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In my previous article I touched upon the power of incentives.
I gave logical arguments questioning the existence and use of interest rates.
This was followed up by a quick history lesson on money.
I highlighted how money isn’t a commodity but a unit of account. Money is a way to measure the value of something and a medium of exchange.
It’s not to say that we can’t use commodities - like gold and silver - as money.
The issue lies in our economic system commoditising money and commercialising lending. Lending is a business. Money is commoditised and traded as if it were an actual good.
A lender can profit from lending money. Whether the money lent to the borrower results in an increase in economic output is an after-thought.
On the one hand, the lender guarantees themselves a return. On the other hand, the borrower will have to pay more than initially borrowed whether they used the proceeds of the loan profitably or not. The lender will ask for collateral as protection in case the borrower cannot pay back the loan with interest.
In Islam this is unfair.
The time value of money is not a sufficient reason to lend at interest. On top of that, money is given unique features that differentiate it from any other good that would be rented or bought.
If you have money, your role in society is not to profit without taking risk alongside the borrower.
If you can secure the loan you give with collateral, do you really care what the money will be used for if you’re guaranteed a profit? This isn’t the best way to allocate capital to where it’s most effective for society.
To clarify, Islam doesn’t prohibit free markets.
Islam teaches us to establish free markets with the right incentives to maximise positive outcomes for society as a whole.
Islam requires us to think beyond the individual.
Otherwise, we end up with a world where the level of inequality becomes ridiculous. Like the world of today. Inequality is a result of our debt-based system (amongst other things).
Those at the top of the social ladder have quality assets. They have more borrowing power. If you want to lend money as an investment, they’re the safest bet. Your risk is practically zero if you lend them money secured against their collateral.
How does your decision affect society as a whole?
Islam promotes second-order thinking. To think beyond the self. To think of the long-term implications.
In this example, investment capital will flow towards those at the top before it funnels its way down. What beats guaranteed profit with very little risk? Why bother going through the process of due diligence and take on risk by taking an equity investment?
Capital becomes trapped within the asset-rich.
You can make a counter-argument. Interest rates will eventually drop as the supply of capital increases. Lenders will chase riskier borrowers to charge higher interest rates. Equity investments will also become more attractive.
It’s a fair point.
But why wait until that happens? Must society rely on trickle-down economics? Islam prevents that from happening in the first place.
Why wait for the forces of the free-market to get to the point where capital is allocated more efficiently?
An economic system without interest rates flips the financing model.
There’s no longer guaranteed returns that are secured with collateral. The priority becomes investing in sound businesses or assets. You create a fair and efficient market where true entrepreneurial spirit can take shape.
This is what Islamic finance aims to do. To create a real marketplace for solid business ideas.
The best business model wins.
The focus turns to generating real economic output.
This provides a level-playing field for everyone to participate and benefit from. Allocating capital efficiently is the real economic problem that Islamic finance solves.
This is just one side of the story.
I’ve oversimplified Islamic finance and the investment options available to keep things brief. I’ll discuss these in more detail in later articles.
One important note to remember. Without debt and interest rates, economies wouldn’t be able to grow as fast as we have been experiencing. Leverage gives us the option to consume a lot more. Undoubtedly there would have to be adjustments on a macro and personal level. Most people wouldn’t accept a world without leverage.
But a world without interest would see smoother economic growth with less volatility. No more debt cycles. No more booms and busts. I’ll touch upon this at the end of this article.
For now, understand that interest rates create the incentive that misallocates capital. It keeps money circulating in the hands of the few until it must chase ‘riskier’ opportunities.
To get a real grasp of what I meant by the “commercialisation of lending” we need to take a closer look at what banking really is.
Imagine you had the power to create money out of thin air.
Some members of society hold that power.
Those are the bankers.
You may think that banks are simply an intermediary. They lend out money deposited by savers.
Not at all.
When you borrow money from a bank, they create new money in the form of a loan. With the touch of a few magic buttons, the credit given to you is new money.
The bank becomes a magic money-making machine. It creates new money (i.e. credit) to lend it out and charge interest. Simple.
Most of the money we use is actually credit.
You often hear that money makes the world go round. But more accurately, credit makes the world go round.
On top of that, the bank doesn’t have all the cash on hand to cover all deposits.
