A matter of Interest

Islamic Financial Management

A matter of Interest

The Rationale of Islam’s Anti-Interest Stance

Dr. M. Umer Chapra

 

The contention that the charging of interest was prohibited mainly because of the injustice it inflicts upon the poor does not go far enough towards the full rationale. During the prophet’s time [May the peace and blessings of God be upon him] borrowing was primarily undertaken not by the poor but by tribes and rich traders who operated as large partnership companies to conduct large-scale trade. This was necessitated by the prevailing circumstances. The difficult terrain, the harsh climate, and the slow means of communication made the task of trade caravans difficult and time consuming.

 

It was just not possible to make several business trips to the east and the west in a given year.

 

Funds remained blocked for a long time. Hence, it was necessary for the caravans to muster all available financial resources to purchase the local exportable products, sell them abroad, and bring back the entire needs of their society for imports during a specific period.

 

Before Islam, such resources were mobilized on the basis of interest. Islam abolished the interest-based nature of the financier-entrepreneur relationship and reorganized it on a profit and loss sharing basis. This still enabled the financier to have a just share in the enterprise, but the entrepreneur was not crushed by adverse conditions such as the caravan being waylaid on the journey.

 

This demonstrates that although the extension of meaningful help to the poor carries a high priority in the Islamic value system, it is not the only reason for the proscription of interest. The primary reason is the realization of overall socio economic justice, which is declared by the Qur’an to be the main mission of all God’s messengers [57:25].

 

Justice, however, is not a hollow term. It has several implications, the most important of which is that the resources provided by God to mankind must by utilized in such a manner that the universally cherished humanitarian goals of general need fulfillment, full employment; equitable distribution of income and wealth, and economic stability, are realized.

 

It is the contention here that these humanitarian goals cannot be realized without a humanitarian strategy. An important, though not the only, element of such a strategy is the abolition of interest. This would necessitate the reorganization of financial intermediation on the basis-of equity and profit and loss sharing; thus making the financier share in the risks as well as the rewards of business, and not assuring him of a predetermined rate of return irrespective of the ultimate outcome of business.

1. Need fulfillment

Financial intermediation on the basis of interest tends to allocate financial resources among borrowers on the criteria of their ability to provide acceptable collateral to guarantee the repayment of principal, and sufficient cash flow to service the debt. End use of financial resources does not constitute the main criterion. Hence, financial resources go to the rich, who fulfill both the criteria, and also to governments, who, it is assumed, will never go bankrupt.

 

However, the rich borrow not only for investment but also for conspicuous consumption and speculation, while governments borrow not only for development and public well-being, but also for chauvinistic defense build up and white elephant projects. This contributes to a rapid expansion in unproductive and wasteful spending and, besides accentuating macroeconomic and external imbalances, squeezes resources available for need fulfillment and development.

 

This explains why even the richest countries in the world, like the United States, have been unable to fulfill the essential needs of all their people in spite of abundant resources at their disposal.

 

2. Full employment

The unproductive and wasteful spending which the collateral linked, interest based financial intermediation has the tendency to promote, has led to a decline in savings in almost all countries around the world. Even in the industrial countries, net national saving as a percentage of national income declined by almost 4 per cent between the 1960s and the 1980s3. The world saving shortfall has been responsible for persistently high levels of real interest rates. This has led to lower rates of rise in investment, economic growth and employment. Unemployment has hence become one of the most intractable problems for all countries, including the rich industrial world.

 

Unemployment stood at 8.6 per cent in OECD Europe in 1988-90, three times its level of 2.9 per cent in 1971-734. It is not expected to fall significantly below this level in the near future because a real rate of economic growth of 3.5 per cent is required to prevent unemployment from rising, and European growth has been below this benchmark since 1976.

 

Even more worrying is the higher than average rate of youth unemployment because it hurts their pride, dampens their faith in the future, increases their hostility towards society and damages their personal capacities and potential contribution.

 

Given the budgetary constraints, the ever-looming threat of inflation, and the prospect of low growth rates continuing in the foreseeable future, the possibility of attaining full employment in the western world is not very bright, a decline in wasteful spending and a rise in savings and investment would be very helpful. But this is not possible when the value system encourages both the public and the private sectors to live beyond their means and the interest based financial intermediation makes this possible by making credit easily available without due regard to its end use. If, however, interest is prohibited and banks are required to share in the risk and rewards of financing, they will be more careful in lending, wasteful spending will decline and more resources will become available for productive investment and development. This will lead to higher growth, a rise in employment opportunities, and a gradual decline in unemployment.

 

3. Equitable distribution

The inequitable allocation of financial resources in the conventional interest based financial system is not widely recognized. According to Arne Bigsten, ‘the distribution of capital is even more unequal than that of land,’ and ‘the banking system tends to reinforce the unequal distribution of capital5.’ The reason, as already indicated, is that interest- based financial intermediation relies heavily on collateral, giving inadequate consideration to the strength of the project or the ultimate use of financing. Thus, while deposits come from a cross section of society. Their benefit goes mainly to the rich.

 

As Mishan so rightly pointed out: ‘Given that differences in wealth are substantial, it would be irrational for the lender to be willing to lend much to the impecunious as to the richer members of society, or to lend the same amounts on the same terms to each6.’ The Morgan guarantee trust company, sixth largest bank in the US, has admitted that the banking system has failed to ‘finance either maturing smaller companies or venture capitalists,’ and ‘though awash with funds, is not encouraged to deliver competitively priced funding to any but the largest, most cash-rich companies7.’

