Man is born free, and everywhere he is in chains.[145]
Jean Jacques Rousseau
Interest-bearing debt is a negative externality because, as this and the chapters to follow show, its social cost far exceeds its private cost, making it equivalent to a financial pollutant. Hence, its preponderance is baffling. Understanding this economic irrationality requires tracking the rise of usury, a spellbinding story of how lenders succeeded in putting the world in financial bondage. It also hints at the difficulty of freeing the world from its awful grip.
Religion and Usury[146]
Usury was vile long before there was a word for it in the English language; the Latin meaning of mortgage is death, a stark reminder of its looming tragedy. Some loan sharks, driven by avarice, specialize in lending to the powerless and charging them excruciating interest rates. Their enforcers solve bad debts by turning nonperforming borrowers into financial slaves. The ethics of “A pound of flesh for a pound of gold” has never left us. Paradoxically, lenders and enforces too are victims of usury’s sadism because it strips away their residual humanity.
The UN’s Supplementary Convention on the Abolition of Slavery (1956) specifically prohibits debt bondage (Article 1a).[147] Despite that, in some countries, defaulting on debt carries a prison sentence, which reinforces debt bondage. Permitting usury entails accepting its immorality, economic irrationality, and worsening financial crises in the West.
Incredibly, two millennia ago, long before any financial crisis, a modest man from Nazareth wanted to spare the world the misery of usury by banning it. Doubtless, Christ was guiding humanity to a gentler and better world. Six centuries later, the Quran affirmed Christ’s teachings by prohibiting usury too. Both Christianity and Islam encouraged interest-free charitable lending in support of the financially distressed, with flexible and lenient repayment.[148] Judaism also forbade Jews from lending to one another with interest, but it allowed them to do so to a foreigner (perhaps implying a pagan).[149]
To understand how and why the West stopped heeding Christ’s command requires going back in time. Original Christians accepted the prohibition of usury as an integral part of their faith. In the intervening centuries, a profound misunderstanding has emerged that banning usury was morally correct, but economically wrong. This entailed an error in logic because morality is always consistent with societal-interest, economic and otherwise. Hence, it is a logical absurdity for usury to be both morally flawed and economically correct.[150]
Despite usury’s unequivocal condemnation, three factors contributed to its revival. First, there was no concerted effort to develop morally correct and viable alternatives to usury. Second, while the degree of indebtedness in the economy remained modest, if increasing, the economic damage from usury remained limited and isolated. Hardly anyone foresaw the cancerous growth of usury or the severity and range of hardships that it would inflict. Third, given the church ban on usury, moneylenders resorted to obscuring their usurious practices. All three factors contributed to usury’s eventual acceptance as a fait accompli.
The spread of usury was foremost a failing of those who did not see the need to provide alternative financing and, in the name of religion, stifled science and, perhaps, equity innovations too. Indeed, in the name of religion grievous misdeeds have been committed such as the burning of witches and scientists, religious wars, and imperialist pursuits. However, these were the failings of men, not religion, just as cars are useful, but drunk drivers cause accidents. The great religions do not stray, but their institutions, leaders, and followers do.
Usury can never claim the high moral ground; hence, its only justification is economic. Doubtless, the spread of usury is a challenge to the great religions. Its preponderance today implicitly suggests that banning it was economically wrong. Yet, the periodic banking crises tell a different story, testimony to an impaired usurious system. Hence, the unequivocal banning of usury that long ago entailed extraordinary vision.
The lack of incisive economic examinations of usury has worked in its favor. By enforcing conformity, Western centers of learning have constrained economic thinking, mostly to topics of marginal value. Hence, we find no profound economic debate or exhaustive research on why Jesus Christ, no less, categorically forbade interest. Conceivably, university administrators avoided such examinations for political reasons; perhaps, they feared the results of such analysis would give the church cause for intervening in economic life, thereby challenging the power of the plutocracy and their financiers. In any case, the decision not to study the economics of banning usury reeks of subservience to authority or intellectual arrogance and in any case, it is a dereliction of academic duty.
It is time that the economics profession remedied this major lapse in responsibility. This blind spot has plagued macroeconomic theory since the days of Adam Smith; the West has been bumping into grave financial accidents ever since. Today, with deepening financial crises, economists need to make a choice: defend usury, sit on the sidelines, or expose usury’s economic faults and articulate viable alternatives to end the grief of perpetual debt crises.
All church denominations and their associated universities have an unambiguous moral obligation to dedicate the necessary resources to investigate the economic significance of Christ’s ban on usury and to research viable, non-usurious financial alternatives. Islamic institutions have a similar obligation to mobilize the best economic minds to investigate the economic rationale for the ban on usury and to seek alternatives to usury. The latter have also neglected to investigate several other religious directives that have economic bearings.
