Islamic Economics & Finance - From Theory to Practice

The dichotomy of the capitalism lies in the misplacement of ‘man’ and ‘money’.

Islam’s main concern is the materialistic world surrounding human beings.

Social sciences mainly deal with the inner elements of human beings and slightly about material environment.

What we expect from ‘MAQASID AL-SHARIAH’ (OBJECTIVES OF ISLAMIC LAW) are for our own pleasure.

Co-operation in Islam is pivotal because of fruits of collective wisdom goes beyond that of individuals separately.

From Islamic perspective, ‘labor’ the same as ‘effort’ and we can use them interchangeably.

Conventional Banking relies on the potentialities of debt but Islamic Banking on the limited capacity of Musharakah (equity financing).

‘the character of incentive systems’ is one of the axes to compare economic systems?

Islamic economic system has three pillars consisting of justice as the ultimate goal, co-operation, and efficiency

In capitalistic economic system goal does not justify means.

Suppose there are 13 commodities in a primitive society, there are 78 different exchange rates.

In a society we have six commodities: K, L, M, N, R, and Q. Commodity K has been chosen as the medium of exchange. The exchange rate between M and R is:
(M)/(R) ÷ (K)/(R)

There are many authorities who are delegated to brand the medium of exchange (ME) on behalf of their constituencies.

As soon as ssfish plays its role as the medium of exchange it does vanish from economic system and can be consumed.

In current economic system, it is not possible for the Central Bank (CB) to increase the nominal value of a paper money by ten times unless incurring prohibitively high cost.

Any additional cost of increasing the nominal value of a paper money by ten times is called the Marginal Cost (MC) of money.

Since in every purchase of goods and services money is needed to play the function of the medium of exchange then such demands for money is called ‘transactions demand for money’.

Of the three types of the demand for money John Maynard Keynes talks about, the speculative demand for money will no longer exist in Islamic Economic System.

The doctrine of vice-gerency indicates that wealth is an end in itself and utmost effort can be put to collect as much as we can.

The choice of the type of ‘money’ used in primitive societies reflects narrow-mindedness of the people who comprised the tribe.

The labor time spent on each good determines the exchange rate.

The relative labor time determines the exchange rate: labor time to grow two pounds rice /labor time to catch one fish.

It is possible to put any chosen medium of exchange in the same row as other commodities that can be taken out from the market (detained) after the prices have been paid.

The velocity of the medium of exchange which is the number of times it circulates and changes hands during a time period is normally greater than unity.

If M stands for money and C for commodity then medium of exchange takes on the form: M—C—M.

If one of the traders withholds ssfisf (sealed-salted fish) in order to get more ssfish by lending it; its effect is to increase the pace of everyday transactions and the society is better-off.

If money is detained from being circulated the result would be the emergence of ‘money whirlpool’.

Money whirlpool exemplifies the origin of ‘interest rate’ production within which money is exchanged for money.

Economics is composed of two inter-related parts; one is ‘normative’ and the other one is ‘positive’. Normative part talks about ‘what ought to be’ and the positive part has to do with ‘what is’.

In capitalistic economies ‘interest’ plays central role but in Islamic economics it has strictly been forbidden. Saying ‘yes’ or ‘no’ to interest comes from within the realm of normative (or ideological) part of any economic system.

In making an economic system the normative part, logically, sets the red lines and the positive part plays within the red lines.

The properties of interest (Riba) do not include time period.

Bond issued by firms and/or governments is an instrument to borrow money and any money paid over and above its par value is ‘interest’ (Riba).

Stock is different from bond in some ways and enjoys different properties and different consequences. Bond is a type of ‘debt’ to the issuer but stock issuer adds it to his/her capital.

Any part of the profit paid to the stock holder cannot be considered cost but any money paid over and above the principal of loan as interest is considered ‘cost’.

Friedman Rule says: “Zero nominal rates of interest are necessary for efficient resource allocation”.

In Aristotle’s time, philosophers were concerned with matters such as “just price” and usury. The fact that these concepts are enjoying something of a revival today might well be a pointer to the serious harm that has been inflicted on many societies.

Interest is a necessary and unavoidable aspect of every economic system, as a common string to tie all economic activities together and without which the system collapses.

In capitalistic economic system all borrowed money on interest would go for investment activities where ‘investment’ has to do with hiring more labor.

According to the classical theory the rate of interest is determined by the intersection of the demand for and supply of ‘money’. Thus, an equilibrium rate of interest is determined at a point at which the demand for ‘money’ equals its supply.

John Maynard Keynes (1883-1946) is a firm critic of the classical theory of the rate of interest.

Money whirlpool (MW) is useful for every country in order to exchange money for money.

Positive time preference (TP>0) means that a basket of commodities tomorrow is preferred to the same basket consumed today. Negative TP (TP<0) means the opposite.

Based on the Prof. Schumpeter’s suggestion of an Evenly Rotating Economy (ERE) the rate of time preference with the suggested age profile of this economy we reach a community with zero rate of time preference which implies that the rate of interest shall be zero.

