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Islamic Economics

‘Civilization and its well-being as well as

business prosperity depend on productivity
and people's efforts in all directions in their own
interest and profit. When people no longer do business
in order to make a living and when they cease all gainful
activity, the business of civilization slumps and everything
decays.”
[Ibn Khaldun (744-820Hijrah 1332-1406AD)
 
 

Islam has never developed a separate theory of political or moral economy in

the way that economic science and analysis have evolved in the western
tradition. There are few thinkers in Islam who have ever discussed economic
matters as a separate discipline. The western tradition of writing economics,
from Adam Smith to Malthus, Ricardo, Mill and into modern times, simply has
no equivalent in the realm of Islam. Islamic economics are embedded in the
broader framework of the jurisprudence of transactions and in the scholasticism
of the moral philosophers and theologians of Islam. None of the key concepts of
economic thought markets, the nature of value, productivity, utility, efficiency,
growth, to name just a few—exists with the same definition, or even broad
meaning. The Sharia did not leave much room for economics. Wherever the
issues of prosperity of the community or welfare of the common person were
discussed, this was part of the same tradition of exhortatory writings to the ruler
about the value of a sound currency, about fairness in dealings and about the
risks of punitive taxation. Otherwise it was assumed that people were ordained
to conduct their business affairs and transactions within the bounds of the Sharia
and its detailed norms concerning the permissible and the lawful in economic
conduct and behaviour. [p.209 The Crisis of Islamic Civilisation by Ali A
Allawi, Yale University Press 2009]
 
Islamic Economics

It is difficult to understand and study Islamic economics and the structure of the
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Islamic financial mechanism in isolation; unlike in ‘Western' type economies

where it is done with some degree of ease. Islamic Economics differs
fundamentally from man-made laws and systems in defining economic problem.

While Islam is one of the principal global religions, more importantly it is a

wholly integrated way of life, where various principles are interrelated and a
dictate under one aspect e.g. family, can logically be relevant to another e.g.
jurisprudence. For starters it can be put that Islamic economics is based on the
socio-economic paradigm. In this approach Islam is seen as a system of ethics.

Possibly one of the starting points to understand Islam and Islamic economics,
is what can be considered as the central theme – 5:120 The Qur'an, where it
states that dominion of the cosmos belongs to God (Allah) and therefore we are
but His vice-regents (or trustees) of all this dominion, whether we seemingly
own some part of this individually, jointly or otherwise. Naturally therefore, all
economic and financial activities that would effect and regulate our lives, must
be driven by this key principle.

There are many contributory verses that guide and lay down the economic and
financial principles, to human beings as individuals or collectively as a society
or as a nation. These principles form the Islamic law which is known as Shari'ah
(the corpus of Islamic law based on Divine guidance, as given by the Quran and
the Sunnah).

Ibn Khaldun's (15th century's) framework provides a summary of the

interdisciplinary dynamic model for Islamic socio-economic system:

“The strength of the sovereign (al-mulk) does not become consumed except by
implementation of the Shari'ah; The Shari'ah cannot be implemented except by
a sovereign (al-mulk); The sovereign cannot gain strength except through the
people (al-rijal); The people cannot be sustained except by wealth (al-mal);
Wealth cannot be acquired except through development (al-‘imaran);
Development cannot be attained except through justice (al-‘adl);
Justice is the criterion (al-mizan) by which God will evaluate mankind; and The
sovereign is charged with the responsibility of actualising justice”
(Chapra, 2000: 147-8)
 
Value of Money
Aristotle (384-322 BC) on Usury

Aristotle understood that money is sterile; it doesn't beget more money the way
cows beget more cows. He knew that "Money exists not by nature but by law":
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"The most hated sort (of wealth getting) and with the greatest reason, is usury,
which makes a gain out of money itself and not from the natural object of it. For
money was intended to be used in exchange but not to increase at interest. And
this term interest (tokos), which means the birth of money from money is
applied to the breeding of money because the offspring resembles the parent.
Wherefore of all modes of getting wealth, this is the most unnatural." (1258b,
POLITICS)
 
And he really disliked usurers: "...those who ply sordid trades, pimps and all
such people, and those who lend small sums at high rates. For all these take
more than they ought, and from the wrong sources. What is common to them is
evidently a sordid love of gain..." (1122a, ETHICS)

Central to Islamic economics and finance is the fact that money itself has no
intrinsic value. As a matter of faith, a Muslim cannot lend money to, or receive
money from someone and expect to benefit through any increase, such as
interest (commonly referred to as riba) is not allowed. To make money from
money is strictly forbidden, wealth can only be generated through legitimate
trade and investment in assets. Money must be used in a productive way. The
principal basis of Islamic finance is based on the concept of trading involving
the sharing of profit and risk (loss). The profit is shared between the person
providing the capital and the person providing the management expertise.
 
The key characteristic of Islamic economics is that economic and financial
activities are linked to real economic sector activities and there is
encouragement to equity based structures backed by tangible assets instead of
debt based ones in investment where in the conventional world the transactions
may not necessarily have to be backed by any real asset. The conventional
investment practices, very often encouraged by uncontrolled greed to make
excessive profits, are the main reason for the current global financial crisis that
is bringing misery to millions. The Pope, Benedict XVI, alluded in 2008 to the
illusory nature of fiat money, and in 2009 the Vatican has also recently been
critical of the free market system.
 
People would find it impossible to live in today's world without money, but one
increasingly comes across interesting appraisals of it like the following for
example: “. . . in spite of all its fervid activity, money remains a naked symbol
with no intrinsic value of its own and no direct linkage to anything specific”
(Kurtzman, 1993). Money has come to be recognized as mere tokens and: there
is something quite magical about the way money is created. No other
commodity works quite the same way. The money supply grows through use; it
expands through debt. The more we lend, the more we have. The more debt
there is, the more there is. (Kurtzman, 1993)
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Islamic Econimic System

The Islamic economic system, on the one hand, aims to guarantee individual
liberty, freedom of choice, private property and enterprise, the profit motive and
possibilities of unlimited effort and reward. On the other hand, it seeks to
provide effective moral filters at different levels of life and activity and
established institutions in the voluntary sector, as well as through state
apparatus to ensure economic development and social justice in the society.

Some argue that early Islamic theory and practice formed a "coherent"
economic system with "a blueprint for a new order in society, in which all
participants would be treated more fairly". Michael Bonner, for example, has
written that an "economy of poverty" prevailed in Islam until the 13th and 14th
centuries. Under this system God's guidance made sure the flow of money and
goods was "purified" by being channeled from those who had much of it to
those who had little by encouraging zakat (charity) and discouraging riba
(interest) on loans.
 
Islam does not prescribe a particular economic system but provides the core
elements and principles, which form the basic philosophy of a system or an
economy. Islam provides primarily normative principles for economics and
finance. However, it is not devoid of positive economic statements or
hypotheses. Several areas of economics are truly positive and cannot be
different in an Islamic or in any other framework.

The Operational and Institutional Features of Islamic Economic System

Extract from “The Political Economy of Islamic Moral Economy” by Mehmet
Asutay, Durham University, UK presented at the seminar held on 30 January
2009 on ‘Comparative Development of the Islamic Economic Model in context
of current market conditions’, organised by KPMG, London, UK.

1. The Islamic scheme for social change and regeneration of human societies is
unique as it is based on methodology that is different from conventional
economic and political ideologies:

Thus, key elements for social change are:

a. Social change has to be motivated, planned and achieved through individual

and collective effort;

b. People are active agents of change through the vicegerency task assigned to
him/her and through the accompanying free will given to him/her… All human,
physical and institutional factors in the production, consumption and
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distribution of goods and services must be subject to his/her deliberate

individual and social choices.

c.There needs to be change not only in the environment, but also within
the hearts and souls of men and women-their attitudes, motivation, and
commitment, and their resolve to mobilize all that is within them and around
them for the fulfilment of their objectives.

d. Life is a network of relationships, and consequently change has to be

balanced, gradual and evolutionary. Innovation is to be coupled with
integration.

2. Self-interest is a natural motivating force in all human life. But self-interest

has to be linked to the overall concept of good and justice

3. Private property and private enterprise are affirmed as inalienable rights and a
natural mode for economic activity.

But the very concept and function of property is transformed by the provision of
moral and legal filters, and instilling in people's minds and hearts the notion that
all in its forms –physical and human, machine power and brain power- property
is a trust (amanah), and as such, property rights are subject to moral limits and
used as a means of fulfilling ethical objectives – the Maqaasid al-Shari'ah (the
objective of the Islamic way).

4. Economic efforts take place through the process of cooperation and

competition.
The market mechanism is the natural corollary of private property, freedom of
enterprise and motivation for profit and reward.

Scriptural guidance and historical evidence establish that trade, the promotion
of production and the exchange of goods and services, the pursuit of genuine
profit, protection of the market mechanism, and a legal framework for the
fulfilment of contracts, are pillars of the Islamic economic system.

Effort, innovation, creativity, division of labour, technology and skills

development have been emphasised by all major Muslim thinkers along with
cooperation, compassion, justice, charity and solidarity.

5. The market mechanism is a fundamental pillar of the Islamic economic

scheme. But Islam demands actions by extra-market institutions to ensure that
the market does not degenerate into jungle capitalism, and that self-interest and
the profit-motive do not create a situation that is socially disruptive and in
violation of norms of justice and fair play.
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 A moral filter at the level of personal motivation;

 Family as a social and economic unit to provide an initial system of social
security and solidarity;
 Government should be able to provide regulative framework;
 A network of voluntary organisations (waqf system), third sector; charity
is transformed by making part of it a legal obligation;
 Concern about the problem of waste, over-utilization and the excessive
exploitation of nonrenewable natural resources and the ecological and
environmental aspects of moral activity (Amanah and haq);
 Consequently, distributive justice and social security have become
structured elements of the Islamic economic system and not merely
voluntary supplements.
 The prohibition of certain sources of income is a particularly distinctive
plank of the Islamic economic system. The most important prohibition is
that of riba (usury/interest). Others relate to gambling, speculation, fraud,
exploitation and extortion.
 It follows then that Islam would prefer to promote an equity based, risk-
sharing and stake-taking economic system to a debt-based system.

The Islamic Economic Strategy (Chapra, 1992; Chapra, 1993; Ahmad, 2000)

a. Filter: moral values plus market-determined prices: “A moral filter that

would moderate and humanize the pursuit of wealth and power”.

b. Motivation: Self-interest plus accountability before God to rein

self-interest:“Accountability before the Supreme Being can serve as a
motivating force for abiding by Islamic values and working for social well
being”.

c. Role of the state: “The state will be expected to play a complementary role
in enforcing the moral code of conduct and ensuring proper functioning of
relevant institutions”.

d. Socio-economic restructuring: The central objective of Islam is socio-

economic justice. This demands that the scarce resources at the disposal of
humankind be used in such a way that the universally-desired goals of need
fulfilment, employment creation, equitable distribution and economic stability
are actualised. If the resources are utilised efficiently and equitably this can be
achieved.

e. A comprehensive approach in financing: Efficiency demands giving of

primary attention to the ultimate use of funds. Financial intermediation on the
bases of interest gives primary consideration to collateral and cash flow and
secondary consideration to the ultimate use of credits. Equity demands that
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credit becomes available to an optimum number of businesses and for financing

the production of need fulfilling and capital goods and services and raw
materials related to these. In a system based on profit and loss sharing, even the
poor may be able to get credit if they have a worthwhile project and sufficient
ability to manage the project efficiently.

