Monetary and Capital Market Exclusive, March 2004

Monetary and Capital Market in Iran

Usury and Interest

What’s the  Difference?

Considering usury and bank interest as the same is a mistake in differentiating concepts or an epistemological error. 

Dr. Moussa Ghaninejad, Senior Economist

Perhaps one can summarize the main reasons for despising usury in various cultures and religions as such: it is windfall profit; that is, an income earned without labor or risk taking and determined beforehand; its destructive social role, that is, the injustice done to borrowers and; finally, lack of a sensible justification for usury, that is, lack of a sound response to the question that how money, as a means of transaction can increase itself in the course of time? Aristotle first posed this question, thus providing a basis for all anti-usury doctrines that emerged in later centuries.

The basic question is that can we generalize such a concept of usury in the ancient world to the modern banking interest rate, which is a result of the development of civil institutions called banks?

In short, is banking interest, the same as usury in its old sense?

Our answer is negative and here we will try to shed some light on this issue. Although the current article stresses differentiation between usury and banking interest from the angle of certainty or uncertainty of a predetermined income, other differential points would also be touched upon.

Considering usury and bank interest as the same is a mistake in differentiating concepts or an epistemological error. Bank interest emerged due to expansion of economic relations in the competitive market and establishment of a new credit system and, in fact, indicates scarcity of capital in an economy based on the competitive market. On the other hand, usury is a phenomenon related to subsistence, static economy in which money plays a marginal role in the economic lives of the public and money lenders (usurers) enjoy an exclusive status. Usury is more or less an exclusive price which is mainly determined by those who control money deposits. We start with the definition of capital to differentiate between capital interest and usury which is a phenomenon related to economic systems existing before capitalism.

Economically speaking, capital, which is rooted in saving, is a means for increasing production capacity. Saving means refraining from immediate consumption, which can be a source of capital accumulation. Consumption, as the final goal of production means to meet human needs and requirements. It is clear that we must not infer from the above definitions that capital is the only means of boosting production capacity, or that any form of abstinence from consumption (saving) would inevitably lead to capital amassment. Saving is turned into capital only when its final goal is to goad production activities. Just in the same way that savings hidden underground cannot be considered capital, savings that are solely lent for consumer purposes cannot be considered capital in its economic sense.

Based on the definition given for capital, it will find its full meaning in an economic system based on indirect production (that is, production by means of production tools) and therefore, under circumstances of division of labor and progressive specialization of production. In other words, the more advanced division of labor has become and the more advanced specialization of production, the need for production means, that is, demand for capital would increase. Therefore, in a closed subsistence economy like the economies of self-sufficient rural or nomad societies in which producers make elementary production tools in addition to producing consumer goods, demand for capital and a capital market would be nonexistent. In such societies where production return is very low, the possibility for saving would be ignorable too and, as a result, the possibility of capital formation would be limited considerably.

Despite the fact that in pre-capitalist societies, monetary and trade relations had existed to various degrees, those relations were often marginal to main production activities. Therefore, monetary deposits resulting from trade in those societies were nothing similar to amassing capital in modern societies in view of its prominent role in modern economic systems. Owners of money caches in the said societies enjoyed an exclusive and even exceptional status and they could ask for very high interest rates in return for the money they lent. Although those high rates could be considered a sign of scarcity of monetary deposits, they cannot be considered an indication of high final return on capital; because as we said before demand and the capital market were nonexistent in those societies in their true economic sense.

In other words, the important economic and social performance considered for capital in modern economic systems, did not hold water for monetary deposits of the ancient world. Perhaps the reason why ancient philosophers condemned usury was the same point; that is, they could not find any political, social or economic justification for it, while its untoward effects in the form of injustice done to money borrowers were tangible.

In ancient times, money was a means of transaction, so that such thinkers as Aristotle differentiated it from wealth. Aristotle believed that money was exclusively a means of transaction and nothing else. For this reason, he did not consider it a form of wealth. Therefore, “it would be in vain to call a metal, whose abundance would not curb hunger, as wealth.” As a result of such a judgment about the performance of money, Aristotle vehemently condemned amassing money as a result of usury as unnatural and unjust. This judgment about money stemmed from the fact that in the ancient world money lacked the capital role it plays in the modern economy—that is, a means of increasing production return through mediated production (technical capital)—or seldom played such a role. In this way, condemning usury by Aristotle had quite a sensible reason and this was the cause of durability of his argument about usury over many centuries.

However, as time went by and the economic relations of the market expanded, and due to division of labor, specialization of production, as well as the emergence of new credit and banking systems, monetary savings assumed an important economic role as capital. Development of market order, led to penetration of monetary relations in all aspects of the economic life. In the new economic system, money is no longer a means of transaction, but it plays another important and essential role as capital reserve and a means of measuring it.

