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The deal’s about to close.
We’re wrapping up the last conference call. We’re in agreement with the client and their lawyers had no more comments. Finally.
Did the client understand every detail of the deal?
Should I care? It's their responsibility and their lawyers' responsibility. I just needed to close the deal. I did my job.
My goal was to get a deal across with the commercial terms as agreed with my committee. That’s it.
Why?
Because my incentive was a payout tied to the deal.
If I wanted that big pay-check, I needed to close this deal. I was representing the fund. That’s all I cared about. If I look after myself, my team, I’ll be rewarded. The client can deal with their own side of the deal. I’m not going to do the job for them. I’m not incentivised to.
There goes that word again: incentive.
Incentives shape our behaviour. It can be the reason why you do a certain thing.
Charlie Munger, one of the most famous and reputable investors, once said “show me the incentives and I'll show you the outcome”.
It’s why you’re told that if you want to persuade someone to do something, you should appeal to their interest and not to reason.
You know exactly what I’m talking about.
How do you get your younger sibling or cousin to do something for you? You promise them sweets, money or to take them to the cinema.
The same thought process is required in my job. If I want to get a deal done, I need to structure it in a way that incentivises all parties involved. I need to put myself in the client’s shoes and figure out what they’re going to get out of this.
Nail this and selling will becomes a piece of cake.
But I’m not incentivised to act on the client’s behalf. If I feel as though they didn’t completely understand something, am I incentivised to dig deeper for them? Clearly not. That’s on them.
The issue is that incentives can also lead us down a shady path.
When we incentivise bad behaviour, guess what? Bad things happen.
The great financial crisis of 2008 is a perfect example of this.
The mortgage brokers were incentivised to give out mortgages to anyone. Even if they had low incomes or already had a lot of debt. Why? Because the broker was paid for every mortgage deal they closed and they didn't bear the risks.
The local bank offering these mortgages was happy to go along because the mortgages they offered were sold to an investment bank. The local banks’ incentive was to sell as many as possible. The investment bank was happy to buy these crappy mortgages that they could package and sell to investors.
On went the circle of misaligned incentives.
You see, everyone was incentivised to do what benefited them because that’s how the system worked.
But then the system broke.
Each party only cared about getting as much profit out of the system. The risks weren’t shared appropriately. Instead, it was the borrowers, the clients of the investment banks, the governments and the average citizen who paid the price. A hefty price.
Now that you have a better idea of incentives, let me show you how interest rates lead to perverse behaviour.
This will be split into 2 articles as there’s a lot of ground to cover.
Interest rates are simply the rate - expressed as an annual percentage - of the cost of borrowing money. A 5% annual interest rate means that for a loan of $100, the borrower will pay back $100 (the principal) and an extra $5 (the interest payment) back to the lender a year later.
Modern society cannot live without interest. We can’t perceive a world without it.
Yet in Islam, interest rates (or riba), is a major sin. A sin so bad that Allah tells humanity in the Qur’an that anyone who consumes, pays, or is a witness to an interest-rate based contract, to prepare to fight a war against Allah.
Good luck.
The unquestionable acceptance of interest rates comes down to the idea of “time value of money”.
Time has value and interest is the price of time. If you can choose between consuming something today and consuming the same thing tomorrow, you will most likely prefer consuming it today.
This is called having a “high-time preference”. Preferring the present to the future.
We’ve come to accept this as a given and stick to using this assumption without questioning it. But does that make it right? Should you always prefer the present to the future?
Using this same logic, if you’re the lender, you should be compensated by the borrower for deciding to not spend your money today. The longer the time to get paid back, the more you should be paid in the form of interest.
Accordingly, people who have patience and a low time preference should be rewarded.
Seems reasonable right?
As Muslims, we have to question this same assumption. Here’s a relevant anecdote from Al-Tabari’s book on the explanation (tafsir) of the Qur’an:
The companion of the prophet Muhammad (peace be upon him) ‘Abd Allah ibn Mas’ud was once reciting Surah al-A’la’ for some of his students. When he reached the following passage: “But you prefer the life of the world, although the hereafter is better and more lasting (87:16-17).”
He stopped and commented, “We have preferred the life of the world over the hereafter.” No one said anything. Ibn Mas’ud continued, “We prefer the life of the world because we see its ornament, its women and its food and drink while the hereafter is remote for us. Therefore, we prefer this which is immediate over that which is deferred.”
Just because you prefer the present over the future does not make it right.
Should you let your preferences and desires dictate your life? You may prefer watching Netflix instead of going for a run but you know damn well what the better option is. The same kind of discipline should be applied to everything you do.
The Qur’an constantly reminds us of a single choice we are tested with throughout our lives: choosing between what you want most instead of what you want now.
Does expending our resources today fare well for future generations? Should the planet we have today with all its bounties be consumed today rather than later?
This is why the issue of climate change requires much more in-depth thought.
On one hand we are told to look after our planet and use our natural resources wisely. On the other hand our economic system favours consumption today at the expense of our future.
There’s clearly a mismatch.
We will always prefer consuming, producing and therefore polluting today, and our children will pay the price. Why? Because the incentives make it so.
Now let’s take a closer look at interest rates. Let’s look at the loan as if it were a transaction.
The borrower is not ‘buying’ money, because if they were, why would they give it back to the lender? Clearly the borrower is ‘renting’ money.
But if the borrower is ‘renting’ money, then this makes money very different to any other thing that can be rented.
