Sunday, July 3, 2011

Monetary Reform, Part II | Lending and Interest

- By: Larry Walker, Jr. -

The interest that U.S. taxpayers pay on behalf of the federal government, for the privilege of having money in our wallets, and to cover irresponsible deficit-spending, is only the beginning of our woes. When it comes to our personal credit needs, American citizens are once again shackled and sold down river. With regards to borrowing and lending, we may be able to take a few pointers from Islamic banking. I know what you’re thinking, but just bear with me. Let me make one thing clear, I am a Christian, and I do not agree with any of the principles of Sharia, except for those it shares in common with the Bible. Upon these, I think most humans can agree. For in this case, we are not talking about matters of heaven or hell; we’re talking about money.

“If one of your countrymen becomes poor and is unable to support himself among you, help him as you would an alien or a temporary resident, so he can continue to live among you. Do not take interest of any kind from him, but fear your God, so that your countryman may continue to live among you. You must not lend him money at interest or sell him food at a profit.” ~ Leviticus 25:35-37

Interest - Sharia prohibits the charging of interest (known as usury) for loans of money. The Bible is also very clear on the matter of usury. The Biblical term for usury, neshek, is strongly negative, coming from a root whose basic meaning is to strike as a serpent. Islamic banking has the same purpose as conventional banking: to make money for the banking institute through the lending of capital. But because Islam forbids simply lending out money at interest, Islamic rules on transactions have been created to avoid this problem. The basic technique to avoid the prohibition is the sharing of profit and loss, via terms such as profit sharing, safekeeping, joint venture, cost plus, and leasing.

Loans in pre-industrial societies were made to farmers in seed grains, animals and tools. Since one grain of seed could generate a plant with over 100 new grain seeds, after the harvest, farmers could easily repay the grain with "interest" in grain. When an animal was loaned, interest was paid by sharing in any new offspring. What was loaned had the power of generation, and interest was a sharing of the result. Interest on tool loans would be paid in the produce which the tools had helped to create.

Monetary problems didn’t surface until societies began using metals, like gold, as forms of currency. When interest was allowed to be charged on loans of metals, with the interest to be paid in more metal, life became more difficult, particularly with agricultural loans. The problem is that inorganic materials, not being living organisms, have no means of reproduction. Thus, any interest paid on them must originate from some other source or process. The same is true with paper money today.

For example, if you borrow money to start a farming business, the only way to pay it back is if you are able to sell your crops to others in exchange for sufficient paper money to cover your expenses, including principal and interest. If your crops happen to get wiped out one season, then most likely, so do you. Even if you borrow money to start any kind of business, and are successful, you must make enough profit to cover the principal and interest payments on the debt. And in case you don’t know it, principal repayments are never deductible for income tax purposes. So a business with $100,000 in profit, which uses it to repay its debt, must then come up with additional money to cover the income taxes thereon; leading to the incurrence of more debt. What we have in the United States is a system of winners and losers, where the big banks always win, while the citizens of the Republic mostly lose.

Mortgage Loans - Let’s say you decide to buy a home for $110,000 by paying $10,000 down, and taking out a $100,000, 30 year - 5% fixed rate mortgage. When the term is over, you will have paid the lender $193,256, plus your down payment, for a total of $203,256. What you get in exchange is the privilege of living in a home which may or may not be worth its original value of $110,000 in 30 years. If your home loses value midstream, as far as the lender is concerned, “too bad”. If you miss, or are late on a payment, the lender will charge you penalties and destroy your credit, preventing you from obtaining future loans. If you get too far behind, the lender will put you out on the street. It doesn’t matter how good your credit was before your troubles, or how long you made timely payments, you will be destroyed. The lender will then confiscate your home, and sell it to someone else, pocketing any profit in the process.

In an Islamic mortgage transaction, instead of loaning the buyer money to purchase a home, a bank might buy the home itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the bank's profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The property is registered to the name of the buyer from the start of the transaction. This arrangement is called Murabahah.

