Published in Express Tribune, 10 June 2010; See bit.do/azoieu for Urdu translation. Version below has been simplified and expanded. Nonetheless, it was written 8 years ago, just after the Global Financial Crisis, and does not cover many important developments which have taken place in the current decade.
Modern finance is based on trading of debt, and on the use of interest. Both of these operations are prohibited in Islam, making it difficult to “Islamize” finance. Secular mindsets dazzled by glories of the West think that we need to abandon archaic laws, and emulate the West, in order to develop and progress. Apologetic supporters of Islam believe that we need to revise and update Islamic laws, to bring them into harmony with needs of modern times. Much effort has gone into finding loopholes and stretched interpretations of Islamic law which will permit creation of the equivalents of Western financial instruments within the framework of Islamic Law. Very often, these efforts seem to stretch the Islamic laws to the breaking point or beyond. For example, Sukuk provide a very complex three part structure which provides a near exact replica of the very simple Western bond — Since the bond is clearly and directly based on interest, it cannot be used in Islamic Finance.
The general public, and many specialists, have expressed a lot of doubts about these efforts to re-create Western financial instruments within the framework of the Islamic law. It seems that the effort is being made to re-shape Islamic laws in order to bring them into conformity with Western ideas about finance, rather than re-shaping finance to bring it into conformity with Islam. The resulting instruments, like Sukuk, seem like they are pointlessly convoluted ways of imitating western ideas about finance. The general public remains skeptical as to whether or not these attempts lead to genuinely Islamic products.
This scenario changed with the occurrence of the Global Financial Crisis (GFC) of 2007. Suddenly, there was a radical realization, surprising to all parties, that instead of being obstacles to progress, the Islamic laws provide barriers against financial disaster. Many western commentators have remarked that adherence to Islamic economic principles would have prevented this crisis. Challenges, a French magazine, went so far as to say that the 7th century text of the Quran offered better guidance than the Pope on financial matters.
It is amazing that Islamic sacred texts, from the days when even the simple financial innovation of paper currency did not exist, offer guidance on how to prevent modern financial crises. How can ancient rules be suitable for modern problems, when nothing remotely resembling modern finance, paper currency, central banks, fractional reserve banking, stock markets, etc. existed in the era in which they were sent down. In the recent past, more than hundred big and small financial crises have occured due to speculation and transactions of types prohibited by Islam. Furthermore, ancient Islamic rules offer guidance on the architecture of a system that would both be proof against such crises and provide a more fair and equitable income distribution. The innovations which are the need of the hour are not in adapting Islamic law to modern institutions, but in changing these modern institutions to bring them into conformity with the ancient laws. In broad outline, six principles of Islamic law which would suffice to prevent financial crises like the GFC 2007, are listed below.
- Islamic law prohibits the trading of debt. It was the trading of collateralized debt obligations (CDOs) which triggered the global financial crisis of 2008.
- Islamic law insists on clarity regarding the product and the price as a condition for a valid sale. According to the famous financial wizard George Soros, complex instruments like CDOs are “so esoteric that the risk involved may not be properly understood even by the most sophisticated investors.”
- Islamic law prohibits interest. There is obvious injustice in a system which requires interest payments of billions of dollars annually to wealthy countries from the heavily indebted poor countries, which cannot afford to feed their own malnourished. The economic consequences of this injustice are apparent in the numerous financial crises resulting from debt defaults in both rich and poor countries. The book “House of Debt” by Mian and Sufi provides an entirely secular argument showing both how debt is extremely unjust and exploits the poor, and creates a crisis prone system. Islamic equity based contracts would avoid many of the problems created by debt, including the global financial crisis.
- Islamic law prohibits gambling. An incredibly large proportion of financial transactions are pure gambles. For example, while real international trade is only about $100 billion daily, foreign exchange transactions amount to $ 4 trillion. Thus the vast majority of such transactions are purely speculative gambles about the freely floating exchange rates.
- Islam requires every financial asset to be backed by a real asset. The value of paper issued on real world assets cannot exceed by much the real world value of the real assets. Western finance is based on violating this Islamic principle. Today firms do not get rich by doing honest productive work, contributing real value to society. Instead, when the firm incorporates and lists its shares on the stock exchange, financiers inflate the value of the stock to around twenty times the value of the firm. If the ground real value of the firm is a Thousand Dollars, stockholders have paper which gives them shares of ownership in the firm — these shares are worth Twenty Thousand Dollars. An illusion of wealth is created which does not exist in reality. The global value of financial derivatives was more than ten times the total GDP of the entire world in 2008, when the crisis occurred. The financial system is based on deceptions created by using speculation, gambling, and other financial gimmicks to create value on paper which has no existence in reality. This illusion often collapses, causing distress and misery to millions.
- Islam does not allow the OWNERSHIP of wealth to be considered as a productive activity, entitled to earning of returns. This is precisely what the prohibition of interest accomplishes. Today, in Western countries, more than half of the total production of a nation goes to people who contribute nothing to this, but are owners of the wealth needed to lubricate the wheels of production. Mere possession of wealth entitles one to earn more returns than anyone can earn by labor and production, not just due to interest, but also due to many other sophisticated techniques developed by the wealthy to capture a big share of the production pie.
Western financial methods have created a topsy-turvy world where financiers juggling papers make tremendously more than the honest laborers who work hard to produce industrial or agricultural products. This is the source of major problems facing the world today, where financiers who contribute nothing to real world production, can create wealth for themselves and the top 1% purely on the strength of the wealth they already own. This leads to the extreme and increasing concentrations of wealth we are witnessing today.
At the World Economic Forum in Davos, many remarked on the need for radical reforms to solve deepening global economic problems. Currently, producers of goods and services get only about 10% of the total output while 90% goes to bankers and financiers. Applying Islamic laws would channel a far bigger share in the output to the producers and laborers. It should be obvious that more incentives for producers would lead both to greater production and greater wealth for those most in need as well as most deserving of it. Islamic laws in the economic realm are explicitly designed to produce circulation of wealth, alleviation of poverty, and equitable income distributions. These ancient laws are the radical reforms needed to remove the massive injustices created by the current economic system designed to transfer wealth from the poor to the rich, both on an individual as well as the national level.
POSTSCRIPT: For original article, and link to references cited, see: On Islamic Economics