A brief introduction: Interest, Economics, and Islam

We all know that Islam forbids interest but for most of us that is about as far as our knowledge goes. But do we know what the logic behind the banning of interest is, and what distinguishes it from trade? Have we ever wondered how a conception of an Islamic economy would look? And what about an answer to that ever-popular question on ‘Islamic mortgages’ that is the staple of every Asian dawat (dinner party)? It is to answer these and other questions that I have written this article. Like it or not, we are economic beings living in a conventional financial system and we need to know at least the basics of what our religion says about our economic lives.

 

Let’s start right at the start. In his famous discussion on Maqasid Al-Shariah, Al-Ghazali outlined five objectives that underpin all Islamic legal theory, and it is from one of these objectives – hifdh al-maal (protection of property) – that the field of Islamic finance and economics stems. At the heart of the Shariah’s teachings on commerce is the desire to protect people’s wealth – be they rich or poor – and a desire to establish a just society (2:188).

 

وَلَا تَأْكُلُوا أَمْوَالَكُم بَيْنَكُم بِالْبَاطِلِ وَتُدْلُوا بِهَا إِلَى الْحُكَّامِ لِتَأْكُلُوا فَرِيقًا مِّنْ أَمْوَالِ النَّاسِ بِالْإِثْمِ وَأَنتُمْ تَعْلَمُونَ

And do not consume one another’s wealth unjustly or send it [in bribery] to the rulers in order that [they might aid] you [to] consume a portion of the wealth of the people in sin, while you know [it is unlawful].

 

This is an oft-missed point when we get into heated discussions on Islamic economics, interest and HSBC Amanah; but if we grasp this point we can understand the core intuition behind Islamic commercial law and many things become clearer.

 

Now let’s talk about the things Islam forbids. Yes, Islam forbids riba (interest) but it is often missed that Islam equally forbids gharar (uncertainty) and maysir (gambling). This unholy trinity is identified in the divine law as harmful for society and strictly forbidden according to both the Qur’an and Sunnah (2:275, 5:90).

 

الَّذِينَ يَأْكُلُونَ الرِّبَا لَا يَقُومُونَ إِلَّا كَمَا يَقُومُ الَّذِي يَتَخَبَّطُهُ الشَّيْطَانُ مِنَ الْمَسِّ ۚ ذَٰلِكَ بِأَنَّهُمْ قَالُوا إِنَّمَا الْبَيْعُ مِثْلُ الرِّبَا ۗ وَأَحَلَّ اللَّهُ الْبَيْعَ وَحَرَّمَ الرِّبَا ۚ فَمَن جَاءَهُ مَوْعِظَةٌ مِّن رَّبِّهِ فَانتَهَىٰ فَلَهُ مَا سَلَفَ وَأَمْرُهُ إِلَى اللَّهِ ۖ وَمَنْ عَادَ فَأُولَٰئِكَ أَصْحَابُ النَّارِ ۖ هُمْ فِيهَا خَالِدُونَ

Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, “Trade is [just] like interest.” But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah . But whoever returns to [dealing in interest or usury] – those are the companions of the Fire; they will abide eternally therein.

 

يَا أَيُّهَا الَّذِينَ آمَنُوا إِنَّمَا الْخَمْرُ وَالْمَيْسِرُ وَالْأَنصَابُ وَالْأَزْلَامُ رِجْسٌ مِّنْ عَمَلِ الشَّيْطَانِ فَاجْتَنِبُوهُ لَعَلَّكُمْ تُفْلِحُونَ

O you who have believed, indeed, intoxicants, gambling, [sacrificing on] stone alters [to other than Allah ], and divining arrows are but defilement from the work of Satan, so avoid it that you may be successful.

 

 

This is an important point to note because while most of us know that interest is haram and stay away from it, we don’t realise that gharar is also haram and we often enter into transaction over which there is uncertainty due to our ignorance. For example it is impermissible to agree to sell something in the future if one does not yet own that item (with some exceptions). The logic behind the banning of gharar is that it removes the possibility of dispute later on between the parties and an Islamic contract stipulates and describes things in as much detail as possible.

 

Secondly, the macroeconomic benefit of the gharar ban is that an Islamic economy will not tolerate highly uncertain, fluctuating and complex financial instruments such as derivatives. This is relevant to our times as derivatives were held largely to be a key cause behind the Global Financial Crisis. Neither the buyers nor the sellers of these derivatives fully understood the products they were selling and the repercussions they could have – to devastating effect. An Islamic economy would either not allow such instruments or highly regulate their trading in order to minimise the excessive uncertainty and opacity which creeps into the market due to these instruments.

