Introduction

This paper examines the theory of interest from the perspective of conventional economic thinking and from an Islamic viewpoint. Initially, it is intended in this introductory section to provide an overview of the Islamic conception of what constitutes optimum economic welfare which is achieved through the introduction of ethics or moral principles in human day to day economic pursuits. It is felt that the discussion in this section will serve as a necessary exordium for an academic analysis of the rationale behind Islam's complete and unambiguous prohibition of interest in all business dealings.

Section two will briefly examine the conventional theory of interest in order to acquaint readers who are not conversant with basic conventional economic literature of what secular economists imply when they talk of a positive rate of interest in all aspects of production and exchange activities.

Section three will analyse the philosophy behind Islam's total forbiddance of a positive rate of interest in business dealings. This section will also examine the implications of such prohibition for optimum economic welfare.

The conceptual study of the economic role of an interest free Islamic economic setting in this paper is thought to be timely because of the general misconception especially among secular academics and policy makers of the logic behind the need for a zero rate of interest even in an economy with scarce economic resources. The central contention of this paper is that, within the disposition of Islamic philosophy, it is ethics (i e. moral principles) that dominate economic performance and not vice-versa. Hence, the Islamic economic optimum differs from other models by an ethical factor. This difference is important because Islam strongly asserts that ethics should symbolize the common values of a society. They should also determine the socio-economic preference structures of the members of that society. What Islam stands for is that ethics, independent of the economic conditions prevailing at any time or in any society, must guide human behaviour for the attainment of optimum socio-economic felicitation as well as spiritual redemption.

The dichotomy of human life into secular pursuits and spiritual endeavours has contributed greatly to the intellectual confusion Prevailing in the modern world. The Islamic solution is to demolish this unhelpful dichotomy by providing a concurrent philosophy of life according to which no ethical vacuum can prevail on the plane of human socio-economic interactions. Accordingly, in the context of Islamic perception, the distinction between the secular and the divine is both absurd and ineffective. The unalloyed requirement that the condition of unity between the secular and the spiritual is satisfied in all aspects of human activity is one of thus most important determinant of economic behaviour under an Islamic economic setting. As a result, all exploitative tendencies whether in the form of monopolies or trade winth interest will find no place in a purely Islamic business environment.

Furthermore, whereas conventional first best economy is entirely  unconcerned with the state of income distribution (irrespective of whether it is fair or not — see Wich, 1971), by abolishing interest. Islam is clearly concerned with income distribution. Therefore, the Islamically first best economic order is certainly superior to the conventional first best model because of Islam's direct concern with the process of income and wealth distribution. For example, Islam unequivocably rejects the closed circle of wealth and income getting narrower at each turn: "let it (i.e. wealth) become not a ccmmondity between the rich among you" (see Al-Qur'an, 59:7). In other words an Islamic economic system would insist, at any given point in time, on optimising total welfare and not just (Pareto's optimal) manual welfare by stipulating that income distribution, among other thigs,must also be the first-best.

It could thus be asserted that a steady rise in the degree of income inequality, for example, due to the existence of positive rate of interest, will tend to diminish overall socio-economic welfare and satisfaction. That is, from the islamic viewpoint, a society with an equal i.e. optimal income distribution policy is economically superior to  one with an unequal income distribution policy even though the average income levels are the same in the two societies. In this regard, it is the contention in this paper that the most important issue that relate to the Islamic requirement for an optimal income and wealth distribution policy is that of total elimination of the institution of Riba (interest). As mentioned above, it is important because the Islamic commandment to abolish interest signifies a unique socio economic ideology which execrates social exploitation in all forms including sub-optimal and discriminatory economic relationships.

Before a more detailed discussion on the issue of interest in section three it may be useful at this juncture to elucidate the following points concerning the islamic injunction against interest. Firstly, the abolition of interest should be conceived as a policy mechanism only and not a policy goal. That is, the ibolition of interest is a means only of fulfilling in practice the preconditions of an exploitation — free economy. Secondly, while a zero rate of interest is a necessary condition for the emergence of an Islamic economic environment, it is by no means a sufficient condition. In other words, although a full-fledged Islamic economic system suggests a zero rate of interest, the opposite does not necessarily hold. Thus, a zero rate of interest should exist whenever the goals of an Islamic economic system are meant to be achieved. But it is possible that a zero rate of interest could occur (e.g. as it is the situation in many socialist countries) even when an Islamic system does not exist. Thus the fundamental thing about the prohibition of interest in Islam, is to ensure the emergence of an interest-free economic setting which will enable a smooth operationalisation of all Islamically approved economic transactions.

