Part Two: The Khilafah, Investment and the Economy

With the development of finance over the last 50 years in the West there exists very little literature on Islamic finance. Over the last five years many institutions in the West have earmarked Shari’ah compliant finance as a growing market and have therefore invested research and money in developing products for this market area. However such products usually mimic conventional products in the West such as credit cards, debt, mortgages and leasing. Research work by many has also centred on looking at Islam through a western economic perspective. Such works have aided the idea that Islam has no economic system and offers little investment opportunities. Unfortunately neo-modernist thinkers such as Ali Gomaa and Abdullah bin Bayya claim that Islam does not have an economic system, and that it is allowed for Muslims to take the Capitalist solutions; this is clearly haraam and will lead to misery as explained in part one.

The Islamic economic system is essentially composed of certain general principles, coupled with a set of derived rules. This system then provides the framework for addressing the diverse economic issues found within the society, which can vary in terms of scope, as it can be very specific to certain individuals and groups or very general such that it affects the entire society. So the framework provides these solutions for the general and detailed issues relating to all spheres of economic activity, such as buying, selling, investing, loans, currency, work, company structures, import and export and contract laws. This article will not focus on the entire economic system, but some aspects which will solve the problems we have witnessed, and produce stability for the world and wealth for the people.

The problem of duel economies

The first aspect to note about the Islamic economic system is that the Shari’ah rules do not recognize the financial markets in their current form and have made the Public Limited company (joint stock (share)) companies haraam for a number of reasons. Fundamentally this type of contract contradicts the Islamic rules for contracts. The company in the West represents a particular type of contract – the ‘Solitary Will,’ this is where an individual agrees to the written constitution of a company by purchasing its shares with no formal offer from anyone. This has come to be termed as the Individual Will whereby shares could be exchanged very quickly without the need for two people to continuously sit down and have a formal offer and acceptance. An example of this is the take-over bid of the world’s richest football club, Manchester United FC by Malcolm Glazier. He imposed his will on the company (i.e. he brought shares) and even though other shareholders were against such an action it was a valid form of acquiring ownership from a legalistic angle even though there was only one person in the contract (acceptance but no offer). Most contracts involve two parties where one party offers terms and the other accepts, however under corporate law in the West setting up a business is a contract of ‘solitary will.’ It is not a contract between two or more people, rather it is an agreement all agree to when they subscribe for shares in the company. So an individual joins himself to the conditions of a company – through purchasing their shares. This means that to become a partner one does not actually need to seek the permission of the owners.

This contradicts Islam as a company is a contract between two people over terms; in corporate law in the West they see giving charity, claiming insurance and the setting up of a company and trade as the same type of contract. In Islam these are considered different types of contracts.

This effectively means that the shape of the Islamic system is very different to the western one, in a very practical way. For example, the Chancellor of the Exchequer or the finance Minster in any country has to juggle between two distinct economic areas; the real economy, and the financial markets.

Although both spheres are interrelated and affect each other they do in many areas have their own norms and regulatory actions in that one can have a damaging effect on the other. In a situation where buoyant consumer spending is leading to inflation (rising prices) a rise in interest rates would have the effect of dampening down consumer demand for goods and services in the real economy as people have to pay more each month for their mortgage and loans. It will in the financial sphere of the economy lead to higher savings due to the higher rate of return. If we look at the current crisis in the UK, the setting of interest rates was given to the bank of England to contain inflation, so interest rates were a tool to be used to control spending and prices in the real economy especially recently with a housing boom driving prices higher. However due to the Northern Rock saga and the potential collapse of the financial sector interest rates have been left unchanged and will probably fall by the end of the year. All of this was triggered by the financial markets and not by the real economy, since the aim now is to keep consumer confidence high and avoid a recession as consumers worry about the state of the banks and lower their purchases.

So rather than lowering inflation by increasing interest rates, we are seeing that the strategy to control inflation is remaining unchecked, due to the condition of the financial markets; risking a potentially dangerous rise in inflation.

Islam does not have a dual economy-a real economy and the other being the financial industry which lives off the real economy. Islam only has the real economy, which is interested in trading, manufacturing, making profits and avoiding losses. All the policies of the Khilafah are geared for the real economy and this has many benefits, which will be demonstrated.

