Growth, Stability & Resource Allocation

Apart from monetary and fiscal issues, the participants in the Islamabad Seminar had an occasion to discuss the macro-dynamics of growth, stability, equilibrium and resource allocation in an Islamic economy. While reviewing contributions in this field, one has to bear in mind that a full-fledged Islamic economy does not exist anywhere in the world at present. Many of the propositions advanced in these contributions are therefore in the nature of hypotheses rather than definitive conclusions derived from observed behaviour of an Islamic economy. This, however, does not detract from the value of these contributions. In fact, theoretical constructs of this nature are essential building blocks for the science of Islamic economics. Moreover, they help in envisioning the inner working of an Islamic economy consequent to its taking practical shape in any country.

The theme that an Islamic economy would be a dynamic, growth- oriented economy recurs frequently in the literature on Islamic economics. As mentioned in the first section of this introductory note, an Islamic economy has two main distinguishing features. Firstly, it does not allow transactions based on interest. Secondly, it has a wellfunctioning Zakah system. Both these features can be expected to provide a powerful stimulus to growth. That the interaction between the incentive and disincentive effects arising from these two basic features of an Islamic economy serves to promote growth is demonstrated once again by Metwally in his paper. He first states the familiar proposition that by penalising idle resources, the Zakah system discourages hoarding and stimulates investment. He then proceeds to demonstrate formally that the demand for investment at a given expected rate of profit will always be higher in an Islamic economy compared to other economies. Since investment is one of the most important determinants of the rate of growth, it follows that an Islamic economy would have a pronounced growth orientat:on.

An apprehension is sometimes expressed that savings which are essential for capital formation and growth, would be discouraged in an Islamic economy because of the prohibition of interest. In fact, some writers go to the extent of suggesting that all savings will cease at a zero rate of interest. The argument employed is that people have a positive time preference, and unless the interest rate is positive, the positive time preference cannot be transformed into negative time preference which is necessary for savings to take place. Anas Zarqa questions the tendency to take positive time preference for granted. In his paper he conclusively demonstrates that positive time preference is neither a principle of rationality nor an empirically established predominant tendency among consumers. It is simply one of three patterns of inter-temporal choice (the other two being zero and negative time preference) each of which is rational and observable under its own conditions. Intuitively also one finds it difficult to believe that people will stop saving if the interest rate is zero because motivations for savings are many and varied and most of them would continue to operate to bring forth positive savings even if the return on savings is zero.

However, even if it is assumed that everyone has a positive time preference, it does not follow that a society cannot do without the institution of interest. What is needed to transform a positive time preference into a negative time preference is the existence of some return on saving. This can be either a fixed return or a variable return. As the CII Report points out, abolition of interest does not mean that the saver will not get any return on his savings. In a system based on Islamic principles, the saver will continue to get a return on his savings; the only difference would be that instead of being fixed in money terms the return would be variable.

It is necessary to probe into this matter further for it can well be argued that the fact of variability of return on saving, including the possibility of making a loss, may discourage saving. However, this argument also does not bear close scrutiny. We know that savers in the interest-based system too are faced with uncertainty of return because while the nominal rate of interest is fixed, the real rate of return on saving is uncertain on account of the unpredictivity of the actual extent of the change in the price level in a future time period. In fact, savers in an interest-based system get a negative return, which means they suffer a loss in real terms, whenever the rate of inflation exceeds the rate of interest. It is true that savers in an Islamic economy face a double uncertainty, that is, uncertainty about the nominal yield and the uncertainty about the inflation rate. However, it is by no means axiomatic that the saver in an Islamic economy will be worse off because of this double uncertainty because, under a porfit-sharing system, increases in the nominal price level are likely to be associated with increases in the nominal return on investment and this could even reduce the variability of the real yield on saving.

