Dear readers, here is a good paper on Interest Abolition, its belong to my Major’s director Mr. Masyhudi Muqorobin, enjoy it….. Yummy…..

Theoretical Analysis of Interest Abolition and

Introducing Profit-Loss Sharing

(Special Paper for Innaugurating the Centennial Mu’tamar of Muhammadiyah)

 

by

Masyhudi Muqorobin

 

Head of Dept. of Economics and Director of International Program for Islamic Economics and Finance (IPIEF)

Universitas Muhammadiyah Yogyakarta

 

masmubin@yahoo.com

 

 

  1. 1. Introduction

The Council of Tarjih of Muhammadiyah has just discussed the issue of a fatwa on prohibition of interest, following a fatwa on the same issue by the Council of Indonesian Ulama (MUI). However, differences in interpretation of riba in Islam make the two fatwas remain unworkable significantly. This is because the majority of the Muslims remains unclear about the difference between riba– and equity-based participation, as represented by conventional and Islamic systems respecvtively, especially in banking and financial activities. Abolition of interest is not merely of religious significance, but also part of economic needs of a society, which necessitates academic analysis. This paper attempts to clarify from theoretical perspective, to provide more understanding about interest prohibition in an Islamic economy, and in support academically of the soundness of the two fatwas.

 

  1. 2. Candid Prohibition of Riba in Islam

Islam prohibits riba, as declared by Allah SWT in Surah al-Baqarah 275. “wa ahallaahul-bay’a wa harramar-ribaa” Allah has permitted trade and prohibited riba. Chapra in the appendix of his “Towards a Just Monetary system” (1986) maintains that this clear injunction concerning prohibition of riba in Islam abbrogates the previous verse “walaa ta’kuluur-ribaa adh’aafaan mudhaa’afah” (and do not eat multiple usury), which had been revealed previously. There are four steps of reveleation of riba. Two first step gives a positive explanation of riba that gives no blessing in the economy, and Jewish acquisitive behaviour generated by applying usury in the economy. Normative aspect of riba was sent down by Allah in two stages. In the first instance, Allah prohibits only multiple usury. Following the years of appreciation of the verse on prohibition of multiple usury, then the final decision on candid prohibition on any additional payment on borrowing was sent down by Allah to clearly prohibits all kinds of interest.

 

  1. 3. Theoretical Perspective of Riba Prohibiton

Differences in interpretation to what extent riba equals the modern economic term “interest” remain unresolved. Some sholars are of the opinion that some forms of “interest” is inevitable as it is a reasonable excess, thus does not meet the meaning of prohibited riba, to which the word “usury” is closer, and “the difference between riba and interest is the one of the degree not of kind” Choudhury (1975). On the other hand, the rest are in agreement to refer interest as riba and therefore rule out the role of interest as a cost of production from the Islamic socio-economic set up (Haneef, 1995; Mannan 1980,1992).

 

Following the abolition process of riba prohibition in the Qur’an, interest abolition from an economy requires a stepwise process, through what Naqvi (1981a, 1981b, 1983, 1994) calls  “transition period.”[1] It is inadequate to abolish interest, particularly using administrative fiat during the period. This also appears in his joint effort with Qadir (1981), and with others in An Agenda for Islamic Economic Reform.[2] However, if all conditions for a “complete” Islamic economic system are satisfied, he maintains, prohibition of riba implies the existence of “exploitation-free” economy, not only “interest-free” economy, as it accordingly implies elimination of the entire capitalistic system. The logic is that abolition of interest is necessary condition for such a system, but not sufficient (Naqvi, 1981a:  110). He further admits, in the context of capitalism as adhered by the majority of Muslim countries, positive interest rate is of its properties and thus satisfies the criterion of equilibrium. Hence, as capitalism bases its operation on limited liability to risk, limited knowledge about large-scale enterprise logically implies only a limited risk (1981a: 111-112). To provide arguments, he develops a model based on the assumption that positive time-preference is given in the society as a decreasing function of time (Naqvi 1981b and 1983, Naqvi and Qadir 1981). It is “reflecting the essentially myopic nature of individual’s economic calculus” (1981a: 115), and should be acceptable in Islam (1994: 114).

 

  1. 4. Interest, Intertemporal Choices and Production Possibilities

Interest is thought being the main pillar of modern conventioanl economy, Interest as a “price” or “cost’ of capotal can be defined, following Fisher (1930, 1970), as “the per cent of premium paid on money (or wheat or any other sort of goods) at one date in terms of money to be in hand one year later.” Interest rate in general determines the rate of investment relative to the gross national income and thereby the rate of economic growth. The lower the interest rates the higher the level of investment and thus the rate of economic growth. Accordingly, the investible resources are influenced by the rate of interest.

 

It is evident that the above proposition had been envisaged in a number of writings in the early years of the century, in the works of prominent economists like Marshall, Bohm-Bawerk, Walras, Knight, Wicksell, Fisher, etc.[3] In a chapter of his Theory of Interest, Fisher (1930) argues that interest is hardly separable from the involvement of time dimension to evolve the discounting concept. Suppose “the value of dinner about to be eaten involves no time of waiting and so no discount or interest,” meaning inversely that the price of any good or service (or in a generalised sense, asset) that involves time for waiting should be discounted, or in other words, “interest should be accounted for.” This is the very beginning of the process of determining the rate of interest.

 

The process begins with the difference between interests of two assets, matched exactly by the expected change in their relative prices, to form an interest parity formula[4]

 

1 + j

—— = 1 + a (1)

1 + i

 

where i and j are the interest parity rates on individual assets 1 and 2 respectively, showing that each asset has its own interest rate related to its future price expectation, and a is expected appreciation of asset 1 relative to asset 2.

 

Fisher accomplishes the model by making use of time preference (consumption) and production possibilities, and their relationship with income in terms of general equilibrium framework. Figure 1 provides two basic foundations of neoclassical theory, which can be blamed for the originating causes of the existence of interest rate. First, time preference that defines the objectives of individuals’ intertemporal preferences. Second, production function that defines the constraint, transformation possibilities, from the available individual’s income.

Figure 1

Time Preference and Transformation Possibilities

 

C1

 

M

 

 

P

A

K

 

 

 

Y1 X      B              I2

I1

45o I0

0               P’ M’                                            C0

Y0

– ( 1+ m )

 

Consider a two-period case, where indifference curves describe present and future individual consumption. Its slope illustrating the rate of exchange between units of present consumption, C0, and that of the future, C1, can be developed in the same way as definition (1) so that

 

dc1

—— =  – (1 + i)                                                           (2)

dc0

 

The slope also reflects the marginal rate of time preference (MRTP) consumption, which is influenced by two factors: available amounts of present and future consumption, and individual income. If an expected future income of an individual is higher than current income, at above 45 degree line (suppose at point A), he will tend to give up a larger amount of C1 for a given increment in C0, than that one at B under the 45 degree line. The 45o line through the origin illustrates the equality amount of present and future consumption. Along the line, the individual still gives up more than one unit of C1 for an additional unit of C0, as indicated by the asymmetrical indifference curves in the figure. This exists because people are impatient and, at the same time, want to get opportunities for investment.[5]

 

On the other hand, MM’ is the only income constraint that reflects the financial opportunities facing the individual, with the slope of, say to avoid confusion from the MRTP slope, -(1+m). If the present individual’s income is entirely spent for C0, the situation is represented by point M’ =  Y0 + Y1 /(1 + m), he avoids using his income for financial opportunities in the future. Conversely, M = Y1 + Y0 (1 + m), represents another extreme for putting all income for future financial opportunities and not to consume today. Along the line MM’, the income (or budget) constraint becomes C0 + C1 /(1 + m) =  Y0 + Y1 /(1 + m), where financial opportunities may be exchanged, so as to form a “market line”.[6]

 

Financial opportunities also provide production possibility frontiers, one of which is, PP’, illustrated as “another blade of a scissors.” K represents an optimum choice of a combined set of production possibilities, shown by the tangential of the market line to the frontier, so that the marginal rate of transformation (MRT) of Y0 into Y1 can be given by:

 

dy1

—— =  – (1 + r)                                                           (3)

dy0

 

If the optimum levels of both, the utilities represented by indifference curves and the production possibilities, meet at one point in this line, where the production frontier is tangential to the indifference curve, there will be no trading. So, his equilibrium condition is attained at such a point. Otherwise, there will be alternatives for mechanism enduring the “lending” and “borrowing” process reflected in the movement along the market line. Given the income in the current period, an individual who wants to attain an optimum productive level at K, can consume at his optimum utility by borrowing the money amount of C0 -Y0 as depicted in Figure 2.