In this system, deposits are rapidly turned into capital through money to increase production yield. Small and medium savings are a result of developing market order and increase in production yield; that is, factors that were not imaginable in the past. These savings, which grew progressively, created big investment possibilities in the society through modern deposit and banking institutions.

The role of regulating relationship between deposits and investments in a market-based economy is played by capital (bank) interest rate. Bank interest is a new and totally different phenomenon from usury and in contrast to the common notion; the former does not stem from the latter and is not a result of its evolution. The etymological origin of bank in European languages is the word ‘banc’ which was used to mean the table used by money changers in medieval markets. Due to higher number of local currencies in the Middle Ages in Europe, money changers played a pivotal role in those markets to facilitate transactions.

Gi Fucan, an economic historian, says that based on more recent studies it has become clear that during the Middle Ages, usurers were creators of neither the credit system, nor banks. They rarely lent money for commercial purposes. Merchants were representatives and agents of commercial credit. With regard to the creation of banks, he writes, “Bank was a successor not to usury, but to money changing. Money changers were a few people in every city and they put their tables—that were called ‘bancs’—in the market. They carried out manual money changing.

Since for a long time, circulating coins were minted by various monetary authorities, their values varied, so that, no active market was needless of money changing services. Soon money changers engaged in more complicated operations in big cities, especially in Italy—that is accepting deposits and transferring credits—and, for the first time, called themselves bankers. Modern banking was a result of the expanding activities of money changers to accepting and transferring deposits and lending loans, on the one hand, and the national will of nation states to regulate money and financial relations and control such activities, on the other.

Emergence of new credit and banking systems was not in line with money lending as usury, but in stark opposition to organized usury. In the third volume of his book, Capital, Marx in a chapter titled ‘Usury Capital before Capitalism’ stresses that how development of new credit system (banks) has been a reaction against usury. He says that banks demolished monopoly of usury capital by pouring all idle monetary reserves (small and medium savings) into the market, on the one hand and limiting monopoly of precious metals as the sole form of money by creating credit money, on the other hand. The great British historian, Macaulay, writes in his book, History of England, how establishment of banking system and the plan for establishing ‘Bank of England’ in late 17th century evoked outcry and hatred of goldsmiths and ‘usury moneylenders’. In his opinion, advocates of the new credit and banking system considered usurers as the scourge of the nation whose harm to the society was more than the harm inflicted by a foreign invading army.

Banking or capital interest in the modern economy is not a purely monetary phenomenon, but a variable related to scarcity of capital (saving). Keynes played a major role in aggrandizing this misgiving that as if interest was a purely monetary variable; so that, increase in its volume could reduce interest rate and even bring it down to zero. As we would see, Keynes misgiving was shared by some Islamic researchers in later ages and made them make incorrect remarks. In a developed market economy, interest rate plays the pivotal role of regulating relationship between deposit and investment. The real interest rate, which is determined by market mechanism independent of the individual and even state will, is in fact an indication of scarcity of savings, on the one hand, and final (marginal) return on capital, on the other hand. The main function of interest in a banking system is guiding deposits, especially medium and small savings toward investment. The saver, by abstaining from immediate consumption, paves the way for capital formation and investment and the result of investment is an increase in productivity in the future. That is, refraining from immediate consumption (saving) would increase production in the future and since the savers have deprived themselves from consumption during a period of time, that is, they have undergone an opportunity cost with regard to consumption, they get part of the added return on production in the future in the form of interest. In this context, interest is a right stemming from participation in increasing production capacity. It is obvious that in a traditional, subsistence economy, in which medium and small savings are practically lacking and production is not fundamentally based on investment, such a system cannot be imaginable. Therefore, we cannot consider bank interest, whose realization would be impossible in traditional, subsistence societies, to be the same as usury in those societies on the basis of an apparent similarity.

Considering usury and interest the same, in view of the clear prohibition of usury in Islam, was the main motive for the establishment of an interest-free banking system. Masterminds of the system emphasized a certain attribute of usury; that is a predetermined, fixed income and believed that the main reason for banning usury was this attribute: “In fact, what is banned in Islam is a fixed or predetermined return for financial transactions and not an undetermined return rate as is the case with bank interest.” Therefore, interest-free or the Islamic banking system can be depicted in its most simple form as a system based on partnership and not a system based on interest. Now, if we note that in an economic system based on a competitive market, fixed and predetermined return on capital would be impossible both theoretically and practically, we would easily recognize the big misunderstanding that has led to likening usury and interest.

