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Here, using a crawling peg for the peso after a short initial period of a fixed peg might have prevented a deterioration in the trade balance. Chapter 17 indicates how an LDC could use inflation targeting with a floating exchange rate to anchor prices while attaining independence of monetary policy.

BENEFITS OF INFLATION

Inflation need not be all bad. In fact, would we not welcome inflation if it contributed to economic growth and higher material well-being? As a matter of fact, the Nobelist Robert A. Mundell’s (1965:97–109) monetarist model indicates that rapid inflation may add 1 percentage point to annual, real economic growth by spurring extra capital formation.

Some economists argue that inflation can promote economic development in the following ways.

1.The treasury prints money or the banking system expands credit so that a modernizing government can raise funds in excess of tax revenues. Even if real resources remain constant, inflationary financing allows government to control a larger resource share by bidding resources away from low-priority uses.

2.The government can use inflationary credit to redistribute income from wage earners who save little to capitalists with high rates of productive capital formation. Businesspeople usually benefit from inflation, as product prices tend to rise faster than resource prices. For example, wages may not keep up with inflation, especially in its early stages when price increases are greater than anticipated. Furthermore, inflation reduces the real interest rate and real debt burden for expanding business.

3.Inflationary pressure pushes an economy toward full employment and more fully utilizes labor and other resources. Rising wages and prices reallocate resources from traditional sectors to rapidly growing sectors.

COSTS OF INFLATION

Yet inflation can be highly problematical.

1.Government redistribution from high consumers to high savers through inflationary financing may work during only the early inflationary stages. When people expect continued inflation, they find ways of protecting themselves against it. Wage demands, automatic cost-of-living adjustments, for example, reflect inflationary expectations. Retirees and pensioners pressure government to increase benefits to keep up with inflation. Government may respond to other political interests to control increases in the prices of food, rents, urban transport, and so forth. Official price ceilings inevitably distort resource allocation, frequently resulting in shortages, black markets, and corruption.

2.Inflation imposes a tax on the holders of money. Government or businesspeople benefiting from inflationary financing collect the real resources from the inflation

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tax. People attempt to evade the tax by holding onto goods rather than money. Yet, to restore the real value of their money, people would have to accumulate additional balances at a rate equal to inflation.

3.Inflation distorts business behavior, especially investment behavior, since any rational calculation of profits is undermined. Entrepreneurs do not risk investing in basic industries with a long payoff period but rather in capital gains assets (for example, luxury housing) as a protection against inflation. Businesspeople waste much effort forecasting and speculating on the inflation rate, or in hedging against the uncertainties involved (Johnson 1965:22–28).

4.Inflation, especially if it is discontinuous and uneven, weakens the creation of credit and capital markets. Uncertainties about future price increases may damage the development of savings banks, community savings societies, bond markets, social security, pension funds, insurance funds, and government debt instruments. For example, Brazil’s annual growth rate in GNP per capita declined from 11 percent in 1968 to 1973 to 5 percent in 1973 to 1979, partly from the adverse impact of inflation on savings. Nominal interest rates remained almost constant while annual inflation accelerated from 13 percent in 1973 to 44 percent in 1977. Because of the resulting negative real interest rates, savings were reduced and diverted from productive investment (Cline 1981:102–105; World Bank 1981i).

5.Monetary and fiscal instruments in LDCs are usually too weak to slow inflation without sacrificing real income, employment, and social welfare programs.

6.Income distribution is usually less uniform during inflationary times. Inflation redistributes income, at least in the early stages, from low-income workers and those on fixed income to high-income classes. This redistribution may not increase saving, as the rich may buy luxury items with their increased incomes. A study of seven LDCs (including Brazil, Uruguay, Argentina, and Chile) by the Organization for Economic Cooperation and Development concluded that “there is no evidence anywhere of inflation having increased the flow of saving” (Little, Scitovsky, and Scott 1970:77).

7.Inflation increases the prices of domestic goods relative to foreign goods – decreasing the competitiveness of domestic goods internationally and usually reducing the international balance of merchandise trade (exports minus imports of goods). Inflation also discourages the inflow of foreign capital, as the real value of investment and of future repatriated earnings erodes. The large international deficits that often come with rapid inflation can increase debt burdens and limit essential imports.

