The question of interest has occupied thinkers for more than two thousand years. Aristotle came to the conclusion that interest is illegitimate and cannot be justified, since “money cannot beget money”, unlike all living things which reproduce themselves. Since “money cannot beget money”, Aristotle argued that it is unreasonable and impossible to demand that money lent should be repaid with a greater amount than the amount of the original loan.
The thinking of Aristotle influenced the Catholic Church, which for centuries banned the taking of interest. Loans with interest were made by Jews, not subject to the laws of the Catholic Church, and by Christians who sinned in doing so, and circumvented the prohibition on interest by schemes which hid the interest under other labels. It was at least partly due to a sense of having sinned, and in atonement for it, that the heads of the great financial dynasty of the Medici of Florence contributed so heavily to the building of the Renaissance temples of that city, and paid splendidly for the beautiful religious art of that period.
There is still, today, a minority who agree with Aristotle. And of course, there is the Islamic ban on the taking of interest, which is substituted in Islamic law or sharia, by having the lender participate, according to a set of rules, in the profits expected by the borrower as a result of obtaining a loan. (Note: I am not endorsing all modern Islamic banking, because it seems to me that the Islamic bankers may be evading their religious law by various schemes, just as the Medici did in their time; one important Islamic scholar and leader has told me that Islam is flatly against all payment of interest whatsoever.)
A popular argument against the Western banking system is frequently expressed as “the banks make loans and in doing so, create money; but they do not create the money to pay the interest. Therefore, the system is unsound and must collapse eventually.” This would appear to be a variant of the Aristotelian objection.
The argument that “banks make loans and thus create money, but do not create the money to pay the interest on the loan” is a specious and confusing argument because, on the one hand the power which modern banking systems have to create money out of nothing by granting credit is an anti-social power based on fraud, since real money can only be gold and silver and these cannot be created out of nothing. And on the other hand, the idea that “there is not enough money in existence at any moment to pay the interest due on loans” is fallacious, because all interest does not come due at any given moment; the payment of interest takes place over time as debts mature and become payable.
The Western banking system has undergone great development, because it has separated the concept of profits from the concept of interest. The prudent banker will want to understand the borrower’s business plan, and how the borrower will use the funds loaned in a way that will produce a profit, but more importantly, he takes care to insure that his loan is given a right of precedence in payment over other obligations of the borrower, and besides that, he may insist on specific guarantees (collateral), and perhaps co-signers as well, on behalf of the borrower. This is done, so that regardless of the profitability of the venture undertaken by the entrepreneur, the banker can be reasonably sure that he will collect his loan and the interest payments on it.
This separation between a) the concept of the profitability of the endeavor for which the loan is granted and b) the concept of the legal right to collect the interest, must date to ancient times; but earlier still, at its very birth, Interest arose out of profit-sharing: the merchant who wished to send his quinquereme across the Mediterranean "with a cargo of ivory, and apes and peacocks, sandalwood, cedarwood and sweet white wine" required an investment to make his enterprise possible. He went to the trapezai - the local bankers - and found one willing to risk his money in return for a portion of the profits of the venture. Over time, this profit was reduced by market practice to various standard percentages and became known as Interest. In the course of its evolution as a financial concept, the origin of Interest as a participation in Profits was forgotten.
It seems to me that the connection between Interest and Profit has been rediscovered by NASOE, the New Austrian School of Economics (see www.professorfekete.com), which points out that the lower bound of interest rates is determined by the Time Preference of the marginal investor, who will keep his gold if the rate of interest on an investment - let us call it a Bond - is insufficient to satisfy his Time Preference, and the upper bound of interest rates is determined by the marginal producer, who will sell his productive enterprise and purchase the Bond if the Bond yields more than his enterprise. Purchasing the Bond raises its price and thus caps the rise in the interest rate. In this way, NASOE is once again linking the upper bound of interest rates to the profitability of industry and commerce - as occurred when Interest first made its appearance in human affairs.
Interest has been regarded as a phenomenon in itself; perhaps as if sunlight could be studied separately from the existence of the Sun. The separation between a) the concept of the profitability of the endeavor for which the loan is granted and b) the concept of the legal right to collect the interest, has allowed specialization in the activity of Western finance and its consequent growth. The banker’s business is simply to make loans and collect both the loans and the interest, and no more. The banker in effect says: “Whether you make a profit or not, I want my interest, and I want my loan paid back.” This specialization of the function of the banker and this limitation of his interest and responsibility has produced high efficiency in Western banking; at the same time it has introduced into society an anti-social element, for the banker has been granted a legal right to demand payment of the interest due on his loan; if not forthcoming, the banker is legally entitled to carve up the debtor’s substance, in effect getting his “pound of flesh”, in order to recover his loan and accrued Interest.
