Islamic Economics

Civilization and its well-being as well as

business prosperity depend on productivity
and people's efforts in all directions in their own
interest and profit. When people no longer do business
in order to make a living and when they cease all gainful
activity, the business of civilization slumps and everything decays.
[Ibn Khaldun (744-820Hijrah 1332-1406AD)
Islam has never developed a separate theory of political or moral economy in the way that economic
science and analysis have evolved in the western tradition. There are few thinkers in Islam who have ever
discussed economic matters as a separate discipline. The western tradition of writing economics, from
Adam Smith to Malthus, Ricardo, Mill and into modern times, simply has no equivalent in the realm of
Islam. Islamic economics are embedded in the broader framework of the jurisprudence of transactions
and in the scholasticism of the moral philosophers and theologians of Islam. None of the key concepts of
economic thought markets, the nature of value, productivity, utility, efficiency, growth, to name just a
fewexists with the same definition, or even broad meaning. The Sharia did not leave much room for
economics. Wherever the issues of prosperity of the community or welfare of the common person were
discussed, this was part of the same tradition of exhortatory writings to the ruler about the value of a
sound currency, about fairness in dealings and about the risks of punitive taxation. Otherwise it was
assumed that people were ordained to conduct their business affairs and transactions within the bounds
of the Sharia and its detailed norms concerning the permissible and the lawful in economic conduct and
behaviour. [p.209 The Crisis of Islamic Civilisation by Ali A Allawi, Yale University Press 2009]
Islamic Economics
Value of Money
Islamic Economic System
Money and Monetary Policy
Division of Labour
Utility: The Islamic Backbone of Islamic Economics
Role of the Market and its Limits
Islamic Governing Principles (Shari'ah)
Human Beings as God's Viceregent on Earth
Prohibition of Interest
Gharar
(risk),
Zakat, Zakah
Contracts Between Parties
Waqf

An
institution
Shariah Fundamentals of an Islamic Economic Order
The Prospects for an Islamic Economic Order

Maysir
for

(gambling)
Socio-economic

Welfare

Islamic Economics
It is difficult to understand and study Islamic economics and the structure of the Islamic financial
mechanism in isolation; unlike in Western' type economies where it is done with some degree of ease.
Islamic Economics differs fundamentally from man-made laws and systems in defining economic
problem.
While Islam is one of the principal global religions, more importantly it is a wholly integrated way of life,
where various principles are interrelated and a dictate under one aspect e.g. family, can logically be
relevant to another e.g. jurisprudence. For starters it can be put that Islamic economics is based on the

socio-economic

paradigm.

In

this

approach

Islam

is

seen

as

system

of

ethics.

Possibly one of the starting points to understand Islam and Islamic economics, is what can be considered
as the central theme 5:120 The Qur'an, where it states that dominion of the cosmos belongs to God
(Allah) and therefore we are but His vice-regents (or trustees) of all this dominion, whether we seemingly
own some part of this individually, jointly or otherwise. Naturally therefore, all economic and financial
activities that would effect and regulate our lives, must be driven by this key principle.
There are many contributory verses that guide and lay down the economic and financial principles, to
human beings as individuals or collectively as a society or as a nation. These principles form the Islamic
law which is known as Shari'ah (the corpus of Islamic law based on Divine guidance, as given by the
Quran and the Sunnah).
Ibn Khaldun's (15th century's) framework provides a summary of the interdisciplinary dynamic model for
Islamic socio-economic system:
The strength of the sovereign (al-mulk) does not become consumed except by implementation of
the Shari'ah;
The
Shari'ah
cannot
be
implemented
except
by
a
sovereign
(al-mulk);
The
sovereign
cannot
gain
strength
except
through
the
people
(al-rijal);
The
people
cannot
be
sustained
except
by
wealth
(al-mal);
Wealth
cannot
be
acquired
except
through
development
(al-imaran);
Development
cannot
be
attained
except
through
justice
(al-adl);
Justice is the criterion (al-mizan) by which God will evaluate mankind; and The sovereign is charged with
the
responsibility
of
actualising
justice
(Chapra, 2000: 147-8).
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Value of Money
Aristotle (384-322 BC) on Usury
Aristotle understood that money is sterile; it doesn't beget more money the way cows beget more cows.
He knew that "Money exists not by nature but by law":
"The most hated sort (of wealth getting) and with the greatest reason, is usury, which makes a gain out of
money itself and not from the natural object of it. For money was intended to be used in exchange but not
to increase at interest. And this term interest (tokos), which means the birth of money from money is
applied to the breeding of money because the offspring resembles the parent. Wherefore of all modes of
getting wealth, this is the most unnatural." (1258b, POLITICS)
And
he
really
disliked
usurers:
"...those who ply sordid trades, pimps and all such people, and those who lend small sums at high rates.
For all these take more than they ought, and from the wrong sources. What is common to them is
evidently a sordid love of gain..." (1122a, ETHICS)
Central to Islamic economics and finance is the fact that money itself has no intrinsic value. As a matter of
faith, a Muslim cannot lend money to, or receive money from someone and expect to benefit through any
increase, such as interest (commonly referred to as riba) is not allowed. To make money from money is
strictly forbidden, wealth can only be generated through legitimate trade and investment in assets. Money
must be used in a productive way. The principal basis of Islamic finance is based on the concept of
trading involving the sharing of profit and risk (loss). The profit is shared between the person providing the
capital and the person providing the management expertise.

The key characteristic of Islamic economics is that economic and financial activities are linked to real
economic sector activities and there is encouragement to equity based structures backed by tangible
assets instead of debt based ones in investment where in the conventional world the transactions may not
necessarily have to be backed by any real asset. The conventional investment practices, very often
encouraged by uncontrolled greed to make excessive profits, are the main reason for the current global
financial crisis that is bringing misery to millions. The Pope, Benedict XVI, alluded in 2008 to the illusory
nature of fiat money, and in 2009 the Vatican has also recently been critical of the free market system.
People would find it impossible to live in today's world without money, but one increasingly comes across
interesting appraisals of it like the following for example: . . . in spite of all its fervid activity, money
remains a naked symbol with no intrinsic value of its own and no direct linkage to anything specific
(Kurtzman, 1993). Money has come to be recognized as mere tokens and: there is something quite
magical about the way money is created. No other commodity works quite the same way. The money
supply grows through use; it expands through debt. The more we lend, the more we have. The more debt
there is, the more there is. (Kurtzman, 1993)
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Islamic Econimic System

The Islamic economic system, on the one hand, aims to guarantee individual liberty, freedom of choice,
private property and enterprise, the profit motive and possibilities of unlimited effort and reward. On the
other hand, it seeks to provide effective moral filters at different levels of life and activity and established
institutions in the voluntary sector, as well as through state apparatus to ensure economic development
and social justice in the society.
Some argue that early Islamic theory and practice formed a "coherent" economic system with "a blueprint
for a new order in society, in which all participants would be treated more fairly". Michael Bonner, for
example, has written that an "economy of poverty" prevailed in Islam until the 13th and 14th centuries.
Under this system God's guidance made sure the flow of money and goods was "purified" by being
channeled from those who had much of it to those who had little by encouraging zakat (charity) and
discouraging riba (interest) on loans.
Islam does not prescribe a particular economic system but provides the core elements and principles,
which form the basic philosophy of a system or an economy. Islam provides primarily normative principles
for economics and finance. However, it is not devoid of positive economic statements or hypotheses.
Several areas of economics are truly positive and cannot be different in an Islamic or in any other
framework.
The
Operational
and
Institutional
Features
of
Islamic
Economic
System
Extract from The Political Economy of Islamic Moral Economy by Mehmet Asutay, Durham University,
UK presented at the seminar held on 30 January 2009 on Comparative Development of the Islamic
Economic Model in context of current market conditions, organised by KPMG, London, UK.
1. The Islamic scheme for social change and regeneration of human societies is unique as it is based on
methodology that is different from conventional economic and political ideologies:
Thus, key elements for social change are:
a. Social change has to be motivated, planned and achieved through individual and collective effort;
b. People are active agents of change through the vicegerency task assigned to him/her and through
the accompanying free will given to him/her All human, physical and institutional factors in the
production, consumption and distribution of goods and services must be subject to his/her deliberate
individual and social choices.

c.There

needs
to
be
change not
only
in
the
environment,
but
also
within
the
hearts
and
souls
of
men
and
women-their
attitudes,
motivation,
and
commitment, and their resolve to mobilize all that is within them and around them for the fulfilment of their
objectives.
d. Life is a network of relationships, and consequently change has to be balanced, gradual and
evolutionary. Innovation is to be coupled with integration.
2. Self-interest is a natural motivating force in all human life. But self-interest has to be linked to the
overall concept of good and justice
3. Private property and private enterprise are affirmed as inalienable rights and a natural mode for
economic activity.
But the very concept and function of property is transformed by the provision of moral and legal filters,
and instilling in people's minds and hearts the notion that all in its forms physical and human, machine
power and brain power- property is a trust (amanah), and as such, property rights are subject to moral
limits and used as a means of fulfilling ethical objectives the Maqaasid al-Shari'ah (the objective of the
Islamic way).
4. Economic efforts take place through the process of cooperation and competition.
The market mechanism is the natural corollary of private property, freedom of enterprise and motivation
for profit and reward.
Scriptural guidance and historical evidence establish that trade, the promotion of production and the
exchange of goods and services, the pursuit of genuine profit, protection of the market mechanism, and a
legal framework for the fulfilment of contracts, are pillars of the Islamic economic system.
Effort, innovation, creativity, division of labour, technology and skills development have been emphasised
by all major Muslim thinkers along with cooperation, compassion, justice, charity and solidarity.
5. The market mechanism is a fundamental pillar of the Islamic economic scheme. But Islam demands
actions by extra-market institutions to ensure that the market does not degenerate into jungle capitalism,
and that self-interest and the profit-motive do not create a situation that is socially disruptive and in
violation of norms of justice and fair play.

A moral filter at the level of personal motivation;

Family as a social and economic unit to provide an initial system of social security and solidarity;

Government should be able to provide regulative framework;

A network of voluntary organisations (waqf system), third sector; charity is transformed by making
part of it a legal obligation;

Concern about the problem of waste, over-utilization and the excessive exploitation of
nonrenewable natural resources and the ecological and environmental aspects of moral activity
(Amanah and haq);

Consequently, distributive justice and social security have become structured elements of the
Islamic economic system and not merely voluntary supplements.

The prohibition of certain sources of income is a particularly distinctive plank of the Islamic
economic system. The most important prohibition is that of riba (usury/interest). Others relate to
gambling, speculation, fraud, exploitation and extortion.

It follows then that Islam would prefer to promote an equity based, risk-sharing and stake-taking
economic system to a debt-based system.