 

 

Figure 2

A Lending-Borrowing Mechanism

 

C1

 

 

M

 

 

 

 

K

 

 

 

Y1 X

 

45o

0          Y0 C0 M’ C0

 

There are two possible reasons for why positive interest rate is said to exist. First, a bias in favour of the availability of future consumption through the attainment of certain level of production, shown by asymmetric production possibility frontiers; and second positive bias of individual’s time preference (Dougherty, 1980). There are also two factors influencing the establishment of equilibrium with a positive time preference, subjective preference affected from tastes and expectation of the consumers and the second is technology that influences the production possibilities.

 

Having elaborated the above issues, it is possible, with the help of Figure 3, to derive the demand for (and supply of) loanable funds, for each individual as a function of the rate of interest. It should be thought that intertemporal efficiency conditions are stipulated in a general equilibrium, which is simultaneously determined by all agents. Accordingly, individual consumption-investment decisions can be undertaken, given the information of interest rate. On the other hand, interest rate is known after the aggregate consumption-investment has been made by occupying market mechanism of loanable funds. The Walrasian auctioneer is hence used to determine the rate of interest. In order to satisfy the Pareto Optimality in general equilibrium, the aggregate lending must equal the aggregate borrowing. Thus, the equality of MRTP or i (definition 2), MRT or r (definition 3), and also interest rate reflected then in the market (m), to all individuals is attainable. Figure 3, derived from Figure 2 by reformulating time preference consumption in terms of saving-investment relationship, depicts the market mechanism of loanable-funds illustrating the equality of saving and investment.

 

Figure 3.

Saving and Investment Equilibrium

Interest rate

(+)

 

Saving

 

 

 

E

 

 

Investment

0                                                                              S,I

(-)

 

 

  1. 5. Abolition of Interest and Islamization of Economy

Now let the paper goes back to an analysis from Islamic perspective. An attainment of the falah in Islam carries time-preference, current and future socio-economic setting. This also tells us that future dimension illustrated by the ultimate objective, i.e. attaining the falah in the hereafter (al-Qasas: 77), should be more valuable than that one in the world. Appreciation of this matter will presumably govern the Muslim to prepare for their future lives better. The Qur’an clearly states the Islamic appreciation of time. Allah says:

 

O, ye who believe! Fear Allah, and let every soul look to what (provision) he has sent forth for the morrow. Yea, fear Allah: for Allah is well-acquainted with (all) that ye do. (al- Hashr 59:18)

 

By the time, verily man is in loss, except such as have Faith, and do righteous deeds, and (join together) in the mutual enjoining of truth, and of patience and constancy. (surah al-‘Asr 103:1-4)

 

 

In an Islamic economic reform, i.e. Islamisation of the economy, Naqvi (1981a) advocates a gradual, dialogic or even a compromising process (Naqvi 1994). The purpose is to let the existing conventional economic system gradually dissolves and smoothly provides a chance for the Islamic reforms to take over its position, without giving any significant impact to the society. He adheres:

 

“The elements of the Islamic reforms must be looked at in relation to its “totality” – i.e. the ‘fact’ that Islam’s is a complete socio-economic system.…

The pace of the Islamisation process must be slow enough to allow the existing economic system to change on abroad front and to maximise the flow of knowledge about how the Islamic system operates in practice.” (Naqvi and Qadir, 1981)

 

However, suggestion is given, such a reform requires a policy package, in which, among others, a priority is given to a programme for Islamising the institution of private property, where Muslims live under oppressive feudalistic system. Differently speaking, the issue here is not a mere prohibition of interest but by and large Islamisation of Muslim economy.

 

By contrast, the majority of Muslim economists who advocate the interest abolition consider undertaking a segmental step of contribution towards the Islamisation process, in which their participation is of great significance. A comparative feature of the above process from the starting point of interest abolition is depicted in Figure 4. Haque and Mirakhor (1986) accentuate that the notion of the absolute prohibition of interest is clear. Thus, application of PLS system, as at least interpreted under mudharabah and musharakah schemes is plausible without resort to charging of interest. However, theoretical elaboration is required to supply with a rigorous support for the study.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Notes:

 

  1. 6. Time Dimension and Intertemporal Analysis in Islam

Those who realise the importance of the time would spend it for the benefits of their future, as the future would be more valuable for them. All their activities are carried out through time. Therefore, they should decide which activities provide better alternatives for achieving their future ends, which can be defined in our worldly life as multiple, and not independent of time. The difficulty arises, as the time for achieving these ends is limited and capable of alternative application, even in the very simple world (Robbins, 1988). Robinson Cruzoe or his Arabic original name Hay bin Yaqzan (Kahf 1994) who lived alone in an island, being defined to provide only two alternative choices of consumption (an apple and a fish) either which he must take the decision to consume, exemplifies this problem. He needed time to enjoy and utilise such consumption or even to decide the best choice. On the other hand, when the activities were defined in terms of investment or production, the scarce resources made him decides to have an appropriate choice.

 

Considering the importance of time dimension, Islam provides the notion of deferment in transaction. In principle, there are two kinds of deferment in Islamic transaction as mentioned in Kahf (1994), and Khan (1991 and 1995): bay’ muajjal or nasi’a (Sa’adillah, 1994) for deferment in price, and bay; salam for item deferment. Khan views the deferment as recognition of time value of money as there is time element involves in the process of exchange. Hence, not only time preference should be considered but also supply–demand mechanism. Accordingly, it should be time preference or intertemporal factor that needs examination here. Choudhury (1986 and 1992) suggests derivation of intertemporal consumption-investment menu from the attainment of the falah in the hereafter, as principles of maximisation of the total felicity attainment. Together with the principles of work and productivity, among others, the principle of maximising total felicity yields Islamic time-preference in consumption and investment.

 

Kahf (1994) is true in revisiting Khan’s (1991) view that time value of money is not a purely consumption phenomenon, it is rather of an investment, which seems to fit for the Islamic precepts. The purpose of the human creation is nothing but for the obedience to Allah (al-Dzariyat 51:56), the activity man can observe. Therefore, the principle of work and productivity or in other word entrepreneurship becomes the pivotal role, which a Muslim has no other choice. It is worth presenting the words as quoted by Hirshliefier (1970) with the opposite emphasis:

 

There is the “work to live” school, in which wants are treated as ends, and the “live to work” school, in which activities are treated as ends….. One who (implicitly perhaps) takes the former position, like Alvin Hansen, is likely to regard existing wants as primary and the consumer as the dominant economic entity. From this it is but a short step to the idea of a stable consumption function to the idea of stagnation. On the other hand one who takes the latter view point, likes Schumpeter, will conceive of activities as primary. The producer-innovator is the dominant economic entity; innovation is the primary theme, even though it may come in waves, and one arrives at theory of economic development.

 

“Life is for struggle” (al-Balad: 90) and not “struggle for a life,” struggle to maximise man’s achievement in fulfilling his obligation and service to Allah. Work or activity (or to be more specific investment or production) is given priority over consumption, as in this sense that consumption constitutes a means and production is an ends. Combination of both may lead to attaining his optimum obedience to Allah, and he can survive to maximise his service to Allah. The emphasis on production or investment side obtains philosophical bases, as discussed in the beginning, as compared to consumption that deserves only “moderation” (not “maximisation”) of human commitment, even from Khan (1995) himself. It is therefore theoretically reasonable to find using this way the rate of profit as appropriate measure of investment criterion in an Islamic economy (Azhar 1992).