 

The Islamic financial system can be more conducive to the realization of equity. Risk / reward sharing would compel the financier to give due consideration to the strength of the project, thus making it possible for even the poor but competent entrepreneurs to get financing if they have worthwhile projects.

 

A large number of small and medium enterprises would thus be able to get financing from financial institutions without being able to offer the collateral. This should enable society to harness the pool of entrepreneurial ability from even among the poor. The rich contribution that such entrepreneurs can make to output, employment and need fulfillment could thus be tapped.

 

There is no reason to be unduly apprehensive about loan losses from such financing. The experience of the International Fund for Agricultural Development (IFAD) is that credit provided to the most enterprising of the poor is quickly repaid by them from their higher earnings8. Other small loan programmers have yielded similar results in several countries.

4. Economic stability

The rate of interest has become one of the most important destabilizing factors in the present day world economy. Milton Friedman, a Nobel Laureate, attributed the unprecedentedly erratic behavior of the US economy to the erratic behavior of interest rates9. The high degree of interest rate volatility injects great uncertainty into the investment market. It makes the share of interest in the total return on invested capital (interest+profit) continually fluctuate. This makes it difficult to take long-term investment decisions with confidence. It drives borrowers and lenders alike into the shorter end of the financial market, thus bringing about a shift in the short and long-term commitment of funds and between equity and loan financing.

 

Fluctuating interest rates also create gyratic shifts in financial resources between users, sectors of the economy and countries, causing erratic movements in loan-based investment, commodity and stock prices, and exchange rates. With every rise in the rate of interest in  a floating rate system in a short ended  market, there is a rise in the rate of business failures, not because of any inefficiency or slackness on the part of the proprietor, but because of the sudden decline in profit, which is the entrepreneur’s share in the total return on capital. Business failures mean not only personal financial losses to proprietors and stock holders, but also a decline in employment, output, investment and productive capacity losses which take longer, and are more difficult to make up. All these factors have, no doubt, serious implications for economic activity and stability.

 

In a wholly equity based system, the entrepreneur’s share in the total return on capital would depend on the profit-sharing ratio and the ultimate outcome of the business. The profit-sharing ratio between the entrepreneur and the financier cannot fluctuate from day to day or even month to month like the rate of interest because it would be determined by  custom and considerations of justice and remain  contractually stable throughout the  duration of the financing agreement. Since the ultimate outcome of business depends on a number of factors which do not change erratically, an equity-based economy would therefore tend to be more stable than a loan-based economy. This has been recognized by a number of prominent western economists, including Henry Simons, Hyman Minsky and  Joan Robinson10.

 

Conclusion

Thus it may be seen that the prohibition of interest has to be an indispensable part of the strategy of any system, which believes in the brotherhood of mankind and wishes to to actualize the humanitarian goals of need fulfillment, full employment, equitable distribution of income and wealth, and economic stability. The reason why capitalism has not been able to realize these goals is that there is a conflict between its goals and its strategy. The goals are humanitarian, originating from its religious past, while the strategy is social-Darwinist, based on the concept of the survival of the fittest.

 

For the allocation of scarce financial resources, capitalism relies primarily on the rate of interest, which gives an edge to the rich and leads not only to a concentration of wealth but also a rise in conspicuous and wasteful consumption. This hurts the goal of need fulfillment and contributes to a slower growth in saving, investment, employment and output, thus frustrating the realization of overall human well being.

 

References

 

1. James Hastings, Encyclopedia of religion and ethics (NewYork): Charles Scribner’s Sons n. d.). Vol. 12, pp.555. See also john Noonan, the scholastic analysis of usury (Cambridge, mass: Harvard Univ. press, 1957), p.20.

2. See: the bible-Ezekiel, 18:8, 13,7; 22:12. See also Exodus, 22:25-27; Leviticus, 25:36-38; Deuteronomy, 23:19; Luke, 6:35.

3. See: Bank for International Settlements 61st Annual Report,1 April 1990-31 march 991, Basle 10 June 1991, p.32. See also OECD Economic Outlook, December 1991, p.21.

4. OECD Economic Outlook. December 1991, Tab. 2,p.7.

5. Arne Bigsten, ‘Poverty, Inequality and Development, in Norman Gemell, Surveys in Development Economics (Oxford: Basil Blackwell, 1987). P. 156.

6. E.S. Mishan, Cost Benefit Analysis: An Introduction (New York: Praeger, 1971),p. 205.

7. Morgan Guarantee Trust Co. of New York, World Financial Markets , January 1987, p.7.

8. See: The Economist, 16 February 1985, p.15.

9. Milton Friedman, ‘The Yo-Yo US Economy’, Newsweek, 15 February 1982,p.4.

10. Henry Simons Economic Policy for a Free Society (Chicago: Univ. of Chicago Press, 1948), p. 320.

Hyman Minsky, John Maynard Keynes (New York: Columbia Univ. Press 1975). See also: Summary of Minsky’s argument cited by Joan Robinson in ‘what are the Questions?’, Journal of Economic Literature. December 1977. p. 1331. The quotation on the instability of credit is from C.P. Kindleberger, Manias, Panics, and Crashes (London: Macmillan, 1978). p.16.  Joan Robinson, op.cit.p.1331

Dr. Chapra is the Senior Economic Advisor to the

Saudi Arabian Monetary Agency (SAMA)

He is well known for his contributions to Islamic economics over more than two decades-contributions which earned him two international awards in 1989: the King Faysal International Award in Islamic Studies and the Islamic Development Bank Award in Islamic Economics.

 

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