Islamic Economic Theory presents a different reading of certain key socio-economic concept

  • 10 Pages
  • Published On: 30-10-2023


Islamic economic theory and finance is deeply rooted in the concepts of ethics and morality. Due to this background, Islamic finance and banking activities are performed within ethical boundaries that are themselves embedded and prescribed in the Islamic Canonical law (Shari’a). If the finance activities fall outside the scope of the Shari’a, then such activities are not valid. In this sense, Islamic finance is different from conventional finance where the primary focus is not on morality that emanates from religious precepts, but on profitability. Islamic finance does not eschew profitability, but mandates that ethical considerations that are prescribed in the Shari’a take prominence. In other words, Islamic finance combines religious and profit motivations (Pollard & Samers, 2007). At the same time, Islamic finance encourages and secures ownership of private property, profitability of business and market forces (Iqbal & Mirakhor, 1999, p. 387). This makes it similar to conventional finance principles.

The Shari’a provides behavioural norms for the all Muslims and some of these norms have a direct impact on the finance and banking activities. Due to the influence of the Shari’a on the economic theory, there may be a question as to how Islamic economic theory relates to the other traditional economic theories such as the market economy theory, command economy theory and social market economy. However, as this essay will show, it is possible to find parallels between Islamic economic theory as well as the other traditional theories. At the same time, Islamic economic theory may present the financial market with a viable new option. This is so because Islamic economic theory provides certain key socio-economic concepts that may be more efficient in the economic conditions left in the wake of the 2007-08 economic crisis. At this point, it is important to understand the role played by finance institutions in the economic crisis and the sub-prime crisis that led to the economic crisis. This essay argues that the Islamic economic theory combines the best aspects of Islamic theory and secular theories to provide a viable option that may be useful in preventing such economic crises.

Islamic Economic Theory: Key Concepts


Islamic banking concepts are rooted in the Fiqh-Al-Muamalat (Islamic commercial jurisprudence), which is based on the Qur’ān and the Sunnah (verbally transmitted record of Prophet Mohammed’s teachings), and other secondary sources of Shariah (Aldohni, 2015). Islamic finance is a fairly new concept in the format in which it is found in most Islamic nations and even in Western nations, where Islamic banks do exist.

The Shari’a prescribes three rules, which are the philosophical foundations of Islamic finance and banking. These rules are: (i) La Darar Wa La Derar, which emphasises that there should be no injury or counter-injury can be seen in the context of finance (ii) Al-khara bi-al-daman meaning that returns on something should be proportional to the assumed risks, or when put more succinctly, ‘revenue goes with liability’. (iii) Al-Ghorm Bel-Ghonm, which refers to the sharing of risk and reward (Amanat, 2007).

The Shari’a behavioural norms include the obligation to give alms to the poor and needy (zakah/zakat) and prohibition of interest (riba). These, along with the prohibition of speculation (al-Gharar) are very important aspects of Islamic finance restrictions, which deserve some discussion because these not only provide the essential differences between Islamic finance and banking and conventional finance, but these are also the important characteristics of Islamic finance, which may help it to become a viable option for the financial market.

Islamic banking differs from conventional banking in two key respects and these have a bearing on Islamic finance and banking. The first key difference is that there is a prohibition of interest (Riba) in Islamic banking. Instead, the Islamic banks reward the depositors with a variable rate of return depending on the gain or loss resulting from using funds during a given period, based on the profit and loss sharing (PLS) principle that is applied as between the institution and the customer (Arab & Elmelki, 2008). Importantly, the Islamic finance instruments, such as mortgages are also not based on interest. The second key difference is that there is a prohibition of speculation (al-gharar). This is a very important difference between Islamic finance and conventional finance, as the latter involves speculation and this has also been the reason why major conventional finance institutions were instrumental in the sub-prime crisis. The Islamic finance system prohibits speculation but encourages asset-based transactions and the sharing of profits and losses (Pollard & Samers, 2007). This makes the Islamic financial products, such as mortgages, more insulated from events such as the sub-prime crisis.

The Islamic economic system is based on the understanding of Islam and of the essential needs of people. Persons have various economic rights and economic disposals, however, these are to be regulated by the moral and ethical values that are prescribed by Islam. Thus, where Islam recognises private property in general, it also prescribes the framework of Shari’a to regulate the right of private property of individuals. Furthermore, Islam does not stop individuals from pursuing any economic activity, provided that it is lawful. At the same time, the Shari’a sets limits on the freedom of the individual to consume, save and invest money. Thus, as mentioned before, the Shari’a behavioural norms include the obligation to give alms to the poor and needy (zakah/zakat) it prohibits investing money with the intention of earning profit from interest (riba), and also prohibits investment of money in a manner, which is speculative in nature (al-Gharar). There is nothing in Islamic law that is particularly against the free market but at the same time there are specific regulations, which are motivated by the need to ensure that there is no appearance of monopoly and concentration of economic power in few people.

