A modern economy is built around debts that bear interest. Monetary management as well as financial intermediation is effected through interest-bearing debts. This makes the system crisis prone. It also makes the system unfair and inequitable.
The amount of fiat money the monetary authority decides to float in the economy finds its way to people is mostly through banks and other financial institutions. Whatever monies are given to people directly as salaries, wages and grants, etc., also find their way to banks and other financial institutions as deposits and investments. The monies that go out from banks and other financial institutions mostly do so as debts carrying interest. Some of these debts are repaid and that much new money is cancelled, but the interest paid remains as revenue for the bank. Some debts are renewed on maturity, often with accrued interest added to the principal. Bank loans are part of an economy’s money supply. To the extent the volume of interest bearing loans increases, the money supply also increases.
Para1lel to this stream of debts runs another stream and in the same direction. It is bonds issued by the government – Central, State and Local – as well as bonds floated by private sector corpora1tions. Government bonds’ supply has had a tendency to increase over time.
As time passes the volume of debts in the economy goes on increasing. Obligations to pay interest due and/or return the principal can be met from wealth newly created or already existing. In case debt financed productive enterprises fail to produce additional wealth large enough to meet obligations of repayment with interest, a dip unto old wealth already existing before the debt-financed projects were started becomes necessary. Wealth redistribution in favour of lenders is inalienable feature of an economy in which debt financing predominates.
In money terms, there is not sufficient money to meet all payment obligations, in view of the interest added to the principal that came out as newly created money. The only way out is to renew some of the outstanding debts. The debt based system of creating new money and financing productive enterprises necessitates ever increasing volumes of debts. It is difficult to imagine how these debts can ever be paid. To lighten the burden of debt a severe bout of inflation will be necessary with all its unhealthy consequences.
An alternative to debt financing from which interest is absent is the first step towards change. Parallel to this we need a way of creating money in which interest plays no role. Equity can easily replace debt as the basis for issuing new money by the monetary authority and/or by other financial institutions.
[Excerpts from the article ‘Dealing with Financial crisis – an Islamic Approach’ by Prof. M. Nejatullah Siddiqi, [email protected]]