Friday, November 7, 2008

The Problem with Interest (Poverty and Tangible Driven Economic Order)

The Prophet (saw): said that "Even though usury (may) be much it (thus) leads in the end to utter poverty" (Hadith Al Tirmidhi, narrated by Abdullah Ibn Mas'ud. Ibn Majah, Bayhaqi transmitted it in Shu'ab Al Iman and also transmitted by Ahmad.)

Got this in an email from a brother studying in the UK - thought it's an interesting sharing (thanks Jauhari).

The following was taken from:
The Problem with Interest by Tarek El Diwany (1997). Another suitable read would be probably: The Return of the Gold Dinar by 'Umar Ibrahim Vadillo (1996).

"An Islamic economy cannot be built upon un-Islamic money, and to know why this is so requires a brief digression into monetary history.

The European goldsmith bankers of the seventeenth century are widely seen as the forefathers of modern banking. These men took deposits of gold coins from customers and issued paper receipts in return. Each receipt promised repayment of the underlying gold upon presentation at the bank, and the goldsmith would often charge a fee for his service of safe-keeping. In due course, the public began to trust paper receipts to the extent that they would use them in payment for goods and services among one another.

The goldsmiths' paper receipts had, for all practical purposes, become "money". This development was the key to the goldsmiths' future wealth. They gradually turned to society not as safe-keepers of coins but as lenders of money, and when borrowers came to take their loans they would be given not gold coins but newly printed paper.

The goldsmith had obtained the ability to manufacture money out of nothing, and charge society interest for the privilege of borrowing it. Loans would be secured against property or other assets of the borrower; collateral that could be seized and liquidated if the borrower fell into trouble.

The financing of poorer members of society therefore became the exception from the earliest days of banking practice.

The reason for the lack of profit-sharing in commercial banking emerges when we imagine an economy in which the banking system creates all of the money supply. Here, if a total of 400 units of paper money have been advanced to borrowers on a profit sharing basis, the maximum that all borrowers will be able to repay is 400. No opportunity exists under these arrangements for the banking system as a whole to make a profit. By charging 10% interest on the other hand, the banks may stipulate that 440 is to be repaid in one year's time, thus making the system commercially viable.

Such a stipulation leads directly to what is probably the most disturbing feature of the modern monetary system. If the repayment amount at the end of year one is 440, but there is still only 400 of money in existence, where will the extra 40 come from? The answer is that it has to be created, either under the authority of the state, or by the banking system.

Given that most of the modern money supply is created by the banking system, it becomes immediately obvious why repayment of yesterday's debt tends to leave society in even deeper debt today. If the commercial banks create sufficient money to repay yesterday's debt we enjoy a healthy or inflationary economy. If they don't, recession or deflation will eventually arise.

The former scenario is adopted as a policy target by almost all modern governments, but leads inevitably to an increase in both debt and money supply in the long term.

At a time when education, health and housing services are suffering financial stress in many countries of the world, an almost embarrassing bias in resource allocation towards the banking sector is encouraged by the interest-based monetary system.

In August of 2002, Fortune magazine ranked the top 500 global corporations of 2001 by revenue. Taking one example, 33 of those companies were in the UK, and among them were six banking organisations. These UK banks made $20.62 billion in profit during the year. All of the other UK corporations on the list, when added together, made a loss of $0.97 billion. 37 companies on the Fortune 500 were headquartered in France. Here, the five banks made $7.99 billion profit, and the remaining 32 corporations when added together made a loss of $2.41 billion.

Today, Islamic commercial banks indulge in money creation just as much as conventional commercial banks. This single sin is sufficient on its own to conclude that Islamic banking isn't Islamic but, as the earlier example demonstrates, it is a sin that requires interest-based lending in order to make it profitable.

Though Islamic bankers may not realise it, the business model of interest-based banking is forced upon them and it is putting true profit sharing beyond their reach. The crop of 'Islamic' mortgages that are now appearing in the UK are a clear manifestation of the fixed rate mentality that now predominates in Islamic banking. In not one of those mortgages does the bank contract to take capital risk. Even in the so-called Ijara mortgage, in which the bank is held to own the property and rent it to the client, arrangements have been put in place to pass capital risk to the lessee. Thus, if the client is unable to keep up with rental payments and the property is repossessed by the bank, the bank has recourse to the client if it realises a capital loss when selling the property on the open market.


In time, a fresh start will be made in Islamic banking practice. An entirely new methodology will be adopted, one based upon a surplus of money, not upon the artificial shortage that is maintained by the modern commercial banking system. Debt will no longer be the pre-requisite to every major act of spending or investment.

The time value of money will no longer dominate our view of how to manage the earth's resources, for the money with which we measure value will no longer bear interest as a condition of its creation. I believe that this change will occur either by force of reason, or by force of circumstance as the world grows weary of perpetual indebtedness.

The society that witnesses the change to interest-free money will recognise the new system as a pillar of true freedom. It will enjoy the release into productive employment of substantial human and physical resources, those that are presently engaged in the value-subtractive processes of the modern financial economy.

There will of course be much resistance to such a change, and the lobby that presently benefits from the interest-based monetary system will spend heavily in order to protect its future."


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