Is interest free lending inevitable?

As the author of a blog about green issues on the Times website, I’m used to receiving critical comments from sceptics. But nothing prepared me for the criticism I received after writing recently about green economics – and calling, half-seriously, for an end to compound interest.

Within hours, I’d received dozens of comments, many calling for me to be sacked for being economic illiterate.

In writing the piece, I wanted to draw attention to something that increasing numbers of people seem to be saying: that an economic system that depends on constant growth is inherently unsustainable.

Compound interest has been with us so long that we take it for granted. We borrow money and accept that we must pay interest to compensate the lender.

But look what happens. If we pay 3% on £100 then at the end of the first year we should pay back £103. If we fail to repay that then we must also pay 3% on the £103. This seems innocuous but the debt increases exponentially. A debt left unpaid, at 3%, doubles every 24 years. At 6% it doubles in 12 years.

Developing countries know all about this. “All that we borrowed up to 1985 or 1986 was about $5bn,” said Nigeria’s president in 2000. “So far we have paid back about $16bn. Yet we’re being told that we still owe about $28bn. If you ask me what is the worst thing in the world, I would say it is compound interest.”

The governments of rich nations, as Colin Tudge wrote recently in Resurgence magazine, have declared a war on poverty while presiding over an economic system in which the rich are bound to grow inexorably richer while the poor grow poorer.

You might ask: What has this to do with the environment? A great deal – because in order to repay debts businesses and whole economies must grow, and that usually involves consuming ever greater quantities of non-renewable resources. If a moneylender at the time of Christ had lent an ounce of gold at 5% it would today require an amount of bullion weighing several planet Earths in repayment.

Is there another way? There certainly is. Until relatively recently, the charging of interest was called usury – it was a sin. (If that word makes you feel uncomfortable, remember that it only means something that most people considered deeply wrong.)

And doing without money that was lent at interest didn’t stop our predecessors trading, or building incredible monuments, from Westminster Abbey to the colleges of Oxford and Cambridge.
Even now, Muslims are taught that lending at interest is wrong. “There is no such thing as a ‘usurious’ rate of interest,” writes the Islamic financier Tarek El Diwany in the same issue of Resurgence, “because all rates of interest are usurious.” He describes alternatives to interest-bearing loans, such as the sharing of profit and loss, and points out that the universities, hospitals, welfare systems and infrastructure of great civilisations in Iraq, Spain and the Ottoman empire were all built without interest-bearing loans. “Interest-based finance is not a pre-requisite for society’s sustainable advancement,” he writes. (For more detail, see his site, The Problem with Interest.)

Though many people found my post ridiculous, others mercifully recognised merit in the points I raised.

Hoping to do this important subject greater justice, I followed up by interviewing a recognised expert – Richard Douthwaite of Feasta, The Foundation for the Economics of Sustainability.

JPF Hello Richard. Why do you think that people reacted so strongly to my post calling for an end to compound interest?

RD Your post seems to be demanding massive changes in the way the world works. People find that very threatening and react emotionally. But besides being emotional, your contributors were confused because the relationship between rent and interest was not clarified.

JPF That’s my fault. Can you explain the difference for me?

RD Rent is the fee you pay for using something. You rent a house because you need somewhere to live. The use of the house has a cost and you are prepared to pay it for the benefits you get in return. That’s fine. No-one has any problems with that.

Interest, on the other hand, is the rent one pays for the use of money. But money itself is sterile. It is only the things that you can buy with it that are of use. So charging people for using money is illegitimate whereas charging them for the use of the goods that were bought with the money is OK. This may seem a fine distinction but it is an important one.

JPF It is a fine distinction, but I think I have grasped it. So, returning to compound interest – what’s the problem?

RD The distinction goes to the root of the difficulties people were having distinguishing between simple interest and compound interest. Simple interest is paid off quarterly or annually. Just like the rent on a house, it is never allowed to build up. So it’s fine for loans which are made for consumption purposes like buying a house or a car. Compound interest involves paying interest on interest and this is generally allowed only on loans made to provide funds for someone to invest. There’s no problem with simple interest – people expect to pay that out of their normal income. With compound interest, however, economic growth is required if everyone who has borrowed to invest is to be able to pay the interest on their loans without impoverishing themselves.

So lending money at interest for investment purposes means that economic growth has to happen if it is to be successful. It was easier to recognise this in the days when gold was used as currency. Gold did not increase itself, and very little was being mined – so where, people asked, was the extra bullion to come from to pay the interest when both principal and interest had to be handed over at the end of the loan?

Obviously, the person who had borrowed gold to invest could only obtain the extra gold to pay the interest if someone else had less, so lending gold at interest in a no-growth society meant that either the borrower impoverished himself when he paid over the extra or he impoverished someone else. And neither outcome was socially desirable.

JPF This is why lending at interest was regarded as a sin?

RD Yes. Usury, as all forms of moneylending were called – no matter how low the interest rate – stood morally condemned by both the Roman Catholic Church and by Islam. The Catholics only formally lifted their ban in the 1830s when European economies had begun to grow.

