A Legal Perspective Towards Islamic Finance

Students of economics are traditionally and quite properly exposed to different subjects related to economics, such as accounting, business law, management and organization, etc. However, they seldom get a chance to appreciate their direct relevance to a better understanding of economics, for the main concerns of economic textbooks, generally speaking, are the technicalities of economic theory. I venture to say that not a single microeconomics textbook ever treats the theory of the firm in its legal environment. Yet, specific formal laws and regulations, supplemented by social contracts, decisively influence the behaviour of all economic agents. The absence from the standard economic literature of a clear account of a firm in its legal environment is then remarkable. Another (and, as we shall see, related) blind spot is the defining boundary between money (potential capital, M) and actual capital (K). That distinction depends in its turn on a proper appreciation of the distinction between interest and profits. Interest and money are artificial social conventions. Most schools of economic thought recognize money as a necessity and one of many highly valued human inventions. The necessity, even usefulness, of interest has, on the other hand, always been questionable. Now interest is a form of return on money: taking that for granted, a familiar analysis introduces three factors of production, puts them together, and shows how they turn a profit/determine interest. In this analysis, capital has been wilfully misplaced in order to show the necessity and realness of interest. In fact the analysis only shows that capital is productive of profit — money, qua money, is not productive. Also, many economists have argued that in the end, profit and interest come to the same thing, as over time the rate of profit would equal rate of interest. To the contrary, there is ample historical evidence that the real rate of interest and the real rate of profits over a long period of time for the G- countries have never been the same.

Some economists hold firmly that time preference alone is sufficient to prove the necessity of interest. Assuming this is true, interest, according to Schumpeter, would not exist in the evenly rotating economy consisting of overlapping generations. Furthermore, as is generally understood, while the Islamic tradition recognizes the concept of ‘time preference’, it rejects interest, surely on the grounds of the two being quite distinct. Rate of profit, determined in the real sector, and capital, are both such real phenomena that every school of economic thought has to take them seriously and incorporate them into economic analysis. These concepts are very important in the Islamic economic system. Indeed, the rate of profit is (unlike in the capitalistic system, which centres on interest) pivotal in the Islamic economic system and, more importantly, in enabling equilibrium in the labour, capital, and commodity markets to be simultaneously determined.

Keynes drew a clear distinction, which had been confused in the old orthodoxy, between interest as a reward for lending money and profit, which was the reward or return that a businessperson hoped to get. This distinction between money and capital is the necessary foundation of a sound and healthy economy. The question that needs to be asked is whether interest is necessary for the proper functioning of an economic system. Serious doubts have recently been raised about its necessity, which is a strong argument for the enduring relevance of the Islamic prohibition of interest. Treating the monetary sector independently of the real sector of the economy seems to me to lead to what Keynes called ‘some objectionable features’ of capitalism. Business cycles are believed to be as old as capitalism, a historical fact. Why then should we not be seeking a way of avoiding these cycles? In a capitalist system centred on the rate of interest, discretionary monetary policy affects the economy in a way notorious for generating instability, since both promote speculation. A sound economic system is surely one with relatively stable fundamental factors and, more importantly, a money supply that is endogenously determined. Despite the great abundance of admirable writings on many aspects and elements of the conventional capitalist system, there remain important, unanswered questions. One of those is the distinction between money and capital. Robinson at least raised the question.

When Robinson calls both capital and net receipts of a business ‘a sum of money’ and says that the two never co-exist in time, she altogether forgets the legality of an established firm. Legal processes have to be undertaken before ‘a sum of money’ is transformed into actual capital. As soon as these processes have taken place, under some simplifying assumptions, both will coexist in time. It would be unfair to assume that Robinson was simply unaware of the legal aspects of the matter. She rightly criticizes Keynes for creating confusion by describing a purchase of shares on the Stock Exchange as an act of investment. She consciously distinguishes between shares and loans on legal and philosophical grounds.

By asking the question“how can finance be treated as a factor of production?” Robinson came close to solving the long-standing question, but failed to push the discussion forward. The distinct models developed particularly in the United States to determine the meaning of capital did not satisfy her. Disappointed, she appears to have given up, abandoning the controversy about capital as “a great waste of mental energy” . Not finding the perfect answer to the question she had raised, she gave up, even ignoring what Keynes had to tell us about it. Keynes said that capital in existence at any moment may be treated simply as “part of the environment in which labour works”. This is an important pointer, which, combined and elaborated with some terms borrowed from other disciplines related to economics, brings us very close to an answer to the question.

The financial system is undoubtedly part of the general functioning of the economy but, as has often been explained, the monetary system is independent of the real sector. The lawfulness in the conventional system of money loaned on interest exemplifies (as it also exalts) individualistic behaviour in the economy in that the lender (or bondholder) takes no part in the outcome of the borrowed money wherever or however it is used. This contrasts with the profit and loss sharing (PLS) contract, whose only manifestation is stock, and in which the stockholder does take responsibility for the outcome of the ‘capital’ invested.

As Robinson puts it: “a new business sets out with a sum of money whether owned by the proprietors or borrowed at interest”. But she is not clear as to the process by which ‘a sum of money’ is put in business. In a later study, she tried to revive the old question and asked whether the quantity of capital was supposed to be a sum of money or a list of ‘machines’. It is self-evident that in order to set up a business, there is a need for ‘a sum of money’. This sum of money represents the market value of ‘something’. The next section in this paper deals with this ‘something.’

Source: Prof. Iraj Toutounchian, Integrating Money in Capital Theory: A Legal Perspective Towards Islamic Finance. Republished with permission.