Islamic banking differs from conventional banking in two key respects and these have a bearing on Islamic finance and mortgages. The first key difference is that there is a prohibition of Riba (interest) in Islamic banking. Instead, the Islamic banks reward the depositors with a variable rate of return depending on the gain or loss resulting from using funds during a given period, based on the profit and loss sharing (PLS) principle (Arab & Elmelki, 2008). Even the Islamic finance instruments are not based on interest. The second key difference is that there is a prohibition of al-gharar (speculation), and instead the system encourages asset-based transactions and the sharing of profits and losses (Pollard & Samers, 2007).

In Islamic philosophy, the concept of sharing in profit or loss drives the principles of finance and banking activity. Investment in business ventures when funded with loans taken from someone, does not put the entire liability or risk of loss on the debtor. At the same time, the debtor does not pay a fixed sum of interest to the creditor. Both the debtor and creditor partake in the profits or losses arising out of the business. The forbidding of interest is in order to avoid exploitation and unjust dealings, whether the beneficiary is the lender or the borrower. This principle is reflected in Islamic banking as well, because the banks do not pay interest on deposits and nor do they take interest on loans (Alotaibi, 2015).

Islamic Economic theory, Social Market Economy, Command Economy and Market Economy

The three prominent theories or economic systems are market economy, command economy and social market economy. The interrelationship between each of these with the Islamic economic theory, and whether the latter can be fitted with any of the former theories will be discussed in this section.

From a purely academic point of view, Islamic economics as an academic discipline, seeks to combine secular economic theories or the neoclassical models with teachings from Islamic philosophy and law (Nienhaus, 2010). This is a relatively new phenomenon. Admittedly, there is a contrast between the early model of Islamic finance and the lassaiz-faire capitalism, other than the fact that Islamic finance was never opposed to private ownership of means of production. On the other hand, Islamic law recognizes private ownership of the means of production and nationalisation and state control of the economy not permissible under the Islamic law, barring in certain limited circumstances (Nienhaus, 2010).

In the contemporary period, the Islamic jurisprudence (Fiqh) and Islamic economics have combined with the secular economics theory and the result of the same is the application of some principles of market economy within the Islamic banking and finance system (Nienhaus, 2010).

Market economy, which is based on an unrestricted competition in the market and therefore the production and prices are determined by the market forces, without any interference by the government. A laissaez faire economy is a classic example of a market economy. The question is can Islamic economic thought be fit into this system? Islamic economic theory does not really prohibit competition and open and free markets, nor is there any prohibition on private ownership of property and means of production. However, there are certain limitations in Islamic economic theory, such as prohibition of monopoly and the regulation by the state, which may not be concomitant with the market economy thought (Nienhaus, 2010).

The Command economy is a system where the state controls the market and there is not really a system of free markets in such economies. The state determines all the important aspects of the market, such as, the goods which are to be produced, the quantities of production and the prices that the products and the services are to be sold at. In the Islamic economic system, production of goods serves the two purposes of use and exchange and it is therefore seen that Islamic economic system presents a combination of features of traditional and market economy (Hameed, 1995, p. 23). Due to this dual role of production in Islamic economic system, it is said that Islamic economic theory restricts both market mechanisms as well as the imperatives of the command economy (Hameed, 1995). In a command economy, there are too many restrictions on individual’s ability to acquire private property and means and production, which is also not acceptable in Islamic economic theory.

There seem to be the most parallels between the Islamic economic theory and social market economy (Nienhaus, 2010). At the outset, it is essential to understand the different contexts in which the Islamic economic theory and the social market economy have developed. Social market economy concept was created for “highly developed and structurally differentiated economies only in the twentieth century in the Western world, where it has proved itself”, whereas in Islamic countries, this concept was unknown till the 20th century, when many of these Islamic countries gained independence (Nienhaus, 2010, p. 75). Nevertheless, the social market economy concept by itself exists in different forms in the different countries where the concept is found.

Both the Islamic economic thought and system and social market economy system have some areas in common, therefore, it is not difficult to fit Islamic economic theory with other theories. First, Law and the rule of law are important Islamic economic theory and therefore, concepts of an Islamic economic system are compatible with different forms of government, such as, democracy, monarchy, etc. Second, there is legitimacy and protection of private property, including the means of production and positive assessment of entrepreneurial achievement in Islamic economic theory (Nienhaus, 2010). Thirdly, justice is important within the economic theory precepts, therefore, we find the prevalence of fairness of price, state protection of competition and even occasional state intervention in price control and control of monopolization (Nienhaus, 2010). Fourthly, in principle, Islamic economic theory accepts open markets for all goods, services, and labor, at the same time providing certain restrictions, such as prohibition of interest and speculation (Alexakis & Tsikouras, 2009). Therefore, insurance is not permitted in the Islamic law, as it is seen to be speculative in nature.

