The Value of Time and Risk in Islamic Economics
Professor of Economics
University of Illinois, Urbana-Champaign
Unpublished draft, circulated for discussion;
shared here with the permission of the author
The one feature of Islamic economics most familiar to all is that interest is prohibited by Islam. [i] This feature dates from the prohibition of “riba” in the Quran and the general identification of “riba” with interest. Modern commentators have justified this ban in two ways: on the one hand, it is said that one who receives interest gets paid for no service and hence riba involves injustice; on the other hand, the social consequences of interest, in permitting the growth of an idle, exploitive rich class is depicted as adequate reason for its prohibition. As interest is most prominent in the banking system, this has even led to “interest-free banking” as a major characterization of Islamic economics. However, from a theoretical point of view, it is the first consideration that is of greatest importance. Under the exigencies of modern conditions, a variety of arguments have been put forth to justify the interest-laden banking system: it has been said that riba applies only to excessive interest rates, that riba occurred primarily for consumption loans and do not reflect modern banking conditions and some scholars have even tried to challenge the ready identification of riba with interest. [ii] In this note, I would like to urge that the issue be reassessed by pointing to a serious internal contradiction in the schema of accepted Islamic practices.
To begin with, I would like to emphasize that I have no intention of finding fault with the Islamic banks that have been set up on the basis of partnership or “modaraba.” On the contrary, there is no difficulty in principle with the functioning of such banks and they even possess certain advantages over the interest based banking mechanism. If Islamic banks, which provide shareholders with equity shares instead of nominally fixed deposits, are faced with an exogenous loss of assets then the value of the shares immediately fall to reflect the new position of the bank. Under the traditional system, however, a large exogenous shock can’t be sustained because the liabilities of the bank are fixed in nominal terms. As a result, in order to prevent the spread of bankruptcies, the government typically insures bank deposits. What this amounts to then is that the public at large is taxed to provide for the solvency of the banks. On equity grounds, the Islamic system certainly seems better—indeed, the desirability of a change from the fixed nominal value system has also been advocated by several prominent Western economists. [iii] From a historical point of view, it is clear from the existence of extensive profit-sharing partnerships in the Islamic Middle East that standards of commercial probity can be developed to a point where distant partners can transact faithfully with each other. In the words of S. D. Goitein, who spent a lifetime studying such commercial records. [iv]
The present writer must confess that it took him quite a number of years until he understood the nature of informal business cooperation as evident in countless Geniza papers. For at first sight it seemed strange that a merchant should invest so much time and work in the mere expectation that his efforts would be properly reciprocated, or, as our sources say, “he serves there and I serve here,” “you are in my place there, for you know well that I am your support here.” However, this is exactly what happened. An ‘umlah, or commission, was paid for special service, not for the relationship with that the Mediterranean and Indian trade, as revealed by the Cairo Geniza, was largely based not upon cash benefits or legal guarantees, but on the human qualities of mutual trust and friendship.
In any attempt to interpret Islamic economics it is essential to have on hand appropriate authority. For the Sunni point of view, I shall use Yusuf al Qaradawi’s The Lawful and the Prohibited in Islam while for the Shia view I shall use the translation of Ayatollah Khomeini’s A Clarification of Questions. [v]
The real difficulty from the economists point of view is the claim that interest, even between two otherwise equal individuals, is prohibited. [vi]
First: The taking of interest implies appropriating another person’s property without giving him anything in exchange, because one who lends one dirham for two dirhams gets the extra dirham for nothing. Now, a man’s property is for (the purpose of) fulfilling his needs and it has great sanctity, according to the hadith, “A man’s property is as sacred as his blood.” This means that taking it from him without giving him something in exchange is haram.
What this quote clearly implies is that time, in the Islamic view, has no value. This is clearly the crux of the issue. Whether banking exists with or without interest is a minor affair by comparison.
Why should time not have an economic value? When we transport rice between two locations we think nothing of paying for the cost of transport. Why then should there be a special onus on transporting purchasing power over time, which is the only essential function of credit? No doubt there is a long tradition, dating from Aristotle’s claim that “money is barren” which will support the view that time need not be paid for, but surely Aristotle and the other philosopher’s have no hold on Islamic ways. It is remarkable that the Christian West long adopted the Greek mode of thought and dissipated much of its energies in trying to halt all forms of usury. From the Christians point of view, it is almost pathetic to not that the ban on usury appears to have fallowed a misinterpretation of the ancient texts .[vii]
It has been claimed that economists may well place a value on time, but that Muslims are obligated to follow Allah. Before adopting quite so rigorous a stance it may be helpful to see some of the difficulties involved in living with such a viewpoint. Consider an economic planner in a fully Islamic economy who I given the task of choosing between a variety of investment projects. As larger capital outlays normally bring larger returns over longer periods of time, we shall suppose that the choices available are as follows, for indivisible projects.
