Difference between interest and trade

In the pre-Islamic Arabian society, interest or riba was considered similar to trade. But the Qur’an has enunciated that trade and interest are not the same[16]. Therefore, it is necessary to explain the reasons which actuated Islam in forbidding interest and permitting trade. Islam, in making trade lawful and interest unlawful, stipulates that there are fundamental differences between interest and trade.

In trade, there are tow parties involved – one is the purchaser and the other is the vendor. The vendor makes a particular product or commodity by exerting his labor, money and time or he purchases it from someone else. In both cases, the vendor along with his capital employs labor, time, intellect and experience and presents it before that buyer and by selling he makes some profit on top of it. In exchanging the product, sometimes he may incur a loss instead of making a profit. So he (the vendor) has to take the risk of looses while going for trade[17].

On the other hand, in interest transactions there is no division of profit between the two parties on the basis of equality. A person lends his money to someone as a loan on the condition that the borrower has to pay a certain amount of money in addition to the principal within the given time period. Here, the lender or financier gets additional pre-fixed money with the principal. During this period it is not always possible for the debtor to make a profit. This is, in fact, an exchange of time and leisure[18]. From the point of view of trade, the moment a commodity is exchanged for its price the transaction comes to an end. The purchaser does not give anything after that transaction to the vendor. In their transaction, whether of houses, land or other material, the original remains intact and is returned to the owner afterwards. It is only for the use of it that the hirer has to pay the rent to the owner, but in the case of interest, the debtor actually spends the amount borrowed form the creditor and has to return the same amount with an addition by way of interest[19].

Rationale of the prohibition of riba

To begin with we need to look at what might possibly be wrong with the institution of interest. In the Holy Qur’an, Allah (swt) did not mention any specific reason for the prohibition of interest. Islam being a complete code of life, offers its own economic system to guide human behavior in the economic sphere. Muslims believe that the absence of the practice of interest is an essential feature of an Islamic economic system.

The reasons can be best understood only in terminology and precepts which can be comprehended easily by the people of a particular period of time. In some case reason has been mentioned by the Holy Qur’an, it is in very broad terms, as “This is better for you if you know or understand,” “This is better for you if you practice,” or “This is better for you because it is closer to piety and fear of Allah.”[20]

More just on fairer application of this approach of the Qur’an with respect to the reasons if applied to the economic spheres, is the demand for social justice[21]. This could be considered the real reason for the prohibition of interest. Gambling and alcohol are also prohibited in Islam. In the case of the prohibition of wine and gambling, it was mentioned that “In them is great sin and some profit for men, but their sin is greater than their profit.”[22] This is the general approach of the Qur’an with regard to reason.

Islam gives in detail the punishment for those involved in interest and narrates the condemnation of interest in different manners in different places. However, in connection with the condemnation of interest in one place it comes very close to giving a rationale. The Qur’an says: “Allah has permitted trade and prohibited interest”[23]. The implication of this is that the principle of interest is quite opposite to that of business. This shows Islam does not consider lending on interest as a business in the real sense[24].

In fact, the rationale of the prohibition of interest has to be viewed in the context of the basic characteristics of an Islamic economic system. The fundamentals of an Islamic economic system may be enumerated as follows:

Islam believes in the economic freedom but it must be within the limit of the Islamic Shari’ah.
Zakat is compulsory for those who have zakatable Nisab (threshold), so that undue concentration of wealth in a few hands can be prevented.
The Islamic law of inheritance has to be implemented.
Hoarding should be discouraged and the use of wealth for productive purposes should be encouraged, so that everyone will have at least a minimum subsistence.[25]

The delineation in the Holy Qur’an of the practice of interest as an act of “War with Allah and His messenger” provides a clue to the philosophy behind the prohibition of interest in Islam. It is clear that the institution of interest is something which runs counter to the scheme of things which Islam stands for and which Allah wants to see established on earth. That the words “Allah has blighted riba and made sadaqah fruitful” occurs in verse 276 of surah al-Baqarah also points towards the fact that the practice of interest militates against the objectives of an Islamic society while sadaqah promote these objectives[26].

