Can an Islamic financial system exist within the current monetary system?

The article below is based on simplistic examples. I appreciate that in reality the monetary system is far more complex; however, the idea is to depict to a lay person that interest in a key tool of the current monetary system.

This is not intended to be a scholarly paper but is rather focused on explaining the current monetary system to a layperson. If Allah will, I will follow this up with a proper scholarly paper.

Introduction

A large proportion of the literature on Islamic finance is focused on the various Islamic financial products and principals and not many have challenged the current monetary system and whether an Islamic financial system can exist within the current monetary system.

To the vast majority of the population the major difference between a conventional financial system and an Islamic financial system in the absence of interest and over the years many debates have been focused on the how the alternative Islamic financial system offers products and services that are ethical and largely interest-free. Whilst I have my reservations on the claim that the present Islamic financial system is interest free, the purpose of this article is not to go into detail of the various Islamic financial products and services but to study the current monetary system and assess whether an interest-free financial system can coherently exist within it.

Before we start getting into the details of the monetary system it is important to understand the need for an interest-free monetary system.

Why interest-free?

Lending money on interest is prohibited in Islam and As Mufti Taqi Usmani states in his book ‘An Introduction to Islamic Finance’:

“Over the last few decades, the Muslims have been trying to restructure their lives on the basis of Islamic principles. They strongly feel that the political and economic dominance of the West, during past centuries, has deprived them of the divine guidance, especially in the socio-economic fields. Therefore, after acquiring political freedom, the masses are striving for the revival of their Islamic identity to organise their collective life in accordance with the Islamic teachings.”

The current monetary system

Before we analyse the current monetary system it is important to understand monetary economics.

Monetary economics is simply the study of money and the interaction of various monetary systems. It looks at how currencies become a medium of exchange and the role of government and other institutions in shaping and controlling the system. A detailed literature review of the developments in monetary economics is outside the scope of this article.

The present monetary system is based on fiat money which derives its value from government regulation. To understand fiat money, simply look at any bank notes that you may possess. They are pieces of paper with ink on it (or coins with a value embossed on it) and the value is derived from the number printed on it by the respective government. There is essentially no difference between a U.S Dollar, a Pakistani Rupee and a Euro apart from the value attributed to it.

Fiat currency generally has the following attributes:

−    It has no intrinsic value (its value is derived from government regulation); and

−    It is legally not convertible into any asset and it is not fixed in value to any objective standard (i.e it is not backed by any real asset).

Contrary to that sunnah money (money used during the time of Prophet (PBUH) always had intrinsic value which was determined by the demand and supply of that commodity be it gold, silver, dates or any other commodity.

Whilst, it would be too early to conclude but based on the aforementioned definition of fiat currency it is clear that it is unjust and far away from the principals of Islam as it gives the power of creation of wealth to an institution. The Quran clearly states Al-Razzak (the All provider of wealth) to be an attribute of Allah.

Some scholars would argue that mankind is free to use anything as money as no restriction has been placed on forms of money. It is not the purpose of this article to go into details of the definition of money from Quran and Sunnah, however, it is important to address this comment as the entire argument to be presented in this article can be rejected merely on the basis of this statement.

Let us assume that the above statement is correct and mankind is indeed free to use paper as money. However, the value of paper should be defined by market forces and not by the numbers printed on it. Subject the paper to free trade and the value defined by market forces should be the value of that paper. Two pieces of paper having the same dimension and weight cannot be given different value simply by printing a number on it.

To illustrate this consider the following hypothetical situation:

A particular society uses leaves as currency and the value of leaves as a medium of exchange is determined by the transactions in the open market. For the purpose of this illustration assume that all leaves are exactly similar in dimensions and other attributes, and that leaves have intrinsic value in this society (similar to gold).

The King of the society is greatly troubled by his diminishing wealth and one day he comes up with a brilliant idea. He orders a printing machine, prints ‘2 leaves’ on all his leaves and claims that his leaves are double the value of the leaves held by other people.

 

By doing so the King clearly created wealth out of nothing and thereby reduced the wealth of all others which is not just and not allowed by Islamic principles. Money in Islam has always been commodity money which has intrinsic value and not fiat money. Therefore, whilst it may be permissible to use leaf or any other thing as money, it is definitely not permissible to attach a fictitious value to it.

In the example above it was the King who created wealth out of nothing, however, in the modern world the creation of wealth is in the hands of private bankers. This is called monetary realism. A detailed discussion of how and why the private bankers have the authority to create wealth is a topic worthy of an article devoted to it. This article will not be discussing the hegemony of private bankers on the creation of wealth.