How are these projects evaluated? If Islam does indeed prohibit any valuation for time then any consistent method will involve totaling the net benefit over some fixed time horizon. Since time discounting is not permitted the totals must consist of arithmetic sums. By this procedure, it is clear that projects of greater longevity are more beneficial. So, to be consistent, the project with the largest gestation period will be chosen. And if an engineering blueprint for an infinite stream of such projects can be generated, we shall be building forever in order to consume unto eternity!
The problem can be approached differently. It is well known that Islam believes in a freely functioning market and there is even a hadith of the Prophet (PBUH) that appears to take an extreme stand by asserting that prices come from Allah and are not to be interfered with. From the economists point of view the rate of interest is just the price of transportation over time and so it too should be left free. It so happens that certain markets are in fact left free and give rise to the contradiction that motivated this paper.
If there really is no price for time then is should follow that payment in advance or deferred payment should also not exist- or rather, such payments should not involve any difference in price from a spot price. However, this is not the case. I begin by quoting al-Qaradawi, who is clearly uncomfortable with the notion of credit but supports it nevertheless.[viii]
While it is best to buy an article by paying cash, it is also permissible to buy on credit by mutual consent. The prophet (peace be on him) bought some grain from jew, to be pad for at specific time, pledging his coat of mail as security.
A group of jurists are of the opinion that, should the seller increase his price if the buyer asks for deferred payments, as is common in installment buying, the price differential due to the time delay resembles interest, which is likewise a price for time; accordingly, they declare such sales to be haram. However, the majority of scholars permit it because the basic principle is the permissibility of things, and no clear text exists prohibiting such a transaction. Furthermore, there is, on the whole, no resemblance to interest in such a transaction, since the seller is free to increase the price as he deems proper, as long as it is not to the extent of blatant exploitation or clear injustice, in which case it is haram. Al-Shawkani says, “on the basis of legal reasons, the followers of the Shafi’I and Hanafi schools, Zaid bin ‘Ali, al-Muayyid Billah, and the majority of scholars consider it lawful.”
In the case of payment in advance, the problem is less complicated because now there is no spot price to be compared with. [ix]
The Muslim is allowed to make an advance payment of a specified price for a specified price for a specified quantity of merchandise to be delivered at a fixed time in the future. This type of transaction was prevalent in Madinah when the Prophet (peace be on him) arrived, and he introduced certain changes and conditions in this type of transaction in order to bring it into conformity with the Islamic Shari’ah. Ibn ‘Abbas narrated, “When Allah’s Messenger (peace be on him) came to Madinah, they were paying one and two years in advance for fruits, but he then said,
Those who pay for anything in advance must do so for a specified measure and weight, with the fixing of a specified time.
Now these two transactions make it evident that time per se is no difficulty in Islamic economics. As a result, economic planners can discount and evaluate streams of money. Indeed, the combination of the two above transactions leads to a perfectly legal way of taking interest.
I give Taka 100 to you as advance payment for a handkerchief to be delivered next year. You promise to pay me Taka 120 next year for a pair of socks delivered just now. Assuming the socks and the handkerchief are of equal value, this perfectly legal transaction provides for an interest rate of 20 percent.
The crux of the matter is that transactions undertaken at different moments of time are permitted to have different prices. As soon as this point is established, there ceases to be a difference, in principle, between the Islamic and the economic viewpoint. The issue is of such importance that it is worth establishing the legality of credit transactions in more detail.
Consider the following question, which was posed by a devout Malaysian student. Is it legal for there to be two stalls in a market, which sell the same commodity, one at a fixed cash price and the other at a fixed credit price? Let the commodity be rice. Stall A sells rice at 400 Taka/maund to be paid for at once; Stall B sells rice at Taka 450/maund regardless of whether you pay now or a year for now. There is nothing in the existing laws to prohibit such an arrangement. [x] But then such a market is entirely equivalent to a credit market.
The situation is even clearer for the Shia, as may be seen by the following quotes from A Clarification of Questions. (As there is some doubt about whether the translation was correct I have withheld this evidence for the end.) In describing sale on credit, the Ayatollah says the following. [xi]
In a credit transaction the due-time must be perfectly clear. Thus, if he sold a commodity and is to receive its money by harvest time the deal is void since the due-time had not been specifically set.
The deal is void if he gives someone who has no knowledge of the price an amount of commodity without telling him its price. But there is no concern in selling on credit and at a higher price to someone who knows the cash price of an article; for example, if he says that I sell you on credit at a price which is 10% higher than that for cash, and the buyer agrees.
The example given could not be clearer about the legitimacy of charging a price for time. The there is continued into the next point. [xii]
There is no concern if a person, who has sold something on credit and for a known due-tie, reduces the amount due by some amount, for example half way through the due-time, and receives the remainder in cash.
At least for Persian muslims then, the question of time having economic value is entirely academic. Indeed, it is notable how the Ayatollah, reputedly so strict on other issues, takes a liberal stand on questions of trade. Consider his view regarding usury on goods: [xiii]
There is no concern when the one who gives the lesser amount. Adds something to what he gives, such as when he sells a man of what plus a handkerchief in exchange for a man and half of wheat. The same holds when both sides add something, for example, when he sells one man of wheat plus a handkerchief in exchange for a man and half of wheat plus one handkerchief.
