Articles on Islamic Economics

Islamic View on Interest as Price of Capital


Salman Ahmed Shaikh

In modern mainstream economics, the definition of physical capital stock implies that it includes ‘produced means of production’. Some examples of physical capital stock in contemporary businesses include equipment, tools, machinery, buildings, furniture, infrastructures, installations and production plants.

As per the definition of physical capital stock, it does not include money capital. However, since there is interest based banking operating everywhere, the opportunity cost of buying physical capital stock with money capital is considered to be the market interest rate forgone on an alternate interest based investment of money capital. 

The cost of using physical capital stock in the production process is the real interest rate plus the depreciation rate. The real interest rate is the opportunity cost of using money capital in buying the physical capital good. If the interest rate on money capital investments is 10%, then, it is considered that the physical capital investment should yield at least 10% for it to be a comparatively better investment decision.

Else, if physical capital investment yields a lower return than the return expected on money capital investment, then a rational investor taking into account only the self-interest shall choose money capital investment over physical capital investment in the production process. The argument goes as follows.

If an entrepreneur has an option to invest $1,000 with a bank and earn 10% rate of interest on it, then the $1,000 invested in buying equipment for the production process should generate a minimum of 10% return for the justification of efficient allocation of resources.

Apart from the real interest rate, the other component in the user cost of capital is the depreciation rate. It is the rate per period at which there is wear and tear in the physical capital good when it is used in the production process for a period.   

The user cost of capital per period as explained by Hall and Jorgenson can be expressed as follows:

UC=Pk (r+d)                           — (1)

Where,

‘UC’ represents user cost of capital,

‘Pk’ represents the price of physical capital stock,

‘r’ represents the real rate of interest, and

‘d’ represents the rate of depreciation.

Even from the perspective of economics, there are several issues in interest based financial intermediation. It creates distributive inequity, concentration of wealth, limiting potential investments and as a result, it may give rise to unemployment, financial exclusion, rising income inequalities and even ecological imbalances when producers strive hard to pay off debts without considering the external social costs of their operations on the environment.

Since collateral based lending in interest based financial intermediation mostly entertains large scale businesses, they are able to gain scale advantage and beat the competition from the smaller entrepreneurs.

With a greater degree of pricing power in imperfect markets, the producers pass on the cost of capital to the consumers by raising the prices. This fuels inflation in the economy which is not driven by real variables or supply shocks. Rather, it is the result of providing risk free return to the money capital in the economy. Thus, the cost of interest is also by and large paid by the consumers.

In the interest based financial intermediation, the market interest rate becomes a benchmark return or hurdle rate of return. Social and environment friendly investment projects yielding a lower rate of return than the market rate of return remain unfunded as a result.

In addition to that, firms having an obligation to service debts with fixed payments regardless of their profitability are compelled to push growth in revenues. Often, this results in aggressive advertising and promoting consumerism to meet the cost of interest on borrowed funds.

If the demand remains sluggish, then the surplus output remains unsold and causes a recession in the economy leading to unemployment. 

Furthermore, since interest is an additional cost in the production process, there is lesser chunk of cost budget available to invest in environmental-friendly technologies. Thus, firms squeeze budget by paying less to unskilled labour and overuse other resources which may cause environmental problems. Rather than internalizing the cost of damaging ecological imbalance, firms free ride on whatever leeway they obtain to use and overuse public goods and common property resources.   Finally, since the loans are usually provided to richer segments of the population who can furnish collateral and already have sufficient incomes to service the cost of debts, the gap in incomes between those who are able to access credit services and those who are not able to access credit services rises over time.

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