Articles on Islamic Economics

Distributional Inequity and Welfare Loss in Interest Based Financial System

Salman Ahmed Shaikh

Capitalism, the way it is practiced as an economic system, has largely allowed and provided legal cover to certain exploitative institutions and their operations based on free market philosophy. Such institutions have been chiefly responsible for much of the distributional inequity in the world today.

To put the matters in right perspective, income inequality even in OECD (Organization for Economic Cooperation & Development) countries is at its highest level for the past half century. The average income of the richest 10% of the population is about nine times that of the poorest 10% across the OECD, up from seven times 25 years ago. OECD countries represent developed world with sophisticated financial markets.

High income inequality in OECD countries shows that more sophisticated the interest based financial system, less equitable the income distribution will be and as various reports suggest, the high economic growth even in long term does not and has not made income distribution to become equitable. Rather, economic growth has worsened income distribution. Past growth experience of Japan and USA or even recent growth experience of India and China has resulted in increased income inequality in these countries. Growth not only has failed to improve income distribution, but when it is obtained in presence of interest based financial system, the income distribution has worsened as the empirical evidence shows for these countries.

Having perfect markets leads to efficiency and economic welfare, but the institution of interest hampers potential investment by arbitrarily making capital scarce. It encourages concentration of wealth and creates a barrier in the way of use of funds in the productive enterprise. Positive economics says that given an interest based investment opportunity; consider productive enterprise only if the rate of return exceeds the market interest rate, but positive economics does not consider the negative externalities. For instance, increased income inequality, poverty and below full employment use of real scarce resources resulting from artificially making capital scarce.

No matter whatever is the initial distribution of wealth in society, interest based financial intermediation can bring concentration of wealth eventually in every society by granting private right of fiat money creation to central bank and allowing fractional reserve banking system which gives right to private banks to create credit money. Apart from the people from top income group, majority of people remain financially excluded due to income based lending criteria and requirement of collateral.

Industrialization gave birth to sustainable economic growth in countries that led the technology frontier. This growth was not equally shared across countries and hence, it created the gap between the pioneers and the laggards. In the twenty first century, we face the challenge to ameliorate the great gap between the rich and the poor countries that has appeared in the course of twentieth century economic growth program. Nonetheless, many of the poor countries are trapped in huge levels of debt. Debt servicing takes away a major portion of public revenues. As a result, many poor countries spend less on health and education than on servicing debt denominated in fiat currency. Often, the poor countries export their natural resources and commodity exports to fill the debt servicing burden. Natural resources and real sector output is used to pay interest on debt denominated in fiat currency. In the debt markets, developed countries are able to raise debt at near zero interest while the yield on debt issued by poor countries is the highest.

On the other hand, tied aid, non-tariff barriers and the squeezed space for bringing industrial reforms hamper value addition and sustainable economic growth. Countries with high incidence of poverty like Gabon and Mozambique pay as much as 1.5% and 1.4% of their GNI in interest payments alone on their external debt. In at least 9 countries, the interest payments as percent of GNI exceed net ODA received as percent of GNI. These include Kazakhstan (-2.08), Lebanon (-1.48), Indonesia (-1.27), Turkey (-1.11), Malaysia (-1.0), Gabon (-0.71), Tunisia (-0.42), Guyana (-0.13) and Algeria (-0.01). The numbers in parentheses indicate the difference between the net ODA received as percent of GNI and the interest payments on external debt as percent of GNI.

Income inequality can result from wealth inequality if there is fixed return on loanable wealth in the form of interest. Interest based financial intermediation brings concentration of wealth eventually in every society by granting private right of fiat money creation to the central bank and by allowing fractional reserve banking system which gives right to private banks to create credit money. This money capital can be loaned out and fixed interest can be earned on it. As per Oxfam, 26 people together own the same amount of wealth as the combined wealth of 3.8 billion people who make up the poorest half of humanity. These 26 wealthiest people own $1.4 trillion. Interestingly, 10% interest on it can give them a risk-free increase in wealth of $140 billion, just enough to feed all the poor people for eight months of the year alone.

