Islamic economics: Intertemporal prices, interest rates and discount rates

Abstract

The discussion draws upon core aspects of microeconomics and macroeconomics. Relevant comparisons are between (a) analyses as respectively introduced by Adam Smith and John Maynard Keynes, and (b) analyses constrained by Islamic religious law (Sharia) as interpreted and developed by Islamic scholars.

The views here reported reflect conversations at the conference ‘Mainstreaming Islamic Economics in Islamic Banking and Finance’ held at the Markfield Institute of Higher Education, Leicestershire, UK, in July 2023. The discussion also draws from Steele (2022) and Koehler (2023).

The ‘classical’ economic distinctions of the eighteenth century between the economically productive contributions of labourers, landowners, and capitalists were superseded in the late nineteenth century by the analytical approach of ‘neoclassical’ economics. The focus then became supply, demand, and the costs incurred in producing and sending goods and services to market. With production and distribution occurring over periods of varying length, payments forthcoming further into the future generally have a lower commercial value than payments immediately received. That distinction is systematised in the valuation of discounted cash flows. In broad terms, as labour-intensive methods generally deliver goods promptly to market, capital-intensive methods deliver greater volumes over extended periods.

In making appropriate adjustments, as directed by competitive discount rates, cost-efficient investments are achievable: for example, those relating to hiring premises, purchasing materials and machinery, recruiting labour and marketing products. As discount rates fall/rise, optimal readjustments to those components can be made. Motivated by competition, returns from production periods of different length eventually equalise. Such systematic adjustments underpin Austrian business cycle theory (see Steele, 1988, 1992).

Under a planned (state-controlled) system, dirigiste interventions might set production targets. In a competitive free-enterprise economy, decisions taken by consumers and businesses determine market prices and sales. Large profits and disastrous failures are features common to both. The general relevance is (a) that shortages and surpluses are indicative of suboptimal adjustments, and (b) that all investments are intertemporal activities, where the application of appropriate discount rates allows rational evaluations of prospective returns across different production periods.

Schematically, the mathematical presentations of interest rates and discount rates are conceptually equivalent: one forward-looking, the other backward-looking. Together, it is those presentations that indicate optimal deployments of labour, capital and other productive inputs. Yet, where time per se is generally relevant to profitability, it is only in respect of the payment of interest, and not by the application of discount rates, that ethical prohibitions fundamental to Sharia arise. Those prohibitions were arguably established by the prophet Muhammad (d.633 ce) and thereafter have remained open to endorsement, or moderation, by Islamic scholars.

By the Islamic repudiation of interest payments and related prohibitions, the teaching and application of ‘Islamic economics’ is constrained to microeconomic principles (i.e. efficiency in the use of scarce resources). Macroeconomic principles, as developed and taught in the West (where guidance is generally delivered by national fiscal and monetary authorities), can have no relevance to any Islamic discussion. Under Sharia, unequal exchange (riba) is emphatically denounced as an ‘exploitative’ gain, where the payment of interest has special significance. In consequence of that long-held condemnation of interest payments, a significant academic rift exists in regard to the identification of ‘exploitative’ gains. In direct contrast to the distinctions associated with Islamic economics, all human action – including entrepreneurial business ventures – can be viewed as necessarily speculative in that all, some, or none of those taking part might draw benefits. Stated more controversially, that Sharia does not countenance the use of interest rates to facilitate business transactions might be viewed as an unnecessary and harmful inhibition of trade.

Under Sharia, condemnation of the payment of interest is associated with doubt cast upon the legitimacy of money, that is, for an item (‘coin’ or ‘banknote’) to serve as money; an Islamic view is that it must possess intrinsic value. Clearly base-metal coins and paper banknotes fail that test. Within the broad context of trade, a counterclaim might be that value is determined not by the shape, weight, colour, or any other of the many features by which money notes and coins might be described. Instead, it is arguable that market values are determined by opportunities ‘to buy cheap and to sell dear’; that is, entrepreneurial activity strives generally to increase profitable sales by engagements with risk.

