In such an ever-changing global economy, and in light of the continuous failures that leading economies such as the US and Europe have faced, Arab Business Review questions whether the time has come for macroeconomic policy makers to implement the zero-interest rate policy in the Arab World. It is argued that this would lead not only to enhanced economic growth, but also to stable inflation and lower unemployment. Zero-interest rate policy stimulates investments, increases productivity and opens the door for more innovations.
Keynes suggested that only a very low or zero interest rate could ensure continuous full employment and distributional equity. Keynes’s endorsement of such a policy does not necessarily make it right, but his analysis does suggest that it should be regarded as a serious proposition. Has the time come for the Arab region to seriously look into the merits of the zero-interest rate policy and work on establishing a rigid and water-tight macroeconomic policy framework taking into account the fiscal, regulatory and governmental considerations?
♦ Would it be better if Arab governments mandated that apple prices be set to zero? Apples are healthy and many Arabs do not get to eat as many apples as they should because of their price. Setting it at a constant predictable zero would allow far more people to consume the apples they need, resulting in better health and nutrition for everyone.
♦ While this may sound appealing, it is wrong and counter-productive. The price of apples is an important market signal, without which a market for apples cannot exist. A price arrived at by free consensual agreement between buyer and seller means that both are satisfied with the transaction. Hence, government intervention in the price of apples must lead to a distortionary negative impact on the economy as a whole: shortage if the price is set too high; surplus if too low. If government mandates a price of zero, this will harm both consumer and producer: the latter will stop producing apples if he cannot be reimbursed for them; the consumer will not find any apples to consume. Setting the price of apples at zero does not mean an endless supply of free apples, but an end to apple supply.
♦ Like with apples, the interest rate regulates the supply and demand for capital; the interest rate is the price that savers receive for investing their capital, and the price that borrowers pay to borrow savers’ capital. A functioning capital market, like a functioning apple market, would allow the price to be set freely through the interaction of borrower and lender. Interest rates rise if demand exceeds supply; but fall when supply exceeds demand. What is important, then, is not the level of interest in place, but that the interest be set freely through the free interaction of borrower and lender.
♦ In a system of irredeemable fiat currency and fractional reserve banking, if the interest rate is set artificially low, the shortage of savers is not felt immediately, since banks create new money when issuing loans, and central banks stand ready to inject liquidity if needed. In effect, the fiat monetary system can ‘solve’ the shortage of capital caused by interest rate manipulation by creating more money. But creating money is different from creating actual capital, and this monetary expansion has four adverse long-term effects that outweigh any ephemeral short-term benefits.
♦ The first effect is the constant erosion of the purchasing power of fiat money. This can be best illustrated by comparing the value of various fiat moneys against real money—gold. Since 1971, when the US abandoned fixed USD/gold exchange rate, and entered the era of ever-expanding money supply, the price of a dollar has gone from around 1/35 of an ounce of gold to less than 1/1200 an ounce of gold—a reduction of more than 97% of the dollar’s purchasing power. Other economies, also seeking the Keynesian panacea of low inflation and high growth via monetary expansion, have hardly fared better; the British Pound, Swiss Franc and Japanese Yen have lost 95%, 86%, and 89% of their purchasing power compared to gold, respectively, in the same period.
♦ Secondly, as money loses its value, people question the usefulness of saving for the future. People’s time-preferences shift towards immediate gratification ahead of long-term reward; they consume and borrow too much and save too little, becoming financially fragile and highly-dependent on their jobs and government benefits. As a result, individuals, firms, and governments are drowning in ever-increasing debt, with periodic collapses and bankruptcies. The savings rate in the US has been plummeting since 1971, and has been near zero for the past decade. Only 43% of American households have enough savings to cover three months’ expenses.
♦ Third, as economist Richard Cantillon illustrated, the parties that print new money or receive it first benefit the most from this expansion, while the rest of society is hurt from rising prices. Recent experience bears testimony: repressed interest rates punish the majority of society, particularly the poor and wage-earners, with reduced purchasing power, and reward the financial system, the government, and well-connected economic interests with ever-growing economic and financial power. It is no coincidence that inequality in the US has surged since 1971.
♦ Finally, manipulated interest-rates are the cause of the endless cycles of boom-and-bust. Entrepreneurs calculate costs, expected revenues, economic conditions, and others market signals to move capital to where it is most productive, away from sectors where its return is below the interest rate. But for this market process to function it needs a constant unit of measure with which capitalists can perform their calculations, and that measure is money. But monetary expansion, by increasing the supply of money available, distorts the value of money, and thus destroys the capitalists’ unit of measurement, leading to faulty calculations. The effect is similar to an engineer trying to build a house with several conflicting and inaccurate measures of a meter. The results are as disastrous.
♦ When interest rates are artificially lowered, many non-productive industries will appear profitable, and more capital will be directed to them. This redistributes existing capital away from productive sectors to unproductive sectors. Worse, by incentivizing people to consume more and save less, there will be even less real capital available. ♦ Just like the apple market will collapse from price manipulation, the capital market will collapse in the form of the recessionary bust that exposes the shortage and misallocation of capital into failed enterprises. History again bears testament: lowered interest rates in the 1990’s led to capital going to unprofitable investments, particularly dot.com start-ups, and the crash of 2001 destroyed more capital than was created in the preceding years.