The wealth deception :Money itself is not wealth, only a generally accepted measuring unit of wealth

Although the GDP’s of the West are rising this does not mean the people are better off. This is because a distinction needs to be made between income and wealth and then the distribution of such wealth.

The recent actions by the world’s central banks of flooding financial markets with money by printing more (known as liquidity) in order to overt a complete meltdown does not actually add wealth. Liquidity (printing more and more money) accelerates financial transactions that can create or destroy wealth depending on a number of factors. In the real economy, wealth is created by the development of productive hard assets (such as land, property, products etc), which are then sold for a profit. Wealth is increased by increasing production (i.e. you produce more good and services and sell them for a profit).

In finance Capitalism, wealth is created only by earnings, which increase only money income. If one floods the financial markets with money you create phenomena known as inflation, this is because their is more money chasing around the same number of goods, which devalues the money and means you have more money to the same goods over a period of time. So the cost of a basket of apples today will cost you more then a year ago, primarily because the value of money has been devalued. For example if the price of an apple is £1, a basket of apples would cost £10. The government decides due to the Christmas season arriving to print more money, this would mean there is more money chasing the same number of goods, prices will rise to bring the market back into equilibrium and the price of apples rises to £2. Now with the same original £10 one will only get five apples, so the creation of more money cuts your purchasing power in half.

Assets such as property and land do not generally devalue as they keep the same intrinsic value at all times, but due to the effects of money creation the amount one can purchase with their money continues to fall as governments continue to print more and more money. The net effect of this is that although their is more money in the economy the purchasing power (ability of money to buy goods and services) is lowered, and hence in real terms wealth is actually falling, because money is being devalued, compared to real hard assets such as housing and land which generally keep their value. So in effect higher incomes does not mean more, because price rises due to money creation cancels this out. So in the West the purchasing power of money has declined in real terms as the value of assets generally remain the same, but the amount of money required to buy hard assets (land, property, goods) is increasing.

Islam put the emphasis on wealth and seeks to guard people’s wealth by ensuring that its policies do not devalue money. The Islamic system does not print money as it pleases since all its currency is backed by gold reserves. This means that the currency itself has a value relative to all assets. So this means that the value to the consumer of land will always remain in proportion to the value of gold. This creates stability in the value of the State’s currency. Furthermore, since the Khilafah does not print money freely, then there will not be an increasing amount of money chasing the same number of goods; hence the Islamic system is inoculated against inflation, since the main factor behind inflation is the easy printing of money. Inflation within the Khilafah will be a rare occasion. This has also been the case historically, in 1507, 58 silver aspers, the Ottoman unit of currency, could buy one gold coin. 82 years later, in 1589, 1 gold coin cost 62 silver aspers, an inflation rate of only 7% over eight decades.1

This means that as businesses make more profits and acquire more wealth; their wealth is not devalued due money creation, since it keeps its value. So in the Islamic system wealth increases and the Islamic system assists this, whereas the Capitalist system increases money, but decreases wealth. The underlying cause of this is the fact that money in Capitalist countries floats freely and is not linked with anything of intrinsic value; hence western countries can print money, either by direct printing or by the money multiplier effect carried out by the banking system.

The Islamic system promotes entrepreneurship

Critics of the Islamic economic system state that the Islamic system does not promote investment as without interest there is no motive to invest due to the lack of return on money (via interest rates). So if you invest £100 in a company, you receive £100 back in two years, which is no gain – hence there is no motivation to invest, whereas if you put £100 in a bank now, you would receive your £100, plus the money accrued in interest payments. With the closing of the stock markets as well as the financial markets in the Khilafah, this means firms have nowhere to go to raise funds needed for investment in land and creating new jobs and other investments that create wealth.

This argument is incorrect for a number of reasons. Firstly, it should be pointed out that interest rates simply establish return on money adjusted for inflation. What this means is that, since western countries can print more money, £100 today does not buy the same basket of goods as £100 in 3 years time. The interest rate is the amount of extra money that needs to be topped up each year to ensure that £100 today buys the same basket of goods as £100 in 3 years time. So in real terms, there is no real gain here in terms of an increase in wealth (unless you are acquiring a rate of interest on your investment that is very high). Since the Islamic system only prints money backed up by gold, we do not need to adjust the value of money by the interest rate to keep the purchasing power the same.

