1. We all know that Riba or interest or usury is haram in Islam but what are the reasons for its prohibition. The following article tries to elaborate the very core of the concept and highlights some reasons for its prohibition.
Usury as an Unearned Profit
2. Before we make any comments about the economic rationale for the prohibition of Riba in Islam it is important to study the difference between interest and trade.
SUPPLY
DEMAND
3. In trade two parties meet under a contract where capital and expertise is used to produce an output or product that is later sold to the customers. Here the capital can be supplied by one of the member and the expertise by the other or the ventured can be shared in all aspects by both. Either ways both the parties bear risk of loss. While in an interest contract one party supplies the capital to the other party for an amount over the principal amount. Now here the following points are noteworthy:
In interest transaction only one party faces the risk of loss.
The lender sits idle a gets the reward while the borrower does all the work.
The borrower has to sometimes use his hard earned profits to pay back the interest on the loan.
The distribution of the gains is unjust between the to parties.
True dignity and full reward for labor is dignified.
On the contrary Islam not only abolishes usury, but also imposes Zakat or wealth tax.
4. This is perhaps one of the most crucial points of this discussion. It is commonly asserted that when Islam has allowed trade so it has allowed profits, and when it allows unearned income in the form of rent from land and income property, and profit form sleeping partnership, what justification is there for not allowing interest or Riba. Aristotle said:
"Money cannot beget money"
Usury as a Doubling Billing
5. If we sell a person a loaf of bread then rational thinking would say that we charge him for the bread and not the use of the bread. In case of interest the opposite occurs since money is a fungible or consumable good for which the borrower should pay the exact amount he takes. It a slightly weak argument but still holds well in our debate elating to the ills of usury.
Saving and Investments
6. Saving and investment are the two most important determinant of economic growth in fact they serve as an engine to the economic well being. Keynes states that saving is a function of income and not interest rates as believed before. Comprehensively, a person would save more if his income is more rather than the prevailing interest rates. Therefore interest outs a downward pressure on the marginal efficiency of capital and capital does not reach its optimum point. Since the capital that could have been available to the producer to produce product is now used in debt financing.
7. Interest dampens the investment activity and serves as an engine for inflation where the producer charges the cost of capital from the consumer. Comprehensively it can be summarized that higher returns or higher income determine the level of savings, people will save more in a share economy than in an interest based economic system.
Unemployment and Inflation
8. Interest financing requires the producer to increase the price of the product and this triggers a chain reaction where the demand can get shrunk resulting to retrenchment of excess employees', closure of production units and the chain continues. Hence a gain by the lender causes the whole economy to suffer.
9. The central bank in fact argues that increase in the interest rate that is a concretionary monetary policy helps in soaking up the excess money from the market. This reduced money supply in fact helps in dampening the inflation. But its noteworthy here that interest causes the inflation at the first place so it can not be used as a remedial measure.
10. Banks usually pay heed to this because interest rate is the key tool in monetary policy and source of their monopoly. Interest can also cause stagflation which remains unearthed for a long time and becomes evident once much damage has been caused.
Security Oriented Banking System
11. The interest based banking system is security oriented rather than growth oriented. Because of the commitment to pay a pre-determined rate of interest to depositors, banks in their lending operations are mostly concerned about the safe return of the principal lent along with the stipulated interest. This leads them to confine their lending to the already well-established big business houses or such parties as are in a position to pledge sufficient security. If they find that such avenues of lending are not sufficient to absorb all their investible resources, they prefer to invest in government securities with a guaranteed return. This at times acts as an impediment to the economic growth cutting of the capital supply to small but capable entrepreneurs. Economic growth is dependant on entrepreneurship.
Profitability and Productivity
12. Some people think that profit-sharing (which is the Islamic alternative to interest) will not be profitable to the financiers compared to traditional interest based system. This contention has been refuted. Taking the example of a PLS account against an interest based investment.