With inflation in excess of 30 percent a year in the mid-to-late 1970s, Brazil depreciated the cruzeiro relative to the U.S. dollar at a steady, predictable rate to keep domestic prices competitive. However, devaluation stimulated inflation through the increased demand for Brazilian goods and cost–push pressures from higher import prices. Furthermore, Brazilian inflation was too erratic for steady exchange-rate changes to prevent fluctuations in real export and import prices. Yet most LDCs

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are not even so capable as Brazil in managing monetary, fiscal, and exchange-rate policies to limit the evils of inflation.

THE DYNAMICS OF INFLATION

Once high inflation occurs, the disintegration of financial institutions (such as bond markets, lending agencies in domestic currency, savings banks, and holding money as a store of value) exacerbates inflation further. If there is any delay between the accrual and payments of taxes, their real value erodes disastrously (2004 taxes paid in 2005 wreaks havoc with the real value of tax collection). As inflation accelerates, contracts or indexation lags shorten (to avoid real wages declining as inflation erodes the purchasing power of the constant nominal payments), which causes inflation to accelerate. Under extreme inflation, governments may abandon domestic currency for foreign currency, as U.S. dollars in Russia, 1992–94. Doing this means the government must continue to increase inflation to get any seigniorage. As economic institutions collapse and wage contracts and financial asset maturities shrink, hyperinflation becomes inevitable. The erosion of the real value of taxation, the shortening of contracts, and financial adaptation to inflation all react perversely to widen the deficit and accelerate the inflation rate explosively (Dornbusch 1993:18–24).

INFLATION AND GROWTH: EMPIRICAL EVIDENCE

As indicated earlier, Mundell’s monetarist model suggests that inflation can increase real economic growth. However, the earlier empirical evidence is mixed, depending on the time period, country group, and range of inflation examined. Opposing Mundell’s work, Henry C. Wallich’s (1969:281–302) study of 43 countries from 1956 to 1965 finds a negative relationship between inflation and real economic growth. A. P. Thirlwall and C. A. Barton’s (1971:263–275) review of 51 countries from 1958 to 1965 finds no significant correlation between inflation and growth. But U Tun Wai’s (1959:302–17) study of 31 LDCs from 1946 to 1954, and Graeme S. Dorrance’s (1966:82–102) research on 49 DCs and LDCs from 1953 to 1961, indicate a positive relationship between the two variables.

Thirlwall, Barton, Tun Wai, and Dorrance find that, among LDCs, growth declines when annual inflation exceeds 10 percent. The early evidence suggests that inflation in LDCs has not contributed to economic growth but may inhibit growth, especially at annual percentage rates in the double digits (Nugent and Glezakos 1982:321–334).9 The MIT economist Stanley Fischer (1993:485–512), subsequently the IMF’s Deputy Managing Director, finds that, during the 1980s, low inflation and small deficits were not essential for high growth rates even over long periods but high inflation (40 percent or more yearly) is not consistent with sustained growth. Inflation,

9Could the causal relationship lead from growth to inflation rather than the other way around? Thirlwall and Barton (1971:269–70) argue that “if growth is a supply phenomenon, higher growth should lower inflation not exacerbate it. Real growth by itself cannot be the cause of inflation unless it sets in motion forces which themselves generate rising prices and persist” – such as shortages in the produce and factor markets. Attempts to expand demand in excess of the growth rate of productive potential can cause inflation, but it is a non sequitur to argue from this that real growth causes inflation.

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by reducing capital accumulation and productivity growth, is negatively correlated with economic growth.

The IMF economists Mohsin Khan and Abdelhak Senhadji (2001:1–21) find a threshold level of 11–12 percent, above which inflation is negatively correlated with growth. But the economists were not able to determine the direction of causality.

Since the early 1990s, macroeconomic policies and performance in LDCs have improved markedly. Inflation has been more stable than previously (see Table 14-4 for evidence concerning reduced inflation since the early 1990s). The international economy has been less volatile and central bankers and monetary policy makers have improved tools and knowledge for stabilizing output and prices. Moreover, a reduction in direct state ownership of banks and the introduction of explicit deposit insurance have improved the effectiveness of monetary policy in stabilizing the macroeconomy (Cecchetti and Krause 2001).

