The nature of interest and Riba

With every passing day, these controversies get deeper and more complex as new approaches are adopted by the Muslim thinkers to substantiate a given point of view on the issue. During the last five to six decades, extensive literature has appeared to establish the equivalence of interest and Riba. To this ever-growing stream of intellectual output, an addition has been made by learned scholar M. Abul Fazl whose article titled ‘The origin, nature of interest and Riba’ appeared in Daily Dawn on December 12, 2010.

The article belongs to the new genre of Islamic thinking which violates and distorts the fundamental economic principles to underscore the prohibition of interest in Islam. By stitching together the disparate strands of economic thought, the article in its essence, espouses the Marxian theory of surplus value along with his theory of exploitation to claim that social value is generated by the physical labour alone.

It follows, therefore, that all income received through the productive process must be distributed in the form of wages only and claimants of rent, interest and profit should have no share in the value added. Interest being a component of surplus value and source of labour exploitation is a form of Riba and must be eliminated from the economic system. The simplistic as well as distortionary contents of the article necessitate that the actual working of an economic system be diagnosed with a view to highlighting the indispensable role of capital and its pricing parameter namely interest.

An economic system refers to the set of values, norms and institutions which interact to determine the volume of production in the economy and the mechanisms for its distribution. The economic system performs multiplicity of functions both at micro and macroeconomic levels and provides tools for solving essential problems of resource allocation. As Frank Knight in his ‘Economic Organisation’ has pointed out, the economic system has to perform the five interrelated tasks, namely (i) fixing standards, (ii) organising production, (iii) distributing the product (iv) providing for economic maintenance and progress, and (v) adjusting consumption to production.

These tasks of the economy can be handled by adopting either a ‘command’ i.e. central planning system or through the ‘market economy’. While these two systems are diametrically opposed to each other in their means and methods for achieving the objective of efficient resource allocation, the actually prevailing economic systems in the world represent a significantly varying mixture of these two extremes. The spectre of communism no more haunts Europe or rest of the world. The 20th century has witnessed the fall of a major ‘command’ economy of a powerful industrial country like former Soviet Union, which could be considered as a unique experiment in centralised organisation of economic management. Numerous causes can be put forward to explain the debacle of the mighty communistic state. It is, however, generally recognised that the most fundamental flaw of such organisation stems from its basic characteristic that the orders of the highest planning authority such as ‘Gosplan’ in Soviet Union have had to be transmitted down a rigid but extensive hierarchy of governing entities with the result that these orders lost much of their effectiveness in the filtering process. Moreover, the central authority at the apex of the command pyramid, before making any rational decision, must be able to collect detailed ‘atomistic’ information and data from the widely diffused field of social and economic activity ‘a task rendered increasingly difficult by the growth in the number of operating agents in the economy as well as the bewildering complexity of economic structure at the lowest levels.

Juxtaposed with the ‘command’ economy, the free exchange economy performs the essential tasks of resource allocation by evolving ‘a system of effective, proportional representation that permits every group in the society to express its wishes to the extent of its dollar votes’ as Milton Friedman has put it in his ‘The Price Theory.’ He adds: ‘The votes of the members of a free-enterprise exchange economy are manifested through prices, which in turn, reveal the standards of the society.’ The price system based on the interaction of two sets of prices namely product prices and factor prices serves as the guidepost to where resources are wanted most and thus helps in determining what, where and how much is to be produced. Analogously but critically, it is the price system which plays the pivotal role in deciding who is to get what and in what proportions. In terms of Frank Knight’s five tasks succinctly described above, prices have vital roles to play namely ‘they transmit information, they provide an incentive to users of resources to be guided by this information, and they provide an incentive to owners of resources to follow this information. The theory of production recognises that output is the outcome of the joint efforts of four factors namely land, labour, capital and enterpreneurship and according to factor price theory, their rewards or returns namely rent, wages, interest and profit must be determined by the marginal productivity of each factor in a given process of production, assuming of course, that factor markets are competitive and there are no distortions to hinder their free operations. Since ‘capital’ is a basic factor of production, its services must be priced.

To abolish interest from the economic system would invariably require the destruction of all capital stock from the economy wherever and in whatever form it exists. By abolishing capital, you, eliminate interest from the economy altogether, even though you may enter a primitive-cum-prehistoric stage of economic development sans capital, sans interest.

An interesting scenario would be that of a society where government has monopoly of issuing capital but abolishes ‘interest from the economy through state legislature. Now, let us suppose that the growth in population, introduction of some latest technological innovations, immigration of a new generation of entrepreneurs or a combination of all these factors create additional demand for capital of sizeable proportion. Since the government is bound to keep the economy interest free, it must supply the additional capital requirements at zero price to meet the instituted demand.

In this case, the supply schedule of capital when plotted in the Cartesian coordinate plane, must pass through the origin as an identical line to abscissa x, showing infinite elasticity, and implying that the government is committed to supply all the needed capital at zero price. Such a situation, however, cannot be maintained for long, because government must exhaust all its capital stock at a certain point of time. At that moment, demand will push the interest rates from a zero threshold to a positive magnitude.

Money as one particular form of capital performs useful functions in the economy, as a medium of exchange and as a measure and a store of value. For these functions, money is regarded as a time and uncertainty phenomenon. The holding of money provides a refuge from the uncertainties inherent in the flow of time, reminding us the well-known observation of J.M Keynes: ‘Our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. The possession of actual money lulls our disquietude. Given these properties of money, should we postulate that given an interest-free economy, government as the monopoly producer of money can ensure an infinitely elastic supply of money and thus meet all levels of money demand. It is self-evident that such a condition is altogether untenable because the monetary system will collapse if printing of money is carried out beyond the prescribed safe limits. Money would be completely debauched of its value once its supply is allowed to explode.

The conclusion is thus straight forward. On the basis of economic logic, interest cannot be equated with Riba. At the same time as price of capital, it is ineliminable from the economic system. For that very reason, all Islamic banks are interest-based camouflaged under nomenclatures such as Profit Loss Sharing (PLS), Modaraba, Ijara, Murabah and so on.