Chapter 18: Fundamentals of Islamic Economic System by Dr. Muhammad Sharif Chaudhry



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Fundamentals of Islamic Economic System

By Dr. Muhammad Sharif Chaudhry



  1. Efforts for Elimination of Interest

  2. The Failure and Its Causes

  3. Real Solution of Problem of Interest

  4. Credit and Loans in Islamic System

  5. Banking and Insurance in Islamic Economy

I- Efforts for Elimination of Interest

The greatest challenge which the modern Muslim states face today is how to eliminate interest from their economies particularly from the banking sector. For the last three decades very serious efforts are being made to meet this challenge. Islamic institutions, universities, advisory bodies are making research and studies. Many commissions and committees have been setup by the government of Islamic countries to study various sectors of their economy specially finance, banking and insurance and furnish reports suggesting how to eliminate interest in order to Islamize the economy. A number of books, articles and research papers have been written and published by various Muslim scholars, economists and study-groups. Some practical measures have also been taken to abolish interest gradually from banking and financial sectors. Attempts are being made to organise system of loan and credit free of interest. Scores of Modarabah and leasing finance companies have lately emerged in Islamic lands particularly in Pakistan who claim to provide loans on profit and loss sharing basis in accordance with principles of Modarabah and Shirkah. Of all the Muslim countries, Pakistan has been in the forefront in Islamic Jehad against ‘Riba’ (interest). Profit and loss sharing accounts have been introduced by banks in Pakistan after 1980 for the depositors, while loans are advanced by the banks on mark-up system. Investment Corporation of Pakistan and National Investment (unit) Trust and many other financial institutions in Pakistan attract deposits from the middle class investors on the basis of profit-loss sharing. The Federal Shariat Court of Pakistan, in its historic judgement of November 1991, has declared all forms of interest as ‘Riba’. Appeal against this judgement filed by the Government of Pakistan is awaiting decision in the Supreme Court of Pakistan.

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II- The Failure and Its Causes

But what is, after all, the result of all these hectic efforts made by the Muslim world particularly by Pakistan. Have we been successful, even partly, in eliminating interest from our economies? The categorical answer to this question is big No! We have only succeeded in making cosmetic changes here and there and that too in very few sectors of economy. The only success achieved by us so far is the change of name of interest to profit, dividend, mark-up, service charges, commission, fee, and use of Islamic terminology like Modarabah, Shirkah, profit-loss sharing, etc. Banks are paying interest to their depositors and charging interest from their borrowers under various names. Modarabah and leasing companies are providing capital to business and industry on fixed and pre-determined interest under the garb of lease-rental and lease-finance arrangements. In this whole exercise only the rates of interest have gone up! No effort has worked out and achieved the desired goal. Given the moral standards and business ethics prevailing in the society, no person or institution is prepared to take risk and provide finance on profit-loss basis. It is, therefore, rightly said that efforts made in the Islamic lands so far tantamount to protecting the institution of interest rather than abolishing it.

The causes for this historic failure of the Muslim world in eliminating ‘Riba’ from economy are many. Firstly, the socio-economic changes brought in Islamic lands by political domination of the West and industrial revolution have weakened religious and moral values of the people. The leaders, who in fact have mostly their own problem of legitimacy, have failed to offer themselves as role models before the citizens. Merely lip service is paid to Islamic values such as honesty, truthfulness, trustworthiness, fair dealing, fellow-feeling, justice and equity, fraternity and brotherhood, moderation in consumption and standard of living, austerity and simplicity, etc. Strict observance of these values is, however, a condition precedent for Islamising economy. But the same is unfortunately conspicuous by its absence in the Islamic society of today. People are living beyond their means. Everybody is after maximising his material comforts which can only be achieved through money. So earning of wealth through fair or foul means has become religion of today. As a consequence, no moral values and code of business ethics exist these days. Nobody trusts any other person at least in money matters and business dealings. In business partnerships, brother cheats brother, son deceives father, friend commits fraud with a friend. Therefore, every person and institution is, justifiably, reluctant to participate on profit-loss sharing basis. And to eliminate interest, profit-loss basis is the only way for providing capital to business and other economic development projects.