The
Islamic
(Chapra, 1992; Chapra, 1993; Ahmad, 2000)

Economic

Strategy

a. Filter: moral values plus market-determined prices: A moral filter that would moderate and
humanize the pursuit of wealth and power.
b. Motivation: Self-interest plus accountability before God to rein
self-interest:Accountability before the Supreme Being can serve as a motivating force for abiding by
Islamic values and working for social well being.
c. Role of the state: The state will be expected to play a complementary role in enforcing the moral code
of conduct and ensuring proper functioning of relevant institutions.
d. Socio-economic restructuring: The central objective of Islam is socio-economic justice. This
demands that the scarce resources at the disposal of humankind be used in such a way that the
universally-desired goals of need fulfilment, employment creation, equitable distribution and economic
stability are actualised. If the resources are utilised efficiently and equitably this can be achieved.
e. A comprehensive approach in financing: Efficiency demands giving of primary attention to the
ultimate use of funds. Financial intermediation on the bases of interest gives primary consideration to
collateral and cash flow and secondary consideration to the ultimate use of credits. Equity demands that
credit becomes available to an optimum number of businesses and for financing the production of need
fulfilling and capital goods and services and raw materials related to these. In a system based on profit
and loss sharing, even the poor may be able to get credit if they have a worthwhile project and sufficient
ability to manage the project efficiently.
Mechanisms/Institutions/and
Instruments
of
Islamic Economic System
Islamic economic and financial activities are shaped by there kinds of measures:

Positive measures (zakah)

Voluntary measures (sadaqah or alms giving; awqaf or pious foundations)

Prohibitive (riba')

Islamic Institutions and Instruments:

i. Elimination of riba;
ii. Islamic financial system;
iii. Zakah;
iv. Takaful;
v. Awqaf system
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the

Money and Monetary Policy

Extract from The Political Economy of Islamic Moral Economy by Mehmet Asutay, Durham University,
UK presented at the seminar held on 30 January 2009 on Comparative Development of the Islamic
Economic Model in context of current market conditions, organised by KPMG, London, UK.
The theme of money was tackled very early on in history by a number of Muslim thinkers such as alGhazali, Ibn Taymiyya, Ibn al-Qayyim, Ibn Khaldun and al-Maqrizi.
Al-Ghazali has highlighted two functions for money: means of exchange and a measure of value. He
argues that money becomes a necessary means of exchange to overcome the problems of a barter
economy. Al-Ghazali says that money also constitutes a unit of value and an instrument of measurement
whose role is to increase exchange and commercial relations. That is why al-Ghazali insists on the fact
that money should not be considered as a commodity, an object of transaction and a source of profit
(interest), nor hoarded and withdrawn from the commercial circuit.
Ibn Taymiyya examines two functions of money, namely, a standard of measurement and a means of
exchange, and condemns the trade in money. Furthermore, he examined the problem of money erosion
and also its impact on the general economic situation and on the welfare of the population: The
authorities should issue the money (other than gold and silver) up to the level that is just necessary to
correspond to the volume of transactions of the peoples without causing them any injustices.' This lead
Ibn Taymiyya to describe the principle, bad money chases good money', known as Gresham's Law in the
textbooks of political economy.
Ibn al-Qayyim recognizes the two functions of money described by the earlier scholars, but he was more
precise in his formulation. He wrote that money is issued not for its own sake but to be used in
transactions (that is to say that it constitutes only a means of exchange)'. Therefore money should be
stable so as to facilitate the evaluation of the products and their exchange.
According to Ibn Khaldun, God created gold and silver to serve as a standard (or yardstick) of
measurement for all goods. Contrary to the Mercantilists, Ibn Khaldun demonstrated, well before them,
that gold and silver do not constitute wealth as such, but have a value of exchange like other metals or
precious stones. The argument of Ibn Khaldun is based on the theory of value which he put forward
centuries before Karl Marx. It is human labour, the source of wealth, he said, which contributes to
increasing or decreasing the quantity of precious metals. The countries producing gold and silver
exchange them against money to acquire the goods they need.
Taqi al-Din Ahmad al-Maqrizi (1364-1444) is known for his works on money and prices. He considers that
only gold and silver constitute money which could be used as a standard of value, in the nature of things
and according to the Shari'a. Because of the relationship between the non-measured issue of money and
the rise in prices, al-Maqrizi proposes that the increase in mass-money should correspond to, and not
exceed, the total volume of transactions.
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Division of Labour
Extract from The Political Economy of Islamic Moral Economy by Mehmet Asutay, Durham University,
UK presented at the seminar held on 30 January 2009 on Comparative Development of the Islamic
Economic Model in context of current market conditions, organised by KPMG, London, UK.
The importance of the role of labour in the creation of wealth was underlined by al-Ghazali (1058-1111),
Ibn Taymiyya (1263-1328) and Ibn Khaldun (1332-1406). Seven centuries earlier than Adam Smith, alGhazali highlighted the importance of the division of labour required by the necessary diversity of human

activities. It is astonishing to see that Ghazali used the example of a needle factory to illustrate his point
while Adam Smith used the example of a pin factory.
Ibn al-Qayyim (1292-1350) emphasized the necessity of establishing economic cooperation between the
different parties of a society, which constitute the whole. Cooperation among human beings allows them
to obtain results that would never have been realized individually. The division of labour induces
multiplication and diversification of economic activities.
It is Ibn Khaldun who should receive credit for analysing with a greater scientific rigour the concepts of
labour, value and the division of labour- five centuries before David Ricardo and Karl Marx.
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Utility: The Islamic Backbone of Economics

Mehmet Asutay, Durham University UK 2009
Treatment of utility as a scientific tool of analysis is the scholarly product of most notably al-Ghazali(550
H), Izzaddin ibn Abdelsalam (or al-Izz) (660 H), ibn Taimiyah (728 H) and al-Shatibi (790 H).
Al-Izz: Most worldly utilities are recognizable through the [human] mind. The approaches of al-Izz and
ibn Taimiyah are the most relevant to micro economic theory since they both depart from a behavioural
concept of utility as a fundamental basis for the macro concept.
Al-Ghazali and al-Shatibi focused mainly on the macro theory of utility. Therefore, it is possible to review
the salient features of utilities jurisprudence through the macro / micro classification as it will shortly be
tackled.
Their views can be summarised as: The goal of Shari'ah is defined to achieve utilities and avert
difficulties. This postulate forms a general consensus among Muslim scholars, with the added provision
that no contradiction is perceivable between worldly utilities and Hereafter's utilities except through
misunderstanding of either. It is the basic jurist provision whereby economics and ethical values are firmly
linked in the pursuit of a better economic order.
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The Role of Market and its Limits

Mehmet Asutay, Durham University UK 2009
Many thinkers recognize private property, the liberty of economic activities and the free movement of the
market forces but within the confines of Islamic values. That is why they anticipate the intervention of the
state in case of dysfunction of the market in order to protect the general interest.
Abu-Yusuf (731-798) admits the determination of prices through the free play of supply and demand
though he maintains the necessity of measures that tend to block monopoly, fraud and corruption.
Al-Mawardi (11th century) was also a proponent of state intervention in the economy through
the muhtasib whose function, among other things, would be to regulate the market. The precision of
weights and measures would have to be assured, fraud clamped down on, and commercial operations
controlled so that they conformed with Islamic legislation.
Nizam al-Mulk al-Tusi (11th century) advocates state control of the economy, emphasizing the necessity
of maintaining national stability. According to him, such stability would not be obtained unless the basic
needs of the population were safeguarded. He was preoccupied by the necessity of organizing assistance

to the poor amid the needy amid the struggle against the penury of alimentary products by assuring their
permanent availability in the markets, especially in cases of catastrophe or drought.
Al-Ghazali implicitly recognized the idea of determining prices by the forces of the market (in his analysis
of commercial activities and the related functions of transport and storage), to ensure the availability of
products almost everywhere. But he also evoked al-hisba (supervision and control) by describing the
qualities of the muhtasib (supervisor), the activities that are subject to control, and he nature amid rules of
supervision. He has also indicated some other areas that need to be supervised such as concealing the
defects of products or services and false declarations for achieving profit.
Ibn Taymiyya has also well expounded the role of the market where prices are determined by the laws of
supply and demand. After identifying the demand and supply conditions, Ibn Taymiyya suggests that the
state should not intervene in fixing prices except in the event of an injustice, monopoly, dissimilation, or
voluntary withdrawal of merchandise from the market circuit to realize illicit profits. For Ibn Taymiyya, it is
clear that in such cases the intervention of the state becomes inevitable in eliminating, or at least limiting
as far as possible, market imperfections, which disturbs the smooth operation of the market and its
transparency.
Islamic Governing Principles (Shari'ah)
The moral underpinnings and purposes of economic and trade regulations in the traditional Islamic order
were accompanied by a massive legacy of detailed rulings on the fundamentals of economic rights and
duties, as well as on the nature and scope of business contracts and commercial dealings.
There are a few key principles that directly set down the economic guidelines and hence determine the
central structure of Islamic economics as well as regulate business and financial transactions.
I) The first is the principle of RIBA. Literally, in Arabic, Al Riba means an increase or addition. In Islam it
is interpreted as usury or a loan with the condition that the borrower will return to the lender more than
and better than the quantity borrowed. This act of ribais prohibited in Islam. There are many verses in the
various chapters of the Quran that make riba illegal - haram
There are two significant implications of this ruling of prohibiting riba / charging of interest. (1) Without
interest there are no debt based contracts and (2) the absence of interest focuses on the value of an
asset, rather than the value of money', as it is through interest that money acquires its value.
The most frequently asked question therefore when someone learns of this concept of interest being
prohibited is how then can any one make money?
Islam recognises man's need to acquire wealth. It therefore allows people to make money through the
avenue of profit. Simply put, a lender' of funds may only give money to a borrower' of funds, if the lender
shares in the risk of the business for which the money is being lent. The lender can determine before
lending the money, as to what his share of the profit will be. If however the business fails, then the
investor looses his investment. It follows then that Islam promotes equity based, risk-sharing and staketaking
economic
system,
to
a
debt-based
system.
(Source: knowislamicbanking.com)
II) The next important principle is the principle of Gharar. The Arabic word Gharar has a multiplicity of
meanings - risk, uncertainty hazard and deception. Unlike riba, gharar is not specifically and extensively
defined. While the prohibition of riba is absolute, some degree of gharar or uncertainty is acceptable in
the Islamic framework. Only conditions of excessive gharar must be avoided. This includes Maysir or
Qimar which refers to gambling or any games of chance.

For example a transaction involving deception or excessive uncertainty or a zero' sum transaction in
which one party must loose for the other to gain are prohibited under Shari'ah law.
III) The third key principle is the principle of ZAKAT (Zakah). Zakat is one of the five key pillars of
Islam. It is a form of religious tax' making it a requirement of every Muslim to give a percentage of their
income to a charitable cause, provided such income or wealth is above a defined amount. During the
Islamic period, Zakat payments were collected by the State and the funds were used to alleviate all kinds
of human distress including setting free the slaves by paying off their masters. The objective is to take
away a part of the wealth of the well-to-do and to distribute it among the poor and the needy. Depending
on the income / wealth (cash, cattle, agricultural produce, minerals, capital invested in industry, and
business etc) the amount of Zakat varies from 2.5% up to 10%. (9:60)
The Islamic world view of economics are based on these key principles

vice regent (trustees) of all that is Allah

prohibition of riba charging of interest

prohibition of gharar - gambling and taking of undue risk

giving of Zakat a moral tax

and some other key related Shari'ah principles

Al-adl wa'l-ihsan- ensuring balance and beneficence of the socio economic structure through
an appropriate process of jurisprudence

Ikhtiyar exercising the free-will' within specific societal contexts, and to suit the needs of
changing times

Fard- the issue of responsibility ..over the assets of which one is viceregents/ trustees, in the
interest of social / public good

Rububiyyah- fundamental law of the universe, the useful development of resources and their
mutual support and sharing.

