Part IV: Flaws in the theory of interest & roots of the crisis

Muslim economists have always searched and are still searching for flaws in an economy that is driven by interest so that they could justify their theories of a just monetary system. After intense reading of different publications regarding flaws in the theory of interest that are written by Muslim scholars, I did not find a well-constructed argument supporting the flaws in interest rates that is worthy of extracting the idea of adding it to this research.

The general consensus that I found on this issue of a macroeconomics level is the harm which interest rates have contributed to thus far. Muslim economists continually refer to the global economic crisis as a result of interest rates from the great depression to the crisis in Southeast Asia. Huge budgetary imbalances, excessive monetary expansion, large balance of payments deficits, insufficient foreign aid, and inadequate international cooperation can all be related to flaws in the theory of interest, which is also the root of the crisis. Muslim economists see the demand for economic growth as parallel to inflated interest rates and global economic crisis. It is healthy to say that most countries, which make the transition to a market ecomony, had developed some kind of crisis in the early stages. Inflation often occurs as a result of a fast growing economy, hence, contracting the monetary policy is a must to offset inflation. This increase in interest rates would only add to the unemployment level. The Keynesian school had emphasized the problem of high interest as a contributor to unemployment, therefore, stressing the need of reducing interest rates to the lowest possible. But the question is what is the optimal rate of interest? Or should interest exist? The answer of both these questions would be discussed at the end of this article where I will conclude with my own opinion and insight.

Goals of Islamic Economics

The money and banking system should, like all other aspects of the Islamic way of life, be made to contribute richly to the achievement of the major socio-economic goals of Islam. The system should also continue to perform the usual functions that relate to its own special field and which other banking systems perform. From the previous arguments in this project, I came up with a list of goals and functions in the framework of Islamic banking which is illustrated in the following:

1. Broad-based economic well-being with full employment and optimum rate of economic growth.

2. Stability in the value of money to enable the medium of exchange to be a reliable unit of account and a stable store of value.

3. A just return is ensured on investment and development projects.

4. Effective rendering of all services normally expected from the banking system.

5. Socio-economic justice and equitable distribution of income and wealth.

Aspects of an interest free system & its efficiency

A banking system is a must for any economy to flourish or to stay in shape. The primary function of banks is to allocate capital to support entrepreneurs or industrialists in seeking economic prosperity. But, from the Islamic perspective, this kind of support from banks in the form of lending, has to be done without charging interest and, hence, being a risk taker instead of risk averter (Islamic economists point of view). From that, Islamic economists came to an interest free banking system which will supposedly replace the current system and will be more efficient.

An interest free system is a system that relays heavily on profit sheering. This system is derived from the Arabic term Mudarabeh. Mudarabeh is the kind of system where both the lender and the borrower are equally exposed to risk because of the fact that the lender shares profits or losses with the borrower are equally (partnership). The profits in this case are the substitute for the interest. But one might ask, how would banks have the capital that is necessary to lend, when banks do not pay interest for savings accounts or capital providers. Banks will have the funds that are necessary for lending, because according to Islamic economics there would be a triangle or three way system where all participants are mutually beneficial or not beneficial from engaging themselves in projects. Those are 1) the bank, 2) the supplier of saving or funds, 3) the actual user of capital or the entrepreneur. Now, it is obvious that not only banks and entrepreneurs are exposed to risk but also the supplier of funds. After discussing the previous, one might come to the conclusion of what is the role of banks. Why don't we cut the middle man (banks) and maximize profits by having only a lender, borrower and a regulatory force in the form of a central bank. The lender would be a venture capitalist who is interested in profit sharing. But, the major argument in which Islamic economists see the need for banking services, is that banks can study applications of borrowers and, hence, extend credit, offer portfolio investment for lenders, and undertake foregone-trade services.

Islamic economics alternatives to the current system

Business financing in an Islamic economy would of necessity have to be equity-oriented where the financier shares the profit or loss of the business financed. Such financing would not only distribute equal returns between the financier and the entrepreneur, but will efficiently allocate risk. Equity financing in an Islamic ecomony may thus have to be of joint stock companies or shares in partnerships, or a definite (short, medium, or long) period as it is in the case of borrowed capital. Since borrowed capital would also be on the basis of profit and loss sharing and could not be interest-based, it would be in the nature of temporary equity financing and would mature on the expiry of the specified period. Such financing would hence not carry the same connotation as it does in the capitalist economies. It would, like equity, not enjoy any lien on the assets of the firm.

The liability to secure a lien on the assets of the businesses financed, possible in the case of interest-based lending, would make the financier more careful in evaluating the prospects of the business and cautious in providing the necessary financing. Moreover, it would be difficult to find medium or long-term financing in an Islamic economy without sharing the ownership and control of the business. Expansion of the business would hence be closely related to the distribution of ownership and control. Similarly it would not be possible for anyone to earn an income on savings without being willing to share the risks of business. Thus, we would see a more efficient allocation of risk in an Islamic economy.

As previously mentioned, an Islamic economy is an economy that always puts full employment as the first priority. Also, Islam is a religion which degrades and prohibits unwanted or unnecessary consumption. for both of these two reasons, one could say that consumption loans are not a big issue, but if a family or an individual found him or herself in need, there is always the Islamic tax on fixed assets (Zakat) to provide for any consumption or human need. Zakat is a 2.5% tax on fixed assets. It is paid annually to people in need. Zakat is a practice in which every Moslem who enjoys excess wealth must pay to fulfil the Islamic obligations.