In most cases, a bank only needs to keep 10% in reserves and lend the rest.
So if you deposit $100, the bank can lend out (i.e. create new money) equal to $90. This only works because the bank knows it’s unlikely you’re going to need all of your $100 at once. Now scale this over millions of customers, and there’s a minuscule chance that every single customer will come and collect all their cash at once.
If they did, a bank-run would ensue.
The bank simply doesn’t have all the cash needed to cover every deposit.
Yes, it sounds like a ponzi scheme. Because it is.
The more technical term is fractional-reserve banking.
Sure, there are risks involved but in most cases this works relatively well. I say relatively well because history shows that bank-runs aren’t totally rare.
But generally it’s fine. Until it isn’t.
So if there’s a risk of a bank-run, why would the bank operate this way?
The answer is simple. Because of incentives. Of course, they’ve been granted powers to create new money. But because of interest rates, they have an incentive to lend newly created magic money.
Let’s go back to how this all started.
You’re a successful merchant in London in the middle of the 17th century.
You’ve accumulated a bunch of gold, because that’s what’s used as money during this time. You need to store it somewhere. You take it to the goldsmith banker who will keep it safe for you.
In return you receive a note that says you own a certain amount of gold. Whenever you want, you can give them this note in exchange for your physical gold.
You now need a new horse cart.
Most other merchants expect to receive gold for any of the goods they sell.
But you’re not bothered to get your gold from the bank.
You tell the horse-cart seller that you’ll pay with the same note (assuming it’s equal in value to the price of the horse-cart). The merchant knows the bank that issued the note. They trust the bank will give them the gold backing the note if they ever asked for it.
But do they really need to take the gold out? Not really. They can use the same note with other merchants and exchange it for other goods.
The goldsmith bankers realised this.
Most people were making transactions using these notes that were backed by physical gold. Very few came to collect their physical gold.
Guess what happens next?
“Show me the incentive and I’ll show you the outcome”
The goldsmith bankers started lending ‘money’ in the form of notes that were backed by gold. They created new money to do this, similar to how I described it above.
But was there enough gold to back all these loans? Clearly not. They just banked (pun intended) on the owners of the gold deposited not coming and collecting all their gold at once.
Given the goldsmiths could make money by lending out money (i.e. issuing notes) that’s what they did. Thanks to interest rates, the fractional reserve banking system was born. They only needed a small amount of physical gold for the amount of notes issued.
Whether new money in the form of notes was used for anything productive didn’t matter to the goldsmith bankers. All that mattered was the interest rate they would receive for each loan.
This evidently came with risks. The goldsmith bankers were incentivised to lend out a large amount relative to the amount of physical gold they stored. Eventually many of them went through bank-runs.
So interest rates provide an incentive for banks to create new money.
But newly created money leads to booms and busts.
You’re told that economic expansions and recessions are natural events of the economic cycle.
But how do they come about?
It’s all down to credit.
As the economy expands, as more people join the labour force, productivity increases and economic output increases.
This naturally leads to people wanting to invest more and consume more.
They’ll borrow money for this. Why wait for future income when I can spend and invest now knowing that my future income will cover it?
Banks are happy to lend during the good times.
New money is created. The supply of money increases.
This new money is used to further increase consumption and investing which leads to further economic growth.
Asset prices increase thanks to increased investment and spending. This further stimulates borrowing.
As long as incomes grow faster than the interest expense on the debt this is fine.
But what happens when that’s no longer the case?
When debts become unbearable - they eventually do because of greed - consumers and businesses have to cut back spending. Consumers spend less. Businesses lay off workers to cut costs.
So the reverse happens.
Not only that. But every time a debt is paid back the newly created money is destroyed. The money supply shrinks.
To pay back debt you need to sell assets or reduce spending. That’s the equivalent of an economic u-turn.
You see, money was created without tying it to real economic output. The new money is issued first which then chases goods or investments.
Put this in reverse and the economy contracts. Simple boom and bust.
We won’t ever be able to escape the cycle of economic highs and lows as long as we have debt. As long as credit is there.
Why?
Because the incentives make it so.
A bank has the power to create money. The most profitable way to use this power is by creating money that can be lent out at interest.
This is inevitable.
Well what if there was no interest rate?
