Chapter 4 of "Short Circuit" - page 3
"Social economy businesses have had problems with accessing money from mainstream finance organisations" ICOF Community Capital said in its prospectus. "Traditional institutional investors are sceptical about any legal structure which denies personal wealth accumulation and emphasises common ownership and local democracy....We recognise that [the] level of profitability [of social economy businesses] may be constrained by the achievement of social or environmental profit and we expect our investors to share this recognition. We accept money as an investment and although no guarantee can be given, it is expected that results will enable interest to be paid. It will be a goal to provide interest in line with inflation. The minimum investment is £250, the maximum is £20,000 and normally withdrawals can be made on six months' notice. We hope the monetary value of your investment will be maintained but it may go down."
Despite these and other warnings, such as the right of the Trustees to suspend withdrawals which in any case can only be made on six months' notice, Community Capital received deposits of £140,000 in its first four months. Threequarters of the depositors waived their interest payments to allow them to be used to build up a guarantee fund to cover any loan losses which are incurred, thus increasing the safety, if not the return, of their investments. Click for 2002 update on ICOF by Caroline Whyte
In Ireland no similar provident society has been established in recent years and an official at the Registrar of Friendly Societies' office in Dublin described them to me as 'a dying breed', their historic role in mobilising workers' savings taken over by the country's highly successful credit unions. However, Malcolm Lynch is confident that the legal work involved in forming one would present no difficulties since Irish law is still based on the original British Act. He estimates that fees, including Stamp Duty, would be between £1,500 and £2,000.
Workable legal structures therefore exist, three in Ireland, two in Britain, which community groups could use to set up their own enterprise loan funds. These are the limited company and the provident society models in both countries and the credit union format in Ireland where Britain’s stifling £5,000 loan limit does not apply. But although these structures exist, all the organisations using them are very small and lending very little. Even the best-known, Mercury, had more limited resources before its merger than any of Ireland's twenty biggest credit unions. Moreover, apart from TILT and the emerging Aston Reinvestment Trust, all have a national rather than a local focus. And, except for Mercury, their bad-debt record is generally poor. Could these problems arise because they are using the wrong approach?
And what about interest rates? Although some Mercury and Community Capital savers have shown themselves willing to accept little or no interest from organisations whose aims they support, community businesses seem unlikely to be able to get enough low-interest funds through local organisations modelled on the lines of those we have just discussed to enable them to compete with multinational corporations. And even if they could, what would be a reasonable interest rate to demand from a local business? Should interest be demanded at all?
Economists justify charging interest by arguing that people need to be rewarded if they are not to spend all their money the moment they receive it and agree to allow others to use it temporarily instead. However, their argument is flawed as most people would still save if they were paid no interest at all because everyone faces financial uncertainty and likes to have something put by for a rainy day. Moreover, everyone grows old and wants to have savings to draw on when they retire. What people need to be paid for, then, is not saving itself but allowing others to use their savings instead of hiding them in their mattresses. After all, there is a real risk if they lend their money that it will not be paid back. In addition, if a borrower benefits financially from investing someone else's funds, it seems right that part of the benefit should be shared with the saver who made it possible.
Then there is the question of inflation. While people still wish to save when inflation is rapid - indeed, there is evidence that they save a higher proportion of their incomes in order to maintain the real value of their security cushions - they will want to put as much of their savings as practical into assets such as land or antiques which can be expected to retain their value in relation to other goods and services and which can be converted back to cash by being sold later on. If people are to agree to keep their wealth in money in order that others might use it, they therefore need to be compensated by the borrowers for any loss of purchasing power.
In summary, then, a fair interest rate does three things: it rewards the lender for the risk he or she runs when making the loan; it compensates for any loss in the purchasing power of money; and it shares between borrower and lender the benefits which flow from the way the money is used. In practice, of course, reasons one and three can be rolled into one: the promise of a share in the potential benefits should cover the risk inescapably involved in making a loan.