Secondly, the Muslim scholars and economists have miserably failed so far to provide a practical, simple, safe and workable substitute for interest. The interest-no doubt it has been prohibited by Islam (and also by Christianity and Judaism) and there are many moral and socio-economic justifications for this prohibition-provides a very simple and practical mechanism to establish and govern the relationship between the lender and the borrower. It assures the lender the safety of his capital and profit on the one hand and it frees the borrower on the other hand from many worries such as maintenance of books of accounts to the satisfaction of the lender and the lender’s constant interference in his business affairs which generally leads to disputes, litigation and ultimate closure of business. But the substitutes for interest given by the Muslims scholars are many often vague, complicated and impracticable. The substitute of profit-loss sharing hardly appeals to the lenders and the borrowers who cannot work in partnership because they strongly suspect each others’ motives in view of the low moral standards and business ethics obtaining in the society. It is brought to the notice of the common reader that the Qur’an and the Sunnah have abolished interest but have not recommended any substitute. Modarabah and Musharikah have not been referred to anywhere in the Qur’an or the Hadith. These are actually forms of business organisations whose rules and regulations were laid down by classical Muslim jurists of middle ages. Even those classical jurists did not introduce these concepts of Modarabah and Musharikah as substitutes of interest. It is actually the scholars of recent period who have taken fancy to Modarabah and Musharikah and have set them up as Islamic substitutes of interest. But these scholars have not yet been able to modify these concepts to the changed socio-economic circumstances of modern age and the needs of modern complex economies.

Thirdly, interest has been prohibited by Islam to prevent exploitation. Traditionally borrowers, being persons in need, were exploited by few moneylenders who controlled substantial portion of wealth and capital of the community and who charged exorbitant rates of interest on their loans. But now the economic revolution brought about by recent technical and scientific advancements has changed the scenario. The introduction of the modern banking system has inverted, in a sense, the traditional relationship between the borrowers and the lenders. The lenders in these days are not a small number of usurious money- lenders who monopolise wealth in the society. They consist of millions of middle class individuals who deposit their life savings in the banks to meet needs of their families in a rainy day. Many of the borrowers on the other hand are wealthy people and corporations who have setup industrial empires. Therefore, it is now the lenders and not the borrowers who need to be protected. However, the Muslim economists who recommend Modarabah and other profit-loss sharing schemes for the lenders as substitutes of interest have done nothing to protect the interests of the lenders. It is a well-known fact that many businesses do not give fair returns to their shareholders. Many public companies do not declare dividends for years and the value of their shares is much lower in the market than the equity subscribed by the shareholders. Thus, if the banks resort to financing in accordance with the Modarabah or Musharikah arrangements, which are in fact similar to equity financing in joint stock companies, it would lead to the mass deprivation of the savings of the depositors. Some reasonably safe mechanism needs to be evolved to check the malpractices of businessmen and to ensure that false books of accounts are not maintained with a view to declare heavy loss and thus deny the lenders their share of profit and sometime even deprive them of their loan capital. But unfortunately, the Muslim scholars have not yet evolved any such mechanism.

Fourthly, the scholars have not provided satisfactory solutions to the issues as to how the government would be able to raise loans from internal and external sources in the absence of interest. What would be the incentive for the public to provide loans to the government particularly when the government cannot give any profit on the basis of profit-loss sharing as most of the ventures of the government are not profit-generating in the business sense? What would be the incentive for foreign countries and international lending agencies to give loans to the poor Muslim countries like Pakistan? How in the absence of interest, international trade and other international dealings would be transacted? The concept of global village is fastly taking its shape and economic inter-dependence of countries of the world on each other is increasing everyday. No country lives is isolation these days. In this situation, how a poor country like Pakistan or even all the Muslim countries put together can abolish interest in international dealings when most of these countries owe huge debts to non-Muslim countries and world agencies? These are the questions to which we have paid little heed.

And lastly, the major cause of our failure in elimination of interest is that we are attempting to make impossible to happen. Not that interest cannot be eliminated from economy. The fact is that it cannot be eliminated from capitalistic system of economy. In every Islamic state capitalistic system of economy with all its evils is in vogue. Interest is the backbone of this system. It is like a pillar on which the edifice of modern capitalist economy is standing. If you want to keep this system, you cannot withdraw this pillar as in that case the whole system would collapse. In capitalism you will have to swallow this forbidden fruit of interest under one name or the other. If you want to act upon Islamic teachings and abolish interest then you will have to abolish capitalistic form of economy root and branch from Islamic lands and enforce instead a simple system of Islamic economy in its pure and unadulterated form based on social justice and concept of welfare state.

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III- Real Solution of Problem of Interest

Thus the real solution of the problem of interest lies in the total enforcement of whole Islamic economic system. Partial or piecemeal enforcement of the Islamic economic system will not work. The Qur’an says : O ye who believe ! Enter into Islam whole heartedly and follow not the footsteps of the devil…… (2 : 208).