Mechanisms/Institutions/and Instruments of the Islamic Economic System

Islamic economic and financial activities are shaped by there kinds of measures:

 Positive measures (zakah)

 Voluntary measures (sadaqah or alms giving; awqaf or pious
foundations)
 Prohibitive (riba')

Islamic Institutions and Instruments:

i.  Elimination of riba;
ii.  Islamic financial system;
iii. Zakah; iv. Takaful;
v.  Awqaf system

Money and Monetary Policy

Extract from “The Political Economy of Islamic Moral Economy” by Mehmet

Asutay, Durham University, UK presented at the seminar held on 30 January
2009 on ‘Comparative Development of the Islamic Economic Model in context
of current market conditions’, organised by KPMG, London, UK.

The theme of money was tackled very early on in history by a number of

Muslim thinkers such as al-Ghazali, Ibn Taymiyya, Ibn al-Qayyim, Ibn Khaldun
and al-Maqrizi.

Al-Ghazali has highlighted two functions for money: means of exchange and a
measure of value. He argues that money becomes a necessary means of
exchange to overcome the problems of a barter economy. Al-Ghazali says that
money also constitutes a unit of value and an instrument of measurement whose
role is to increase exchange and commercial relations. That is why al-Ghazali
insists on the fact that money should not be considered as a commodity, an
object of transaction and a source of profit (interest), nor hoarded and
withdrawn from the commercial circuit.

Ibn Taymiyya examines two functions of money, namely, a standard of

measurement and a means of exchange, and condemns the trade in money.
Furthermore, he examined the problem of money erosion and also its impact on
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the general economic situation and on the welfare of the population: ‘The
authorities should issue the money (other than gold and silver) up to the level
that is just necessary to correspond to the volume of transactions of the peoples
without causing them any injustices.' This lead Ibn Taymiyya to describe the
principle, ‘bad money chases good money', known as Gresham's Law in the
textbooks of political economy.

Ibn al-Qayyim recognizes the two functions of money described by the earlier
scholars, but he was more precise in his formulation. He wrote that ‘money is
issued not for its own sake but to be used in transactions (that is to say that it
constitutes only a means of exchange)'. Therefore money should be stable so as
to facilitate the evaluation of the products and their exchange.

According to Ibn Khaldun, God created gold and silver to serve as a standard
(or yardstick) of measurement for all goods. Contrary to the Mercantilists, Ibn
Khaldun demonstrated, well before them, that gold and silver do not constitute
wealth as such, but have a value of exchange like other metals or precious
stones. The argument of Ibn Khaldun is based on the theory of value which he
put forward centuries before Karl Marx. It is human labour, the source of
wealth, he said, which contributes to increasing or decreasing the quantity of
precious metals. The countries producing gold and silver exchange them against
money to acquire the goods they need.

Taqi al-Din Ahmad al-Maqrizi (1364-1444) is known for his works on money
and prices. He considers that only gold and silver constitute money which could
be used as a standard of value, ‘in the nature of things and according to the
Shari'a. Because of the relationship between the non-measured issue of money
and the rise in prices, al-Maqrizi proposes that the increase in mass-money
should correspond to, and not exceed, the total volume of transactions.

Division of Labour

Extract from “The Political Economy of Islamic Moral Economy” by Mehmet

Asutay, Durham University, UK presented at the seminar held on 30 January
2009 on ‘Comparative Development of the Islamic Economic Model in context
of current market conditions’, organised by KPMG, London, UK.

The importance of the role of labour in the creation of wealth was underlined by
al-Ghazali (1058-1111), Ibn Taymiyya (1263-1328) and Ibn Khaldun (1332-
1406).
Seven centuries earlier than Adam Smith, al-Ghazali highlighted the importance
of the division of labour required by the necessary diversity of human activities.
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It is astonishing to see that Ghazali used the example of a needle factory to

illustrate his point while Adam Smith used the example of a pin factory.

Ibn al-Qayyim (1292-1350) emphasized the necessity of establishing economic

cooperation between the different parties of a society, which constitute the
whole. Cooperation among human beings allows them to obtain results that
would never have been realized individually. The division of labour induces
multiplication and diversification of economic activities.

It is Ibn Khaldun who should receive credit for analysing with a greater
scientific rigour the concepts of labour, value and the division of labour- five
centuries before David Ricardo and Karl Marx.

 
Mehmet Asutay. 2009. Utility: The Islamic Backbone of Economics, Durham
University UK,

Treatment of utility as a scientific tool of analysis is the scholarly product of

most notably al-Ghazali(550 H), Izzaddin ibn Abdelsalam (or al-Izz) (660 H),
ibn Taimiyah (728 H) and al-Shatibi (790 H).

Al-Izz: “Most worldly utilities are recognizable through the [human] mind”.
The approaches of al-Izz and ibn Taimiyah are the most relevant to micro
economic theory since they both depart from a behavioural concept of utility as
a fundamental basis for the macro concept.

Al-Ghazali and al-Shatibi focused mainly on the macro theory of utility.

Therefore, it is possible to review the salient features of utilities jurisprudence
through the macro / micro classification as it will shortly be tackled.

Their views can be summarised as: The goal of Shari'ah is defined to achieve
utilities and avert difficulties. This postulate forms a general consensus among
Muslim scholars, with the added provision that no contradiction is perceivable
between worldly utilities and Hereafter's utilities except through
misunderstanding of either. It is the basic jurist provision whereby economics
and ethical values are firmly linked in the pursuit of a better economic order.
 
 
The Role of Market and its Limits, Mehmet Asutay, Durham University UK
2009

Many thinkers recognize private property, the liberty of economic activities and
the free movement of the market forces but within the confines of Islamic
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values. That is why they anticipate the intervention of the state in case of
dysfunction of the market in order to protect the general interest.

Abu-Yusuf (731-798) admits the determination of prices through the free play
of supply and demand though he maintains the necessity of measures that tend
to block monopoly, fraud and corruption.

Al-Mawardi (11th century) was also a proponent of state intervention in the

economy through the muhtasib whose function, among other things, would be
to regulate the market. The precision of weights and measures would have to be
assured, fraud clamped down on, and commercial operations controlled so that
they conformed with Islamic legislation.

Nizam al-Mulk al-Tusi (11th century) advocates state control of the economy,
emphasizing the necessity of maintaining national stability. According to him,
such stability would not be obtained unless the basic needs of the population
were safeguarded. He was preoccupied by the necessity of organizing assistance
to the poor amid the needy amid the struggle against the penury of alimentary
products by assuring their permanent availability in the markets, especially in
cases of catastrophe or drought.

Al-Ghazali implicitly recognized the idea of determining prices by the forces of

the market (in his analysis of commercial activities and the related functions of
transport and storage), to ensure the availability of products almost everywhere.
But he also evoked al-hisba (supervision and control) by describing the qualities
of the muhtasib (supervisor), the activities that are subject to control, and he
nature amid rules of supervision. He has also indicated some other areas that
need to be supervised such as concealing the defects of products or services and
false declarations for achieving profit.

Ibn Taymiyya has also well expounded the role of the market where prices are
determined by the laws of supply and demand. After identifying the demand
and supply conditions, Ibn Taymiyya suggests that the state should not
intervene in fixing prices except in the event of an injustice, monopoly,
dissimilation, or voluntary withdrawal of merchandise from the market circuit
to realize illicit profits. For Ibn Taymiyya, it is clear that in such cases the
intervention of the state becomes inevitable in eliminating, or at least limiting as
far as possible, market imperfections, which disturbs the smooth operation of
the market and its transparency.
 
 
Islamic Governing Principles (Shari'ah)
 
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The moral underpinnings and purposes of economic and trade regula¬tions in

the traditional Islamic order were accompanied by a massive legacy of detailed
rulings on the fundamentals of economic rights and duties, as well as on the
nature and scope of business contracts and commercial dealings.

There are a few key principles that directly set down the economic guidelines
and hence determine the central structure of Islamic economics as well as
regulate business and financial transactions.

I) The first is the principle of RIBA. Literally, in Arabic, Al Riba means an

increase or addition. In Islam it is interpreted as usury or a loan with the
condition that the borrower will return to the lender more than and better than
the quantity borrowed. This act of riba is prohibited in Islam. There are many
verses in the various chapters of the Quran that make riba illegal - haram

There are two significant implications of this ruling of prohibiting riba /

charging of interest. (1) Without interest there are no “debt based” contracts and
(2) the absence of interest focuses on the value of an “asset”, rather than the
value of ‘money', as it is through interest that money acquires its value.

The most frequently asked question therefore when someone learns of this
concept of interest being prohibited is “how then can any one make money”?

Islam recognises man's need to acquire wealth. It therefore allows people to

make money through the avenue of profit. Simply put, a ‘lender' of funds may
only give money to a ‘borrower' of funds, if the lender shares in the risk of the
business for which the money is being lent. The lender can determine before
lending the money, as to what his share of the profit will be. If however the
business fails, then the investor looses his investment. It follows then that Islam
promotes equity based, risk-sharing and stake-taking economic system, to a
debt-based system. (Source: knowislamicbanking.com)

II) The next important principle is the principle of Gharar. The Arabic word
Gharar has a multiplicity of meanings - risk, uncertainty hazard and deception.
Unlike riba, gharar is not specifically and extensively defined. While the
prohibition of riba is absolute, some degree of gharar or uncertainty is
acceptable in the Islamic framework. Only conditions of excessive gharar must
be avoided. This includes Maysir or Qimar which refers to gambling or any
games of chance.

For example a transaction involving deception or excessive uncertainty – or a

‘zero' sum transaction – in which one party must loose for the other to gain – are
prohibited under Shari'ah law.
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III) The third key principle is the principle of ZAKAT (Zakah). Zakat is one
of the five key pillars of Islam. It is a form of ‘religious tax' making it a
requirement of every Muslim to give a percentage of their income to a
charitable cause, provided such income or wealth is above a defined amount.
During the Islamic period, Zakat payments were collected by the State and the
funds were used to alleviate all kinds of human distress including setting free
the slaves by paying off their masters. The objective is to take away a part of the
wealth of the well-to-do and to distribute it among the poor and the needy.
Depending on the income / wealth (cash, cattle, agricultural produce, minerals,
capital invested in industry, and business etc) – the amount of Zakat varies from
2.5% up to 10%. (9:60)

The Islamic world view of economics are based on these key principles –

 vice regent (trustees) of all that is Allah

 prohibition of riba – charging of interest
 prohibition of gharar - gambling and taking of undue risk
 giving of Zakat – a moral tax

and some other key related Shari'ah principles -

 ‘Al-‘adl wa'l-ihsan- ensuring balance and beneficence of the socio

economic structure through an appropriate process of jurisprudence
 Ikhtiyar– exercising the ‘free-will' within specific societal contexts, and
to suit the needs of changing times
 Fard- the issue of responsibility …..over the assets of which one is vice–
regents/ trustees, in the interest of social / public good
 Rububiyyah- fundamental law of the universe, the useful development of
resources and their mutual support and sharing.

One can over simplify and summaries that Islamic economics attempts to create
a ‘moral / ethical' economy for the good of all. It is a free market economy; but
this state of ‘free enterprise' is managed by

(1) restrictions – matters that are prohibited – haram, and

(2) obligations that Muslims have and are required to bring about themselves
through the practice of the various principles of Islam / Shari'ah law, without
unduly curbing individual freedom and creativity or creating an imbalance in
the macroeconomic and ecological environment.

