds

Since the returns that the bank gets on the capital sum lent by them is fixed and not linked in any way to the actual profits, there are no incentives for the banks to give priority to the ventures with the highest profit potential. In the interest based system, the banks are only interested in recovering their capital along with interest. The interest system is inherently incapable of allocating available liquid funds among firms and activities in the society according to considerations of efficiency, productivity and growth. Theoretically speaking an interest-free financial system would offer a much better substitute for allocating available funds among firms and activities.

3. Promotes Inequity

Transactions based on interest violate the equity aspect of economic organization. The interest system encourages passive behaviour to develop among people having liquid funds by helping them to relinquish responsibilities and risks in investment activities. In contrast sharing in responsibilities and risks is inherent in the profit/loss sharing methods of finance. The interest system brings about and effectively maintains a pattern of income distribution which is biased towards wealthy people and large businesses, irrespective of rational economic considerations. This way, resources tend to remain in a few hands. This perpetuates inequity in the distribution of resources. So interest gives rise to both inefficiency and inequity, the two major concerns of the discipline of economics.

4. Exploitation of Needs

Interest, which is the kingpin of the modern banking and financial system, serves as a powerful tool of exploitation of one sector of the society by another. The taking of interest implies appropriating another person's property without giving him anything in exchange, because one who lends one dirham for two dirhams gets the extra dirham for nothing.

5. Hinders Productivity

Dependence on interest prevents people from working to earn money, since the person with dirhams can earn an extra dirham through interest, either in advance or at a later date, without working for it. The value of work will consequently be reduced in his estimation, and he will not bother to take the trouble of running a business or risking his money in trade or industry. This will lead to depriving people of benefits, and the business of the world cannot go on without industries, trade and commerce, building and construction, all of which need capital at risk.

6. Moral Aspect of the Interest

Permitting the taking of interest discourages people from doing good to one another (moral aspect of the prohibition of interest). In a society in which interest is lawful, the strong benefit from the suffering of the weak. As a result, the rich becomes richer and the poor poorer, creating socio-economic classes in the society separated by wide gulfs. To pay interest on money lent is to pay for something that no longer exists, and so the practice is nothing short of theft--which is, of course, a sin.

7. Inflation

When a businessman who wants to set up a factory borrows money from the bank or from capital markets, he has to pay interest on the borrowed money even if the business is under a stressful condition and needs to retain funds, rather than paying them out as interest. When the lender pressurizes the businessman/business entity to pay interest even in tough times, the businessman then recovers that amount of interest from the consumers by charging a higher price for his product or service. This rise in prices further aggravates inflation. Therefore, interest plays a part in aggravating inflation.

8. Deterrent to productive economy

Interest is a deterrent to productive economic activity. This is evident from the commonly observable fact that when rate of interest is low, economic activity increases and people are more willing to start and expand businesses, which adds positively to the economy. In contrast, when interest rates are high, people tend to be discouraged from making real investments and are more interested in saving that money and earning interest on it. This is not good for the economy because, when a small entrepreneur gets discouraged from borrowing money and starting or expanding his business due to high interest rates, the country loses out on small scale and medium sized businesses. These small and medium sized businesses are vital to a healthy economy because they provide employment to many people. They also add to productive efficiency of the economy because due to meager resources, they cannot afford wastage and inefficiency, like the large businesses can.

9. Interest is based on expectation and not reality

Interest rates have a component of risk premium. This risk premium is, to a large extent, based on perceptions of the investors regarding how a company will perform in the future. Since interest rates might be fixed well in advance of the actual performance of the company, a well-performing company may end up paying a higher rate of interest than a poor-performing company because the expectations with the latter were higher initially, before the actual performance showed up. So a lot is dependent on prior expectations rather than actual facts that come along later on but can have only a minimal effect. This is not the case in profit and loss sharing, where equity holders can share in the profit only after the company has performed well and has actually made a profit. This way, the profit and loss sharing system rewards the owners of the business when a business performs well, while in an interest based system, actual good performance of the business has little effect on a pre-determined interest rate.

10. Oligopolistic situation

Going by a purely economic argument, productive economic resources concentrated in a few hands would lead to an oligopolistic situation and competition would be reduced, while we all agree that competition is very important for efficiency. In a capitalistic system, too much emphasis and dependence is on people who already possess capital and productive resources (one need not go into details that capitalistic system propagates unethical practices when the only concern of people is to get the possession of capital by hook or by crook). But in awarding unnecessarily high importance to the capitalists, contemporary economists forget that beyond a certain level, incentive ceases to be an incentive. It becomes a cover for inefficiency. This inefficiency today can be seen in both the production by the rich capital owners and their consumption. This is because they can afford to waste. These large corporations can afford to pay high interest rates. They can also get the interest rates negotiated due to their monopolistic bargaining power. This increases economic dependence of a country on a few large corporations and stifles growth of small and medium sized businesses, which are essential for a country's economic health and also for competition. Often these large corporations are the giant multinational companies (MNCs) with huge resources at their disposal. If these MNCs come into a monopolistic position, by crushing the small industrial base of the country, it can have very bad repercussions for the sovereignty, culture and tradition of that country

Conclusion

A very simple consequence of the prohibition of interest is that it produces a balance and uniformity in the distribution of wealth, a more equitable distribution of income and wealth, and increased equity participation in the economy. It has been argued that profit-sharing can help allocate resources efficiently, as the profit-sharing ratio can be influenced by market forces so that capital will flow into those sectors in early history which offer the highest profit- sharing ratio to the investor, other things being equal. Interest has been condemned across the religions and there are numerous evidences to support the claim that an interest-free economy would lead to widespread prosperity and productivity.
 


Najmul Hoda
Senior Lecturer
NIILM Centre for Management Studies
New Delhi
 

Source: E-mail March 31, 2009

          

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