Pitfalls

In
Economic Thinking

Present economic systems are based on some fallacies that, by the lapse
of time, have been accepted as if they represent a part of the natural life
which people have to live with.

HOW CAN WE GET RID OF THEM?

Maher Kababji
maherkababji1@hotmail.com

Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1902705
http://ssrn.com/abstract=1902705
 Introduction

While economics studies the many activities undertaken in relation to wealth, economic
systems organize the ways by which a society utilizes available resources so as to produce
wealth and the ways by which wealth is exchanged and distributed. Each economic system has
its own peculiar features which form its foundation and from which it can be distinguished and
recognized. The most dominant economic systems at present are capitalism and socialism.

Socialism denotes an economic system of state ownership, and/or worker ownership, of the
means of production and distribution. Abolishment of the rights of private ownership and
economic freedom leads to management of means of production by bureaucracy. Bureaucracy
results into inefficiency and low production since the money incentive is lost and the bureaucrats
lack initiative and follow rigid rules. Bourgeois class is liquidated and strong dictatorship of the
proletariat class is established. Mainly, the lack of motivation of profit is responsible for the
failure of the socialist planned economies.

In theory, capitalism is an economic system which is characterized by private ownership of

the means of production, and unrestricted economic freedom. In practice, capitalism leads to
concentration of wealth in few hands, earning of wealth through foul means, and destruction of
minor enterprises and firms. The institution of interest has become the major part of capitalism.
By the lapse of time, capitalism has been transformed into the recent monopoly-finance
capitalism leading to regional and global financial crises.

Mixed economies refer to an economic system in which governments hold state ownership
of major and economically vital industries while permitting capitalism to continue in the rest.

Some Islamic countries apply what is called Islamic economic system. They imitate
present economic policies. Controls over interest rates are replaced by controls over profit rates
on Islamic certificates. Controls over volume of these certificates replace controls over volume
of credit. Traditional fiscal policies are used to control prices, wages, and taxes. Welfare systems
are applied for redistribution of wealth. Interest based banks are replaced by interest free banks.
Islamic banks introduce different financial instruments as an alternative to the interest-based
products provided by traditional banking. The difference is that Islamic financing products are
based on selling or renting assets for generating profit, while traditional financing products are

Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1902705
http://ssrn.com/abstract=1902705
mostly based on lending activities for generating interest. Marketable Islamic profit-sharing
certificates are also issued as an alternative to the marketable interest-based bonds.

In spite of the fact that each of present economic systems has its own features, they share
same common characters. Money controls economic growth. Financial activities represent
majority of economic activities. Money plays an inflationary role. Present systems consider
living with inflation. The extensive growth of government services reflects the high growth of
public expenditures and the increase in public debts. Legalized monopolies and fiscal policies
limit freedom of market. Instead of directing all resources toward production, non-productive
sector of the economy has provided a considerable outlet for seeking easy profit in form of
interest or through appreciation of financial assets. As financial markets all over the world are,
directly or indirectly, linked together, globalization brings up the impact of economic
performance of other countries on domestic economy.

The bursting of several financial bubbles in last four decades points to the fact that present
economic systems have failed to achieve the goal of prosperity. Consumers are being hard hit by
inflation. Growing inequality of income and wealth causes a relatively small number of
individuals and corporations control huge pools of capital. Most of resources are directed toward
financial activities.

This research assumes full responsibility of inflation for the failure of present economic
systems to achieve the objective of prosperity. In its first chapter, the research gives different
definition to inflation and illustrates its destructive roles. The second chapter explains the
inflationary role of money and introduces different monetary theory based on viewing money as
just a thing invented to be a medium of exchange. In the third chapter, optimal output growth and
fair distribution of wealth are presented as the aim of a sound economic system. The fourth
chapter introduces an integrated inflation-free economic system. Finally, the last chapter presents
the ideological viewpoints of Islam with regard to economy.

ِThe world is looking for an alternative economic system that would reflect fair economy.

Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1902705
http://ssrn.com/abstract=1902705
 CHAPTER 1

Inflation
The magic to concentrate wealth

In economics, inflation is defined as a rise in the general level of prices of goods and services.
Keynesians believe that inflation is a pricing phenomenon. They propose that inflation is the
result of pressures in the economy; an increase in aggregate demand, a drop in aggregate supply,
or a rise in labor cost. From the viewpoint of the Monetarists, inflation is regarded as erosion in
the purchasing power of money. They assert that inflation has always been a monetary
phenomenon. When the price level rises, each unit of currency buys fewer products.

Inflation as a pricing phenomenon

A distinction between fair price and market price introduces a different approach for
understanding the phenomenon of inflation from the pricing aspect.

