Shadowy Argument for Using a Shadow Interest Rate

Some Muslim economists have said that an interest-free Islamic economy must use a shadow or accounting rate of interest to ensure efficient allocation of investments. We shall now contend that to say so is to err twice. Firstly by conceding the capitalist assertion that efficiency requires an interest rate, and secondly by adopting the Marxist defence that an accounting interest rate may be used instead (a superfluous defence for an Islamic economy which permits profits).

It would help to look first at the genesis of this idea.

a. A False Lead

Professor Samuelson adopts the commonly encountered argument about the role of interest in allocation, and presents it thus:

"the interest rate has an important function in capitalistic, socialistic or any other kind of economic system . . .(it) acts as a sieve or rationing device: all projects that can yield JO per cent are under- taken before any projects that yield only 8 per cent. . . The interest rate must be used to allocate scarce 'capital supplies’ optimally and to determine the priority of alternative projects”. (Samuelson, 1976, p. 640).

The grave defect of this argument is that it slurs over the crucial question of uncertainty — so let us examine it from that perspective:

If perfect foresight is assumed, we may validly cross out in the above quotation the words “rate of interest” and write instead “the rate of profit” (or the “rate of rent” or the “rate of return on equity”, because all these rates are equal in a world of oracles) (see Section 111.1). Truth is: in such a world, any one of those rates serve equally well in the allocation of scarce capital.

Coming down to our actual world of uncertainty, we see that Professor Samuelson’s above assertion is not valid. For under uncertainty, the rate of interest and the rate of return diverge, and we have seen (Section 111.3) that the latter rate and not the former is then the proper criterion for project choice.

Within the market sphere, it is not interest but profit which allocates scarce real “capital supplies”. For it is obvious that interest is what businessmen pay, profit is what they earn. And it is elementary economics, my dear Watson, that businessmen invest not where interest is higher but where profits are higher!

b. Is an Accounting Interest Rate Needed?

Several Muslim economists, after uncritically conceding that only interest rate can allocate real capital, conclude that an interest-free Islamic economy should rely on an accounting or shadow rate of interest to allocate investment and evaluate projects. The erroneous argument by which that conclusion is usually reached runs as follows:

Because interest is banned in an Islamic economy, real capital has zero market price.

But capital is scarce and must command a positive price for efficient allocation.

The way out, so the argument goes, is to use an accounting rate of interest as a price for real capital.

But both (a) and (c) are wrong. In the actual world of uncertainty, real equity capital does not have contractual price, but it has nonetheless a real non-contractual opportunity cost that is expressed in the market by rates of return or the earnings-price ratios of common stock (Dorfman, pp. 245-46). Why not use this real price instead of chasing shadow rates of interest!

There is however a valid reason of using “a shadow price of capital”. It is based on the argument that the market price (in this case the risky rate of return) may not express the true opportunity cost to society, so it is better for public authorities in their investment decisions to use a shadow rate of return instead. To this kind of argument, we can add that an Islamic economy may or may not use a shadow price of capital. It may need a shadow price for cement or shoe laces or capital etc., not because the institution of interest is eliminated, but because of possible market imperfections. In other words, what an Islamic public authority may need is a shadow rate of return on equity (if the market rate of return is distorted). What it never needs is a shadow rate of interest.

Source: Fiscal Policy and Resource Allocation in Islam, Ziauddin Ahmed, Munawar Iqbal and M. Fahim Khan. Republished with permission.