One can over simplify and summaries that Islamic economics attempts to create a moral / ethical'
economy for the good of all. It is a free market economy; but this state of free enterprise' is managed by
(1) restrictions matters that are prohibited haram, and
(2) obligations that Muslims have and are required to bring about themselves through the practice of the
various principles of Islam / Shari'ah law, without unduly curbing individual freedom and creativity or
creating an imbalance in the macroeconomic and ecological environment.
Thus the Islamic concept of economics and economic growth and development follows from its concept
of tazkiyah as it addresses itself to the problem of economic aspect of human life in all its
dimensions; tazkiyah is concerned with growth towards perfection through purification of attitudes and
relationships. The result of tazkiyah is falah, prosperity in this world and the hereafter (Ahmad, 1994: 20).
Human Being are God's Viceregent on Earth

Humankind is viewed in Genesis 1:26-28 as having a governing role. In v. 27 humankind is created in the
image of God. (cf. H. W. Wolff, Anthropology of the Old Testament, 159-64). Human beings have a role of
rulership, but they rule only as a re-presentation of God.
Bernard Anderson, a veteran scholar of the Hebrew Bible, reinforces this understanding that the humanity
which is to fill the earth is also a viceregent of God (in Biblical Studies in Contemporary Thought, ed. M.
Ward [1975] and more popularly and directly in Bible Review 8, 5 [1992]).
A principle of Islam is that everything belongs to God, and wealth is held by people in trust. Muslims also
have a responsibility to care for the less fortunate. To Muslims The Qur'an is also a way of life dealing with
issues that emphasis socio-economic justice. It emphasises the concepts of trusteeship of human beings
as God's vicegerent on earth, care for others, moderation in consumption, productive effort as a means of
serving God, charitable assistance, maintenance of family, duty to produce more than one's needs, wealth
not as a means of end and many others.
Prohibition of Interest
"The most hated sort (of wealth getting) and with the greatest reason, is usury, which makes a gain out of
money itself and not from the natural object of it. For money was intended to be used in exchange but not
to increase at interest. And this term interest (tokos), which means the birth of money from money is
applied to the breeding of money because the offspring resembles the parent. Wherefore of all modes of
getting wealth, this is the most unnatural."
(1258b, POLITICS, Aristotle 84-322 BC))
Charging interest is detestable to God and man, damned by the sacred canons and contrary to Christian
charity." (POPE SIXTUS V)
Charging and paying interest is also forbidden in the Qur'an in the strictest terms. This prohibition is
based on arguments of social justice, equality, and property rights. Islam encourages the earning of
profits but forbids the charging of interest because profits, determined after the event, symbolize
successful entrepreneurship and creation of additional wealth whereas interest, determined before the
event, is a cost that is accrued irrespective of the outcome of business operations and may not create
wealth if there are business losses. Social justice demands that borrowers and lenders share rewards as
well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the
economy be fair and representative of true productivity.
The essential problem with interest is that interest divorces the lender from any moral responsibility for the
use of money lent. The return is guaranteed no matter what the changed circumstances of the borrower
are. The possession of money does not of itself cause any increase. It is only when the money is put to
some use that it can yield a profit. By divorcing the lender from any responsibility over the use of the
money what is introduced is a problem called a moral hazard. The lender does not have to care where the
money is lent so long as the returns are guaranteed which may be at the expense of the borrower and
without taking into account genuine reasons for default. Often, the real profitability of the use of the
borrowed money is hidden from the financial system.
The general consensus among Islamic scholars is that riba covers not only usury but also the charging of
"interest" as widely practiced. It is for that reason that conventional mortgages are not acceptable to many
Muslims as the payment of interest conflicts with their ethical and religious principles. Islamic Finance has
therefore provided a means for many people to purchase their own home in accordance with their beliefs,
which was previously not available to them.
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Gharar (Risk or Uncertainity) also Maysir (Gambling)

Gharar refers to a risky or hazardous sale, where details concerning the sale item are unknown or
uncertain. This may be because the transaction involves pure speculation, thus is a form of gambling and
the outcome and future benefit are uncertain and unknown.
Gharar is forbidden by the Qur'an, which explicitly forbids trades that are considered to have excessive
risk due to uncertainty.
There are strict rules in Islamic finance against transactions that are highly uncertain or may cause any
injustice or deceit against any of the parties. In finance, gharar is observed within derivative transactions,
such as forwards, futures and options, in short selling, and in speculation. In Islamic finance, most
derivative contracts are forbidden and considered invalid because of the uncertainty involved in the future
delivery of the underlying asset. Gharar is also observed in insurance.
Zakat, Zakah
"Of their wealth take alms, that so thou mightest purify and sanctify them; ." [The Qur'an 9:103]
The word zakah comes from the verb meaning to purify or cleanse. The literal meaning of Zakat is grow
(in goodness) or 'increase', 'purifying' or 'making pure'. The act of giving zakat means purifying one's
wealth to gain God's blessing to make it grow in goodness. Human being's possessions are purified by
setting aside a proportion for those in need, and, like the pruning of plants, encourages new growth.
One of the most important principles of Islam is that everything on earth belong to God, and held by
human beings in trust, including all possessions and wealth. Zakat is a certain portion of one's wealth that
all Muslims who are financially able must give as a welfare contribution for the poor and needy, including
widows and orphans, irrespective of their colour, ethnicity or religion or other specified charitable causes
in the service of God. The Qur'an equates failure to meet the needs of the poor and orphans, which Zakat
represents, to denial of religion.
The Qur'an (9:60) classifies the due recipients of zakat under the following eight categories.
"Alms are for the poor, and the needy, and those
who employed to administer (the funds); for those
whose hearts have been (recently) reconciled
(to Truth);for those in bondage and in debt;
in the cause of Allah; and for the wayfarers: ."
Zakat's similar sounding, Arabic language analog is the Hebrew word Tzedakah, the charitable obligation
in ancient Israel through to present day Judaism. During the Islamic period, Zakat was collected by the
State who had the duty not just to collect Zakat, but to distribute it fairly as well.
Contracts between Parties
Compliance with Islamic principles is the basis of all contracts between parties performing some specified
act in exchange for a lawful consideration, and the most important building block for an Islamic financial
and economic system. Most of the financial products, services and instruments are based on such
contract. Therefore a thorough understanding is required of the Shari'ah-acceptable contracts in their
multifarious and varied forms that could be used to design and develop Shari'ah-based financial products
and to provide Shari'ah-compliant financial solutions.
Musharakah, mudarabah, murabahaand ijarah contract types form the basis of a variety of Shari'ah
compliant alternatives to conventional interest-based financing solutions. The basic premise of Islamic
finance lies in the need to eliminate both interest (Riba) and uncertainty (Gharar) in all business and
financial transactions.
In brief, the following are key types of Islamic contracts applied today.
Mudarabahand Musharakah

both

are

contracts

of

partnership.

Islamic

scholars

have

preferred mudarabah and musharakah as the ideal forms of permissible contract that comply with the
rules and objectives of the Shari'ah. The basic reasoning is that these contracts pool resources and
expertise as well as spread the inherent risk in a project among the various parties involved.
Murabaha a term often referred to as cost-plus financing' and in its simplest form, this contract involves
the sale of goods on a deferred basis. The goods are delivered immediately and the price to be paid for
the item includes a mutually agreed margin of profit payable to the seller. In this contract, the Shari'ah
requires a financier to first procure the goods and then sell it on to the actual buyer at a mutually agreed
mark-up as the financier's profit, and in that process the financier must also disclose to the buyer the
market cost price (true cost) of the goods procured. The amount of profit earned (the mark-up on the true
cost) in this transaction is not a reward for the use of the financier's money as the financier cannot receive
the marked-up profit if the financier fails to perform the required service, such as delivery of goods
purchased with the financing..
Ijarah a term used for a leasing contract in Islamic law where a specified asset required by a party may
be purchased by a financier and then leased by the financier to the party for an agreed rental and for an
agreed period. The way lease rentals are calculated and the fact that the leased asset continues to be
owned by the financier throughout the lease period, the rentals is not equated with receiving interest.
The Ijara contract can be designed to allow return of the leased asset to the party at the end of the leased
period. However, if the party may wish to acquire the leased asset at the end of the leased period, the
party would have to have a separate agreement for this purpose before entering into the ijarah contract; in
terms of the Shari'ah rules, such agreement cannot be binding on the parties.
WAQF An institution for Socio-economic Welfare
Waqf - (plural: awqaf), refers to the gift of money, property or other items to charity. It is an endowment by
a Muslim or assignment of revenues for religious or charitable purposes in a form of trust, meaning that
the revenues may not be shifted to another purpose.
A waqf in pre-commercial society would ordinarily be arable land, farms or oases. In theory the waqf is
absolutely permanent, and once established, the contract cannot be altered or the property sold or
alienated. The revenues from the waqf may finance mosques, religious and other institutions or charities.
Waqf continue even after the donor's death - for as long as people continue to benefit from the Waqf.
The basic rules governing waqf trusts are laid down in the Shari'ah, but interpretation and implementation
may vary in different Muslim societies.
After the Islamic waqf law and school foundations were firmly established by the 10th century, the number
of hospitals multiplied throughout Islamic lands. In the 11th century, every Islamic city had at least several
hospitals. The waqf trust institutions funded the hospitals for various expenses, including the wages of
doctors, ophthalmologists, surgeons, chemists, pharmacists, domestics and all other staff, the purchase
of foods and medicines; hospital equipment such as beds, mattresses, bowls and perfumes; and repairs
to buildings. The waqf trusts also funded medical schools, and their revenues covered various expenses
such as their maintenance and the payment of teachers and students.
The waqf in Islamic law, which developed in the medieval Islamic world from the 7th to 9th centuries,
bears a notable resemblance to the English trust law. Every waqf was required to have
a waqif (founder), mutawillis (trustee), qadi (judge) and beneficiaries. Under both a waqf and a trust,
"property is reserved, and its usufruct appropriated, for the benefit of specific individuals, or for a general
charitable purpose; the corpus becomes inalienable; estates for life in favor of successive beneficiaries
can be created" and "without regard to the law of inheritance or the rights of the heirs; and continuity is
secured by the successive appointment of trustees or mutawillis." [Wikpedia]
The only significant distinction between the Islamic waqf and English trust is "the express or implied
reversion of the waqf to charitable purposes when its specific object has ceased to exist", though this

