Islamic Economics (Banknig/Interest)

[ahmedqman]

Asalaamualaykyum:

I read these arguments on another website:

"I read the Wikipedia article about Islamic banking, and the claim that they "don't charge interest" just doesn't hold up. Under IB, the bank buys something and then resells it to you for more, but allows you to pay in installments.

Sorry, but that's charging interest."

"Arguments about the evil of interest fundamentally fail. Even if everyone rejected the whole idea of lending or borrowing money at interest, or the government could somehow enforce a complete ban, interest would still enter into most economic calculations. People would still gravitate toward a discount of the present value of future goods. People would still buy things that draw rents and can be resold such that they earn a return. (The German word for interest, Zins, comes from the Latin census, which was the tabulation of someone's wealth which was at the time mostly land. People soon realized that owning land had the same financial effect as loaning money at interest and so the name stuck.)

Futhermore, the idea of interest as a drain on society is ultimately contradictory. If any and all interest income is evil, then the more, the worse. So the longer you loan out the money, the more evil you're committing. The most evil thing you could do then would be to loan the money out *forever* and let the interest accrue. Of course, this means never redeeming it to consume resources. Since you had to produce something at some point to earn the interest, that would imply that the absolute worst thing you could do is to produce, and never consume. In reality, of course, that's the best thing you could do! Hence, a contradiction.

Interest, exponential value growth, is a manifestation of the exponential growth involved in *production*. By producing rather than consuming, you bring into effect a chain of events which enables and exponentially growing level of output. Your satisfaction of someone's desires freed him to satisfy someone else's desires, who was then free to satisfy someone else's desires, and so on. Society is *not* indifferent to when production occurs; all else equal, the sooner production happens, the better. Interest rewards those who produce sooner and consume later, and thereby enable a larger amount of wealth for all.

Finally, it's true that interest allows past injustices to increase in severity because the profits accrue interest. This is an argument for assigning interest penalties to those illicit profits, not to condemning interest."

Is anyone knowledgable on economics to speak on this issue?

[tamiki]

first, we have to know that interest is haram - we don't really care about all the economic benefits or perils invovled. with that said...

interest today is charged for two reasons - it is (1) a way of maintaining the purchasing power of the dollar lent and (2) the charge for not being able to deploy that dollar into some kind of money producing business.

i don't know anything about how modern day islamic "banks" operate or if they try to lend money with a scheme that "resells it to you for more" and if that is halal or haram.


people can go on debating economic theory forever. there is no definitive answer on what kind of production is the most optimal.

all of the discussion focuses on the quantitative production and consumption of wordly goods without consideration of other factors.

muslims don't produce and consume for the sake of it. we do what we need to get by through halal means and get on with our goal of ibadah through islam.

and finally, all of it isn't really logical.

Since you had to produce something at some point to earn the interest, that would imply that the absolute worst thing you could do is to produce

it's not true. production isn't inherently tied to lending and so isn't inherently tied to accruing interest.

this is just all nonsense.

the bottom line is that no human being or group of human beings will be able to come up with a perfect economic system.

our only job is to implement the laws of Allah and we don't need to be concerned about all of this economic mumbo jumbo. we can already see the problem with the world's current interest based economy.

we don't need to institute an "interest penalty" as a patchwork solution. we need to get rid of it all together because that is Allah's hukm.

. Interest rewards those who produce sooner and consume later, and thereby enable a larger amount of wealth for all.

this is typical capitalist rhetoric.

it sounds reasonable in writing, but is absolutely horrendous in practice.

do you need a more coherent, detailed reply?

[ahmedqman]

I would like one.

If you have expertise in such a subject, then please enlighten me with your knowledge. It might be "capitalist rhetoric" to you, but such language might reveal your own biases. If it's "capitalist rhetoric", please demonstrate that it is through facts and so on.

[ahmedqman]

If you could do a point by point breakdown, that'd be nice.

[tamiki]

If you could do a point by point breakdown, that'd be nice.

it is forthcoming , please give me some time

[ahmedqman]

it is forthcoming , please give me some time

Jazakallahu Khairun

[haqq]

we don't need to institute an "interest penalty" as a patchwork solution. we need to get rid of it all together because that is Allah's hukm.

Exactly! And this new breed of the so-called 'Islamic Banks' institute a penalty on late payment.

