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The Tentacles of Interest
Economic Issues
Muhammad Akram Khan


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 Ribā?’ 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


Interest and Fiscal Deficit
Case of High Indebted Countries


Fiscal Deficit

Interest Payments


































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 Ribā are not based on strong premises. This paper has argued that Ribā 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 hasanah. 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.

1. Drucker, P. F., Managing for the Future, Oxford: Butterworth-Heinemann. 1993, p. 56 ff.

2. Sh Mahmud Ahmad, in his seminal, forthcoming work Man and Money has collected empirical evidence to establish a positive correlation between interest and price level. He has contested Wicksellian thesis of inverse relationship between interest and prices.

3. Panico, Carlo, Interest and Profit in the Theories of Value and Distribution, London: Macmillan Press, 1988, p. 32.

4. Panico, Carlo, Ibid. pp. 177-78.

5. Ahmad, Sh. Mahmud, op. cit.

6. Guidotti, P.E. & M.S. Kumar, Domestic Public Debt of Externally Indebted Countries (Occasional Papre No. 80), Washington: D.C. IMF, 1991, p.7.

7. Guidotti & Kumar, Ibid. p. 17.

8. Guidotti & Kumar, Ibid. p. 18.

9. Sh Mahmud Ahmad has given some interesting examples. A saving scheme in Pakistan offers 5 times the deposit over 14 years. In 98 years, Rs. 1,000/- will grow to Rs. 78,125,000/- i.e. an annual average rate of Rs. 797,193% for Rs. 1,000/-. In another real-life example, Otto F. Shoenbeck, a social worker of Germany deposited 100 Marks in 1972  7% for 250 years. His descendants would receive 221,792,400 Marks in year 2222 A.D., i.e.  887170% per annum. (See Sh. Mahmud Ahmad Man and Money, Chapter-III, pp.29-30, unpublished).

10. Guidotti & Kumar, op. cit., p. 26.

11. World Development Report 1996, World Bank, p. 220.

12. World Development Report 1992 (Statistical Tables).

13. Brandt, W. World Armament and World Hunger, London: Victor Gollanez, 1986, p. 134.

14. World Development Report 1996, World Bank, pp.220-21.

15. Brandt, W., op. cit. p. 149.

16. Chapra, M.U. ‘Islam and International Debt Problem’. Journal of Islamic Studies, 1992, p.230.

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