Islamic Economic System brings the solution to the economic crises. How and Why?

Introduction:
The fundamental objective of this report is to carefully analyze the system through which Islamic economic system results in the development and prosperity of the society by bring solutions to all kinds of economic problems. The differences and policies of both, the conventional and the Islamic economic system will be examined to comment by drawing up a valid conclusion. Islamic economics is a financial system which functions under Islamic law (Shariah) principles. The basic sources of Shariah are the Holy Quran and the Sunna of the Prophet (P.B.U.H), which are followed by the consensus of the Ulmas/Muftis and interpreters of Islamic law. The central feature of the Islamic financial system is the prohibition of the payment and receipt of interest (Riba) as clearly ordered in the Holy Quran. The foremost belief around which all the Islamic concepts revolve is that the whole universe is created and controlled by Almighty Allah only. He has created man and appointed him as His vicegerent on the earth to fulfill certain objectives through obeying His commands. These commands are not restricted to some modes of worship or religious rituals. They, on the contrary, cover a every aspect of our life. Islam is not only a religion but a complete system for mankind through which they can earn success in this life and thereafter. The Islamic economic system lies on the fundamental Islamic policy of the socio-economic development of the society. Islam uniquely considers distribution as the economic problem, and Muslims do not share the obsession of capitalists and communists with production. Because Islam differentiates between the basic needs and luxuries, there exists no concept of scarcity of resources in Islam. The resources available on earth are sufficient to secure the basic needs (food, clothing, and shelter) of more sixty billion human beings at a time. Under the Islamic system, Nigeria alone could support the whole of Africa, as occurred in the past when, under the system of Islam, Africa sent food to relieve the famine in Madina during the rule of Omar bin al-Khattab.

Essentials of Islamic Finance

Main Principles of Islamic Economic System:
The main principles of Islamic financial system include: 1. The prohibition of taking or receiving interest. 2. Capital must have a social and ethical purpose rather than merely maximizing profit. 3. Investments in businesses dealing with alcohol, gambling, drugs or anything else that the Shariah considers unlawful are deemed undesirable and prohibited. 4. A prohibition on transactions involving speculation or high degree of risk. 5. A prohibition on gharar, the uncertainty about the subject-matter and terms of contracts – this includes a prohibition on selling something that one does not own. 6. Zakat as an essential part of the Islamic economic system. 7. Only financing through participation. No concept of lending money/resources on fixed markup or return. 8. Money in itself doesn‟t have any value but is backed by an asset such as Gold, Silver etc. 9. Money can‟t be traded like a commodity. It can only be used as a medium of exchange. 10. Highly emphasis on socio-economic development rather than merely economic development. 11. Needs and wants do not affect the supply of the resources. 12. Islamic economic system regards man, money and commodity as factor of production. 13. It permits 3 types of ownership i.e. individual, state and public ownership. 14. Circulation of Wealth.

Fundamental Differences between the Conventional and Economic System:
While conventional economists are now in the process of understanding the failure of evil based system, Islamic economics never got entangled in a secular and materialist worldview. It is based on religious foundations which strike at the very basics of secularism. To ensure the true wellbeing of all individuals, irrespective of their sex, age, race, religion or wealth, Islamic economics does not seek to abolish private property, as was done by communism, nor does it prevent individuals from serving their self-interest. It recognizes the role of the market in the efficient allocation of resources, but does not find competition to be sufficient to safeguard social interest. It aims to promote human brotherhood, socio-economic justice and the well-being of all through an integrated role of moral values, market mechanism, families, society, and good governance. This is because of the great emphasis in Islam on human brotherhood and socio-economic justice. On the basic policy differences of both the systems, the following differences have been highlighted.

Essentials of Islamic Finance

1. The synchronized Role of the Market, Families, Society, and Government.
The market is not the only institution where people interact in human society. They also interact in the family, the society and the government and their interaction in all these institutions is closely interrelated. There is no doubt that the serving of self-interest does help raise efficiency in the market place. However, if self-interest is overemphasized and there are no moral straints on individual behavior, other institutions may not work effectively - families may disintegrate, the society may be uncaring, and the government may be corrupt and self-centered. Mutual sacrifice is necessary for keeping the families glued together.. Lack of willingness to make such sacrifice can lead to a decline in the quality of the human input to all other institutions, including the market, the society and the government. It may also lead to a fall in fertility rates below the replacement level, making it difficult for society not only to sustain its development but also its social security system. Therefore Islam puts high value on participation and societal development through the attainment of Halal earnings. Contradictory to other systems, it regards high value on the human talent and treats it as a factor of production.