 

  1. 7. Developing a PLS Equity-Based Intertemporal Analysis

Having discussed the philosophical basis, and thus holding the assumption of selecting time preference from the investment viewpoint, we can develop a theoretical construct of intertemporal analysis. The study hence underlines Azhar’s (1992) explicit statement that optimality conditions primarily pertain to saving and thus investment, which leads to optimality in intertemporal consumption, as the latter is dependent on the former. These conditions provide for an emergence of intertemporal consumption as a concomitant fact, in exactly the same way as neoclassical analysis treats the emergence of investment from intertemporal consumption.

 

The process begins with leaving aside the positive time preference in consumption, in favour of the negative one. The second step is to transform from consumption to production perspectives through a saving-investment mechanism. We can thus reformulate positive bias in “time preference” in terms of investment where positive rate of discount may still exist. In short, we resort to finding justification from consumer theory. Figure 5, following the same notation as in Figure 1, depicts the negative bias in time preference, shown by the asymmetric indifference curves in favour of future consumption. It follows the logic for the existence of positive time preference illustrated in the previous sections.

Figure 5

Negative Time Preference in Consumption

 

 

C1

N’                                                                       R’

 

 

M

 

P

I2

 

I1

Io

 

 

 

 

 

 

 

 

45°

Co

0        N                                                   P’ R                 M’

 

 

Supposing a symmetric production possibility frontier, the optimal point (X) lies at the above 45° ray from the origin, and there exists the negative rate of time preference. The study considers the rationality axiom of lexicographic preferences (ordering) in conventional framework, as also suggested by Zaman,[7] reflecting the fulfilment of five basic necessities as mentioned previously, represented by NN’ line. Moreover, Zaman’s axiom of satiation of basic needs is borrowed, and expanded to accommodate all types of consumption in general, to be applied within Prodigality frontier, RR’, as discussed by Zarqa’,[8] or under Choudhury’s (1986, and 1992), and Choudhury and Abdul Malik’s principle of avoiding israf. This can be so under time preference concept derived from the principle of attaining the maximum falah as presumably being held on one hand, and holding both the physical and Islamic ethical constraints i.e. of avoiding extravagance (al-Isra 17:27) to achieve efficiency.

 

Anyone will obviously decide to consume first before saving decision is undertaken. However, it should be assumed that after fulfilment of basic necessities, a Muslim’s income is sufficient to make him decides whether to put aside a fraction of it for saving or to entirely spend it on consumption. Therefore, the dharuriyyat (necessities) line (NN’) is the minimum level after which he, as a Muslim, is faced with two choices: investment decision, and pursuing further consumption for hajjiyat (conveniences) and tahsiniyyat (refinements) approaching the maximum consumption level, the israf line (RR’). He should first think of its postponement in favour of future consumption or investment, for the reasons explained above.

 

Hence, the optimality conditions occur at X, where the absolute value of the slope of an indifference curve (dc1/dc0) as defined in equation (2) is less than unity. At such a point, MRTP equals MRT (and as claimed in conventional analysis, equals interest rate, OM/OM’). So that MRTP is less than zero. (1 + i ) < 1, i < 0. It is seen that the positive interest rate constitutes something impossible to exist under such a condition.

 

It should be thought that in Islam, the lexicographical ordering and satiation concepts (reflected in the fulfilment of basic necessities and prodigality frontier respectively) altogether inherently entail individual and social obligatory responsibility for the people and the government to sustain the needy, whose income is not sufficient to meet these basic necessities, including those who have no income, i.e. children and disabled. This responsibility is then explicated through the formation of future consumption that can be defined in terms of saving. In addition, this also open to possibiity of expanding the analysis of the presence of zakah.

 

There will be two alternatives for the consumer, whether he wants this saving to be idle; or converts it into investment for production purposes. Both of these purposes have individual and social welfare enhancement roles too. The former i.e. idle saving exceeding the level of nisab (minimum level to allowable deduction) is subject to yearly 2.5% zakah rate,[9] which individually purifies his saving, and increases his spiritual uplift and achievement of falah in the Hereafter. Hence, this saving will be gradually diminishing to a certain level every year. To prevent it from diminishing because of zakah, he can thus take the latter position for investment, from which he can get the returns. The social dimensions of this choice stem from the schemes under PLS system, in particular, where participation of workers is considered. A brief discussion on such social dimensions shall be in a separate paper.

 

The advocacy of using investment viewpoint necessitated in time preference analysis, however, does not necessarily means that analyses emphasising on consumption lose their relevance, as both perspectives are inseparable. Consideration to time preference consumption function will serve a clear view in analysing the society-wide context, in order to incorporate redistribution of consumption of outputs of an investment (either private or public) through time (see for instance Feildstein, 1964). Naqvi (1981b and 1982), and Naqvi and Qadir (1981) modeling the capital theory, start their analysis from production function. Haque and Mirakhor (1986) use equations of Y = C + I and S = Y – C = I to define the utility in macro-consumption space in terms of investment with a certain rate of return. A positive investment time preference, or in our term MRT (r) equating to positive rate of return, is possible to exist, resulting from positive bias in future production for the availability of future consumption.

 

However, since the significance of consumption time preference is merely considered as a concomitant fact, its optimal point (X) always coincides with optimality condition yielded from an investment decision (K) as illustrated in Figure 6. Consequently, there is no lending-borrowing mechanism as happens in conventional analysis (compare to Figure 2). It is unanimously agreed that Islam does not allow such a mechanism. The figure depicts the “only possible” cause of the existence of positive rate of return stemming from positive bias in production possibilities, from which profit rate comes to the existence.

This positive bias in future production is reasonable due to factors, as mentioned previously. First, subjective preference affected from tastes and expectation of the consumers, which being consistent hence shall be defined as such that future consumption will serve higher quality as associated with the second. Secondly, technological changes, on which, as Haque and Mirakhor theoretically prove, entrepreneur’s investment decision depends. There are some other factors, it is observed, which (should) influence such a bias:

Figure 6

Positive Bias in Intertemporal Production Possibilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Labours participation in PLS schemes increases their job responsibility, accordingly, ensures the quality enhancement of their products over time;
  2. Research and development (established in a company) is an important factor in improving the product quality too; and
  3. A possible increase in demand that calls for further expansion of the product, given the fact of high increase in population particularly in Muslim countries.

 

 

 

  1. 8. The “Fallacy” of Fisherian Approach

From the Islamic viewpoint, the above discussion does at the same time correct the “fallacy” of the Fisherian approach, which can be discerned from two features. First, Fisher’s (1930) first stage (approximation) says that the income stream of an individual can be modified trough lending-borrowing mechanism. Islamically, it is acceptable (but not encouraged)[10] especially for consumption purposes, provided no interest bearing entails in the mechanism, as he otherwise necessitates as a consequence of the “fallacy” of his human impatience. Fisher is true that humankind by nature, as the Qur’an says, is hasty (al-Isra: 11), impatient, and sometimes combined with fretful and niggardly (al-Ma’arij: 19-21). These characteristics in general belong to all mankind. However, Islam comes into the world to make use of human Free Will to get them emancipated from domination of such bad natures. Therefore, the assumption of the obedience of the Muslim following the Qur’anic teaching, rules out the assumption that the believers and non-believers behave similarly, or in other words, that these characteristics are applied, too, to the Muslims “eternally” (especially in consumption). On the other hand, PLS system for production purposes seems to fit with the Islamic teaching, though in the modern times Muslim economists have invariably considered several modes of financing that combine both (interest-free) lending-borrowing and PLS mechanisms, with the use of some Islamised conventional modes of financing.[11]

 

Second, in the second approximation, he suggests that modification of income stream is possible by (“buying and selling” the income to) investing, with interest rate as a “price”. He equalises the “intermediate rate of interest,” and the “rate of return over cost” as a result of investment, as explained in Table 1 (partially quoted from his Table 7, p.156).