Exposing the profound economic logic of banning usury is all the more surreal precisely because Jesus did not devote his life to the study of economics at elitist universities. Indeed, for the best economic minds not to have fathomed the economic significance of Christ’s command could be an unforeseen gift to the church, serene proof of the living miracle of Christ, precisely because his moral order promotes economic efficiency and not just kindness.
Christ’s economic miracle will become self-evident for the world to witness when the first vibrant, fair, and non-usurious economy replaces a sickly debt-ridden one. The church today has an extraordinary opportunity to become the catalyst in crystalizing ideas and unveiling institutions to realize Christ’s vision.
The Catholic Church in Rome has upheld usury as a deadly sin. For centuries, it punished unrepentant usurers, and the princes who failed to curb them, with excommunication and even death. Circumventing and eroding this uncompromising edict required cunning. Usury stealthily tiptoed in on a lack of understanding, lies, and deception. Its rehabilitation during the Renaissance inched forward in diverse places.[151]
At the School of Salamanca—a Spanish school of theologians and jurists—instead of devoting their energies to developing non-usurious alternatives, its scholars began advocating charging interest on non-consumption business loans, without comprehensive assessment of the long-term economic consequences of this course, to say nothing of violating Christ’s prohibition. In due course, this paved the way for other church denominations to repeat this mistake.
In 15th-century Florence, Bank de Medici began skirting the ban on usury by covering it with opaqueness and complexity, not unlike the exaggerated intricacies of today’s financial products. Medici’s clever financial charade made usurious lending appear as trade, concealing the interest by inflating the selling price of the merchandise in return for delayed payment (financing), without mention of usury or interest. Another technique to mask the interest was to lend in one currency and accept repayment later in another at an inflated exchange rate.
The Evolution of a Ponzi Scheme
Centuries ago, goldsmiths had to acquire safes, build strong rooms, and hire guards to protect their precious wares. Merchants and wealthy individuals also needed safekeeping for their gold and silver coinage. To recover some of the operational costs associated with their facilities, goldsmiths began to offer custody services for a fee and issue receipts for the deposits in their safes. Merchants quickly discovered that, instead of carrying gold and silver coins to settle payments, it was safer and more convenient to endorse and surrender goldsmiths’ receipts to counterparties. These receipts evolved into promissory notes payable on demand to the bearer and later into bank notes or paper currency.
Because endorsing deposit receipts became an accepted means of settling accounts, the gold and silver that these receipts represented, instead of changing hands, remained mostly in the safes of the goldsmiths. Steadily, it dawned on goldsmiths that their receipts were circulating on sheer trust because third parties did not know the actual amount of precious coinage on deposit. This realization launched moneylending. As a side business, goldsmiths began to grant loans and charge interest by issuing deposit receipts without corresponding coinage or gold bullion to back their lending. They expected most of these receipts, and their replacements, to continue circulating indefinitely, along with the rest of the float of the deposit receipts, with no one ever calling their bluff.
This process created a virtual gold stock that increased the effective money supply. The goldsmiths had accidentally initiated fractional reserve banking, a clever feat of financial sorcery that created currency out of thin air. The easy profit of earning interest on nonexistent gold was tempting, inducing lenders to lend more, thereby creating ever more virtual currency. This dishonesty was profitable until the day when there were too many withdrawals, and the lender could not honor them all. Thus, whenever a rumor circulated that a big merchant had lost his ships in a storm, the depositors—fearing the loss would bankrupt the lender—rushed to withdraw their money, triggering a run on the lending goldsmith (the bank). Thus, the survival of lending goldsmiths rested on continued public confidence, an elusive and volatile foundation. At the same time, avarice drove banking to ever more leverage until it failed.
The high risk of failure stemmed from the intrinsically crooked and insolvent business model because the goldsmiths were lending and risking money that they did not have. This remains the natural fate of all financial sorcery, tempered by government rescue packages and central banks acting as lenders of last resort. Still, in good times, moneylending was sufficiently enticing that some goldsmiths dropped their jewelry trade to focus exclusively on lending, thereby propelling banking as a separate business.
This development had several moral and economic implications. It was more immoral than usury, on its own, because it entailed two additional immoralities. First, it was dishonest because it loaned nonexistent gold and silver. Second, it betrayed the public trust by putting depositors’ funds at risk. These three immoralities are the sources of the intrinsic structural weakness of banking and the cause of its periodic crises. Despite appearances to the contrary, in essence, banking is an elaborate Ponzi pyramiding scheme and, like all Ponzi schemes, it is inherently unstable.
More generally, the unified theory of macroeconomic failure expects banking to fail because its basis is immoral and represents a negative externality. Moreover, as the immoralities of banking have increased over time, as will become clear in due course, the effect of the negative banking externality has become progressively larger, making it impossible for banking to survive without heavy overt and covert subsidies to the detriment of taxpayers.