So enter in Islam fully and establish Islamic economic system in full. We have already outlined the structure of this system in this book and have elaborated its various elements. To recapitulate, it will suffice to submit that Islamic economic system, in brief, is based upon the following five pillars or articles which are its essential constituents or components :

1.       Discrimination between Halal (permitted things being lawful) and Haram (forbidden things being unlawful).

2.       Equitable distribution of wealth through Zakat, Sadaqat and laws of inheritance (Social Justice).

3.       Provision of basic necessities of life for every citizen (Social Security).

4.       Prohibition of hoarding of wealth and promotion of its circulation in productive channels.

5.       Elimination of interest.

Thus the Islamic economic system should be completely established as one package of which the abolition of interest is the last item. We cannot enforce the last item ignoring the first four. It should be kept in mind that verses regarding prohibition of interest were revealed last of all, much after the verses relating to establishment of system of Zakat and Sadaqat, laws of inheritance, distinction between Halal and Haram, circulation of wealth, establishment of prayer, Hajj and fasting, and enforcement of moral and social code, had been revealed.

The establishment of complete Islamic economic system whole-heartedly will, by the grace of God, usher a new economic era for the now-impoverished and backward Islamic Ummah. A general level of prosperity would prevail in Islamic society in which none would be hungry or naked and none would be shelterless. Due to Islamic social justice and wide network of social security system, every citizen living anywhere in Islamic world would get his due share in national wealth. He would enjoy a reasonable standard of living much above subsistence level. He would not only get his basic necessities of life fulfilled but also he would get employment, healthcare and education for his children. History is witness to the fact that in the time of Caliph Umar-bin-Abdul Aziz if someone wanted to give his Zakat he could not easily find some needy person who would accept it. The same situation would be revived.

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IV- Credit and Loans in Islamic System

In this atmosphere of happiness and bliss, anybody would hardly need loan for personal needs. And if anybody does, he would be provided the same without interest by his relatives and friends who are comparatively in easy circumstances. In case they cannot do so, public treasury (BaitulMal) would step in and provide Qard-e-Hasanah (loan without interest) to such needy person.

So far as loan for business is concerned the people would hardly feel such need because of their simple and austere living which does not require earning of too much wealth. The people would do their business with whatever capital and economic sources they have and they would not be generally too ambitious to expand it with borrowed capital. Since the exceptions are there and some more ambitious and more enterprising people try to earn more, so such people would contact Islamic banks to fulfil their needs for capital which would, of course, be supplied to them on profit-loss sharing. A foolproof mechanism would be evolved to ensure that those who borrow capital from banks honestly maintain accurate accounts to provide legitimate profits to the lenders. Generally individuals and small private sector enterprises will be discouraged to launch big industrial or business ventures. However, cooperative societies and joint stock companies shall be allowed to operate capital-intensive big ventures in the field of industry, agriculture, transport, communications, etc. with borrowed funds. But basically big projects in the fields of health, education, defence, irrigation, communication, science and technology, infrastructure, social welfare and economic development would be in public sector and would be operated by the government of the Islamic welfare state for the general benefit of the entire populace.

Islamic state would be rich due to its vast collection of Zakat, Sadaqat, taxes and other compulsory and voluntary contributions and also on account of its earnings from its properties and projects. As already discussed by us in the chapter on public expenditure, the state would exercise moderation and would make balanced budgets avoiding extravagance which results into budget deficits. Therefore, there would be no public or national debt as the state would not incur any loan. But if in emergency situations or national crisis caused by war or natural calamities, it needs finance, the same would be raised through extra taxes or printing of currency provided these extra ordinary measures are discontinued as soon as the crisis is over. In case of a grave emergency, the government can issue an appeal to the nation for donations and voluntary contributions. History is witness to the fact that followers of Islam do not hesitate to make big sacrifices for a national cause. We know that on appeal of the Holy Prophet at the time of Tabuk expedition, the Muslims surrendered all or considerable portion of their belongings to help the noble cause of Jihad. Even today, if properly motivated by Islamic government in which the people have confidence, the people can surrender the whole of their surplus wealth to help the government in national emergencies. Thus the state would need hardly any loans-internal or external – in any situation howsoever untoward it may be. But if the state fails to raise funds through the above mentioned measure and the emergency is grave and the need is dire, it can resort to borrowing. However, the borrowing should be restricted to need only (not a single penny should be borrowed more than need) and loans should be raised preferrably from internal sources and free of interest. Otherwise the loans may be raised from brother Muslim countries free of interest. In any case loans should be repaid as soon as possible because prolonged or habitual indebtedness is undesirable being repugnant to national interest.