Despite these justifications, the charging of interest was condemned by the Roman Catholic Church until the 1830s and Islam still bans it today. Indeed, many thoughtful people of all faiths and of none continue to have serious reservations. One root of their unease runs back to the time when gold was used as currency. Since gold did not increase itself, and very little was being mined, where, people asked, was the extra bullion to come from to pay the interest when both principal and interest had to be handed over at the end of the year?. Obviously, the borrower could only obtain more gold if someone else had less, so lending money at interest meant that either the borrower impoverished himself when he paid over the extra or he impoverished someone else. And, as neither outcome was socially desirable, usury, as all forms of moneylending were called no matter how low the interest rate, stood morally condemned.
Even though we now use paper currencies, this source-of-interest problem has not gone away. As we saw in the discussion of the Guernsey Experiment in the last chapter, almost all money in circulation is issued on loan. This means that money to cover interest payments can only be obtained by borrowers if other borrowers have borrowed sufficiently more. Moreover, the necessity to pay interest on these additional borrowings means that the economy needs to expand if the proportion of world income which is paid over in interest to the lenders is not to increase. This in turn explains why the capitalist system is unsustainable: it depends on borrowing money at interest which can only be paid without impoverishing the borrowers if the economy grows. If growth stops, the borrowers find themselves having to service loans which have not generated any return. Their profits fall and they therefore cut back on their borrowing and investing the following year, throwing out of work many of those who would have built the factories, shopping centres and office blocks they would otherwise have ordered. This cuts demand and, unless governments take up the slack by borrowing themselves in order to spend more to compensate, the economy sinks into a depression. In short, the borrowers' need to pay interest means that governments have no choice but to allow growth to continue, despite the damage that the changes involved may well do to the natural environment, to communities and to the social order. Consequently, whether we are concerned with countries or communities, without an economic system which avoids interest we cannot hope to achieve a sustainable way of life.
Muslim economists have been trying to develop such a system. They reject the payment of interest because of what they see as the basic injustice of transactions in which the borrower has to return more than he or she received. "An equitable transaction is equal for equal. Usury is something for nothing" write Fazlun Khalid and Umar Ibrahim Vadillo, both members of the progressive Murabitun movement of European Muslims, in a crystal-clear 1992 essay 'Trade and Commerce in Islam'.7 "The profit of usury is like a parasite in the market - it sucks wealth without giving anything in return. The parasite forces the market to increase artificially in size, like a diseased body, just so it can feed. But as the market grows, the parasite also grows. Usury produces an imbalance in natural trading, and this has now penetrated everything."
They explain that Islam forbids the taking of a guaranteed fixed return on an investment regardless of the way the investment turns out. "A profit from money can only be justified if it is invested in a business and that business produces a profit. Money by itself cannot produce a profit. Islamic law requires that the investor shares both in the success and the failure of a venture [according to a] mutually agreed contract."
The only way that devout Muslims can therefore hope to make a profit by letting someone else use their savings is by taking what is effectively a share stake in the borrower's venture, recovering their money when it is completed, or by selling their shares in it later on. Anyone wanting avoid the risks inherent in putting all their savings in one project would have to join with other investors and set up a fund to take shares in a number of businesses, a route which would also make it easier for them to get their money out. Umer Chapra, an economic adviser to the Saudi Arabian Monetary Agency, proposes exactly this approach in his 1985 book Towards a Just Monetary System,8 which is essential reading for anyone interested in how a zero-interest financial system might be built. However, as Chapra points out, Islamic law imposes two requirements on such funds. One is that all those who have invested in a venture have to have equal decision-making powers regardless of the amount they have invested because one party would otherwise have an advantage and the others would cease to be effective owners. Voting at shareholders' meetings has therefore to be on the basis of one shareholder, one vote, exactly as with a co-operative society. The other stipulation is that the results of the venture are shared among the co-owners in proportion to their investments, which need not be in cash or property: time, skill and effort can counted as investments as well.