2. High importance to Moral Values
While conventional economics generally considers the behavior, tastes and preferences of individuals as given, Islamic economics does not do so. It places great emphasis on individual and social reform through moral uplift. This is the purpose for which all Allah‟s messengers, including Hazrat Abrahim, Moosa, Issa, and Prophet Muhammad (P.B.U.H), came to this world. Moral uplift aims at the change in human behavior, tastes and preferences and, thereby, it complements the price mechanism in promoting general well-being. Before even entering the market place and being exposed to the price filter, consumers are expected to pass their claims through the moral filter. This will help filter out striking consumption and all wasteful and unnecessary claims on resources. The price mechanism can then takes over and reduce the claims on resources even further to lead to the market equilibrium. The two filters can together make it possible to have optimum economy in the use of resources, which is necessary to satisfy the material as well as spiritual needs of all human beings. It is also necessary to reduce the concentration of wealth in a few hands, and to raise savings, which are needed to promote greater investment and employment. Islamic system strictly prohibits monopoly as regard resources as the property of Almighty Allah only and men as the custodian of His wealth. However it has not restrictions on the amount of wealth a person can earn but it will be subject to Zakat. While the subject matter of both is the allocation and distribution of resources and both emphasize the fulfillment of material needs, there is an equal emphasis in Islamic economics on the fulfillment of spiritual needs. While both recognize the important role of market mechanism in the allocation and distribution of resources, Islamic economics argues that the market may not by itself be able to fulfill even the material needs of all human beings. This is because it can promote excessive use of scarce resources by the rich at the expense of the poor if there is undue emphasis on the serving of self-interest. Sacrifice is involved in fulfilling our obligations towards

Essentials of Islamic Finance

others and excessive emphasis on the serving of self-interest does not have the potential of motivating people to make the needed sacrifice.

3. The Concept of Life after death.
This is where the concepts of the innate goodness of human beings and of the life after death comes in; concepts which conventional economics ignores but on which Islam and other major religions place a great deal of emphasis. Because of their innate goodness, human beings do not necessarily always try to serve their self-interest. They are also humane and are willing to make sacrifices for the well-being of others. Furthermore, the concept of the life after death does not confine self-interest to just this world. It rather extends it beyond this world to life after death and the accountability of the life of this world. We may be able to serve our self-interest in this world by being selfish, dishonest, uncaring, and negligent of our obligations towards our families, other human beings, animals, and the environment. However, we cannot serve our selfinterest in the Hereafter except by fulfilling all these obligations. Thus, the serving of self-interest receives a long-run perspective in Islam and other religions by taking into account both this world and the next. This serves to provide a motivating mechanism for sacrifice for the well-being of others that conventional economics fails to provide. The innate goodness of human beings along with the long-run perspective given to self-interest has the potential of inducing a person to be not only efficient but also equitable and caring.

4. Justice
Without justice, it would be difficult to realize even development. Muslim scholars have emphasized this throughout history. Development Economics has also started emphasizing its importance, more so in the last few decades. Rendering justice to those wronged and eradicating injustice, raises tax revenue, accelerates development of the country, and brings blessings in addition to reward in this world and the life after death. Justice and the well-being of all may be difficult to realize without a sacrifice on the part of the well-to-do. The conventional economics doesn‟t bind any obligation to promote justice and equality; rather it results in the survival of the fittest. It not recognize any solution if it requires a sacrifice on the part of a few (rich) for raising the well-being of the many (poor). Such a position is in clear conflict with moral values & ethical standards of Islam and the free market economy. Hence, this concept did not arise in Islamic economics. In fact, Islam makes it a religious obligation of Muslims to make a sacrifice for the poor and the needy, by paying Zakat at the rate of 2.5 percent of their net worth. This is in addition to the taxes that they pay to the governments as in other countries.