The Conventional Theory of Interest

Interest is generally conceived to represent the extra payment made to owners of capital funds which they are prepared to put at the disposal of others. The payment of interest in conventional economics deals with the economic function of money. By its definition, money accords on its possessor complete financial liquidity. That is, it provides its holder the ability to turn capital into any form without loss or complications. One important economic factor which seems to make the holders of capital to have very high financial liquidity preference is human suppositional intuition. To understand this liquidity preference supposition, it is crucial to consider the relationship between current (i.e. prevailing) market rates of interest and the price level of securities or bonds.

In general, the price of a fixed interest security tends to move in opposite direction with the prevailing market rate of interest. The initial nominal value of a fixed security representing the amount for which it was initially sold, has no relevance to the determination of its current market price. The price for it on any particular period will depend upon:

1. the income it offers potential investor.

2. the prevailing market rate of interest.

If the prevailing market rate is the same as the rate prevailing when the bond was initially issued, then the price at which the bond will be quoted on the stock exchange will be the same as its nominal value. But if the prevailing rate of interest is different from the rate prevailing at the time of issue, the bond will now command a higher or lower price than it did then, depending on whether the rate of interest has fallen or risen since the bond was first issued. Considering this relationship between the price of a bond and the current market rate of interest, if, is not difficult to establish why the need for financial liquidity at any period of time arises. It arises in so far as investors speculate that the market rate of interest is going to rise.

Suppose that the prevailing market rate of interest is 9 percent; and that an investor holds an irredeemable security providing an annual income of N9. Also suppose that the investor is of the 'view that the market rate of interest will shortly rise to 10 per-cent. It is certain that he will prefer to hold his capital in a liquid form rather than to acquire the security. His security must have a current price of N100 representing the value of an income of N9 a year when the prevailing rate of interest is 9 percent. If his speculation of the probable rise in interest rate to 10 percent is correct the price of his security will soon fall 90 representing N9 a year valued at a current rate of 10 percent. If he sells his security now at the 9 percent current market rate of interest and buys it again after the rate of interest has risen to 10%, he will automatically make a profit of N10 without any entrepreneural  effort on his part. Thus, the stronger the supposition that interest rates are going to rise, the greater will be the expected demand for financial liquidity. In other words, where interest rates are anticipated to rise, then a demand will exist for financial liquidity on the part of investors seeking to avoid capital losses on income generating securities.

Given the above discussion of the relationship between investors' liquidity preferences and the prevailing market rate of interest, the quantity of cash which potential investors may wish to hold at different rates of interest can be formally demonstrated.

In general, there is usually a small demand for liquidity when interest rates are high and large demand for liquidity when interest rates are low. That is, the smaller th amount of financial liquidity which is available to investors, the greater will be the reward (i.e. amount of interest) they will have to be offered if they are to sacrifice more of their cash balances.

As is known, whenever traditional economists talk of demand for something the aspect of its supply also fundamental especially for decision making purposes. In our present context, the total money supply at any point of time will depend on the ratio of financial reserves to total deposits which conventional banks are allowed to adopt by government monetary authorities. The supply of money is therefore fixed at any moment, and does not fluctuate in response to changes in the rate of interest. The rates of interest will settle at the point of intersection of the two demand and supply curves. As is the situation in all demand and supply relationships, both the liquidity curves and the money supply curve are liable to shift to right or left. If investor's liquidity preferences suddenly in- crease, a given liquidity curve will shift to the right. Similarly, if the quantity of money remains constant then the rate of interest will rise from one level to another. Correspondingly, a shift in the money supply curve to the right representing an increase in the quantity of money, with a constant liquidity preference curve will result in a fall in the rate of interest.

Thus from the discussion in this section, it can be perfectly supposed that the rate of interest, as conventionally conceived by economists, represents the reward for parting with financial liquidity. Given the existing supply of money wich is periodically determined by the government's monetary establishments, an enterprise can obtain funds only by persuading a vestor who possesses liquidity to exchange it for some securities the rate of interest is the main device of persuasion on all conventional economic activities. 

The connections between the discussion in this section and the main theme of this paper (i.e. the prohibition of interest in Islam) are that:         

(1) The institution of interest is crucial aspect of capitalism, without it capitalism will automatically    collapse. As is fully known, Islam has always conceived of capitalism as exploitative and its moral injunctions are designed, among other things, to see to the replacement of capitalism with an Islamically based interest-free economic order.

(2) The use of a positive rate of interest in conventional economics as a major determinant of investor's liquidity preference has tended to plunge both investors and entrepreneurs in diabolical speculative relationships rather than in beneficial entrepreneural economic co-operation.

