By Rashid Ahmed
Jul 17 - 23, 2000
Interest is the amount of money you pay in addition to the amount of
borrowed money if you have got a loan from somebody. From the Islamic point of view a
transaction involving interest is illegal. In our times while dealing internationally, it
is argued that interest cannot be eradicated altogether. Nevertheless, we must try to
avoid such transactions in domestic dealings. We can evolve alternative Islamic methods
e.g. Partnership for making financial gain on the money we invest.
Not having a clue to such viable alternative methods our Banking
industry and some of Muslim scholars like their Christian and Jewish counterparts have
tried to legitimize interest by saying that interest is just like rent and profit. Here in
this article I have tried to prove that interest is not like profit or rent at all and can
be eradicated only through Government decree and willingness as was done in the times of
To do this, we shall first examine the foundations of interest, which
are based upon our use of money.
Money is not a resource. It is not a factor of production. According to
Parkin, Capital is all the equipment, building, tools, and other manufactured goods used
to produce goods and services. Money cannot produce goods and services, therefore it is
not capital. Money has power to purchase the factors of production or capital such as
equipment, buildings, land and labour.
Money is what money does. There are three basic functions of money:
1. Store of value,
2. Medium of exchange,
3. Unit of account.
Anything that performs these functions is money. Thus salt, wheat,
rice, silver and gold can be used as money if they perform these functions. In fact, these
commodities were used as money in past. Such money is called commodity money. It is not
used as such at present.
Modern economists define interest as
Price paid for the use of money for a period of time.
Which means that if you lend someone 50 rupees for 60 rupees to be
delivered in future, the extra 10 rupees is price paid for use of Rs 50. Or is it? Is 10
rupees the price or rent of 50 rupees. I think rent would have been more appropriate word.
So, the definition should have been like this:
Interest is the rent paid for the use of money.
Lawrence Gitman calls it "the Rent or level of compensation that a
demander of funds may pay a supplier".
Parkin and Miller call Interest the return to Capital. To them
Interest is the payment for the use of Capital.
But defining capital Parkin says:
Capital is the goods that have been produced and can now themselves be
used in production of other goods and services.
See the confusion created by these economists. Capital is the Goods
such as building, equipment etc. The return or payment for use of these things is called
RENT (when Land or building is involved) or Lease (when equipment or machinery is
involve), but certainly not Interest. And Parkin is calling it Interest!
According to McConnel and
Money cannot produce goods and services.
So, how can Money be called Capital if it cannot produce goods and
services? And if money cannot be called Capital then how can return on money be called
What Parkins and Miller are trying to do is to Equate and Confuse Money
with Capital, to prove that profits, rent, (which are returns to capital) and interest
(return to money lent) are the same. But this clearly is not the case. (If it were then
why do we have different chapters for each of these categories in almost all economics
The above discussion proves that money is not Capital or a capital good
at all as it cannot produce goods and services. The western economists are deliberately
trying to create confusion to legitimize Interest and keep on earning interest income.
About those who confuse Interest with Profit from trade and industry
Allah says in Koran:
Those who swallow Interest cannot rise up save as he arises whom the
Devil has prostrated by his touch. That is because they say Trade (Profit) is just like
Interest, whereas Allah permits trading and forbids Interest.
Our own western influenced economists have tried to legalize interest
by saying that the Islamic scholars have confused usury with interest. They contend that
usury i.e. interest in excess of amount fixed by statute, is forbidden but interest is
not. They forget to point out that the term usury was formerly applied to any type of
interest. And how does one know that 16% interest rate is usurious and it is all right to
charge 15% and it is no burden for common man?
Charging of interest was considered a sin in medieval Christendom and
before. The position of Christian Church as defined by St. Thomas Aquinas, condoned
interest on loans for business purposes, because the money was used to produce new wealth,
but adjudged it sinful to pay or receive interest on loans made for purchase of consumer
The position of Old Testament in Deuteronomy is that "You may lend
on interest to a foreigner, but to your brother you shall not lend on Interest". Does
it mean that the Jews can charge interest from Christians and Muslims? See how for their
own interests they have misconstrued the teachings of their respective religions. Our own
so-called enlightened economists are trying to do the same with Islam and spending their
energies to make us follow Christians and Jews. How true is the saying of the Holy Prophet
Muhammad (May peace be upon him) that:
"You will follow the people before you, so much that had one of
them entered hole of lizard, you would do the same." The companions asked:
"which people, Jews and Christians?" Prophet replied: "Who else"?.