It is not necessary that every financial system shall have self-correcting and self-adjusting mechanisms. Any deviations from the right path can be corrected by manipulating the relevant factors.

In capitalistic economies there are two external sources to increase the level of corporations’ assets in addition to internal sources.

Stockholders assume the financial risk of investing in a corporation. They have all rights to vote. Bond-holders do not own the company to which they have lent neither do they accept any risk. They do not have the right to vote. Finally, they in fact transfer the risk to the borrower.

All the money earned from bonds issued by a corporation goes for investment projects and enhance employment.

In capitalistic finance theory those who are in risky markets can be classified either as risk lover, risk averse or risk neutral; all three groups can be found in behaviors in the stock markets.

Greed, non-satiation, and piety go hand in hand in a zero-sum game of capitalism which mean to legally put your hands on someone else’s wealth.

Muslims believe that the Divine Rules are perfect and thus unchanging and created with man’s well-being in mind. As a result in our studies the Divine Rules are given the veto power, on the understanding that man-made rules cannot compete with them.

In capitalistic economic system ‘capital’ means: financial assets, the factories, machinery and equipment, and so on. It does refer to its legal aspect and with explicit relationship with money.

In capitalism Money market is ‘loan market’ for up to one year. Capital market is also loan market but for longer than one year. Both markets are fundamentally of ‘loan’ nature. The way money market has been distinguished from capital market is the length of time ‘loan’ is made which is non-scientific.

Although money is potential capital but in Islamic Economic System (IES) can neither claim a reward (price) as interest nor is it considered as a factor of production in any economic system.

Islamic Finance works with profit, rate of profit, profit sharing, and thus risk sharing but not with debt, interest and risk-transfer.

The weaknesses of conventional banking system are loan (debt) and the debtor’s sole responsibility for the outcome the borrowed-money is used for perpetuates itself and leads to greed and greed, in turn, leads to higher risks (of default) and thus highly probable bankruptcy.

Money whirlpool resulting from speculative activities does not allow saving (S) in the economy to equal investment (I). The
equality between the two variables (S = I) guarantees full employment.

In Islamic Finance we concentrate on the banking facilities channel as well as on the balance sheet channel but more emphasis is on the structure of the balance sheet because of the crucial role Islamic Banks play in granting facilities having Wakalah on behalf of the depositors.

Some great Western economists have emphasized the importance of financing frictions and inherent instability of the conventional financial system.

Debt which is the backbone of the interest-bearing conventional banking system has come with some severe drawbacks such as adverse shock that wipes out large fraction of the levered borrower’s net worth, limiting his/her risk bearing capacity in the future; both are the effects of the limited capacity of borrowed money.

There are three elements that can be attributed to the origin of volatility in financial intermediaries. They are interest rate expectations, artificial risk, and demand volatility unaccounted for. Last element is justifiable in almost all economic systems but not the first two.

Volatility in financial markets has primarily to do more with ‘loan’ (debt) than with Profit & Loss Sharing (PLS). Domino effect will become active whenever new debts, which usually carries higher interest, are used to pay off earlier loans at different maturities.

In conventional banking system the rational investor who is a borrower anticipates that the entrepreneur may lie.

Money is an accounting concept and capital a legal concept.

The structure and the entries of the two financing systems (capitalism and Islamic) are totally different with two different outcomes without frictions in macroeconomic policies.

“Too many chiefs, not enough Indians" refers to the misleading idea that money (as medium of exchange) can itself be
another commodity which stands side by side with other commodities.

Capitalism has taken it for granted that Riba-based financial system is a sound and viable system, in a way. While this system has, in itself, become part of the problem!

Muslims believe that the Divine Rules are perfect and thus unchanging and created with man’s well-being in mind. As a result in our studies the Divine Rules are given the veto power, on the understanding that man-made rules cannot compete with them.

The followings are part of the negatives of capitalistic economic system:
(a) Equity (justice), a second-hand argument with no guarantee of success,
(b) Conflict between efficiency and equity,
(c) Endorsement of all kinds of risks, artificial or else,
3
(d) Scarcity of capital arising from positive nominal interest rates on money and the resulting speculative activities,
(e) Unemployment as a result of scarcity of capital,
(f) Satiation checked via social considerations.

In capitalistic economic system ‘capital’ means: financial assets, the factories, machinery and equipment, and so on. It does refer to its legal aspect and with explicit relationship with money.

Love, empathy, altruism, cooperation, sacrifice, mutual concern, forgiveness, gratitude, virtue, benevolence and honesty are as much a part of human heritage as hatred, self-interest, apathy, revenge, vice, dishonesty and fraud.

Forbidden Riba (interest) means that we should put all our efforts in setting the rate of interest equal zero; that is, to manipulated demand for and supply of money so that they intersect at the point where rate of interest becomes zero.

Debt has limited capacity in contrast with Musharakah whose potentiality can grow limitless.

“Whether or not ideology can be eliminated from the world of thought in the social sciences, it is certainly indispensable in the world of action in social life”.

There is no reason to believe that whatever man earns and accumulates over his life time should be used for his salvation that please Allah (swt). His own well-being comes first.