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V- Banking and Insurance in Islamic Economy

It is not without interest to say a few words about banking and insurance in Islamic economy. Some people are apprehensive that banks and insurance companies would cease to function in Islamic economy. No doubt the present working of banks and insurance companies is contrary to Islamic teachings and thus in the present form these institutions will not be allowed to function in the event of complete enforcement of Islamic system. However, banking and insurance are very vital to any modern economy and so the same cannot be banned. Therefore, they would be radically reformed and modified in accordance with Islamic teachings by a body of seasoned economists appointed for this purpose. A brief picture, as envisaged by the writer, of banking and insurance sector which would operate in the Islamic economy, is discussed as under:

The main function of banks in the modern society can be summed up in one sentence : The banks borrow to lend. They borrow in the form of deposits which are of three types : Saving Bank Deposits; Current Deposits, and Fixed Deposits. They basically lend in three ways : On open account or overdraft facility; loans on cash credit basis, and discounting of bills. Besides this main function, the banks perform a lot of other services for the people. They help in the transfer of funds from one place to another and from one person to another through the use of cheques. Some banks accept bills on behalf of their clients and thus make them more easily negotiable. They supply information and advice to their clients on matters relating to investment. In addition, they perform miscellaneous services like taking charge of valuables and securities, acting as agents, trustees and bailees of their customers, purchasing and selling stocks and shares on their behalf, paying subscriptions to clubs and charitable institutions at regular intervals, and so on.

The above mentioned services performed by the banking system are so essential and useful for the modern society that the society cannot make any progress in economic sector without banking. But unfortunately the whole system of modern banking is built upon the institution of ‘Riba’ or interest which is banned by Islam. Thus the right approach for the Muslim community is to adopt banking with its good and useful things and to benefit from it without involving interest. Therefore, Islamic banking would be based on the principle of partnership. In Islamic banking, the shareholders, the depositors and the borrowers-all would participate on profit-loss sharing basis. The mechanism and the ways and means regarding working of the partnership system will have to be evolved in the light of Islamic tenets. Consequently, in the Islamic economy the banks would continue performing their functions of borrowing and lending on the basis of profit-loss sharing instead of earning and giving interest, whereas for their other services they would charge reasonable fee.

Those who think that in the absence of incentive of interest people would stop saving, and if at all they save they would keep their savings hoarded with them and thus the flow of money into banks would cease, are not correct. In fact, it has been established by modern economists like Lord Keynes that interest hardly influences savings. Practically, rate of investment and level of income determines the rate of savings in a society. In Islamic society the rate of savings would be rather boosted because of simple and austere living of the people who avoid luxurious living and shun expenses on social evils like drinking, adultery and gambling. The fear that without incentive of interest the people would keep their savings in hoarded form is again not genuine. Zakat penalises those who keep their money idle as regular payment of it every year would diminish such idle money. So the savers would be forced to bring their money into investment or deposit it into banks with prospects of earning profit in participation with banks.

The convertion of interest-based banking to interest-free banking in the Islamic state would do a great good to the economy. In the present system, some shrewd persons arrange huge capital by borrowing on interest from banks and thus build up big industrial empires which cause concentration of wealth in few hands. In the Islamic system which is based on profit-loss sharing instead of interest, capital would be available on equity basis and not on loan basis and, therefore, it would be impossible to establish industrial empires. This would help growth of small and medium size enterprises which, as proved by modern economic theory, go a long way to promote economic development of a nation.

It is unanimously held by the Muslim jurists that presence of riba (interest), maisir (gambling), garar (risk or uncertainty) and juhala (unknown) in any business contract or transaction makes it unlawful. Whenever any of these four elements is found in any transaction or deal that renders it void in the sight of Islam. If you analyse the contract of modern insurance, you will find that almost all these four unlawful elements are present in it in sufficient degree so as to make it illegal in Islam. Therefore, when Islamic economic system is enforced, modern commercial insurance will have no place in Islamic lands. Muslim economists and insurance experts, however, suggest that insurance needs of Islamic society will be met by organising insurance on the principle of mutuality and co-operation. In other words, co-operative and mutual insurance in which the policy holders are themselves the insurers as well as the insurees is acceptable to Islam with suitable modifications so that no tenet of Islam is violated otherwise.

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