The Prohibition of Interest in Islam

As indicated in the introduction even in the field of business and economics, Islam directs that all human values must converge towards the emergence of socio-economic justice. Among the most important teachings of Islam for establishing justice and eliminating exploitation in business transactions, is the prohibition of all sources of inequiturs enrichment. The Qur'an categorically instructs Muslims not to acquire each others' property wrongfully (see Al-Qur'an: 2:188,4:29, 4:161 and 9:34).

One of the important sources of unjustified earning is receiving any financial advantage in business dealings without giving a just counter value. In the Islamic ethical system, interest represents a major source of unjustified earnings.

The prohibition of Riba (i.e. Interest) appears in the Qur'an in four different revelations. The first one (see 30:39) emphasised that interest dispossessed wealth of divine blessings. The second (4:161) strictly condemned the institution of interest. This revelation places all those who take interest in contiguity with those who wrongfully commandeer other people's property.

The third revelation (3:130—132) enjoined Muslims to keep away from interest if they desired their own welfare. The fourth revelation (2:275—281) strictly reprimanded those who take interest. This revelation has also established a clear dichotomy between trade and interest and directed Muslims to take only their principal amounts, and if necessary to forego even the principal in the form of sadqa, in cases of borrowers genuine hardship to repay.

Under the Islamic law, just as is the case in conventional economic theory, interest is defined to represent the excess (i.e. premium) that must be paid by the borrower to the lender along with the principal amounts as a condition for the loan or for an extension of its maturity.

In its prohibition of interest {Al-Qur'an: 2:275—281), Islam draws a dividing, line between trade (which is lawful) and interest which is prohibited. While in trade an entrepreneur has the chance of making a profit, he also faces the risk of incurring a loss. On the other hand, interest is predetermined to be positive irrespective of the final outcome of business performance which may be positive or negative depending to a large extent upon many factors beyond the control of the entrepreneur.While the earning of profit is uncertain, the payment of interest is predetermined and certain. Thus the fundamental distinction between profit and interest, that produces different moral and economic results inculdes:

(1) The settlement of profit is as a result of trading between the buyer and the seller, Except in a monopoly setting (which is forbidden in Islam), trade between the buyer and the seller is made on equal terms. The buyer proc- res the commodity he requires and the seller gets profit for the time, labour and enterprise he employs in producing the commodity. In contrast to this, in the case of interest the debtor cannot settle the transaction on equal terms with the creditor because of his weaker position. This is because the payment of interest which is certain in return for profit which is uncertain inflicts a harm on the debtor.

(2) The trader charges his profit, however high it may be, once for all, whereas the money-lender goes on charging interest over and over a again. These compound interest charges will go on increasing with the passage of time.

(3) In the case of loan with interest, the debtor has to reproduce it to the creditor along with its interest. He is thus exposed to a double danger; he has to reproduce the principal and also to produce its interest.

Interest-free Islamic Economy and Allocative Efficiency:

Perhaps, conventional economists might argue that an interest-free economic order will not be able to bring about an optimum allocation of resources. This is because, in conventional economics, interest is considered as a price and like all prices, it performs the function of allocating scarce economic funds among the vast users of such funds in  an objective manner on the basis of ability to pay the price. As discussed in section two, if the demand for or supply of economic funds changes, a new equilibrium is attained at different rates of interest. This conventional, theory of interest is based on the presumption that in the absence of interest investment funds will be available almost free to borrowers. As a result, the demand for funds will be immensely large such that there may not be any economic instrument available for equating demand with supply. This suggests that interest is the only objective criterion for allocation of resources and in its absence, scarce investment resources will be used ineffectively to the detriment of social welfare.

This conventional assumption is unfounded because investment funds will not be available free in an Islamically interest-free economic system. They will be available at a cost, and the cost will be the investors' share in profit The rate of profit will thus become a criterion for allocation of economic resources as well as providing the mechanism for equating demand with supply. The greater the anticipated rate of profit in any business activity, the greater wil be the supply of funds from potential investors to an entrepreneur. If the actual (i.e. ex-post) profit for certain enterprises is consistently lower than the expected (i.e. exante) profit, such enterprises may face diificulties raising funds in the future. Thus while anticipated profit will be helpful in measuring the flow of  investment funds, the ex-post performance of business enterprises will be fundamental for their futures success in raising funds. This should help enforce a greater discipline investment appraisal through a more careful evaluation of projects thereby eliminating all inefficient and uneconomic projects. This is not the same in interest based investments. As mentioned before, the financier does not share in the risk of the enterprise and assures himself of a predetermined rate of return irrespective of the eventual net outcome of the entrepreneurs' performance. thus the use of the rate of profit as provided in the Islamic economic system would tend to produce a more efficient mechanism for allocation of economic resources rather than the use of a positive rate of interest.