Table 1

Farming and Forestry Use Compared in Terms of

Rate of Return over Cost

 

 

Net Value of Farming Use Net Value of Forestry Use Net Difference in Favour of Forestry Use
1st year $ 100 $   0 -$ 100
2nd year 100 210 + 110
3rd year 100 100 0
Each Subsequent Year 100 100 0

 

 

 

For more convenience, occupying the interest parity formula (formula 1), we may obtain:

 

 

1 + j

—— = 1 + a (4)

1 + i

 

which can be reformulated to get:

 

1 + j (1 + j) – (1 + i)

a =   ——  – 1  =  ——————  =   j (5)

1 + i 1 + i

 

where (1 + i) and (1 + j) representing an asset in two different points of time, say now and one year later. If the values of i and j are respectively 0 and 10%, therefore, we can find that a is 10% representing an “intermediate rate of interest”. He immediately shifts to the concept of “rate of return over cost.” The Table shows that there are two options (or investment opportunities) the farmer faces, say by the farming use; to produce Qi, and second, forestry use; to produce Qj. At the initial period (first year), he thinks of taking the second option with the cost of losing his opportunity to get the first option (QiQ0 = $100). Q0 represents the dollar amount to be reduced at the initial period, when he undertakes the investment project (equals zero). Fisher calculates the rate of return over cost, say p, as:[12]

Qj  – Qi

p = ————                                                                                   (6)

Qi – Q0

210 – 100

p = ————  = 10%

100

 

Equation 6 is not really similar as equation 5, that the former talks about interest rate, while the latter explains more on profit rate. It is seen that rate of return over cost at that particular time is appropriately considered as profit rate rather than interest rate, though all values may be similar. Formula 6 is also the same as formula 3 at a particular point, namely K, as shown in Figures 1 and 2.

 

 

  1. 9. Generalisation of Two-Period Model

We now turn to generalisation of the functions over time, and move towards social time preference analysis, which is considered to have the same pattern as that of individual. On consumption space, an assumption is taken that utility functions represented by indifference curves are convex and monotonically increasing with a diminishing rate. This assumption fulfils the macroeconomic requirement that consumption is a function of (disposable) income, likewise saving. As income is expected to increase over time, consumption (and saving) accordingly will also increase. Prodigality (israf) frontier however will slacken the rate of consumption in favour of saving. The consumption path thus will be steeper as depicted in Figure 6.

Figure 6

Consumption Path over Time

 

 

 

 

 

 

 

 

 

 

I2

 

I1

I0

 

 

 

 

 

 

 

 

 

 

Other factors including prices being constant, it is reasonable to assume the increase in MRT over time as accumulation of reinvested capital is expected to be higher. The assumption of future consumption preference leads to high growth rate of consumption, as a result of reinvestment of saving that produces future consumption. The increase in growth rate, given the assumption of convexity properties of indifference curves, will produce an MRT (or MRTP, or in general term discount) rate (Feildsten, 1986). However, this is subject to possible changes in population. When discussion on consumption per capita is held, prodigality frontier (RR’) is still reasonable for consideration. Figure 7, derived from Figure 6 explains an increase in discount rate as a result of the increase in consumption growth rate. This conclusion differs from Azhar (1992: 233) who observes linear (constancy) rate of return (profit) over a period of time.

Figure 7

Rate of Return over Time

 

Rate of Return

 

 

 

 

 

 

 

 

 

 

O                                                                                                    Time

 

 

 

 

 

Above all, it should be thought that the approach could optimally work if several assumptions are satisfied. As believed in neoclassical tradition, perfect competition is considered the main assumption, which sets the condition of perfect foresight, so that the lack of uncertainty is also held. Continuity and convexity are also held for both the indifference curves and possibility frontiers, so as to produce a unique optimum solution for each schedule at the same market line.[13]

 

 

 

 

 


[1] Naqvi defines the “transition period” as “the transition from the present un-Islamic economic system to a complete Islamic economic system” as the “second best” choice before arriving at the “first best” or the complete economic system (see Naqvi, 1981a, p.33). The period “of translating the Divine message within the crucible of real-life institutions” (Naqvi, 1992, p. 8).

[2] An Agenda is a report of the Committee on Islamisation of Pakistan Economy, appointed by the Government of Pakistan, having members: Naqvi, H.U. Beg, Rafiq Ahmed and Mian M. Nazeer. An Agenda was published by Pakistan Institute of Development Economic, Islamabad, 1989. See pp. 20-21.

 

[3] Among the good elaboration and enumeration of such theories is F.A. Lutz’s Theory of Interest, D. Reidel Publishing Company, Dordrecht, Holland, 1967. However, it may be unfortunate, due to time and space limitations, this subsection can only accommodate the views of Irving Fisher and a little addition from Bohm-Bawerk and Keynesian views, being of great relevance to the discussion in the next two subsections. It should be noted that Fisher’s Theory of interest (The theory of interest as determined by impatience to spend and opportunity to invest, Macmillan, New York, 1930) was dedicated to two previous writer on the related subject as discussed in this particular section, John Rae and Bohm-Bawerk. Therefore, it is reasonable to relate one of both, Bohm-Bawerk, with his Capital and interest: history and critique of interest theory, transl. by George D. Hunke and Hans F. Sennholz, vol I, Libertian Press, Illinois, 1959,  to Fisher’s theory of interest. On the other hand, Keynesian approach is meant to enriched the picture from which the next discussion  is expected to be clearer.

[4] Adopted from J. Niehans, “Irving Fisher”, a chapter inside A history of economic theory: classic contributions, 1720-1980, John Hopkins University Press, Baltimore, 1990, p. 274.

[5] The belief in such that positive time preference always exists in an empirical fact may also be seen from the title of  Fisher’s book itself. See n. 48 (Ibid).

[6] This market line is steeper than 45 degree line as “future income decreases faster than the present income increases,” when there exists interest rate. See ibid, p. 236.

 

[7] For mathematical details see Asad Zaman, Towards foundations for an Islamic theory of consumer behaviour, inside Sayyid Tahir, Aidit Ghazali, and Syed Omar Syed Agil, Readings in microeconomics, pp. 81-89. He exemplifies the preference of bread as a primary need placed in the horizontal axis, and diamond as a luxury need put in the vertical axis.

[8] Muhammad Anas Zarqa’, A partial relationship in a Muslim’s utility function, inside Sayyid Tahir, Aidit Ghazali, and Syed Omar, Readings, pp. 105-112. He defines “prodigality frontier” as maximum permissible “refinements” or “tahsiniyyat” .

 

[9] The rates of zakah(t) are, as already well known according to the traditions of the Prophet (pbuh), fixed 2.5%, 10% (‘ushr), 20% (khums), etc.(See for instance Naqvi, 1994, p. 102). However, we take a normal rate for this kind of wealth as also taken by Bashir and Darrat (1991); Choudhury (1986, 1992); Choudhury and Abdul Malik (1992); Hallaq (1994); Khan, 1995; Sattar (1991).

[10] The Prophet (pbuh) is reported to have said: “O Allah; I seek refuge in Thee from sin and from being in debt.” Someone asked him: “How often does thou, O Messenger of Allah; seek refuge from being in debt?” He said: “When a man is in debt he speaks and tells lies and he promises and breaks the promise.” (narrated by al-Bukhari). Quoted from M. A. Mannan, Understanding Islamic finance, p. 27.

[11] See  this Understanding Islamic finance throughout the book.

 

[12] For further elaboration see L.L. Pasinetti, Switches of technique and the ‘rate of return’ in capital theory, The Economic Journal, September 1969, pp. 508-531.

[13]Continuity and convexity are among the properties by which indifference curves (and also production possibility frontiers) may achieve unique solutions. Continuity states that if two bundles (x and y) are close to each other in the feasible set, they will be assigned utility numbers that are close to each other as well. This implies that (suppose in case of consumer behaviour) the consumer is indifference between an initial bundle (i) and any point/bundle (say, z) along the path connecting any bundle less than the initial one (x) to any other bundle that is better than such an initial bundle (y). This property is however violated by either lexicographic or satiation preferences, or  both. On the other hand, convexity property explains that on the line segment between two equivalent (equally preferred) feasible bundles (a and b), any bundle (c) generated by taking a fraction k of one bundle (a) and a fraction (I-k) of another one (b), where 0< k <1, is also a feasible bundle. This implies that if any other bundle (d) is better than both a and b, then it is also better than c. For further (mathematical) detail, see for instance J.M. Handerson and R.E. Quandt, Microeconomic theory, 3rd ed., McGraw-Hill Book Co., Auckland, 1980.

