This question should have come in the minds of a large number of entrepreneurs more often than not. By interest what I mean is the “excess” money a borrower has to pay to a lender for a period for having borrowed a certain amount of money. This is the principle on which the capitalistic mind driven “interest – based economy” works.
Now what is the fault? Ans. Money is considered as a capital good to make profit. The major point of defense from a supporter of this system will be that ‘interest’ is a consideration for ‘risk taking’ on the part of the lender just as ‘profit’ is that for a businessman producing goods/ providing services. The point to be noted here is that the end use of the money is only to produce goods and increase wealth and the actual risk taken to create wealth is by the businessman and not the lender. In other words, the risk of loss in the process of the real value addition to an economy is borne by the businessman and not the lender.
Where does this system fail?
Consider the universal equation Cost + Profit = Selling price; “financiers” take “interest”, “investors” take “profit”
Interest is charged as a fixed percentage even if the business suffers a loss and constitutes a significant portion of the cost. The lenders will be happy to lend more to an established business, where the potential for repayment is high, when compared to a business which is in the primitive stages of development. For want of funds, the smaller business finds itself tough to compete with an established enterprise which has the capability to borrow the money at will. Looking from another angle, this definitely restricts the scope for innovation. Assuming after meeting the requirements of the lender, a small entity avails the loan. The fixed amount of interest payable irrespective of the result, will always be at the back of the mind and thereby hinders the entity from attempting a transaction which is risky, but if works, the profit will be higher than normal. This fact can be appreciated better by the people who know that the economic growth is determined by the dynamic function of entrepreneurship which is nothing but innovation and technological changes. The process of innovation thus gets restricted only to highly credit rated entrepreneurs who keep improving their wealth and of those unable to avail the credit stays constant or in most cases, erodes. This affirms the classical thought of “rich get richer, poor get poorer”. Moreover, the non-monetary resources will not be utilized to the maximum level resulting in low productivity.
Another cause for imbalance in the economy is the differing mind set of the financiers (lenders) and the investors / entrepreneurs. If the business does well then financiers regret for getting a “low” fixed return in interest when the investor gets a higher return. If the business is not operating at the optimum level, the investor is uncomfortable to give a “high” fixed rate of interest to the financier when he gets a lower rate of profit from the business.
Unemployment – A major concern
It can be said that interest (irrespective of the rate being high or low) is a contributing factor for unemployment. For instance, if the interest rate is high, it adds to the cost of production, then reduction in profit. So not many will be investing in a low profit entity and it may end up causing closure of the entity. For readers who may feel that the happening of such an event is highly improbable, do understand that this instance or for that matter any of those mentioned in this article, does not happen in a short run, whereas, they contribute substantially towards the stagnation of economic development.
Take a case of low interest on borrowed funds. If an enterprise is able to borrow heavy sums at low rates of interest, it may substitute its prevailing human labor with machines (Capital-intensive system) which can be bought with the sum borrowed, thereby causing unemployment. The question which will pop up right now to many is “If there is no interest, then all industries will go capital-intensive and get rid of manual labor thereby creating gross unemployment!”To answer this, it should be understood that “interest on borrowings” should not be the deciding factor for choosing between human and machines but should be based on “efficiency”. Hence, if you are efficient, you will be employed in an interest-free economy.
Does interest contribute to instability in various sectors of economy? The answer is yes. Economic stability is achieved only when all sectors grow at similar magnitude. A lender prioritizes credit facility and charges differential rates of interest depending on such priority. For instance, short term loans are preferred to long term loans. In other words, businesses having a short operating cycle (say 4 months) are preferred to the entities having longer operating cycle (say more than a year), thereby clearly demonstrating the difference in opportunities available to various sectors. The end result is the volatility in the national growth rate and the stock markets.
How to solve?
The obvious point to be clarified now is as to where will the banks and financial institutions go if the prevailing system is scrapped. They should be more than happy to take the role of an investor i.e. the concept of two different sources of funds should be scrapped and the only category should be investors who will have a return on the basis of profits earned from the business. There should be a shift from the “cost” to the “profit” head of the equation in case of the remuneration to the banks. This profit and loss sharing system (PLS) will create a sense of ownership, responsibility, mutual – cooperation and equality with all those contributed to the entity’s capital employed. There will be none who enjoy a fixed income no matter how badly the business suffers or rather, there will not be anyone having to pay a fixed amount of money to another person who is unaware as to the quantum of risk with which the business operates. Some may think that PLS will not be profitable for some financiers as they may end up getting returns less than the fixed % of interest. It can be argued that if the entire business of financing is taken as a whole, it will enjoy profit considerably higher than what it earns in a interest-based system. It will be the innovative enterprises setting the rules of the game and not interest rates. The amount borrowed by poor countries from IMF, will not make their burden magnify due to the absence of interest component. The prices of goods will reduce as the interest component is removed from the cost of production thereby reducing inflation. Banks will not continue to show huge amounts of fictitious interest receivable in their books and avoid the possibility of insolvency due to inability to recover the same. The growth in the various sectors will be uniform and not just the fund keepers (bankers) amass huge wealth.
Unfortunately, almost the entire global system is working on interest structure and it is an inconvenient truth that PLS is more of an eye-candy or a concept existing only in theory(existed before interest system came into picture) which will be the only solution for the prevailing inconsistent system, full of flaws. The objective of this note is not to ignite any emotions on the part of the reader to raise all of a sudden against interest, but is to communicate the fact, make the readers learned, and in case of any debate over this system is going to occur in the future, to vote against it. It does not surprise me as to why so many philosophers and economists are/were against such a system and why the idea of interest is considered as a sin according to various monotheistic religion scriptures, notably Islam. Ultimately the best of the proved thought is “God knows the best”!!!!
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