Thus the Islamic concept of economics and economic growth and development
follows from its concept of tazkiyah” as it addresses itself to the problem of
economic aspect of human life “in all its dimensions”; tazkiyah is “concerned
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with growth towards perfection through purification of attitudes and

relationships. The result of tazkiyah is falah, prosperity in this world and the
hereafter” (Ahmad, 1994: 20).
 
Human Being are God's Viceregent on Earth
Humankind is viewed in Genesis 1:26-28 as having a governing role. In v. 27
humankind is created in the image of God. (cf. H. W. Wolff, Anthropology of
the Old Testament, 159-64). Human beings have a role of rulership, but they
rule only as a re-presentation of God.
 
Bernard Anderson, a veteran scholar of the Hebrew Bible, reinforces this
understanding that the humanity which is to fill the earth is also a viceregent of
God (in Biblical Studies in Contemporary Thought, ed. M. Ward [1975] and
more popularly and directly in Bible Review 8, 5 [1992]).
 
A principle of Islam is that everything belongs to God, and wealth is held by
people in trust. Muslims also have a responsibility to care for the less fortunate.
To Muslims The Qur'an is also a way of life dealing with issues that emphasis
socio-economic justice. It emphasises the concepts of trusteeship of human
beings as God's vicegerent on earth, care for others, moderation in consumption,
productive effort as a means of serving God, charitable assistance, maintenance
of family, duty to produce more than one's needs, wealth not as a means of end
and many others.
 
Prohibition of Interest

"The most hated sort (of wealth getting) and with the greatest reason, is usury,
which makes a gain out of money itself and not from the natural object of it. For
money was intended to be used in exchange but not to increase at interest. And
this term interest (tokos), which means the birth of money from money is
applied to the breeding of money because the offspring resembles the parent.
Wherefore of all modes of getting wealth, this is the most unnatural."
(1258b, POLITICS, Aristotle 84-322 BC))

Charging interest is detestable to God and man, damned by the sacred canons
and contrary to Christian charity." (POPE SIXTUS V)
 
Charging and paying interest is also forbidden in the Qur'an in the strictest
terms. This prohibition is based on arguments of social justice, equality, and
property rights. Islam encourages the earning of profits but forbids the charging
of interest because profits, determined after the event, symbolize successful
entrepreneurship and creation of additional wealth whereas interest, determined
before the event, is a cost that is accrued irrespective of the outcome of business
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operations and may not create wealth if there are business losses. Social justice
demands that borrowers and lenders share rewards as well as losses in an
equitable fashion and that the process of wealth accumulation and distribution
in the economy be fair and representative of true productivity.
 
The essential problem with interest is that interest divorces the lender from any
moral responsibility for the use of money lent. The return is guaranteed no
matter what the changed circumstances of the borrower are. The possession of
money does not of itself cause any increase. It is only when the money is put to
some use that it can yield a profit. By divorcing the lender from any
responsibility over the use of the money what is introduced is a problem called a
moral hazard. The lender does not have to care where the money is lent so long
as the returns are guaranteed which may be at the expense of the borrower and
without taking into account genuine reasons for default. Often, the real
profitability of the use of the borrowed money is hidden from the financial
system.

The general consensus among Islamic scholars is that riba covers not only usury
but also the charging of "interest" as widely practiced. It is for that reason that
conventional mortgages are not acceptable to many Muslims as the payment of
interest conflicts with their ethical and religious principles. Islamic Finance has
therefore provided a means for many people to purchase their own home in
accordance with their beliefs, which was previously not available to them.
 
Gharar (Risk or Uncertainity) also Maysir (Gambling)
Gharar refers to a risky or hazardous sale, where details concerning the sale
item are unknown or uncertain. This may be because the transaction involves
pure speculation, thus is a form of gambling and the outcome and future benefit
are uncertain and unknown.

Gharar is forbidden by the Qur'an, which explicitly forbids trades that are
considered to have excessive risk due to uncertainty.
 
There are strict rules in Islamic finance against transactions that are highly
uncertain or may cause any injustice or deceit against any of the parties. In
finance, gharar is observed within derivative transactions, such as forwards,
futures and options, in short selling, and in speculation. In Islamic finance, most
derivative contracts are forbidden and considered invalid because of the
uncertainty involved in the future delivery of the underlying asset. Gharar is
also observed in insurance.
 
Zakat, Zakah
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"Of their wealth take alms, that so thou mightest purify and sanctify them; …."
[The Qur'an 9:103]

The word “zakah” comes from the verb meaning to purify or cleanse. The literal
meaning of Zakat is grow (in goodness) or 'increase', 'purifying' or 'making
pure'. The act of giving zakat means purifying one's wealth to gain God's
blessing to make it grow in goodness. Human being's possessions are purified
by setting aside a proportion for those in need, and, like the pruning of plants,
encourages new growth.

One of the most important principles of Islam is that everything on earth belong
to God, and held by human beings in trust, including all possessions and wealth.
Zakat is a certain portion of one's wealth that all Muslims who are financially
able must give as a welfare contribution for the poor and needy, including
widows and orphans, irrespective of their colour, ethnicity or religion or other
specified charitable causes in the service of God. The Qur'an equates failure to
meet the needs of the poor and orphans, which Zakat represents, to denial of
religion.

The Qur'an (9:60) classifies the due recipients of zakat under the following eight
categories.
"Alms are for the poor, and the needy, and those
who employed to administer (the funds); for those
whose hearts have been (recently) reconciled
(to Truth);for those in bondage and in debt;
in the cause of Allah; and for the wayfarers: … ."
 
Zakat's similar sounding, Arabic language analog is the Hebrew word
Tzedakah, the charitable obligation in ancient Israel through to present day
Judaism. During the Islamic period, Zakat was collected by the State who had
the duty not just to collect Zakat, but to distribute it fairly as well.
  
Contracts between Parties

Compliance with Islamic principles is the basis of all contracts between parties
performing some specified act in exchange for a lawful consideration, and the
most important building block for an Islamic financial and economic system.
Most of the financial products, services and instruments are based on such
contract. Therefore a thorough understanding is required of the Shari'ah-
acceptable contracts in their multifarious and varied forms that could be used to
design and develop Shari'ah-based financial products and to provide Shari'ah-
compliant financial solutions.
 16

Musharakah, mudarabah, murabahaand ijarah contract types form the basis of

a variety of Shari'ah compliant alternatives to conventional interest-based
financing solutions. The basic premise of Islamic finance lies in the need to
eliminate both interest (Riba) and uncertainty (Gharar) in all business and
financial transactions.
 
In brief, the following are key types of Islamic contracts applied today.

Mudarabahand Musharakah – both are contracts of partnership. Islamic

scholars have preferred mudarabah and musharakah as the ideal forms of
permissible contract that comply with the rules and objectives of the Shari'ah.
The basic reasoning is that these contracts pool resources and expertise as well
as spread the inherent risk in a project among the various parties involved.

Murabaha– a term often referred to as ‘cost-plus financing' and in its simplest

form, this contract involves the sale of goods on a deferred basis. The goods are
delivered immediately and the price to be paid for the item includes a mutually
agreed margin of profit payable to the seller. In this contract, the Shari'ah
requires a financier to first procure the goods and then sell it on to the actual
buyer at a mutually agreed mark-up as the financier's profit, and in that process
the financier must also disclose to the buyer the market cost price (true cost) of
the goods procured. The amount of profit earned (the mark-up on the true cost)
in this transaction is not a reward for the use of the financier's money as the
financier cannot receive the marked-up profit if the financier fails to perform the
required service, such as delivery of goods purchased with the financing..

Ijarah– a term used for a leasing contract in Islamic law where a specified asset
required by a party may be purchased by a financier and then leased by the
financier to the party for an agreed rental and for an agreed period. The way
lease rentals are calculated and the fact that the leased asset continues to be
owned by the financier throughout the lease period, the rentals is not equated
with receiving interest. The Ijara contract can be designed to allow return of the
leased asset to the party at the end of the leased period. However, if the party
may wish to acquire the leased asset at the end of the leased period, the party
would have to have a separate agreement for this purpose before entering into
the ijarah contract; in terms of the Shari'ah rules, such agreement cannot be
binding on the parties.
 
WAQF – An institution for Socio-economic Welfare

Waqf - (plural: awqaf), refers to the gift of money, property or other items to
charity. It is an endowment by a Muslim or assignment of revenues for religious
 17

or charitable purposes in a form of trust, meaning that the revenues may not be
shifted to another purpose.

A waqf in pre-commercial society would ordinarily be arable land, farms or

oases. In theory the waqf is absolutely permanent, and once established, the
contract cannot be altered or the property sold or alienated. The revenues from
the waqf may finance mosques, religious and other institutions or charities.
Waqf continue even after the donor's death - for as long as people continue to
benefit from the Waqf.

The basic rules governing waqf trusts are laid down in the Shari'ah, but
interpretation and implementation may vary in different Muslim societies.
 
After the Islamic waqf law and school foundations were firmly established by
the 10th century, the number of hospitals multiplied throughout Islamic lands.
In the 11th century, every Islamic city had at least several hospitals. The waqf
trust institutions funded the hospitals for various expenses, including the wages
of doctors, ophthalmologists, surgeons, chemists, pharmacists, domestics and all
other staff, the purchase of foods and medicines; hospital equipment such as
beds, mattresses, bowls and perfumes; and repairs to buildings. The waqf trusts
also funded medical schools, and their revenues covered various expenses such
as their maintenance and the payment of teachers and students.

The waqf in Islamic law, which developed in the medieval Islamic world from
the 7th to 9th centuries, bears a notable resemblance to the English trust law.
Every waqf was required to have a waqif (founder), mutawillis (trustee), qadi
(judge) and beneficiaries. Under both a waqf and a trust, "property is reserved,
and its usufruct appropriated, for the benefit of specific individuals, or for a
general charitable purpose; the corpus becomes inalienable; estates for life in
favor of successive beneficiaries can be created" and "without regard to the law
of inheritance or the rights of the heirs; and continuity is secured by the
successive appointment of trustees or mutawillis." [Wikpedia]
 
The only significant distinction between the Islamic waqf and English trust is
"the express or implied reversion of the waqf to charitable purposes when its
specific object has ceased to exist", though this difference only applied to the
waqf ahli (Islamic family trust) rather than the waqf khairi (devoted to a
charitable purpose from its inception). Another difference was the English
vesting of "legal estate" over the trust property in the trustee, though the "trustee
was still bound to administer that property for the benefit of the beneficiaries."
In this sense, the "role of the English trustee therefore does not differ
significantly from that of the mutawalli." [Wikpedia]
 
 18

SHARI’AH FUNDAMENTALS OF AN ISLAMIC ECONOMIC ORDER

“Some Sharia Fudamentals of an Islamic Economic Model” by Noureddine

Kirchene and Abbas Mirakhor presented at the seminar held on 30 January 2009
on ‘Comparative Development of the Islamic Economic Model in context of
current market conditions’, organised by KPMG, London, UK.

Introduction
An Islamic economic model embraces science and draws on economic theory,
except in areas prohibited in Islam (e.g., interest rates, gambling, violation of
property rights, etc.). It has, however, features that confer to it dimensions that
do not appear in standard economic theory. More specifically, an Islamic
economic model is based on principles that recognize: the full supremacy of
Allah; the view that man is not only a material object, but is, in essence, a
spiritual being; that all comes from Allah and goes back to Allah [The concept
of “mother nature” does not exist in an Islamic economic model. It is replaced
by a deterministic and ever ubiquitous presence of Allah SWT, a presence of
which a Muslim is consciously and constantly aware and acts accordingly.
Hamid, Iqbal, and Mirakhor, 2008, reviewed most of conventional economic
development models and demonstrated their serious shortcomings. Because of
its divine nature, an Islamic economic model is immune to shortcomings of
conventional models, and offers a better framework for economic development
and social justice than any other conventional model] ; that man was favored by
Allah above all other creatures with the power of intelligence; and consequently
is accountable for his/her actions; and that the act of worship is inseparable
from the economic life. The faith precepts underlying an Islamic economic
model can be stated as following: 1.The belief that there is no God, except
Allah, and that Mohammed, PUH, is His Messenger, which means total
submission to Allah and to His Messenger, believing in all previous
Messengers, embracing, and acting accordingly, all Allah’s commandments and
teachings with full conviction and without doubt or questioning.