Chapra, who holds a PhD from an American university and taught economics in the United States, devotes a chapter of his book to countering conventional arguments that an interest-free system would lead to a misallocation of resources or simply would not work. On the contrary, he argues, it would be more efficient since a would-be profit-sharing investor would undertake a much more careful investigation of a potential project than does a conventional, interest-oriented lender who shifts the entire risk to the entrepreneur by demanding property deeds or other types of security for his loan, thus assuring himself of a predetermined rate of return irrespective of the success of the borrower's business.
Moreover, Chapra says, the use of interest rates to allocate capital between competing borrowers is itself inefficient:
The rate of interest tends to be a 'perverted' price and reflects price discrimination in favour of the rich - the more 'credit-worthy' a borrower is supposed to be, the lower the rate of interest he pays and vice versa. The result is that 'big' business is able to get funds at a lower price because of its 'higher' credit rating. Thus those who are most able to bear the burden because of their bigness or claimed 'higher' productivity bear the least burden. In contrast, medium and small businesses, which may sometimes be more productive in terms of contribution to the national product per unit of financing used and at least equally 'credit-worthy' in terms of honesty and integrity, may be able to secure relatively much smaller amounts at substantially higher rates of interest. Hence many potentially high-yielding investments are never made because of lack of access to finds which flow instead into less productive but 'secure' hands.
Therefore, the rate of interest reflects, not the 'objective' criterion of the productivity of the business but the 'biased' criterion of 'credit rating'. This is one reason why in the capitalist system, big business has grown bigger beyond the point dictated by economies of scale, thus contributing to monopoly power, while small and medium businesses have often been throttled by being deprived of credit. This is particularly so when interest rates rise and create a liquidity crunch by reducing the internal cash flows. Small businesses are rarely given a respite by the lending banks. Loans to them are called in at the slightest sign of trouble, thus causing widespread bankruptcies. However, when big businesses are in trouble, there is rescheduling accompanied by additional lines of credit. Does this indicate an optimum allocation of resources or an efficient banking system?
Instead, if credit is made available on the basis of profitability, then not only will the banks be more careful and rational in evaluating projects but also small, medium and big business would stand on an equal footing. The higher the rate of profit, the greater will be the ability to secure funds. Big business, if it is really more profitable, should pay a higher and not smaller rate of return to the lending institutions. The Islamic system could reflect an innate ability to favour entrepreneurs with talent, drive and innovation but who, as Ingo Karsten has put it [in a March 1982 IMF staff paper, 'Islam and Financial Intermediation'], 'have not yet established their credit-worthiness'. Thus resources would not only be more effectively utilised but also equitably distributed. (Italics in the original)
Even The Economist magazine likes Islam's theoretical framework for a zero interest economy: 'It gives the provider of money a strong incentive to be sure he is doing something sensible with it' it wrote in 1994. 'What a pity the West's banks did not have that incentive in so many of their lending decisions in the 1970s and 1980s. It also emphasises the sharing of responsibility, by all users of money. That helps to make the free-market system more open: you might say more democratic.'9
But have Muslims established an interest-free economy anywhere, or at the very least, opened a successful zero-interest investment fund in an industrialised country which could be taken as a model by believers and non-believers alike? The answer to both questions is, unfortunately, no although Dr El Naggar appears to have established a successful rural profit-and-loss-sharing savings bank in Egypt in the 1960s. This failed, however, when it was taken over by the state under President Nasser and radically remodelled so that it ran on over-ambitious top-down lines."The sad reality is that .... there is not a single Muslim country which is running its financial institutions without resorting to interest. The fact is that no-one knows how to do it and when political pressure mounts, they can only resort to some kind of subterfuge" writes Shaikh Mahmud Ahmad in his 1992 book Towards Interest-Free Banking.10
Why is this? Fazlun Khalid blames western-educated Muslim economists like Chapra for advising Muslim countries to 'set up central banks and issue worthless paper money'. "They wield enormous influence on the rulers of Muslim states who are committed to the west-engineered development model" he says. Chapra is particularly suspect because he wrote in 1992 that Muslim governments were 'juristically permitted' to charge interest in particularly difficult circumstances and also perhaps because he advises the Saudi Royal Family which permits western banks to operate extensively in its country.