This improved proficiency is reflected in studies examining LDCs’ control of inflation. Michael Bruno and William Easterly’s (1998:3–24) study for the World Bank shows no negative correlation between inflation and economic growth for inflation rates under 40 percent annually; the negative relationship between inflation and growth holds only for high-inflationary economies. Based on this, the World Bank Chief Economist Joseph Stiglitz (1998:8) argues, in his U.N. University/World Institute for Development Economics Research lecture, that below this level, “there is little evidence that inflation is costly” [his italics]. Indeed, Stiglitz (1988:4; 2002a:27, 45, 107) indicates that the preoccupation of the IMF, along with U.S. economic officials, with contractionary monetary and fiscal policies (increased interest rates and reduced taxes and government spending) exacerbated the downturn during the East Asian 1997–99 crisis, stifling growth and spreading the downturn to neighboring countries. Moreover, the IMF contributed to financial instability by urging reduced financial regulation when inadequate financial-sector supervision and monitoring was a more serious problem among developing countries (Stiglitz 2002a:81). Christopher Cramer and John Weeks (2002:43–61) contend that the focus of IMF macroeconomic stabilization programs, often draconian monetary measures, the conditions for lending of last resort to LDCs, is usually unnecessary and harmful. Reviving growth should generally take precedence over monetary and fiscal orthodoxy. In 1995, more than half the LDCs had inflation rates of less than 15 percent annually, indicating to Stiglitz (1988:14) that for these countries, “controlling inflation should not be an overarching priority.”10

Financial Repression and Liberalization

The LDC money markets tend to be highly oligopolistic even when dominated by domestic banks and lenders. Government financial repression – distortions of the

10Even the IMF Chief Economist Kenneth Rogoff, 2001–03 (2004:65) admits that “in today’s world of very low inflation, the Fund remains a bit too concerned about whether central banks are ambitious enough in their inflation targets.

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interest rates, foreign exchange rates (Chapter 17), and other financial prices – reduce the relative size of the financial system and the real rate of growth.

Frequently, the motive for LDC financial restriction is to encourage financial institutions and instruments from which the government can expropriate seigniorage (or extract resources from the financial system in return for controlling currency issue and credit expansion). Under inflationary conditions, the state uses reserve requirements and obligatory holdings of government bonds to tap savings at low or negative real interest rates. Authorities suppress private bond and equity markets through transactions taxes, special taxes on income from capital, and inconducive laws to claim seigniorage from private holders’ assets. The state imposes interest rate ceilings to stifle private sector competition in fund raising. Imposing these ceilings, foreign exchange controls, high reserve requirements, and restrictions on private capital markets increases the flow of domestic resources to the public sector without higher taxes or interest rates, or the flight of capital overseas (see Chapter 16).

Under financial repression, banks engage in nonprice rationing of loans, facing pressure for loans to those with political connections but otherwise allocate credit according to transaction costs, all of which leave no opportunity for charging a premium for risky (and sometimes innovative) projects. Overall, these policies also encourage capital-intensive projects (Chapter 9) and discourage capital investment. The LDC financially repressive regimes, uncompetitive markets, and banking bureaucracies not disciplined by market and profit tests may encourage adopting inefficient lending criteria. The high arrears, delinquency, and default of many LDC (especially official) banks and development lending institutions result from (1) failure to tie lending to productive investment; (2) neglect of marketing; (3) delayed loan disbursement and unrealistic repayment schedules; (4) misapplication of loans;

(5)ineffective supervision; (6) apathy of bank management in recovering loans; and

(7)irresponsible and undisciplined borrowers, including many who (for cultural reasons or misunderstanding government’s role) fail to distinguish loans from grants. Additionally, Argentina’s, Brazil’s, Chile’s, Uruguay’s, Mexico’s, Turkey’s, Thailand’s, and pre–World War II Japan’s bank-lending policies have suffered from collusion between major corporations and banks.

Combating financial repression, which is as much political as it is economic, can reduce inflation. Financial liberalization necessitates abolishing ceilings on interest rates (or at least raising them to competitive levels), introducing market incentives for bank managers, encouraging private stock and bond markets, and lowering reserve requirements. At higher (market-clearing) interest rates, banks make more credit available to productive enterprises, increasing the economy’s capacity and relieving inflationary pressures. Trade liberalization, which (often) threatens politically influential import-competing industrialists, increases product competition and reduces import prices (see Chapter 19), reducing input prices and cost– push inflation (McKinnon 1973; Shaw 1973; Blejer 1983:441; Gill 1983: Morris 1985:21; Fry 1988:7–18, 261–335; Je Cho 1988:101–10; McKinnon 1993:43– 83). (Box 14-1 gives examples of how liberalization in India affects individual firms.)