13. A PLS system is likely to be more attractive for both the firms and the financiers. This is because PLS system promises leverage benefits to the firms free of risk and a return higher than the rate of interest to the financiers. Fluctuations in the rate of profit on equity under PLS finance are likely to be smaller than the rate of profit on equity under the interest finance and that PLS operations may have a smaller destabilizing potential for the economy as a whole compared to financing on interest.
14. Another factor that makes profit-sharing more profitable that interest-based system is that the burden of the risks on the part of the investors is reduced. This encourages entrepreneurs to be more innovative and venture into high risk projects which are usually characterized by high profitability.
Trade Cycle
15. Variation in the interest rates allows room for speculation business. It encourages people to hoard capital, waiting for the right time when the gain get higher. This deprives the economy from capital which could be employed in productive processes. It is argued that these vast movements of funds contribute to the fluctuations in the trade cycles and make economic planning and organization problematic.
16. The solution is simple. Abolish the interest in the economy resulting in lesser speculation and lesser debt management. This would at length result in a stable economy.
International Finance
17. Third world countries are crippled with servicing foreign debt. Often countries are badly managed, and given state assets financial institutions readily lend to incompetent governments regardless of the project, knowing a guaranteed return on capital is available. This result in poor projects receiving funding, funds siphoned away with the lenders taking no responsibility or involvement in the project or the debtors - simply requiring repayments are made. The resulting debt, which has benefited the receiving society very little, leads to limited spending on developing their infrastructure and human capital as large amounts of future revenue are spent on debt servicing.
18. The only solution viable enough is to remove the interest bearing instrument with profit and loss mechanism as proposed by Islamic economics. Moreover equity based financing can help countries who are not readily making enough profits at the time. If Islamic equity based financing is effectively employed in the third world countries, they would more closely enjoy the fiscal security similar to that of a low geared company.
Exploitation of the Needy
19. Apply the same concept to a local scenario we see that interest can be effectively used to exploit people and in extreme cases to enslave them and deprive them of their rights. We need not go very far for an example. Pakistan houses many such people who have been enslaved by this devil's tool, being exploited generations after generations.
Mechanism of Inequitable Redistribution of Wealth
20. Islam guides the believer in every aspect of their financial lives. It not only tells the believer what code of ethic he is supposed to follow when earning his livelihood but also guides him about how he is supposed to dispense his earnings. Comprehensively:
Earning through deeds of righteousness (truth, honesty, justice, disclosure of information to concerned parties in a transaction, measuring and weighing accurately, seeking pleasure of Allah (SWT) in dealings etc.)
Prohibition (Riba, gharar, gambling, transaction of haram items, hoarding, speculation, fraud and exploitation etc.)
Charity, Zakat and helping the needy.
21. But in a system that is based on interest, we see that the distribution of wealth is skewed and inclined towards the class that already possesses much of the wealth. Since money is considered as a government service to which public should have access to in equal proportions. It can be concluded that redistributive mechanism in an interest based economy violated the basic constitutional rights o the people.
22. We see that the marginal utility of wealth diminishes for the rich with passage of time but for the poor this occurs at an even faster rate hence the overall utility decreases.
Discounting the Future
23. If you leave his year crop of lets say apples you won't be able to pick compounded heavier crop the next year. Moreover, if Judas Iscariot had deposited thirty pieces of silver at bank, or just a few percentage points the repayable amount in silver today would be more than the weight of the world. There is a disjunction between the financial and ecological economy. One works on principals of compound interest while the other on simple interest.
24. For instance, Pearce and Turner (1990) noted that discounting effects the rate at which we use up natural resources -The higher the discount rate (derived partly from the interest rate), the faster the resources are likely to be depleted. Daly and Cobb(1990) give a more logical conclusion and show that discounting can lead to the "economically rational" extinction of a species, simply if the prevailing interest rate happens to be greater than the reproduction rate of the exploited species. Meanwhile, Kula argues that when making decision regarding long-term investments the Net Present Value guides the decision maker to maximize the utility of the present generation at the expense of the future ones. Hence discounting violates intergenerational equity and NPV methodology can only be justified if the utility of the future generation is discounted.
