Why Interest is Banned in Islamic Economics?   by Islamic Economy

in Finance    (submitted 2012-01-19)

Acting upon the view that a business in which capital is used is more productive than one without capital, the capitalistic interest theories regard capital as absolutely productive; hence, they justify paying a fixed income to the capital owner.

It is hard to oppose the fact that capital is productive. However, the fact that capital is productive can not explain why a certain rate of interest is paid for it. If the reason for the interest payment is the productivity of capital, should not the return -that is interest rate- of the capital be changeable and be determined according to the outcome of the business since the productivity of capital changes depending on time, place and sector?

As a matter of fact, the interest rate is fixed at the beginning of the production or lending process; and the same rate of interest is applied at the end of the business without considering the negative or positive incidents that take place during the process. Consequently, there will be an unavoidable deviation between the initially detemined interest rate and the finally realized rate of return (RoR) on investment. It is the borrower who loses out when RoR is lower than expected, and the lender when it is higher than expected. In the first case, interest is an unearned income, in the second case it is an earned, but unequally distributed income.

Furthermore, if capital helps increase productivity of labor, what is the share of labor in this extra production since there cannot be any production without labor? Why are all uncertainties and risks laid on labor while the share of capital is determined at the beginning?
On the other hand, loans for consumption purposes are not generally regarded as productive. Charging interest on loans for educational and medical purposes although they are not productive is not a just application from the social point of view. However, it is generally obligatory to pay interest for these loans. The reason why a certain rate of interest is paid for such consumption loans in which capital is not productive cannot be explained by the productivity of capital, and interest theories cannot find answers to those questions.
The productivity of capital is accepted by Islam, too. However, Islam does not neglect the clear fact that a fixed income -allocated to capital at the beginning of business without taking the share of labor into consideration- inevitably causes either labor or capital to suffer a loss in the end. Thus, Islam does not accept any interest rate policy in order to protect the financial rights of both capital and labor in all-embracing manner.

Should we make it clearer metaphorically, it could be said that; capitalism decrees that a female being shall definitely give birth to a baby after mating with a male, whereas Islam does not decree anything at the beginning taking into consideration the probabilities that she may not give birth at all, she may give birth to twins or triplets, and even she may die before giving any birth, etc. and decrees in the end. Here, the female being stands for capital and male for labor/entrepreneur.

According to Islam, except for naturally productive domestic animals, any monetary or physical capital does not grow itself. Monetary capital that is infertile and frozen on its own needs to be accompanied with labor and join the production process in order to bring in yield. Then, interest income -which is a return on loan without being based on labor or risk, and which causes an unjust sharing of outcome between the borrower and the lender- is illegitimate in terms of Islamic criteria.
For a Muslim society, interest rates have no encouraging characteristic for capital accumulation or capital formation. Most generally, the accumulation of capital refers simply to the gathering or amassment of objects of value. In the broad sense, capital formation refers to any method for increasing the amount of capital owned or under one's control or any method in utilising or mobilizing capital resources for investment purposes. Thus, capital could be "formed" in the sense of "being brought together for investment purposes" in many different ways.

One of the basic factors for accumulation of capital in Islam is labor that is physical or mental work; because capital is accumulated labor. When labor contacts natural resources and processes them, it provides community with ready produced goods. If individuals do not consume all of those goods and save some of them, new production tools will be obtained that help labor in production. It is necessary to restrict consumption today in order to increase production in future. Islam uses profit as an encouraging element for accumulation of capital.
Islam has closed all ways that cause wealth to be collected in certain hands because it aims social welfare. Income and wealth are broken into small pieces and distributed to individuals. Consequently, it becomes difficult for individuals to realize large investments. Instead, Islam wants great investments to be realized by companies (musahama). Individuals take part in the process of capital formation of companies to be established with their small and big savings.
Moreover, the prohibition of actions like hoarding, stockpiling and speculation accelerate the process of production and hence that of capital accumulation. This process is also promoted with the fact that capital owner is urged to put his goods on the market fearing that the obligatory tax of zakat by 2.5% a year imposed on inactive capital will consume it in time.

Income transfer from high-income groups to low-income groups through zakat, alms, and other ways increase demand for consumption goods. In turn, it leads to an increase in production and national income. Increase in national income means that individuals have more opportunity for savings. Prohibition of extravagance in spendings has also an important role in capital accumulation.

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