In my view, the answer to both the old Aristotelian objection and the modern objection is that payment of interest cannot be anything else than a name given to a distribution of profit, in other words, another name for “dividends”. It seems to me that the distinction between “interest payment” and “dividend payment” is merely a legal distinction, not a real distinction.
This is why the modern concept of “EBITDA” is so important to financiers. The letters stand for “Earnings Before Interest, Taxes, Depreciation and Amortization”. The importance of “Earnings” is primordial for a very good reason: if there are no Earnings (profits) the payment of Interest is in jeopardy, as well as Dividends.
Successful entrepreneurial activity leads to the creation of profit. There is such a thing as profit, and no one disputes its legitimacy. If the creation of profit is a reality, then the distribution of profit to the equity owners of an enterprise is also legitimate and certainly possible. Conversely, if there is no profit, there is no substance which can be distributed either for interest payment or for dividend payment. In actual reality, it is the creation of profit that makes payments of both Interest and Dividends possible.
This is the approach to lending of the Islamic banking system: the lender is entitled to a share in the profits of an enterprise which he finances, subject to the existence of those profits. This share may be negotiated, but the fundamental question is that there must be a profit to share, for the lender to obtain what we call interest. (The sharia law that governs Islamic banking includes provisions for the recovery of the lender’s capital, which are not pertinent to the present discussion of the subject of interest payments. Again, I must emphasize that not all Islamics agree regarding the religious legitimacy of "Islamic banking").
This approach to the question of Interest, by those who favor Islamic banking, eliminates the objections of both the Aristotelians and the modern day critics who say that at any given moment there is not enough money in existence to pay the accrued interest: the payment of “interest” is another name for a distribution of profit. Under Islamic banking, a loan and interest are substituted by a sort of transitory equity agreement; the loan takes the form of an equity participation in the enterprise, which ends when the equity investment plus the profit it produced is returned to the investor.
Islamic banking is in this respect quite unwieldy when compared to Western banking, but in my view, it is just and realistic. It also makes for more prudent banking, for a slower expansion of credit. It is a just system, because it unites the interest of the entrepreneur in obtaining a profit, with the interest of the lender in the same objective.
The specialization of the Western system of banking, which divorces the objective of the entrepreneur from the objective of the lender, has allowed the great growth of finance in the West but at the cost of justice; for if interest is only another name for a distribution of profit, how can payment of interest be justly demanded if there is no profit to distribute?
Western banking rides roughshod over this reality – the fundamental requirement of the existence of a profit that can be distributed – and allows the banker to liquidate the operations of the borrower and pay himself a non-existent profit when he collects both the loan and accrued interest in a bankruptcy court.
We, who operate under the Western banking system, have seen to what depths of injustice it has descended as illustrated in the predatory lending practices described by John Perkins in his book, “Confessions of an Economic Hit Man” (Berrett-Koehler Publishers, Inc.) This lending, as documented by Perkins, is done with the ulterior criminal object of taking possession of the borrower’s assets, whether the borrower is a corporation or a sovereign nation, and not, as most of us assume, with the intention of providing funds to further the borrower’s productive activity, with the simple objective of collecting interest and eventually, the capital loaned.
Critical remarks have been expressed with regard to the outrageous behavior of certain bankers named by Perkins, but what is really necessary is an evaluation of the general constitution of Western banking, which is conceptually structured in such a way that it makes such outrages possible.
The relatively unwieldy Islamic system has the virtue of being realistic, in that it obligates the lender to be much more careful in his approval of a loan, since the failure of the borrower to make a profit implies no return of “interest” (which they call a “share of the profits”) upon the loan. Both lender and borrower are partners in any venture.
The divorce between the interest of the borrower in taking a loan and the interest of the banker in granting it is to a degree responsible for the condition of excess which prevails in Western finance, currently enjoying a boom gone out of control. We are all going to pay a costly price for this divorce which in the last analysis is a divorce from economic reality.
A final note: I have no interest in promoting Islam. If I refer to Islamic Banking, it is because it provides an alternative approach to the question of Interest in the realm of finance.