2. The goal of creation is to worship Allah alone, as clearly stated in Surat 51,
verse 56: I have created Jinns and men except that they should worship Me
Alone. No sustenance do I require of them, nor do I require that they should
feed Me. Verily Allah is the All Provider, Owner of Power, the Most Strong.

3. To fulfill this goal of worship, Allah has created resources so that man can
fulfill the worship obligation, as clearly stated in many verses: 45; 12: It is
Allah who has subjected the sea to you, that ships my sail through it by His
command, that you may seek of His bounty, and that you may be grateful. And
He has subjected to you, as from Him, all that is in the Heavens and on Earth:
 19

behold, in that are signs indeed for those who reflect. 35; 3: O men! Call to
mind the Grace of Allah unto you! Is there a Creator, other than Allah, to
provide sustenance from Heaven and Earth? There is no God but He: How then
are you deluded away from truth? 41;9: Say: Is it that you deny Him Who
created the Earth in two Days? And do you join equals with Him? He is the
Lord of all the Worlds. He set on the Earth mountains standing firm, high above
it, and bestowed blessings on the Earth, and measured therein its sustenance in
due proportion in four days in accordance with the needs of those who seek
sustenance. 15;21: And there is not a thing but its sources and treasures
(inexhaustible) are with Us; but we only send down thereof in due and
ascertainable measures.

4. Those who submit to Allah should accept Islamic legislation in its integral
whole, without selecting some principles and abandoning. Allah SWT has stated
in 6; 38: We have neglected nothing in the Book. In 45; 17, Allah says: We
have put you on a Sharia path. So follow it and follow not the desires of those
do not know.

5. Believe in what Allah has ordered is the best as clearly stated in 5; 3: This
day, I have perfected your religion for you, completed my favor on you, and
have chosen for you Islam as your religion; and that disobeying Allah will result
in failure either in this life or in the life after, as mentioned in14;28: Have you
not seen those who have changed the Blessings of Allah into disbelief and
caused their people to dwell in the house of destruction?

Allah did not make the results of disobedience a surprise. He clearly warned
Adam (20;117) that these results will be hunger, nakedness, thirst, and misery.
Such indeed remains the plight of millions of people around the world who
continue to suffer abject poverty and malnutrition. Quran and Sunnah have fully
covered all aspects of economic, political (Shura, i.e., consultation) and social
legislation and have set forth all principles that should organize economic,
political and social life. Allah has called on mankind to embrace all Islamic
laws, and not to choose some and ignore others.

Following their access to independence many Muslim countries chose a

Leninist-Marxist model and lost out on decades of economic development. In
spite of long periods of economic planning, many Muslim countries continue to
suffer high unemployment rates exceeding 20 percent of the labor force, which
creates a drag on their economic growth. Abject poverty is spreading in many
countries, particularly in African and some Asian Muslim countries. Only
immigration to developed countries provides a relief out of unemployment and
poverty. Although the Muslim world owns 80 percent of world oil reserves and
60 percent of gas reserves, very rich lands, it suffers wide disparities and
 20

economic disintegration. While many countries enjoy large external surplus,

almost solely from oil and natural gas exports, other countries suffer large
external deficits and unsustainable external debt.

In the post war period, the technological gap between Muslim and industrial
countries has grown very large. While industrial countries made large strides in
technical progress in all fields of activity, inventing new technologies, such as
in the fields of computer sciences, internet, medicine, satellite
telecommunications, aerospace, ships, automobiles, photocopying, medical
equipments, and pharmaceuticals, no such progress was made in the Muslim
World. The trade pattern that has emerged out of this deepening technological
gap shows a growing trade gap and total dependence, through borrowing, on
industrial countries for filling food deficits and importing industrial products. In
particular, industrial countries are self sufficient in food products and want to
import only raw materials in which they are deficient. Muslim countries are
deficient in food products and want to import industrial products [Food riots
have erupted in 2008 in many Muslim countries. Malnutrition and acute food
deficiencies are aggravating in many Muslim countries]. Exports of raw
materials do not cover fully imports of food and industrial products. The gap is
filled through continuous borrowing and therefore higher external debt and
dependence.

Based on tangible experience over many decades, the cost of conventional

development models has been high while achievements were meager. Prospects
for achieving a balanced and autonomous economic growth, and overcoming
unemployment and spreading poverty are not encouraging even in the so-called
middle income countries. An Islamic economic model is a promising alternative
and offers significantly better prospects for a sustained balanced economic
growth, overcoming the unemployment problem, narrowing poverty, and
reducing dependence on external financing. The promise for successful results
are explicitly and repeatedly made by Allah and His Prophet PUH.

This paper discusses some Sharia fundamentals of an Islamic economic model

[Many of the Islamic Sharia rules have been extensively discussed in Hamid,
Iqbal, and Mirakhor, 2008]. Section II addresses a most distinguishing aspect of
an Islamic economic model, which is zakat. Contrary to all other economic
system, an Islamic economic system has built in a perfect safety net against
poverty and social inequities. Zakat is a prerequisite for abolishing interest. By
fully establishing zakat, an Islamic economic model could easily eradicate
poverty and achieve higher economic growth and employment.

Section III addresses public finance in an Islamic economic model. The main
principle that has governed Islamic finance was fiscal discipline, trust,
 21

efficiency in public expenditure, and avoidance of waste. Many types of

spending that do not benefit the social welfare should not be allowed. The
primary spending under the Prophet PUH and the succeeding Khalifs was for
social coverage. Wasteful spending on overpaying civil service or subsidies that
are not targeted (e.g. fuel subsidies that generally benefit the rich) should not be
acceptable. An Islamic tax system cannot be simply a transposition of a
conventional tax system. The principle of taxation should obey strict criteria of
social solidarity, social welfare, and public interest. Users’ fees help social
equity; the government is encouraged to levy charges for the use of public
infrastructure, such as ports, airports, and freeways. The government is entitled
to royalties from mineral resources. While the state cannot establish obligations
on income and wealth, beyond those stipulated by zakat, it may nonetheless
resort to moderate taxation subject to the criteria of public interest, such as
defense and internal security, or for the construction and maintenance of public
infrastructure that is being used by all firms in conducting their economic
activities.

A main principle of Islamic public finance is for the government to run a

surplus on the current fiscal balance that will help finance capital expenditure
[This is to alleviate the scarcity of capital and reduce its marginal efficiency to
mitigate one reason for emergence of a rentier class that earns a living off
loaning money to entrepreneurs to finance capital investment]. In case of deficit
on the current fiscal account, the government should forcefully tailor its current
spending in line with ability to raise revenues with a view to generate a current
fiscal surplus. The financing of the fiscal deficit should obey Islamic principles.
More specifically, the government should not contract interest-bearing debt. It
can only contract non-interest bearing debt. Inflationary financing of the deficit
is not acceptable as it distorts prices, extracts large tax on fixed income groups
(pensioners, wage earners), absorbs savings, destabilizes the financial system,
encourages speculation, and decelerates economic growth.

Section IV discusses the nature of Islamic finance in mobilizing savings and

promoting investment. An Islamic financial system avoids interest and interest-
based assets [Hassan and Lewis (2007) offered a comprehensive description of
Islamic modes of financing which are based on profit and loss sharing
investment, types of risks in Islamic banking, and financial innovations,
including access to capital markets and securitization, introduced by Islamic
banks],and thus restricts speculation [Speculation may create a disconnect
between the market price of an asset (e.g., common stock, house, etc.), or a
commodity, and its true economic value or fundamentals. For instance, the
construction cost of a house may decrease, due to productivity gains and lower
wages; however, because of speculation, its market price may increase two,
three, or fourfold]. Mirakhor (1988) showed that an Islamic financial system
 22

can be modeled as non-speculative equity ownership model that is intimately

linked to the real sector and where demand for new shares is determined by real
savings in the economy. All causes of financial instability inherent to a
conventional financial system, namely money creation out of thin air,
speculation, and interest-based financial assets are absent in Islamic finance.
Banks own directly real assets and operate like an equity holding system.
Savings is redeployed into productive investment with no ex-nihilo money
creation. Mirakhor (1988) showed that the rate of return on equities is
determined in a growth model by the marginal efficiency of capital and time
preference and is significantly positive in a growing economy, implying that an
Islamic banking is always profitable provided that real economic growth is
positive. Mirakhor (1988) finding establishes a basic difference between Islamic
banking where profitability is fully secured by real economic growth and
conventional banking where profitability is not driven primarily by the real
sector [Conventional banks may suffer large losses, as seen recently in many
industrial countries, in spite of continuing real economic growth]. An Islamic
banking system has two types of banking activity. A deposit banking for
safekeeping and payment purposes. This system operates on 100 percent reserve
requirement, and fees may be collected for this type of banking services. An
investment banking system which operates on risk and profit sharing basis with
an overall rate of return which is positive and determined by the economy
growth rate. The paper shows that Islamic banks do not create and destroy
money; consequently, the money multiplier, defined by the savings rate in the
economy as suggested by Mirakhor (1988), is much lower in an Islamic system
compared to a conventional system, providing thus a basis for strong financial
stability, greater price stability, and a sustained economic growth [This inherent
instability of conventional banking has led famous economists (Irving Fisher
(1936), Henry Simons (1948), Maurice Allais (1999), and many others) to
formulate monetary reform proposals that share basic features of Islamic
banking. These proposals are known as the Chicago Plan; they call for
dissociating banking into two independent activities: (i) 100 percent reserve
deposit banks; and (ii) investment banks that redeploy savings into investment
through selling securities].

Section V discusses labor markets in an Islamic economic model. A main

purpose of an Islamic economic model is to eliminate distortions in labor
markets with a view to maximize employment and promote exports. It aims at
establishing perfect wage flexibility capable of equilibrating labor markets. In
spite of many decades of economic development, the rate of unemployment,
which was very low at the natural rate prior to development planning, has
reached by 2008 disturbing levels in most of Muslim countries, averaging 15
percent in middle income countries, and above 25 percent in low income
 23

countries, particularly in sub-Saharan African countries, and is expected to

worsen in the period ahead. The paper argues that applying an Islamic economic
model will help establish a balanced economic growth path, increase
employment, and reduce poverty.Section VI discusses private sector
development and asset and product markets in an Islamic economic model.
Private property and private sector initiative have been essential components of
an Islamic economy. Asset and product markets have to operate freely without
price fixation or impediments to entry and competition. Exchange rates have to
be market-determined. Price distortions and monopolistic or oligolopolistic
competition could constrain economic growth and impose a social welfare cost.
 
Section VII addresses economic development planning and human development
in an Islamic model. Long-term planning and defining national development
priorities are important elements of an Islamic economic model. A Muslim
economy has to have long-term plans for economic and social infrastructure,
human development, and setting national priorities in terms of food security,
energy balance, and high employment. The financing of development projects
should be through non interest modes. It could also be through public private
partnership.
 
