Interest Rates and Financial Instability

Several financial crises, which have occurred in different geographical areas over the past 100 years have reinforced the notion that crises and market imbalances are inherent characteristics of capitalism. By surveying the transitions of financial markets, especially during the last three decades, it has been clarified that the existence of interest rates can be considered as a fault line in the economic system and will disrupt the harmony between the real and financial sectors. Based on quarterly information in the real and financial markets of the United States during 1993-2014, and econometric analysis of Granger causality, the result of this study shows that the presence of usury and its growth in the conventional economic system will expand the debt markets, which cause the separation between nominal values in the financial markets and their intrinsic values in the real sector of the economy. With the emergence and increase of this separation, asset price bubbles are created. The greed of economic agents to take advantage of profitable opportunities, which occur due to price bubbles, increases borrowing and, therefore, expands the debt markets. Moreover, during this process, speculation activities will inflate asset prices excessively, causing more separation between the real sector and the financial sector. Consequently, the amount of monetary resources for the real sector will be decreased and, therefore, economic growth and employment will decline. Although some macro-prudential policies have been implemented to mitigate systemic risks and reduce the incidence of financial crises, they will not remedy the inherent instabilities of financial contracts. Islamic financial rules provide the economic system with mechanisms, which bring robustness and resilience to the financial system.