In Islam, a person has to earn what he seeks to obtain. The lender of money does nothing thereby to entitle him to anything other than the money lent. It may be argued that the interest which the lender charges is by way of exacting a reward for him originally having taken the trouble and possibly undergone the hardship of amassing the capital which is being lent. This may be true, but the objection to the arrangement where interest is charged for a loan is that the borrower is under obligation to return the loan and run the risk of incurring a loss. The lender, in fact, puts no effort, the capital that lies in the hands of the lender means a purchasing at his command[27].

At least four characteristics define the prohibited interest rate[28].

It is positive and fixed ex-ante,
It is tied to the time period,
Its payment is guaranteed regardless of the outcome or the purposes for which the principal was borrowed,
The state’s apparatus sanctions and enforces its collection.

Economic rationale behind the prohibition of riba

This is perhaps one of the most crucial points of this theses. It is commonly asserted that when Islam has allowed trade it has allowed profits, and when it allows unearned income in the form of rent form land and income property, and profit form sleeping partnership, what justification is there for not allowing interest or riba.

Saving and investment

Saving and investment are tow of the most important determinants of economic growth and development. The classical belief that saving is determined by the interest rate is refuted by Keynes[29]. According to Keynes, aggregate saving is governed by the aggregate income. The empirical evidence does not show any significant relationship between saving and interest rates, the results have at best been inconclusive[30]. In fact, interest puts a limit to the marginal efficiency of capital. Riba is inversely related to the marginal efficiency of capital. In the presence of riba the marginal efficiency of capital does not rise to its optimum level. As a result, all the resources available cannot be fully utilized. This causes a fall in investment.

Interest rate, in fact, limits investments. Interest is also considered as a cost of production and hence the price of the product is adjusted to it so that consumers are affected because of the higher prices of goods and services[31]. Interest dampens investment activity because it adds to the cost of investment. However, if interest rate is raised to contain monetary demand in situation where excessive fiscal deficits are fuelling inflation, private investment receives a severe setback leading to stagflation. This has actually been the experience of a number of developed countries in recent years[32]. So, the prohibition of interest is unlikely to reduce the volume of savings. In fact, in an interest –free Islamic economic system savings are likely to be promoted. First of all, in the profit sharing arrangement the return to capital will include “reward for both savings and risk-taking” which means a high return to financiers that in an interest-based system. This means if 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.

Secondly, profit-sharing in mass production between employer and employees will on the average give higher income to the employee who constitute the majority of the population. Lastly, Fahim Khan[33] pointed out that adherence to the moderation in spending enjoined by Islam is likely to promote savings in an Islamic economy compared to a secular one.

On the other hand, in an interest-free scheme, where both the financiers and the investors have a stake in the return of their investments, low returns may not deter them from investing, as neither the investors nor the financiers will be better off or worse off, one at the cost of the other. In fact, both can be worse off by not investing. In the profit sharing system, it is innovative enterprises that are likely to set constraints to investment rather than finance. This is because capital does not impose a limit to investment such as in the interest based system. Thus innovative entrepreneurs who are ready to develop new profitable investments will always raise funds for such ventures.

Unemployment and inflation

It is true that interest rate causes unemployment and inflation in several ways. When interest rate is high it makes cost of production also high, causing a decline in investment and in some cases closure of production units, resulting in retrenchment of workers by employers to reduce cost. Alternatively, producers increase the prices of goods and services to cover the increased cost, thereby causing inflation. On the other had, when interest rate is low the tendency is to switch to capital intensive method of production thereby causing technical unemployment due to the replacement of labor by machinery. On the consumer side, low interest rate encourages borrowing for consumption which usually increases the demand for goods and services, hence resulting in demand pull inflation. It was believed by most economists until the early 1970’s that there is a trade-off between unemployment and inflation. However, subsequent findings have shown that both high unemployment and inflation can co-exist. This gives rise to a new phenomenon known as stagflation. That is a situation where high unemployment and inflation are positively related. This phenomenon has caused many economic problems in the industrialized countries. Weitzman[34] has stated that all the mechanisms attempted in solving the problem of stagflation have failed. He proposed that profit-sharing is the best form of policy for combating unemployment and inflation. He further mentioned that profit-sharing represents a easy of building into the system, the kind of natural resistance to unemployment and inflation that could really disarm stagflation at its source.