1- Fair price
Fair price represents the total sum of returns to the real factors of production. Production is a
process of converting inputs into outputs. It includes excavation of new products, adding value to
available products, moving products to a different time or place. Products take the form of goods,
services, or assets. A mine excavates raw material, a factory transforms raw material into
products, a retailer adds marketing services to products, and a doctor provides professional
services.

Human and natural resources represent the primitive factors of production. Only labor force out
of human resources may be employed for production. Out of natural resources, only discovered,
dominated, and extracted materials may be exploited in production. The production process
requires the combination of labor and materials. The combination cannot be achieved unless an
investor is willing to bear investment risk. Accordingly, the real factors of production and its
returns may be classified as follows:
 Material refers to all productive items that add value to national product. It includes those
resources ready to contribute in production process, such as machines, roads, equipments,
buildings, energy, seeds, and raw materials. Investors are obliged to pay for the prices of
needed material; therefore they are entitled to charge consumers for rent (or cost of
depreciation) as return for material.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Labor refers to all types of physical and mental efforts directed at production. It includes
planning, management, and decision-making. In return for labor, investors have to pay wages
in cash or in form of benefits. Investors are entitled to charge consumers for wages.
 Investment risk is an intangible asset which causes hardship for the investor. Profit is
regarded as reward given to investors for bearing investment risk and for their contribution to
the production process. In the absence of profit, there will be no incentive for investors to
take investment risk.

The fair price of a product represents the total sum of returns to the factors of production (rent,
wages and profit). Natural price system determines the fair price as a result of free interaction
between the two factors of demand and supply in a market characterized by free competition.

A natural rise in cost of material, wages paid to labors, supplier‟s profit margin, or volume of
demand relatively to the volume of supply results in natural price increase. Natural rise in price
of a product reflects an increase in its real value. If the price of steel goes up because of a
shortage of supply, the rise of the price of buildings will reflect an increase in the real wealth of
its owners.

Natural increase in prices of some products has negligible impact on the general level of fair
prices because of the interaction of market forces, the huge variety of products and the
continuous discoveries and technological developments;
 Higher price encourages investors to increase quantity of supply. Lower price encourages
consumers to increase quantity of demand. Natural free interaction of demand and supply
returns the market price to the equilibrium point where quantity of demand balances with
quantity of supply and fair price is determined. Increased competition among suppliers
lowers their profit rates and prevents greed.
 The huge variety of products makes the fall in prices of some products offsets the increase in
prices of some other products.
 Continuous discoveries and technological developments help price reduction because they
provide competitive products, cheaper substitutes, and economical methods of production.
For example; prices of electronic equipments are continuously declining.

2- Market price
Market price of a product represents the amount paid by a consumer to acquire the product. It
includes additional charges over the fair price. Such charges, which are not related to production,
will be referred to as “inflation charges”.
Inflation charges constitute a major part of the market price of any product. They are included,
directly or indirectly, in the total cost of products. A breakdown of market prices shows that
inflation charges include taxes, financing charges, and hidden inflation tax, in addition to the
excess profits generated by producers.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Taxes include all type of present taxes such as custom duties, production tax, purchase tax,
and other before-sale taxes, indirect taxes, business income tax, labors income and social
security tax paid by labors, social security tax paid by investors, in addition to after-sale tax
and value added tax.
 Financing charges represents interests or any type of returns for lending money to suppliers.
In reality, interest is the reward to lenders as the return to borrowed money. But, in their
classification of the factors of production, economists consider interest as return to capital.
This entitles investors to generate interest in addition to their profit as return to another factor
of production known as enterprise.
 Hidden inflation tax refers to the reduction of value of the currency unit as a result of the use
of money for paying interests on credits granted to other than suppliers, profits on speculative
activities, and earnings from corrupted and illegal transactions.
 Excess profits generated by suppliers as a result of monopolistic advantages.
 Excess profits generated by suppliers as a result of the increase in the cost of production by
the inflation charges. Normally, suppliers care about their after-tax net profit.

Unlike the natural rise in price of a product which reflects an increase in its real value, a rise in
inflation charges results in an intentional increase in prices of all products and the general level
of prices.

Inflation charges are responsible for the intentional increase in the general level of market prices.