Khalid also thinks that there is not a single truly Islamic bank operating anywhere at present and says that those banks which claim to be Islamic either charge interest or do things which are also condemned as usury by Islam such as creating money by issuing loans greatly in excess of the amount of savings they hold on deposit, just as conventional banks do everywhere in the world. The use of paper money, cheques and plastic cards as money also amounts to usury because it leads to inflation.
Accordingly, the Murabitun movement has minted gold coins in Scotland, Spain and Germany and is using them to enable its members and others to trade across Europe without needing cheques, plastic cards or paper money. "Special markets are being organised in which there are three zones - a white zone, in which paper currency can be used, a grey zone for either gold or paper currency, and a green zone restricted to gold and barter. We’ve got to start from where people are but we obviously want them to move out of the black zone as time goes on" he told me at the end of 1995. "The prototype of these markets was held in Birmingham in 1992 and they have since been held in Grenada in Spain, Amsterdam and Zurich. Umar Vadillo who lives in Scotland is the driving force behind them."11
Despite Islam’s failure to provide a suitable model, interest-free community banks do exist, and are functioning successfully in the Nordic world. In Denmark, in fact, they are offering the conventional banks such strong competition that improper means might have been used to get one of the most expansionary of them closed down, as the story in the panel tells.
Click for panel from original book on a rural bank which offered interest-free loans
But the best example of what a community bank can achieve and how the interest rate problem can be handled is provided by the Lankide Aurrezkia - the Working People's Bank, or in Spanish, the Caja Laboral Popular - which operates largely in the Basque region of northern Spain. It is, however, impossible to describe how this bank came to be set up and how it operates without also telling the story of the Mondragon co-operatives which now employ 21,000 people in the same area and in whose expansion the bank played a crucial part.
The bank and the co-operatives owe their existence to a one-eyed priest, Don José Maria Arizmendiarrieta, who was so unimpressive when in 1941 aged 26, he was appointed to work as assistant curate among young people in Mondragon, a steel town of some 8,500 inhabitants, that some of his parishioners wished the bishop would re-assign him. "He spoke in a monotone with intricate and repetitive phraseology difficult to understand. He hardly even [read] with grace" someone who became a close colleague wrote 45 years later.12
One of Fr. Arizmendiarrieta's duties was to teach classes in religious and human values at a school run for its apprentices by the town's steelworks. This was the only secondary school of any type in Mondragon and demand for places far exceeded the supply. Fr. Arizmendiarrieta therefore asked the steel company to expand the school, offering to help raise part of the extra cost. The company refused, so the priest decided to open a technical school of his own. He had boxes placed on street corners in which people could post offers of labour or cash and, when they were opened, a quarter of the town's households had offered concrete support.
The school opened in December 1943 with twenty pupils and added a higher class each year so that, by 1952, there were 170 students and eleven members of the first intake had just completed an external engineering degree from the University of Zaragoza. These men - the first Mondragon workers' children ever to graduate - had been meeting Fr. Arizmendiarrieta each week and it was through them he developed his plans. However, he also held hundreds of meetings with other groups and by 1956, it was estimated that since he had come to the parish in addition to his teaching he had conducted over 2,000 small group discussions and a study session on average every 2.7 days.
Five of his eleven disciples went to work with the steel firm and when it decided to increase its capital by issuing more shares, they asked that the workers be allowed to subscribe for them. The company refused, convincing the five that it was impossible to democratise this particular capitalist company from within. Accordingly, they decided to start their own company, and set about raising money from friends. Eventually, they raised 11m. pesetas from a hundred people on nothing but the strength of their personal promises. This was equivalent at the time to $362,000, a huge sum from a working class community, and in 1955, it was used to buy a bankrupt factory making paraffin stoves in Vitoria, The plant was moved to Mondragon and opened in 1956 with 24 employees under the name Ulgor - a composite of the initials of the surnames of the five men - to make copies of a British-made Aladdin stove the group had purchased in France and stripped down. Only some time later did Ulgor regularise its position by buying the Spanish rights. Demand for stoves was strong and Ulgor soon began designing its own, buying an existing foundry in the town so as to be able to make all the parts. A few months later the firm added a range of electrical equipment to its product line and then, after opening a second factory, bottled-gas cooking stoves under the brandname Fagor. By the end of 1958, Ulgor had 149 worker-co-operators and its success had inspired several other co-ops to set up in Mondragon and elsewhere in the region.