Two kinds of interest rate could be distinguished in a modern economic system: a real interest rate and a nominal interest rate. Theoretically speaking, the true interest rate is a manifestation of the final (marginal) inclination to investment, on the one hand, and a reflection of the final (marginal) return on capital, on the other hand. That is, in a market system, the interest rate is determined when the final cost of abstinence from consumption—marginal tendency to saving—equals marginal benefit from saving. Like other prices in a market system, the interest rate cannot be accurately forecasted and it changes in response to factors affecting market, which are not predictable either. The nominal (monetary) interest rate, however, is a variable that is determined by supply and demand for nominal money. Although supply of nominal money could be controlled by monetary authorities (central bank or government), demand for money is basically a function of true economic variables, such as the return of investments and cannot be controlled by any authority. Therefore, in an economic system based on the market, even the nominal interest rate cannot be determined for a long period in advance. This is not contradictory to the fact that in the short run, monetary and governmental authorities can push the market interest rate toward increase or decrease by adopting certain monetary and financial policies. However, these are true economic variables that finally correct severe deviations from real interest rate through the market mechanism.

As an explanation, we can say that the real interest rate is approximately the same as nominal (monetary) interest rate after adjusting it for inflation rate. Despite the fact that in a market economic system, repayment of interest on deposits is guaranteed at a certain rate, since the inflation rate cannot be forecasted beforehand, determination of the real interest rate would be practically impossible. The “fixed and predetermined return” (usury) can only be imaginable in societies with traditional subsistence economies because since monetary exchange relations are marginal to mainstay of production activities and since social and economic developments as well as technical and technological upheavals are sluggish, changes in relative prices as well as the level of prices even in the long run would be ignorable. It is only under such circumstances, that the nominal and real return of money become equivalent and usury could be defined.

However, in an economic system based on the market in which relative prices, marginal tendency to saving, and marginal return on capital are constantly changing due to the changing tastes of consumers, severe dynamism of production factors as well as rapid technical and technological developments, no financial dealing with a fixed or predetermined return would be possible. Prices and all other information about economic variables in modern economic systems are a result of past performance of market forces. Therefore, even if the inflation rate is zero, there is no guarantee that the nature of economic variables (including the real interest rate) could be determined for future. It is true that with a zero inflation rate, average purchasing power of money would remain constant, but since relative prices are constantly changing as a result of the abovementioned factors, purchasing power of money for every single commodity would change. ‘Fixed or predetermined return’ requires that the purchasing power of money should remain constant.

As noted before, only under circumstances of a static subsistence economy one can imagine a constant purchasing power for money. However, under new dynamic economic conditions, such an idea would not be permissible. Therefore, one can claim that those who consider usury and bank interest to be the same have committed an epistemological error; that is, they have generalized a concept that would be imaginable under certain circumstances to a totally different situation under which that concept would be inapplicable.

The advocates of interest-free banking, after equalizing interest rate and usury, tried to substitute a banking system based on partnership in which return on capital (profit) was uncertain for a system based on interest whose return was apparently fixed and predetermined (usury). However, if we note that depositing on the basis of interest is basically an activity whose theme is partnership in profits and losses, we could conclude that the effort to establish an interest-free banking or a banking system based on partnership stems from an epistemological misunderstanding about performance of a market economic system. In fact, the main difference between depositing at interest and participation in profit (investing) is in their probable risk not in presence or absence of that risk. Since depositor is reluctant to take risks and is not willing to make an investment or take part in one, they reduce fluctuation of their profits and losses compared to direct investment (partnership) by getting a determined nominal interest whose real value cannot be determined beforehand. Depositing and investing are similar in that both entail risks and partnership in profits and losses, which cannot be determined in advance. Depositors that are being given a fixed (nominal) profit will generally lose their money under conditions when inflation of prices is higher than the interest rate because the real interest rate would be negative. Obviously, under conditions that the true interest rate might be negative, making deposit is, in fact, a kind of partnership in profit and loss. However, uncertainty of predetermined, nominal income is not restricted to these special conditions—that is inflationary economy. As noted before, since relative prices are constantly changing in an economy based on the market and since direction and dimension of these changes cannot be accurately forecasted, the purchasing power of money for various groups of goods would be changing too. This unpredictable change in the purchasing power of money will preclude decisiveness of the predetermined, nominal income. The following numerical example will shed some light on this issue:

Assume that only two commodities called A and B are being dealt in a society at the respective prices of 10 rials. Now assume a person who lends 100 rials at the annual interest rate of 8% percent and takes 108 rials by the year-end as principal and the interest. During the same period, price of commodity A reduces by 20% and price of commodity B increases by 20%, so that, by the end of the year prices of commodities A and B stand at 8 rials and 12 rials, respectively. It is evident that the general price level will not change by the year-end because the 20% increase in the price of one commodity would be offset by a 20% reduction in the price of another commodity. In other words, average inflation rate would be zero by the year-end; but relative prices have changed. If the moneylender is only willing to use commodity B, it is obvious that purchasing power of his money has reduced despite its nominal sum has increased from 100 rials to 108 rials because he could have bought 10 units of his favorite commodity at the beginning of the year, while he would be able to purchase only 9 units of his favorite commodity at 108 rials by the year-end. So, his actual income according to his favorite commodity not only has not increased, but also decreased.