Nejatullah Siddiqi has sought to demonstrate in his paper that change-over to interest-free system will not only foster growth but would also lead to greater equity. In the interest-based system, the entrepreneur has to bear all the risks and all the losses. Losses often arise from unexpected developments and changing valuation of products by society which, due to imperfect foresight, cannot be accurately foreseen by the entrepreneurs. Losses are a natural concomitant of the changing economic scene and serve as guides in the restructuring of investment and redirection of productive enterprise. The entrepreneur performs a socially useful function in the society. He is often an agent of change and his productive activities create employment opportunities for others. In line with its humanistic approach, the Islamic system gives a fair deal to everyone. It does not give a privileged position to providers of capital by insulating them from all risk. The price the society has to pay for changing valuations and imperfections of human foresight is, in a profit-sharing system, shared by the providers of capital,and entrepreneurs in a manner which does not disable or destroy any one and serves the ends of equity.

Consideration was also given in the Seminar to the implications of a change over to an interest-free system for the stability of the system and for allocative efficiency. In his paper, Nejatullah Siddiqi seeks to demonstrate that replacement of interest by a system of profit-sharing will cause no problems as regards its smooth functioning and stability. In this context it seeks to dispel the apprehension expressed in certain quarters that a profit-sharing system will be exposed to wide fluctuations as the changes in the entrepreneurial profit will be communicated back all along the line. The two profit-sharing ratios on which attention is concentrated in the paper and which have relevance for the stability of the system are the ratios in which business profits are shared between the bank and the entrepreneur, and the ratio in which bank profits are shared between the bank and the depositors. The paper employs a partial equilibrium approach to analyse the likely behaviour of these two profit-sharing ratios in a changing business situation. The original version of the paper presented at the Seminar gave the impression as if the author believed that his main thesis has been proved by demonstrating the long run stability of these ratios. Some of the deficiencies of the analytical apparatus employed by the author and the arguments used by him in reaching this conclusion were pointed out by Ziauddin Ahmed and other participants in the Seminar. In the revised version of the paper, included in this volume, the analysis has been considerably refined but it is doubtful whether the point that the author is trying to make is even now fully established. However, this does not detract from the value of his contribution. In fact, the paper by Nejatullah Siddiqi has served a very useful purpose by stimulating further thought in a difficult area of macro-dynamics of an Islamic economy.

It might be in order to mention at this stage that fluctuations in the money rate of return on deposits under a profit-sharing system should not be a cause for concern. Neither should this be regarded as a factor necessarily militating against the stability characteristics of an Islamic economic system. In fact, if the rate of return to depositors rises in money terms in an inflationary situation, it would help preserve the real rate of return on deposits and will serve an economically useful purpose. In recent years even the interest-based economies have witnessed considerable fluctuations in money rates of return. In fact, gyrating interest rates and continuously fluctuating exchange rates are now a familiar part of the economic scenario in Western economies.

Allocative efficiency of an interest-free economy has been an area of major concern for the Muslim economists. The paper presented by Anas Zarqa at the Islamabad Seminar, the revised version of which is published in the second volume (Fiscal Policy and Resource Allocation in Islam), represents a great step forward in this field. The main contribution of the paper lies in an effective refutation of the thesis that interest is indispensable for an efficient allocation of resources. Anas Zarqa does not deny that investment efficiency requires the use of discounting to take proper care of the time dimension of costs and benefits. He, however, emphasises that use of an interest rate is not inescapable for discounting purposes. In fact, he forcefully argues that interest rate is not the proper discount factor under conditions of uncertainty even in interest-based economies. Under conditions of uncertainty, the rate of return on equity is the proper discount rate. Since the real world is a world of uncertainty and since no real investment in any economy can be undertaken without facing risks, cash flows of such investment should be discounted not by a riskless interest rate but by the true opportunity cost of venture capital.

Participants in the Seminar were unanimously of the view that discounting as a technique of computing the present value of future cash flows does not violate any Islamic injunction. Work is necessary, however, to determine an appropriate discount rate for an Islamic economy. Anas Zarqa suggests rate of return on equity as the appropriate discount rate but does not suggest any specific procedure for choosing a representative rate for the purpose. Masudul Alam Choudhry, in his paper, outlines a methodology for calculating an appropriate discount rate for an Islamic economy. This turns out to be a sum of the marginal efficiency of investment determined through a process of inter-temporal allocation of income to real investment and of the price for risk bearing in a mudarabah. This is one possible approach to project evaluation in an Islamic economy and opens the way for further work in this field.

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