5. The Role of State:
Moral values may not be effective if they are not observed by all. They need to be enforced. It is the duty of the state to restrain all socially harmful behavior including injustice, fraud, cheating, transgression against other people‟s person, honor and property, and the non-fulfillment of

Essentials of Islamic Finance

contracts and other obligations through proper upbringing, incentives and deterrents, appropriate regulations, and an effective and impartial judiciary. The Quran can only provide norms. It cannot by itself enforce them. The state has to ensure this. Prophet Muhammad (P.B.U.H) was the practical example of how a person should comply with the regulations of Sharia which results in the prosperity in his life. According to the father of Modern Islamic economics, Ibn Khaldun, the state should not feel that, because it has authority, it can do anything it likes. It should be welfare-oriented, moderate in its spending, respect the property rights of the people, and avoid onerous taxation. This implies that what Ibn Khaldun visualized as the role of government is what has now been generally referred to as „good governance’.

Islam and Economic Problems
Despite the development of various economic models, traditional economics has failed to rovide permanent and sustainable economic solutions to our economic problems. Still, a vast majority of world population lives in poverty and relying on mainstream economic thoughts does not prevent the world from witnessing financial and economic crises every few years. This led to a growing trend of dissatisfaction with existing economic system and many economists nowadays raise the question: Is there an alternate system? The current economic problems are crossing national boundaries. Recent developments in the world economic scene have brought various questions regarding the allocation and distribution mechanisms in the current global economic system. The growing income inequalities between the rich and the poor nations prompt serious deficiencies in the distribution mechanisms. The world now has 358 billionaires with a combined net worth exceeds the combined net worth of the world's poorest 2½ billion people. The recent history of various crises in financial markets sheds doubts on the effectiveness of the global financial systems. In the international currency markets, approximately $800 billion to $1 trillion changes hands each day, unrelated to productive investment or trade in actual goods and services. There is a growing trend of dissatisfaction with existing economic system. Islamic Economics as a scientific discipline to address the contemporary economic problems came into light when the conventional economic problem failed to address the problems like scarcity, disparity in demand and supply and unequal distribution of wealth. Islamic economics make a difference in the areas of macroeconomics and particularly in banking, finance and public finance. The prohibition of interest and the unique system of zakat introduces significant departure from the conventional system. Ibn Khaldun established the causal link between bad government and high grain prices by indicating that in the later stage of the dynasty, when public administration becomes corrupt and inefficient, and resorts to coercion and oppressive taxation, incentive is adversely affected and the farmers refrain from cultivating the land. Grain production and reserves fail to keep pace with the rising population. The absence of reserves causes supply shortages in the event of a famine and leads to price escalation. The socio-political determinants of the prevailing 'system

Essentials of Islamic Finance

crisis' by taking into account a number of variables like corruption, bad government policies, and weak administration. All of these together played a role in worsening the impact of the famine, which could otherwise have been handled effectively without a significant adverse impact on the population. The Christianity, Judaism, Hinduism and Islam, prohibit collecting interest on money loaned. Interest is the excess amount of money paid on the loaned principal. This is considered exploitation or RIBA. The main source of profit for the banks is from the interest they charge and from other ancillary services. The bank relies on their client to pay back the borrowed money with interest. As a precautionary measure the bank obtains collateral against the loan. The primary interest of the bank is to make a profit from the interest and not from reclaiming collateral. The borrower believes that by leveraging the commodity/collateral he will make more money than interest paid to the bank. For example: If you buy a Rs100,000 land with a 20% down payment, and sell the house after 2 years for Rs110,000, your profit is 50%. That is, on your initial down payment of $20,000. The interest you paid on the borrowed money was the rent you would have paid if you had lived elsewhere. The transaction occurs on mutual confidence. The bank being confident of his client‟s ability to make interest and principal payments on regular basis. The client being confident of making more money on his product against which he has borrowed money. Note, the payment of interest from one party to another is unrelated to the value of the house. You may put down 10% (instead of 20%) in order to make more profit and the bank will be willing to lend you more in the hope of receiving more interest. These types of transactions ultimately create fear, greed and corruption. In Islamic financing, the purchaser of the house and the “lender” both become partners in the equity of the house in proportions to their contributions say, 20% and 80% as in the above example. Here the “Islamic banker” either rents him the house till the price is paid off or sells him the house outright with an agreed-upon long term payment contract. We can see the clear difference in both systems. In the present banking system one party gains at the expense of the other without due regard to the price paid for the home. In Islamic finance, the arrangement is based on equity participation, called Murabaha. The focus in this type of financing is the individual, the product and the society. Islam has no objection in creating wealth, but must be based on partnership and fairness. The Islamic Bank providing the equity to finance the house will share in the loss as well as in the profit as earlier agreed upon when the product is sold. The whole society ultimately benefits from such transactions. By elimination of interest, monopoly, money trading and imposing Zakat as compulsory tax to be paid on wealth, the Islamic system develops a mutual relation and zeal towards socieeconomic development of the society. It only strives towards Riba free market mechanisms but also provide better and profitable alternatives for the attainment of higher yet halal profits which is regarded as the reward against the capital invested or the talent/ability utilized.