Now, assume that the person had not asked any interest for the loan he had lent and was only interested in consuming commodity A. In that case, although the nominal amount of his money would not change during the year, his actual purchasing power would have increased; that is, if he could buy only 10 units of commodity A at 100 units at the beginning of the year, he would be able to purchase 12.5 units of the same commodity by the year-end at the same 100 rials. The result is that under conditions when relative prices are changing—that is, in dynamic economies based on the market—purchasing power of the money will change for every consumer of various goods even at the time when increase in average prices is zero. When purchasing power of money changes, we cannot talk about a ‘fixed or predetermined return’. Usury should be used for conditions under which in addition to unchanging general level of prices, relative prices would remain unchanged too, that is, under conditions of a static subsistence economy.

Among well-known contemporary economists, Keynes perhaps is among the few people who like old thinkers considered interest rate a purely monetary and not capital variable; and for this reason, criticized neoclassic economists. Keynes clearly considers the interest rate as price of money or, in his own words, ‘the means of balancing supply and demand of monetary loans’. Unlike neoclassic economists (Marshal), he does not explain interest rate as the final return on capital, but in contrast, considers final return on capital and the level of investment a function of the interest rate. For this reason, the best economic policy, in his view, is “reducing interest rate in relation to capital return, so that, by increasing investments, a full-blown employment situation is realized. Keynes was of the opinion that reducing interest rate through increasing supply of money, could lead to more investment and increased investment facilities. Increasing investment facilities, in his opinion, is a practical way for eliminating scarcity of capital and, as a result, granting reward (interest) to an inactive investor.

There is a clear contradiction in Keynes’ interest theory that we have discussed elsewhere. Here, we briefly say that from his standpoint at one time, the interest rate is considered a merely monetary variable that monetary officials can reduce to near zero through increasing supply of money and, at another time, Keynes opines that the reward of an inactive investor—that is, interest—is a result of scarcity of capital and he is of the opinion that scarcity of capital and, as a result, interest rate can be eliminated through increasing capital equipment through reducing interest rate.

Apart from this vicious cycle in Keynes’ theory, based on which the interest rate should be reduced in order to decrease the interest rate, the logical question posed is if interest rate is a purely monetary issue, why should capital equipment be increased to eliminate it? And finally, the more basic question is that to what extent ending capital scarcity would be scientific or even logical? Today few economists take Keynes’ viewpoints regarding the abovementioned points seriously. Unfortunately, however, some advocates of interest-free (Islamic) banking have adopted his incorrect viewpoints with respect to interest and capital as the latest scientific achievements on the strength of Keynes’ fame, and considered an interest-free economic system to be possible and desirable. Ending capital scarcity and, as a result, doing away with capital interest, is only an imaginary concept because capital is a means of producing goods and services for which the varied and endless human needs and demands is a production motivation. Putting an end to scarcity of capital would be only imaginable when the human population, their needs, production methods as well as technical and technological advances come to a halt. Obviously, realization of such conditions is not only impossible, but also undesirable.

Another important point ignored by Keynes and other advocates of eliminating capital interest in their normative and moral judgments, is that if in pre-capitalist era usurers were mostly wealthy people who did injustice to the impecunious people by giving loans to them and asking for high interest rates, in new economic systems, those who get interests are usually owners of small and medium capital and not those owning big, inactive capital. As put by one of renowned contemporary economists, in ancient times, for example in ancient Athens and Rome or during the Middle Ages, moneylenders were generally well-to-do people and borrowers were impecunious people. Today, however, at the age of bonds, mortgage banks, deposit banks, life insurance funds and social insurance institutions, moneylenders are often mostly people with medium incomes. On the other hand, the affluent, as stockholders of companies, factories, farms and residential property, are often borrowers rather than lenders.

In view of what we have said so far, one can conclude that based on the following considerations, there is a fundamental difference between usury and interest and they cannot be considered the same and treated in a similar manner:

1.   Usury in the sense of ‘fixed or predetermined return’ can only be imaginable in subsistence and static economies where relative prices do not fluctuate remarkably even in the long run. Due to constant changes of relative prices, return on capital in new economic systems cannot be considered usury.

2.   Usury predates capitalism and cannot be compared with interest, which enjoys an important economic role in new economic systems.

3.   Historically, the interest of capital had a quite different origin from usury, so that, its advent was, in fact, against monopoly and domination of usury.

4.   Usury was criticized by early thinkers due to the destructive social role it played while capital interest is logically and morally justifiable due to its positive and constructive economic performance in guiding capitals toward investment.