Theoretical Analysis of Interest Abolition and

Introducing Profit-Loss Sharing

(Special Paper for Innaugurating the Centennial Mu’tamar of Muhammadiyah)

 

by

Masyhudi Muqorobin

 

Head of Dept. of Economics and Director of International Program for Islamic Economics and Finance (IPIEF)

Universitas Muhammadiyah Yogyakarta

 

masmubin@yahoo.com

 

 

  1. 1. Introduction

The Council of Tarjih of Muhammadiyah has just discussed the issue of a fatwa on prohibition of interest, following a fatwa on the same issue by the Council of Indonesian Ulama (MUI). However, differences in interpretation of riba in Islam make the two fatwas remain unworkable significantly. This is because the majority of the Muslims remains unclear about the difference between riba– and equity-based participation, as represented by conventional and Islamic systems respecvtively, especially in banking and financial activities. Abolition of interest is not merely of religious significance, but also part of economic needs of a society, which necessitates academic analysis. This paper attempts to clarify from theoretical perspective, to provide more understanding about interest prohibition in an Islamic economy, and in support academically of the soundness of the two fatwas.

 

  1. 2. Candid Prohibition of Riba in Islam

Islam prohibits riba, as declared by Allah SWT in Surah al-Baqarah 275. “wa ahallaahul-bay’a wa harramar-ribaa” Allah has permitted trade and prohibited riba. Chapra in the appendix of his “Towards a Just Monetary system” (1986) maintains that this clear injunction concerning prohibition of riba in Islam abbrogates the previous verse “walaa ta’kuluur-ribaa adh’aafaan mudhaa’afah” (and do not eat multiple usury), which had been revealed previously. There are four steps of reveleation of riba. Two first step gives a positive explanation of riba that gives no blessing in the economy, and Jewish acquisitive behaviour generated by applying usury in the economy. Normative aspect of riba was sent down by Allah in two stages. In the first instance, Allah prohibits only multiple usury. Following the years of appreciation of the verse on prohibition of multiple usury, then the final decision on candid prohibition on any additional payment on borrowing was sent down by Allah to clearly prohibits all kinds of interest.

 

  1. 3. Theoretical Perspective of Riba Prohibiton

Differences in interpretation to what extent riba equals the modern economic term “interest” remain unresolved. Some sholars are of the opinion that some forms of “interest” is inevitable as it is a reasonable excess, thus does not meet the meaning of prohibited riba, to which the word “usury” is closer, and “the difference between riba and interest is the one of the degree not of kind” Choudhury (1975). On the other hand, the rest are in agreement to refer interest as riba and therefore rule out the role of interest as a cost of production from the Islamic socio-economic set up (Haneef, 1995; Mannan 1980,1992).

 

Following the abolition process of riba prohibition in the Qur’an, interest abolition from an economy requires a stepwise process, through what Naqvi (1981a, 1981b, 1983, 1994) calls  “transition period.”[1] It is inadequate to abolish interest, particularly using administrative fiat during the period. This also appears in his joint effort with Qadir (1981), and with others in An Agenda for Islamic Economic Reform.[2] However, if all conditions for a “complete” Islamic economic system are satisfied, he maintains, prohibition of riba implies the existence of “exploitation-free” economy, not only “interest-free” economy, as it accordingly implies elimination of the entire capitalistic system. The logic is that abolition of interest is necessary condition for such a system, but not sufficient (Naqvi, 1981a:  110). He further admits, in the context of capitalism as adhered by the majority of Muslim countries, positive interest rate is of its properties and thus satisfies the criterion of equilibrium. Hence, as capitalism bases its operation on limited liability to risk, limited knowledge about large-scale enterprise logically implies only a limited risk (1981a: 111-112). To provide arguments, he develops a model based on the assumption that positive time-preference is given in the society as a decreasing function of time (Naqvi 1981b and 1983, Naqvi and Qadir 1981). It is “reflecting the essentially myopic nature of individual’s economic calculus” (1981a: 115), and should be acceptable in Islam (1994: 114).

 

  1. 4. Interest, Intertemporal Choices and Production Possibilities

Interest is thought being the main pillar of modern conventioanl economy, Interest as a “price” or “cost’ of capotal can be defined, following Fisher (1930, 1970), as “the per cent of premium paid on money (or wheat or any other sort of goods) at one date in terms of money to be in hand one year later.” Interest rate in general determines the rate of investment relative to the gross national income and thereby the rate of economic growth. The lower the interest rates the higher the level of investment and thus the rate of economic growth. Accordingly, the investible resources are influenced by the rate of interest.

 

It is evident that the above proposition had been envisaged in a number of writings in the early years of the century, in the works of prominent economists like Marshall, Bohm-Bawerk, Walras, Knight, Wicksell, Fisher, etc.[3] In a chapter of his Theory of Interest, Fisher (1930) argues that interest is hardly separable from the involvement of time dimension to evolve the discounting concept. Suppose “the value of dinner about to be eaten involves no time of waiting and so no discount or interest,” meaning inversely that the price of any good or service (or in a generalised sense, asset) that involves time for waiting should be discounted, or in other words, “interest should be accounted for.” This is the very beginning of the process of determining the rate of interest.

 

The process begins with the difference between interests of two assets, matched exactly by the expected change in their relative prices, to form an interest parity formula[4]

 

1 + j

—— = 1 + a (1)

1 + i

 

where i and j are the interest parity rates on individual assets 1 and 2 respectively, showing that each asset has its own interest rate related to its future price expectation, and a is expected appreciation of asset 1 relative to asset 2.

 

Fisher accomplishes the model by making use of time preference (consumption) and production possibilities, and their relationship with income in terms of general equilibrium framework. Figure 1 provides two basic foundations of neoclassical theory, which can be blamed for the originating causes of the existence of interest rate. First, time preference that defines the objectives of individuals’ intertemporal preferences. Second, production function that defines the constraint, transformation possibilities, from the available individual’s income.

Figure 1

Time Preference and Transformation Possibilities

 

C1

M

 

 

P

A

K

 

 

 

Y1 X      B              I2

I1

45o I0

0               P’ M’                                            C0

Y0

– ( 1+ m )

 

Consider a two-period case, where indifference curves describe present and future individual consumption. Its slope illustrating the rate of exchange between units of present consumption, C0, and that of the future, C1, can be developed in the same way as definition (1) so that

 

dc1

—— =  – (1 + i)                                                           (2)

dc0

 

The slope also reflects the marginal rate of time preference (MRTP) consumption, which is influenced by two factors: available amounts of present and future consumption, and individual income. If an expected future income of an individual is higher than current income, at above 45 degree line (suppose at point A), he will tend to give up a larger amount of C1 for a given increment in C0, than that one at B under the 45 degree line. The 45o line through the origin illustrates the equality amount of present and future consumption. Along the line, the individual still gives up more than one unit of C1 for an additional unit of C0, as indicated by the asymmetrical indifference curves in the figure. This exists because people are impatient and, at the same time, want to get opportunities for investment.[5]

 

On the other hand, MM’ is the only income constraint that reflects the financial opportunities facing the individual, with the slope of, say to avoid confusion from the MRTP slope, -(1+m). If the present individual’s income is entirely spent for C0, the situation is represented by point M’ =  Y0 + Y1 /(1 + m), he avoids using his income for financial opportunities in the future. Conversely, M = Y1 + Y0 (1 + m), represents another extreme for putting all income for future financial opportunities and not to consume today. Along the line MM’, the income (or budget) constraint becomes C0 + C1 /(1 + m) =  Y0 + Y1 /(1 + m), where financial opportunities may be exchanged, so as to form a “market line”.[6]

 

Financial opportunities also provide production possibility frontiers, one of which is, PP’, illustrated as “another blade of a scissors.” K represents an optimum choice of a combined set of production possibilities, shown by the tangential of the market line to the frontier, so that the marginal rate of transformation (MRT) of Y0 into Y1 can be given by:

 

dy1

—— =  – (1 + r)                                                           (3)

dy0

 

If the optimum levels of both, the utilities represented by indifference curves and the production possibilities, meet at one point in this line, where the production frontier is tangential to the indifference curve, there will be no trading. So, his equilibrium condition is attained at such a point. Otherwise, there will be alternatives for mechanism enduring the “lending” and “borrowing” process reflected in the movement along the market line. Given the income in the current period, an individual who wants to attain an optimum productive level at K, can consume at his optimum utility by borrowing the money amount of C0 -Y0 as depicted in Figure 2.