difference only applied to the waqf ahli (Islamic family trust) rather than the waqf khairi (devoted to a
charitable purpose from its inception). Another difference was the English vesting of "legal estate" over
the trust property in the trustee, though the "trustee was still bound to administer that property for the
benefit of the beneficiaries." In this sense, the "role of the English trustee therefore does not differ
significantly from that of the mutawalli." [Wikpedia]
SHARIAH FUNDAMENTALS OF AN ISLAMIC ECONOMIC ORDER
Some Sharia Fudamentals of an Islamic Economic Model by Noureddine Kirchene and Abbas Mirakhor
presented at the seminar held on 30 January 2009 on Comparative Development of the Islamic
Economic Model in context of current market conditions, organised by KPMG, London, UK.
Introduction
An Islamic economic model embraces science and draws on economic theory, except in areas prohibited
in Islam (e.g., interest rates, gambling, violation of property rights, etc.). It has, however, features that
confer to it dimensions that do not appear in standard economic theory. More specifically, an Islamic
economic model is based on principles that recognize: the full supremacy of Allah; the view that man is
not only a material object, but is, in essence, a spiritual being; that all comes from Allah and goes back to
Allah [The concept of mother nature does not exist in an Islamic economic model. It is replaced by a
deterministic and ever ubiquitous presence of Allah SWT, a presence of which a Muslim is consciously
and constantly aware and acts accordingly. Hamid, Iqbal, and Mirakhor, 2008, reviewed most of
conventional economic development models and demonstrated their serious shortcomings. Because of its
divine nature, an Islamic economic model is immune to shortcomings of conventional models, and offers
a better framework for economic development and social justice than any other conventional model] ; that
man was favored by Allah above all other creatures with the power of intelligence; and consequently is
accountable for his/her actions; and that the act of worship is inseparable from the economic life. The faith
precepts
underlying
an
Islamic
economic
model
can
be
stated
as
following:
1.The belief that there is no God, except Allah, and that Mohammed, PUH, is His Messenger, which
means total submission to Allah and to His Messenger, believing in all previous Messengers, embracing,
and acting accordingly, all Allahs commandments and teachings with full conviction and without doubt or
questioning.
2. The goal of creation is to worship Allah alone, as clearly stated in Surat 51, verse 56: I have created
Jinns and men except that they should worship Me Alone. No sustenance do I require of them, nor do I
require that they should feed Me. Verily Allah is the All Provider, Owner of Power, the Most Strong.
3. To fulfill this goal of worship, Allah has created resources so that man can fulfill the worship obligation,
as
clearly
stated
in
many
verses:
45; 12: It is Allah who has subjected the sea to you, that ships my sail through it by His command, that
you may seek of His bounty, and that you may be grateful. And He has subjected to you, as from Him, all
that is in the Heavens and on Earth: behold, in that are signs indeed for those who reflect.
35; 3: O men! Call to mind the Grace of Allah unto you! Is there a Creator, other than Allah, to provide
sustenance from Heaven and Earth? There is no God but He: How then are you deluded away from
truth?
41;9: Say: Is it that you deny Him Who created the Earth in two Days? And do you join equals with Him?
He is the Lord of all the Worlds. He set on the Earth mountains standing firm, high above it, and bestowed
blessings on the Earth, and measured therein its sustenance in due proportion in four days in accordance
with
the
needs
of
those
who
seek
sustenance.
15;21: And there is not a thing but its sources and treasures (inexhaustible) are with Us; but we only send
down
thereof
in
due
and
ascertainable
measures.

4. Those who submit to Allah should accept Islamic legislation in its integral whole, without selecting some
principles and abandoning. Allah SWT has stated in 6; 38: We have neglected nothing in the Book. In 45;
17, Allah says: We have put you on a Sharia path. So follow it and follow not the desires of those do not
know.
5. Believe in what Allah has ordered is the best as clearly stated in 5; 3: This day, I have perfected your
religion for you, completed my favor on you, and have chosen for you Islam as your religion; and that
disobeying Allah will result in failure either in this life or in the life after, as mentioned in14;28: Have you
not seen those who have changed the Blessings of Allah into disbelief and caused their people to dwell in
the
house
of
destruction?
Allah did not make the results of disobedience a surprise. He clearly warned Adam (20;117) that these
results will be hunger, nakedness, thirst, and misery. Such indeed remains the plight of millions of people
around
the
world
who
continue
to
suffer
abject
poverty
and
malnutrition.
Quran and Sunnah have fully covered all aspects of economic, political (Shura, i.e., consultation) and
social legislation and have set forth all principles that should organize economic, political and social life.
Allah has called on mankind to embrace all Islamic laws, and not to choose some and ignore others.
Following their access to independence many Muslim countries chose a Leninist-Marxist model and lost
out on decades of economic development. In spite of long periods of economic planning, many Muslim
countries continue to suffer high unemployment rates exceeding 20 percent of the labor force, which
creates a drag on their economic growth. Abject poverty is spreading in many countries, particularly in
African and some Asian Muslim countries. Only immigration to developed countries provides a relief out of
unemployment and poverty. Although the Muslim world owns 80 percent of world oil reserves and 60
percent of gas reserves, very rich lands, it suffers wide disparities and economic disintegration. While
many countries enjoy large external surplus, almost solely from oil and natural gas exports, other
countries
suffer
large
external
deficits
and
unsustainable
external
debt.
In the post war period, the technological gap between Muslim and industrial countries has grown very
large. While industrial countries made large strides in technical progress in all fields of activity, inventing
new technologies, such as in the fields of computer sciences, internet, medicine, satellite
telecommunications, aerospace, ships, automobiles, photocopying, medical equipments, and
pharmaceuticals, no such progress was made in the Muslim World. The trade pattern that has emerged
out of this deepening technological gap shows a growing trade gap and total dependence, through
borrowing, on industrial countries for filling food deficits and importing industrial products. In particular,
industrial countries are self sufficient in food products and want to import only raw materials in which they
are deficient. Muslim countries are deficient in food products and want to import industrial products [Food
riots have erupted in 2008 in many Muslim countries. Malnutrition and acute food deficiencies are
aggravating in many Muslim countries]. Exports of raw materials do not cover fully imports of food and
industrial products. The gap is filled through continuous borrowing and therefore higher external debt and
dependence.
Based on tangible experience over many decades, the cost of conventional development models has
been high while achievements were meager. Prospects for achieving a balanced and autonomous
economic growth, and overcoming unemployment and spreading poverty are not encouraging even in the
so-called middle income countries. An Islamic economic model is a promising alternative and offers
significantly better prospects for a sustained balanced economic growth, overcoming the unemployment
problem, narrowing poverty, and reducing dependence on external financing. The promise for successful
results
are
explicitly
and
repeatedly
made
by
Allah
and
His
Prophet
PUH.
This paper discusses some Sharia fundamentals of an Islamic economic model [Many of the Islamic
Sharia rules have been extensively discussed in Hamid, Iqbal, and Mirakhor, 2008]. Section II addresses
a most distinguishing aspect of an Islamic economic model, which is zakat. Contrary to all other economic

system, an Islamic economic system has built in a perfect safety net against poverty and social inequities.
Zakat is a prerequisite for abolishing interest. By fully establishing zakat, an Islamic economic model
could easily eradicate poverty and achieve higher economic growth and employment.
Section III addresses public finance in an Islamic economic model. The main principle that has governed
Islamic finance was fiscal discipline, trust, efficiency in public expenditure, and avoidance of waste. Many
types of spending that do not benefit the social welfare should not be allowed. The primary spending
under the Prophet PUH and the succeeding Khalifs was for social coverage. Wasteful spending on
overpaying civil service or subsidies that are not targeted (e.g. fuel subsidies that generally benefit the
rich) should not be acceptable. An Islamic tax system cannot be simply a transposition of a conventional
tax system. The principle of taxation should obey strict criteria of social solidarity, social welfare, and
public interest. Users fees help social equity; the government is encouraged to levy charges for the use
of public infrastructure, such as ports, airports, and freeways. The government is entitled to royalties from
mineral resources. While the state cannot establish obligations on income and wealth, beyond those
stipulated by zakat, it may nonetheless resort to moderate taxation subject to the criteria of public interest,
such as defense and internal security, or for the construction and maintenance of public infrastructure that
is
being
used
by
all
firms
in
conducting
their
economic
activities.
A main principle of Islamic public finance is for the government to run a surplus on the current fiscal
balance that will help finance capital expenditure [This is to alleviate the scarcity of capital and reduce its
marginal efficiency to mitigate one reason for emergence of a rentier class that earns a living off loaning
money to entrepreneurs to finance capital investment]. In case of deficit on the current fiscal account, the
government should forcefully tailor its current spending in line with ability to raise revenues with a view to
generate a current fiscal surplus. The financing of the fiscal deficit should obey Islamic principles. More
specifically, the government should not contract interest-bearing debt. It can only contract non-interest
bearing debt. Inflationary financing of the deficit is not acceptable as it distorts prices, extracts large tax
on fixed income groups (pensioners, wage earners), absorbs savings, destabilizes the financial system,
encourages
speculation,
and
decelerates
economic
growth.
Section IV discusses the nature of Islamic finance in mobilizing savings and promoting investment. An
Islamic financial system avoids interest and interest-based assets [Hassan and Lewis (2007) offered a
comprehensive description of Islamic modes of financing which are based on profit and loss sharing
investment, types of risks in Islamic banking, and financial innovations, including access to capital
markets and securitization, introduced by Islamic banks],and thus restricts speculation [Speculation may
create a disconnect between the market price of an asset (e.g., common stock, house, etc.), or a
commodity, and its true economic value or fundamentals. For instance, the construction cost of a house
may decrease, due to productivity gains and lower wages; however, because of speculation, its market
price may increase two, three, or fourfold]. Mirakhor (1988) showed that an Islamic financial system can
be modeled as non-speculative equity ownership model that is intimately linked to the real sector and
where demand for new shares is determined by real savings in the economy. All causes of financial
instability inherent to a conventional financial system, namely money creation out of thin air, speculation,
and interest-based financial assets are absent in Islamic finance. Banks own directly real assets and
operate like an equity holding system. Savings is redeployed into productive investment with no ex-nihilo
money creation. Mirakhor (1988) showed that the rate of return on equities is determined in a growth
model by the marginal efficiency of capital and time preference and is significantly positive in a growing
economy, implying that an Islamic banking is always profitable provided that real economic growth is
positive. Mirakhor (1988) finding establishes a basic difference between Islamic banking where
profitability is fully secured by real economic growth and conventional banking where profitability is not
driven primarily by the real sector [Conventional banks may suffer large losses, as seen recently in many
industrial countries, in spite of continuing real economic growth]. An Islamic banking system has two types
of banking activity. A deposit banking for safekeeping and payment purposes. This system operates on
100 percent reserve requirement, and fees may be collected for this type of banking services. An
investment banking system which operates on risk and profit sharing basis with an overall rate of return
which is positive and determined by the economy growth rate. The paper shows that Islamic banks do not
create and destroy money; consequently, the money multiplier, defined by the savings rate in the
economy as suggested by Mirakhor (1988), is much lower in an Islamic system compared to a