Take the example of a tractor. A farmer borrows a tractor from the owner and pays them rent for using it. One day the farmer wakes up to see that their tractor has been stolen. Who bears the loss?
Clearly the owner of the tractor as it’s their tractor.
But with a loan, if the borrower loses the money because of a bad investment, the borrower is still forced to pay back the principal with interest. So technically they ‘own’ that money. Now if they own it, why are they paying rent in the form of interest?
Another argument for a lender to charge interest to the borrower relates to the idea of abstinence. The lender is abstaining from investing and consuming their money and should be paid accordingly.
Is that always the case?
Lenders usually have a lot of surplus cash and don’t need to abstain from anything if they are lending extra funds.
We could also argue that the lender is foregoing receiving interest on their savings when lending the money out. For that reason they should be compensated. But that’s a bit of a catch-22. If there were no interest rates, then this argument wouldn’t hold in the first place.
Society is therefore treating money as a commodity. That it's a good in itself.
But that’s not true.
We need to go back to understanding what money actually is.
Most of us don’t question what money is, where it comes from and how it came about.
But we need to understand money if we want to better understand the role of interest.
Money, should have the following characteristics for it to be considered sound:
The US Dollar, more or less, meets all the criteria above. You can argue about its scarcity and stability given all of the money printing by the US central bank (the ‘Federal Reserve’, or the ‘Fed’) but it’s still not at uncontrollable levels. Everyone is happy to be paid in USD. Well nearly everyone… but we’ll get to that another time.
Trust in the money is the single most important thing. If people lose trust in the money, then no one accepts it, hence you can’t buy anything with it.
You're taught from economics 101 that money replaced the old barter system.
This is where our ancestors were supposedly trading one type of good for another. Each person would have their specialty in terms of what they grow or manufacture. If you grow wheat, you could swap it with someone else that has chickens and vice versa.
Clearly this isn’t efficient. This works because you need chicken at the time and the other person needs wheat. Over time people resorted to using other mediums - gold, silver, sea shells etc. - to exchange goods.
That’s the typical story. One that people have come to accept.
But you’re not most people, are you? You’re accustomed to questioning the status quo. This is why you’re reading this.
The barter system has been challenged by anthropologists such as David Graeber. He wrote a fascinating book called Debt and explains how money first started off as debt. Quite fitting.
Money as debt? But you need money to create debt?
Hold on a second. Let me explain.
During the 19th century, we discovered clay tablets from Mesopotamia - modern day Iraq - that are around 5,000 years old. This is the most ancient civilisation in recorded history. They had an elaborate economic system where they used money. These tablets were inscribed with quantities relating to certain commodities. They’d record who is owed what and by whom.
You can think of these tablets as IOUs. The holder of the tablet is owed whatever is inscribed on it and can claim to be paid what’s due to them by the issuer of the tablet.
The Temples of Mesopotamia issued these tablets. These organisations were a lot more than religious structures. They played an important part in the local economy - they handled tax collection, lent money and invested also.
So workers back then were paid in kind. Not in actual money, but in most cases they were paid in barley and then eventually in silver. We have proof that they would have received tablets with the payment that was owed to them.
These were IOUs (i.e. debt). They simply said ‘I promise to pay you X’. X could be an amount of barley, silver or whatever.
Someone could take this IOU and use it to pay someone else in exchange for something.
The merchant would happily accept these IOUs. The tablets were issued by the Temple and they knew that they could go back to the Temple to collect whatever was owed to them as written on the tablet. Or they could just re-use the tablet to pay someone else. And so on it went. This is how transactions took place.
Money started off as debt.
With the introduction of silver, it was easier to calculate the debt in a common unit. Silver became money and debt was calculated in silver, even though the debt didn’t have to be paid in silver as long as you could keep using these IOUs.
This system eventually developed further. Money took on different forms but in most cases it was the use of precious metal coins like gold and silver.
Now that we got this history lesson out of the way, we can go back to the point I was making.
The point is this, first there was debt, which was used as money, we then had to find a common way of calculating debt in an easy way. Imagine using barley to calculate debt?
Can you imagine being an accountant back then? That would’ve been dreadful.
So we can agree that money, in itself, is not a commodity but an accounting tool.
We use money to measure the value of something. The measure of that thing we’re valuing is based on a rule that everyone follows and trusts. We also use money to exchange it for other things when we want to buy something. That’s it.
So money cannot be treated as a good in itself. It is only a means to an end.
Following this logic, we cannot then make money from money without producing any real value.
What do I mean by real value?
That real economic output has been created. Be it a new product (i.e. a manufactured car) or a service (i.e. a consultation that has made a client’s work more efficient because they can now produce more cars with the same amount of inputs).
If money is made from lending money, then on one hand, the money lender sees their wealth increase without an equivalent increase in output in the real economy.
You can argue that the borrower may use the funds to increase economic output. But what if their business failed? The lender is still compensated without taking any risk in the borrower’s business venture.
This is what Islam frowns upon.
Money as a measure of value should be tied to real economic output. If nothing is created (i.e. no real economic output) but the lender sees their wealth increase then it can lead to all kinds of problems.
So guess what happens when money is treated as a commodity and lending is commercialised?
This incentive leads to all kinds of problems that our modern economy is now facing.
This is what I’ll be discussing in more detail in my next article.
I manage a $100m private investment fund and I explore Islamic finance and economics through a personal lens. I help simplify financial markets from a Muslim perspective.
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