 

 

Figure 2

A Lending-Borrowing Mechanism

 

C1

 
M

 

 

 

 

K

 

 

 

Y1 X

 

45o

0          Y0 C0 M’ C0

 

There are two possible reasons for why positive interest rate is said to exist. First, a bias in favour of the availability of future consumption through the attainment of certain level of production, shown by asymmetric production possibility frontiers; and second positive bias of individual’s time preference (Dougherty, 1980). There are also two factors influencing the establishment of equilibrium with a positive time preference, subjective preference affected from tastes and expectation of the consumers and the second is technology that influences the production possibilities.

 

Having elaborated the above issues, it is possible, with the help of Figure 3, to derive the demand for (and supply of) loanable funds, for each individual as a function of the rate of interest. It should be thought that intertemporal efficiency conditions are stipulated in a general equilibrium, which is simultaneously determined by all agents. Accordingly, individual consumption-investment decisions can be undertaken, given the information of interest rate. On the other hand, interest rate is known after the aggregate consumption-investment has been made by occupying market mechanism of loanable funds. The Walrasian auctioneer is hence used to determine the rate of interest. In order to satisfy the Pareto Optimality in general equilibrium, the aggregate lending must equal the aggregate borrowing. Thus, the equality of MRTP or i (definition 2), MRT or r (definition 3), and also interest rate reflected then in the market (m), to all individuals is attainable. Figure 3, derived from Figure 2 by reformulating time preference consumption in terms of saving-investment relationship, depicts the market mechanism of loanable-funds illustrating the equality of saving and investment.

 

Figure 3.

Saving and Investment Equilibrium

Interest rate

(+)

 

Saving

 

 

 

E

 

 

Investment

0                                                                              S,I

(-)

 

 

  1. 5. Abolition of Interest and Islamization of Economy

Now let the paper goes back to an analysis from Islamic perspective. An attainment of the falah in Islam carries time-preference, current and future socio-economic setting. This also tells us that future dimension illustrated by the ultimate objective, i.e. attaining the falah in the hereafter (al-Qasas: 77), should be more valuable than that one in the world. Appreciation of this matter will presumably govern the Muslim to prepare for their future lives better. The Qur’an clearly states the Islamic appreciation of time. Allah says:

 

O, ye who believe! Fear Allah, and let every soul look to what (provision) he has sent forth for the morrow. Yea, fear Allah: for Allah is well-acquainted with (all) that ye do. (al- Hashr 59:18)

 

By the time, verily man is in loss, except such as have Faith, and do righteous deeds, and (join together) in the mutual enjoining of truth, and of patience and constancy. (surah al-‘Asr 103:1-4)

 

 

In an Islamic economic reform, i.e. Islamisation of the economy, Naqvi (1981a) advocates a gradual, dialogic or even a compromising process (Naqvi 1994). The purpose is to let the existing conventional economic system gradually dissolves and smoothly provides a chance for the Islamic reforms to take over its position, without giving any significant impact to the society. He adheres:

 

“The elements of the Islamic reforms must be looked at in relation to its “totality” – i.e. the ‘fact’ that Islam’s is a complete socio-economic system.…

The pace of the Islamisation process must be slow enough to allow the existing economic system to change on abroad front and to maximise the flow of knowledge about how the Islamic system operates in practice.” (Naqvi and Qadir, 1981)

 

However, suggestion is given, such a reform requires a policy package, in which, among others, a priority is given to a programme for Islamising the institution of private property, where Muslims live under oppressive feudalistic system. Differently speaking, the issue here is not a mere prohibition of interest but by and large Islamisation of Muslim economy.

 

By contrast, the majority of Muslim economists who advocate the interest abolition consider undertaking a segmental step of contribution towards the Islamisation process, in which their participation is of great significance. A comparative feature of the above process from the starting point of interest abolition is depicted in Figure 4. Haque and Mirakhor (1986) accentuate that the notion of the absolute prohibition of interest is clear. Thus, application of PLS system, as at least interpreted under mudharabah and musharakah schemes is plausible without resort to charging of interest. However, theoretical elaboration is required to supply with a rigorous support for the study.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Notes:

 

  1. 6. Time Dimension and Intertemporal Analysis in Islam

Those who realise the importance of the time would spend it for the benefits of their future, as the future would be more valuable for them. All their activities are carried out through time. Therefore, they should decide which activities provide better alternatives for achieving their future ends, which can be defined in our worldly life as multiple, and not independent of time. The difficulty arises, as the time for achieving these ends is limited and capable of alternative application, even in the very simple world (Robbins, 1988). Robinson Cruzoe or his Arabic original name Hay bin Yaqzan (Kahf 1994) who lived alone in an island, being defined to provide only two alternative choices of consumption (an apple and a fish) either which he must take the decision to consume, exemplifies this problem. He needed time to enjoy and utilise such consumption or even to decide the best choice. On the other hand, when the activities were defined in terms of investment or production, the scarce resources made him decides to have an appropriate choice.

 

Considering the importance of time dimension, Islam provides the notion of deferment in transaction. In principle, there are two kinds of deferment in Islamic transaction as mentioned in Kahf (1994), and Khan (1991 and 1995): bay’ muajjal or nasi’a (Sa’adillah, 1994) for deferment in price, and bay; salam for item deferment. Khan views the deferment as recognition of time value of money as there is time element involves in the process of exchange. Hence, not only time preference should be considered but also supply–demand mechanism. Accordingly, it should be time preference or intertemporal factor that needs examination here. Choudhury (1986 and 1992) suggests derivation of intertemporal consumption-investment menu from the attainment of the falah in the hereafter, as principles of maximisation of the total felicity attainment. Together with the principles of work and productivity, among others, the principle of maximising total felicity yields Islamic time-preference in consumption and investment.

 

Kahf (1994) is true in revisiting Khan’s (1991) view that time value of money is not a purely consumption phenomenon, it is rather of an investment, which seems to fit for the Islamic precepts. The purpose of the human creation is nothing but for the obedience to Allah (al-Dzariyat 51:56), the activity man can observe. Therefore, the principle of work and productivity or in other word entrepreneurship becomes the pivotal role, which a Muslim has no other choice. It is worth presenting the words as quoted by Hirshliefier (1970) with the opposite emphasis:

 

There is the “work to live” school, in which wants are treated as ends, and the “live to work” school, in which activities are treated as ends….. One who (implicitly perhaps) takes the former position, like Alvin Hansen, is likely to regard existing wants as primary and the consumer as the dominant economic entity. From this it is but a short step to the idea of a stable consumption function to the idea of stagnation. On the other hand one who takes the latter view point, likes Schumpeter, will conceive of activities as primary. The producer-innovator is the dominant economic entity; innovation is the primary theme, even though it may come in waves, and one arrives at theory of economic development.

 

“Life is for struggle” (al-Balad: 90) and not “struggle for a life,” struggle to maximise man’s achievement in fulfilling his obligation and service to Allah. Work or activity (or to be more specific investment or production) is given priority over consumption, as in this sense that consumption constitutes a means and production is an ends. Combination of both may lead to attaining his optimum obedience to Allah, and he can survive to maximise his service to Allah. The emphasis on production or investment side obtains philosophical bases, as discussed in the beginning, as compared to consumption that deserves only “moderation” (not “maximisation”) of human commitment, even from Khan (1995) himself. It is therefore theoretically reasonable to find using this way the rate of profit as appropriate measure of investment criterion in an Islamic economy (Azhar 1992).

