Monday, September 9, 2013

Islamic finance and interest.

No one with more than three brain cells falls for the argument that interest is wrong because it says so in the Koran. But there are some Muslims who can produce better anti-interest arguments than the above “learn by rote” argument.
One is TarekEl Diwany. One anti-interest argument he puts is flawed, but it's an argument that many non-Muslims also fall for, e.g. Paul Grignon.
It’s the argument that goes as follows (in green).
If commercial banks create money and charge interest on it, where does the money to pay the interest come from? It can only come from creating yet more money. Ergo interest gives rise to a vicious circle: a never ending increase in the money supply.
The flaw in that argument is that interest payments are simply part of a FLOW into and out of the banking sector. That is, the non-bank sector certainly has to pay interest to banks. But banks in turn pass on the money to various non-bank sector entities: shareholders, bondholders, depositors, bank staff, etc. Plus banks have to pay for a whole host of expenses: computer systems, building maintenance, etc.
Thus no PERPETUAL increase in the money supply is needed.

Money creation means debt creation?
Diwani puts another anti-interest argument here. Again, this is an argument that many Westerners fall for. It’s the argument that for every £ of money created by commercial banks, there is a £ of debt. And debt is bad, bad, bad.
The reality is a bit more nuanced, as I’ve explained here. To summarise, one type of bank activity is to CONNECT borrowers and lenders. To that extent, banks to not create debts: they simply facilitate or organise an activity that would take place even if there were no banks: one person lending to another.
A second activity of banks is, as Diwani correctly spells out, is to actually create money. As I explain at the above link, where banks simply create money to enable people to engage in day to day transactions rather than with a view to borrowing a significant sum for an extended period, it is true that those who the bank supplies with money undertake to eventually pay it back, so to that extent a debt is created. But there is no reason to charge interest.
Interest is a payment in respect of forgone consumption. E.g. if I abstain from consuming goods and services so as to enable someone I lend to be able to consume real resources, I’ll probably want a reward for doing that. And that is genuine interest.
Now if a bank just takes someone’s collateral and credits £Y to their account, the bank does not forgo any consumption: it just does book-keeping entries.
In contrast to genuine interest, the bank WILL CHARGE FOR the administration costs involved in setting up the latter loan, and it may very well CALL THAT CHARGE “interest”. But it’s not genuine interest.

Resource depletion.
Another argument put by Diwani here is that interest leads to resource depletion or non-sustainable forms of economic activity.
I suggest the arguments for and against interest are quite separate from arguments about sustainability. For example, if a business borrows nothing at all, the owner of the business will always be tempted to extract extra profits in the short term at the expense of environmental despoilation in the long term.
If Diwani’s above three points are any guide, Muslims are in as much of a muddle when it comes to banking and money as the West.

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