THE WISDOM OF PROHIBITION OF
INTEREST
Mohammad Nejatullah Siddiqi
email: mnsiddiqi@hotmail.com
Web: http://www.siddiqi.com/mns
[Presented at LaRiba
annual meet at
Interest
is prohibited because it is unfair (zulm )
.
In
the case of productive loans the borrower may sometime lose, yet interest based
lending obliges him/her to repay the principal plus interest. Some time the
borrower may reap huge profits, yet the lender gets only the stipulated rate of
interest which is usually a very small part of the actual profits.
Modern
researches have shown that interest has bad consequences for the economy. It
results in inefficient allocation of society’s resources. It contributes to the
instability of the system. Also, it increases the inequality in the
distribution of income and wealth as it guarantees a continuous increase in the
monies lent out, mostly by the wealthy, and puts the burden of bearing the
losses on entrepreneurs and, through loss of jobs, the workers.
Islamic
economics research has shown that the economic system can function
without interest. A system using profit-sharing modes where possible and trade based
modes, e.g. murabaha,
leasing, etc. where necessary, will be more equitable, more efficient and more
stable than the current interest based system.
In the case of
consumption loans, if it is for food, drinks, clothing, etc. necessary for
survival, charging interest violates the nature of social life which requires cooperation, care
and help of the needy by the well to do. If the loan is for consumer durables
aiming at increase in efficiency, murabaha provides a safer, better way of financing than
interest based lending.
Let
us have a closer look.
Prohibition
of interest means prohibiting the exchange of present money for future money,
with an increase. Those who need present money in order to use it in economic
enterprise with a view to making profits are obliged, because of this prohibition,
to adopt other means. There are, broadly speaking, two other means available.
They can enter into a profit-sharing arrangement with the owner of money. Or
they can ask the money owner to buy the things they need for the business and
sell those things to the business at a price higher than the purchase price, to
be paid after a specified period of time. Both these alternatives to interest
based finance are better in their consequences for the economy.
The profit sharing arrangement may either involve
the money owner in management, in which case it becomes a partnership, or it
may leave management
to the one taking the money, in which case we call it mudaraba. In both cases the money owner shares
the resulting profits in proportions agreed upon. But in both cases he or she
bears the loss in
capital if and when it occurs. However, the entrepreneur becomes
liable to loss in capital if he or she violates the terms of agreement reagrding the nature and scope of business, etc.
This
mode of finance exposes the money owner to some risk but it may bring him or
her higher returns. It is fair to the business partner as it does not oblige
him/her to bear losses occurring despite good, honest management. It is better
for the society as it allocates resources on the basis of expected profits from
the project being financed, which reflect productivity. The interest based finance
allocates investible funds on the basis of
creditworthiness of fund seekers, and creditworthiness does not reflect
productivity. It reflects only ownership, which may be inherited or due to past
achievements which do not necessarily indicate the soundness of current
projects. It has the added advantage of the projects being financed being
double checked, once by the fund seeker and secondly by the fund supplier, as
their rewards/returns depend on the actual outcome of the project itself.
In
the interest free Islamic environment savers can share with banks the risks
associated with choosing the right investment. Banks share the risks as well as decision making
with the businesses they finance. As compared with the current situation risk
and decision making, hence economic enterprise, will involve a much larger section of
the population in an interest free Islamic economy.
Profit-sharing finance synchronizes payment
obligations of firms with its revenue accruals, thus removing a great source of
instability in the system. Interest based finance subjects the firm to a rigid
schedule in which the amounts due for payment as well as the dates payment is
due does not take the current project status into account. This may oblige the
firm either to borrow(usually at a higher interest
rate) or to sell its products at a lower than expected price in order to meet
its contractual payment obligations. The third alternative is default which
sends shock waves through the system.
Should the fund owner not like to expose his/her funds to the relatively higher risks
involved in profit-sharing, or the business party be unwilling to share
profits, they can resort to one of the several trade based modes of finance
mentioned above. They save the fund owner from loss and bring him/her a positive return to their capital. But the
risk of default remains, though it can be covered by a
collateral. On the other hand the business party has the advantage of
keeping all the profits
to itself. But it bears all the risks of business including that
of the loss of capital as it has to pay the price of the goods and services
obtained on credit.
