“Neither a borrower, nor a lender be; For loan oft loses both itself and friend” [Hamlet, William Shakespeare].

The categorical prohibition of interest in Islam is well known, less well known is that lending is very strongly encouraged in Islamic society. The Prophet (peace be upon him) said: “No Muslim would give another Muslim a loan twice, except that one would be written for him as charity.”.

Which means that to loan to someone twice carries the same high reward of giving charity. It was narrated by Abu Huraira that the Prophet (Peace be upon him)said: “There was a merchant who used to lend to the people, and whenever his debtor was in straitened circumstances, he would say to his employees, 'Forgive him so that Allah may forgive us.' So, Allah forgave him.”.

The making of loans and leniency in demand for repayment are highly encouraged in Islam. Similarly the non-repayment of loans is treated harshly with the Prophet(Peace be upon him) refusing to lead the funeral prayer over such individuals. The most important point to note, however, is that the taking and giving of loans in Islam is without compensation (interest) which means that it is impossible to inflate lending assets beyond what is actually available of real assets in the society. All lending at interest is prohibited in Islam so banks or anyone else cannot seek to gain from lending. In such a society the question is raised as to where the incentive comes for anyone to lend? The key to this question is in understanding the incentive for investment, and the allowable forms of investment within the Islamic environment. Without loans at interest and without credit creation via open market operations or the monetisation of derivative securities a major avenue for insecurity in society is closed off.

The Asymetric Threats Contingency Alliance (ATCA) recently estimated that in the past 12 years of the most recent “boom” period 100 trillion dollars of debt securitisation has been created (part of the 1.1 quadrillion dollar derivatives mountain they estimate has been created in the same period). The word created is used advisedly here as these “assets” dwarf the real assets which are truly in existence on this planet (the sum of all goods and services are estimated at 60 trillion dollars, with US dollars in circulation (M2) at 16 trillion dollars). In Capitalist economies banks can, and do create money and derivative products from nothing, and at enormous multiples of the real economy. If a bank has a reserve requirement of 5% it can create loans 20 times the size of assets on deposit. This is before the complex web of leveraged derivative products are also considered (the SEC in the US in 2003 gave the then 5 largest investment banks the green light to leverage their own assets by up to 30 times). Beyond this banks have seen fit to develop “off Balance sheet” assets which are further from reality and certainly out of public oversight. It is little wonder that these banks took full advantage of what was a green light to create from nothing products that would pay high returns in what has traditionally been a low risk environment – generally banks earn from interest on loans, and guarantee returns by repossessing assets when the business cycle moves down. In the down cycles there is of course deleveraging as loan positions must be unwound. When the unwinding is slow and punctuated by bank or institutional failures a credit crunch results with all available cash going to repay loans, prop up ailing balance sheets or covering losses. Due to the unprecedented scale of the run-up in credit creation in this past decade, by necessity the unwinding will be more painful and on an equally massive scale. It is no different from the fallout from any of the myriad of pyramids or bubbles witnessed over the centuries, only this time numbers 10 or even 20 times the size of the whole world economy are at stake. This very painful credit crunch is now panicking governments worldwide into thinking of ways to resume an upward growth trend without recognising the mess they are currently in due to these corrupt practices.

Islam views the charging of interest and repossession of assets by the money lender as oppressive and forbids it. The creation of new money from nothing to then lend at interest is also clearly corrupt and a recipe for disaster which we unfortunately are now witnessing. This prohibition extends to these practices whether in the small or large scale. Instead those with capital are faced with options to invest which are non interest oriented and which are based on the principle of sharing of investment returns and sharing of risks of actual loss (in accordance with the capital share of the investors).

The incentive to invest and ensure a consistent circulation of wealth that all economists desire, stems from two distinct features of the Islamic economy both fiscal and legislative. Faced with non interest bearing bank accounts and the levying of zakat at 2.5% per annum against unutilised (according to various criteria) wealth there is simply no incentive to take money out of circulation. If it lay fallow in a bank account it will be subject to the zakat charge. The other great stimulus in Islamic economy for investment is via the effective nil rate of company income and dividend tax. Although certain stocks and inventories of companies are subject to the annual 2.5% zakat levy, punitive corporation tax and the disincentive of being taxed on the dividend payouts of company activity, which is also absent in the Islamic economy acts as a strong incentive to invest. The Islamic taxation system does not tax income, but taxes wealth (although modestly). With greater disposable income available for goods and services, and tax liable on unspent wealth, there is a strong fiscal boost to demand for goods and services right across the economy which will generate an increase in trade and in turn an increase in wealth for businesses. All of this will create a dynamic economy which creates more jobs. As more jobs are created, more money is spent in the economy or re-invested in the economy, which creates more jobs in turn. This type of dynamism does not exist in the world, and only existed in America after World War II.

The key legislative factor leading to high and consistent investment levels is the prohibition of hoarding money, which is the practice of taking money out of circulation for no purpose (saving for a purpose such as a large asset purchase is not considered as hoarding). The Quran clearly sets out: “And let those who hoard gold and silver and do not spend them in the way of Allah know that a severe and painful punishment is awaiting them”.

[Translated Meaning Quran 9:34] In a Hadith Qudsi (Imam Nawawi) the Prophet (Peace be upon him) narrated: “Spend oh son of Adam, and I will spend on you”.

The combination of prohibiting banks from trading with interest, or acting as the sole middle man in effectively controlling the money markets, together with the incentive for investment (zakat on unused assets and prohibition of hoarding) has meant that the Islamic society benefited from high and consistent investment. These disincentives to take wealth out of circulation have consistently been applied over hundreds of years and massively softened the impact of business downturns, which usually resulted from natural shocks such as climactic disasters. The current liquidity crisis is as much about those that are taking their cash and wealth out of circulation as the incredible levels of losses that banks are experiencing which have caused massive retrenchment.

Compare the Islamic rules for consistent investment levels with the comments of Andrew Lahde a hedge fund manager that announced the closing down of his hedge fund in October 2008 23. While denigrating the “idiot bankers” who had lost in their “bets” against him, he announced that he was closing down his hedge fund to “spend time with his money”. Not so much has been written about the winners of these gambling sprees, but you can be assured that many more like Mr Lahde are spending time with their money at the expense of the wider society. Not only are governments bailing out banks for their gambling debts, but stimulus packages are now on offer to try and put money into the economy as billions have been spirited away by those that will have nothing to do with the idiots they fought against and won, and have purely selfish reasons and no disincentive to now hoard cash. With stock markets plummeting and bond yields set to plunge with inflation soaring, much of this money will sit on the sidelines (or in the playgrounds of the super-rich), possibly for years, and all at a time when its wide circulation is most needed.

[Translated Meaning Quran Al-Hashr 59: 7]

The Islamic system provides a compelling investment model, and there is no basis to suggest that the Islamic economic system does not promote investment. The truth is that Islam encourages business and investment, but does not encourage interest based investments which ultimately restricts the flow of wealth around the economy. Allah (swt) distinguished between this when He said:

[Translated Meaning Quran Al Baqarah 2: 275]

Stability in the economy is built upon investments only being permitted in real products or business which makes wealth generation a result of work and profits, not debt.