Section VIII addresses Islamic jurisprudence as a legal and regulatory
framework for an Islamic economic model. Islamic jurisprudence purports to
establish a safe and free of crime environment that enables economic prosperity,
reinforces contracts, and forbids all form of injustice and aggression. It is
incumbent on the state to apply Quran and Sunnah laws regarding insuring
social safety and providing an enabling environment for enterprise, investment,
and economic growth [Hamid, Iqbal, and Mirakhor showed that modeling an
Islamic economy is fundamentally different from the conventional economic
model. Conventional economics has developed theories and propositions
regarding the behavior of economic agents to deduce economic laws. An
Islamic model building is how to get the Muslim behavior to converge on that
ordained by the our Supreme Creator. agents to, in their view, deduce laws].
Section IX concludes that an Islamic economic model, thanks to its free-of-
interest and stable financial system, balanced fiscal policy, redistributive
aspects, and free competition offers a robust macroeconomic framework
conducive to sustained growth and full employment. The development cost of a
conventional model has been overburdening; however, economic and social
achievements were mediocre.

Zakat, a mandatory redistributive element of an Islamic economic model

Zakat is the most distinguishing feature of an Islamic economic model which
makes it far superior to the rest of economic systems. Zakat is a prerequisite for
abolishing interest. In Quran and Sunnah, Islamic finance has always been
 24

conceived as the finance activity of an Islamic economy where social equity is

enhanced through mandatory zakat. In Quran, the verses that deal with interest
(riba) have always been preceded or followed by verses that prescribe zakat.
Hence, when social equity is secured through zakat, motives on the side of
lenders to practice interest and dire needs of the poor to accept interest will
disappear. In such an economy, Islamic finance will be essentially guided
toward investment and wealth creation and much less toward consumption. An
Islamic economic model cannot be established without full discharge of the
zakat [The topic of zakat has been extensively discussed in Hamid, Iqbal, and
Mirakhor (2008). They demonstrated its role in promoting economic
development and achieving social balance with no extravagance or degrading
poverty. Seyed Kotb (1954) discussed thoroughly the role of zakat in achieving
social justice and mitigating skewed income distribution]. Zakat is the third
pillar of Islam. Those who deny it are considered non Muslims. Allah has
admonished those who deny zakat: 41;6: And woe to Al-Mushrikeen (the
polytheists, idolaters, disbelievers in the Oneness of Allah. Those who practice
not Zakat and they are disbelievers in the Hereafter.

Our Prophet warned against withholding zakat. Refusal to pay zakat will cause
economic losses as is explicated in many parts of Quran. Zakat is not a favor of
the rich on the poor; it is a right of the poor in the wealth of the rich.

Zakat is defined by fixed ratios to savings, gold, silver, crops [Vegetables and
perishable fruits are not subject to zakat], livestock [Horses, mules, and donkeys
are not subject to zakat], inventories, rent income, and real estate wealth. Zakat
is essentially destined to eight categories of eligible recipients, as specified in 9;
60: Alms are for the poor and the needy, and those employed to administer the
funds, for those whose hearts have been recently reconciled to truth, for those in
bondage of dent, and for the wayfarer; thus is it ordained by Allah, and Allah is
full of knowledge and wisdom.

Historical experience established that if zakat and khumus are fully paid,
poverty will completely disappear in the Muslim world for essentially two
reasons. First, Allah will multiply wealth when zakat is paid. Second, Zakat is
fairly sufficient to satisfy the needs of the poor and the needy. Unfortunately,
throughout Muslim world, only a small fraction of zakat is actually paid.

Besides obligatory zakat, Infaq (i.e., spending in the way of Allah) has been
highly praised by Allah and His Messenger (PUH). Infaq is purely voluntary.
The Prophet PUH and His companions had set most generous example in Infaq,
sparing no wealth in favor of the needy [Infaq is not charity; it is the redemption
of the property rights of the poor (beyond zakat) in the wealth of the rich. The
praise of Infaq is because the rich recognizes the duties Allah has imposed on
 25

them]. However, the Prophet PUH has discouraged excessive charity that may
deprive the family of the donor from decent living.

Public finance in an Islamic Economic Model

The concept of the state and central power is fully embedded in an Islamic
economic model. The state has the responsibility for defense, maintaining order,
redistributing income in favor of the poor, establishing justice, providing public
services, and investing in economic development. The notion of a modern state
has emerged under the Prophet PUH and the Khalifs who succeeded him. The
State’s Treasury was established under the Prophet PUH under the name of Beit
Mal AlMuslimeen. The concept of public finance has been a fundamental aspect
of an Islamic economic model. The main principles that have governed Islamic
finance were fiscal discipline, trust, and efficiency in public expenditure: as
clearly stated in many verses of Quran: 25; 67: And those who, when they
spend, are neither extravagant nor niggardly, but hold a medium (way) between
those extremes. 17;27: Verily, the spendthrifts are brothers of the Satan, and the
Satan is ever ungrateful to his Lord. 6; 141: And waste not by extravagance.
Verily, He likes not those who waste by extravagance.

Spending of public resources has to obey Islamic criteria that enhance social
welfare and economic growth. Rulers and civil servants are entitled a
compensation, however, in due proportion and not in excess of the government
fiscal balance. Many types of spending should not be allowed, such as spending
on personal security to preserve absolute power, and activities that do not
benefit the social welfare. The primary spending under the Prophet PUH and the
succeeding Khalifs was for social coverage. Later, with higher revenues,
spending was extended to infrastructure, namely water, schools, and
construction of cities. Spending in favor of the poor and handicapped should be
maintained in due proportion as a fundamental aspect of Islamic public finance.
Wasteful spending on subsidies, such as fuel subsidies, should not be
acceptable. In many Muslim countries, the civil service and army are paid
wages beyond acceptable ratios in relation to government revenues, while high
rates of unemployment are prevailing in these countries. In many of these
countries, the government borrows either from foreign or domestic sources to
pay for salaries, which aggravates the internal and external imbalances. Capital
spending should also obey strict criteria of enhancing social welfare and
economic growth. Spending money on stadiums, theaters, monuments, and
rulers’ mansions is not acceptable. Capital spending should aim at building an
economic and social infrastructure.

Government revenues in the early era of Islam had been essentially zakat,
khumus (one fifth of gains bestowed by Allah, including discovery of mineral
 26

resources), and voluntary contributions (Infaq). Some form of taxation was

strictly forbidden by the Prophet PUH. It was called “Max” a form of fee paid to
public authority before allowing merchandise access to the market place.
Certainly, an Islamic tax system cannot be simply a transposition of a
conventional tax system. Certain taxes such as heritage tax may not be allowed
in an Islamic tax system. The principle of taxation should obey strict criteria of
social solidarity, social welfare, and public interest. Property and municipal
taxes may become mandatory for the public good of safeguarding the
environment, and public health to the extent that these taxes enable to provide
sanitation, garbage disposal services, and cleaner streets. Quran and Sunnah
urge Muslims to enhance social solidarity and spend for the public good. Users’
fees help social equity; the government is encouraged to levy charges for the
use of public infrastructure, such as ports, airports, and freeways. The
government is entitled to royalties from mineral resources. While the state
cannot establish obligations on income and wealth, beyond those stipulated by
zakat, it may nonetheless resort to moderate taxation subject to the criteria of
public interest, such as defense and internal security, or for the construction and
maintenance of public infrastructure that is being used by all firms in
conducting their economic activities. Levying taxes simply for overpaying
rulers and public servants, army, and for waste and inefficient expenditure is not
acceptable in an Islam economic model.

A main principle of Islamic public finance is for the government to run a

surplus on the current fiscal balance that will help finance capital expenditure.
In case of deficit on the current fiscal account, the government should forcefully
tailor its current spending in line with revenues with a view to generate a current
fiscal surplus. The financing of the fiscal deficit should obey Islamic principles.
More specifically, the government should not contract interest-bearing debt. It
can only contract non-interest bearing debt. The government may earn
seignorage, through mint or money injection; however, such money financing
has to be strictly consonant with a fixed rule regarding the growth of money
supply. Inflationary financing of the deficit is not acceptable as it distorts prices,
extracts large tax on fixed income groups (pensioners, wage earners), absorbs
savings and decelerates economic growth.

Banking and financial intermediation in an Islamic economic model

Islamic finance is fully developed in Quran and Sunnah. In Quran and Sunnah,
Islamic finance has always been conceived as the finance activity of an Islamic
economy where social equity is enhanced through mandatory zakat. In Quran,
the verses that deal with interest (riba) have always been preceded or followed
by verses that prescribe zakat. Hence, when social equity is secured through
zakat, motives on the side of lenders to practice interest and dire needs of the
poor to accept interest will disappear. In such an economy, Islamic finance will
 27

be essentially guided toward investment and wealth creation and much less
toward consumption. While it prohibits interest, Islamic finance supports trade,
capital accumulation (investment), and production. The notion of capital is
explicit in Quran. There are the notions of productive capital, working capital,
and money capital. Classical growth theory recognized that economic growth
depended on capital accumulation. The relationship between economic growth
and capital accumulation can be easily stated via Harrod-Domar Model

Where is the rate real GDP growth, is the rate of savings (investment), and is
the incremental capital output rate. According to this formulation, the higher the
rate of savings and therefore investment, and the higher the productivity of
capital, the higher will be economic growth.

Financial intermediation plays a fundamental role in mobilizing savings and

channeling it to investment. Such financial intermediation has made it possible
to increase investment and to enable industrial countries to reach the stage of
mass production and grow at sustained rates.

Financial intermediation is a fundamental aspect of an Islamic economic model.

It will enable to mobilize large volumes of savings and channel them to
productive investment. Without financial intermediation, mobilized savings and
investment will be very small, and therefore economic growth will be slow.

Mirakhor (1988) defined an Islamic financial system as one in which there are
no risk-free assets and where all financial arrangements are based on risk and
profit and loss sharing. Hence all financial assets are contingent claims and
there are no debt instruments with fixed or floating interest rates. Modeling the
financial system as non speculative equity shares, he showed that the rate of
return to financial assets is primarily determined by the return to real sector, and
therefore in a growing economy, Islamic banks will always experience net
positive returns [Henry Simons’ views set forth in his Economic Policy for a
Free Society and influenced by the Great Depression of the 1930s were closest
to an Islamic banking system. His policy recommendations, known as the
Chicago Plan, called for a separation of the banking system into warehousing
with a 100 percent currency reserve against bank deposit and investment banks
whose liabilities will be in form of equity shares. His reform plan aimed at a
vigorous effort to stamp out elasticity of credit in the financial system. This
would involve restrictions on open-book credit and installment loans, as well as
limitation of government debt to non-interest-bearing money and to very long-
term debt (consol). He advocated a system in which all financial wealth would
be held in equity form, with no fixed money contracts, so that no bank
institution could create money substitutes].
 28

Financial intermediation in Islam is different from that in a conventional

system. More specifically, commercial banking under an Islamic system is
generically different from conventional commercial banking. Banks do not
contract interest bearing loans and do not create and destroy money. They
participate directly in production and trade operations on a profit-loss sharing
basis. Banks do not act as simple lenders; they have to be directly involved in
trade and investment operations, and assume direct ownership of real assets.
Deposits at an Islamic financial institution could be seen as shares or equities
and, unless insured, are subject to risks [Typical Islamic products are
Mudarabah, Musharaka, Murabaha, Istisnaa, and Ijara (See Hassan and Lewis
2007 for detailed definitions)]. They can earn a profit and face losses (Iqbal and
Mirakhor, 2007).