Inflation as a monetary phenomenon

A distinction between the total sum of returns to the real factors of production in term of
monetary units, which will be referred to as “Productive Money”, and the total sum of returns
from all operations of the economy in term of monetary units, which will be referred to as
“National Money”, introduces a different approach for understanding the phenomenon of
inflation from the monetary aspect.
1- Productive Money
As returns to the real factors of production, productive money represents the total sum of income
form of rent, wages, and profits.
2- National money
National accounts translates an equilibrium situation which is based on the balance between
national product, national expenditure and national income, where; national product represents
the sum of value added over whole economy in form of final sales, national expenditure
represents the total of purchases of final goods, and national income refers to the sum of returns
received by members of the economy.
National Product National Income National Expenditure

Electronic copy available at: https://ssrn.com/abstract=1902705

Income forms the link between output and expenditures and explains the equilibrium situation.
The sale of output is paid out as incomes used to buy the output. Members of the equation are
expressed in term of currency units. National money represents the total sum of income from all
operations of the economy. The equation of national accounts can be introduced as;
National Output = National Expenditure = National Income = National Money

National money, which equals national income, includes:

 Productive money which represents returns from productive activities in form of rent, wages
and profits.
 Inflation money which represents returns from non-productive activities. It takes many
forms;
 Returns to lenders in form of interest or any other type of financing charges.
 Returns to speculators in form of speculative profits.
 Returns to government in form of taxes.
 Returns to corrupters in form of illegal gains.
 Excess returns to suppliers as a result of monopoly.
 Excess returns to suppliers as a result of intentional inflation.

Inflation money represents the excess of national money over productive money. It is used to pay
taxes, interests, speculative profits, illegal earnings and excess profits to suppliers.

According to the equation of the national accounts, national product is valued at much higher
price than it is worth, and general level of market prices is much higher than the general level of
fair prices. If national product at fair price equals $1 billion and national money equals $10
billion, it is a matter of truism to say that the national product at market price equals $10 billion
and the average market price of a unit of the national product is 10 times its fair price.

Excessive expansion of money reduces the value of the currency unit. Suppliers have to pay
more monetary units for material and labor. Consumers have to pay more currency units for final
products of goods, services, and assets.

Inflation money is responsible for the intentional decline in the value of money.

Definition of inflation
Having both pricing and monetary aspects into consideration, it is obvious that:
 Inflation charges and inflation money are of equal amount and that inflation money is used to
pay inflation charges.
 From one side, inflation represents the excess of the general level of market prices over the
general level of fair prices. Fair prices reflect the sum of returns to the real factors of
production.

Electronic copy available at: https://ssrn.com/abstract=1902705

 From the other side, inflation represents the excess of quantity of money over quantity of
money needed to pay returns to the real factors of production.
 Natural increase in the fair price of a product reflects an increase in real wealth and does not
produce inflation.
 Inflation can be defined as an intentional reduction in the value of monetary unit or as an
intentional rise in the general level of prices.

Inflation is an intentional man-made phenomenon.

Effects of inflation
Inflation represents the main cause of concentration of wealth. Also, it causes economic
instability.

1- Concentration of wealth
Causes of inequality in distribution of income among people may be classified as follows:
A. Natural inequality: It is a result of the different contribution in the production process. It is a
fair natural phenomenon. It has its justification as long as people have different capacities.
B. Intentional Inequality: It is the result of special advantages legally given to a group of
individuals or corporations so that they can increase their share in national income. Inflation
is used to legalize many forms of such advantages. It creates intentional inequality through
making private gains on account of public losses;
Gains to lenders
 Interests generated by lenders as return on public debts are charged to public in form of
tax which is public loss. This helps redistribution of wealth from public to lenders. In his
article “The biggest financial crime in the history of the United States” addressed to the
US citizen via Internet, Dr. Don J. Grundmann, D.C., M.H. says: “Since in 1996
approximately 40% of the United States budget went to the payment of interest on the
national debt”.
 Interests earned by lenders on debts to finance non-productive activities are charged to
public in form of hidden inflation tax. The excess of money supply used to pay the
interest is translated into reduction in the value of the currency unit.
Gains to suppliers
 Taxes paid by producers to government are charged to consumers in form of price
increase. Unlike business owners who have tax shelter, consumers do not have similar
opportunity to restore their payments of taxes.
 Interests generated by lenders on credits provided to finance productive activities, are
charged to consumers in form of price increase. Viewing this interest as return on capital
entitles producers to restore interests in addition to generate investment profits. In
practice, interest is a return on money which cannot be included in capital as a factor of
production it is transformed into a real factor of production (material or labor).