The disincentive to enter in entrepreneurial pursuits because of lack of willingness of capitalists to risk capital while having the opportunity to earn fixed interest income brings down investment in the economy. Decline in the potential investment in productive pursuits reduces real sector economic growth, keeps unemployment high and it adds burden on fiscal position of the government to expend on transfer payments. Then, if more money is printed, it increases national indebtedness and which can eventually result in a country paying major portion of its gross national income every year in the form of interest, which is a price of valueless fiat money in a loan transaction.

In the Islamic economics framework, the principle of risk based productive enterprise can foster capital formation and entrepreneurship. Islam disallows fixed return on money capital in the form of interest. Interest free financial intermediation can stabilize the economy from credit default shocks by ensuring wide risk sharing. A uniform Zakat levy on wealth and produce can result in tax rate smoothing and automatic stabilization of business cycle. Inheritance laws of Islam ensure intergenerational redistribution of endowments. Endowment redistribution in every generation in each family unit can automatically keep the inequitable distribution of resources in check without depending on the pace, nature and distribution of economic growth.

8 replies »

  1. Islamic finance is also in practice now since few decades. But still, it lacks in addressing the issues raised in article on conventional economic system. Equity financing is just a nominal portion of Islamic banks portfolio. The issue is capitalist orientation which even exists in Islamic finance practices. So, we are not moving ahead to tackle the real economic issues as pointed out in the article.


  2. I certainly agree that interest-based financial systems by definition make the rich richer and the poor poorer, but I am afraid that the problem goes well beyond Capitalism. We see the same widening gap between the rich and poor in Islamic countries as well. We even saw similar issues under Communist regimes because it’s not only about money – but also about power and privilege going unchecked.


    • Yes, I totally agree with you Cliff. Interest based financial system is widespread in Islamic countries as well and no country can claim to be interest free. Yes, power disparty leads to both wealth and income inequality. Power and privilege can be better checked through independent and strong judicial system and participative and accountable democracy.


  3. ….Even Adam Smith’s “invisible hand” to perfect market mechanisms in the “long run” has failed to deliver. The question is how long is the so called long run? infinity?.
    And for the person requesting models, it is striking that he cannot see wisdom in practical reality. This and similar false claims with concepts like “factual”, “objective”, “universal” and all other jargon is being used to deceive the rest of humanity for more than 200 years. Enough is enough.


  4. Br. Salman, it is now an open secret that classical economics was founded on deciet, self interest and greed. It was never meant to provide nor capable of providing effective solutions for world’s economic problems. This assertion is attested by one of the founding fathers of neo classical economics (Keynes); “pretend that fair is foul, and foul is fair” “for foul is useful and fair is not.” By pursuing wealth using foul means of avarice and greed, humankind should free itself from economic problems (Khan, 2004).


  5. From this article, can we conclude that economic growth is neither necessary nor sufficient for reducing social inequality? What I mean is that can we generalize the empirical outcomes? I completely agree with you that banks are deliberately pushing interest rate at a point that curtails the potential level of investment, and with their surplus funds, banks are involving in direct investment in stock markets and indirectly through providing margin loans to stock market investors.


    • Economic growth is vital, but how it is achieved and with which institutional mechanism it is achieved, makes a big difference in its sustainability and socio-economic impact. Wealth inequality exists and is perpetuated and worsened by interest based system. Financial intermediation along the lines of equity financing has better prospects from distributional standpoint. This is complimented by interest free economy, levying wealth tax in the form of Zakat and lenient and broad based income tax on income (like Ushr and Khamsa) can greatly facilitate investment and growth in production along with positive impact on income distribution. On the monetary architecture, we also need to study how alternate monetary standard can facilitate the economy. Indeed, fiat currency is not ideal and the process of money creation which ultimately involves debt creation also needs to be altered.


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