Comments on the Financial and Monetary Structure for an Interest Free Economy

Dr. Ma‘bid Ali Al-Jarhi has addressed a question of considerable policy and theoretical importance. What would (or should) be the institutional structure of monetary and financial system in an interest- free economy? The answer to this question is essential if a modern economic system can be erected based on fundamental Islamic doctrine. I shall briefly state the essential arguments of the author and then raise some questions about them.

The author correctly proceeds to identify the main features of the present Western-type financial and monetary structure and compares it with the alternative structure that might exist in an interest-free Islamic economy. An essential feature sets the modern financial and monetary structure apart from that the author argues will prevail in an interest-free economy. The present system allocates investible resources and creates monetary assets from lenders’ vantage point. Resources are handed down by their owners to the investors through lending organizations which use nominal interest rates as an allocative device to ration resources to different investors. The modern banking system also creates money which is lent to government, consumers, business, etc. The basic feature common to both these activities is that money balances are lent on the basis of being repaid in fixed monetary sums with an agreed interest return. Solvency of the borrowers becomes paramount while the “productivity” of investment undertaken by them is considered secondary.

What Dr. Al-Jarhi proposes is to replace this system with what he calls as productivity based financial-monetary structure. The organizational structure of his alternative system is essentially the same as the existing systems in the U.S. and other Western developed countries: there exist a central bank, a number of commercial banks and the public sector that uses the facilities of the monetary system. However, what is different is how the central and commercial banks and the treasury operate in an interest-free economy. Central bank creates fiat money but not against government interest-bearing securities. It anchors the growth of money supply to the growth rate of the economy and if full employment prevails the rate of inflation will be zero. In this system there is no fractional reserve and the central bank issues certificates as liabilities and holds loan accounts and deposits in mem- ber banks and some of its assets are held in form of cash. The member banks hold assets in form of cash, equity shares, profit-sharing and leasing accounts while their liabilities consist of non-interest-bearing demand deposits and deposits and certificates issued to their customers. The treasury is assigned the role of collecting and distributing the proceeds from Zakah and management of society’s social resources. Finally, in this system there is a multiplicity of financial instruments such as Central Deposit or Lending Certificates, Profit-sharing Certificates, Leasing Certificates, etc.

What is important in this structure is that none of the financial instruments commands any interest; instead what propels the system is that member banks are basically investment banks which participate in different investment projects and make their profits or losses by taking equity position in real investment projects. Thus the present indirect link between the financial market and the goods market established by the intermediation of the financial institutions is replaced by direct participation of banks in productive investment projects.

The following questions can be raised about the proposed financial and monetary structure:

1. It is not clear as to how the proposed system would work when there are unanticipated shocks in the real sector of the economy which may require expansion of credit; what motivates member banks to hold central bank certificates is also not quite^clear.
2. The author suggests that the banking system should provide interest-free loans for the purpose of smoothing out the consumption expenditure. But what should be the size of these loans and how should they be distributed? What would be the criteria for allocation?
3. In an international environment where money balances could be shifted from one banking system to the other, what would prevent firms and individuals from shifting resources out of the interest- free economy?
4. Though there is a tax on all idle balances, would it be enforceable and the tax rate be high enough to compel holders of idle cash balances to relinquish them?
5. The process of how different financial instruments are traded in the financial market where there is no interest bearing securities is not obvious enough; can there exist an implicit interest rate structure in such a market and how is this determined?

If the government is completely barred from the financial markets and if its activities can only be financed through direct borrowing from the public or through taxation, would this not hinder the economic role of public sector? It is true that politically motivated deficits are less likely to occur in Dr. Al-Jarhi’s system, but how can the government meet external economic shocks which require immediate fiscal action? Also what will the treasury offer to the public to persuade them to hold government certificates?

1. Finally, it is not clear that inflation is always a monetary phenomenon and that an economy can be on its steady state where the rate of growth of money supply is equated to the real rate of growth. If these two conditions do not exist then it may be difficult to visualize how the monetary system will operate.

These questions are raised to stimulate discussion and hopefully be of use to Dr. Al-Jarhi. He has addressed a very important and relevant issue and has made considerable progress. However, it would be useful to see further development of his system since a great deal depends on whether it is possible to convince people to abandon an entrenched financial and monetary structure for a new, perhaps better, but nonetheless, untried system.

Dr. M. Ishaq Nadri

Source: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.