Security oriented banking system

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 exaggerated security orientation acts as a great impediment to growth because it does no tallow a smooth flow of bank resources to a large number of potential entrepreneurs who can add to gross national product by their productive endeavor, but do not possess sufficient security to pledge to the banks to satisfy their criteria of credit-worthiness[35].

Interest and entrepreneurship

According to Schumpeter, economic growth is determined by the dynamic function of entrepreneurship and this dynamic function is an innovation which leads to technological changes[36]. So, the entrepreneurs are the real pillars of economic edifice. The interest based system discourages innovation, particularly on the part of small scale enterprises[37]. Large industrial firms and big landholders can afford to experiment with new techniques of production as they have reserves of their own to fall back upon in case the adoption of new practices does not yield a good dividend. Small scale enterprises hesitate to go in for new methods of production with the help of money borrowed form banks as the liability of the banks for the principal sum and interest has to be met irrespective of the results while they have very little reserves of their own. In this way economic development is hindered.

Priority sector lending by interest based banks

Under the interest based system, banks are only interested in recovering their capital along with the interest. The interest in the ventures they finance is therefore strictly limited to satisfying themselves about he viability and profitability of such ventures from the point of view of the safety of their capital and the ability of the venture to generate a cash flow which can meet the interest liability[38]. There is no incentive for the banks to give priority to ventures with the highest profit potential. In fact, an interest based institution makes loan to priority sector at concessional rate of interest. But such lending is not comparable with social operations of any interest-free institution on the following grounds[39].

1) The difference between normal rate and the concessional rate is marginal in most cases needs to be reimbursed by the central bank.

2) In most cases the principal amount so lent by the interest based banks does not constitute their own mobilization. They simply re-lend the funds provided by the government or the central bank.

3) The interest based bands have no operation comparable to the zakat and charity based projects of Islamic banking. Lending process of interest based institutions involved a rigid mechanism which cannot be varied to suit the different levels of profitability and desirability of the projects.

Interest and stability

It may, in fact, be asserted that interest is one of the most destabilising factors in the capitalist economy. Milton Friedman, posing the question, “What accounts for this unprecedentedly erratic behavior of the US economy?”, responds by saying, “The answer that leaps to mind is the correspondingly erratic behavior of interest rate”[40]. The erratic fluctuation of the rate of interest creates erratic shifts in financial resources between users, sectors of the economy and countries, causing erratic movements n the loan based investments, commodity and stock prices and exchange rates. They also bring about shifts in short and long term commitment of funds and between equity and loan financing. The high degree of interest rate volatility has injected great uncertainty into the investment market which has had the effect of driving borrowers and lenders alike form the longer end of the debt market into the shorted end, thus fundamentally altering the investment decisions of businessmen[41].

Profitability and productivity

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. It has been argued that for the financiers as a group, profit-sharing is more profitable than traditional interest based system.

According to Hasan,[42] 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 destabilising potential for the economy as a whole compared to financing on interest. 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 has been reduced. This encourages entrepreneurs to be more innovative and venture into high risk projects which are usually characterized by high profitability. Furthermore, the spirit of mutual co-operatives and sense of ownership and responsibility promoted by profit-sharing results in efficient use of resources and increased output in turn increases profit.

Jones and Svejnar[43] an empirical study of Italian producer co-operatives, have come out with the interesting conclusion that, for producer co-operative, profit-sharing participation and individual worker ownership of assets have a positive, or at least a non-negative, effect on productivity, and that collectively owned reserves have a negative effect on productivity. In fact, these findings support the proposition that profit-sharing encourages co-operation, greater sense of belonging and responsibility among the partners. Consequently, greater productivity and profitability is achieved.