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BOX 14-1. EXAMPLES OF THE EFFECT OF LIBERALIZATION IN INDIA ON INDIVIDUAL FIRMS

Because of long-standing restrictions, Indian companies did not participate in the borderless Asian-Pacific economy (discussed in Chapters 3 and 17) and were at a major disadvantage in winning contracts overseas. In 1990, one year before India’s liberalization program, TRP Software, Limited, a Calcutta data systems and software company, undertook a detailed study to bid to design information management services for the municipal government of a major Australian city. Foreign-exchange restrictions prevented TRP’s director, J. T. Banerjee, from taking more than one trip to the city to do the planning. Nevertheless, TRP took advantage of India’s low-salaried professional designers, software engineers, and systems analysts to put together a highly competitive package for the Australian city. Other firms from countries without foreign-exchange restrictions sent executive officers to Australia with the design and bid. Because of the prohibitive amount of time necessary to receive Reserve Bank of India foreign-exchange permission for the trip, TRP had to rely on an express package service, which delivered the firm’s bid ten minutes late, thus losing the opportunity to win the contract.

In 1991, in response to an international balance of payments crisis, India undertook liberalization. TRP no longer faced limitations in competing overseas. A number of other firms found that foreign-currency decontrol had facilitated acquiring imports to improve plant and machinery (albeit at higher rupee prices) and spurred them to seek market overseas. The liberalized foreign-exchange regime (higher rupee price of the dollar and delicensing of many foreign purchases) was a welcome change for a southern marble products entrepreneur, who reduced his time for clearing imported machines through Indian customs from an average of one month before 1991 to two days since 1993.

In the 1960s and 1970s, the Indian government tried to influence industrial investment and production by physical controls operated partially through a licensing system. The purposes of these controls were to guide and regulate production according to targets of the Five Year plans, to protect balanced economic development among the different regions of the country. Jagdish Bhagwati explains that the 1991 economic reform was not a return to laissez-faire policies, but an effort to prevent the government from counter-productive intervention (Bhagwati 1993:98).

India’s licensing policy enticed entrepreneurs to focus on making profits from long-term government-granted monopoly rents, such as those from influence and connections to acquire licenses rather than from innovation, which provides only a temporary monopoly gain. Most firms that failed to acquire licenses or quotas were unable to survive. By contrast, several manufacturing firms with input licenses continued to operate, although variable cost exceeded revenue in manufacturing. They could still make a profit by acquiring inputs on the controlled market and selling them on the free market for higher prices. A number of firms were producing enough to give the appearance of being genuine manufacturing firms, while making their profits on buying and selling controlled inputs.11

(continued )

11Nafziger (1978:108–119); Nafziger and Sudarsana Rao (1996). My colleagues and I conducted interviews of Indian entrepreneurs and managers in 1971 and 1993. J. T. Banerjee is a pseudonym I use for an entrepreneur I interviewed; likewise, TRP Software is not the real name of Mr. Banerjee’s firm.

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BOX 14-2.

A manager of one of the largest industrial conglomerates complained about a major plank of India’s financial liberalization, the increase in interest rates charged by banks, which had been previously state-owned. This industrial aggregate, which had adapted to the sluggishness of license-protected monopoly production, would no longer be profitable at these higher interest rates.

For entrepreneurs in India, liberalization measures have been a two-edged sword, resulting in the entry or expansion of firms previously blocked, and eliminating many inefficient firms formerly protected through monopoly rents from a licensing regime. Some entrepreneurs have gained and some have lost from liberalization. The major advantage of liberalization, however, is to reduce the number of entrepreneurs who survive from monopoly rents and to increase the number of entrepreneurs who survive as a result of innovation, efficiency, and production managerial ability.

But liberalization also requires greater restrictions by the monetary and fiscal authorities. The central bank and finance ministry must regulate the growth of banks and other enterprises that grant credit, create checkable deposits, and provide cash on demand. An independent board should replace government industrial departments in managing foreign exchange, in order to restrict the excessive bidding for foreign currency by enterprises desperate to find a nondepreciating liquid financial asset to hold during high inflation. The central government must limit spending, maintaining a balanced budget, especially in the transition to a liberal market economy. As the private sector increases in size relative to the state sector, the fiscal authorities need to maintain their collection of turnover and excess profits taxes on state enterprises until the transition to a new tax system that raises revenue from both private and government firms. In the early 1990s, Russia’s failure to restrict the creation of “wildcat” banks and unregulated quasi-bank intermediaries, to restrain the holding of foreign-exchange liquid assets, to collect revenues, and to limit state spending contributed to inflation rates in excess of 700 percent annually from early 1992 to late 1993 (IMF 1993:86–90; McKinnon 1993:1–10, 120–61, 213; IMF 1995:52– 58). (See Chapter 19 for more discussion of optimal sequences in the transition from state socialism to a market economy.)