Both the social market economy and Islamic economic theory provide for social security. In the social market economy, such as in the UK, social security is a function of the state, for which the state also levies taxes on individual income and assets, in order to provide social security. In the Islamic law, the concept of the obligation to give alms to the poor and needy (zakah/zakat) is like a social security system, where there is some distribution of production in order to benefit those who may be in need of it (Zayas, 2003). In the Islamic economic thought, zakat is representative of the claim of a poor and needy person to a share in the wealth of the society and, “as such, is at the core of the social security system” (Nienhaus, 2010, p. 84).

Despite the commonalities between the Islamic financial system and social market economy, there are some fundamental differences between the two. The most important difference is the Islamic prohibition of interest (riba), which could bring up a question as to whether there is a real compatibility between the Islamic economic system and the social market economy, “since financial markets perform essential functions for a decentralized, competitive economy, in particular providing savings for productive investments and managing risks” (Nienhaus, 2010, p. 89). However, in reality, despite the prohibition on interest, Islamic finance products do allow the charging of some such amount in investments provided that this is not exploitative, because the prohibition of riba is basically aimed at prevention of exploitation. Therefore, riba is seen where the transaction is unjust since there is a clear disparity between the bargaining powers of each party, or a disparity between the price that is paid for an item and the goods, which are traded (Gemmell, 2006). The Qur’ān does not proscribe profiting from the productive use of commodities and of assets, but does stipulate that charging a weaker party simply for the use of money, which is not considered to be a commodity, but rather tradable, according to Sharí’a principles, and thus exploitative (Agha, 2009).

The Islamic banks have come up with a way to circumvent the prohibition of interest on mortgages by devising the murabaha mortgages, which already contain the markup price within the loan payments, and this is based upon the capitalised value of future interest payments. These cannot be reduced later, although the financier may offer a rebate at the time of closing the mortgage, he certainly cannot promise such rebate at the time of making the mortgage contract (Visser, 2013, p. 63). It is true that murabaha transactions are viewed with some suspicion by Islamic scholars since there are several components of the transaction which come close to resembling interest and, therefore violate the Qur’ān’s prohibition of riba. This is particularly apparent in the case of the mark-up that these transactions carry, which, under a strict interpretation can be considered conventional interest (Akgunduz, 2010, p. 38). However, the writings are scattered and such an objection to these mortgages is not really seen in a more crystallised manner (Nyazee, 2009). Therefore, one may see that there are possibilities of integration between Islamic economic theory and social market economy theory. This integration may even be a beneficial thing for the financial market.

The SubPrime crisis of 2008 was brought on by great part by the lack of regulation of the mortgage market in America. Many Islamic scholars have pointed to the motivations of riba as the prime cause of the crisis. Banks and financial institutions, driven by self-interest irresponsibly allowed mortgages on properties in a highly inflated market. If these banks had been motivated by the PLS principle (Profit and Loss sharing), be it in business arrangements or mortgages, they would have been much more circumspect in choosing which mortgages to finance (Hassan, n.d.).

However, some scholars have expressed concerns about the integrated and independent Islamic economic system, where the concepts of social market economy and the traditional Islamic economic thought can be combined. This is so despite the great interest seen in such integration especially in the face of increased Islamic banking in many Western economies.

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There is now a tremendous amount of literature on the Islamic economic system is, and its interactions with other systems, especially social market economy. It is also pertinent to note that for some economists, in both the Western and Islamic economic thought traditions, Islamic economic system may actually help in decreasing some of the inequities caused by the conventional market system, and the problems suffered by financial markets around the world after the sub-prime crisis (Chapra, 2000).

Studies show that Islamic economic system is consistent with the social market economy, however, the Islamic economic system may even be superior in its overall performance because Islamic system relies on equity and not so much on credit and interest and speculative investments (Chapra, 2000).

The Islamic economic thought and theory does not deny the compatibility of the Islamic system with most of the principles of capitalism. It recognizes private ownership, the profit motive and market forces (Iqbal & Mirakhor, 1999). Nevertheless, the Islamic economic system differs from the capitalist system in that profit is not the only motivation for investment. In other words, it is right that the Islamic institutions might be just another device to capture some market share in intensely competitive markets, but this does not deny the religious motivations of these institutions or the combination of profit motives and religious adherence (Pollard & Samers, 2007).


The practice of Islamic economic activities does not demonstrate any real incompatibility between the Islamic economic system and capitalism. In fact, Islamic economic system and capitalism, particularly in the social market economy concept do share some common foundations (Pollard & Samers, 2007). Therefore, there is a possibility of integration. Not only that, it may be said that such integration may be for the benefit of the financial markets as a whole because the Islamic economic system is structured in such a way that it may be insulated from the ill-effects of speculation as seen during the sub prime crisis.


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