There is no credit creation out of thin air. Under conventional banking, deposits
at one bank can be instantaneously loaned out or used to purchase a financial
asset and become reserves and a basis for a new loan at a second bank, thus
contributing to purchasing power creation and inflation of prices of goods and
assets; such step does not exist in Islamic banking. Deposits have to be re-
invested directly by the bank in trade and production activities and create new
flows of goods and services. New money flows arise from the proceeds of sales
of goods and services. Money is not issued by the stroke of the pen,
independently of the production of goods and services. Investment is equal to
savings, and aggregate supply of goods and services is always equal to
aggregate demand.

There can be no bank run or speculation, as the source of credit for speculation,
which is credit multiplication, does not exist. The liabilities of the financial
institution are covered by tangible real assets that are owned directly by the
institution. They are not covered by financial assets. Risks for Islamic financial
institutions are mitigated as they relate essentially to returns from investment
operations and not to the capital of these institutions (Khan, 1987).

In such system, the central bank has the sole monopoly for creating money.
Interest rate cannot be used as a policy instrument. The central bank does not
refinance banks as in conventional banking. It does not buy or sell financial
assets to banks. The central bank has to apply quantitative ceiling on money
aggregates. Such policy has been effective in maintaining financial stability and
precluding speculative booms and inflation even in the conventional system.
Money injection occurs through central bank buying foreign exchange, gold, or
non-interest bearing government debt, possibly indexed on gold, a commodities
basket, or a portfolio of real assets created by the government (See Choudhry
and Mirakhor (1997) and Haque and Mirakhor (1999)).
 29

1. Nature of Islamic Banking

Conceivably, an Islamic banking system may have two types of banking

activities [Simons (1948) and Allais (1999) proposed a similar system
composed of two types of banking: a 100 percent reserve system for
safekeeping, and an investment banking system]: safekeeping and payments
activity as in pre-Islam and early Islam period and also as in goldsmith houses.
This type of activity is similar to 100 percent reserve system, with deposits
remaining highly liquid and checking services fully available. This system has
to be a fee-based system to cover the cost of safekeeping and transfers and
payments services.
The second activity is an investment activity whereby deposits are considered as
longer-term savings and banks engage directly in risk taking in trade, leasing,
and productive investment in agriculture, industry, and services. Most important
characteristic of this activity is that it is immune to un-backed expansion of
credit. An Islamic bank is assumed to match deposits maturities with investment
maturities. Short-term deposits may finance short-term trade operations, with
the bank purchasing merchandise or raw materials and selling to other
companies; liquidity is replenished as proceeds from sales operations are
generated. For longer-term investment, longer-term deposits are used. Liquidity
is replenished as amortization funds become available. In all these investments,
an Islamic bank is a direct owner of the investment process which is awarded
through a due diligence process. In such a system, a financial institution
therefore participates directly in the evaluation, management and monitoring of
the investment process [Criticism was made that operational cost is higher than
in conventional banking because of close monitoring and involvement in the
investment process. This criticism has not been substantiated with data.
Moreover, gains from stability and minimization of credit and market risks can
largely offset presumed higher operation costs. Think of the cost of large
bailouts and bank failures caused by recent financial crisis; these costs can be
compounded by other economic and financial costs arising from inflation and
economic slowdown]. Returns to invested funds arise ex-post from the profits or
losses of the operation, and distributed to depositors as if they were
shareholders of equity capital.

2. Balance sheet of an Islamic bank, investment activity

Let a deposit of $100 be made at an Islamic bank. This deposit is by definition

savings; it is subject to certain maturity condition and cannot be drawn on sight.
As mentioned above, safekeeping and payments functions of banks can be
easily conceived; however, fees may have to be paid for this banking service.
Upon deposits, the balance sheet looks as follows
 30

Exhibit 1: Simple Illustration of Islamic banking

Balance Sheet of an Islamic Bank, investment activity: step 1: deposit

Assets Liabilities
Reserves = 100 Deposits (savings) =100
Total =100 Total =100

Balance Sheet of an Islamic Bank, investment activity: step 2: investment

Assets Liabilities
Merchandise (gold, wheat, Deposits (savings) =100
oil, fertilizers, etc) and
working capital = 100
Total =100 Total =100

Balance Sheet of an Islamic Bank, investment activity: step 3: closing of the

operation
Assets Liabilities
Reserves = 110 Deposits (savings) =100

Profits = 10
Total =110 Total =110

Contrary to conventional banking, an Islamic bank is prohibited from making a

loan at fixed or floating interest rate. It has to engage in real trade or production
activities. The Islamic bank may engage in short-term operations. It may, for
instance, undertake trade operations, or it may finance crop transactions. It may
buy goods, on the behalf of a trader, for resale at profit. The possession of goods
takes place in physical terms, and not in form of financial or speculative
contracts. For example, when it finances a crop transaction, the bank cannot act
as a pure financier who accepts risk in financing activities. It has to be a full
partner; it buys fertilizers on behalf of farmers and makes available financing
for operating costs; it participates in the marketing activity of crops. The bank is
 31

involved directly in all phases of the transaction on a profit-loss sharing basis; it

faces directly the risk of price and exchange rate fluctuations. It may lose part of
the loan if sales proceeds from crops fall short of the amount of loan. It may
also incur operating losses. The invested capital is repaid from the proceeds of
crop sales. Net profits are distributed according to an agreed formula.

Exhibit 2: Islamic modes of financing

Balance Sheet of an Islamic Bank, investment activity: investment step

Assets Liabilities
Mudarabah, Musharaka, Murabaha, Installment sale, Deposits (savings)
Istisnaa, =100

Leasing = 100
Total =100 Total =100

Balance Sheet of an Islamic Bank, investment activity:

closing step
Assets Liabilities
Reserves Deposits (savings) =100
= 110
Profits = 10
Total Total =110
=110

Depositors may withdraw or renew their deposits at maturity. An Islamic bank

is basically a different specie from a conventional bank. It is not a pure financial
intermediary as in the conventional system. It has to finance real activities in
production of goods and services. It does not lend money to a borrower at fixed
or floating interest rate. It does not acquire financial assets. An Islamic bank
identifies investment opportunities and evaluates them to minimize risks;
participates directly in the management, monitoring and execution of trade and
investment operations; and releases funds for purchases of goods and services
as required for the completion of these operations. There is no credit creation
which is not backed by real savings, the amount of deposits in the investment
branch will be determined by real savings and savings to income ratio
 32

(Mirakhor, 1988), and not by credit multiplier as in conventional banking. New

cash flows to an Islamic investment bank originate from new savings, and not
from the proceeds of loans transferred from one bank to the other. There is
therefore a wealth creating activity that generates new cash flows and not
money creation by the stroke of the pen as in the case of conventional system.
The growth of financing activity will therefore be stable and determined by real
growth in the economy (Mirakhor, 1988), and not by unstable speculative
finance or money creation by financial institutions. Accordingly, an Islamic
system would not be expected to experience deep boom and busts cycles.
Moderate and brief booms and recession may be generated by good crops,
productivity, technical change, or by adverse shocks. They cannot be generated
by the financial system itself as experience showed for conventional system. As
shown in Mirakhor (1988), equilibrium in an Islamic economy thus structured
will be stable and the rate of return to the financial sector will be fully aligned
with the profit rate in the real sector of the economy.

Exhibit 3 compares the process of deposit creation under Islamic and

conventional systems assuming a saving ratio of 20 percent of real GDP and
reserve requirement ratio of 10 percent of deposits, respectively. It can be
observed that total money expansion is $125 with a money multiplier equal to
1.25, and $1000 with money multiplier equal to 10 in Islamic and conventional
system, respectively.[ If the savings rate is 10 percent of GDP, and reserve
requirement is 5 percent of deposits, then total deposits become $111 and
$2,000 under an Islamic and conventional banking system, respectively.
Theoretically, while an Islamic system faces no risk of a run or credit freeze,
conventional system may face a risk of a run and credit freeze. In the event of a
run or credit freeze, experience showed that conventional banks had to suspend
conversion into currency, go bankrupt, or require large amounts of new
liquidities from the central bank]. Invoking quantity theory which postulates
MV=PY, where M is money stock, V is velocity of money circulation, P is the
price level, and Y is real income, and assuming fixed Y and V, the price level
would tend to rise at much slower pace under an Islamic as compared to the
conventional system. Furthermore, as an Islamic system is immune to large
economic fluctuations caused by financial instability, its rate of real economic
growth, because it is supply and not demand determined, would be stable at a
higher level than in conventional system. Under conventional banking system,
economic growth preceding financial instability could be virtually wiped out
during ensuing recession or depression phases.

Exhibit 3: Contrasting Islamic and Conventional Banking

 33

Islamic banking, Conventional banking

investment activity
Reserve ratio=10 percent
Saving ratio = 20 of deposits
percent of GDP
Bank 1 Deposit = $100 Bank 1 Deposit = $100
Bank 2 Deposit = $20 Bank 2 Deposit = $90
Bank 3 Deposit = $4 Bank 3 Deposit = $81
Etc. Etc.
Total deposits = $125 Total deposits = $1,000

Labor markets in an Islamic Economic Model

Labor economics have been a fundamental aspect of an Islamic economic
model. Allah praises the virtues of work, learning, and using fruitfully time. He
dislikes idleness and waste of time as clearly stated in many verses.

23;1.2.3. Successful indeed are the believers, those who offer their prayers with
all solemnity and full submissiveness, and those who turn away from dirty,
false, evil vain talk, falsehood, and all that Allah has forbidden.

23;72. And those who do not bear witness to falsehood, and if they pass by
some evil play or evil talk, they pass by it with dignity.

31; 6. And of mankind is he who purchases idle talks (i.e. music, singing, etc. )
to mislead (men) from the Path of Allah without knowledge, and takes it (the
Path of Allah, or the Verses of the Quran) by way of mockery. For such there
will be a humiliating torment in the Hell Fire.

Our Prophet PUH recommended to make best use of time, and that we are
accountable for the way our time is used. He praised hard work for earning
living and disliked idle healthy and able men [The Prophet PUH promoted the
notions of micro-finance and self employment. In many instances, He (PUH)
helped very poor people raise seed capital and establish a profitable business.
For healthy people, he strongly recommended gainful employment in lieu of
begging]. The example of the life of the Prophet PUH, his family, and his
companions offer a model to emulate for using time in a productive and
learning way.

While advocating hard work and learning, Sharia (and therefore an Islamic
economic model) explicitly forbids and imposes severe sanctions against
unlawful ways for earning income. Applying Sharia laws against unlawful ways
and means of income generation is mandatory and is therefore a fundamental
element of the institutional infrastructure underpinning an Islamic economic
 34

model. If crimes spread, social peace will be perturbed and economic activity
will suffer.

A main purpose of an Islamic economic model is to eliminate distortions in

labor markets with a view to maximize employment and promote exports. It
aims at establishing perfect wage flexibility capable of equilibrating labor
markets. In spite of many decades of economic development, the rate of
unemployment, which was very low at the natural rate prior to development
planning, has reached by 2008 disturbing levels in most of Muslim countries,
averaging 15 percent in middle income countries, and above 25 percent in low
income countries, particularly in sub-Saharan African countries, and is expected
to worsen in the period ahead. The only relief has become from immigration to
developed countries. These high unemployment rates cannot be explained by
unavailability of productive employment opportunities; they are imputable
mainly to labor markets distortions.