So what is interest then? Let us put a definition, which proves it is
actually an exchange process.
The Hadith of Holy Prophet says:
Do not exchange gold for gold, silver for silver, wheat for wheat,
except in equal quantity of each.
This Hadith prohibits commodity exchange in unequal quantities, as that
will be interest. Likewise because money is a commodity it cannot be exchanged in unequal
quantity. Any exchange of unequal quantity of money will make the transaction usurious.
So we arrive at the definition of interest according to Islam as:
The exchange of a certain quantity, (volume, weight or number) of a
good with unequal quantity, (volume, weight or number) of the same good on the spot or in
* It means if the quantity is same it is not interest
* It means if the goods in question are different
there will be no interest.
The time dimension does not enter into any calculation because
according to this definition a spot exchange of Rs.50 with Rs. 60 (e.g. changing old notes
with new) is interest of Rs. 10.
It also means that if you exchange 1 kg of wheat with 1 1/2 kg of
wheat, the additional 1/2 kg is interest. If you exchange 10 grams of gold with 12 grams
of gold, the extra 2 grams is interest. This is exactly the type of transaction Islam
How can the price of Rs 50 be Rs 60? Can the price of 1-kg sugar be
11/2 kg sugar? How can these be equal? But the price of 1-kg sugar can be equal to Rs 50,
or it can be equal to 2 kg wheat. So interest is not a value measuring price, but an
exchange of something more then the original. When you are getting a one-year loan of Rs.
100,000 for buying a car and have to pay 10% interest per annum, you are buying
(exchanging) Rs. 100,000 for Rs. 110,000.
Let us see why interest arises:
The fault lies with the Government management of its revenue. When the
government does not collect enough taxes to meet its budgetary expenditure it either
prints or borrows money:
1. When government prints money
Suppose the government has to pay a contractor for some public work.
Because it has not collected enough revenue it makes payment by printing money. The income
of contractor has increased which also increases the money supply. Because production of
goods and services has not expanded the additional income increases the demand for
products. This causes demand-pull inflation.
2. When government borrows money
Alternately the government will borrow the money on interest. This
interest is a cost. How does government pay interest when it already has little revenue?
By printing more money. Borrowing money also causes crowding out which is a tendency for
an increase in government purchases of goods and services to bring a decrease in
investment by the private sector.
The cited remedies to finance bridge the deficit, result in inflation.
Government fears that if it did not pay interest then people will deposit their money with
the banks paying interest and government won't be able to borrow. But if govt. banned
interest the alternative of keeping money with the banks will be less desirable, and there
will be more real investment by the Public, which in turn generate more taxes for the
Many economic evils arise due to govt. failure to curtail deficits.
Contrary to Samuelson's belief that the Government need not balance its budget, I think
that instead of borrowing and fueling inflation it should make revenue collection more
efficient, root out corruption which is a source of leakage, stop non-developmental
expenditure, and stop meddling in the economy unnecessarily.
According to Milton Friedman " Inflation is always and everywhere
a monetary phenomenon"
When commodities were used as money, inflation resulted form the
discovery of new sources of money. In modern times, inflation has resulted from increases
in money supply that has accommodated increases in costs. To avoid inflation, money supply
must be held in check. A key source of avoiding inflation is central bank independence. In
low-inflation countries such as Germany and Japan, the central bank decides how much money
to create and at what level to set interest rates and does not take instructions from the
government. In high inflation countries, such as the United Kingdom and Italy, the central
banks takes orders from the government about interest rates and money supply growth. This
connection between central bank independence and inflation has been noticed by the makers
of a new monetary system for the EU, who are modelling the European Central Bank on
Relationship with inflation
Inflation causes interest rates to rise. Lower the inflation, lower the
interest rate. Higher the interests rate higher the inflation. Both variables are
interdependent. If there is no inflation, there is no need for interest. If the Consumer
Price Index does not rise after one year, do you really need to have more money then you
Demand-pull inflation is good as it signals the producers to produce
more of a product. But what if demand has risen due to increase in income cause by
Government's handing down printed notes to its suppliers thus increasing money supply?