♦ The Federal Reserve Board learned nothing from this crisis and proceeded to ‘fix’ it by doubling down on the inflationary policies that caused it in the first place. This time, real interest rates dropped below zero, and the result was the housing and finance bubbles that blew-up in 2008, damaging the entire world economy and global financial system. Yet, the FRB has doubled-down by dropping interest rates even lower, which is now fueling the next round of disastrous allocation of capital, this time into government bonds.
♦ None of these problems is necessary or inevitable, and they are exclusively the result of the delusion of politicians and economists that a free lunch can be engineered by constantly creating more money—a delusion precisely as ridiculous as trying to improve healthcare in a country by printing more MD diplomas and handing them out to people with no medical training. To create new doctors, there is no alternative to painstakingly training them; the diploma is but the indicator of the training having taken place. Printing more diplomas will not increase the number of doctors; it will destroy the integrity of the diploma as an indicator of medical training. Similarly, to create more capital for investment, there is no alternative to diverting real resources away from current consumption towards savings for future production. Creating more loans via manipulated interest rates will not create more capital and economic growth; it will only destroy the integrity of the currency as a medium of exchange, store of value, and unit of account.
♦ At the outset, it would be necessary to elaborate on a very important point. I do not support zero-interest per se, and I am against treating zero-interest as no-interest because zero-interest is now commonly understood in response to monetary policy only and it can be changed or manipulated any time by policy makers.
♦ To make things simple, I will, for the sake of this debate only, assume that no-interest is equivalent to a PERMANENT adoption of zero-interest (assuming also that a no-interest system prevails in the entire economy and no lending/borrowing takes places on interest).
♦ In the interest of being on the same playing level field, let us agree at the outset that we are discussing the monetary policy of a central bank to lower interest to zero or close to zero, to stimulate macroeconomic growth, because injections of money fail to reduce interest, and people continue to hoard or hold cash. No doubt that is Keynesian Economics.
♦ Maurice Allais, a French economist and a Noble Laureate in Economics (1988), states that: “In essence, the present creation of money, out of nothing by the banking system, is similar – I do not hesitate to say it in order to make people clearly realize what is at stake here – to the creation of money by counterfeiters, so rightly condemned by law”. Allais gives strong arguments against credit creation: “All our difficulties stem from ignoring the fundamental reality that no [market system] may properly operate if uncontrolled credit creation of means of payment ex nihilo allows (at least temporarily) an escape from necessary adjustments”. Allais laid out basic principles for the necessary reform, which would prevent the creation of money from nothing. Although all banks would be private, except for the Central Bank, all income derived by the Central Bank’s creation of money should be returned to the State, enabling the latter, under present circumstances, to do away with practically the whole of the progressive tax on income. This would eliminate the present circumstance where profits and their beneficiaries are not transparent. Such revenues, he wrote, “merely generate inflation, and by encouraging investments that are not really profitable for the community, they only generate wastage of capital.”
♦ What makes Allais position more interesting and useful than Keynesian economics is the paradigm shift in the financial system that Allais is suggesting, compared to maintaining existing paradigm with only peripheral changes.
♦ I suggest that it will be more interesting to discuss a no-interest-based economy as opposed to zero-or-near-zero-interest based economy. The latter implies a lending-based financial system secured by physical guarantees and collaterals from borrowers. The former implies risk-sharing an investment based financial system (lending and borrowing being primarily outside the financial system and would carry no interest and would provide writing it off in case of borrower’s hardship or inability to pay). This comparison does not have to be faith based. It can be made purely on their economic merit.
♦ The argument is that the no-interest-but-risk-sharing investment-based financial system in the economy (call it PS) is a superior option than the interest-based financial system in the economy (call it IS) on grounds of efficiency, stability and equity as well as on grounds of growth, development and human resource mobilization. PS would force capital to go where it is more productive. This compulsion does not exist in the IS system. In PS, Capital would seek profitability, and feasibility while net worth of client being a secondary consideration. Efficiency and equity go side by side as a natural outcome of the PS. On the other hand, the IS gives primary importance to credit-worthiness and net worth, profitability and feasibility being secondary consideration. There is clear conflict between efficiency and equity in IS because Capital’s reward remains fixed and guaranteed and collateralized. Capital therefore seeks high net worth clients.
♦ Stability considerations in PS arise from the fact that capital gets rewarded only by sharing the risks of the investment. If bank is providing such capital from the depositors’ money and if bank loses some big investment, it will not cause a run to the bank to withdraw their deposits because in that case they will simply be sharing all the losses on bank’s investment. It will be in their interest to refrain from rushing to the bank to withdraw deposits and instead wait until bank recovers its losses.
♦ In IS, however, it will be in the interest of the depositors to rush their bank and withdraw money guaranteed by the bank. This run to the bank will have a contagion effect and there will be run on other banks and the banking system will collapse. There are other merits of PS particularly with respect to growth, development, human resource mobilization and poverty alleviation.
♦ If Arab Business Review has to suggest anything to the Arab region for economic growth and development, then let it be the suggestion to adopt the no-interest-but-risk-sharing investment-based financial system and replace IS by PS.