Electronic copy available at: https://ssrn.com/abstract=1902705

  Excess returns to suppliers as a result of monopoly or intentional inflation are charged to
consumers in form of price increase.
Gains to speculators and corruptors
 Profits generated by speculators and those who act corruptly, are charged to public in
form of hidden inflation tax. The excess of money supply used to pay the profits is
translated into reduction in the value of the currency unit.
Gains to banking sector
 The money creation process makes the banking sector the wealthiest sector. Assume that
a central bank sets the obligatory reserve to be retained by banks to 10% of deposits.
This allows banks to loan 90% of deposits. If a bank received a deposit of $1000, the
bank can lend $900. If the borrower used the loan to buy products, and the seller
deposited the amount into a bank account, banking deposits will be $1900, out of which
$810 can be loaned, making the total deposits $2710, and so on. In theory, on receipt of
an original deposit of $1000, the banking sector can initiate new deposits which increase
volume of money in circulation by $9000, and can lend $9000. Assume 5% is the interest
rate on deposits, and 8% is the interest rate on credits, the banking sector will pay $500 to
depositors and gain $720 from borrowers. As a result of the money creation process, the
banking sector makes profit of $220 or %22 instead of $22 or %2.2 (((900 X 8%) – (1000
X 5%)) / (1000 X 100)). This advantage is not available to other economic sectors.
 Compound interest system increases profits of the banking sector. Banks normally
charges borrowers interest on the interest on daily or monthly base.

Intentional concentration of wealth has destructive impacts on societies;

 Impacts on living standard: While living standard of rich rises, living standard of middle
class and poor declines. Those living on fixed incomes suffer a severe decline in their living
standard.
 Impacts on social life: Concentration of wealth has social costs like alcoholism, families
breaking up and increased criminal rate. The state of harmony and cooperation between
peoples is replaced by a state of hate, hostility, and envy. Inequality is a main cause of public
demonstrations, political instability and revolutions.
 Impacts on economic activities: Concentration of wealth helps the shift of investments
toward financial activities so that rich can generate easy profits in shorter period.
 Impacts on productive activities: Concentration of wealth in few hands creates a constant
pressure for the most profitable large scale investments rather than ecological investments
related to prosperity. Profits in the military sector are far greater than any profits made in the
civilian sectors. Profits on luxuries are higher than profits on necessities.
 Impacts on market freedom: Concentration of wealth enables rich to control commodities
markets through monopoly and speculations. The sharp rise of prices of oil during last years
is a direct result of speculation on false contracts of buying oil.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Impacts on ruling authority: Concentration of wealth enables a tiny group of oligopolists to
dominate both economy and policy through direct involvement in the ruling system or as a
return for their spending on the election campaigns.

2- Economic instability
As an intentional rise in the general level of prices, inflation is responsible for market
fluctuations that do not secure steady exchange of goods and services. As an intentional decline
in the value of the monetary unit, inflation is responsible for the deterioration of the confidence
in the currency;
 Inflation wreaks havoc in society.
Prices soar, workers have less money to consume, demand falls because each monetary unit
buys fewer goods and services, exports become more expensive to sell, imports increase
because they are relatively cheaper than locally produced products, saving is discouraged
because consumers have to spend more, pressure for increased wages mounts to keep up with
consumer prices, rich generate profits from appreciation of their assets, and business owners
stand to gain from increased profits. Eventually, inflation charges are paid by consumers.
 Money of innocent people is at risk.
Most of money invested in financial markets is borrowed money. Banks and financial
institutions lend investors and speculators money borrowed from depositors. Most of
premiums paid by people to social security, retirement entities, and insurance companies are
deposited in banks or invested in speculative activities and financial markets. Protection of
deposits is introduced to justify the use of money owned by public to support financial
system in case of breakdown. Supporting financial institutions and speculators in case of
crisis is a sort of social oppression because people have to settle the public debts via
increased taxes.
 Utilization of resources in non-productive activities.
The progressive shift from production to financial and speculative activities is a result of the
excessive expansion of money. The shift inflicts greatest harm to the society in form of
unemployment, inflation, and concentration of wealth.
 Growing financial corruption
Reliance on public debts helps excessive expansion of government spending and growing
financial corruption. World Bank report “The Many Faces of Corruption” underlines, “the
nature and quality of a country‟s PFM (Public Financial Management) system to a large
extent determine the ease with which public corruption can occur”.
 Value of currency is at risk.
Inflation rate may rise at very high levels destroying the confidence in the currency and
leading to currency devaluation. Currency speculation is considered a highly suspect activity.
In 1992, currency speculation forced the central bank of Sweden to raise interest rates for a
few days to 500% per annum, and later to devalue the Swedish krona.
 Breakdown of the market economy.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Reliance on foreign investments for development can cause a breakdown of the market
economy. Speculative investments are very unstable. The sudden removal of capital from a
country can result in a severe economic crisis and hardship for the people. Inflationary
process is potentially unstable, and can accelerate into hyperinflation. Soviet economy had a
period of hyperinflation from 1921 to 1924.
 Global risk.
As a result of globalization and technological developments, financial markets, money
markets, stock markets, and commodities markets all over the world are, directly or
indirectly, linked together. Globalization makes economic performance of other country or
countries affects domestic economy.
 Financial crises
A historical review of financial crises explains the destructive role of lending and speculative
activities on societies and the failure of monetary remedies to prevent the ghastly impacts on
economic growth. The excessive expansion of credit is responsible for the Wall Street Crash
of 1929, the 2008 US Mortgage Crisis, the 1997 Asian Financial Crisis, 1998 Russian
Financial crisis, and the Latin American Debt crisis.
 Poor countries
Reliance on foreign public debts for development involves an oppressive operation by which
rich countries and giant lenders make profit in form of interests on account of poor countries.
Over and above a poor country has to respect the terms and conditions of granted loans
which may have severe impacts on its sovereignty. Natural resources of poor countries are
used to pay foreign public debts and interests.