The major objection to an interest-free economy is that, in the absence of interest, it would not be possible for the government to finance its budgetary deficits by borrowing from the private sector. Government budgetary deficit, is an important means of generating growth and improving living standards. How will the government budgetary deficits be financed after interest has been abolished?

Unfortunately, Moslem scholars have reached a conclusion, on government borrowing, which has a mixed signal, or in other words, not convincing. Moslem economists, feel that the government should work in a very efficient matter in terms of their spending. If there was a deficit situation, the government should resort to a contractual fiscal policy or borrow money from the central bank. But in terms of government borrowing, I have a different theory which came from past experience. Islam is a religion that always encourages Zakat and other types of spending by the private sector for poor people, institutions, and infrastructures. So that, in my opinion, may lessen or reduce the burden on government spending and hence solve for budgetary deficits. Islam seldom discusses spending as a government task, rather, Islam stresses that spending for increasing standard of living is a task that should be performed by the private sector.

Part V, Conclusion: Challenges facing Islamic Banks

Islamic banks certainly face many challengers today which are due to the fact that we live in an economy that is driven and manipulated by interest. The following is an illustration of the different challenges facing Islamic banking.

In a market economy, the banking sector is supported and regulated by the central bank. One could see this kind of support in terms of discount rates on loans given by the central bank to commercial banks in times of need. Also, the central bank to commercial banks in times of need. Also, the central bank regulates commercial banks, which will add to the health of those commercial banks. Unfortunately, Islamic banks in the region, do not enjoy such privileges. Because of the fact that most countries have a central bank which operates in a market economy, there is no support to Islamic banks. Islamic banks debunk the theory of interest and hence will not operate or do transactions with the central banks. This lack of support situates Islamic banks in an unenviable position. No one would want to save or invest in a bank that has no means of support or acts solely. This would hence create the problem of the lack in liquidity which is vital to a bank's existence.

Another hurdle, is the absence of liquidity instruments, such as bonds and other marketable securities, which could be utilized to either cover liquidity shortages or to manage excess liquidity. This problem is aggravated since many Islamic banks work under operational procedures different from those of the central banks; the resulting non-compatibility prevents the central banks from controlling or giving support to Islamic banks if a liquidity gap should occur.

The previous were the most important or serious challenges for an Islamic banking system. I think that these challenges and many others are a result of trying to build an Islamic banking system in economies and banks that operate and literally exist around interest. In my opinion, building Islamic banks in a market economy is an obvious failure. Islamic banks can survive only in a Christian, Jewish, or Islamic economy that abolishes interest.

Final comments & Perspectives

The idea of Islamic banking is certainly very interesting and a must in the case of the three holly-book religions. An interest free system could work and provide unlimited prosperity but certainly, absolutely, and undoubtedly it will not work under the current system. The whole economic system should be altered and changed in order for the Islamic framework to succeed.

There are several points in which Islamic scholars could be criticized. First, is their theory of risk. Islamic scholars and economists claim that the lender bares absolutely no risk. This fact could be proven wrong. In finance we constantly deal with risk calculation for the lender. For example, we use the Capital Asset Pricing Model (CAPM) to calculate the risk based on the two factors. 1)The risk free securities i.e. Government securities and 2)The market risk i.e. Beta. The formula is: K = K risk free + (K market - K risk free) Beta where K is the required rate of return. Also, there are risk calculations for small lenders by calculating the standard deviation of their investment which pays interest. There are also many kinds of calculations done by the lender for risk analyses. Although the previous risk calculations may be convincing in terms of the lender also claiming risk, the question is, how many times do lenders do not receive their principal + interest? I think nominal in this day and age.

Another thing that I am critical of is the new Islamic version of profit in Islamic banks (Murabahah) where if a person wants capital from a bank, the bank would buy it and a finance it for the entrepreneur at a predetermined profit margin. This kind of transaction is thought of lawful by Moslem economist because God has banned interest and allowed trade. In my opinion, this type of transaction only adds to the theory of unequal risk and inefficient allocation of risk because the lender of capital has claimed or decided the profit margin in which the entrepreneur would pay to obtain the necessary capital. I do not think that God meant this type of trade or transaction to be allowed in reference to the holly-book. Unfortunately, Islamic banks today take full advantage of their deliberate misunderstanding of fair trade and build on such a propaganda by advertising to the public that their way is the right and religious way, hence, attracting capital to their banks on the expense of the uneducated individual. Islamic banks in Kuwait charge profit margins that are extremely higher than interest rates in conventional banks and justifying it by their deliberate misunderstanding of religious guidelines.

There are also unsolved or not understood issues for example, why does a pre-determined cost of capital prevent full employment, how would the government borrow money, and how could we solve for global financial crisis. It is a possibility that no crisis or hardships would take place in an Islamic system, but the main point, is that it is impossible to see the Islamic system work as a sub-system to the current market economy, and we can not provide Islamic economic solutions under capitalism.

Source: http://www.african-renaissance.com/economy.html