This discussion is around a brief post by the well-known Islamic economist Dr Mohammad Anas Zarka in an email-group, in the year 2010. The Economist (June 24, 2010 issue) published a special report on debt. The first article of this issue started with a very interesting statement. “Debt is as powerful a drug as alcohol and nicotine.” This in a way endorsed the position often taken by Dr Zarka that riba (interest) is prohibited, also because it creates an addiction as alcohol does.
The Economist in the said article further reports: In the 18th and 19th century, debtors in Britain were often thrown into jail, though Samuel Johnson, arguably the most distinguished man of letters in English history spotted the flaws of the practice in these words: “We have now imprisoned one generation of debtors after another, but we do not find that their numbers lessen. We have now learned that rashness and imprudence will not be deterred from taking credit; let us try whether fraud and avarice may be more easily restrained from giving it.”
Dr Zarka also felt, if it can be shown that debt is addictive implying that a good number of people are potentially addictive to debt (it need not be true of all debtors), then the marginal utility of more debt to an addictive borrower increases the more indebted s/he becomes! Thus, an addict’s behaviour cannot be rectified by price signals, that is, by charging him/her a higher price (interest rate). S/he is likely to keep borrowing if s/he can, till s/he is completely ruined. For price signals to work under this scenario, they must be directed towards the borrowers who presumably show normal behaviour.
Who are these different types of borrowers in the market?
Using a simplified framework let me attempt to classify borrowers in the market into the following categories:
(1) Entrepreneur-borrowers: Their decision to borrow is backed by a careful consideration of several factors, such as, economic and financial feasibility of the project where the borrowed funds would be utilized, comparison of cost of capital from alternative sources of debt, equity or quasi-equity and the ultimate value-implications of the borrowing decision. They may be high networth individuals coming from high income strata of the society, yet opt for borrowing because their planned investment expenditure falls short of their own accumulated savings and since the expected return from investment exceeds the cost of borrowing.
(2) Consumer-borrowers: They use credit cards and other vehicles to finance uninterrupted and/or often avoidable and intuitive consumption of goods and services. They are essentially believers in and driven by consumerism and borrow for convenience and instant consumption. They may come from high or moderate income strata of the society and borrow as long as they are able to meet the “minimum payment” requirement of credit card companies and other consumer finance providers.
(3) Borrowers with low networth and/or low income: They come from the lowest strata of the society and are not eligible for loans from market-based suppliers, like banks and financial institutions. The microfinance sector caters to this “unbankable” segment, providing loans usually to the skilled and productive among them. The unproductive (unskilled, handicapped etc.) among them usually do not qualify until their skill level is increased through related projects funded through grants and charity funds.
Let us now undertake a comparison between how conventional and Islamic finance seek to address the needs of the above categories of borrowers and examine the same in the light of the “debt addition” hypothesis.
Riba and Productive Debt
Category 1 is presumably dominated by normal, rational and prudent borrowers not afflicted by debt-addiction. It is interesting to note that “interest on productive loans” does not fall in the definition of “usury” in the conventional financial system and also according to scholars of faiths other than Islam. The original religious prohibition of interest under Judaism, Christianity and others applies to “usury” defined as “exorbitant interest rates on non-productive consumption loans”, according to these scholars. The present day consensus among Islamic scholars on the definition of riba as any excess in repayment of a debt/loan rules out any differential treatment of interest on debt based on whether the debt is meant for a productive use or for consumption.
Arguably, the “debt-addiction” justification behind riba prohibition may not apply here. It is interesting to draw parallel with a justification behind riba prohibition by some early Islamic scholars in terms of the rich lender “exploiting” the poor borrower. The “exploitation” argument no longer stands in the face of the fact that the US government is the largest borrower today, borrowing from the public that includes the rich and the poor.
One may also note, in an Islamic financial system, there is a possibility of seeking and providing debt both using for-profit and non-for-profit mechanisms. Rationally speaking, the for-profit Islamic debt instruments, such as, bai-muajjal or bai-bithaman-ajil etc. are meant for Category 1 borrowers. Such debt comes at a price that serves as a signal for allocation of credit enhancing the allocational efficiency of the financial system. Highly profitable and less risky projects/ entrepreneurs would be able to borrow at less cost and vice versa. The financing rate would direct the flow of credit resources in the economy. Note the parallel that we draw with the conventional argument regarding the role of interest rate in credit allocation. No, an Islamic financial system does not need an interest rate for allocation of credit.
By the same token, one may argue that zero-cost Islamic loans or qard hasan may not be meant for Category 1 borrowers. The absence of any price signal may result in scarce non-profit resources being misdirected to the for-profit sector.
Riba and Consumption Debt
Credit cards are the key weapons with the commercial banks and other consumer credit providers to promote large-scale consumerism. These are supposed to be instruments that bring huge “convenience” to the users. These enable instant and intuitive consumption even without money in the wallet. Higher usage also brings in other benefits, such as, points that can be converted to items of consumption. The “minimum monthly payment” requirement eases tensions for the consumer by allowing him/her to pay at ease, pay later. Notwithstanding these benefits, financial counsellors often sound a word caution against them, especially against owning multiple credit cards and exhort card holders to pay in time within the cycle of repayment, resisting the temptation to postpone. The cost of delay is an exorbitant interest rate (higher than the rate on any other form of loan) that is often hidden in the fine prints. The immediate benefits of convenience and instantaneous consumption cloud out prudence. One can see debt addition in full play as the consumer struggles to come out of it, impoverished.
It is interesting to recall the Quranic verse cautioning against gambling and addiction.
“They ask you about wine and gambling. Say, in them is great sin and (yet some) benefit for the people. But their sin is greater than their benefit.” (2:219)
The verse does not completely rule out the accrual of some apparent benefits. Arguably, the convenience factor with credit cards or consumer credit has some benefits. But there is much greater harm as it often leads to impoverishment of the users. The prohibition of riba holds also on the grounds of riba leading to addiction and ruin for the addict.
Riba and Microfinance
Conventional microfinance has often been touted as the solution to the challenge of poverty. Yet, the sector has witnessed major pitfalls and crises almost wherever this has been attempted. There is either mixed evidence on its success (say, in Bangladesh), or serious charges of leading to further impoverishment and often no-pay movements (as in Nicaragua, India, Bosnia Herzgovina, Latin American countries). A careful examination of the lending methodologies adopted in conventional microfinance would show the presence of almost all the elements of classical riba — high (usurious) lending rate, ultra-easy and convenient loan sanctioning and disbursement process, easy extension of credit period via rescheduling by increasing the loan amount, few checks on multiple borrowing. One can clearly see a process of creating debt-addiction at work.
The solution of Islamic finance for meeting the challenge of poverty is both through charitable finance (grants via zakat and sadaqah) and non-profit interest-free financing called qard hasan. The zero-cost financing is recommended in Islam through qard hasan that translates to a beautiful loan on the part of the lender as there is no material gains associates with it for him/her. The lender provides this loan purely to earn the pleasure of his Creator and gains in the hereafter. The absence of price signal induces no distortion in the resource allocation process, since it creates wealth outside the profit-oriented segment of the economy and adds to the wealth and well-being of its people. The possibility of debt-addiction is kept in check as there is neither a price, nor a market for such debt.