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Islamic Economic System

The Islamic economic system is the collection of rules, values and standards of conduct that organize economic life and establish relations of production in an Islamic society. These rules and standards are based on the Islamic order as recognized in the Koran and Sunna and the corpus of jurisprudence opus which was developed over the last 1400 years by thousands of jurist, responding to the changing circumstances and evolving life of Muslims all over the globe.

Three aspects of the economic system are usually referred to as the major distinguishing elements of any economic system.


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1.1 Property

In the Islamic system, property is a trust. The real owner is Allah (Subhanahu Wa Ta’ala). Man’s disposal of worldly goods is in the capacity of a viceroy and a trustee. His rights are, therefore, circumscribed by the limits Allah has prescribed, and should be exercised toward the ends Allah has defined. Unlike the capitalist system, the right to property is not absolute but has limitations and qualifications enforced not by the power of the government but by the power of one's faith and desire to be a pious Muslim. Hence, the common-good and the welfare of fellow Muslims are internalized in the decision making process of every Muslim. It is Socialism with at the state.

In view of the purposive nature of man's life in the Islamic world view, even these limited rights of ownership are not devoid of purpose. Wealth is an instrument in the effective discharge of man responsibilities as the viceroy of Allah, and the achievement of well-being in the life for himself, his fellow Muslims and fellow human beings. No where this viceroyship is displayed like in the Shari’ah laws of inheritance. These laws clearly assume that once the individual is dead, his wealth goes back to the original owner, who specifies to whom the wealth should go. The laws of inheritance specify where exactly this wealth should go, regardless of the approve or the consent of the deceased owner. He is permitted to endow only 1/3 of his legacy. Even then, such endowment should not go to a beneficiary (one also is included in the inheritors) not to uses that are not considered is Shari’ah a charity.

1.2 Distribution

Because al-adl (justice and fairness) is a basic value of the Islamic economic order, distributive justice is a major concern of the system. Equitable distribution of income and wealth is therefore an objective by itself. Operationally, this is accomplished through certain institutions which form the backbone of the social security in Islam. Examples are a bound:

1.2.1 Zakah

Zakah is the third pillar of the Islamic faith. It is a unique system of social security. Zakah is not a hand-out from the rich to the poor. It is a right of the have nots in the wealth of the haves. It is a measure designed to directly transfer part of the wealth from the well-to-do to the poor and not to the government. Because the purpose is redistribution of income and wealth, without creating a class society zakah is levied on almost every one. Even the not very well to do, pay zakah. He may then receive the zakat of others at the same time. Zakah is levied annually on the wealth itself and not on the individual or income, at a general rate of 2½ % per annum. This is not all. Zakah is a requirement. However, a Muslim is always engaged not to confine his charity to that requirement by giving alms (sadaqat).

1.2.2 Laws of Inheritance

It would not be possible to guarantee the functioning of the system free from injustices without a built-in-mechanism to prevent injustice reproducing itself generation after generation. Studies show that one of the major causes of inequality in income distribution, is the distribution of wealth. One major outcome of the Islamic laws of inheritance, is to prevent concentration of wealth. This is because legacy is distributed in a pre-set ratios which take into consideration need and closeness to the deceased. Yet giving the deceased the right to assign part of his wealth (not exceeding 1/3) to charitable uses.

1.3 Economic Freedom

Freedom is a cornerstone in the Islamic economic system. In fact, it is so basic that the whole message of Islam came to free man from all kind of slavery. Freewill is a necessary condition for the validity of all contracts. The basic human rights which are now included in the laws of civilized countries has been a part of legal system of Islam since the Prophet (P.B.U.H ) . In fact, all the so called Magna Charta has been enjoyed as the basic individual rights in Islam for centuries. Furthermore, to guarantee competition in the marketplace and freedom of transaction, many measures were adopted by the Prophet (P.B.U.H). Prohibition of monopoly, manipulation of prices and restricting entry to the market are but a few of these measures.

1.4 The Islamic Economy is Interest-Free

Today’s trade and commerce in the whole world is run on the basis of interest based debt. If we look at the money and capital markets in any country we find that they are basically markets for exchanging financial obligations and receivables. It is no wonder that just the mere thought that interest rate may go up (or down) will bring havoc to all sectors of the economy. Standard economic analysis tells that interest rates play important roles in the economy. Firstly, that it provides incentives for savings, and secondly that it performs an allocative function with regard to capital. The argument goes as follows:

  1. Saving is essential to any economy because on which depends the rate of investment, and hence the rate of growth of the economy and the property of its citizens. Since economic development is the objective of every society, improving the nascent rate of saving becomes a basic requirement for the achievement of a viable and sustainable economic growth. Because too much saving may be just as unproductive as too little, interest rates, furthermore, provide a tool for policy as regards savings where this rate is controlled in such a way as to attain the right magnitude of savings as required by the going economic circumstances.
  2. As regards the distributive function of interest, it is believed that interest rate plays a yardstick (benchmark) for evaluating the feasibility of investment projects and other uses of scarce resources. Since capital is scarce, the economy need a tool through which this resource is directed to the best use, i.e. the one that produces the highest returns. Without such a tool, it is quite possible to see capital going to relatively poor projects, while the sound ones are left out of investment capital. With the tool of interest rate, expected profits are always compared to the rate of interest. Since the latter measures the cost of capital, only these projects which make more returns than “cost” will be financed. Even self financing will be subject to such a benchmark since interest plays an “alternative” to any investment opportunity (i.e. an opportunity cost).