At this point Fr. Arizmendiarrieta suggested that his ex-students should establish a bank so as to be able to tap local savings to finance the co-ops' expansion. "Our initial reaction was one of annoyance and we literally sent him packing" one of Ulgor's founders said later. "We told him 'yesterday we were craftsmen, foremen and engineers. Today we are learning how to be managers and executives. Tomorrow you want us to become bankers. That is impossible'". Undaunted, the priest drew up the bank's constitution and bylaws, concocted the minutes of a fictitious founding meeting, forged two of his disciples' signatures and - lo and behold - the Lankide Aurrezkia bank was formed as a co-op to be run by representatives of its own staff and the workforces of its member co-ops. It was recognised by the Spanish government in July 1959 and opened two branches, one in Mondragon, the other in Elorrio in the neighbouring province of Vizcaya, just so that it could continue to operate should one province decide to revoke its licence and close it down. Persuaded of its potential importance, four of Ulgor's founders joined its board, one as president, another as chief executive. The fifth had already left Ulgor to found his own company.
In many ways Lankide Aurrezkia was, and is, the equivalent of an industrial holding company because each co-op signed a Contract of Association with it which set out in some detail how the co-op would operate. For example, wages paid by member co-ops were tied to those in the bank by a clause which stipulated that their minimum rate of pay be no more than 10% above or below the minimum paid by the bank to its staff and that their top rate would not be more than three times their minimum. Each co-op also had to supply financial data to the bank every month plus full accounts and details of future plans every year and was subject to a detailed assessment and audit by the bank every four years.
Naturally, all a member co-op's funds had to be banked with the Lankide Aurrezkia and the Contract of Association also set the maximum and minimum amount that anyone joining that co-op would have to provide as his or her share of its capital: this could not be less than 80% or more than 120% of the bank's own joining fee which was, at the time, equivalent to roughly a year's wages for anyone on its minimum rate. (New entrants could borrow the required sum interest free and have deductions made from their wages until the amount was repaid; as the minimum Mondragon wage was usually above the equivalent in ordinary commercial companies in the region, this entailed little hardship. However, a firm principle of the co-ops was always that worker-co-operators must risk their own capital).
Finally, the Contract of Association set out how the profits of the co-ops were to be divided. Ten per cent had to go to charity, as required by Spanish law, a minimum of 20% had to be retained by the co-op itself and the balance was to be allocated to the co-op's workers and lodged in individual accounts to be withdrawn in full only when the worker retired: anyone leaving prematurely or being sacked could lose up to 30%. In the first year this system operated, 1960, workers were allowed to take 10% of their co-op's profit in cash and this fraction rose to 30%, equivalent to more than a month's wages, between 1962 and 1965. However, since then, these cash payments have been abolished and the only top-up to their wages that the workers now receive is interest up to a maximum rate of 6% on whatever funds they have invested with their co-op. As David Morris says in the best recent report on the way Mondragon operates: "This disbursement formula means that the enterprise effectively controls 90% of its net surplus. The individual capital account might be considered a long term, low interest loan to an enterprise that might not have the collateral to be able to borrow money outside."13
What did the co-ops get in return for signing such a restrictive contract with the bank? Two massive advantages. One was and is low-cost funds. According to Morris, about half the capital of the member co-ops is made up of loans from Lankide Aurrezkia for which they pay interest at rates which are sometimes as much as 5% lower than the prevailing market rate. This is possible because the top salaries in the bank were, at least until recently, very significantly lower than those paid by banks outside and because the bank has automatic access to the surpluses of its member co-ops. The bank is effectively the only source of capital open to the co-ops apart from the savings of their own members.
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