What dose Islamic Banking Offer?
Islamic banking is steadily moving into an increasing number of conventional financial systems. It is expanding not only in nations with majority Muslim populations, but also in other countries where Muslims are a minority, such as the United Kingdom or Japan. Similarly, countries like

Essentials of Islamic Finance

India, the Kyrgyz Republic, and Syria have recently granted, or are considering granting, licenses for Islamic banking activities. In fact, there are currently more than 600 Islamic financial institutions spread over 51 countries, plus well over 250 mutual funds that comply with Islamic principles. Over the last decade, this industry has experienced growth rates of 10-15 percent per annum, a trend that is expected to continue. The Islamic financial system can prevent all financial crises as it is biased on the laws of nature which are truly error free. It offers four main kinds of products that are the perfect replacement of several interests based financial products. Modarbaha – Ability and Talent Financing Morabaha – Commodity Financing Musharka – Partnership Financing Ijara (leasing) – Asset Financing

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Conclusion:
After thoroughly understanding the key differences of the conventional and the Islamic economic system, I come to the conclusion that even thou interest is essential part of the banking industry but the objectives of banks is merely higher profits with safe investments and Islamic financial system aims to do the same through the Sharia compliance way. The policies of which we see innovate Islamic Financial and banking products being introduced in this free market are based upon the Holy Quran and the Sunnah. Making it precise, they rely on the principles of Allah which are surely error free and a promise & guaranty of success within itself. The conventional system regards the economic system as the natural system where as Islam regards this system as socio-economic system designed for mankind‟s own benefit. Many investor have realized the glimpse of higher and safer investment portfolios in the Islamic financial system. The reason, today even many western countries are not using the term “Islamic Finance” but closely follow the Sharia principles in order to save their nations from economic crises similar to 2008 – 2009 where so called effective or ration economic system collapsed and resulted in the extreme failure of interest based mechanism. Even thou all the policies of Islamic Financial system are evident but more clearer and comprehensive explanations are needed in order for deep understanding of several aspects of this system. Now, as the students of Islamic Finance we should try to contribute as much possible so that the development in this sector can be increased with pace. As this system prevails, it would eliminate all in flaws and loopholes but this would require certain amount of time and efforts from all the stakeholders of the society and the financial system.

Essentials of Islamic Finance

References:
IMF Working Paper; Monetary and Capital Markets Department. Introducing Islamic Banks into Conventional Banking Systems. http://www.islamic-world.net/ http://www.bos.frb.org/commdev/c&b/2006/summer/islamicfinancef http://www.islamicfinanceboard.com/files/islamicbanking10 Islam and the Economic Challenge by M. UMER CHAPRA http://www.islamic-banking.com/resources http://www.globalfinance.org/portal/data/conferences/Islamic-Financial-Products http://alaiwah.wordpress.com/2009/04/06/islam-the-present-economic-crisis/ http://elgamal.blogspot.com/2008/10/islamic-economics-and-financial-crisis.html The resource book of Mr. Yousuf Ibnul Hassan.

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