Whether contemporaneously identified by economic analysis, or viewed as having operational relevance to the interpretation of Sharia, among the ‘examples that are important in real life’ (point 4 above) comparisons between welfare gains that are possible in advanced industrial economies and opportunities generally open within primitive communities are stark:

The Five Books of Moses (the Torah) are at the core of the Jewish faith and the primary source of its ethics and laws. The Talmud is a record of rabbinic debates on aspects of the Torah that occurred between the second and the fifth centuries. Together, these form the background of modern Judaism. Although initially in full accord with the Talmud, Christianity, Islam, and Judaism became split. Thereafter their differences were marked by an unmitigated condemnation of usury (‘lending at interest’), which generally undermined all distinctions that might apply to profit: “usury had circumscribed what usury consisted of but had not described what usury consisted in” (Koehler, 2023, p. 433). The suggested remedy is to unfold carefully “the ramifications of that finding, step by step, by evaluating exchanges in social relationships, by demarcating lending from renting and investing, and by distinguishing licit from illicit profit” (Koehler, 2023, p. 433).

In respect of the contributions of land, labour and capital, not only are wage payments to labourers and rental payments for the use of land and capital regarded as Sharia compliant, so too are adjustments to earnings in line with money inflation. More significant is the argument that, without incorporating the provision of time, nothing can be produced. The conclusion that follows is clear: the market value of goods and services is the aggregate of four requirements: to recompense the use of land, the use of labour, the use of capital and the use of time.

With regard to banking, business finance and economics: Sharia prohibitions do not apply if a bank enters into a partnership with a depositor to invest jointly in a Sharia-compliant business. The profit or loss from the investment is then shared between the bank and the depositor. The distinction may be simply demonstrated (see Box 1).

More extensively, Sharia forbids riba (unequal exchange), gharar (excessive uncertainty), maysir (gambling), and financing activities deemed harmful to society. Parties must not engage in speculation or exploitation; and they must share both the risks and the rewards of business transactions. It follows that Sharia places unique constraints upon Islamic finance, as it has developed by encompassing banking, leasing, sukuk,² insurance (takaful) and microfinance. Although raised to greater prominence by the wealth of oil-producing nations, Islamic banking and finance remains constrained by centuries of deeply embedded religious teaching.

Established in 1979, the Dubai Islamic Bank was the first commercial Islamic bank. Thereafter, the rapid growth of Islamic banking has been matched by that of jurists, whose fatwas have added detail to the general rejection of conventional banking practice. In 1990 the Accounting and Auditing Organization for Islamic Financial Institutions was established in Algiers. Also in 1990, tradable sukuk were introduced in Malaysia as the Islamic alternative to conventional bonds. Where bond-holders receive interest, sukuk confer direct asset ownership.

Where conventional banks safeguard their investments with collateral security, Islamic banking and finance must look to alternative means. Among issues needing to be addressed are the following. Managing liquidity risk is constrained by the relative scarcity of Sharia-compliant financial markets. Profit/loss sharing invites novel corporate structures. For Islamic investors to hold expectations similar to those delivered by conventional banks, higher costs might be offset by lower shareholder profitability. In respect of these and many other considerations, the Islamic Financial Services Board³ is tasked to monitor economic and financial stability.

Islamic financial institutions and their Sharia supervisory boards are influential in the certification of Sharia compliance. That task became more complex as, attracted by the wealth of oil-rich Gulf states and possessing staff already skilled in creating financial products, conventional banks sought the means to enter the Islamic market. Increasingly challenged by new and unfamiliar proposals, rulings by Sharia scholars became more intricate and difficult to obtain. That context gave the incentive for ‘fatwa shopping’. Although sometimes applied as a derogatory term, a more sanguine view is that jurists might honestly deliver different opinions on doctrinal niceties. With the pace of change raising the demands for juristic rulings, fatwa may entail merging different schools of thought or deciding how innovations might accommodate novel risk-management practices. Parallel considerations relate to the practice by which Western common law (also known as case law) evolves; that is, precedents are set by judicial authorities and public juries whose deliberations are constrained by earlier, similarly established precedents. Whether to eliminate contradiction and/or confusion, common law may be superseded by the enactment of legislation.