Control of inflation
Control of inflation is one of the most intractable economic problems facing a government. In its
effort to control inflation, monetary authorities apply monetary controls over interest rate, bank
discount rate, money supply, and currency exchange. Also governments employ fiscal controls
over prices, wages, government expenditure, and taxes.

In general, the common impact of all these remedies is that they control, directly or indirectly,
the expansion of credit. Credit squeezes may discourage investment in financial economy, but it
causes economic slump, reduces national product, and raises unemployment rate. Expansion of
credit may stimulate investment in financial economy, but it has bad impact on productive
economy because it raises the inflation rate and develops destructive inflation‟s consequences.

A monetary authority tries to balance between positive and negative results of the controlling
process, but in all cases they cannot prevent economic instability. Markets may not respond in
the way expected by the authority.

Electronic copy available at: https://ssrn.com/abstract=1902705

A failed monetary policy can have significant detrimental effects on the society. These include
hyperinflation, stagflation, recession, high unemployment, inability to export goods, and even
total monetary collapse.

Do we have to live with inflation?

Most economists recommend living with moderate inflation. They claim that:
 While the primary aim of macroeconomic policy is stated to be realization of full
employment and optimal growth without inflation, this objective is not yet a feasible target.
The real choice is different combinations of growth and employment from one side and
inflation on the other side.
 Moderate inflation helps realization of full employment and optimal growth because it
provides an incentive for investment as long as prices are rising and are expected to continue
rising. By moving to full employment, a country could have more output and more income
for everyone.
 There is no way to cure inflation without moving the economy into recession. It may be
better to live with moderate inflation than to pay the costs of its cure.

No doubt that inflation provides an incentive for investment because of the increased profits
generated by investors, and that the direct result is an increase in supply and a decline in
unemployment rate, but this is just a temporary reaction. It will not last too long as supply will be
reduced to balance with the fall in demand which is the result of inflation. Inflation makes labors
in worst shape. Normally, the rate of increase in wages is less than the rate of the rise in cost of
living.

The simple relationship between growth and employment is quite clear. Optimal growth refers to
the level of output when economy is operating at capacity. Also, full employment refers to the
level of employment when economy is operating at capacity. The shortage of actual output in
comparison to the possible output reflects unused resources. Also, unemployment represents
unused resources.

The conflicted relationship between these two variables (growth and employment) and inflation
is a false statement made to present inflation as unavoidable phenomenon;
 Production has relation with productive money. An increase in productive money is
translated into growth of output and decline in unemployment rate by creating employment
opportunities in productive sector.
 Inflation represents inflation money. An increase in inflation money is translated into growth
of financial and speculative activities and decline in unemployment rate by creating

Electronic copy available at: https://ssrn.com/abstract=1902705

 employment opportunities in non-productive sector. If equal amount of inflation money is
used in productive activities, equal or more employment opportunities shall be created.
 Moderate steady inflation is a hypothetical target. Present economic policies failed to
introduce an example of a society living permanent moderate inflation. Economic instability
is a common feature of present economies.

Should the inflationary charges (taxes, interests, speculative profits, and illegal earnings) are
discarded; both targets of higher rate of growth and lower unemployment rate can be realized
without inflation. It is possible but not so simple, because present economic systems have
assigned important roles for inflation charges; taxes normally represent a main source of revenue
to finance public spending, part of lending transactions are directed to finance development and
productive activities, financial and speculative activities provide opportunities to invest the
excess of money supply.

Viewing inflation as an unavoidable phenomenon is one of the main pitfalls in

economic thinking.

