ISLAMIC ECONOMIES – THE EMERGENCE OF A NEW PARADIGM
JOHN PRESLEY AND JOHN SESSIONS
Western economists have been somewhat remiss in the last decade in failing to recognise what has been the appearance of a new paradigm in economics – that of Islamic economics.
This neglect is not surprising: most of the literature on the subject is published in Muslim countries and so is not readily available to Western economists. Nevertheless, there is now sufficient momentum behind the development of Islamic economics for it to be taken seriously.
By applying the ideas developed in the Western contract literature it is possible to show that mudaraba might be used as an efficient revelation device. The central idea is that if the project outcome is stochastic, and if managers have an informational advantage regarding this stochasticity over investors, then a mudaraba contract between managers and investors will lead to a more efficient revelation of that information.
Well-Established Model
The first misconception, that must be abandoned quickly, is that Islamic economics is a new paradigm. That Islamic economics has come to the fore in recent years in certain Muslim states is indisputable, but it has existed since the Qur’an was revealed, and in this sense, it is much older than most Western economic paradigms.
Economic Intervention
The scope of the state’s intervention in the economy is broad and can take many forms, including general guidance and regulation. However, it might also embrace more direct state ownership.
An Islamic economic system operates on the fundamental principle that the forces of supply and demand should work freely in the determination of prices in all markets. Only in exceptional circumstances is there a justification for state intervention and even here, the objective of such intervention is not to hinder the freedom of trade but to secure more perfect information in the market place or to regulate or organise economic freedom without harming either buyers or sellers.
Perhaps the most far-reaching and controversial aspect of Islamic economics, in terms of its implications from a Western perspective is its prohibition of interest. The elimination of interest payments would clearly involve the rewriting of capitalist economics as it exists today and would produce a major change in both the national and international economic and financial system.
In banning Riba, Islam seeks to establish a society which is again based upon fairness and justice. According to Islam, all income should be commensurate with the work effort involved. Lending money for interest permits the lender to augment his capital without effort, as money does not create a surplus value by itself. Only through the marriage between labour and capital can a surplus or deficit result, and so it is fairer for the provider of capital to share the profit or loss with the borrowers than to obtain a fixed return, regardless of the outcome of the borrower’s business.
The prohibition of interest is obviously a complex issue; in general, however, there are a number of themes running through modern Islamic literature. In short:
i) an individual who abstains from consumption, by saving, is not automatically entitled to a financial reward
ii) there is no justifiable reason why a lender should automatically receive a reward simply through the act of lending.
iii) interest as a reward for saving has no moral foundation or justification.
A sharp distinction exists between money and capital – money cannot be equated with capital although it may be regarded as potential capital, and the transformation of money to capital, requires the addition of enterprise, that is, risk taking and the knowledge of how to combine factors of production to money. The lender has no right to an automatic reward for supplying money unless he shares in the provision of enterprise, and even then, the reward is not fixed or guaranteed, but dictated by the proportion of his contribution, which in turn determines his share of profits or losses.
Rules Governed by Fairness
The Islamic concept of fairness has two dimensions. The supplier of capital has a right to share in the profits to an extent commensurate with the risk and work effort supplied. It should not be determined by the current going market rate of interest, but by the rate of return of the individual project for which the capital is supplied, and only time will dictate whether this exceeds or falls short of the current market rate of interest.
In Islam, the creditor/debtor relationship breaks down. The lender bocomes a partner in the business or project, sharing in the provision of enterprise, and is not distanced from the use to which his money is put.
Property Rights
The position on interest can be further clarified by referring to property rights. Lending money is no more than a transfer of a property right. If the borrower does not utilise the loan productively to generate incremental wealth, then there is no claim to additional property rights on either the borrower or lender.
In contrast, if the money is used productively in creating additional wealth, the lender as well as the borrower has a claim to a share of the additional wealth but not in terms of a fixed return irrespective of the level of that additional wealth.
Mudaraba – an Efficient Revelation Device
In Islamic economics the prohibition of interest has led to the creation of alternative schemes for the remuneration of capital. The prevalent method of compensation is by means of a mudaraba profit-and-loss-sharing contract, whereby the return to the lenders of capital is in accordance with an agreed ratio in the profit-or-loss outcome of the project in which they have invested.
It is possible to show that under certain conditions, Mudaraba-based contracts will act to raise the level of capital investment in a project, which is crucial where the outcome of a project is determined by the level of capital investment.
Asymmetric Information
The key assumption here is asymmetric information. The manager is assumed to have superior information to that of investors in two respects; first, he is able to observe the demand or productivity conditions affecting the project before committing himself to production decisions; and second, he alone observes his personal level of effort. Such an asymmetry of information is not unusual and, indeed, may be used to justify the delegation of production decisions to the manager. But this does lead to problems in exploiting managerial expertise.
Since his effort is private information, the manager cannot be compensated directly for the cost of supplying it, and the problem of revelation therefore arises. The manager’s preferences over productive inputs will not coincide with those of investors unless he personally bears the entire risk of adverse shocks.
If the manager is risk-adverse, then it can be shown that such a policy – whilst assuring productive efficiency – is sub-optimal. Furthermore, a policy of paying the manager a fixed return independent of outcome is inefficient, because there is no incentive for the manager to supply more effort when his marginal product is high.
Incentive Compatible Contracts
One way out of this dilemma is to design incentive compatible contracts that ensure that the cost of misinformation by the manager is sufficiently high so as to make honesty the best policy. It has been claimed that in order to ensure such incentive-compatibility with the minimum loss in efficiency requires the contracts to specify inefficiently low levels of productive inputs in particular states of the world.
We can then assume two states of nature only, ‘good’ and ‘bad’ and a production technology such that both total and marginal revenue products are higher in the good state than in the bad state. It is possible to show that, with those assumptions, an incentive-compatible Riba contract implies that capital investment in the bad state is set below the full information productively efficient level, whilst in the good state it is set at the productively efficient level.
The result arises from the temptation on the part of the manager under a Riba contract to substitute capital for effort and thereby reduce effort cost, which is not public knowledge. Intuitively, a reduction in investment in the bad state has only a second order effect on the outcome of the project, but nevertheless imposes a first onwer cost on the manager should he chose to misrepresent the true state of nature.
This permits the difference in compensation between the good and bad states to be made smaller whilst maintaining incentive compatibility.
Managerial Effort
Under a Mudaraba profit-and-loss-sharing contract, it is managerial effort which picks up the role of policing the contract. A Riba contract creates an explicit mapping between the input and compensation of capital. Under a standard incentive-compatible Riba loan contract, the manager is left free to choose the individually optimal level of effort in each state, contingent on the specified level of investment.
A mudaraba contract, in contrast, creates an explicit mapping between the remuneration to capital and the outcome of the project, the prohibition of interest implying that compensation cannot be tied directly to the level of capital investment.
Mudaraba, therefore, allows the contract to directly control the manager’s incentive to exert effort, since this effort affects the relationship between capital investment and the outcome of the project. Under a Mudaraba contract, the manager is left free to choose the individually optimal level of investment in each state contingent upon his contractually specified level of effort.
These individually optimal levels correspond to the full information productively efficient levels and therefore, as a consequence, a mean-variance improvement in capital investment is obtained – average investment is increased whilst inefficiently large fluctuations around this level are reduced.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
Comments
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.