In modern times, the institution of interest is regarded as critical for the stability of an economy. Nearly all the economic and financial institutions are, in one way or the other, connected to the interest based transactions. Interest is considered as an incentive to save money. Secular economic theory claims that the whole interest mechanism guarantees an efficient allocation of available funds. It keeps the flow of credit stable in the economy.
Today, nearly all financial institutions work on interest based transactions. They all share a common belief that interest based systems provide good incentives to invest and simultaneously earn as per the standard requirements, the result of which ultimately leads towards capital formation and economic growth.
But in practical world, this is not the case every time. What if a person bears a loss? Or what if he cannot afford to pay above the principal amount he borrowed? In both the cases, one becomes a permanent slave of the creditor. He loses his identity and becomes bound to obey what the creditor commands. Today, Pakistan has to pay half of its tax revenues in paying interest alone.
In the earliest times in recorded history, Aristotle – who is considered as a pioneer figure in secular philosophy – criticized the institution of interest. Thomas Acquinas also stated that the just price of money lent is nothing more than the principal amount lent itself. All Abrahamic religions denounced the institution of interest in clear terms. Even great thinkers like Martin Luther said: “You cannot make money just with money.” Making money with money is referred to as earning something in trade by selling what does not exist.
Thomas Aquinas said: “To take usury for money lent is unjust in itself, because this is to sell what does not exist and this evidently leads to inequality which is contrary to justice.”
In the interest based lending, the lender bears no risk in the enterprise of borrower and yet demand and is guaranteed a fixed return. Hence, it leads to an inequitable distribution of income. This can be seen by taking an example. Suppose there are three people who consume all of their income in a given year. One of them starts with $1,000 in savings, a second with $100 and a third with zero. At 10% interest per annum, by the end of the year, the first person has $1,100, the second has $110 while the third person has zero in his account. If the same scenario follows in the next year, the first person will have $1,210, the second will have $121 and the third will have zero. One can see how the wealth distribution between them gets unequal every year. This scenario ultimately leads to an autonomous inequality in society generated by no one, but suffered by everyone. Note that those in debt paying interest that grows every year have not been added to the picture. In their case, as interest rate continues to grow, more and more of their overall income will be consumed by interest and therefore, further exacerbating the skewed distribution of income.
On the behavioral side, the one receiving interest indirectly tags money as risk-free and work-free. This leads to a lifestyle mainly based on consumption. But more importantly, it leads to a very irresponsible attitude towards one own self and the society.
On the social equality front, the one paying interest becomes a slave of those who lent him money since the burden gets bigger over time. This leads to dependency and leaves self-empowerment as mere fantasy and ultimately leads towards loss of self-identity, self-honor and destruction of humanity.
John Maynard Keynes, a well-known economist of the west, who unveiled the mysteries behind the greatest economic crisis on earth (Great Depression on 1930s), also argued that the best way to revive the economy is to increase the money supply so that the rate of interest falls. A fall in the rate of interest would lead to higher investment, employment and output. In fact, Keynes held that ultimately an ideal economy is one wherein interest does not exist.
Economists like Milton Friedman, Kindle Berger and H.C. Simon regard fixed interest rates to be responsible for economic instability. Friedman contends that changes in rate of interest bring about either inflation or deflation and both are harmful to the society. He therefore argues “Our final rule for the optimum quantity of money is that it will be attained by a rate of price deflation that makes the nominal rate of interest equal to zero”. This proposition is known as Friedman’s Rule, and it is one of the most celebrated propositions in modern monetary theory.