A recent development is that of independent banks and financial companies competing within a formalised ‘marketplace’. Founded in 1973 as a German credit institution, the Payment Services Division of Bankhaus August Lenz & Co. AG was acquired in 2022 by Raisin UK, an online platform serving over 400 banks, building societies and Sharia-compliant accounts within and outside the UK. Just as UK authorised banks are protected by the Financial Services Compensation Scheme, those held with UK-based partner banks are similarly protected. As a final ‘reassurance’, Islamic banks may commit to a ‘Make Good’ offer, which applies if profits fall short of the agreed ‘expected profit rate’. Where that revision is applied, the requirements of Sharia and UK legislation both apply.

Macroeconomics is a twentieth-century ‘innovation’. As the Great Depression became prolonged in the 1930s, John Maynard Keynes propagated the idea that government action could (and should) be managed to sustain full employment.⁴ The general argument, that fiscal and monetary policy might be guided to benefit the economy became referenced as ‘macroeconomics’. Given that the bulk of tax revenue is obtained from earned income, as revenue falls in a recession, expenditure on social and welfare increases: that is, a sovereign budget surplus varies inversely with business cycles. And so, “if nations can learn to provide themselves with full employment by their domestic policy … there need be no important economic forces to set the interest of any one country against that of its neighbour” (Keynes, 1936, p. 382). From initial attempts by the UK in the 1940s through to the present day, beneficial social and political outcomes⁵ have been the objective of HM Treasury and the Bank of England.

Where an initial post-war recovery had bred high aspirations for macroeconomic initiatives, long-term success has been disappointing. For macroeconomic interventions to be effective, economic forecasts are necessary of the current state and the expected future paths of the economy, both with and without fiscal and monetary intervention. As an erstwhile UK Chancellor of the Exchequer, Denis Healey, gave expression to his general disappointment, he likened macroeconomic forecasts to weather:

Although accurate forecasts are a prerequisite for policy coordination, macroeconomic forecasting has proven to be generally no better than statistical extrapolation. That economic forecasts are occasionally accurate is generally a consequence of their number and diversity. Hence, the twin classification of economic forecasters: ‘Those who don't know and those who don't know they don't know.’ Equally excoriating is the comment: ‘The only function of economic forecasting is to make astrology look respectable.’⁶

A more recent concern is the perceived opportunity for incumbent politicians to indulge in pre-election ‘largesse’ in order to court electoral favour. To address that temptation, Bank of England ‘base rate’ decisions have been removed from Treasury influence. Yet bold claims by different politicians – to have inspired the notion of an ‘independent central bank’ – are undermined by an alternative explanation. The separation of monetary and fiscal policy was (and remains) necessary to support the single currency adopted by the European Union.⁷

In general alignment with conventional central banks across Europe and North America, the immediate policy objective of the Bank of England is price stability (keeping inflation at 2 per cent) and, thereafter, to support government economic policy, including growth and employment objectives.⁸ Monetary policy is adjusted by applying interest, at Bank Rate, to overnight deposits. The implication is that Bank Rate (and expectations about future levels) influence interest rates for all maturities and therefore is central to the decisions of financial institutions, commercial banks and international currency valuations.

Macroeconomic analysis invokes fiscal policy (set by a sovereign treasury) and monetary policy (set by a sovereign central bank). That the respective consequences are interdependent is integral to macroeconomic analysis. For example, if deficit spending drives up prices, monetary policy must be more restrictive to restrain the inflation. Upon that basis, a moment's consideration is sufficient to understand that long-standing Islamic principles are incompatible with the instruments of macroeconomic policy, that is, selling government bonds and setting a central bank base rate.

Although a variety of welfare comparisons continue to be discussed within an Islamic context (including those that focus upon the determination of economic growth and social welfare within both developed and developing Islamic economies), ‘Islamic macroeconomics’ can have no relevance to the analysis initiated by John Maynard Keynes in the 1930s.