Before moving on to the details of the current monetary system and how interest is a key functioning principle of the system, it is important to revisit the definition of interest.

What is interest?

Riba can be literally defined as excess or increase. In the Islamic terminology riba/(interest) can be defined as effortless profit or profit which comes free from compensation or excess earning obtained that is free of exchange.

Based on the above definition the very act of creating wealth out of nothing or assigning a fictitious value to paper could be constituted as riba,

So what gives the fiat currency its value?

If the fiat currency has no intrinsic value and is not backed by any asset then what gives it the value it has. This is a very complicated and intricate system but I will try to explain it as simply as I can.

Let us carry forward the story of our King. The King had a hard time convincing people that his leaf was really worth ‘two leaves’ because of the text on it. Therefore, he thought of another plan to ensure that he remains wealthy forever whilst the other people in the country remain poor so that he can continue ruling them.

This time he printed paper money and assigned it a value. To ensure that the population of the country cannot reject this as money, he passed a law stating that this is a legal tender for all debts public and private and made it illegal to use anything else, in this case leaf, as currency.

 

Now since this new currency does not have any intrinsic value, the King had to create mechanisms to retain and manage the value of this fiat currency. By ensuring that all major products are traded using this new ‘paper currency’ only, he preserved the value of the currency to some extent.

This mechanism provided the King a control over the wealth of the entire nation as he could just print more currency and purchase whatever he wanted with it. However, a few months down the road the King encountered a problem. He realised that the assets of the nation are limited and by printing more and more currency he was diminishing the value of his currency and the prices of the goods were increasing. He immediately called on his council of ministers to identify a solution for this problem. For if this continued than sooner or later his people will become fed-up and revolt.

 

Inflation redefined

 His council of ministers advised that this is a clear case of ‘too much money chasing too few goods’. As the supply of money increases (with assets not increasing at the same rate as the supply of money) the value of money falls.

However, they recommended that to avoid a revolt from the people they need to brand this fall in the value of money as inflation and redefine it as a rise in the price of goods rather than a fall in the value of money. If the people get to know that inflation is in reality a fall in the value of their wealth as the King prints more money there is a chance that the people will revolt.

Furthermore, they recommended that to control the inflation they need to use the interest rates. The King was very fascinated by the advice of his ministers and ordered that all economics textbooks in the country to teach inflation as the rise in the price of goods and services.

Interest as a tool to control inflation

The example below is very simplistic and in reality the monetary system is far more complex. However, the idea is to depict to a lay person that interest in a key tool of the current monetary system.

The ministers suggested the King to use the interest rate in the economy to control the rate of inflation. When the interest rate is increased, more and more people will save their money in the banks and the supply of money in circulation will decreases leading to a decrease in the rate of inflation. Decreasing the interest rate will lead to an opposite effect.

Going back to our previous example:

 

To understand it simply, if the interest rate on savings in increased to a rate more than what can be obtained on investments in other industries then people will save more to benefit from the higher return. Also, borrowing (hence injection of money into the economy) will reduce due to higher interest rates. As the supply of money reduces in the economy the value of that paper currency increases and hence prices will seem to come down (lower inflation).

On the other hand if interest rate is reduced, people will save less and borrow more, hence creating and injecting more money into the economy. As the supply of money increases in the economy, the value of money will reduce and hence prices will seem to increase (higher inflation).

 

Can an Islamic financial system exist within this monetary system?

If an Islamic financial system is a system based on zero interest and just distribution of wealth then the answer is no. The reason why the current Islamic financial system is called Islamic is primarily because the focus of all major scholarship has been on the dynamics of financial products and not many people have focused on the workings on the current monetary system which cannot function without interest. Even if we do not consider interest, the very act of creating wealth out of nothing can be classified as Riba. Even if we do not classify that as Riba, surely the power of creating wealth and unjustly reducing peoples hard earned labour bestowed upon a few individuals is certainly unjust and not Islamic.

This article does not even delve into how money is created by private banks through fractional reserve banking. In layman terms fractional reserve banking allows the bank to loan out the money that it does not have.

To sum up, an Islamic financial system cannot exist within the current monetary system and any banking system purported to be based on Islamic principles is a mere mirage as the underlying monetary system cannot function without interest.

To create a true Islamic financial system, the monetary system would need to be reverted to be based on commodity money. Whilst it may not be an easy task it is certainly not impossible.