The concept of loan has undergone a significant change under capitalism. In the pre-capitalist era loans represented real savings. Command over social produce acquired by making some contribution to it was temporarily transferred to the borrower. As the propensity to consume of the borrower is higher than that of the lender, the act of lending had an anti-deflationary effect that contributed to the health of the economy.
With the advent of banking, a loan became so much purchasing power created and passed on to the borrower. It constitutes an additional claim to the stock of goods and services available in the society. It is not matched by any prior or simultaneous contribution to the social product. It is therefore inflationary in its impact. In so far as bank loans are for consumption, no addition to the social product is expected even in the future. In the case of productive loans an increase in production may take place after a time lag provided idle resources exist in the economy. A continuous stream of bank loans is bound to exert an inflationary trend in view of this time lag. A society which lacks idle resources or faces serious bottlenecks in the supply of capital goods, skill or raw materials required will be the worst sufferer in this regard.
If, in the pre-capitalist era, the borrower had to pay an additional sum of money as "interest" beside repaying the principle, it involved a simple transfer of command over real resources from one class of people to another. Payment of interest on money created ad hoc for lending magnifies this effect to such a great extent that its very nature changes. If the reserve ratio is 10 per cent so that saving deposits worth 100 enable the bank to advance 1000 as loans, and the annual rate of interest is also 10 per cent, the amount transferred will be 100 per year. Lending of the 100 saved, without intervention of banks and creation of money by them, would, however, involve a transfer of 10 per year only. While the repayment of the bank loan will extinguish the money the bank has created, the interest paid to the bank will remain. The redistributive role of the institution of interest on loans has therefore become much too decisive with the advent of banking.
Notwithstanding the fallacy of the various justifications offered for the saver's claim to interest, the new situation calls for a fresh justification for the lender's claim to interest when the money lent is created in the process of lending, exists as long as the loan exists, and is extinguished as soon as the loan is repaid.
It is a social convention that enables this remarkable thing to happen, i.e. the habit of people to keep their cash with the banks and deal in cheques, their confidence in the banking system being ultimately rooted in the protection given by the central bank. It is society which permits new purchasing power (unaccompanied by a simultaneous addition to social production), to be created and tolerates the inflationary pressure involved in the hope that it will lead to a subsequent increase in the social product through utilization of idle resources.
Why does the economics of capitalism fail to emphasize the obvious difference between loans that represent real savings and loans that do not? Why does it treat the creation of additional claims to social production on a par with a mere transfer of existing claims? Why is the same concept supposed to cover two dissimilar entities? The reason lies in the legitimization of interest on bank loans which the cover of the old concept provides. Once the social origin of the privilege extended to borrowers is recognized society is bound to claim the resulting benefits, whatever they are. The banks could not be entitled to more than service charges, with an extra amount to cover the risk of non-repayment if it is not taken care of in a different manner.
It does not suit the conceptual framework of Islamic economics to treat the two kinds of loan alike. Lending proper must be distinguished from the social permission for exercising additional purchasing power in anticipation of additional production. From the Islamic point the act of lending is an act of charity, a good deed. It is not an act of business motivated by profits. The borrower is not obliged to pay back anything over and above the principal borrowed. Lending belongs to the area of altruistic cooperation, an important dimension of economic activity in Islam. The social permission for exercising additional command over resources in anticipation of additional production is a new phenomenon. The rights and duties of the parties involved have not been defined by the text of Islamic Law; this has to be done now in accordance with the spirit of that law. It is evident, however, that they would be different from those laid down for "loans" in the earlier sense.
Source: Dr. Muhammad Nejatullah Siddiqi, Economics An Islamic Approach. Republished with permission.