No doubt it can be claimed that those who use credit and advance payments are not looking to the spirit of the prohibition of riba. By the same token, one can retort that those who object to interest should really be attacking the evils that interest is meant to prevent. A welcome movement in this direction is a recent Pakinstani document which urges that “wad adl wal ihsan” as the guidelines for the construction of Islamic economics. [xiv]
It is not my aim here to argue against Islamic banking. Not only are such institutions feasible, in countries where there are significant numbers of devout muslims who will not accept traditional banking, they are even very necessary and beneficial. From the point of view of economics the crucial point is the valuation of time. If it were indeed true that Islam does not permit any time-discrimination of economic values, it would also follow that the Islamic system must be economically inefficient.[xv] This is not the case.
[i] F. L. Pryor, “The Islamic Economic System,” Journal of Comparative Economics (1985), 197-223.
[ii] For a variety of views see: S.Ahmed, “Reflections on the Concept and Law of Riba,” in Outlines of Islamic Economics (Indianapolis 1977), 26-34; Z Ahmad, “The Quranic Theory of Riba,” Islamic Quarterly (1978), 3-14; F. Raham, “Riba and Interest,” Islamic Studies (1964), 1-43.
[iii] My views on this issue have been considerably influenced by the work of Mohsin S. Khan of the World Bank. I am grateful to him for letting me see his unpublished work.
[iv] S. D. Goitein, “Commercial and Family Partnerships in the Countries of Medieval Islam,” Islamic Studies (1964), 316. This should serve to modify the unequivocal assertion of Maxime Rodinson that Islami commercial society has always been interest-based. Islam and Capitalism (London: Penguin 1977), 35-36. At the same time, he is correct in noting the existence of a considerable casuistic hiyal literature. For the case of the Ottomans, see N. Cagatay, “Riba and Interest Concept and Banking in the Ottoman Empire,” Studia Islamic (1970), 32, 53-68.
[v] Yusuf al Qaradawi, The Lawful and the Prohibited in Islam (Indianapolis 1980); Ayatollah Khomeini, A Clarification of Questions, translated by J. Borujerdi (Westview, Colorado 1984).
[vi] Qaradawi, op. cit., 265.
[vii] B. J. Gordon, “Lending at interest: some Jewish, Greek and Christian approaches, 800 B.C. – A.D. 100, History of Political Economy (Fall 1982), pp. 420-421.
[viii] Qaradawi, op. cit., 269-270.
[ix] Loc. Cit.
[x] The discomfort with a situation where time has no value is clearly indicated in a paper of Dr. Anas Zarqa, who suggests the se of the rate of profit because this can be variable. Whether we use a variable or a constant discount-rate, this significant fact is that discounting is recommended. Since we use the same number to discount an infinite future stream, it does not appear to be very significant that this number be derived from a “variable” such as the profit rate. M. Anas Zarqa “An Islamic Perspective on the Economics of Discounting in Project Evaluation,” in Z. Ahmed et. Al., editors, Fiscal Policy and Resource Allocation in Islam (Islamabad. 1983), 203-234. The question posed to some Shariah scholars, on p. 223, is however entirely in the spirit of this paper.
[xi] Khomeini, op. cit., 276-277.
[xiii] Op. cit., 272.
[xiv] An Agenda for Islamic Economics Reform (Islamabad 1980). This is the Report of the Committee on Islamisation.
[xv] The importance of focusing upon the value of time may be illustrated by the fact that a number of scholars who have carefully considered this issue have nonetheless failed to distinguish between the existence of “interest” in an economic system and the validity of time-discounting. In the studies of Mohsim Khan on interest-free banking, various intertemporal values are reduced to their present value, without noticing that such a reduction may reflect an unIslamic mode of thought. Hence we may have the curious situation where Islamic banking can be economically justified by arguments that Muslims cannot use!
M. Ali Khan has provided a very careful study of intertemporal pricing and interest rates from the neoclassical point of view and argued that intertemporal prices are all this is essential. But the validity of having different intertemporal prices is the same as that of the value of time. M Ali Khan, “General Equilibrium and the Non-Interest Pricing of Capital in an Islamic Economy” (Islamabad 1986).
The careful reader will have noticed that though the word risk appears in the title it is nowhere present in the text. A reading of Quaradawi will show that he considers insurance to be like a gamble, hence forbidden and that forward contracts for green dates are also considered haram. However, forward contracts for items regularly harvested, whose risk is known, such as cucumber, is permitted! So it is not risk per se but rather “large risks” that are suspicious. This is clearly a matter for judgment and not for formal law. I see little point in enforcing this message by quoting original texts.
I am grateful to M. Ali Ayub, Hadi Esfahani, A. Hadi Harmashah, M. Ali Khan and Mohsin S. Khan for their guidance. All errors are attributable solely to me.
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