The Legitimacy of the Prohibition of Interest
The Failures of the Classic Financial System
The legalization of the interest rate is considered a significant success achieved by the liberal current. However, Islamic civilization condemns lending at interest. In his Encyclopedia of Islam, Joseph Schacht states that usury is “any illegitimate precarious advantage without the equivalent of the service rendered.” Already, the prophet Mohammad condemned the interest at a low rate as well as that at a high rate: “From Anas Ibn Malik: the prophet said: “When someone grants a loan, and the borrower offers him a dish, he must not accept it; if the borrower proposes him a ride, he should not accept it unless the two were in the habit of exchanging such favors mutually” (Bari & Radi, 2011). Unlike other schools of thought, Islam does not distinguish interest from usury; these two operations are reprehensible. Islam is neither the only one nor the first to condemn the loan at interest; other monotheistic religions (Jewish and Christian) and other schools of thought have done it before: Aristotle (-384 – -322), for example, qualifies the practice of lending at interest as detestable, because it consists in creating money from itself when money was created for exchange, not to serve itself (Čihák & Hesse, 2010).
One might think that this debate on lending at interest is exceeded in the economies of the existing century, which is not the case since there are regulations on interest rates in several “emergent” economies worldwide. Contrary to the idea supported by Islamic finance, which fixes the interest rate at 0% and does not differentiate between low rates (interest loan) and high rates (usury), Western economies tolerate low rates and prohibit and sanction the practice of high rates. Several criteria can justify this regulation. Prohibition, therefore, persists in our contemporary economies under different names and with, on the one hand, reasons similar to those invoked by morality, such as “the protection of the weaker party,” and on the other hand, more rational reasons, like economic efficiency (Hesse, Jobst and Sole, 2008).
According to papers by Sidney Homer and Richard Eugene Sylla (2001), the norm has been to regulate the interest rate throughout history. These practices are more commonly known as usury laws (Jobst, 2007), and they have always aroused the indignation of economists who see them as an obstacle to the spontaneity of transactions (Jobst, 2007).
From a technical point of view, setting an interest rate hinders the free functioning of the capital market and over-determines investment decisions in all funding markets. From a competitive point of view, the usurious system catalyzes the accumulation of capital and the creation of monopolies skewing competition and entrepreneurial initiative (Chapra & Umer, 2008).
Theories of Motivation
According to various research, the classic financial system has the following effects:
✔️ Inhibition of the investment decision: The interest rate, as a reference for all other usurious transactions, inhibits investment because the internal rate of return of projects must necessarily be higher than the interest rate to hope to be profitable;
✔️ Allocation of capital to the least risky or best-guaranteed debtors;
✔️ Short-term investment strategy: In the climate of financial preference for the present and of repression of the risk resulting from the usurious practice, short-term investments with high profitability and little risk are preferred to investments with better economic rationality, strategic and environmental;
✔️ Inequitable distribution of profits;
✔️ Debt problem: the refusal to share the risk on the part of the creditor introduces a debt trap mechanism that leaves little chance of exit to the debtor. This phenomenon can be observed in the international indebtedness of the poorest countries;
✔️ Problem of prudential rules: The usurious banking system, characterized by the authorization given to private banks to generate money through the fractional reserve system, makes the prudential control of their banking activities problematic (Basel I 1988 and Basel II 1998) because only the criterion of profitability constitutes the main motivation of the business world (example of Enron and Anderson 2003).
✔️ Reduction of the national level of the investment ratio due to the selection of projects: The interest rate creates a ratchet effect exerting an inverse selection on any investment project whose internal rate of return is lower than the interest rate. As a result, a barrier to entry into the credit market is artificially maintained, with the consequence of reducing the national level of investment;
✔️ Rigidity of the price level: By setting ex-ante a rate of remuneration for the loan of money, the entire elementary price adjustment mechanism according to supply and demand is biased;
✔️ Debt problem: Indebtedness becomes a brake on economic growth at national and international levels. It blocks the everyday life of business and creates risks of insolvency;
✔️ Monopoly concentration of capital;
✔️ Systemic instability problem;
✔️ Accumulation of capital and deactivation of market equilibrium;
✔️ Financial instability and chronic crises;
✔️ Mobility of financial assets against the natural rigidity of the production tool (stateless capital);
✔️ Increase in unemployment.