Unemployment is a serious economic disequilibrium. It means a large loss in

output and deterioration of poverty. The loss of output is estimated according to
Okun’s law as , where is actual real GDP, is full employment real GDP, the
prevailing unemployment rate as a percent of the labor force, is the natural rate
or frictional unemployment, generally estimated at 3 percent of the labor force,
and is a technological parameter. In view of the high unemployment rate, it can
be inferred that prevailing wage rate is far above an equilibrium wage rate that
would bring unemployment to a natural rate at 3 percent of the labor force.
Firms face therefore a cost disadvantage of the order . Achieving full
employment is an overriding objective of an Islamic economic model and is
thought to be the best strategy for reducing poverty and achieving social equity.
It is also the main theme of macroeconomics, both in the classical and
Keynesian traditions.

The nature of unemployment has been thoroughly studied by the International

Labor Office in case studies pertaining to many developing countries, including
Kenya, Columbia, and Philippines. Unemployment could be attributed to low
capital accumulation arising from low savings, exodus from rural to urban
zones, mismatch between education and skills required by the economy,
unfulfilled high expectations regarding wages, distorted consumer preferences
that favor industrial products from developed countries and therefore encourage
imports at the expense of traditional industries. In many countries, excessive
government controls of investment, marketing, and prices have stifled private
sector development and accentuated the unemployment problem.

Very few labor surplus countries managed to develop relying fully on their
labor resources and absorbing steadily their labor surplus. These economies
followed basically a market model and export-oriented growth, emphasized
 35

labor intensive technologies, and removed major distortions in their economies.

Most of the developing countries followed a dualistic economic model, with a
small modern sector using capital intensive technologies paralleled with a large
informal sector using very little capital. These economies relied on foreign debt
to finance the modern sector development as well as sustain industrial countries
consumption patterns. Many development economists in the 1950s feared that
foreign aid could accentuate technological dependence on industrialized
countries and called for trade instead of aid.

Distortions could be a major handicap to labor creation and employment

absorption. Distortions could arise from many sources related to factor and
product markets as well as to the regulatory and institutional framework. Price
controls, trade barriers, overvalued exchange rates, under priced capital,
subsidies, and high taxation could cause distortions in the economy. Obstacles
to market entry and competition also create distortions and support monopolistic
competition. Besides distortions, negative attitude toward work could become a
handicap to employment.

While major reforms for liberalizing the economy and promoting private sector
development are essential for an employment strategy, important distortions
relating to the labor market itself have to be removed. Fully competitive labor
market freed from distortionary laws is a prerequisite for absorbing
unemployment. Many Muslim countries have inherited industrial countries’
labor laws which have hampered seriously employment creation and
undermined their economic development process. These laws prescribe
minimum wages far above marginal productivity, prohibit firing, limit the
working hours, and impose excessive insurance cost on employers. In view of
the very high cost of labor, legislative constraints, and low skilled and poorly
disciplined labor force, firms in many Muslim countries have pushed for an
outright use of capital intensive production methods (use of machinery in
agriculture, industry, and construction) thus reducing the use of labor and
displacing large number of employment opportunities.

The classical macroeconomic model does not allow for unemployment, simply
because during the 18th and 19th centuries labor unions either did not exist or
were in their infancy stage, and government labor legislation was also
inexistent. Hence, labor market was always in equilibrium and full employment
was maintained throughout. The classical model is based on the assumption of
full flexibility of wages and prices. Models proposed by Ricardo (1817) and
Arthur Lewis (1954) require that the wage rate be maintained at the marginal
product level for savings to increase and capital accumulation to proceed. In
such a model, the demand for labor by firms is determined by the marginal
product. The labor supply curve is related to the real wage rate. The labor
 36

market clears at a wage rate that insures full employment. The volume of
employment will in turn determine real GDP.

In contrast, Keynes’ model, elaborated in 1936, assumes the presence of

powerful labor unions, as the case was in the United Kingdom, that will
preclude downward adjustment of the nominal wage rate, and massive
unemployment. Hence, there will be involuntary unemployment, and the
economy will settle in an underemployment equilibrium.

In many Muslim countries, wages are pre-determined both in the private and
public sectors and are considered as fixed cost. However, sales or sales prices
may decline and firms may incur operating losses. Firms have to absorb fully
the losses and cannot transfer part of them to labor through flexible downward
wage adjustment. Similarly, the government may incur severe drop in taxes or
royalties; however, the wage bill is pre-determined; the government cannot
adjust it in relation to loss in revenues and is forced to run a fiscal deficit. Wage
rigidity has led to considerable economizing on labor use, and has become a
source of inflation.

The pervasiveness of structural unemployment in many Muslim countries

provides evidence of labor redundancy and therefore very low marginal labor
productivity. When the value of marginal labor productivity in agriculture,
industry, and construction is compared to the actual average wage in these
sectors, a major distortion appears. Such distortion will stand against short-term
full employment of the labor force.

The relationship between product prices and wages is usually described in a

simplistic fashion using the notion of markup. Namely, the price level can be
formulated as , where stands for average labor productivity, denotes the markup,
and denotes the average wage in the economy. In this relationship, an
improvement in productivity would lower product prices; however, an increase
in the wage rate would be passed through to prices, unless offset by higher labor
productivity.

Wage distortions which make prevailing wages much above equilibrium wages
could be a serious source of loss in external competitiveness. Define the real
exchange rate, or equivalently external competitiveness by:where denotes the
nominal exchange rate, defined as the number of national currency units per one
unit of foreign currency, and and denotes the price levels in the home and in the
foreign competitor country, respectively. The real exchange rate conveys a
notion of purchasing power parity (PPP).

The real exchange rate has also been defined in terms of unit labor cost.
Invoking the notion of mark up, the price level can be formulated as , where
 37

stands for average labor productivity, denotes the markup, and denotes the
average wage in the home economy. The same markup relationship applies to
the foreign competitor country; namely: , where stands for average labor
productivity, denotes the markup, and denotes the wage level in the foreign
country, respectively. The real exchange rate can be reformulated as

Assuming and are fixed, then the ratio can be subsumed into a constant . The
real exchange rate can be equivalently reformulated as

Assume an overvaluation of wages by 30 percent, i.e., , then home exporters

face a cost disadvantage and a loss in competitiveness of the same order. To re-
establish competitiveness, the exchange rate has to depreciate sufficiently to
offset wage distortions.

The rising unemployment in the US and Europe was brought about by an

excessive expansionary monetary policy that sent food and energy prices
skyrocketing to levels that triggered food riots and crippled many key sectors,
such as industry and transports, widened external deficits, and pushed savings to
very low levels. The unfolding financial crisis precipitated by over indebtedness
and dramatic loss of financial wealth could worsen the economic recession
[Over-indebtedness and loss of financial wealth were considered to be main
cause of the Great Depression]. The approach followed so far wanting a quick
recovery through exclusive role of the central bank has only worsened the
economic crisis. Such approach pushed interest rates to record lows with a view
inflate prices in order to protect debtors and prevent adjustment of asset prices,
including housing prices, to market fundamentals, has dramatically worsened
the economic and financial situation. The approach is being reinforced by
massive fiscal stimulus in order to push aggregate demands to full employment
levels. The proponents of excessive money and fiscal expansion to fight
economic downturn draw their theory from Keynesian economics.

Besides the risk of causing high or hyperinflation, excessive demand policy as a

quick fix for a major economic crisis may not be the appropriate policy
response, as this policy was in the first place the cause of the economic and
financial crisis. It could push public debt to unmanageable level and would
deplete real savings and private sector investment. A more elaborate
stabilization and supply-oriented policies could be better approach with durable
cure. Monetary policy has to be stabilized, factor prices, i.e., have to be market-
determined and suffer much less distortions, and asset prices have to adjust to
market fundamentals. The classical approach for reducing balance of payment
deficits through price adjustment and improving competitiveness would
stimulate exports and reduce imports. Although exchange rate depreciation
could alter instantaneously export and import prices, such policy has entailed
 38

competitive devaluation and therefore was not able to improve competitiveness,

namely cost and prices remained main determinants of export and import prices.
Governments have to address supply shortfalls in food, energy, infrastructure,
and elaborate sectoral policies for boosting production in these areas. A supply
side approach does not aim at a quick recovery through indiscriminate use of
macroeconomic policies. It addresses deep-seated distortions in the economy,
removes inflationary expectations, stabilizes both fiscal and money policies, and
lays down a basis for durable growth. Such policy was implemented in 1980s
and brought about a long period of economic prosperity.

Opting for a development model that uses fully the labor force is the most
recommended strategy of an Islamic economic model not only for reducing
poverty and social inequity but essentially to restore a durable, balanced, and
export-oriented economic growth. Besides investing in education and
developing the skills of manpower in various occupational fields, a most
efficient way to absorb labor surplus is to remove all types of price and
institutional distortions and encourage the implementation of a competitive
wage structure that reflects the true productivity of labor. Realigning wages in
line with productivity and productivity growth will mitigate inflationary
pressure arising from faster increase of wages than productivity and will
encourage the demand for labor in sectors that are traditionally large employers
of manpower such as agriculture, industry, construction, and services.
Undistorted wages will allow savings to increase rapidly, and capital
accumulation to proceed faster. They will help support exports, reduce imports,
and remove a source of overvaluation of the exchange rate. Competitive wages
in agriculture will help increase the agriculture surplus and will therefore
mitigate pressure on food prices.

Maintaining highly distorted wage structure would play havoc with the
development process, and will exacerbate the unemployment situation. It will
lead to both migration to urban zones and immigration in a bid to find
employment. Rigidities in laying-off workers should be removed. Vocational
training which increases productivity and teaches workers new skills that
increase their inter-occupation mobility would be recommended. Only when
wages are in line with productivity and legal constraints eliminated would
private enterprises find it profitable to invest in vocational training. High
unemployment is extremely costly as millions of people have to be fed and
provided with necessary amenities without contributing to real GDP, leading
thus to a drain of savings and higher foreign financing. Furthermore, poverty
and deterioration of standard of livings become pervasive. Income inequality
becomes very high. Such high unemployment has become a cause of alarming
crime rates and social insecurity.
 39

Private sector development and asset and Product markets in an Islamic

economic model.

An Islamic economic model emphasizes private property, private sector

development, promotes free domestic and foreign trade, enhances
competitiveness, and aims at eliminating distortions in asset and product
markets. While natural monopolies due to invisibilities are acceptable in an
Islamic economic model, restrictions to entry and trade, however, are forbidden
[The Prophet PUH and succeeding Khalifs were careful not to introduce
distortions. Umar refused to impose a retaliatory import tax on goods imported
from Christian countries that had imposed tariffs on imports from Muslim
regions]. In many countries, monopolistic competition in form of large
corporations that control markets stands against expanding supply and reaching
higher social welfare. Namely, product prices become rigid because of market
power and cannot fall, and quantities sold are lower than under pure
competition. Antitrust laws contribute to improve competition and expand
supply and reduce prices. Intermediaries that group to control agriculture
markets impose low prices that do not enable farmers to earn sufficient profits
and could therefore contribute to a falling agriculture production.
 
Asset prices have to be market determined. While interest rates do not exist in
an Islamic economic model, reward to capital is through profits and profit and
loss sharing arrangements. The exchange rate, defined as the price of gold in
terms of commodities, the price of gold in terms of currency, or the price of a
unit of local currency in terms of a foreign currency, has to be market
determined. Such was indeed the case in the early era of Islam.

An Islamic economic model rests on free competition, undistorted equilibrium

prices, and precludes price fixation by the Government and many forms of price
distortions (e.g., excessive duties, subsidies, etc.), except in natural monopolies
or public services (e.g., transport). State marketing boards and price fixing can
be detrimental to private investment and to long-term supply. Fraud, cheating in
weight, altering the quality of products, such as adding water to milk or diluting
honey, had been condemned both in Quran and Sunnah as abhorrent activities.
Allah has repeatedly warned those who cheat, diminish weights, or falsify
merchandise.