An innovative approach applied by some banks for home loans, called Musharaka al-Mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity.

Business Loans - U.S. banks lend money to companies by issuing fixed or variable interest rate loans. The rate of interest is based on prevailing market rates and is not pegged to a company’s profit margin in any way. U.S. banks currently borrow the money they lend to businesses at rates as low as 0.25%. When was the last time you saw an ad for small business loans charging 0.50%, which would give the lender a 100% return? The fact is that banks are still charging rates of between 4.0% and 30.0%, in spite of the cost of money. When prevailing interest rates are too high fewer businesses are able to borrow, thus inhibiting economic growth; and when rates are too low, profit-dependent banks are less willing to lend, also hindering the economy at large. If a business with a profit margin of just 5.0% could only borrow money at interest rates of 10.0% or more, why would it bother?

Islamic banks lend their money to companies by issuing floating rate loans. The floating rate is pegged to the company's individual rate of return. Thus the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded. This practice is called Musharaka.

Risk - Under our present system, if a company has a bad year and misses a few payments, it may be forced into bankruptcy. In the U.S. the risk of failure is placed squarely on the back of entrepreneurs. If a small business owner defaults on a loan, he is run out of business and his future ability to borrow is destroyed. In the case of government guaranteed loans, which are backed by the full faith and credit of you and I, the banks get their money back, while the failed entrepreneur, having been made a personal guarantor, is hunted down by his own government, like a fugitive, for the rest of his days.

Islamic banks also lend through Mudaraba, which is venture capital funding to an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.

End Usury, Now - Our monetary system needs a complete overhaul. But so far, the only reforms offered have been to further back big banks, at the expense of U.S. citizens. This is not acceptable. Until there is real reform, you and I, our children and grandchildren will remain enslaved. Backing our currency with gold is not the answer. The first step is for the government to begin printing its own fiat currency. The second step is to outlaw the practice of charging interest.

References:

Islam in the Bible - Usury

Islamic banking

Leviticus, Chapter 25

Related:

Monetary Reform, Part I | End the Debt

2 comments:
  1. "Capital used to start businesses comes from savings from prior production."

    We would like to believe that, but in reality it comes from fractional-reserve banking, through which banks are allowed to lend out 5 times (or more) the amount actually on deposit. It's money literally created out of thin air; not from past savings, but rather from future indebtedness.

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  2. "...it is difficult to envision anything challenging gold in our lifetimes or those of our children and grandchildren."

    Have we forgotten about the "Nixon Shock" of 1971? There is a reason that our currency is no longer backed by gold. We learned that lesson when our nation's gold reserves were nearly depleted through manipulation in the 1970's.

    "The year 1970 was the crucial turning point, which, because of foreign arbitrage of the U.S. dollar, caused governmental gold coverage of the paper dollar to decline from 55% to 22%. That, in the view of neoclassical economics and the Austrian School, represented the point where holders of the U.S. dollar lost faith in the U.S. government’s ability to cut its budget and trade deficits."

    "By 1971, the money supply had increased by 10%. In the first six months of 1971, $22 billion in assets left the U.S. In May 1971, inflation-wary West Germany was the first member country to unilaterally leave the Bretton Woods system — unwilling to devalue the Deutsche Mark in order to prop up the dollar. To preempt dumping of the Deutsche Mark on the open market, West Germany did not consult with the international monetary community before making the change. In the next three months, West Germany’s move strengthened their economy; simultaneously, the dollar dropped 7.5% against the Deutsche Mark."

    "Due to the excess printed dollars, and the negative U.S. trade balance, other nations began demanding fulfillment of America’s “promise to pay” – that is, the redemption of their dollars for gold. Switzerland redeemed $50 million of paper for gold in July. France, in particular, repeatedly made aggressive demands, and acquired $191 million in gold, further depleting the gold reserves of the U.S. On August 5, 1971, Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against foreign price-gougers. Still, on August 9, 1971, as the dollar dropped in value against European currencies, Switzerland unilaterally withdrew the Swiss franc from the Bretton Woods system."

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