conventional system, providing thus a basis for strong financial stability, greater price stability, and a
sustained economic growth [This inherent instability of conventional banking has led famous economists
(Irving Fisher (1936), Henry Simons (1948), Maurice Allais (1999), and many others) to formulate
monetary reform proposals that share basic features of Islamic banking. These proposals are known as
the Chicago Plan; they call for dissociating banking into two independent activities: (i) 100 percent reserve
deposit banks; and (ii) investment banks that redeploy savings into investment through selling securities].
Section V discusses labor markets in an Islamic economic model. A main purpose of an Islamic economic
model is to eliminate distortions in labor markets with a view to maximize employment and promote
exports. It aims at establishing perfect wage flexibility capable of equilibrating labor markets. In spite of
many decades of economic development, the rate of unemployment, which was very low at the natural
rate prior to development planning, has reached by 2008 disturbing levels in most of Muslim countries,
averaging 15 percent in middle income countries, and above 25 percent in low income countries,
particularly in sub-Saharan African countries, and is expected to worsen in the period ahead. The paper
argues that applying an Islamic economic model will help establish a balanced economic growth path,
increase employment, and reduce poverty.Section VI discusses private sector development and asset
and product markets in an Islamic economic model. Private property and private sector initiative have
been essential components of an Islamic economy. Asset and product markets have to operate freely
without price fixation or impediments to entry and competition. Exchange rates have to be marketdetermined. Price distortions and monopolistic or oligolopolistic competition could constrain economic
growth and impose a social welfare cost.
Section VII addresses economic development planning and human development in an Islamic model.
Long-term planning and defining national development priorities are important elements of an Islamic
economic model. A Muslim economy has to have long-term plans for economic and social infrastructure,
human development, and setting national priorities in terms of food security, energy balance, and high
employment. The financing of development projects should be through non interest modes. It could also
be through public private partnership.
Section VIII addresses Islamic jurisprudence as a legal and regulatory framework for an Islamic economic
model. Islamic jurisprudence purports to establish a safe and free of crime environment that enables
economic prosperity, reinforces contracts, and forbids all form of injustice and aggression. It is incumbent
on the state to apply Quran and Sunnah laws regarding insuring social safety and providing an enabling
environment for enterprise, investment, and economic growth [Hamid, Iqbal, and Mirakhor showed that
modeling an Islamic economy is fundamentally different from the conventional economic model.
Conventional economics has developed theories and propositions regarding the behavior of economic
agents to deduce economic laws. An Islamic model building is how to get the Muslim behavior to
converge on that ordained by the our Supreme Creator. agents to, in their view, deduce laws]. Section IX
concludes that an Islamic economic model, thanks to its free-of-interest and stable financial system,
balanced fiscal policy, redistributive aspects, and free competition offers a robust macroeconomic
framework conducive to sustained growth and full employment. The development cost of a conventional
model has been overburdening; however, economic and social achievements were mediocre.
Zakat, a mandatory redistributive element of an Islamic economic model
Zakat is the most distinguishing feature of an Islamic economic model which makes it far superior to the
rest of economic systems. Zakat is a prerequisite for abolishing interest. In Quran and Sunnah, Islamic
finance has always been conceived as the finance activity of an Islamic economy where social equity is
enhanced through mandatory zakat. In Quran, the verses that deal with interest (riba) have always been
preceded or followed by verses that prescribe zakat. Hence, when social equity is secured through zakat,
motives on the side of lenders to practice interest and dire needs of the poor to accept interest will
disappear. In such an economy, Islamic finance will be essentially guided toward investment and wealth
creation and much less toward consumption. An Islamic economic model cannot be established without
full discharge of the zakat [The topic of zakat has been extensively discussed in Hamid, Iqbal, and
Mirakhor (2008). They demonstrated its role in promoting economic development and achieving social
balance with no extravagance or degrading poverty. Seyed Kotb (1954) discussed thoroughly the role of

zakat in achieving social justice and mitigating skewed income distribution]. Zakat is the third pillar of
Islam. Those who deny it are considered non Muslims. Allah has admonished those who deny zakat:
41;6: And woe to Al-Mushrikeen (the polytheists, idolaters, disbelievers in the Oneness of Allah. Those
who practice not Zakat and they are disbelievers in the Hereafter.
Our Prophet warned against withholding zakat. Refusal to pay zakat will cause economic losses as is
explicated in many parts of Quran. Zakat is not a favor of the rich on the poor; it is a right of the poor in
the wealth of the rich.
Zakat is defined by fixed ratios to savings, gold, silver, crops [Vegetables and perishable fruits are not
subject to zakat], livestock [Horses, mules, and donkeys are not subject to zakat], inventories, rent
income, and real estate wealth. Zakat is essentially destined to eight categories of eligible recipients, as
specified in 9; 60: Alms are for the poor and the needy, and those employed to administer the funds, for
those whose hearts have been recently reconciled to truth, for those in bondage of dent, and for the
wayfarer; thus is it ordained by Allah, and Allah is full of knowledge and wisdom.
Historical experience established that if zakat and khumus are fully paid, poverty will completely
disappear in the Muslim world for essentially two reasons. First, Allah will multiply wealth when zakat is
paid. Second, Zakat is fairly sufficient to satisfy the needs of the poor and the needy. Unfortunately,
throughout Muslim world, only a small fraction of zakat is actually paid.
Besides obligatory zakat, Infaq (i.e., spending in the way of Allah) has been highly praised by Allah and
His Messenger (PUH). Infaq is purely voluntary. The Prophet PUH and His companions had set most
generous example in Infaq, sparing no wealth in favor of the needy [Infaq is not charity; it is the
redemption of the property rights of the poor (beyond zakat) in the wealth of the rich. The praise of Infaq
is because the rich recognizes the duties Allah has imposed on them]. However, the Prophet PUH has
discouraged excessive charity that may deprive the family of the donor from decent living.
Public finance in an Islamic Economic Model
The concept of the state and central power is fully embedded in an Islamic economic model. The state
has the responsibility for defense, maintaining order, redistributing income in favor of the poor,
establishing justice, providing public services, and investing in economic development. The notion of a
modern state has emerged under the Prophet PUH and the Khalifs who succeeded him. The States
Treasury was established under the Prophet PUH under the name of Beit Mal AlMuslimeen. The concept
of public finance has been a fundamental aspect of an Islamic economic model. The main principles that
have governed Islamic finance were fiscal discipline, trust, and efficiency in public expenditure: as clearly
stated in many verses of Quran:
25; 67: And those who, when they spend, are neither extravagant nor niggardly, but hold a medium (way)
between those extremes.
17;27: Verily, the spendthrifts are brothers of the Satan, and the Satan is ever ungrateful to his Lord.
6; 141: And waste not by extravagance. Verily, He likes not those who waste by extravagance.
Spending of public resources has to obey Islamic criteria that enhance social welfare and economic
growth. Rulers and civil servants are entitled a compensation, however, in due proportion and not in
excess of the government fiscal balance. Many types of spending should not be allowed, such as
spending on personal security to preserve absolute power, and activities that do not benefit the social
welfare. The primary spending under the Prophet PUH and the succeeding Khalifs was for social
coverage. Later, with higher revenues, spending was extended to infrastructure, namely water, schools,
and construction of cities. Spending in favor of the poor and handicapped should be maintained in due
proportion as a fundamental aspect of Islamic public finance. Wasteful spending on subsidies, such as
fuel subsidies, should not be acceptable. In many Muslim countries, the civil service and army are paid

wages beyond acceptable ratios in relation to government revenues, while high rates of unemployment
are prevailing in these countries. In many of these countries, the government borrows either from foreign
or domestic sources to pay for salaries, which aggravates the internal and external imbalances. Capital
spending should also obey strict criteria of enhancing social welfare and economic growth. Spending
money on stadiums, theaters, monuments, and rulers mansions is not acceptable. Capital spending
should aim at building an economic and social infrastructure.
Government revenues in the early era of Islam had been essentially zakat, khumus (one fifth of gains
bestowed by Allah, including discovery of mineral resources), and voluntary contributions (Infaq). Some
form of taxation was strictly forbidden by the Prophet PUH. It was called Max a form of fee paid to public
authority before allowing merchandise access to the market place. Certainly, an Islamic tax system
cannot be simply a transposition of a conventional tax system. Certain taxes such as heritage tax may not
be allowed in an Islamic tax system. The principle of taxation should obey strict criteria of social solidarity,
social welfare, and public interest. Property and municipal taxes may become mandatory for the public
good of safeguarding the environment, and public health to the extent that these taxes enable to provide
sanitation, garbage disposal services, and cleaner streets. Quran and Sunnah urge Muslims to enhance
social solidarity and spend for the public good. Users fees help social equity; the government is
encouraged to levy charges for the use of public infrastructure, such as ports, airports, and freeways. The
government is entitled to royalties from mineral resources. While the state cannot establish obligations on
income and wealth, beyond those stipulated by zakat, it may nonetheless resort to moderate taxation
subject to the criteria of public interest, such as defense and internal security, or for the construction and
maintenance of public infrastructure that is being used by all firms in conducting their economic activities.
Levying taxes simply for overpaying rulers and public servants, army, and for waste and inefficient
expenditure is not acceptable in an Islam economic model.
A main principle of Islamic public finance is for the government to run a surplus on the current fiscal
balance that will help finance capital expenditure. In case of deficit on the current fiscal account, the
government should forcefully tailor its current spending in line with revenues with a view to generate a
current fiscal surplus. The financing of the fiscal deficit should obey Islamic principles. More specifically,
the government should not contract interest-bearing debt. It can only contract non-interest bearing debt.
The government may earn seignorage, through mint or money injection; however, such money financing
has to be strictly consonant with a fixed rule regarding the growth of money supply. Inflationary financing
of the deficit is not acceptable as it distorts prices, extracts large tax on fixed income groups (pensioners,
wage earners), absorbs savings and decelerates economic growth.
Banking and financial intermediation in an Islamic economic model
Islamic finance is fully developed in Quran and Sunnah. In Quran and Sunnah, Islamic finance has
always been conceived as the finance activity of an Islamic economy where social equity is enhanced
through mandatory zakat. In Quran, the verses that deal with interest (riba) have always been preceded
or followed by verses that prescribe zakat. Hence, when social equity is secured through zakat, motives
on the side of lenders to practice interest and dire needs of the poor to accept interest will disappear. In
such an economy, Islamic finance will be essentially guided toward investment and wealth creation and
much less toward consumption. While it prohibits interest, Islamic finance supports trade, capital
accumulation (investment), and production. The notion of capital is explicit in Quran. There are the
notions of productive capital, working capital, and money capital. Classical growth theory recognized that
economic growth depended on capital accumulation. The relationship between economic growth and
capital accumulation can be easily stated via Harrod-Domar Model
Where is the rate real GDP growth, is the rate of savings (investment), and is the incremental capital
output rate. According to this formulation, the higher the rate of savings and therefore investment, and the
higher the productivity of capital, the higher will be economic growth.
Financial intermediation plays a fundamental role in mobilizing savings and channeling it to investment.
Such financial intermediation has made it possible to increase investment and to enable industrial
countries to reach the stage of mass production and grow at sustained rates.

