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.