3 Principles for an Interest free economic system

A person who is maintaining a current bank account, never took any loan, and if the need arises, opts for an Islamic banking route for financing, may have a genuine question as to why he/she should at all be worried about an interest in the economy.

It is important to address this concern at the outset before moving forward and here are the 3 key reasons:

• From Pakistan’s perspective, almost 60% of our tax is going towards debt servicing. So even if someone is not directly engaged in interest-based transactions willingly or willingly he is contributing towards that.
• Rate of return in Islamic banks is also based on the conventional KIBOR; hence assuming doing business with Islamic banks is completely interest-free, carries a big question mark?
• Last but not the least; interest has an overarching impact on society and not only restricted to few individual decisions; meaning the true benefits can be reaped only if an economy is completely interest-free.

Understanding the root cause of interest

Now, before touching on as to how interest can be eradicated from an economy it is of significant importance to understand the root cause of interest in our modern economic system. The below-presented graph sheds light on the subject:

We can see here that in the last 20 years or so the growth in the quantity of money in an economy is outpacing the growth in our Gross Domestic Product (GDP). What does that mean? It means that fewer goods are being chased by the comparatively large sum of money and the one that is in large supply would naturally start losing its value hence causing inflation in an economy being represented by the gray bars in the above chart.

The Vicious Circle

Next question: Why is the quantity of money more than GDP and what it has to do with interest?

I call it a vicious circle and it starts from the fact that the government earns less than what it has to spend resulting in either printing money or borrowing from the public. When it prints money, it erodes the value of money and creates an expectation in the mind of lender that he has to at least cover up for this erosion in the value of money and hence needs to charge interest. Similarly borrowing money from the public sets a base rate or a price to the money. An example of this is treasury bonds that were being traded to the tune of PKR 29 trillion in FY 2019; almost 80% of GDP.

This is a pure creation of money out of money and money being traded as a commodity. Further, our daily avg. volume of the Stock Exchange is around PKR 23 billion approx. 15-20% of what is being traded-in money market. This kills the genuine business.

When banks know that they can easily earn by lending to the government, without taking any risk, why would they bother in providing financing for the business? This reduction in business activity reduces tax collection again giving rise to fiscal deficit and printing more money. 

Three Principles to Come Out of The Vicious Circle

In my humble opinion, 3 principles need to be implemented and followed to come out of this vicious circle.

1. Money to be used only as a Medium of Exchange

Money has a long history but without going into details of what has been used as money throughout human history, we just need to objectively think about the purpose of money and whether currently it is serving that purpose or not.

We know that money is the fuel to the economy but not an economy in itself. Numerous transactions are executed on a daily basis. These transactions cannot be made through exchanging goods because our needs and timing of those needs may be different, hence we need a judge, a mediator in between to complete these transactions and this is where the money comes in. Hence money its self is not an objective rather a means towards reaching the objective.

Do we think that when approximately PKR 140 bn worth of treasury bills are traded in a market; money is used as a medium of exchange? The answer is No.

When money is used only as a medium of exchange and not as a commodity, then it will be utilized in productive assets or for exchange of real goods and services hence ensuring the flow of wealth. Also, the price of goods and services will be determined only concerning their respective supply and demand position and not be impacted by the designed inflation in the system

2. Business is about accepting and embracing risk

Business means risk – we all know, but then why do we expect to get a fixed return or want to give a fixed return and not share the actual profits? We currently have available windows of opportunity in the form of treasury bonds etc. where the price of money is set considered as the risk-free rate of return. Hence, the expectation is always to earn something more than that and taking minimal risk. When money will be used only as a medium of exchange and there are no markets available that set the price of money itself, then investment will be made in the business as it deserves.

3. Tax as a policy lever to incentivize business and discourages hoarding

Tax has an important role to play in this whole equation of having an interest free economy. Not only for plugging the fiscal gaps but also to ensure the flow of wealth in an economy, hence through tax policies, money being invested in productive assets and for employment generation should be taxed at a lower rate and the one being hoarded in the form of cash or unutilized assets, at a higher rate.

Making It Happen

These are very basic principles but, in my opinion, are key to bring shared economic prosperity. A mindset that is too quick to separate what is practical and what is not, would not work. We need to have a mindset that is passionate enough to make practical what is right, and stop doing that is practical, but wrong.