 

Having said all that; let me clarify. Every business has an element of uncertainty about it. Islam isn’t against that. What Islam is against is speculative risk-taking where one bets on horses for example. Here one has a chance of winning or losing and one has gone out of one’s way to expose oneself to this risk by making the bet. There is no tangible thing being actually bought or sold here and one has gone out of one’s way to expose oneself to this risk. However risks like those taken in starting a business are incidental and one does not necessarily aim at taking those risks. These risks have no upside to them. For example we all face the risk of being hit by a car every time we step onto a road. However that is not our intention when we step out onto a road – and we certainly don’t benefit from exposure to this risk! These risks are natural and unavoidable and can be insured against. Yes, Islam has a concept of insurance too, where every individual in a pool promises to insure the rest of the participants in that pool.

 

Let’s now turn to interest. I often get asked what the difference between interest-based financing and Islamic financing is. The easiest way to explain this is to think of the following example: imagine you need £10 to buy a pen. However you do not have this £10 and so ask for an interest-bearing loan. You receive your £10 and buy your pen. A month later you pay back the bank £11 (with £1 interest) and sell the pen for £20 and make £9 profit. Now let’s consider Bob. Bob needs £10 to buy this pen but approaches an Islamic bank. The Islamic bank can use a number of transactions to help this individual but let’s say they choose the mudarabah model. With this model, the bank provides the capital while Bob does the labour. So Bob buys the £10 pen again, and sells it for £20 after a month. At this point the bank receives back its share of the profit and gets back £11, while Bob takes £9 once more. In terms of pure numbers there is no difference. The bank has still made £1 and Bob £9. It would seem that the two transactions are identical.

 

However there is an important distinction between the two cases. In the first case the bank does not take on the risk of buying and holding an item and taking part in a business venture. It simply gets its fixed interest profit. In the second case however the Islamic bank exposes itself to a potential loss by entering this business venture. It may or may not get that £1. In a nutshell that’s the difference. Islamic economic morality teaches that profit should only go hand in hand with risk-taking and entrepreneurship. Profiting from interest is forbidden because a) it is not productive (you’re not creating anything, you’re simply making money from money); and b) it has the potential to exploit those who are poorest.

 

One may argue “the commercial bank needs to be compensated for losing the use of its £10 for the duration of that month. It could have used it in other ventures instead.” This argument seems appealing at first reading but the problem with it is that even if the bank was to use that £10 in an alternative business venture instead of lending to you, in that alternative use, the return would not be guaranteed. For example the bank decides to set up a toy business with that £10 for that month instead of lending to you. The success or failure of that venture is unclear. So it seems odd that we should compensate the bank for the loss of ability to use the £10 in another hypothetical venture – the profit or loss of which is unclear. In effect we would be compensating the bank with a risk-less fixed income return due to the lost hypothetical opportunity to take a risk and return either a profit or loss. To put it more intuitively “if the bank is so confident it was going to make a killing by not lending to me; then why didn’t it just do so?” The answer of course is because it’s far riskier to be an entrepreneur than it is to be a lender.

 

A second benefit to a risk-sharing approach to banking is that banks pay much closer attention to which businesses they invest in; because unlike commercial banks their money is inextricably linked up with the success of the ventures they invest in.  A conventional bank on the other hand will get its return no matter if the business makes a profit or not. This means that an economy with only Islamic banks will allocate resources to the best businesses as there will be much closer due diligence prior to any money being given to this new business. This means fewer businesses fail overall and a more productive and efficient economy results.

 

Finally, an aspect of Islamic economic discussions which is often overlooked is the role the infaq (charity) sector has to play in the economy. Muslims are the most philanthropic religious group, ahead of Christians, Jews and atheists. This is because of the Muslim community’s long history, culture and dependence on charity. Throughout the medieval Islamic period, the waqf (endowment) funds ran substantial parts of the economy with up to 25% of arable land and income-generating properties being waqf holdings. These waqf would provide free health and education and national poverty alleviation. In fact it was the waqf system which inspired the modern day University of Oxford college endowment structure. Sadly however, due to colonisation and seizure of waqf properties by the state, this Islamic institution is now a shadow of its former glory. But the important point to remember is that in an Islamic economy the not-for-profit sector is a major infrastructure provider and significantly changes the responsibilities of government.

 

To conclude this was a whistle-stop tour on Islamic economics and finance, let me reiterate that one must not miss the other areas of the rich and vast field of Islamic economics and finance and simply focus on the debate over interest and mortgages. In fact; because there is so much interconnection between issues in Islamic economics and finance; by limiting ourselves to discussions of Islamic mortgages and interest in isolation we in fact limit our understanding of even these topics.

 

Article By:

Ibrahim Khan is currently studying for a Masters in Islamic Banking and Finance and is a Dars Nizami student in Leicester. He previously read Philosophy, Politics and Economics at Oxford University.

 

 

 

 

 

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