My Own Thoughts
As outlined in my book, I also argue in a similar vein. Citing the Quranic verses 2:275-276, 3:130, and 2:278-280, I argue that the Quran’s sanction of trading (and implicitly profit) and condemnation of riba are predicated on the notion that profiting from trade is normal and legitimate, while riba is exploitative. Note, however, that though the Quran has permitted trading, it has not sanctioned exploitative trading, where the seller can dictate the price (seller’s market), and where the buyer can dictate the price (the buyer’s market). Exploitative or monopolistic trading gives rise to excessive or extortionate profit, which the Quran certainly does not approve of. Extortionate interest or usury (i.e., riba) is analogous to extortionate profit. Both deserve the same condemnation. If exploitation elements are stripped from both trading and usury, they should stand on the same footing. So it follows that interest, which can be conceived of as exploitation-free is not really disapproved of by the Quran.
I also make the point that while extending a loan, the lender should consider the financial situation of the borrower. The Arabian practice of riba is suggestive of the fact that the lenders at that time of history did not consider the plight of the borrowers. Where circumstances of a borrower warrant humanitarian consideration, the lender should consider lending at concessional rates, remitting interest altogether, or postponing the loan repayment (all of which come under the Quranic banner of qard hasana) or, still better, writing off the loan as an outright grant (or sadaqa), as the Quran likes us to do in 2:278-280. Thus the Quranic message of interest-free loans is applicable only for disadvantaged borrowers, who deserve to be treated with a humanitarian approach. This is qard hasana or a beautiful loan that the Quran talks about in several verses (2:245; 57:11, 18; 64:17; 5:12; 73:20). This is a loan without a return or interest to deserving people or entities on humanitarian grounds or on considerations of temporary financial difficulties. The question of interest cannot arise in such cases. The Quran even encourages the lenders to write off the original loans in cases where the borrowers are in difficulty to repay them (2:278-280).
Interest used in modern finance and banking is an altogether different thing. Here the very Quranic concern for maintaining justice (adl) demands that interest be used to compensate lenders and bank depositors in a just and fair way. Abolition of nominal interest on loans extended in business transactions will rather result in inflicting injustice on the bankers and depositors who fund the banks.
I also point out that we should make a distinction between nominal and real (i.e., price-adjusted) interest, which Muslim scholars generally ignore. The same level of nominal interest leads to a lower real interest in an inflationary situation and a higher real interest in a deflationary situation. This will hurt the lender or the borrower respectively if the nominal level of interest is not adjusted for inflation or deflation. Thus money lending or borrowing almost invariably involves some interest element in real terms, even if no nominal interest is charged on the loan. In an inflationary situation, which is almost always the normal situation, zero nominal interest on deposits means negative real interest for the depositors. In the real-world situation, providing no nominal interest on bank deposits – so-called zero-interest in Islamic Banking terminology – thus makes little sense.
That brings us to the major causes that give rise to interest. As just discussed, inflation is one condition that gives rise to positive nominal interest. A second reason for interest to arise is people’s time preference – valuing goods and money at the present moment more than at a future date. If, for example, a person would like to exchange $100 today for $110 a year after, his rate of time preference would be 10 percent. Interest plays an essential vital role in helping individuals allocate their income into present consumption and future consumption (i.e., saving) by bringing their time preference at the margin into equilibrium with the interest rate. The higher is individuals’ time preference, the higher will be the interest rate that will be in equilibrium with their time preference, which means that the interest incentive will need to be higher for one to save for the future. Or which means the same thing, an individual will go on saving his present income up to the point at the margin, i.e., up to the last dollar of his saving, where he finds his time preference for this last dollar of saving equal to the prevailing interest rate. Because of individuals’ time preference, it will be hard for a government or a business enterprise to mobilize saving and investment without providing sufficient positive interest on the lent money.
A third, and perhaps the most important, reason for interest to arise is a return or profit that can be earned on capital invested in any economic activity such as trading, production, or provision of any service. A producer would like to borrow money to use in his enterprise so long as he earns a return at the margin higher than, or at least equal to, the rate of interest he pays on borrowed capital. The higher is the return on capital, the higher will have to be the interest rate to be in equilibrium with the rate of return situation.
In both cases, it can thus be seen that interest plays a vital role in allocating resources – in the second case between consumption and saving, and in the third case, between different uses of capital. In the third case, interest also plays the role of a rationing device, rationing the uses of resources to the limit of the available resources. The scarcer the available amount of capital, the higher is the interest rate that will serve as an appropriate rationing device.
In an equilibrium situation, the prevailing rate of interest is equal not only to the marginal rate of time preference, but also to the marginal rate of return on capital. That means that interest that is paid to depositors of a bank must be closely linked to, and must mirror, the actual profitability situation on the ground. Interest here is a substitute for the profit that can be actually earned with the money. So, this interest cannot be termed as exploitative, and is not disapproved of by the Quran.
The actual pace of economic growth in an economy also has an influence on the interest rate. The real (as well as nominal) interest rate rises with a higher pace of economic growth. Interest is lower in a slower-growing economy. Conversely, a low interest-rate regime needs to be applied in an economy where economic growth needs to be promoted. In recent years, the US and European economies have been maintaining low interest-rate regimes to stimulate economic recovery from a deep economic recession that took place in 2008.
The foregoing analysis amply suggests the crucial role interest plays in the modern economy. Economic policymakers use interest as an effective policy tool to ensure that an economy does not get overheated to generate undue inflation or it does not slide into a recession with deflation. Even a slight increase or decrease in the interest rate can work as a damper or stimulant to economic activity. An inflationary situation warrants the use of a higher interest rate and vice versa in a deflationary situation. Modern economic theory shows how interest plays a pivotal role in allocating productive resources in the most efficient manner. It plays an equilibrating role in bringing all economic forces to work in a systematic, symbiotic way toward an equilibrium situation where the marginal rate of return or profit on capital as well as the marginal rate of time preference is equal to the prevailing rate of interest.
Interest plays a central role in many kinds of economic decision-making. In both developed and developing economies, interest is a vital instrument used for directing appropriate monetary policy for achieving sustained economic growth with reasonable price stability. Countries’ commercial and other banks adjust their interest rates on loans and deposits to the central rate that is governed by the central bank. Interest influences, among other things, money supply and demand in the economy, economic project planning, selection, and evaluation, inventory planning and management, and a myriad of other economic decisions. Interest represents the opportunity cost of capital. Unless a producer is conscious of such a cost, it is likely that he will engage in inefficient lines of production, use inefficient methods of production, and end up producing the wrong goods, which are uneconomic or unprofitable. Interest is an important tool used also for proper appraisal of public projects. Indeed the role of interest in economic decision-making of various kinds is so deeply entrenched that the efficient working of a modern economy is not conceivable without interest. This is interest that plays a very useful and beneficial role in the economy. It is not exploitative interest or usury that the Quran prohibits.