 

  1. 7. Developing a PLS Equity-Based Intertemporal Analysis

Having discussed the philosophical basis, and thus holding the assumption of selecting time preference from the investment viewpoint, we can develop a theoretical construct of intertemporal analysis. The study hence underlines Azhar’s (1992) explicit statement that optimality conditions primarily pertain to saving and thus investment, which leads to optimality in intertemporal consumption, as the latter is dependent on the former. These conditions provide for an emergence of intertemporal consumption as a concomitant fact, in exactly the same way as neoclassical analysis treats the emergence of investment from intertemporal consumption.

 

The process begins with leaving aside the positive time preference in consumption, in favour of the negative one. The second step is to transform from consumption to production perspectives through a saving-investment mechanism. We can thus reformulate positive bias in “time preference” in terms of investment where positive rate of discount may still exist. In short, we resort to finding justification from consumer theory. Figure 5, following the same notation as in Figure 1, depicts the negative bias in time preference, shown by the asymmetric indifference curves in favour of future consumption. It follows the logic for the existence of positive time preference illustrated in the previous sections.

Figure 5

Negative Time Preference in Consumption

 
C1

N’                                                                       R’

 

 

M

 

P

I2

 

I1

Io

 

 

 

 

 

 

 
45°

Co

0        N                                                   P’ R                 M’

 

 

Supposing a symmetric production possibility frontier, the optimal point (X) lies at the above 45° ray from the origin, and there exists the negative rate of time preference. The study considers the rationality axiom of lexicographic preferences (ordering) in conventional framework, as also suggested by Zaman,[7] reflecting the fulfilment of five basic necessities as mentioned previously, represented by NN’ line. Moreover, Zaman’s axiom of satiation of basic needs is borrowed, and expanded to accommodate all types of consumption in general, to be applied within Prodigality frontier, RR’, as discussed by Zarqa’,[8] or under Choudhury’s (1986, and 1992), and Choudhury and Abdul Malik’s principle of avoiding israf. This can be so under time preference concept derived from the principle of attaining the maximum falah as presumably being held on one hand, and holding both the physical and Islamic ethical constraints i.e. of avoiding extravagance (al-Isra 17:27) to achieve efficiency.

 

Anyone will obviously decide to consume first before saving decision is undertaken. However, it should be assumed that after fulfilment of basic necessities, a Muslim’s income is sufficient to make him decides whether to put aside a fraction of it for saving or to entirely spend it on consumption. Therefore, the dharuriyyat (necessities) line (NN’) is the minimum level after which he, as a Muslim, is faced with two choices: investment decision, and pursuing further consumption for hajjiyat (conveniences) and tahsiniyyat (refinements) approaching the maximum consumption level, the israf line (RR’). He should first think of its postponement in favour of future consumption or investment, for the reasons explained above.

 

Hence, the optimality conditions occur at X, where the absolute value of the slope of an indifference curve (dc1/dc0) as defined in equation (2) is less than unity. At such a point, MRTP equals MRT (and as claimed in conventional analysis, equals interest rate, OM/OM’). So that MRTP is less than zero. (1 + i ) < 1, i < 0. It is seen that the positive interest rate constitutes something impossible to exist under such a condition.

 

It should be thought that in Islam, the lexicographical ordering and satiation concepts (reflected in the fulfilment of basic necessities and prodigality frontier respectively) altogether inherently entail individual and social obligatory responsibility for the people and the government to sustain the needy, whose income is not sufficient to meet these basic necessities, including those who have no income, i.e. children and disabled. This responsibility is then explicated through the formation of future consumption that can be defined in terms of saving. In addition, this also open to possibiity of expanding the analysis of the presence of zakah.

 

There will be two alternatives for the consumer, whether he wants this saving to be idle; or converts it into investment for production purposes. Both of these purposes have individual and social welfare enhancement roles too. The former i.e. idle saving exceeding the level of nisab (minimum level to allowable deduction) is subject to yearly 2.5% zakah rate,[9] which individually purifies his saving, and increases his spiritual uplift and achievement of falah in the Hereafter. Hence, this saving will be gradually diminishing to a certain level every year. To prevent it from diminishing because of zakah, he can thus take the latter position for investment, from which he can get the returns. The social dimensions of this choice stem from the schemes under PLS system, in particular, where participation of workers is considered. A brief discussion on such social dimensions shall be in a separate paper.

 

The advocacy of using investment viewpoint necessitated in time preference analysis, however, does not necessarily means that analyses emphasising on consumption lose their relevance, as both perspectives are inseparable. Consideration to time preference consumption function will serve a clear view in analysing the society-wide context, in order to incorporate redistribution of consumption of outputs of an investment (either private or public) through time (see for instance Feildstein, 1964). Naqvi (1981b and 1982), and Naqvi and Qadir (1981) modeling the capital theory, start their analysis from production function. Haque and Mirakhor (1986) use equations of Y = C + I and S = Y – C = I to define the utility in macro-consumption space in terms of investment with a certain rate of return. A positive investment time preference, or in our term MRT (r) equating to positive rate of return, is possible to exist, resulting from positive bias in future production for the availability of future consumption.

 

However, since the significance of consumption time preference is merely considered as a concomitant fact, its optimal point (X) always coincides with optimality condition yielded from an investment decision (K) as illustrated in Figure 6. Consequently, there is no lending-borrowing mechanism as happens in conventional analysis (compare to Figure 2). It is unanimously agreed that Islam does not allow such a mechanism. The figure depicts the “only possible” cause of the existence of positive rate of return stemming from positive bias in production possibilities, from which profit rate comes to the existence.

This positive bias in future production is reasonable due to factors, as mentioned previously. First, subjective preference affected from tastes and expectation of the consumers, which being consistent hence shall be defined as such that future consumption will serve higher quality as associated with the second. Secondly, technological changes, on which, as Haque and Mirakhor theoretically prove, entrepreneur’s investment decision depends. There are some other factors, it is observed, which (should) influence such a bias:

Figure 6

Positive Bias in Intertemporal Production Possibilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  1. Labours participation in PLS schemes increases their job responsibility, accordingly, ensures the quality enhancement of their products over time;
  2. Research and development (established in a company) is an important factor in improving the product quality too; and
  3. A possible increase in demand that calls for further expansion of the product, given the fact of high increase in population particularly in Muslim countries.

 

 

 

  1. 8. The “Fallacy” of Fisherian Approach

From the Islamic viewpoint, the above discussion does at the same time correct the “fallacy” of the Fisherian approach, which can be discerned from two features. First, Fisher’s (1930) first stage (approximation) says that the income stream of an individual can be modified trough lending-borrowing mechanism. Islamically, it is acceptable (but not encouraged)[10] especially for consumption purposes, provided no interest bearing entails in the mechanism, as he otherwise necessitates as a consequence of the “fallacy” of his human impatience. Fisher is true that humankind by nature, as the Qur’an says, is hasty (al-Isra: 11), impatient, and sometimes combined with fretful and niggardly (al-Ma’arij: 19-21). These characteristics in general belong to all mankind. However, Islam comes into the world to make use of human Free Will to get them emancipated from domination of such bad natures. Therefore, the assumption of the obedience of the Muslim following the Qur’anic teaching, rules out the assumption that the believers and non-believers behave similarly, or in other words, that these characteristics are applied, too, to the Muslims “eternally” (especially in consumption). On the other hand, PLS system for production purposes seems to fit with the Islamic teaching, though in the modern times Muslim economists have invariably considered several modes of financing that combine both (interest-free) lending-borrowing and PLS mechanisms, with the use of some Islamised conventional modes of financing.[11]

 

Second, in the second approximation, he suggests that modification of income stream is possible by (“buying and selling” the income to) investing, with interest rate as a “price”. He equalises the “intermediate rate of interest,” and the “rate of return over cost” as a result of investment, as explained in Table 1 (partially quoted from his Table 7, p.156).