JPF But we don’t use gold any more. We can issue as much paper money and electronic money as we like, surely?

RD Even though we now use paper and electronic currencies, the source-of-interest problem has not gone away. Since almost all money in circulation in the world is issued on loan, borrowers can only obtain the money they need to cover interest payments if other borrowers have borrowed sufficiently more.

So, the fact that we create our money supply on the basis of debt, and charge interest on that debt, means that our money supply has to expand year by year at the rate at which interest payments take money out of circulation. If the rate of interest is 10%, and the cost of running the banks is 4%. the money supply has to increase by 10 – 4 = 6% if the average borrower is to be able to find the cash to pay their interest bill because that is the net amount of money that interest payments extract from the circular money flow.

But if the money supply increases by 6% and the real economy only grows by 2% – what then? The answer is that we’ve got too much money chasing to few goods and services and an inflation results.

So, because we charge interest on the money the banks lend into circulation, we’ve got to have growth, or inflation, or a bit of both if defaults are not to become a problem, eventually threatening the lenders’ solvency. In short, the charging of interest by the banks creates a need for growth, a growth compulsion, which contains the seeds of its own destruction since infinite growth is impossible in a finite world.

JPF A lot of people will not like the idea that you seem to be suggesting – that we must stop growing. I don’t think many will even think it’s possible.

RD Although our continuing efforts to grow have already done enormous environmental damage without making people any happier, I’m not saying that we must stop growing. I’m saying that we will be stopped. That, sooner or later, we are bound to reach the limits to growth and our money creation system will break down. Indeed, I believe that with climate change and oil peak, we already have.

JPF Blimey. And what does that mean?

RD If I’m correct, in the next year or two people won’t be prepared to borrow enough for investment purposes to keep the money supply increasing because they won’t be sufficiently confident of making profits if they do. This means we will have to start putting money into circulation in an entirely different, interest-free way if a serious depression is to be averted. If the reforms are radical enough to solve the problem permanently, banks will lose the right to create money in the way they do at present. Borrowing and lending would still go on, of course, but the basis on which both were done would be closer to the interest-free Islamic model than the one we currently operate.

JPF In a capitalist economy, that’s a pretty revolutionary suggestion. Do you really think banks will allow anybody to deprive them of that right?

RD I think they will be in no position to object because their losses will have brought them to the point at which they need rescuing by the government. The government should therefore be planning to turn the developing banking crisis into an opportunity for real reform. It’s not just a matter of incentivising bankers in some other way so that they lend more responsibly as some commentators suggest. The entire money creation system needs to be re-built in a different form.

JPF I’m informed by my correspondents that this “interest-free” model would be more expensive than compound interest. Others laugh at the idea because they think I’m calling for “free money”. Who is right?

RD I’m not sure what they mean by “free money”. Money has to be scarce if it is to have any value. There’s no evidence that interest-free banking is any more expensive to provide than the interest-charging kind. The JAK bank in Sweden does not charge interest on its loans but it does impose a service charge to cover its operating costs. This works out at about 3%. The arrangement is that you can have the use of other people’s money interest free provided that you repay the loan and then give the other members the use of your money for the same number of kronor-months as you had theirs. It works well and means that, if you use a JAK loan to buy a house, you come away after 25 years with the loan paid off and a lump sum equal to the amount you originally borrowed. As you don’t get that from any of the British mortgage lenders, that seems to indicate to me that JAK is cheaper. There’s a good article on how the JAK bank works here.

JPF Several people who commented on my post last week said that if I didn’t like compound interest I should just stop borrowing. I have a lot of sympathy with them because I hate centrally imposed regulation and would rather see change effected through individual personal decisions. But is their suggestion practicable, at the individual level? And what effect would it have on the economy if a lot of people stopped borrowing?

RD: If you stopped borrowing, it would not mean that you stopped paying interest. You would continue to pay it indirectly because every business borrows and has to make sure that you, its customer, pays a price which is high enough to cover its interest costs. For this reason, if money was issued in a debt-free way, it seems likely that prices would fall.

As for your second point, if everyone stopped borrowing today, the economy would gradually collapse because the money supply would contract as past loans and interest were paid off, making it increasingly hard to do business and for taxes to be collected.

JPF What kind of problems have you had trying to get your ideas heard by mainstream economists?

RD Surprisingly, very few economists are interested in the way that money gets into circulation and the effect that has on the way the economy operates. Some years ago I spoke to a professor at a university in the north of England who was interested in the topic but he told me it had proved a professional dead-end and he was moving to another area.

JPF Many people seem to feel that changing from the system we use currently would effectively mean returning to the Middle Ages, or even the life of a cave man? Are they, in any sense, correct?

RD: I’ve been developing scenarios for dealing with the climate crisis and peak oil. The most plausible scenario, which we call “enforced localisation”, would return countries to a life of poverty in which their people scraped a meager living from the resources of their local areas. That scenario is based on continuing with the systems we have now until they break down as growth becomes impossible.

By contrast, reforming the money creation system promises to enable countries to retain a decent standard of living – provided that other policies, such as a rapid transition to a renewable-energy-only economy, are adopted too.