Efficiency is an objective of every modern economy. To attain “more” efficiency, resources have to be allocated in the economy in such a way as to attain the maximum overall return (rate of growth for the economy).

It appeared to many economists that no modem economy can function without "interest" for then saving will be very low, and utilization of scarce resources will not be efficient.

An Islamic economy is free of usurious transaction, hence interest based finances are not allowed. This may appear unattainable in this modern age. Islamic Economists claim that this is not only possible but it is superior to the interest based system. Firstly, we need to qualify some of the statements we just mentioned. Even in a capitalist economy, the rate of interest is not the “raison d’être” of saving. Savings does not hinge on interest. J.M. Keyens, in his famous General Theory, had shown how the volume of savings basically depended on income. If income rises, savings will rise regardless of the level of interest. Empirical studies, furthermore, have shown in all major industrial countries, the validity of this conclusion. The motives for saving are, in the most part, unrelated to the rate of interest.

Hence, in a society where interest is not used, one cannot say that saving will not exist, nor that it will be lower than otherwise. However, interest rate does play an effective means of attracting savings to the banking system.

This is because is considered interest a “reward” given to the saver. In an interest-free Islamic economy, savers will still be rewarded. Any banking system, Islamic or otherwise, will fail to attract savings without such rewards. However, the reward will be contingent on the performance of the fund users, i.e. a share in the profits generated through the use of savings and not a predetermined fixed return. It , therefore, cannot be assumed that saving will have to decrease in a system where interest is not used.

It might be claimed that deposits in a profit/loss sharing (PLS) banking system will bear a higher degree of risk compared to a conventional banking system. Hence, savers in an interest free system are at a disadvantage. However, this is true only of rates of return in an interest-free banking system are equal to interest rates in conventional banking system while risk in the former increases. Since returns will significantly increase in a PLS system, more risk will be tolerated by depositors, because it is then compensated for by higher rate of return. More importantly, however, differed-payments sales which constitute the backbone of Islamic banking are similar in their risk profile to interest based lending. It can't be claimed, therefore, that they will have a different effect on saving.

As regards the allocative function, interest will play the role of an efficient allocator only in a market that is perfectly competitive, and where marginal productivity of every project is perfectly known and comparable to the going interest rate. In reality, no such markets exists. Even in the advanced industrial economies, money markets and capital markets suffer from “great” imperfections. One aspect of such imperfections is the fact that credit-worthiness of the borrower is far more important to the lender than the feasibility of the project. There are many good projects whose rate of return exceeds interest rate, and which meet the efficiency rate criteria described above, will go unfinanced. The reason is that they are too risky from banking point of view which only looks at credit-risk not profitably. Furthermore, governments almost everywhere, rarely rely fully on market forces in the allocation of scare resources. They do influence the market mechanism, directing resources in accordance to “social” considerations and political priorities, away from marginal productivity.

Interest rate is a financial benchmark. Investments in the real sector which produce real goods and service will not produce “interest”, but profit. Hence for purpose of efficiency and optimal allocation of resources, profit rate is a more relevant an indicator than interest. Not only that rate of profit is a “real” (not monetary) index, its use for the purpose of resource allocation will reduce to dominable of the financial sector over the real sector in the economy. This will introduce a higher degree of stability in the system. After all, people who invest in the production of real goods and services receive profit not interest.

1.5 Usury in Islamic Jurisprudence

Usury is as old as money. Almost all human societies since time immemorial practiced usury, and almost always struggled with reformers and learned men who felt, even before the advent of religions, that usury is unjust. There is little or no difference between usury which was practiced in antiquity and that of a modern money center bank.

At the advent of Islam, the Makkans were principally merchants. The economy of Makkah, a city in the heart of the desert, depended on the annual trade journey done by these merchants. In financing their caravan consisting of no less than 2000 camels, carrying goods from southern Arabia to the borders of the Roman empire, the Makkans depended heavily on usury. It is that type of usury (called riba in Arabic) which was addressed in the Koranic prohibition. Riba is basically two types: One doing with debt the other takes place in contain types of sales. The riba of debt is itself two kings: a stipulated 3 increase in loans, and a compensating increase in the nominal value of debt when payment of such in postponed payment. These are not dissimilar to contemporary banking practices. The other type of riba, which is not mentioned in the Quran but narrated through authentic Hadiths from prophet Muhammad (P.B.U.H) is called riba of sales. This riba, is prohibited to edge against from principal mode of usury, which is riba of debt. The prophet (P.B.U.H) specified six items (commodities) and set special rules for their exchange. The common denominator of these six items is their capability of being a medium of exchange. On top of the list is gold and silver both as coins or bullion. The rules go as follows: When the exchange contract involves gold for gold, then it is not permissible to conclude a sale except if the quantities exchanged are exactly the same and transaction is done with no delay in delivery of either. In transactions involving gold and silver (or dirham and dinar) equality of quantity is not a requirement. However, the contract is void if delay in delivery of either is part of the agreement. Contemporary scholars agree, unanimously, on applying the rules of exchange of gold and silver on modern paper money transaction. An exchange involving dollar ($) and pound (£) must have spot delivery. No delay is allowed. It is not hard to see that if such delay is allowed then it would be easy to circumvent the prohibition of interest.