CAN RIBA BE LEGALIZED TO PUNISH A MAN FOR LATE PAYMENT OF INSTALMENTS?

[tamiki]

I would like one.

If you have expertise in such a subject, then please enlighten me with your knowledge. It might be "capitalist rhetoric" to you, but such language might reveal your own biases. If it's "capitalist rhetoric", please demonstrate that it is through facts and so on.

(1) I don't have expertise in the subjects.
(2) I do have a bias because interest is haram.

okay, i will try to deal with the issues from the "Article" you quoted first and then my comments.

"I read the Wikipedia article about Islamic banking, and the claim that they "don't charge interest" just doesn't hold up. Under IB, the bank buys something and then resells it to you for more, but allows you to pay in installments.

Sorry, but that's charging interest."

This is may or may not be a fiqh issue and I'm not qualified, willing, or even know the reality of it to discuss it.

"Arguments about the evil of interest fundamentally fail. Even if everyone rejected the whole idea of lending or borrowing money at interest, or the government could somehow enforce a complete ban, interest would still enter into most economic calculations.

there is no evidence for this. he only assumes that this will occur due his reasoning below:

People would still gravitate toward a discount of the present value of future goods. People would still buy things that draw rents and can be resold such that they earn a return.

okay, so we have to look into the issue of "discounting"

discounting is a way of assessing the future value of money.

usually, this is done in relation to the change in the cost of a good (Consumer price index-CPI), in relation to the average annual inflation rate, or in relation to the opportunity cost with some sort of capital asset pricing model.

so for example:

we live in an inflationary economy since the dollar is not backed by gold and silver. the value of the dollar depends solely on the supply and demand of the dollar, which is linked to U.S. production and consumption.

I have 100 dollars in the year 2006.

Today, with 100 dollars I can buy about 150 Reeses Peanut Butter Cups at .65 cents each.

With the standard inflation rate, 5 years from now in 2011, 100 dollars might only allow me to buy about 130 Reeses Peanut Butter Cups at .75 cents each.

In order to buy the same 150 Reeses Peanut Butter Cups in 2011, i would probably need 112 dollars.

So because of inflation, I should do something with my $100. If I just hold on to it, it will be worth only $84 dollars in real value (purchasing power)


I have 100 dollars. I can buy a U.S. treasury security that pays me an annual interest rate of 4.5% over 5 years.

This 4.5% rate represents the *risk-free* interest rate.

Instead of buying the Reeses Peanut Butter Cups or holding onto my money, I buy a Treasury security for 5 yeas.

I earn 4.5% compounded to give me about $124 (nominal dollars) in 2011 (100*1.045^5)

So with this interest rate of 4.5% on my $100 and the 4% annual inflation rate, my purchasing power in *real* dollars has remained somewhat constant. I actually EARNED about 2.5 dollars.

I can now go ahead and buy 150 Reeses Peanut Butter Cups in 2011.

Now this risk-free interest rate, is usually used by most people in determining what is known as the "discount rate" based on the Capital Asset Pricing Model.

What does this mean? It means the following:

Suppose, instead of holding onto the $100 dollars, buying Reeses Peanut Butter Cups or buying the 5-year treasury - I *invested* the money into some real estate or business.

Basically, I have the opportunity to deploy my $100 as capital, instead of saving it or spending it on Reeses Peanut Butter Cups.

I can deploy it by purchasing real estate and renting it out or by buying a business that creates earnings through profit.

Rent money and Business earnings are synonymous.

But there is risk involved and also I don't know whether to put the money into the rent, or business 1, or business 2, etc...

there is a cost associated with deploying capital in different ventures.

If you can "predict" or guesstimate the future earning power of your real estate or business opportunity to infinity, then you can discount the sum of all these future cash flows down to present value using your customized discount rate.

you can use something like the "gordon growth model" as a rough calculation for this.

so our choices are now following:

1) consume the $100 right away by buying and eating 150 peanut butter cups leaving us with a fat guy and 0 dollars
2) save the $100, leaving us with $100 in 2011
3) buy the 5-year 4.5% treasury note leaving us with $124 in 2011

now number 3 represents our opportunity cost.

if we do our calculations for the returns from the real estate and business and finds that they don't give us the return we would like to see, then we can just buy the treasury security and be done with the exercise.

but if we can get a better return from the business or land, then we will do that instead of buying the 4.5% treasury.

we will under no circumstances save the $100 as we will lose purchasing power in this inflationary economy.

if we were hungry, we might buy the 150 peanut butter cups.


final note, discounting the sum of all future cash flows to infinity is the exact method for determining the value of a business or real estate.

people only compare this with lending money at a fixed rate because of similarity of the discounting models, inflation and opportunity cost.