Still, mild financial repression – specifically repression of interest rates and contestbased credit allocation – contributed to rapid growth in Japan (both before and after World War II), South Korea, and Taiwan. But each of these economies had competent and politically-insulated bankers and government loan bureaucrats to select and monitor projects, and apply export performance as a major yardstick for allocating credit (World Bank 1993a:237–241, 356–358; Kwon 1994:641; Yanagihara 1994:665–666). Few other LDCs have the institutional competence to ration credit based on performance; usually, the public accuses financial officers who allocate funds at below-market rates of nepotism, communalism, and other forms of favoritism.

Moreover, reducing financial and price repression can, in the short run, spur inflation. Financial liberalization, through abolishing ceilings on interest rates, encouraging private stock and bond markets, creating other new financial intermediaries,

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lowering reserve requirements, and decontrolling exchange rates, means government loses part of its captive inflation tax base (Dornbusch 1993:21–22).

A Capital Market and Financial System

Macroeconomic stability is enhanced by a robust capital market and financial system, which select “the most productive recipient for [capital] resources [and] monitor the use of funds, ensuring that they [continue] to be used productively” (Stiglitz 1998:14). Initially, banks play the dominant role in LDC capital markets, with bond and equity markets secondary.

The major role of banks is as an intermediary between savers and investors and to facilitate payments between individuals and firms. Banks can provide funds to entrepreneurs better than the individual saver for several reasons: investment projects may be large enough to require pooling of funds, savers may want funds back relatively soon or may want to spread funds among several projects, and banks are better than individuals in identifying promising projects. Banks also provide discipline to the market, providing loans to higher quality borrowers at lower costs and charging a premium to lower quality borrowers. They can monitor borrowers, forcing them to restructure their businesses or even discontinuing loans (Lardy 1998:59–60).

In time, government needs to develop a bond market to facilitate raising resources for social spending and economic development. Also important is a central bank, with a director and staff chosen for their technical qualifications, who use economic criteria for making decisions about monetary expansion (Uche 1997). However, Ajit Singh (1999:341, 352) argues that, although improving the banking system is important for increasing low-income countries’ savings and investment, a stock market is “a costly irrelevance which they can ill afford;” for most others, “it is likely to do more harm than good,” as its volatility may contribute to “financial fragility for the whole economy,” increasing “the riskiness of investments and [discouraging] risk-averse corporations from financing their growth by equity issues.”

The Bank for International Settlements’12 Basle Committee, The Core Principles for Effective Banking Supervision (1997), lists principles of supervision: licensing process, criteria for acquisitions and ownership transfers, prudential regulations and requirements, methods of ongoing banking supervision, information requirements, and standards for cross-border banking. Preconditions for supervision include sound and sustainable macroeconomic policies, effective market discipline, procedures for efficient resolution of problems in banks, and public infrastructure (corporate, bankruptcy, contract, consumer protection, and private property laws consistently enforced, internationally acceptable accounting principles, and independent audits of banks and companies) essential for supervision. Few LDCs have the resources to attain Basle standards.

12The Bank for International Settlements (BIS) fosters international cooperation among central banks and other agencies to pursue monetary and financial stability. The BIS has 55 member banks, but is dominated by the Group of Ten (G-10), listed in Chapter 15.

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Financial Instability

The Mexican financial crisis of 1994, Asian crisis of 1997–99, Russian crisis of 1998, and Argentine crisis of 2001–03 contributed to swings in GNI growth of 5 to 10 percentage points, of the same magnitude as in the United States during the 1929–33 and 1937–38 Great Depression. Here I examine the domestic monetary aspects of these crises while discussing the international financial and exchange-rate components in Chapter 16.

According to Frederic Mishkin (1999:3–4), financial markets perform the function of channeling funds to those with productive investment opportunities. When the financial system performs this role poorly, the economy operates inefficiently with negative economic growth, as in Thailand, Indonesia, Malaysia, and South Korea in 1998.

What problems contribute to financial instability? The financial system lacks the capability of making judgments about investment opportunities from asymmetric information, such that lenders have poor information about potential returns of and risks associated with investment projects. Lending is subject to adverse selection, in which potential bad credit risks are most eager to take out loans, even at higher rates of interest, and moral hazard, in which the lender or members of the international community bears most of the loss if the project fails (Mishkin 1999:4).