Financial intermediation is a fundamental aspect of an Islamic economic model. It will enable to mobilize
large volumes of savings and channel them to productive investment. Without financial intermediation,
mobilized savings and investment will be very small, and therefore economic growth will be slow.
Mirakhor (1988) defined an Islamic financial system as one in which there are no risk-free assets and
where all financial arrangements are based on risk and profit and loss sharing. Hence all financial assets
are contingent claims and there are no debt instruments with fixed or floating interest rates. Modeling the
financial system as non speculative equity shares, he showed that the rate of return to financial assets is
primarily determined by the return to real sector, and therefore in a growing economy, Islamic banks will
always experience net positive returns [Henry Simons views set forth in his Economic Policy for a Free
Society and influenced by the Great Depression of the 1930s were closest to an Islamic banking system.
His policy recommendations, known as the Chicago Plan, called for a separation of the banking system
into warehousing with a 100 percent currency reserve against bank deposit and investment banks whose
liabilities will be in form of equity shares. His reform plan aimed at a vigorous effort to stamp out elasticity
of credit in the financial system. This would involve restrictions on open-book credit and installment loans,
as well as limitation of government debt to non-interest-bearing money and to very long-term debt
(consol). He advocated a system in which all financial wealth would be held in equity form, with no fixed
money contracts, so that no bank institution could create money substitutes].
Financial intermediation in Islam is different from that in a conventional system. More specifically,
commercial banking under an Islamic system is generically different from conventional commercial
banking. Banks do not contract interest bearing loans and do not create and destroy money. They
participate directly in production and trade operations on a profit-loss sharing basis. Banks do not act as
simple lenders; they have to be directly involved in trade and investment operations, and assume direct
ownership of real assets. Deposits at an Islamic financial institution could be seen as shares or equities
and, unless insured, are subject to risks [Typical Islamic products are Mudarabah, Musharaka, Murabaha,
Istisnaa, and Ijara (See Hassan and Lewis 2007 for detailed definitions)]. They can earn a profit and face
losses (Iqbal and Mirakhor, 2007).
There is no credit creation out of thin air. Under conventional banking, deposits at one bank can be
instantaneously loaned out or used to purchase a financial asset and become reserves and a basis for a
new loan at a second bank, thus contributing to purchasing power creation and inflation of prices of goods
and assets; such step does not exist in Islamic banking. Deposits have to be re-invested directly by the
bank in trade and production activities and create new flows of goods and services. New money flows
arise from the proceeds of sales of goods and services. Money is not issued by the stroke of the pen,
independently of the production of goods and services. Investment is equal to savings, and aggregate
supply of goods and services is always equal to aggregate demand.
There can be no bank run or speculation, as the source of credit for speculation, which is credit
multiplication, does not exist. The liabilities of the financial institution are covered by tangible real assets
that are owned directly by the institution. They are not covered by financial assets. Risks for Islamic
financial institutions are mitigated as they relate essentially to returns from investment operations and not
to the capital of these institutions (Khan, 1987).
In such system, the central bank has the sole monopoly for creating money. Interest rate cannot be used
as a policy instrument. The central bank does not refinance banks as in conventional banking. It does not
buy or sell financial assets to banks. The central bank has to apply quantitative ceiling on money
aggregates. Such policy has been effective in maintaining financial stability and precluding speculative
booms and inflation even in the conventional system. Money injection occurs through central bank buying
foreign exchange, gold, or non-interest bearing government debt, possibly indexed on gold, a
commodities basket, or a portfolio of real assets created by the government (See Choudhry and Mirakhor
(1997) and Haque and Mirakhor (1999)).
1. Nature of Islamic Banking
Conceivably, an Islamic banking system may have two types of banking activities [Simons (1948) and

Allais (1999) proposed a similar system composed of two types of banking: a 100 percent reserve system
for safekeeping, and an investment banking system]: safekeeping and payments activity as in pre-Islam
and early Islam period and also as in goldsmith houses. This type of activity is similar to 100 percent
reserve system, with deposits remaining highly liquid and checking services fully available. This system
has to be a fee-based system to cover the cost of safekeeping and transfers and payments services.
The second activity is an investment activity whereby deposits are considered as longer-term savings and
banks engage directly in risk taking in trade, leasing, and productive investment in agriculture, industry,
and services. Most important characteristic of this activity is that it is immune to un-backed expansion of
credit. An Islamic bank is assumed to match deposits maturities with investment maturities. Short-term
deposits may finance short-term trade operations, with the bank purchasing merchandise or raw materials
and selling to other companies; liquidity is replenished as proceeds from sales operations are generated.
For longer-term investment, longer-term deposits are used. Liquidity is replenished as amortization funds
become available. In all these investments, an Islamic bank is a direct owner of the investment process
which is awarded through a due diligence process. In such a system, a financial institution therefore
participates directly in the evaluation, management and monitoring of the investment process [Criticism
was made that operational cost is higher than in conventional banking because of close monitoring and
involvement in the investment process. This criticism has not been substantiated with data. Moreover,
gains from stability and minimization of credit and market risks can largely offset presumed higher
operation costs. Think of the cost of large bailouts and bank failures caused by recent financial crisis;
these costs can be compounded by other economic and financial costs arising from inflation and
economic slowdown]. Returns to invested funds arise ex-post from the profits or losses of the operation,
and distributed to depositors as if they were shareholders of equity capital.
2. Balance sheet of an Islamic bank, investment activity
Let a deposit of $100 be made at an Islamic bank. This deposit is by definition savings; it is subject to
certain maturity condition and cannot be drawn on sight. As mentioned above, safekeeping and payments
functions of banks can be easily conceived; however, fees may have to be paid for this banking service.
Upon deposits, the balance sheet looks as follows
Exhibit 1: Simple Illustration of Islamic banking
Balance Sheet of an Islamic Bank, investment activity: step 1: deposit
Assets

Liabilities

Reserves = 100

Deposits (savings) =100

Total =100

Total =100

Balance Sheet of an Islamic Bank, investment activity: step 2: investment

Assets

Liabilities

Merchandise (gold, wheat,

oil, fertilizers, etc) and
working capital = 100

Deposits (savings) =100

Total =100

Total =100

Balance Sheet of an Islamic Bank, investment activity: step 3: closing of the operation
Assets

Liabilities

Reserves = 110

Deposits (savings) =100

Profits = 10
Total =110

Total =110

Contrary to conventional banking, an Islamic bank is prohibited from making a loan at fixed or floating
interest rate. It has to engage in real trade or production activities. The Islamic bank may engage in shortterm operations. It may, for instance, undertake trade operations, or it may finance crop transactions. It
may buy goods, on the behalf of a trader, for resale at profit. The possession of goods takes place in
physical terms, and not in form of financial or speculative contracts. For example, when it finances a crop
transaction, the bank cannot act as a pure financier who accepts risk in financing activities. It has to be a
full partner; it buys fertilizers on behalf of farmers and makes available financing for operating costs; it
participates in the marketing activity of crops. The bank is involved directly in all phases of the transaction
on a profit-loss sharing basis; it faces directly the risk of price and exchange rate fluctuations. It may lose
part of the loan if sales proceeds from crops fall short of the amount of loan. It may also incur operating
losses. The invested capital is repaid from the proceeds of crop sales. Net profits are distributed
according to an agreed formula.
Exhibit 2: Islamic modes of financing
Balance Sheet of an Islamic Bank, investment activity: investment step
Assets

Liabilities

Mudarabah, Musharaka, Murabaha, Installment sale, Istisnaa,

Leasing = 100

Deposits (savings) =100

Total =100

Total =100

Balance Sheet of an Islamic Bank, investment activity: closing step

Assets

Liabilities

Reserve
s = 110

Deposits (savings) =100

Profits = 10

Total
=110

Total =110

Depositors may withdraw or renew their deposits at maturity. An Islamic bank is basically a different
specie from a conventional bank. It is not a pure financial intermediary as in the conventional system. It
has to finance real activities in production of goods and services. It does not lend money to a borrower at
fixed or floating interest rate. It does not acquire financial assets. An Islamic bank identifies investment
opportunities and evaluates them to minimize risks; participates directly in the management, monitoring
and execution of trade and investment operations; and releases funds for purchases of goods and
services as required for the completion of these operations. There is no credit creation which is not
backed by real savings, the amount of deposits in the investment branch will be determined by real
savings and savings to income ratio (Mirakhor, 1988), and not by credit multiplier as in conventional
banking. New cash flows to an Islamic investment bank originate from new savings, and not from the
proceeds of loans transferred from one bank to the other. There is therefore a wealth creating activity that
generates new cash flows and not money creation by the stroke of the pen as in the case of conventional
system. The growth of financing activity will therefore be stable and determined by real growth in the
economy (Mirakhor, 1988), and not by unstable speculative finance or money creation by financial
institutions. Accordingly, an Islamic system would not be expected to experience deep boom and busts
cycles. Moderate and brief booms and recession may be generated by good crops, productivity, technical

change, or by adverse shocks. They cannot be generated by the financial system itself as experience
showed for conventional system. As shown in Mirakhor (1988), equilibrium in an Islamic economy thus
structured will be stable and the rate of return to the financial sector will be fully aligned with the profit rate
in
the
real
sector
of
the
economy.
Exhibit 3 compares the process of deposit creation under Islamic and conventional systems assuming a
saving ratio of 20 percent of real GDP and reserve requirement ratio of 10 percent of deposits,
respectively. It can be observed that total money expansion is $125 with a money multiplier equal to 1.25,
and $1000 with money multiplier equal to 10 in Islamic and conventional system, respectively.[ If the
savings rate is 10 percent of GDP, and reserve requirement is 5 percent of deposits, then total deposits
become $111 and $2,000 under an Islamic and conventional banking system, respectively. Theoretically,
while an Islamic system faces no risk of a run or credit freeze, conventional system may face a risk of a
run and credit freeze. In the event of a run or credit freeze, experience showed that conventional banks
had to suspend conversion into currency, go bankrupt, or require large amounts of new liquidities from the
central bank]. Invoking quantity theory which postulates MV=PY, where M is money stock, V is velocity of
money circulation, P is the price level, and Y is real income, and assuming fixed Y and V, the price level
would tend to rise at much slower pace under an Islamic as compared to the conventional system.
Furthermore, as an Islamic system is immune to large economic fluctuations caused by financial
instability, its rate of real economic growth, because it is supply and not demand determined, would be
stable at a higher level than in conventional system. Under conventional banking system, economic
growth preceding financial instability could be virtually wiped out during ensuing recession or depression
phases.
Exhibit 3: Contrasting Islamic and Conventional Banking
Islamic banking, investment activity
Saving ratio = 20 percent of GDP
Bank 1 Deposit = $100
Bank 2 Deposit = $20
Bank 3 Deposit = $4
Etc.
Total deposits = $125

Conventional banking
Reserve ratio=10 percent of deposits
Bank 1 Deposit = $100
Bank 2 Deposit = $90
Bank 3 Deposit = $81
Etc.
Total deposits = $1,000