Table 1

Farming and Forestry Use Compared in Terms of

Rate of Return over Cost

 

 

Net Value of Farming Use Net Value of Forestry Use Net Difference in Favour of Forestry Use
1st year $ 100 $   0 -$ 100
2nd year 100 210 + 110
3rd year 100 100 0
Each Subsequent Year 100 100 0

 

 

 

For more convenience, occupying the interest parity formula (formula 1), we may obtain:

 

 

1 + j

—— = 1 + a (4)

1 + i

 

which can be reformulated to get:

 

1 + j (1 + j) – (1 + i)

a =   ——  – 1  =  ——————  =   j (5)

1 + i 1 + i

 

where (1 + i) and (1 + j) representing an asset in two different points of time, say now and one year later. If the values of i and j are respectively 0 and 10%, therefore, we can find that a is 10% representing an “intermediate rate of interest”. He immediately shifts to the concept of “rate of return over cost.” The Table shows that there are two options (or investment opportunities) the farmer faces, say by the farming use; to produce Qi, and second, forestry use; to produce Qj. At the initial period (first year), he thinks of taking the second option with the cost of losing his opportunity to get the first option (QiQ0 = $100). Q0 represents the dollar amount to be reduced at the initial period, when he undertakes the investment project (equals zero). Fisher calculates the rate of return over cost, say p, as:[12]

Qj  – Qi

p = ————                                                                                   (6)

Qi – Q0

210 – 100

p = ————  = 10%

100

 

Equation 6 is not really similar as equation 5, that the former talks about interest rate, while the latter explains more on profit rate. It is seen that rate of return over cost at that particular time is appropriately considered as profit rate rather than interest rate, though all values may be similar. Formula 6 is also the same as formula 3 at a particular point, namely K, as shown in Figures 1 and 2.

 

 

  1. 9. Generalisation of Two-Period Model

We now turn to generalisation of the functions over time, and move towards social time preference analysis, which is considered to have the same pattern as that of individual. On consumption space, an assumption is taken that utility functions represented by indifference curves are convex and monotonically increasing with a diminishing rate. This assumption fulfils the macroeconomic requirement that consumption is a function of (disposable) income, likewise saving. As income is expected to increase over time, consumption (and saving) accordingly will also increase. Prodigality (israf) frontier however will slacken the rate of consumption in favour of saving. The consumption path thus will be steeper as depicted in Figure 6.

Figure 6

Consumption Path over Time

 

 

 

 

 

 

 

 

 

 

I2

 

I1

I0

 

 

 

 
 

 

 

 

 

Other factors including prices being constant, it is reasonable to assume the increase in MRT over time as accumulation of reinvested capital is expected to be higher. The assumption of future consumption preference leads to high growth rate of consumption, as a result of reinvestment of saving that produces future consumption. The increase in growth rate, given the assumption of convexity properties of indifference curves, will produce an MRT (or MRTP, or in general term discount) rate (Feildsten, 1986). However, this is subject to possible changes in population. When discussion on consumption per capita is held, prodigality frontier (RR’) is still reasonable for consideration. Figure 7, derived from Figure 6 explains an increase in discount rate as a result of the increase in consumption growth rate. This conclusion differs from Azhar (1992: 233) who observes linear (constancy) rate of return (profit) over a period of time.

Figure 7

Rate of Return over Time

 

Rate of Return

 

 

 

 

 

 

 

 

 
O                                                                                                    Time

 

 

 

 

 

Above all, it should be thought that the approach could optimally work if several assumptions are satisfied. As believed in neoclassical tradition, perfect competition is considered the main assumption, which sets the condition of perfect foresight, so that the lack of uncertainty is also held. Continuity and convexity are also held for both the indifference curves and possibility frontiers, so as to produce a unique optimum solution for each schedule at the same market line.[13]

 

 

 

 

 


[1] Naqvi defines the “transition period” as “the transition from the present un-Islamic economic system to a complete Islamic economic system” as the “second best” choice before arriving at the “first best” or the complete economic system (see Naqvi, 1981a, p.33). The period “of translating the Divine message within the crucible of real-life institutions” (Naqvi, 1992, p. 8).

[2] An Agenda is a report of the Committee on Islamisation of Pakistan Economy, appointed by the Government of Pakistan, having members: Naqvi, H.U. Beg, Rafiq Ahmed and Mian M. Nazeer. An Agenda was published by Pakistan Institute of Development Economic, Islamabad, 1989. See pp. 20-21.

 

[3] Among the good elaboration and enumeration of such theories is F.A. Lutz’s Theory of Interest, D. Reidel Publishing Company, Dordrecht, Holland, 1967. However, it may be unfortunate, due to time and space limitations, this subsection can only accommodate the views of Irving Fisher and a little addition from Bohm-Bawerk and Keynesian views, being of great relevance to the discussion in the next two subsections. It should be noted that Fisher’s Theory of interest (The theory of interest as determined by impatience to spend and opportunity to invest, Macmillan, New York, 1930) was dedicated to two previous writer on the related subject as discussed in this particular section, John Rae and Bohm-Bawerk. Therefore, it is reasonable to relate one of both, Bohm-Bawerk, with his Capital and interest: history and critique of interest theory, transl. by George D. Hunke and Hans F. Sennholz, vol I, Libertian Press, Illinois, 1959,  to Fisher’s theory of interest. On the other hand, Keynesian approach is meant to enriched the picture from which the next discussion  is expected to be clearer.

[4] Adopted from J. Niehans, “Irving Fisher”, a chapter inside A history of economic theory: classic contributions, 1720-1980, John Hopkins University Press, Baltimore, 1990, p. 274.

[5] The belief in such that positive time preference always exists in an empirical fact may also be seen from the title of  Fisher’s book itself. See n. 48 (Ibid).

[6] This market line is steeper than 45 degree line as “future income decreases faster than the present income increases,” when there exists interest rate. See ibid, p. 236.

 

[7] For mathematical details see Asad Zaman, Towards foundations for an Islamic theory of consumer behaviour, inside Sayyid Tahir, Aidit Ghazali, and Syed Omar Syed Agil, Readings in microeconomics, pp. 81-89. He exemplifies the preference of bread as a primary need placed in the horizontal axis, and diamond as a luxury need put in the vertical axis.

[8] Muhammad Anas Zarqa’, A partial relationship in a Muslim’s utility function, inside Sayyid Tahir, Aidit Ghazali, and Syed Omar, Readings, pp. 105-112. He defines “prodigality frontier” as maximum permissible “refinements” or “tahsiniyyat” .

 

[9] The rates of zakah(t) are, as already well known according to the traditions of the Prophet (pbuh), fixed 2.5%, 10% (‘ushr), 20% (khums), etc.(See for instance Naqvi, 1994, p. 102). However, we take a normal rate for this kind of wealth as also taken by Bashir and Darrat (1991); Choudhury (1986, 1992); Choudhury and Abdul Malik (1992); Hallaq (1994); Khan, 1995; Sattar (1991).

[10] The Prophet (pbuh) is reported to have said: “O Allah; I seek refuge in Thee from sin and from being in debt.” Someone asked him: “How often does thou, O Messenger of Allah; seek refuge from being in debt?” He said: “When a man is in debt he speaks and tells lies and he promises and breaks the promise.” (narrated by al-Bukhari). Quoted from M. A. Mannan, Understanding Islamic finance, p. 27.

[11] See  this Understanding Islamic finance throughout the book.

 

[12] For further elaboration see L.L. Pasinetti, Switches of technique and the ‘rate of return’ in capital theory, The Economic Journal, September 1969, pp. 508-531.

[13] Continuity and convexity are among the properties by which indifference curves (and also production possibility frontiers) may achieve unique solutions. Continuity states that if two bundles (x and y) are close to each other in the feasible set, they will be assigned utility numbers that are close to each other as well. This implies that (suppose in case of consumer behaviour) the consumer is indifference between an initial bundle (i) and any point/bundle (say, z) along the path connecting any bundle less than the initial one (x) to any other bundle that is better than such an initial bundle (y). This property is however violated by either lexicographic or satiation preferences, or  both. On the other hand, convexity property explains that on the line segment between two equivalent (equally preferred) feasible bundles (a and b), any bundle (c) generated by taking a fraction k of one bundle (a) and a fraction (I-k) of another one (b), where 0< k <1, is also a feasible bundle. This implies that if any other bundle (d) is better than both a and b, then it is also better than c. For further (mathematical) detail, see for instance J.M. Handerson and R.E. Quandt, Microeconomic theory, 3rd ed., McGraw-Hill Book Co., Auckland, 1980.