For many in the world it is difficult to envisage economic life outside the Capitalist framework. In western economies every economic model is based on the rate of interest, from investment decisions, consumption decisions, savings decisions to financing loans and purchasing housing. The effect of this is that spending and investment are unnaturally skewed. For example, the average person who buys a house is then stuck in the mortgage trap paying back extortionate amounts of interest for 25-30 years. This coupled with loan payments for cars and other luxuries severely erode people’s disposable income. However, even after the costs of taxation, and the costs of interest payments, people are left with some disposable income. The problem is then one of investment; simply put people will not invest if the rate of return of a business venture measured against the risk of the venture is offset by the interest that can be gained from leaving money in a bank account to accrue interest.

Interest rates restricts investment and hence are an impediment to the distribution of wealth.

The basic financial problem everyone faces after taxation and after personal expenses are taken out of the equation is one of where to invest ones wealth? Simply put if the risk of the rate of return on an investment offset by the rate of interest then one would leave their wealth in a bank account rather then actually invest it. Hence the incentive would be to save the money rather then to use (invest) it. Although interest is money sitting in an account which banks use for their investment, this money is still not circulating in the economy as banks invest a large chunk of their money in paper i.e. bonds, shares, IOU’s etc. This means that money is held for a promised rate of return rather then going on actual production of goods, or the building of a plant, factory etc. Although a bank may invest some of its money in physical goods this money is in effect circulating amongst a handful of rich individuals and corporations, hence the money remains being sucked out of the economy. However most of this money ends up in the financial markets, which doesn’t have a bearing on the real economy.

Islam promotes investment by the way it is structured and relies on factors which promote real wealth. The Islamic taxation system does not tax income, but taxes wealth. This means that the average person will have more disposable income on goods and services, and will be liable for tax on whatever wealth is left at the end of the year. The effect of this is that it will increase demand for goods and services right across the economy which will generate an increase in trade and in turn an increase in wealth for businesses.

If we take figures from the British economy, and incorporate an Islamic model we can demonstrate the effect of this. In 2007 the average UK salary is £23,244, and the tax burden on this salary is 34% (income tax and National insurance together), which is just under £8000. This means that the average person will have an extra £700 pounds to spend each month as he will not be taxed on his income. Taking into account that the total UK workforce is approx 31 million this means that the extra money flowing around the economy would be £240 billion, if the income was not taxed.

This £240 billion will be spent on goods and services which will increase the aggregate demand (the total demand for all goods and services in the economy), and hence businesses will benefit effectively by taking their share of this money. This will naturally increase the money available to businesses for further investment in land and create more jobs and increase employment. It will also encourage more businesses to be started to enjoy the wealth that is flowing around the economy. We should point out here that these figures are very conservative, since in western economies, the employee is not paid a wage commensurate to the value he brings to the company, and hence we would expect the average income in the Khilafah to be much higher. To put these figures into perspective, the NHS currently costs the UK Exchequer £96 billion (according to the last UK budget). So this increase of £240 billion around the economy is just under 3 times the cost of the NHS.

At the end of each year, the average person in the Khilafah will be liable to a 2.5% tax on his wealth. So, if we take the figures above as an example, then one would lose £200 of his £8000 wealth to the state treasury. To avoid this loss there is a powerful incentive for him to invest his money.

Since the investments that are open to him are not interest bearing, he will have no choice other than to invest in an Islamic business that is trading in goods and services. So his £8000 will be re-invested to businesses around the economy which will be used to invest again in land or labour, creating more jobs within the economy. Again the 31 million workforce in the UK can mean that up to £240 billion can potentially be invested, although some of that will be spent within the economy during the year. Again we should point out that £8000 of investment at the end of the year is very conservative, and does not take many factors into account.

All of this will create a dynamic economy which creates more jobs. As more jobs are created, then more money is spent in the economy or re-invested in the economy, which creates more jobs in return. This type of dynamism does not exist in the world, and only existed in America after World War II.