Labor markets in an Islamic Economic Model

Labor economics have been a fundamental aspect of an Islamic economic model. Allah praises the
virtues of work, learning, and using fruitfully time. He dislikes idleness and waste of time as clearly stated
in
many
verses.
23;1.2.3. Successful indeed are the believers, those who offer their prayers with all solemnity and full
submissiveness, and those who turn away from dirty, false, evil vain talk, falsehood, and all that Allah has
forbidden.
23;72. And those who do not bear witness to falsehood, and if they pass by some evil play or evil talk,
they
pass
by
it
with
dignity.
31; 6. And of mankind is he who purchases idle talks (i.e. music, singing, etc. ) to mislead (men) from the
Path of Allah without knowledge, and takes it (the Path of Allah, or the Verses of the Quran) by way of
mockery.
For
such
there
will
be
a
humiliating
torment
in
the
Hell
Fire.
Our Prophet PUH recommended to make best use of time, and that we are accountable for the way our
time is used. He praised hard work for earning living and disliked idle healthy and able men [The Prophet
PUH promoted the notions of micro-finance and self employment. In many instances, He (PUH) helped
very poor people raise seed capital and establish a profitable business. For healthy people, he strongly
recommended gainful employment in lieu of begging]. The example of the life of the Prophet PUH, his

family, and his companions offer a model to emulate for using time in a productive and learning way.
While advocating hard work and learning, Sharia (and therefore an Islamic economic model) explicitly
forbids and imposes severe sanctions against unlawful ways for earning income. Applying Sharia laws
against unlawful ways and means of income generation is mandatory and is therefore a fundamental
element of the institutional infrastructure underpinning an Islamic economic model. If crimes spread,
social
peace
will
be
perturbed
and
economic
activity
will
suffer.
A main purpose of an Islamic economic model is to eliminate distortions in labor markets with a view to
maximize employment and promote exports. It aims at establishing perfect wage flexibility capable of
equilibrating labor markets. In spite of many decades of economic development, the rate of
unemployment, which was very low at the natural rate prior to development planning, has reached by
2008 disturbing levels in most of Muslim countries, averaging 15 percent in middle income countries, and
above 25 percent in low income countries, particularly in sub-Saharan African countries, and is expected
to worsen in the period ahead. The only relief has become from immigration to developed countries.
These high unemployment rates cannot be explained by unavailability of productive employment
opportunities;
they
are
imputable
mainly
to
labor
markets
distortions.
Unemployment is a serious economic disequilibrium. It means a large loss in output and deterioration of
poverty. The loss of output is estimated according to Okuns law as , where is actual real GDP, is full
employment real GDP, the prevailing unemployment rate as a percent of the labor force, is the natural
rate or frictional unemployment, generally estimated at 3 percent of the labor force, and is a technological
parameter. In view of the high unemployment rate, it can be inferred that prevailing wage rate is far above
an equilibrium wage rate that would bring unemployment to a natural rate at 3 percent of the labor force.
Firms face therefore a cost disadvantage of the order . Achieving full employment is an overriding
objective of an Islamic economic model and is thought to be the best strategy for reducing poverty and
achieving social equity. It is also the main theme of macroeconomics, both in the classical and Keynesian
traditions.
The nature of unemployment has been thoroughly studied by the International Labor Office in case
studies pertaining to many developing countries, including Kenya, Columbia, and Philippines.
Unemployment could be attributed to low capital accumulation arising from low savings, exodus from rural
to urban zones, mismatch between education and skills required by the economy, unfulfilled high
expectations regarding wages, distorted consumer preferences that favor industrial products from
developed countries and therefore encourage imports at the expense of traditional industries. In many
countries, excessive government controls of investment, marketing, and prices have stifled private sector
development
and
accentuated
the
unemployment
problem.
Very few labor surplus countries managed to develop relying fully on their labor resources and absorbing
steadily their labor surplus. These economies followed basically a market model and export-oriented
growth, emphasized labor intensive technologies, and removed major distortions in their economies. Most
of the developing countries followed a dualistic economic model, with a small modern sector using capital
intensive technologies paralleled with a large informal sector using very little capital. These economies
relied on foreign debt to finance the modern sector development as well as sustain industrial countries
consumption patterns. Many development economists in the 1950s feared that foreign aid could
accentuate technological dependence on industrialized countries and called for trade instead of aid.
Distortions could be a major handicap to labor creation and employment absorption. Distortions could
arise from many sources related to factor and product markets as well as to the regulatory and
institutional framework. Price controls, trade barriers, overvalued exchange rates, under priced capital,
subsidies, and high taxation could cause distortions in the economy. Obstacles to market entry and
competition also create distortions and support monopolistic competition. Besides distortions, negative
attitude
toward
work
could
become
a
handicap
to
employment.
While major reforms for liberalizing the economy and promoting private sector development are essential
for an employment strategy, important distortions relating to the labor market itself have to be removed.

Fully competitive labor market freed from distortionary laws is a prerequisite for absorbing unemployment.
Many Muslim countries have inherited industrial countries labor laws which have hampered seriously
employment creation and undermined their economic development process. These laws prescribe
minimum wages far above marginal productivity, prohibit firing, limit the working hours, and impose
excessive insurance cost on employers. In view of the very high cost of labor, legislative constraints, and
low skilled and poorly disciplined labor force, firms in many Muslim countries have pushed for an outright
use of capital intensive production methods (use of machinery in agriculture, industry, and construction)
thus reducing the use of labor and displacing large number of employment opportunities.
The classical macroeconomic model does not allow for unemployment, simply because during the 18th
and 19th centuries labor unions either did not exist or were in their infancy stage, and government labor
legislation was also inexistent. Hence, labor market was always in equilibrium and full employment was
maintained throughout. The classical model is based on the assumption of full flexibility of wages and
prices. Models proposed by Ricardo (1817) and Arthur Lewis (1954) require that the wage rate be
maintained at the marginal product level for savings to increase and capital accumulation to proceed. In
such a model, the demand for labor by firms is determined by the marginal product. The labor supply
curve is related to the real wage rate. The labor market clears at a wage rate that insures full
employment.
The
volume
of
employment
will
in
turn
determine
real
GDP.
In contrast, Keynes model, elaborated in 1936, assumes the presence of powerful labor unions, as the
case was in the United Kingdom, that will preclude downward adjustment of the nominal wage rate, and
massive unemployment. Hence, there will be involuntary unemployment, and the economy will settle in an
underemployment
equilibrium.
In many Muslim countries, wages are pre-determined both in the private and public sectors and are
considered as fixed cost. However, sales or sales prices may decline and firms may incur operating
losses. Firms have to absorb fully the losses and cannot transfer part of them to labor through flexible
downward wage adjustment. Similarly, the government may incur severe drop in taxes or royalties;
however, the wage bill is pre-determined; the government cannot adjust it in relation to loss in revenues
and is forced to run a fiscal deficit. Wage rigidity has led to considerable economizing on labor use, and
has
become
a
source
of
inflation.
The pervasiveness of structural unemployment in many Muslim countries provides evidence of labor
redundancy and therefore very low marginal labor productivity. When the value of marginal labor
productivity in agriculture, industry, and construction is compared to the actual average wage in these
sectors, a major distortion appears. Such distortion will stand against short-term full employment of the
labor
force.
The relationship between product prices and wages is usually described in a simplistic fashion using the
notion of markup. Namely, the price level can be formulated as , where stands for average labor
productivity, denotes the markup, and denotes the average wage in the economy. In this relationship, an
improvement in productivity would lower product prices; however, an increase in the wage rate would be
passed
through
to
prices,
unless
offset
by
higher
labor
productivity.
Wage distortions which make prevailing wages much above equilibrium wages could be a serious source
of loss in external competitiveness. Define the real exchange rate, or equivalently external
competitiveness
by:
where denotes the nominal exchange rate, defined as the number of national currency units per one unit
of foreign currency, and and denotes the price levels in the home and in the foreign competitor country,
respectively. The real exchange rate conveys a notion of purchasing power parity (PPP).
The real exchange rate has also been defined in terms of unit labor cost. Invoking the notion of mark up,
the price level can be formulated as , where stands for average labor productivity, denotes the markup,
and denotes the average wage in the home economy. The same markup relationship applies to the
foreign competitor country; namely: , where stands for average labor productivity, denotes the markup,

and denotes the wage level in the foreign country, respectively. The real exchange rate can be
reformulated
as
Assuming and are fixed, then the ratio can be subsumed into a constant . The real exchange rate can be
equivalently
reformulated
as
Assume an overvaluation of wages by 30 percent, i.e., , then home exporters face a cost disadvantage
and a loss in competitiveness of the same order. To re-establish competitiveness, the exchange rate has
to
depreciate
sufficiently
to
offset
wage
distortions.
The rising unemployment in the US and Europe was brought about by an excessive expansionary
monetary policy that sent food and energy prices skyrocketing to levels that triggered food riots and
crippled many key sectors, such as industry and transports, widened external deficits, and pushed
savings to very low levels. The unfolding financial crisis precipitated by over indebtedness and dramatic
loss of financial wealth could worsen the economic recession [Over-indebtedness and loss of financial
wealth were considered to be main cause of the Great Depression]. The approach followed so far wanting
a quick recovery through exclusive role of the central bank has only worsened the economic crisis. Such
approach pushed interest rates to record lows with a view inflate prices in order to protect debtors and
prevent adjustment of asset prices, including housing prices, to market fundamentals, has dramatically
worsened the economic and financial situation. The approach is being reinforced by massive fiscal
stimulus in order to push aggregate demands to full employment levels. The proponents of excessive
money and fiscal expansion to fight economic downturn draw their theory from Keynesian economics.
Besides the risk of causing high or hyperinflation, excessive demand policy as a quick fix for a major
economic crisis may not be the appropriate policy response, as this policy was in the first place the cause
of the economic and financial crisis. It could push public debt to unmanageable level and would deplete
real savings and private sector investment. A more elaborate stabilization and supply-oriented policies
could be better approach with durable cure. Monetary policy has to be stabilized, factor prices, i.e., have
to be market-determined and suffer much less distortions, and asset prices have to adjust to market
fundamentals. The classical approach for reducing balance of payment deficits through price adjustment
and improving competitiveness would stimulate exports and reduce imports. Although exchange rate
depreciation could alter instantaneously export and import prices, such policy has entailed competitive
devaluation and therefore was not able to improve competitiveness, namely cost and prices remained
main determinants of export and import prices. Governments have to address supply shortfalls in food,
energy, infrastructure, and elaborate sectoral policies for boosting production in these areas. A supply
side approach does not aim at a quick recovery through indiscriminate use of macroeconomic policies. It
addresses deep-seated distortions in the economy, removes inflationary expectations, stabilizes both
fiscal and money policies, and lays down a basis for durable growth. Such policy was implemented in
1980s
and
brought
about
a
long
period
of
economic
prosperity.
Opting for a development model that uses fully the labor force is the most recommended strategy of an
Islamic economic model not only for reducing poverty and social inequity but essentially to restore a
durable, balanced, and export-oriented economic growth. Besides investing in education and developing
the skills of manpower in various occupational fields, a most efficient way to absorb labor surplus is to
remove all types of price and institutional distortions and encourage the implementation of a competitive
wage structure that reflects the true productivity of labor. Realigning wages in line with productivity and
productivity growth will mitigate inflationary pressure arising from faster increase of wages than
productivity and will encourage the demand for labor in sectors that are traditionally large employers of
manpower such as agriculture, industry, construction, and services. Undistorted wages will allow savings
to increase rapidly, and capital accumulation to proceed faster. They will help support exports, reduce
imports, and remove a source of overvaluation of the exchange rate. Competitive wages in agriculture will
help increase the agriculture surplus and will therefore mitigate pressure on food prices.
Maintaining highly distorted wage structure would play havoc with the development process, and will
exacerbate the unemployment situation. It will lead to both migration to urban zones and immigration in a
bid to find employment. Rigidities in laying-off workers should be removed. Vocational training which