Adverse selection is similar to the Nobel winner George Akerlof’s (1970:488–500) “lemons” problem, in which used-car buyers, lacking information on quality, steer way from buying a car at the lowest price, fearing a low-quality automobile. Analogously, informed lenders may avoid lending at high interest rates, because they lack information on the quality of borrowers who might be less likely to repay the loan.

For Mishkin, the shocks to the financial system from the Asian crisis were a deterioration in financial sector balance sheets (from nonperforming loans as a percentage of lending in excess of 7 percent), increases in interest rates (leading to greater “adverse selection”), increases in uncertainty (about bank failure, future government policy, or a possible recession), and the deterioration of nonfinancial balance sheets (from a fall in asset prices, and thus a fall in the value of borrower collateral) (Mishkin 1999:6–9).

An additional contributor to financial instability, discussed in Chapter 16, is an exchange-rate depreciation when debt contracts are denominated in foreign currency. The Asian financial and currency crisis followed financial liberalization, lifting interest rate ceilings and the type of lending. Expanded lending, fed by international capital inflows, was mainly to new borrowers, increasing risk. Banks had a shortage of well-trained loan officers and information on assessing risk, amid government failure in supervising banks. Pegging exchange rates, as in Asia, increases hidden costs, encouraging risk taking and foreign capital inflows (Chapter 16) (Mishkin 1999:10–16).

Mishkin and fundamentalists with the IMF point to financial sector weaknesses, high debt ratios, current-account deficits, overvalued currencies, moral hazard, and adverse selection by the offending LDC as responsible for the financial crises. For

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fundamentalists, the orthodox IMF prescription, monetary and fiscal contraction, is essential for restoring internal and external balance.

Joseph Stiglitz (2000:1075) argues that the IMF and the international economic architecture must be designed not just for perfect economic management but for “the kind of fallible governments and public officials” that actually occur in LDCs. He doubts that most LDCs have the effective regulatory framework for financial and capital market liberalization. He compares “capital account liberalization to putting a race car engine into an old car and setting off without checking the tires or training the driver” (Stiglitz 2000:1075). The large number of crises suggests to Stiglitz the necessity for reexamining the design of the international architecture for the lender of last resort, the IMF (ibid.).

Islamic Banking

Although Islam, like early medieval Christianity, interprets its scriptures to ban interest, it encourages profit as a return to entrepreneurship together with financial capital. Moreover, like Western banks, Islamic banks are financial intermediaries between savers and investors and administer the economy’s payment system. Bank depositors are treated as if they were shareholders of the bank. Islamic banks receive returns through markup pricing (for example, buying a house, then reselling it at a higher price to the borrower and requiring the borrower to repay over 25 years) or profit-sharing, interest-free deposits (mutual-fund-type packages for sale to investordepositors). These banks operate alongside traditional banks in more than 50 countries (including Malaysia), but, in Ayatollah Ruhollah Khomeini’s Iran (1979–89) and Mohammad Zia ul-Haq’s Pakistan (1985–88), the government eliminated interestbased transactions from the banking system. Interest-free banking can improve efficiency, since profit shares are free from interest rate controls. Indeed, World Bank and IMF economist Mohsin S. Khan argues that Islamic banking, with its equity participation, is more stable than Western banking, as shocks are absorbed by changes in the values of deposits held by the public (Fry 1988:266; Iqbal and Mirakhor 1987; Khan 1986:1–27).13

However, Timur Kuran, Faisal Professor of Economics and Islamic Thought at the University of Southern California, questions whether the Muslim scripture, the Qur’an, bans interest and earning money without assuming risk. According to Kuran, Islamic banks pay profit shares to account holders from income received mostly from bonds and other interest-bearing assets. Moreover, in countries such as Turkey, “where Islamic banks compete with conventional banks, the ostensibly interest-free

13 Jehle (1994:205–215) finds that zakat, one of the five Muslim pillars of the faith that mandates that believers give alms to the poor, reduces income inequality in Pakistan, both within and between provinces. However, the great bulk of giving and receiving is done by the poor and near-poor among themselves. Kuran (1995:163–164) finds that the equalizing effect of zakat has been disappointing, because of low rates, vast loopholes, widespread evasion, the high costs of administering a system that loses substantial sums to official corruption, and the diversion of revenue to finance causes other than poverty reduction, including religious education and pilgrimages to Mecca.