The purpose of this paper is to analyze using modern knowledge and objective standards what the effect of interest is on the economy. The motivation being Koranic verses which deal with interest and other verses in the Koran which give economic guidelines. A supplementary purpose served by this paper would be an objective testing of the Koran [which claims to be God's word] based on modern scientific knowledge, in the field of economics.

I) Modern Banking History:

The real breakthrough for modern banking was in 1453 after the fall of Constantinople. The rich Jews fled being suspicious of the new conquerors, first to Italy and then to London carrying with them their vast wealth. According to one perspective, the word "Bank" originated from the Italian word for "Bench", as these Jews carried on their business of money lending and money changing on benches. They were called Lombards as they carried on their business in Lombardy. The Lombard Street in present day London, England is named after them. The most famous of these Italian bankers were the Medici Family (Meyer, Duesenberry, Aliber 36)

An alternative perspective as to the origin of banking is a German one. In 1401 formal banking started in Germany as partnership institutions. According to this theory, the word "Bank" originated from the German word "Bach" which means a partnership firm with a number of partners.

Modern, present day banking operates mainly by giving interest to people from whom it has borrowed money, and after keeping a small percentage of it [people's wealth or money] as reserves and vault cash, lending or investing the same money [people's wealth] at a higher rate of interest or return and keeping the difference as profit [The major source of revenue for banks]. This is in addition to the profit made by banks on the various bank services provided.

The Koran, over 1400 years back condemned today's modern banking concepts before they were put into wide scale practice: "And what you give in interest [riba in Arabic] that it may increase on (other) people's wealth, increases not with Allah (God)...(Koran 30:39)."

The Koran states explicitly that trade is not the same as interest:

Those who consume interest shall not rise, except as he rises whom Satan by his touch prostrates [i.e one who is misled]; that is because they say:"Trade is like interest"; whereas, Allah [God] has permitted trading but forbidden [Haraam in Arabic] interest. Whosoever receives a warning from his/her Lord, he shall have his past gains and his affair is committed to Allah (God); but whosoever reverts (to devouring interest) those, they are the inhabitants of the fire, therein dwelling forever. (Koran 2:275)

According to the above Koranic verse, trade is not the same as interest. Interest that banks give to us on our money lent is not trade. Trade involves the profit/loss made by the exchange of goods and services mostly involving some medium of exchange (eg. money) while Interest is the cost of borrowing money (the medium of exchange) and does not involve goods and services primarily.

Buying shares in companies is trading [for example] as you become a co-owner of the company to the extent of the face value of your share and as such share in its trading profits. If a person is a Muslim, he/she should have no part of their interest profit. Likewise, debentures issued by companies, pay interest and as such are forbidden to Muslims.

A bank is not just another business like a furniture store or a lumberyard. The decisions made by bankers quite literally permeate the entire economy, affecting the decisions made by other business people, housewives, and government officials. In fact, reduced to its simplest terms, the whole idea behind central banking and monetary policy is that if we can somehow influence the decisions made by bankers, then these decisions, in turn, will influence the decisions made by everyone else and in this indirect fashion we can control the overall functioning of the economy.(Luckett 142)

The Koran talks about inflation [over 1400 years back!] and adjusting the money you lent for inflation [but not charging interest]: "...but if you repent (from devouring interest), you will have your principal, un wronging and un wronged (Koran 2:279)."

If I do not adjust my principal for inflation while receiving the money that I lent someone earlier, I will be "wronged" as that amount, which I receive now [unadjusted] will buy fewer goods than it would have when I lent it. The Koran says that you will have your principal, "un wronging (i.e you wont charge interest) and un wronged (i.e you will adjust for inflation)." Such a conclusion is implicitly suggested by the above verse.

The functions of modern day commercial banks, primarily built upon borrowing and lending for interest, has wide scale effects on the economy [as is suggested by Luckett's quote above].

II) INTEREST & INVESTMENT

Interest plays a big role in reducing capital investment and hence development:

Investment is spending on addition to capital stock [machinery, structures, inventories etc]. Such investment is undertaken with the aim of making profits in the future by operating machines and factories. Suppose firms borrow to buy capital that they use. Then the higher the rate of interest, the more firms have to pay out in interest each year from their investment. Thus the higher the rate of interest, the less they will want to invest. Conversely, a low rate of interest makes investment spending more profitable, therefore reflected in a higher level of planned investment. (Dornbusch, Fischer 115)

If a person borrows to invest, then the higher the rate of interest, the less profitable his investment would be, so he would invest less. Investment would be the most profitable [and hence the highest] if there was no interest in the economy and lent money was only adjusted for inflation at payback time.