increases productivity and teaches workers new skills that increase their inter-occupation mobility would
be recommended. Only when wages are in line with productivity and legal constraints eliminated would
private enterprises find it profitable to invest in vocational training. High unemployment is extremely costly
as millions of people have to be fed and provided with necessary amenities without contributing to real
GDP, leading thus to a drain of savings and higher foreign financing. Furthermore, poverty and
deterioration of standard of livings become pervasive. Income inequality becomes very high. Such high
unemployment has become a cause of alarming crime rates and social insecurity.
Private sector development and asset and Product markets in an Islamic economic model
An Islamic economic model emphasizes private property, private sector development, promotes free
domestic and foreign trade, enhances competitiveness, and aims at eliminating distortions in asset and
product markets. While natural monopolies due to invisibilities are acceptable in an Islamic economic
model, restrictions to entry and trade, however, are forbidden [The Prophet PUH and succeeding Khalifs
were careful not to introduce distortions. Umar refused to impose a retaliatory import tax on goods
imported from Christian countries that had imposed tariffs on imports from Muslim regions]. In many
countries, monopolistic competition in form of large corporations that control markets stands against
expanding supply and reaching higher social welfare. Namely, product prices become rigid because of
market power and cannot fall, and quantities sold are lower than under pure competition. Antitrust laws
contribute to improve competition and expand supply and reduce prices. Intermediaries that group to
control agriculture markets impose low prices that do not enable farmers to earn sufficient profits and
could
therefore
contribute
to
a
falling
agriculture
production.
Asset prices have to be market determined. While interest rates do not exist in an Islamic economic
model, reward to capital is through profits and profit and loss sharing arrangements. The exchange rate,
defined as the price of gold in terms of commodities, the price of gold in terms of currency, or the price of
a unit of local currency in terms of a foreign currency, has to be market determined. Such was indeed the
case
in
the
early
era
of
Islam.
An Islamic economic model rests on free competition, undistorted equilibrium prices, and precludes price
fixation by the Government and many forms of price distortions (e.g., excessive duties, subsidies, etc.),
except in natural monopolies or public services (e.g., transport). State marketing boards and price fixing
can be detrimental to private investment and to long-term supply. Fraud, cheating in weight, altering the
quality of products, such as adding water to milk or diluting honey, had been condemned both in Quran
and Sunnah as abhorrent activities. Allah has repeatedly warned those who cheat, diminish weights, or
falsify
merchandise.
Investment
in
human
capital
and
economic
and
social
infrastructure
Long-term planning and defining national development priorities are important elements of an Islamic
economic model. A Muslim economy has to have long-term plans for water supply, dams construction,
electricity generation, road infrastructure, hospitals, airports, etc. so it will not face sudden bottlenecks or
deficiencies in infrastructure capacity. Investment in human capital is an essential element of an Islamic
economic model and provides a basis for sustained economic growth. Quran and Sunnah have stressed
the
value
of
learning,
sciences,
and
human
capital.
Development planning should also define sectoral priorities, such as achieving food security, expanding
housing, developing mineral resources, increasing energy supply, and promoting exports. Long-term
planning should also aim at maximizing labor employment and sustaining industrialization.
The development plan identifies long-term projects and their financing. Such financing could be from
domestic savings, or foreign financing. It has, however, to satisfy Islamic conditions, namely borrowing
has to be non-interest bearing. Financing also could be through public private sector partnership.
Islamic Jurisprudence, the legal and regulatory framework of an Islamic econmic model
An Islamic economic model is totally different from all other economic models as it recognizes the
supremacy of Allah, derives its laws from Allah, and is built on a set of Islamic laws that strictly forbid

transgression of any form [Hamid, Iqbal, and Mirakhor have emphasized that an Islamic economic model
is based on a set of rules embodied in Quran and Sunnah; Islamic economic modeling consists therefore
in operationalizing these rules. They stressed the importance of property rights and the prohibition of any
form of transgression, including unjust appropriation of other people wealth]. Every economic system
requires a set of laws for its practical implementation and for reinforcing contracts and security. For an
Islamic economic system, such set of laws is provided by the Islamic Sharia (jurisprudence).
In His farewell speech, the Prophet PUH forcefully stated that unlawfully appropriating other people
money, shedding blood, and committing adultery are as strictly forbidden as the eternal sanctity of Mekka.
In 4; 29 Allah says: O you who believe Eat not up your property among yourselves unjustly except it be
trade amongst you, by mutual consent. And do not kill yourselves: for verily Allah has been to you most
merciful.
In 2;188: And eat up not one anothers property unjustly (in any illegal way e.g., stealing, robbing,
deceiving, etc.) nor give bribery to the rulers (judges before presenting your cases) that you may
knowingly
eat
up
part
of
the
property
of
others
sinfully.
Similarly in 4; 10: Verily, those who unjustly eat up the property of orphans, they eat up only fire into their
bellies,
and
they
will
be
burn
in
the
blazing
fire.
Commercial transactions (non-interest-based loans, sales, etc.) have to be recorded in contracts written
by legal notary in the presence of witnesses. In absence of legal notary, a collateral can be taken, which
should
be
remitted
when
the
obligation
is
fulfilled.
Alcoholic beverages, drugs, and gambling are strictly prohibited and should be subjected to sanctions
according
to
Quran
and
Sunnah
injunctions.
Combating theft, banditry, and larceny is a fundamental element in supporting institutional framework of
an Islamic economic model, without which an Islamic system would be doomed to social disorder and
economic stagnation. More specifically, work values deteriorate, trust disappears, and insecurity grows to
alarming levels. Labor markets have suffered considerably from prevalence of crime and deteriorating
work values, which pushed farmers and employers in many Muslim countries to fear employing workers
and to push for capital intensive modes of production, substituting machinery for labor.
Conclusions
An Islamic economic model rests on Allahs Sharia; it aims at operationalizing the Sharia laws into
economic life. Built on interest free finance, balanced fiscal policy, and redistributive zakat, an Islamic
economic model could offer a robust macroeconomic framework for a sustained and balanced economic
growth.
Disappointingly, very few, if any, Muslim countries have followed an Islamic economic model and applied
Sharia fundamental economic and social laws. The rules of behavior according to Quran and Sunnah
have long been abandoned, and most, if not all of elements of an Islamic economic model have been
inoperative, mostly in the name of secularism which stipulates that religion should have no relationship to
the affairs of a modern state. All laws have to be man-made or transposed from conventional models.
Most of the Islamic countries have fallen behind industrial countries, and the technological gap has kept
widening. In spite of large agricultural potential, many countries rely entirely on industrial countries for
their food supplies. Social and political security have deteriorated to alarming levels. The unemployment
problem has grown out of proportion and has become intractable, not because absence of productive
employment, but mainly due to prevailing distortions, deteriorating work ethics and attitude, and prevailing
high crime rates. Official corruption and bribery have become so widespread to a point of paralyzing
economic growth and undermining social stability. Totalitarian rule and the cult of personality over many
decades have kept people in state of fear and undermined economic development. Large resources are

diverted

to

political

security.

While many Muslim countries enjoy excessive surplus, thanks only to oil and natural gas, that is invested
in interest bearing assets, most of the Muslim countries have been suffering growing poverty and
deterioration in social and health standards. Many Muslim countries are heavily indebted and could not
return
to
a
sustainable
external
debt.
Development costs of conventional models have been overburdening, in terms of external indebtedness,
growing inefficiencies, deteriorating social standards, and spreading poverty. Social disenchantment
arising from growing unemployment has become widespread. An Islamic economic model would offer a
promising, and much more efficient, alternative to failed economic systems. Such an economic model is
built on economic and social precept of Quran and Sunnah. It certainly does not select certain precepts
and ignores others. Such approach has been severely condemned by Allah. An Islamic economic model
considers Quran and Sunnah as one body and embraces all economic and social legislation that has
been prescribed by Allah and His Prophet PUH, knowing that such legislation is the best, and will secure
success
here
and
in
the
hereafter.
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The Prospects for an Islamic Economics Order
In The Crisis of Islamic Civilisation (published by Yale University Press 2009), the author Ali A Allawi,
writes on The Prospects for an Islamic Economic Order:
In reality, an Islamic economic order can only be renewed if certain fundamental reforms are undertaken.
The axes of the modern economy are so distant from the moral economy of Islam that nothing short of a
spectacular break would suffice to bring to life a new Islamic economic order. The main features of an
Islamic economy have been in an eroded state for several centuries, so that most are merely religious
vestiges of a long-forgotten past. By the time of the revolt of Islam in the 1970s, the elements of an
Islamic economy were simply theoretical constructs, which may have featured in the education of
seminarians but had no place in the modern economy. Only a few countries such as Saudi Arabia
maintained a zakat (Islamic wealth tax) collection department as part of the public finance architecture of
the state. The vast majority of Muslim countries had relegated the use of Islamic taxes to voluntary
religious tithes, leaving public finance to the usual array of revenue-generating taxes and duties: on
incomes, sales, customs, and so on. Agricultural taxes, which were essential to the functioning of the rural
economy in Islam, also vanished, and were replaced by modern equivalents which had no echo in Islam's
past.
The use of paper currency, issued by a central bank and 'backed' by foreign exchange reserves, also
became widespread in the nineteenth century, gradually decoupling the classical forms of the Islamic unit
of exchange the gold-based dinar and the silver-based dirham from its historical association with
bullion." The unit of exchange in the world of Islam, allowing for the fact that it had atrophied and been
allowed to debase over the centuries, was definitively terminated with the rise of modern central banking.
In the colonial and post-colonial period, many Muslim countries used the same or equivalent currencies
as their European overlords. This explains the widespread use of the colonial French franc, or the British
pound in the Sterling area both of which tied the dependent economy to the metropolis and its needs.
Islamic finance is part and parcel of the world view of Islam. It is not just a tool. Zakat, for example, is not
simply a revenue-generating wealth tax. It is mentioned on numerous occasions in the Quran, in the same
breath as the offering of prayers. It is a fundamental aspect and a pillar of Islam, and an act of worship
designed to bring human beings closer to God. Thus the offering of zakat is not simply the parting with a
portion of one's wealth for the public good. While it is essential to the financial integrity of the Islamic
state, it is also a process that will purify the person. The actual handing over of a proportion of one's
annual wealth is designed to make the process of giving what one holds dear an essential aspect of
worship. `You will not gain righteousness unless you part with what you hold dear,' the Quran
admonishes.' Zakat talks about property as a responsibility. Property is not decoupled from its social use;
neither are property owners, or holders, able to ignore their roles as trustees over the property.
The pious foundations - the Awqaf were the historical institutions which provided these services but
they, too, have atrophied with the passage into modernity. The endowment of large public buildings and
social institutions by the rich and powerful is no longer a practice in the Muslim world. The Awqaf have
turned into bureaucratic and often venal organizations; they manage specific mosques and their attached
properties, and are answerable to a government agency." The old Awqaf institution was far more central
to the life of Muslim society, because it grouped mosques with markets, hospitals, caravanserais, soup
kitchens and schools - the living commercial and spiritual heart of Muslim cities.
The Problem of Interest
It would, of course, be impossible to reconstruct the basis of an Islamic economy without tackling the
problem of interest. For centuries no scholar of any note would question the prohibition on usury, as it
clearly was one of the absolutely reprehensible acts condemned in the Quran The academic Charles
Tripp also maps out the distortion of the Islamic banking movement as it lurched away from its initial

purpose. 'As the Islamic financial sector grew, mobilizing substantial sums of capital, many of the original
intentions faded from view ... The goal of reinforcing the bonds of community, and the ambition of
restoring unity between people's material transactions and the spiritual dimension of their lives, gave way
before the need for financial institutions to survive and thrive in a global market dominated by longestablished and highly competitive institutions which had historically shaped the rules of the market
itself.