Surely this will cause inflation because people have too much money and the goods and
services have not expanded in the market. The additionally printed notes paid by
Government makes its suppliers income artificially higher. The rich become richer. Due to
increase in prices of goods the purchasing power of the poor is curtailed thus the poor
get poorer. Isn't this state sponsored-counterfeiting of money?
Charging of interest results in cost-push inflation, too. For example,
when a shopkeeper gets a loan for his inventory, interest is added to his cost. To recover
such cost, the shopkeeper has to mark his prices higher. The result is Inflation-Interest
Nominal interest consists of real interest plus inflation.
So we see that 10 % interest is due to inflation. Only 6% interest is
explained by deficient theories of western economists. Government can easily eliminate
this major chunk of 10% when it cuts budget deficit. But government thinks that it cannot
borrow at zero-interest rate. If by government decree interest were banned then it would
not have to compete with other institutions.
The role of interest in allocation of capital has been exaggerated. The
same role can be played by the equities market, where the investment flows to those
companies which are most profitable. If some sector of economy shows low earnings,
investors keep away from that sector.
Our bankers need not fear that in absence of interest they will become
unemployed. The banks will always have their deposits. In United States before 1973, banks
did not pay interest on checking accounts. Did they lose their deposits? The banks can
make investment from such deposits and earn profit. There are other functions for Banks
too, which properly exploited can result in handsome profits. The banks can play a role in
investment by underwriting and facilitating import and export trade and earn service
charges. We can redefine the mission for these institutions.
Opportunity cost of money:
When seeing the feasibility of a business project, a businessman takes
into account the money he is going to put into business. He has two alternatives: one to
put money in fixed deposit, other is to use money in his business. If he chooses to put
money in his business he has to forego the interest he would have obtained through fixed
deposit. He thinks that it is costing him interest. So to cover this additional cost of
foregoing interest and obtain a favourable rate of return from business, he has to mark up
his goods at a higher price. Had their been ban on interest then he would not have taken
this cost into consideration. When there is no interest obtainable on loanable funds there
will be no use calculating interest on those funds, because you are losing nothing. So, in
the absence of the interest rate the price level would have been low.
Interest cannot be abolished without government intervention and law
banning it. Let us suppose for example National Bank stops paying interest and Habib Bank
does pay, then all depositors will head for Habib Bank. National Bank will go out of
business. But if both the banks stop paying interest and government keeps paying interest
through National Saving Schemes then all depositors will head for National Savings
Centers. To abolish interest, all parties, the government, the banks and the individuals
would have to work in cohesion. This can be brought about only through a government
Zero interest rate: does not mean that people will stop saving. When
interest rate rises, saving becomes more attractive. But it is also made less necessary.
Consider someone who has decided to save an amount that will ensure 10,000 per year is
available for retirement. Suppose the interest rate is now 5 per cent and the person is
saving Rs. 1000 per year. Now let the interest rate rise to 10 per cent. With such a high
interest rate, the individual needs to save less now to provide the given Rs.10,000 per
year during retirement. It may be possible to provide the same retirement income by saving
only Rs. 650 a year. Thus an increase in the interest rate might actually reduce saving.
Very few researchers have found strong positive effects of interest rate increases on
saving. Research suggests the effects are small and certainly hard to find.
There is a saving phenomenon of 'committee' in Pakistan where people
save some amount of money into a common pool every month. The members of the committee
receive in their monthly the whole amount thus contributed. There is no interest involved,
but people do save compulsorily their monthly contribution under the scheme.
We conclude by saying that interest is different from rent and profit.
It can only be eliminated if Government is willing to cut its deficit, reform taxation,
and stop printing excessive amount of paper money. This is hard but not an impossible