To gain public acceptance, the business of usurious lending exploited every means, including a new vocabulary, to give it the respectability it lacked. Interest, a morally neutral-sounding term, replaced the morally repugnant usury, although the two are precisely the same. Bankers and banks, terms with prestigious and dignified rings, replaced moneylenders and pawnshops. The marketing spin has radically reversed the status of usury and its practitioners, transforming yesterday’s taboo into today’s golden calf. Today moneylenders occupy the highest social pedestals, and their financial powerhouses decree the usurious macroeconomic culture, ideology, and policy. Terminology aside, underneath the veneer, banking remains a ruthless moneylending business as portrayed by William Shakespeare in The Merchant of Venice.
For those interested in developing genuine interest-free financing, they need to be alert to the pitfalls they face. Like Christianity, Islam prohibits usury. The past few decades saw the introduction of “Islamist banking” to provide “non-usurious,” interest-free banking as an alternative to conventional banking. Despite excellent intentions, “Islamist” banking was unfortunate in that its founders came from conventional banking backgrounds; they understood interest-bearing debt and its instruments, but they were not versed in equity investments, the only mode capable of providing interest-free financing. In other words, the founders of “Islamist banking” lacked the requisite expertise for setting up an interest-free financing model and as such, their efforts were doomed. Hence, their focus was on relabeling and repackaging conventional banking transactions, unaware that they were mimicking the techniques used by Bank de Medici centuries earlier to obscure usury from the eyes of the church. Like Bank de Medici, they also earned a predetermined profit for financing, wrapped in fictitious trade deals. Most significantly, like Bank de Medici, they refused any business risk, requiring full repayment with “profit,” regardless of whether their counterparties lost or profited from the underlying transactions.
Thus, current “Islamist” finance sets a predetermined “profit” (interest). “Islamist” banks routinely fix their short-term “Islamist” profit with reference to the London inter-bank offered rate (LIBOR) and their long-term “profit” targets with reference to long-term bond yields. As with conventional lending, the nonpayment of a principal amount or “profit” bankrupts the borrower.
“Islamist” banks execute financing deals by creating synthetic merchandise trades. The bank makes a cash purchase of a virtual commodity from a client and simultaneously sells it back to the same client for delivery at a future date and a higher price to secure the bank’s “profit.” Typically, the client does not intend to purchase the commodity in question. In any case, the commodity only changes hands on paper, recording phantom purchase and sale transactions. Not surprising, numerous conventional banks have found it easy to engage in “Islamist” banking, dedicating special departments and subsidiaries to that end. The changes they needed to make to their regular operations were superficial, consisting mostly of relabeling and repackaging their conventional banking business.
Unlike conventional banks, in the event of a default, “Islamist” banks do not charge a “profit” for late payment. The downside, however, is that they rush delinquent borrowers to court to minimize lost time and lost income, giving borrowers even less breathing space to solve their problems than conventional banks permit. The ultimate irony, based on a personal experience, was that one “Islamist” investment company charged a significantly higher rate of “profit” than a conventional bank did—at 10 percent and 8 percent, respectively. Worse still, a year later, the “Islamist” rollover offer was prohibitive at 15 percent, claiming they wanted to discontinue personal finance.
Still, “Islamist” banks, like most non-Western financial institutions, coped well with the 2008 debt crisis, requiring relatively modest assistance from their respective governments. In large part, this was because non-Western economies have a lower degree of financial deepening and leverage than that prevailing in the West.
In addition, the guidance of religious committees that oversee the operations of “Islamist” banks proved helpful. First, the religious committees consider it unlawful, based on Islamic law, to trade debt, which barred “Islamist” banks from participating in “Islamist” versions of securitized sub-prime toxic products. Second, Islamic law also prohibits selling anything one does not own. This prohibition spared “Islamist” banks from engaging in short selling. Third, Islamist religious committees suspected that derivatives entailed debt and, therefore, usury. Thus, despite the determined efforts by Western “Islamist” economics and finance scholars to convince them otherwise, the religious committees remained unconvinced. This disallowed the “Islamist” banks from diving into the derivatives swamp. These restrictions have limited the leverage of “Islamist” banks—so far.
Genuine non-usurious financing must be in the form of equity, which requires accepting the loss of profit and principal as a business risk, instead of treating it as an event of default. Perhaps one day, religious committees will ban cleverly disguised usurious lending too, once they see through it, and insist on replacing it with religiously correct equity alternatives.[152] Perhaps organizing competitions to innovate non-usurious financial products could transform the financing business, especially if enticing prizes were on offer.
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A Greek philosopher once said, “Endings are defined by their beginnings.” In other words, if we take the wrong path, we will arrive at the wrong destination. Economists set economics on the wrong path the day they assigned factor incomes as wages to labor, rent to land, and interest, instead of profit, to capital.