You’re probably thinking: what does an economy without interest rate look like? Is it possible?
We’ve established how interest rates incentivise the commercialising of lending instead of participating in economic growth. The banks are less focused on trade but prefer exchanging money.
They think they trade. Their argument is that thanks to lending money they are participating in economic trade. But that’s technically misleading.
Not only that, but interest rates don’t allow for the most efficient allocation of capital. We’ve covered that previously.
A bank would rather lend to someone that has collateral. So the asset-rich individual will be able to borrow more. We see how this keeps the wealth within the hands of a few before it trickles-down.
The one thing we can all agree on is that capital will always chase returns.
We all want our wealth to grow.
This isn’t bad from an Islamic point of view either:
The second caliph, Umar ibn Khattab (may Allah be pleased with him) advised:
“Trade with the wealth of orphans so that it will not be eaten away by zakat (i.e. charity)." (Muwatta Malik, no. 592)
If we are incentivised to invest in order to grow our wealth, naturally the money will go to where capital is needed. If there’s no interest rate, the only alternative is by investing in business ventures.
Let’s say you’re a wealthy person and you have $1m to invest.
You have to choose between:
A - Buy US government debt that provides an annual interest of 5% (where the US government gives you the strongest form of assurance to pay back the money - future tax dollars of US citizens).
B - Invest in a relatively safe business business but the cash flows are less predictable.
If the investor is risk-averse, 9 times out of 10 they will pick option A. So capital goes from the wealthy to the government and in return they receive interest.
A great incentive for the investor.
A poor incentive for the economy given capital isn’t flowing to where it’s needed most.
So if option A is removed then clearly the investor will have to choose between different types of ventures. They can invest in a mature company with steady cash-flows or a tech start-up depending on how much risk they want to take.
Capital will flow to productive use-cases.
Capital will now chase the best executable ideas. It’s not a matter of just seeking returns. It’s a matter of investors now striving to see businesses flourish because the incentives are aligned with the business owners.
This is how to create a circular economy.
Where investors share risks and profits with those seeking investments. Capital flows to where it’s needed most for real economic production.
Now I touched upon government debt in my example above.
The fractional-reserve banking system (the technical term for ponzi banking) incentivises politicians to keep borrowing.
If you’re a politician, you know you can win votes by promising to spend more on infrastructure, education, healthcare or whatever it could be.
Will you need to create a fund that investors can invest in directly to share the risks?
Of course not.
You can’t be bothered with coming up with a profitable investment plan that will get investors onboard.
You can simply issue debt. Debt that is backed by future income tax and use that money to spend on your “promises”.
On average you're in power for 5 years. You have no skin in the game. Whichever decisions you make, once you leave your job, you’re free from all repurcussions.
You’re able to make economic decisions that will impact the next decades.
Is that fair?
There’s a clear misalignment of incentives. Politicians are borrowing from the future income of its citizens. Future generations will pay the price. Most likely with an increase in taxes.
This is a real issue. Look at developing nations borrowing from international institutions like the International Monetary Fund (IMF). This ‘international bank’ is often seen in a positive light. Revered as a savior for helping developing countries boost their economies.
Many emerging and frontier economies become trapped. They’re buried in debt owed to the IMF.
Guess who then decides how these indebted countries spend their money? That’s right, the IMF.
They will impose measures ‘to balance the government budget’ should they fear that the borrower can’t pay back its debt. All this does is divert the country’s resources away from its people to paying off this debt. In the end it’s the average citizen that suffers.
On one hand, you can say that the IMF has a right to be paid back for having loaned the money. They took on that risk. That’s what modern society has come to accept. Islam prevents such lending in the first place.
Remove interest rates and you remove the incentive for investors to seek investment in debt instruments.
The debt market no longer becomes the biggest investment market in the world. Investors no longer have the option to invest without sharing the risks. Capital flows to the most productive use cases where real economic output is generated.
What would the world look like then?
In 2022, the global debt market totalled $300 trillion.
How would this capital be invested differently if there were no interest rates?
It's something to think about
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P.S. I hope you enjoyed this 2-part article on interest rate and incentives. I’d love to hear your feedback and answer any questions you may have.
I manage a $100m private investment fund and I explore Islamic finance and economics through a personal lens. I help simplify financial markets from a Muslim perspective.
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