Electronic copy available at: https://ssrn.com/abstract=1902705

 CHAPTER 2

Money
The inflationary tool

In early forms of society goods were exchanged by a process of swapping known as barter. An
axe was bartered for a hen, or a big was bartered for grain. The difficulty of subdivision of goods
used in barter and the dependency on a double coincidence of wants gave rise to the need for a
common denominator to facilitate the process of exchanging products and evaluate products to
be bartered.

The inconveniences of the barter system led to the move to a common system of exchange
involving the use of a commodity which was acceptable to all in the community. Many
commodities such as shells, stones, and birds were used as a medium of exchange. In ancient and
medieval nations, states, as controller of the mint, made pieces of ingots out from metal, such as
gold or silver. Value of the metal ingots comes from the commodity out of which it is made.

The gold specie standard arose out of the need of a universal currency to be used in international
trade. It is a system in which the monetary unit is associated with circulating gold coins of
certain specifications, or monetary units made from other metal stated in terms of gold. The
currency unit derives its value from the specie out of which it is made, and the rate of exchange
of the currency unit for a foreign currency unit reflects the comparative worth of the specie out
of which each currency is made.

Because commodity money is inconvenient to store and transport, it gave way to representative
paper money backed by gold and other species. distinct kinds of gold standard were developed;
 The gold bullion standard is a system in which paper money is convertible into gold bars at a
fixed rate. The currency unit derives its value from the specie by which it is backed and the
rate of exchange of the currency unit for a foreign currency unit reflects the comparative
worth of the specie by which each currency is backed.
 The gold exchange standard is a system in which the rate of exchange of the currency unit of
a country which may possess no gold reserve is expressed by a rate of exchange between that
country and a country which is on the gold standard.
 The modified gold exchange standard was established after the Second World War, by the
Bretton Woods Agreements. Under this modification the U.S. promised to fix the price of
gold at approximately $35 per ounce, the US dollar was introduced as a universal reserve

Electronic copy available at: https://ssrn.com/abstract=1902705

 currency and most countries fixed their exchange rates relative to the U.S. dollar and settled
their international balances in U.S. dollars.

The gold standard collapsed because some countries refused to deflate or inflate at the time of an
outflow or inflow of gold to keep up with equilibrium in the balance of payments which affects
rates of exchange. The fiscal strain of federal expenditures for the Vietnam War and persistent
balance of payments deficits, led the U.S President Richard Nixon to end the direct convertibility
of the dollar to gold on August 15th 1971, at which time nearly all nations had switched to full
fiat money.
Fiat money is a valueless thing neither made of nor backed by valuable specie or foreign
currency reserve. It is state-issued money made of material of negligible cost in form of paper
and coins. It is declared by a government to be legal tender. Issuance of fiat money initiates
public debt. As a result, the fixed exchange rate system was replaced by two distinct exchange
systems;
 Under the new fixed exchange rate system, the rate of exchange is fixed by the government
and the equilibrium in the balance of payments is maintained by control of transactions
involving foreign currency.
 Under the free exchange rate system, the exchange rate fluctuates. It is determined by supply
and demand in the foreign exchange market, so that the rate automatically reflects the change
in the balance of payment. In case of a deficit, the price of the national currency would fall
relatively to foreign currencies, and as a result domestic goods would be cheaper in foreign
markets, exports would increase, imports would fall and the deficit would be eliminated.

Whether it is backed by commodities or foreign currencies or initiates public debt, money issued
by monetary authority does not represent an important part of money in circulation. Present
economies are characterized by accelerated increase of credit money and substitute money.

Originally, credit money was developed to fulfill requirements of exchange of goods and
services on credit base. Credit money is any financial instrument which is not immediately
repayable and can fulfill the functions of money such as a treasury bills, saving bond, corporate
bond, banknotes made by banks payable to bearers on demand, bank money market account
certificate, negotiable commercial papers. Personal checks, certified checks, traveler‟s checks,
cashier checks, debit cards, and banking transfers represent substitute money. The law
recognizes no difference between the different types of money as instrument of debt settlement.
Credit money involves some element of risk; the claimant may default, the value upon
fulfillment will differ from the value at the time of purchase, and credit money as a claim to
money may be transferred over and over again in an indefinite number of indirect exchanges
without the person by whom it is payable ever being called upon to settle it in case of selling
without recourse.

Electronic copy available at: https://ssrn.com/abstract=1902705

Following factors may be presented as causes for the increase of credit money to the extend it
becomes the primary type of money in circulation;
 Money creation process which increases volume of banking deposits as a result of lending.
 Refinancing instruments, such as the marketable mortgage securities.
 Rediscounting of bills by a central bank in order to provide extra cash to banks.
 Lending speculators on margin base so that to make them able to buy financial assets in
return for paying a certain percentage of its value.
 Rapid progress in telecommunication technology to link financial markets all over the world.

