ISLAMIC ECONOMICS: THE EMERGENCE OF A NEW PARADIGM*

John R. Presley and John G. Sessions

Western economists have been somewhat remiss in the last decade in failing to recognise what has the appearance of a new paradigm in economics - that of Islamic economics. This neglect is not surprising: most of the sophisticated literature on the subject is published in Muslim countries and is not, therefore, easily available to western economists. There is now, nevertheless, sufficient momentum behind the development of Islamic economics for it to be taken very seriously. This paper, therefore, has the primary objective of stimulating interest in Islamic economics in the hope that it will encourage the recognition in Western literature of this ‘new’ paradigm and lead to contributions to its evolution from economists of all persuasions.

The paper takes a particular focus, namely the prohibition of interest (riba) in Islamic economics. The payment of riba is explicitly prohibited by the Quran and investors must instead be compensated by other means. The prevalent method for such remuneration is by means of mudarabah profit-and-loss sharing; mudarabah defines a sharing contract where the return to lenders is in accordance with an agreed ratio in the profit / loss outcome of the project in which they have invested. By applying the ideas developed in the western contract literature by Holmstrom and Weiss (1985) and Meyer (1986), we show that the use of mudarabah might act as an efficient revelation device. The basic idea is that if the project outcome is stochastic, and if managers have an informational advantage regarding this stochasticity over investors, then a mudarabah contract between managers and investors will lead to a more efficient revelation of that information. The paper is set out as follows: Section I outlines some general background issues relevant to Islamic economic thought whilst Section II considers in particular the prohibition

of interest within Islam. Section III introduces the idea of mudarabah as an efficient revelation device. Our formal model is set out in Section IV whilst some final comments are collected in Section V.

I. BACKGROUND

The first misconception which 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 been in the background of the Islamic economy since the publication of the Holy Quran, and, in this sense, is much older than the theoretical foundations of most Western economic paradigms. Islam comprises a set of principles and doctrines that guide and regulate a Muslim's relationship with God and with society. In this respect Islam is not only a divine service, like Judaism and Christianity, but also involves a code of conduct which regulates and organises mankind in both spiritual and material life. An examination of the contemporary literature on Islamic political economy yields a number of substantial differences between this new paradigm and modern 'capitalistic' economics in key areas. These arise from the basic principles of Islam, in particular that:

(i) God is the creator and owner of wealth and people are the vicegerent of God; however

people can pursue and use wealth in the form of a trusteeship from God (Quran 20:6).

(ii) It is a divine duty to work. Social justice is the result of productive labour and equal

opportunities such that everyone can use all their abilities in work and gain just reward from

that work effort.

(iii) Justice and equality in Islam means that people should have equal opportunity and does

not imply that they should be equal in poverty or in riches [Chapra (1985)]. However, it is

incumbent on the Islamic state to guarantee a subsistence level to its citizens, that is a

minimum level of food, clothing, shelter, medical care and education (Quran 2:275-279). The

major purpose is to moderate social variances within Islamic society, and to enable the poor to

lead a normal, spiritual and material life in dignity and contentment.

(iv) The scope of economic intervention is broad and can include state interference in many

areas of economic activity [Saqr (1980), p.59]. Such interference can take many forms,

including general guidance and regulation by the State, but also might embrace more direct

state ownership and direction. The duties assigned to the State under Islam primarily consist of commanding, counselling, controlling and protecting. The Quran orders society to obey God,

His Prophet and their rulers (Quran 4:59) (in that order). 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 freedom of trade but to secure more perfect information in the market place or to

regulate or organise economic activities so as to protect economic freedom without harming

either buyers or sellers.

(v) There is no justification for the payment of interest on loans.

It is this latter basic principle that this paper seeks to explore in more depth.