Detective Gregory: Is there any other point to which you would wish to draw my attention?
Sherlock Holmes: To the curious incident of the dog in the night-time.
Detective Gregory: The dog did nothing in the night-time.
Sherlock Holmes: That was the curious incident!
The Adventure of Silver Blaze
There is something curious about the way monetary authorities deal with the current high rates of inflation. A tight monetary policy is necessary to curb demand and stabilize prices. Without a strong stance, the official view maintains, inflation may spiral out of control.
While this view is debatable,1 we may still ask: Why and how would inflation run out of control?
Inflation means prices are rising. From Economics 101, we know that when the price rises, demand declines, ceteris paribus, and the market shall reach an equilibrium with stable price and demand. Markets are supposed to self-correct any imbalances through the price mechanism. Higher prices should curb excess demand, and the economy, as a result, should become stable. At least, that is how a free market is supposed to operate.
So, when we find authorities in market economies tighten monetary policy to slow down inflation, we wonder: Why did they not let the market correct itself?
There must be a reason. And we don’t need rocket science to figure out that reason: The market may not correct itself. But why is that? We argue that, regardless of friction, a major factor behind this failure is interest-based financing.
Without financing, higher prices would curb demand. But with financing, buyers will be able to use borrowed money to compensate for the additional costs. With interest-based lending, however, financing becomes too elastic: It can accommodate demand to an extent far beyond what normal market forces would allow.
Businesses can finance the higher prices of their inputs and add the additional cost of financing to the price of their goods and services. This causes other businesses to borrow as well, adding their costs to their prices, and so on. When everyone does the same, a vicious circle will develop, and inflation will be out of control. This vicious circle can take place even without friction or transaction costs of any sort. Even with complete information and zero agency costs, the interest mechanism may cause inflation to escalate out of control.
So, we can see why higher prices might fail to do their job of restoring market balance. In an interest-based system, the price mechanism will likely lose the ability to bring equilibrium to the market—it will fail to “bark.” The interest mechanism overrules the price mechanism.
Monetary authorities might be right, at least in part,2 in applying tight policies to control inflation. But this is an open admission of the failure of market forces to restore equilibrium and stabilize the economy. The interest mechanism is a significant source of failure, even in the most efficient type of economy.
How about Islamic finance?
Islamic finance is market-based finance. Deferred sale, Salam, leasing, Istisna’, and similar instruments are trade-based financing. They are, therefore, integral to market activities. These instruments expand the domain of trade, but they are still within the boundaries of the market.
While Islamic financing instruments can be used to counterbalance higher prices, they are inherently bound by the market. Financing in this environment cannot expand beyond what market forces can permit. Only when financing is used to refinance outstanding debt, as is the case in an interest-based system, does finance break the limits of the market.
This explains the core difference between Islamic and conventional finance. The latter imposes no restrictions on the growth of financing. Islamic finance, in contrast, not only sets limits on financing, but these limits are also market-based. They enhance the market mechanism rather than inhibit it as interest-based lending does.
From a purely economic point of view, financing must be bound by economic resources. This is the well-known “intertemporal budget constraint” of dynamic economic analysis.3 But this constraint is global or macro in nature. To translate it into daily transactions, financing must be constrained by market activities, exactly as Islamic finance requires.
Despite all the hype, an interest-based system is inconsistent with the market mechanism. The fathers of free markets recognized this long ago: Adam Smith, John Stuart Mill, and Alfred Marshall. They all realized that banking and finance need to be regulated in contrast to markets for real goods and services.4
In fact, the financial sector is often among the most heavily regulated sectors of the economy.5 Not any kind of regulation would be helpful, however. What we need is “smart regulation”: regulation that makes the market more productive and dynamic. Rules of Islamic finance aim precisely to achieve this goal.
1 Stiglitz, J. and I. Regmi (2022) “The Causes of and Responses to Today’s Inflation,” The Roosevelt Institute, December 6.
2 Sandbu, M. (2022) “A political backlash against monetary policy is looming,” Financial Times, October 23.
3 Barrow, R. and X. Sala-I-Martin (2003) Economic Growth, MIT Press, p. 93.
4 Cassidy, J. (2009) How Markets Fail: The Logic of Economic Calamities. Farrar, Straus, and Giroux, pp. 35-36, 163.
5 Mishkin, F. (2007) The Economics of Money, Banking, and Financial Markets. Alternate edition. Pearson, pp. 42-46.