Islam’s Straw Man will Haunt the World, Part IX: Islam and the Economy
Since the early 1980s, Institutional Economics has made significant contributions to our understanding of how economic systems function. It advocates that, in addition to natural resources, human capital, investment and technological progress, the “institutional scaffolding” of a society plays a significant role in its economic performance. It defines institutions as rules and norms governing economic behavior (“rules of the game”) in the society and their enforcement characteristics. Accordingly, how well an economy performs depends on the rules (institutional structure of society) governing economic behavior. Principal among these are: the rule of law, well-defined and protected property rights, trust, efficient contract enforcement and good governance. You don’t have to be an economist to understand that if there are no rules and regulations and their effective enforcement a person has little incentive to work hard, save and invest for the future.
Economics Nobel Laureate Douglass North isolated the causes of poor economic performance as well as the necessary remedies. Poor performance, North believed, is due to past institutional structure, encompassing cultural heritage, which impose “severe constraints on the ability to effectuate change.” Changes that improve economic performance may run counter to the belief system or these changes pose a threat to existing political or business leaders. Needed changes in the institutional structure may also be difficult because although formal rules can be changed by fiat, social norms may be less flexible and their enforcement characteristics respond much more slowly to policies designed to change them. Although acknowledging that improvement in economic performance may be slow to develop because of cultural factors and path-dependency. North nevertheless envisioned an ideal political-economic institutional structure that, in his view, has great potential for achieving good economic performance and societal well-being. Such an ideal framework would incorporate: (i) institutions that protect individual rights, the individual person, property, speech, social/political participation and create incentives for the members of society and organizations to engage in productive activities; (ii) high level of trust; (iii) rule of law and a government which is credibly committed to a set of political rules and enforcement that protects individuals, organizations and exchange relationships; (iv) contract enforcement; (v) an effective price system that leads to low transaction costs in production, exchange and distribution; (vi) sound government rules and regulations; and (vii) an effective, independent and impartial legal system.
How do Islamic teachings differ from modern economic thinking?
Quran reveals a comprehensive set of interconnected rules governing the structure and operations of an ideal economy that extend well beyond what Institutional Economics would consider needed for a good-performing economy. The network includes the worldview of the Quran in terms of rules governing: (1) the Creator’s relationship with humanity as whole as well as with its individual members; (2) the relationship of humans with their Creator; (3) the relationship of each individual with her/his self; (4) the relationship of humans with one another; and, (5) relationship of humans with the rest of the creation. The Islamic conception envisions a system as a collection of rules of behavior. Accordingly, an Islamic economic system is defined as a collection of rules of behavior prescribed by the Law-Giver, and is the discipline that extracts these rules from the Quran and the tradition of the prophet Mohammad. Islamic economics then explains and analyzes the implications of this framework and these fundamental building blocks in the setting of contemporary society.
The major rule of behavior from fundamental axioms of Islam is the Unity of the Creator and His Creation. The specific rules governing economic behavior include, inter alia, rules governing property, trust, contracts, governance, market behavior, distribution, redistribution and, the financial system that would facilitate transactions in such an economy. Compliance with the prescribed rules of behavior reduces uncertainty and promotes coordination as well as growth with minimal levels of poverty. Rules governing transactions, such as trustworthiness, truthfulness, faithfulness to the terms and conditions of contracts, transparency in market transactions, and non-interference with the workings of the markets and the price mechanism, so long as market participants are rule-compliant, create a strong economy where information flow is unhindered and participants engage in transactions confidently with minimal concern for uncertainty regarding the actions and reactions of other participants. Because of the high level of trust, transaction costs can be assumed to be minimal. Risk–return-sharing in financing production, moderate spending and avoidance of extravagant and opulent consumption would provide financial resources for investment. Rules regarding redistribution and the prohibition of idle wealth accumulation would reinforce the availability of resources for saving and investment. The mission of developing the earth, which the Creator has charged humans, provides the imperative for growth and development with no poverty, while preserving the environment for all future generations. In the Islamic economic system, humans, endowed with freedom to choose, are given rules of behavior that would create flourishing and socially just economies.
If the rules are adopted and followed, an Islamic economy is one where everyone who is able works hard, using knowledge to combine with their own labor and the resources provided by the Creator, to produce goods and services for society. Economic, social, and political affairs are conducted with the goal of removing barriers to the progress of all humans and in full compliance with rules, including those governing property rights, market behaviour, exchange and trade, and contracts and trust. Knowing that they are responsible and accountable, individually and collectively, they invest allegiance in a legitimate authority to carry out their affairs, with the legitimacy of the authority established by rule-compliance. The rule “commanding the good and forbidding evil,” applicable to individuals and society, assures that leaders are selected by the community and are answerable for their actions; leaders acquire legitimacy by being more rule-compliant than members of the community; and leaders must be confronted if they do not uphold Divine Rules and enforce them. In turn, this capstone rule assures the full and active participation of all in the affairs of society. The existence of absolute and relative poverty, along with significant income inequality, is evidence of rule-violation and governance failure, for which members of society are, individually and collectively responsible. In Islam, a Loving God has given humanity sufficient resources to build thriving communities as long as resources are shared. In other words, at the global level scarcity is not an issue but is so at the country level because countries do not share with each other and even more so at the local level because individuals do not share with the community. Sharing is an important message of Islam in all dimensions of life.
Based on the Islamic vision, we expect the ideal Islamic solution to differ in the following important ways from the conventional capitalist market-based system: greater degree of justice in all aspects of economic management, higher moral standards, honesty and trust exhibited in the marketplace and thus lower transaction cost, poverty eradication, a more even distribution of wealth and income, no hoarding of wealth, less opulence in consumption, leaders and rulers with lifestyles that reflect the lives of the disadvantaged, no exploitive speculation, little or no corruption, risk sharing in all aspects of life including in financial contracts (as opposed to debt and risk shifting), little or no private and public debt tied to interest payments, enhanced financial stability, better social infrastructure and provision of social services, better treatment of workers, higher education expenditures relative to GDP, higher savings and investment rates, higher foreign aid/GDP, higher degree of environmental preservation, and vigilantly supervised markets and contract performance. It would be expected that these differences would be reflected in more unity and cooperation among the members of society and higher quantitative and qualitative economic growth if the Islamic rules and objectives were adopted. While income and wealth redistribution — an Islamic preoccupation — was traditionally seen in Western economic literature as undermining growth, in more recent years empirical studies are finding a positive relationship between equality and growth.
In the Islamic financial system there is no interest-bearing debt. In Islam financial transactions should reflect the sharing of risk in a project and not shift it from one party to another. As a result, in Islam the issuance of shares (stock) where the investor shares in the project’s risks is endorsed but debt where the investor shifts the risk to the borrower is prohibited. The prohibition of interest-bearing debt encourages closer cooperation and makes a financial system more robust and immune to financial crises.
Although the economy as envisaged in Islam is not the capitalism that we see today, it is a market-based system. It is not socialism as it upholds very strong property rights. Its scaffolding is a caring and just market-based system where individuals must develop the self, help others in their journey, work hard, cooperate and support the community’s development and prosperity. In the Islamic system, the government may have little to do if the community (individuals) has (have) internalized the Divine Rules, follows them and adheres to the capstone rule, “commanding the good and forbidding evil.” Moreover, the government would have little or no interest-bearing debt on its books. However, if rule compliance is lacking, then the government must supervise and enforce the rules. Additionally, the government is commanded to use policies (a modified monetary and fiscal that are the practice today) to ensure that the economy is operating at or close to full employment.
The final post in this series will appear next week.