Islam makes a distinction between earning a return on your capital through business investment, earning a return on your capital through rent and earning a return on your money through interest.

(The German word for interest, Zins, comes from the Latin census, which was the tabulation of someone's wealth which was at the time mostly land. People soon realized that owning land had the same financial effect as loaning money at interest and so the name stuck.)

It has a similar effect, but they are two different things as shown above. And the Shari'ah makes a distinction between the two.

I will address the rest of the points in the following posts soon

[tamiki]

okay, continuing for the brother, we are still at:

People would still gravitate toward a discount of the present value of future goods. People would still buy things that draw rents and can be resold such that they earn a return.

so we are still considering the issues relating to the "time value of money"

today, the basic criteria to determine the "time value of money" is the average annual inflation rate as gauged by the Consumer price index (CPI)

the world today works on: if i give you this money, (1)I want my purchasing power to be maintained at least. and on top of that, (2) i want an additional return since I could be doing something else with it (opportunity cost)

the issue of interest is first seen as a way to counteract inflation, and then and only then as a way of deploying capital.

inflation will always be linked to interest as long as this system exists because inflation erodes earning power as we saw with the Reeses Peanut Butter Cup scandal

The issue of interest and banking in Islam, however, is not a detached one.

Islam is a system that needs to be implemented in its totality.

Another feature of the economic system of Islam is that the currency is all based on gold and silver.

Now, economists can debate forever on the benefits and drawbacks of the gold standard and fiat (not backed by gold) money till the end of time.

The fact is, Allah's hukm is that currency be backed by gold and silver.

I can not provide you with all the evidences from Quran and sunnah or fiqh details.

Historically, inflation has always been a byproduct of introducing fiat money into circulation.

currency based on the gold standard has an inherent price stability.

when the gold standard is adopted, price stability ensues, thus we don't have to worry about inflation and the future purchasing power of money.

will there ever be any inflation or changes in the purchasing power of currency backed by gold and silver?

who knows? i don't know? it is a complex issue.

but the annual inflation rate of the U.S. from 1880 to 1914 was 0.1% and from 1946 to 1990 it was 4.6%

economists will also raise other issues relating the gold standard and stability, lack of control by the federal reserve of the economy, etc...

but we don't care because it is Allah's hukm

so in the next post, we will continue with the details of all this nonsense including the idea of charging interest as the opportunity cost of capital deployment

[tamiki]

okay, continuing for the brother, we are still at:

the world today works on: if i give you this money, (1)I want my purchasing power to be maintained at least. and on top of that, (2) i want an additional return since I could be doing something else with it (opportunity cost)

so in the last post, we "solved" the issue of maintaining the purchasing power of my dollar through backing it with gold and silver.

we said that if we back the money by gold and silver according Allah's legislation, then inflation would not erode it's value as quickly.

this is a very simple oversimplification of course.

now we get to #2 - charging interest for the money you lend because you could have been deploying that capital into a profit producing business or real estate.


islam is very clear about this.

you are allowed to take your capital and invest it into a business. (i don't know the fiqh details about this)

you can charge rent for the land you own. (i don't know the fiqh details about this)

you can not charge a fee or take interest on the money you lend.

end of discussion.

People would still gravitate toward a discount of the present value of future goods. People would still buy things that draw rents and can be resold such that they earn a return.

sure. but they still can not give loans on interest.

they are allowed to earn a return on their capital through halal means.

lending on interest is not one of them.

now, when we give a 5 year loan of $100 and we don't charge interest, the debtor will pay us back $100 in 2011.

this would be bad in an inflationary economy because the real value of the money would decrease (loss in purchasing power)

but in an islamic economy, where currency is fairly stable, the $100 payed back in 2011 will probably allow us to buy the same number of dates that we could have bought in 2006.

okay, still continuing below