Economics and Business

The Prohibition of Riba in Islam: An Evaluation of Some Objections

A number of objections have been raised against the prohibition of Riba (interest) in Islam and it has been alleged that a riba-free economy will face so many problems that it may not be able to survive. This paper evaluates the nature and significance of some of the major objections and, in the process, also indicates the rationale behind the prohibition of riba.

ALLOCATION OF RESOURCES

One of the objections raised against an interest-free economy is that it will not be able to bring about an optimum allocation of resources. The reason given for this is that interest is a price and like all prices it performs the function of allocating 'scarce' loanable funds among the 'infinite' users of such funds in an objective manner on the basis of ability to pay the price. If the demand for, or supply of, loanable funds changes, a new equilibrium is reached at a different rate of interest.

This objection is based on two assumptions. The first assumption is that in the absence of interest loanable funds will be available ‘free’ to borrowers, the demand will thus be infinitely large and there will be no mechanism for equating demand with supply. This implies that interest is the only objective criterion for allocation of resources and, in its absence, scarce financial resources will be used inefficiently to the detriment of society. The second assumption is that the money rate of interest has been a successful mechanism in allocating resources  optimally and that profit cannot perform the function efficiently.

The first assumption is baseless because funds will not be available ‘free’ in the Islamic system. They will be available at a cost, and the cost will be the ‘share’ in profit. The rate of profit will hence become a criterion for allocation of resources as well as the mechanism for equating demand with supply. The greater the expected or ex-ante rate of profit in any business, the greater may be the supply of funds to that business. If the actual or ex-post profit for certain businesses is consistently lower than the ex-ante profit such businesses may face difficulty in raising funds in the future. Therefore, while ex-ante profit will be immediately important in determining the flow of investment, the ex-post performance will be crucial for the future success of the business in raising funds. This should help enforce a greater discipline in investments through a more careful evaluation of projects, weeding out all inefficient and unproductive projects. This is not the same in interest based investment. The interest-oriented lender does not share in the risk of the business financed. He shifts the entire risk of busines to the entrepreneur and assures himself of a predetermined rate of return irrespective of the ultimate net outcome of the borrower’s business. He thus does not have to undertake as thorough an evaluation as the sahib al amal (financier) would have to undertake in a riba-free economy, either by himself or with the help of a bank or consulting firm. Because of a two sided evaluation of projects, the rate of profit in the Islamic system should be a more efficient mechanism for allocation of resources than interest can ever be in the capitalist system.

The second assumption that the money rate of interest has been an efficient mechanism for allocating resources is also not valid. There is little evidence to support the contention that allocation of resources is efficient in interest-based capitalist economies. Convincing evidence to the contrary is in fact available. Enzler Conrad and Johnson have found compelling evidence to conclude that in the United States “the existing capital stock is misallocated-probably seriously-among sectors of the economy and types of capital.”  Pareto optimum in the allocation of resources takes place only in the dream world of perfectly competitive equilibrium models in which market economies have been theoretically formalised. Malinvaud has accordingly pointed out that “When the intertemporal aspect of resource allocation is put forward, one cannot but be impressed by the inadequacy of these models as describing the actual working of our economies.”3 Ralph Turvey contends that “the money rate of interest does not rule the roost” and feels that “the rate of interest was irrelevant to investment decisions” and “should be replaced by the price of existing equipment (or share price^)."

Moreover, the ‘equilibrium’ rate of interest is only a text-book phenomenon. In reality an efficient ‘market, clearing’ rate does not exist. Instead there is a theoretical amalgam of a host of long-term and short term rates with sizeable differences and variations in their levels and without any clear conception of how these numerous rates can be combined into a single measure. Moreover, all the rates which should be combined into the equilibrium rate can by no means be observed in the market. What is important for economic decisions is the expected real rate of interest which cannot be observed in the market and cannot be approximated reliably by econometric techniques. The rate of interest tends to be a ‘perverted’ price and reflects price discrimination in favour of the rich-the more ‘credit-worthy’ a borrower is supposed to be, the lower rate of interest he pays and vice versa. The result is that ‘big’ business is able to get more funds at a lower price because of its ‘higher’ credit rating. Thus those who are most able to bear the burden because of their bigness or claimed ‘higher’ productivity bear the least burden. In contrast, medium and small businesses, which may sometimes be more productive in terms of contribution to the national product per unit of financing used and at least equally ‘credit’ worthy’ in terms of honesty and integrity, may be able to secure relatively much smaller amounts at substantially higher rates of interest. Hence many potentially high yielding investments are never made because of lack of access to funds which flow instead into less productive but ‘secure’ hands.  Therefore, the rate of interest reflects, not the ‘objective’ criterion of the productivity of the business, but the ‘biased’ criterion of ‘credit rating‘.

This is one reason why in the capitalist system, big business has grown bigger beyond the point dictated by economies of scale, thus contributing to monoply power, while medium and small businesses have often been throttled by being deprived of credit. This is particularly so when interest rates rise and create a liquidity crunch by reducing the internal cash flows. Small businesses are rarely given a respite by the lending banks. Loans to them are recalled with the slightest sign of trouble, thus causing widespread bankruptcies. However, when big businesses are in trouble, there is rescheduling accompanied by additional lines of credit. Does this indicate an optimum allocation of resources or an efficient banking system?

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