The World Bank has estimated that money transactions on a world wide scale are from 15 to 20
times greater than necessary for financing world trade.

The huge difference between money transactions and money needed for exchange by products
represents excessive expansion of money. If a consumer paid $20 for a product worth $1, the
difference is inflation money. It explains the inflationary role of money, the sharp rise in taxes,
the excessive and imprudent expansion of credit, the rapid growth of speculative money
circulating the world searching for investment opportunities, and the hasty increase of illicit
money generated by bribery, theft, organized crime, false deals, illegal transactions, and
corporate dealings of tax evasion.

As inflationary tool, money acts beyond its scope of function as a medium of exchange of
products. It is exchanged for taxes, interests, speculative profits, and illegal earnings. The
inflationary role of money explains the drawbacks of present monetary systems.

As long as money plays an inflationary role, no matter the types of remedies,

societies suffer from intentional concentration of wealth and economic instability.

What does it make money play an inflationary role?

Money was a product made of, or fully backed by, precious metals. Except for the small portion
of issued money which is backed by a real commodity such as gold, present money is no longer a
valued commodity, a thing backed by a commodity, or a thing backed by a currency reserve
which is backed by a commodity. Nowadays, money is made of material of negligible cost. It is
just paper money or coins issued or mint by the monetary authority, substitute money, or credit
money created by financial institutions. Present money is just a great social invention which can
be defined as a valueless thing that is generally accepted to function as a medium of exchange
for acquiring products or services and repayment of debts. Economists define money as anything
that is widely used as means of exchange and agree that money is not in itself wealth and that
money has no intrinsic value by itself.

Electronic copy available at: https://ssrn.com/abstract=1902705

 In spite of the change in its nature, money is still regarded as a valued commodity
rather than a valueless medium of exchange.

Does it make any difference?

The answer is based on a comparison between how money is functioning as a valued commodity
and how it will function as a valueless medium of exchange. The comparison leads to
presentation of a different monetary theory based on viewing money as a valueless medium of
exchange.

Issuance of money
Since money is viewed as a valued commodity, the issuance process represents a transaction of
buying money. Issuer of money determines a selling price. Money is sold at its face value for a
price to be paid at issuance or at later date.
 For spot buy, public resources are used to buy currency backing in form of precious metal or
foreign currency reserve.
 For credit buy, a public debt is initiated. Taxes are imposed to settle public debt.

1- Issuance of money backed by currency backing

Currency backing is just a historical tradition. In his book “Modern Economics – Principles and
Policy (1972), Kelvin Lancaster of Colombia University says “From one point of view, currency
backing is inherently ridiculous and based on public lack of comprehension about the nature of
money, but it has one aspect that was of great historical importance: If the currency must be
backed, wholly or partially, by something that is inherently scare, there is a built-in-guarantee
that the currency itself will remain scarce.”.

In practice, getting rid of the currency backing is justifiable;

 Most of money in circulation worldwide is credit and substitute money, not issued money.
Issued money in USA as at January, 2007 was 750.5 billion dollars, while commercial bank
money (in M2) was 6.33 trillion dollars. Credit money is not backed.
 Since the President Richard Nixon declared the end of direct convertibility of the dollar to
gold, the biggest economy in the world becomes not liable to retain currency backing.
 Currency backing has no effect on prices of products. If the price of oil in the international
market is stated to be $70 per barrel, this price will apply for exports of oil from Saudi
Arabia which has stable currency as well as from Iraq which has deteriorated currency.
 Backing gives a changeable value to the currency unit. Money backed by gold, silver, or
other foreign currencies derives its value from the material by which it is backed. The value
of the backing material fluctuates as a result of the interaction of the forces of the market.
The value of fiat and credit money changes as a result of the control over quantity of money.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Giving a changeable value to the currency unit does not comply with the function of money
as a common denominator to measure values of products.
 Currency backing involves hoarding of resources that can be utilized in productive activities.

2- Issuance of money backed by public debts

In practice, the process of issuance of fiat money assumes liability on public to settle public debt.
 Taxes levied to pay public debt are translated into intentional inflation.
 Issuance of fiat money based on initiating public debt contradicts the definition of a debt as a
result of borrowing or credit sale.
 On issuance, public receive nothing. Neither they acquire money on credit nor do they
borrow money. Legally and logically, it is unfair to make public liable for issuance of
things not yet delivered to them.
 On delivery, in form of public expenditures or loans provided by the government to
others, fiat money is transformed into real assets or debts.