Even if a person does not borrow but finances the purchase of capital with the money that he/she possesses, even then a higher rate of interest would reduce investment and if interest did not exist in the economy, investment would be the most profitable and the highest [because of opportunity cost, the cost of the next best alternative that is foregone]: "A decision to increase the amount of capital available usually entails a present sacrifice and a future gain (Lipsey 392)."

III) INTEREST & SAVINGS

Raising the rate of interest does not increase savings:

But should we really expect an increase in the interest rate to increase savings? It is true that when the interest rate rises, saving is made more attractive. But it is also made less necessary. Consider someone who has decided to save an amount that will ensure that $10,000 per year is available for retirement. Suppose that the interest rate now is 5% and the person is saving $1,000 per year. Now let the interest rate rise to 10%. With such a high interest rate, the individual needs to save less now to provide the given 10,000 per year during retirement. It may be possible to provide the same retirement income by saving only about $650 a year. Thus an increase in the interest rate might reduce saving. (Dornbusch, Fischer 278)

The Koran condemns interest [simple & compound]:

"O you who believe! Devour not interest, doubled and redoubled, and be careful of Allah (God); haply so you will prosper." (Koran 3:130)

Devouring interest, according to common sense would be charging interest on the money you lend out whether it be lent out to a bank or another person. The Koran (30:39-quoted earlier) also condemns giving in interest so that further interest can be consumed ("so that it increases on people's wealth").

The Koran condemns consuming interest in strong words:

"O you who believe be careful of Allah (God) and give up the interest that is outstanding. And if you do not then be warned of war from Allah (God) and His messenger.." (Koran 2:278-279)

Note: The above verse refers to believers: "O you who believe.."

According to Koran 2:275 that was quoted earlier, a person when he receives God's warning i.e words of the Koran, can keep the past gains but give up, according to this verse the present and the future claims to interest.

IV) CHARITY, THE KORAN & ECONOMICS

The Arabic word "Zakah",translated into English means 'purity'. As used in the Koran (believed by Muslims to be God's word) it signifies the "purity" a person achieves through giving in charity in God's way. It's principle is discussed in Koran 9:103 & 92:18. It is enjoined on believers according to Koran 9:60 (this verse also narrates the categories of people to whom charity is applicable). The amount due according to the Koran (though Muslim tradition states a different percentage) is 50 % of savings beyond a persons legitimate needs ( see Koran 17:29 & 25:67).

Is Zakah (obligatory charity) good for the economy ?

Zakah is due out of savings according to the Koran (whether the savings (those that are beyond a persons legitimate needs) be small or large,it does not matter). Out of the amount saved 50 % has to be given (spent) in God's way, according to the Koran by those who claim to be Muslims.

"The alms are only for the poor and the needy, and those who collect them (for distribution), and those whose hearts are to be reconciled (resettlement of families, refugees etc), to free captives (slaves etc) and the debtors in need, and for the cause of Allah (God) and the needy travellers; a duty imposed by God. God is Knower, Wise" (Koran 9:60).

What are savings ?

" Saving is income that households receive but do not spend on buying goods and services. " (See any introductory Economics text)

The Koran asks men (women) who are believers to spend on fulfilling their legitimate needs as they wish, keeping within the boundaries set by God, in the Koran and says at the same time, "..but waste not by excesses" (Koran 7:31)

Therefore, what is not spent out of a person's income on fulfilling his (her) legitimate needs should 'Islamically' be saved. And out of what is saved (and what is beyond a person's legitimate needs) 50 % should be given in charity in God's way.

The categories of people mentioned in Koran 9:60 to whom Zakah (charity) is due are all "needy" in some way or the other. By giving your savings to such people, all or at least a major part of it will be spent immediately on consumption. Note that savings are a "withdrawal" from the circular flow of income while consumption is an "injection" into the circular flow of income in the economy. This injection results in an increase in the Real National Income (i.e National Income adjusted for changes in the price level). The economy is given a positive boost, under- consumption is reduced, a more equitable distribution of income is achieved and an economy in depression can well be on its way to recovery.

God's wisdom or the words of a man living in the Arabian desert 1400 years back ?