Investment in human capital and economic and social infrastructure

Long-term planning and defining national development priorities are important
elements of an Islamic economic model. A Muslim economy has to have long-
term plans for water supply, dams construction, electricity generation, road
infrastructure, hospitals, airports, etc. so it will not face sudden bottlenecks or
deficiencies in infrastructure capacity. Investment in human capital is an
 40

essential element of an Islamic economic model and provides a basis for

sustained economic growth. Quran and Sunnah have stressed the value of
learning, sciences, and human capital.

Development planning should also define sectoral priorities, such as achieving

food security, expanding housing, developing mineral resources, increasing
energy supply, and promoting exports. Long-term planning should also aim at
maximizing labor employment and sustaining industrialization.

The development plan identifies long-term projects and their financing. Such
financing could be from domestic savings, or foreign financing. It has, however,
to satisfy Islamic conditions, namely borrowing has to be non-interest bearing.
Financing also could be through public private sector partnership.

Islamic Jurisprudence, the legal and regulatory framework of an Islamic

econmic model

An Islamic economic model is totally different from all other economic models
as it recognizes the supremacy of Allah, derives its laws from Allah, and is built
on a set of Islamic laws that strictly forbid transgression of any form [Hamid,
Iqbal, and Mirakhor have emphasized that an Islamic economic model is based
on a set of rules embodied in Quran and Sunnah; Islamic economic modeling
consists therefore in operationalizing these rules. They stressed the importance
of property rights and the prohibition of any form of transgression, including
unjust appropriation of other people wealth]. Every economic system requires a
set of laws for its practical implementation and for reinforcing contracts and
security. For an Islamic economic system, such set of laws is provided by the
Islamic Sharia (jurisprudence).

In His farewell speech, the Prophet PUH forcefully stated that unlawfully
appropriating other people money, shedding blood, and committing adultery are
as strictly forbidden as the eternal sanctity of Mekka.

In 4; 29 Allah says: O you who believe Eat not up your property among
yourselves unjustly except it be trade amongst you, by mutual consent. And do
not kill yourselves: for verily Allah has been to you most merciful.

In 2;188: And eat up not one another’s property unjustly (in any illegal way
e.g., stealing, robbing, deceiving, etc.) nor give bribery to the rulers (judges
before presenting your cases) that you may knowingly eat up part of the
property of others sinfully.
 41

Similarly in 4; 10: Verily, those who unjustly eat up the property of orphans,
they eat up only fire into their bellies, and they will be burn in the blazing fire.

Commercial transactions (non-interest-based loans, sales, etc.) have to be

recorded in contracts written by legal notary in the presence of witnesses. In
absence of legal notary, a collateral can be taken, which should be remitted
when the obligation is fulfilled. Alcoholic beverages, drugs, and gambling are
strictly prohibited and should be subjected to sanctions according to Quran and
Sunnah injunctions. Combating theft, banditry, and larceny is a fundamental
element in supporting institutional framework of an Islamic economic model,
without which an Islamic system would be doomed to social disorder and
economic stagnation. More specifically, work values deteriorate, trust
disappears, and insecurity grows to alarming levels. Labor markets have
suffered considerably from prevalence of crime and deteriorating work values,
which pushed farmers and employers in many Muslim countries to fear
employing workers and to push for capital intensive modes of production,
substituting machinery for labor.

Conclusions

An Islamic economic model rests on Allah’s Sharia; it aims at operationalizing

the Sharia laws into economic life. Built on interest free finance, balanced fiscal
policy, and redistributive zakat, an Islamic economic model could offer a robust
macroeconomic framework for a sustained and balanced economic growth.

Disappointingly, very few, if any, Muslim countries have followed an Islamic

economic model and applied Sharia fundamental economic and social laws. The
rules of behavior according to Quran and Sunnah have long been abandoned,
and most, if not all of elements of an Islamic economic model have been
inoperative, mostly in the name of secularism which stipulates that religion
should have no relationship to the affairs of a modern state. All laws have to be
man-made or transposed from conventional models. Most of the Islamic
countries have fallen behind industrial countries, and the technological gap has
kept widening. In spite of large agricultural potential, many countries rely
entirely on industrial countries for their food supplies. Social and political
security have deteriorated to alarming levels. The unemployment problem has
grown out of proportion and has become intractable, not because absence of
productive employment, but mainly due to prevailing distortions, deteriorating
work ethics and attitude, and prevailing high crime rates. Official corruption
and bribery have become so widespread to a point of paralyzing economic
growth and undermining social stability. Totalitarian rule and the cult of
personality over many decades have kept people in state of fear and undermined
 42

economic development. Large resources are diverted to political security.

While many Muslim countries enjoy excessive surplus, thanks only to oil and
natural gas, that is invested in interest bearing assets, most of the Muslim
countries have been suffering growing poverty and deterioration in social and
health standards. Many Muslim countries are heavily indebted and could not
return to a sustainable external debt.

Development costs of conventional models have been overburdening, in terms

of external indebtedness, growing inefficiencies, deteriorating social standards,
and spreading poverty. Social disenchantment arising from growing
unemployment has become widespread. An Islamic economic model would
offer a promising, and much more efficient, alternative to failed economic
systems. Such an economic model is built on economic and social precept of
Quran and Sunnah. It certainly does not select certain precepts and ignores
others. Such approach has been severely condemned by Allah. An Islamic
economic model considers Quran and Sunnah as one body and embraces all
economic and social legislation that has been prescribed by Allah and His
Prophet PUH, knowing that such legislation is the best, and will secure success
here and in the hereafter.

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Sons (Asia) Pte Ltd.

Choudhry, Nurun Nabi and Abbas Mirakhor, 1997, Indirect Instruments of Monetary Control in an
Islamic Financial System, Islamic Economic Studies, Vol. 4, no. 2, pp. 27-65.

Fisher, Irving, 1936, 100% Money, Adelphi Company, New York.

Hamid, I S, Iqbal,Z, and Abbas Mirakhor, 2008, Islam and Development, Individual, Economic, and
Societal Dimensions, Manuscript.

Hassan, K., and Lewis, M. K., 2007, Handbook of Islamic Banking, Edward Elgar Publishing Limited.

Haque, Nadeem Ul and Abbas Mirakhor, 1999, The Design of Instruments for Government Finance in
an Islamic Economy, Islamic Economic Studies, Vol. 6, no. 2, pp. 27-43.

Iqbal, Z. and A. Mirakhor, 2007, An Introduction to Islamic Finance, John Wiley, Singapore.

Keynes, J. M., 1936, The General Theory of Employment, Interest, and Money, Harcourt, New York.

Khan, Mohsin, 1987, “Islamic Interest-Free Banking: A Theoretical Analysis” in Khan and Mirakhor
(eds.), 1987, Theoretical Studies in Islamic Banking and Finance, IRIS Books, Houston, Texas, US.

Kotb, Seyed, 1954, Social Justice in Islam, Dar Shurouq, Cairo, Egypt.
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Lewis, W. Arthur, 1954, “Economic Development with Unlimited Supplies of Labor.”

Manchester School of Economic and Social Studies 22: 139-91.

Mirakhor, Abbas, 1988, “Equilibrium in a Non-Interest Open Economy,”

International Monetary Fund, Working Paper, WP/88/111. Also in the Journal of

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Ricardo, David, 1817, On the Principles of Political Economy and Taxation.

Simons, H., 1948, Economic Policy for a Free Society, Chicago, Ill. University of Chicago Press.

The Prospects for an Islamic Economics Order

In The Crisis of Islamic Civilisation (published by Yale University Press 2009),
the author Ali A Allawi, writes on The Prospects for an Islamic Economic
Order:

“In reality, an Islamic economic order can only be renewed if certain

fundamental reforms are undertaken. The axes of the modern economy are so
distant from the moral economy of Islam that nothing short of a spectacular
break would suffice to bring to life a new Islamic economic order. The main
features of an Islamic economy have been in an eroded state for several
centuries, so that most are merely religious vestiges of a long-forgotten past. By
the time of the revolt of Islam in the 1970s, the elements of an Islamic economy
were simply theoretical constructs, which may have featured in the education of
seminarians but had no place in the modern economy. Only a few countries
such as Saudi Arabia maintained a zakat (Islamic wealth tax) collection
department as part of the public finance architecture of the state. The vast
majority of Muslim countries had relegated the use of Islamic taxes to voluntary
religious tithes, leaving public finance to the usual array of revenue-generating
taxes and duties: on incomes, sales, customs, and so on. Agricultural taxes,
which were essential to the functioning of the rural economy in Islam, also
vanished, and were replaced by modern equivalents which had no echo in
Islam's past.

The use of paper currency, issued by a central bank and 'backed' by foreign
exchange reserves, also became widespread in the nineteenth century, gradually
decoupling the classical forms of the Islamic unit of exchange — the gold-based
dinar and the silver-based dirham — from its historical association with
bullion." The unit of exchange in the world of Islam, allowing for the fact that it
had atrophied and been allowed to debase over the centuries, was definitively
terminated with the rise of modern central banking. In the colonial and post-
colonial period, many Muslim countries used the same or equivalent currencies
as their European overlords. This explains the widespread use of the colonial
 44

French franc, or the British pound in the Sterling area — both of which tied the
dependent economy to the metropolis and its needs.
 
Islamic finance is part and parcel of the world view of Islam. It is not just a tool.
Zakat, for example, is not simply a revenue-generating wealth tax. It is
mentioned on numerous occasions in the Quran, in the same breath as the
offering of prayers. It is a fundamental aspect and a pillar of Islam, and an act of
worship designed to bring human beings closer to God. Thus the offering of
zakat is not simply the parting with a portion of one's wealth for the public
good. While it is essential to the financial integrity of the Islamic state, it is also
a process that will purify the person. The actual handing over of a proportion of
one's annual wealth is designed to make the process of giving what one holds
dear an essential aspect of worship. `You will not gain righteousness unless you
part with what you hold dear,' the Quran admonishes.' Zakat talks about
property as a responsibility. Property is not decoupled from its social use;
neither are property owners, or holders, able to ignore their roles as trustees
over the property.

The pious foundations - the Awqaf — were the historical institutions which
provided these serv¬ices but they, too, have atrophied with the passage into
modernity. The endowment of large public buildings and social institutions by
the rich and powerful is no longer a practice in the Muslim world. The Awqaf
have turned into bureaucratic and often venal organizations; they manage
specific mosques and their attached properties, and are answerable to a
government agency." The old Awqaf institution was far more central to the life
of Muslim society, because it grouped mosques with markets, hospitals,
caravanserais, soup kitchens and schools - the living commercial and spiritual
heart of Muslim cities.
 
The Problem of Interest

It would, of course, be impossible to reconstruct the basis of an Islamic

economy without tackling the problem of interest. For centuries no scholar of
any note would question the prohibition on usury, as it clearly was one of the
absolutely reprehensible acts condemned in the Quran …The academic Charles
Tripp also maps out the distortion of the Islamic banking movement as it
lurched away from its initial purpose. 'As the Islamic financial sector grew,
mobilizing substantial sums of capital, many of the original intentions faded
from view ... The goal of reinforcing the bonds of community, and the ambition
of restoring unity between people's material transactions and the spiritual
dimension of their lives, gave way before the need for financial institutions to
survive and thrive in a global market dominated by long-established and highly
 45

competi¬tive institutions which had historically shaped the rules of the market
itself.”