All of this demonstrates that the Islamic system provides a compelling investment model, and there is no basis to suggest that the Islamic economic system does not promote investment. The truth is that Islam encourages business and investment, but does not encourage interest based investments which restricts the flow of wealth around the economy. Allah (swt) distinguished between this when He said:

“…they say, “trade is like usury”, but Allah has permitted trade and has forbidden usury” (Al Baqarah: 275)

“…in order that it may not make a circuit between the wealthy among you” (Qur’an 59:7)

The Islamic system emphasises distribution of wealth

The world today is awash with wealth. Western economies are able to produce quantities of goods not seen before. There is no doubt that the problem in the world is not down to production, but distribution of wealth. In the UK the top 5% of the rich list have enough wealth to ensure that poverty is history, yet we find people in Britain living on the bread line.

We have shown already that in Capitalist economies wealth is hoarded amongst the top tiers and does not reach the average man, who is burdened by the taxation system. Islam emphasises distribution of wealth by a host of specific policies, which for the sake of brevity are:

a) Islam taxes wealth and not income, which means that citizens in the Islamic state have more disposable income which they can spend on goods and services, and the absence of interest rates also mean that people are more likely to invest in the real economy as well, which has a natural distributory effect.

b) The tax on wealth at the end of the Islamic financial year may seem very little for the average person at 2.5%, but this measure is not meant to cripple the average man, but is supposed to tax the ones who are most able to pay. A 2.5% wealth tax on Roman Abramovich who is valued at £30 billion will bring in tax revenue to the bait ul mal [State Treasury]of £750 million, which is the equivalent of taxing 937,500 people earning the average wage! This tax is aimed at ensuring that the wealth being generated by the rich is not kept amongst them, but distributed around the economy.

c) The Shari’ah rules emphasise distribution by the detailed evidences. For example, Allah (swt) commanded the Khalifah to distribute the Zakat to the poorest and most vulnerable in society so that they can meet their requirements, as ordered by Allah (swt). The State also emphasises that the Khalifah must spend such that the wealth has reached everyone so that their basic necessities are met, before non-essentials.

For example, when the Prophet (SAW) conquered Bani Nadheer, he divided it among the Muhajireen and did not give any of it to the Ansar except to Abu Dajana Sammak ibn Kharsha and Sahl ibn Haneef who both were at that time poor just like the Muhajireen, so that they could achieve parity, and ensure that the wealth was not maldistributed.

d) The Khalifah reserves the right to confiscate any land that is uncultivated for three consecutive years, so that this land is not kept as a form of hoarding. This land is then redistributed to those in need of it who then contribute the economic output. The State also reserves the right to distribute land which has no owner, as the Prophet (saw) did when he gave Az-Zubair the land of Naqee’a.

e) The Shari’ah rules emphasised the spending and made it a virtue. Imam Nawawi narrated in his 40 hadith Qudsi that Allah said, “spend, oh son of Adam and I will spend on you”. Islam recognised the need for spending to keep the economy dynamic. Furthermore Rasulallah (saw) emphasised the giving of gifts from that which people like for themselves, and Islam even stipulated that this gift shouldn’t be demanded back. The Prophet said “We do not set the bad example; the one who claims back his grant is like the dog which returns back its vomit”. Islam even rewarded the one who gives a loan to his brother, and elevated the status of the loan to represent the reward of sadaqah, if he loaned his brother money twice. The prophet (saw) said; “No Muslim would give another Muslim a loan twice, except that one would be written for him as charity.”

These evidences demonstrate the fact that spending is enshrined within the Shari’ah and the State does not need to enforce this, since it will exist within the mentality of the Muslim. It is part of the worship of the Muslim. No policy can enforce a trait like this, unless it comes from the very belief.

All of this demonstrates that the Islamic system has checks and balances that ensure wealth is distributed around the economy and not remain in the hands of a few wealthy people which we see in the free-market system.

To conclude, the financial crisis presently being experienced is due to the western financial system which has brought nothing but misery to the people. Inshallah, the coming Khilafah will bring wealth, prosperity and rescue the world from poverty.


Related Articles:

This entry was posted in Economics, Religion of Abraham. Bookmark the permalink.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.