"Whatever spoils of war God has given to His messenger from the people of the cities belongs to God, His messenger, your near kinsmen (who are needy), orphans, the needy and the travellers, SO THAT IT DOES NOT MAKE A CIRCUIT AMONG THE RICH OF YOU." (Koran 59:7)

The paragraph that follows shows the wisdom of this 'ancient' book (the Koran), which skeptics claim was written by a man who had absolutely no schooling and lived in the Arabian wilderness:

The onset and severity of the great depression (1929-1941) can also be attributed to under consumption; production had outstripped consumption .

Under consumption also resulted from the unequal distribution of income. Between 1920 and 1929 per capita income rose about 9% but the income of the wealthiest 1% rose about 75%, accounting for most of the increase. Much of this increase was put into luxuries , savings, stock market investments, instead of being spent on consumer goods. (Chapter 23 page 426. A People & a Nation: U.S History since 1865).

Also:

An unexpected deflation [going down of prices] causes a redistribution of income from debtors [the one who has borrowed money] to creditors [those who have lent money]....This redistribution reduces aggregate demand [AD], since creditors tend to spend only a relatively small share of their added income, while debtors [just like the needy people I mentioned above] have nothing to fall back on and are forced to reduce their consumption to meet their higher real interest payments [this worsens a depression]. (Gordon, Macroeconomics, 6th ed, Prentice Hall, page 169)

What does the Koran say ?

"That which you give in interest that it may increase on people's wealth increases not with God but that which you give in charity ,seeking God's will (and not selfish interest), has increase manifold" (Koran 30:39).

Injections into the circular flow of income in the economy,like the ones caused by charity to the needy, which is immediately spent on consumption, do cause "manifold increase" in GNP via the multiplier. The Charity, however, is not to be coerced out of the person concerned as according to Islam (based on the Koran): "There is no compulsion in religion.." (Koran 2:256). & " You are in no way a compeller over them.." (Koran 50:45)

V) THE KORAN AND PARETO OPTIMALITY:

"O believers, consume not your goods between you in falsehood, instead let there be trading by mutual consent.." Koran 4:29

A pareto optimal position is reached when the condition of a particular person cannot be made better off without making the other person worse off. Therefore mutual benefit is optimized at a pareto optimal position. The Koran knew about this much before economists.

If the exchange between two individuals is voluntary, the strong presumption is that both individuals gain from the exchange. Indifference curve analysis can be used to determine that only through voluntary exchange which the Koran recommends, can a pareto optimal position be reached. The Edgeworth Box diagram

VI) CONCLUSION:

By lending and borrowing for interest like banks do, the result is decreased investment (due to profits from investment being made less attractive i.e a higher opportunity cost of investing, or a higher interest cost of investing by borrowing funds), they also cause inflation without a corresponding increase in production and decrease in unemployment by speculative investment rather than productive investment.

Further, interest does not necessarily make savings more attractive because an increase in the rate of interest can make savings less necessary also (to reach a given goal, when interest rate rises you now have to save less per period of time to reach that goal and so have to sacrifice less present consumption for future consumption). Therefore the presence of interest doesn't increase society's well being at all.

On the contrary, charity and its consequences will according to the above exposition, increase investment by increasing demand through a more equitable distribution of income. The system of trade encouraged by the Koran, that which involves "Mutual Consent" would lead to societal well being, being maximized.

We can therefore safely conclude:

WORKS CITED

The Koran. Translation

Asadi, Muhammed A. Koran: A Scientific Analysis. Lahore. IPU. 1992.

Dornbusch, Rudgier. Fischer, Stanley. Macroeconomics. 4th ed. McGraw Hill International editions.

Katzman, Norton, Escott, Chaudoff, Peterson, Tuttle Jr, Brophy. U.S History Since 1865. A People & A Nation. 3rd ed. Boston. Houohton Mifflin Co.

Gordon. Robert S. Macroeconomics. 6th edition. Prentice Hall.

Lipsey, Richard G. An Introduction to Positive Economics. 6th ed. George Weidenfield & Nicholson Ltd.

Luckett, Dudley G. Money & Banking. Mc Graw Hill Book Co Inc. 1976.

Thomas, Meyer. Duesenberry, James S. Aliber, Robert Z. Money Banking & the Economy. London, NY. W. W Norton & Co 1981.

Please visit Muhammed A. Asadi's website at:
http://www.rationalreality.com/

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