1.6 Is Interest Riba?

It is not difficult to see that interest in conventional banking is riba. It does fit the definition: an increase stipulated in a loan contract. Credit provided by the bank to its clients which is based on interest is clearly so. But even time deposits and current accounts are nothing but loan contracts (The lender here is the depositor and the borrower is the bank) with stipulated increase. (current accounts are loans with no stipulated increase). Furthermore, revolving credit is a type of loan where interest calculation is based on outstanding debt which is payment postponed. Claiming that interest is not riba is therefore unattainable.

1.7 Time Value of Money

Does the fact that Islam prohibits interest mean that there is no time value of money in the Islamic economic system? The answer is negative. Shari’ah does recognize the time value of money. There is ample evidence to show that monetary value in many Shari’ah prescribed transactions is attached to time.

For example, it is permitted in Shari’ah to increase the price in deferred payment sales in accordance to the length of the term of debt arising from such sale. Shari’ah scholars, do recognize this, and many of them allow seller to reduce the price of deferred payment sale in cases of pre-payment. Their argument is that part of the price was related to time. Now that "time" is shorter, price should be reduced. There are similar direction in the rules of other exchange contracts. In particular the Salam contract shows very clearly that Shari’ah does recognize the time value of money. This Forward sale of goods where goods that are already available in the market are sold for a lower price but future delivery, shows that time is basically what is paid. It is only in loans and debt obligations that are outstanding that time related increase is not allowed.

However, even the prohibition of increase in these two transactions shows Shari’ah recognition of the time value of money. For instance in loan, Shari’ah clearly states that the hereafter reward for loan is even bigger than that of giving alms to compensate for the loss of the utility of one’s money loaned at no interest. It has been narrated from the prophet (P.B.U.H), that loan recipient is more likely to be in need than one who receives Alons. It is important to remember here that the purpose of loan in Shari’ah is benevolence and philanthropy nonprofit. Profit generating uses of funds must always be financed through profit and loss sharing arrangements. Giving more time to debtors who genuinely are not capable of making their timely payments , is by itself considered a sort of donation, and generously rewarded in the hereafter.

But why does Shari’ah, while recognizing the time value of money allows it to have a monetary consideration only in certain transactions. More interestingly why is it prohibited to attach monetary value to time in sale but not in loans?

It is only now that we can understand the wisdom of such prohibition. Allowing lenders to generate income from pure monetary transactions (i.e. not involving goods or services) will create a financial sector in the economy which generates its income just from the passage of time independently of the real sector where goods and services are produced. A dichotomy will then take place in the economy, creating instability (boom and bust) and redistributing income and wealth in, towards one sector or the other depending on the state of the economy. Injustice is then created.

1.8 Islamic Model of Financial Intermediation

The function of banks is financial intermediation. While experts may differ on the history of banking, there is no question that the importance of financial intermediation had been recognized even by ancient societies. It is because of this, we find that people in antiquity had always had arrangements to carry out such function. Temples and chapels at the time of the Pharaohs and the time of Hamorabi carried out the function of by arranges the transfer of funds between lenders and borrowers financial intermediation. The Greeks did have an even more advanced arrangements for financial intermediation.

What gave rise to such financial intermediation is the fact that human societies, since time immemorial had been divided to two groups. One with more resources that it needs now and the other needs more resources now that it owns today. People discovered very early that the welfare of both groups will be significantly improved if a process of transferring resources from the first to the second group was initiated. Because every individual in society is prone to be m the first or the second, it is quite advantages to everyone to participate in this process.

At the dawn of the middle ages, a social movement towards division of labor and specialization took place. It included the institutionalization of many activities which used be rendered as part of the religious or social relationships.

The ‘bank” as an institution for financial intermediation was born.

It was quite natural that such institution is built on the same arrangement which was the basis of financial intermediation in almost all historical stages, that is the Loan contract.

The bank is, therefore, based on a borrower-lender relationship. The bank borrows (and depositors lend) and then lends (and users of tends borrow)

In both asset and liability sides of the bank’s balance sheet, this borrower lender relationship is easily recognizable. The term "loan" is never used in the realign of banks relations with its sources of funds (depositors). This, however, doesn't hide the legal and actual fact that all bank deposits are loans; the borrower is the bank and the lender is the bank client.

But why didn't savers go directly to borrowers and cut the cost of the middle man? In other words: why did bank came to existence? The answer relates to the cost of information. An institution that specializes in credit analysis is more efficient in minimizing the risk involved in lending because of its ability to gather and analysis information. It is because of this the role of banks is decreasing as the cost of information is reduced, giving more space to finance market where savers select their choice of visits.

Source: An Introduction To Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.