Murabaha and other trade based modes
of finance create
debts. But these debts can not be traded except at par value which prevents
them from ballooning into several times their original volume. Since they arise
in the process of supplying real goods and services, they do not have much
expansionary effect on the system. This is quite unlike interest based finance
in which debts are created on the basis of creditworthiness of borrowers and
they are traded like any other commodity, sometimes serving as collaterals
against more debts. The financial sector then acquires a life of its own
independent of and only tenuously linked with the real sector of the economy.
This makes it vulnerable to speculation bordering on gambling in which risks
are created for the purpose of taking risk, with no relation to the production
of wealth.
It
will be seen that in the murabaha
finance unlike interest based debt finance changes in spending will
automatically be reflected in changes in demand and supply of goods and
services. No modern economy can function without credit. But the way credit is
created in the absence of interest rules out the possibility of excessive debt
creation or its continued accumulation at an accelerated rate because the price
to be paid in future for goods and services supplied in the present once
determined can not be increased. No debt crisis can take place in a system
without interest in which all debt is for goods and services supplied and,
most likely, against collateral .
A
decreased role for debt in the economy would have far reaching consequences for
international movement of capital, the terms and conditions of its entry into
and exit from countries. There would be no room for sudden mass movements of
funds as happened in South East Asia during 1997-98, with disastrous
consequences.
We can now look at consumer credit. It is good for people
to be able to acquire a refrigerator, a car or a house early in their earning
life. It increases efficiency, their earning capacity. They are, generally
speaking, able to pay in installments out of their future earnings. There are
two ways of doing so. The conventional interest based system would either
provide a loan to be repaid with interest , or supply the durable good against a mortgage
paid in installment, ownership being transferred to the user when the mortgage
is fully paid up. Islamic financial institutions are supplying these goods on
the basis of murabaha.
Ownership belongs to the user from day one, the price (higher than the spot price ) is paid in installments over a period of time. The
financier generally maintains a lien on the durable till payment is complete.
The
difference in comparison to interest based loan is clear. The difference in
installment sale lies only in the murabaha price being fixed once for all, no roll over of the
debt being allowed. Both systems are able to supply durables on lease, often
ending in the user owning the durable. Even though currently the market rate of
interest provides a benchmark for the rate of mark up in murabaha or leasing it is not
obvious that it will continue doing so in a system in which interest is
abolished. It is more likely that the rate of mark up in an interest free
market economy will be determined by supply and demand, whereas the rate of
interest in modern economies has largely become a policy determined variable.
It can be reasonably claimed that the Islamic arrangement meets the need and is
not at a disadvantage in this regard.
As regards lending for meeting urgent basic
consumption needs like food, Islam obliges the
lender to do it as a curtsey ( Of course it forces nobody to lend).These
are the cases in which, most probably,
no future income is in view for the seeker of the loan. In the last
resort, the society owes it to these indigent members to help them tide over
the difficulty, but it is more efficient if it is done person to person or in
the voluntary sector through charitable institutions/NGOs.
The
conventional system, by legitimizing interest, leaves a section of these needy individuals to the
mercy of loan sharks.
Like
many other evils, the practice of charging a fixed positive return to
loan capital has survived strictures from all world religions and condemnation
by all moral philosophers. In the earlier days the role of capital in the
economy was much less important than it is today. Humanity has much more to
suffer because of making interest the linchpin of its financial system in a globalized world using huge quantities of capital. As
briefly mentioned above much of the inequity, inefficiency and instability of the modern economy
owes itself to interest. It is also a major stumbling block in the way of a
moral approach to the global economy based on sharing of resources and caring
about the weak and the poor. It is time the negative economic role of interest and its immoral
nature was realized by all.
The
wisdom of prohibition of interest lies in the divine hand guiding men and women
towards a better economy and a better society.