Interest Free Islamic Economic and Economics Progress:

Among the basic components for steady economic development are saving, investment and hard work.

The position of Islam on hardwork is clearly mentioned in the Qur'an (28:26): Truly, the best of men for you to employ is the (man) who is strong and trusty". As regards saving and investment, Islam has recognised the rate of profit and has permitted the individual entrepreneur to pursue profit, though within the constraints of moral values and general welfare. It has been demonstrated above that allocation of resources would tend to be more efficient and fair in Islamic economy than in the traditional interest-based system.

The abolition of interest and its replacement by profit sharing according to a fair ratio between the investor and entrepreneur should eliminate a major source of inequity thereby providing a more conducive setting for investment and economic progress. By making investors to be fully involved in the process of decision making (as they stand to lose if business operations are founded on unsound and faulty decision), the risk of business can be more equitably distributed thereby improving the trend of investment opportunities. Moreover, by involving the investors in the success of the entrepreneur's business, greater expertise should become available to the enterepreneur leading to an improvement in the availability of information, skills, efficiency, profitability and economic progress.

Furthermore, an interest-free Islamic economic order will tend to drastically reduce excessive government deficit financing. Deficit financing by definition suggests that expected government expenditure is higher than anticipated revenue and the government is unable or un prepared to raise revenue through additional texes.

As is commonly known, a grievous blow to economic progress is experienced because most of the funds raised by governments trough deficit budgeting are generally not utilised for investment in tangible assets but only to meet recurrent short term government's expenditures. As a result, we continue to observe a steeply rising mountain of internal and external debt with a continuing rise in the accompanying interest Charges. However, it is not being suggested that under an Islamic economic system, government will function only on the basis of strictly balanced financial budgets. The point being made is that under an Islamic economic setting, governments must of necessity cut their public expenditures to the barest minimum, This can be achieved if: 

(a) wasteful and unnecessary expenditure is eliminated and;

(b) if corruption and wanton destruction of government's assets are controlled through a complete moral reform of the society.

But despite the real need for government to try and avoid unnecessary financial deficits through a policy of conscientious austerity, the state can and should have tolerable levels of budget deficits. One method of balancing these deficits would te through equity financing of public projects. That is through financing public projects on the basis of profit and loss sharing between all the investors in government projects. Apart from helping to cut government borrowing, equity financing would tend to create the need for maximum efficiency and discipline in the management of government projects;

Summary and Conclusion

From the discussion of this paper, the use of a positive rate of interest in business dealings clearly carries with it the following three evils:

(a) Those enterprises that cannot pay an interest higher than or equal to the current market rate cannot draw in capital howsoever useful they may be for the society. In the end, all loanable funds will flow into those channels of business which can bring interest equal to or greater than the market rate of interest, howsoever deleterious they might be from overall socio-economic welfare viewpoint.

(b) As the capitalist himself is not directly a partner in the profit or the loss of the entrepreneur but keeps in view only his guaranteed fixed interest, he is not interested in the enterprises' welfare. As such he can selfishly attempt to withdraw and with-hold his funds whenever he has even the slightest apprehension of a slump in the market. In this way, by his selfish action, he will contribute more and more in driving a short term economic crisis situation into a long term national disaster.

(c) It is now well perceived that the rising compound interest burden of third world economies has made the payment of their debts almost impossible. As such they have the tendency of borrowing one loan after the other with the hope of getting out of this mess. But even after paying their interest charges at times equal to many times the original principals, the principals still continue to remain as they were before. The inefficiency caused in this type of financial relationship has tended to lower the quality and standard of national production. Thus it is quite clear that even from the economic point of view, while trade helps to construct society, interest, leads to its destruction.

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NOTES & REFERENCES

1. Beardshaw, J., Hanson's Introduction to Applied Economics, third edition, (Macdonald and Evans: U.K.), 1981.

2. Chapra, M.U., Towards a Just Monetary System (The Islamic Foundation: U.K.), 1985.

3. Graaf, J., Theoretical. Welfare Economics (Cambridge: U.K.), 1971.

4. Khan, W.M., Towards an Interest-Free Islamic Economic System (The Islamic Foundation,: U.K.), 1985.

5. Naqvi, N.H., Ethics and Economics: An Islamic Synthesis (The Islamic Foundation, U.K.), 1981.

6. Nevin, E., Text Book of Economic Analysis, Fifth Edition (Macmillan), 1982.

7. Siddiqui, M.N., Banking without Interest (The Islamic Foundation, U.K.), 1983.

8. Winch, D.M., Analytical Welfare Economics (preguin), 1971.