When money is viewed as a valueless medium of exchange, the issuance process is regarded as a
process of issuing a valueless thing. At issuance, money will not be given any value. Money is of
zero value. The face value is just an indicator to the number of currency units expressed by the
paper or the coin used as a currency. Neither currency backing will be required to be retained nor
will a public debt be required to be initiated.
 Since currency backing will not be required, it will be utilized in development.
 Since public debt will not be initiated, taxes will not be levied on issuance of money.
 The real backing of the currency is the confidence that the currency gives to its holder a right,
which can be exercised at any time, to obtain products for the value of money. National
output guarantees this right.

National output is the real currency backing

Money before being used for exchange

Since money is viewed as a valued commodity, money is available in the market like any other
commodity.
 Money becomes subject to demand and supply. Demand expresses the desire to buy money
as a property. Supply refers to the quantity of money offered for sale. The value of currency
unit fluctuates.
 Money supply is affected by the fiscal and monetary policies applied by money suppliers.
Demand on money is affected by the flow of investments.

When money is viewed as a valueless medium of exchange, money will not be a marketable
commodity.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Money will not be subject to the market forces because it is not a product.
 Money will be retained with its zero value until being used in exchange transactions.

Money in use for exchange

Since money is viewed as a valued commodity, the exchange process represents a process of
selling money.
1- Money is sold for free. Payment of inflation charges (Taxes, Interests, Speculative profits,
and Illegal profits) does not involve an exchange process, as payers (the public) receive
nothing in return of selling money. Those who receive income from non-productive activities
steal money from public.
2- Money is sold for profit. Lending money for profit represents a process of sale of money on
credit in return for interest.
3- Money is sold for a product (goods, assets, or service). Selling for a product involves an
evaluation process in which money acts as a measure of value.
 Because the currency unit, as a commodity, is given fluctuated values during circulation
before being in use for exchange, the price of the product is given in terms of currency
units valued at the date of selling.
 The price of the product is affected by the value of the currency unit at selling date.

As a result of the exchange process, money does not express the real price of the product subject
to evaluation. Its value reflects a mix of impacts of the market forces on both the product and the
money itself. This highlights the issue of the neutralization of the money as a measure of value.

Value of money
As a measure of value, money acts as a measuring rode to enable its holders to measure value of
products. For a subject to be fairly measured, a measure must be subject to the criterions of the
measuring units:
 A measure must have no intrinsic value by itself so that values of subjects would not be
affected by the use of the measure.
 A measure must express value in common terms so that values of all subjects can be
expressed in same generally accepted terms such as kilogram, mile, and dollar.
 A measure must be stable so that all subjects can be valued and compared in constant
common terms. A certain length of a road measured as 10 kilometers in a certain moment,
may not be measured as 11 kilometers in other moment without the road becomes longer.
Similarly, a ton of cement valued at $40 in a certain moment, may not be valued at $45 in
other moment without the market price, which is freely determined by demand and supply,
becomes higher.

Electronic copy available at: https://ssrn.com/abstract=1902705

Like any other measures, money must be subject to the criterions of the measuring units so that
products can be fairly valued. Simply, money has to act as constant common denominator
(standard).

When money is viewed as a valueless medium of exchange, money will act within its scope of
function as a medium to be exchanged for products.
1. Money will not be used to pay inflation charges (Taxes, Interests, Speculative profits, and
Illegal profits). Inflation charges are not products.
2. Money will not be used as a profit generator. Interest free lending money will reflect social
cooperation and represent a transaction of money transfer.
3. Money will practice its function as a medium of exchange. Exchanging money for a product
(goods, assets, or service) involves an evaluation process in which money acts as a measure
of value.
 The currency unit will act as a constant common denominator to measure values.
 The currency unit will derive a value from the price of the product subject to evaluation.
It is a matter of truism to say that;
Value of currency unit at exchange = Quantity produced / Amount of production
In other words;
Value of currency unit at exchange = 1 / Price of one unit of the product
Value of currency unit is expressed in term of number of units of product. If the price of
one kilo of rice equals 2 currency units, the currency unit will derive a value equals to 0.5
kilo of rice.

After being exchanged, the valueless money will become a legal tender with certain value which
fairly expresses the market price of the product at the date of exchange.

Money after being used in exchange

Since money is viewed as a valued commodity, money is available in the market again.
 The value of currency unit fluctuates again as a result of the interaction of demand and
supply. The value of the currency unit at the date of exchange varies accordingly.

Because of the variability of the value of currency unit, money cannot protect the rights of its
holder to obtain products of future amount equals the amount of the products he might acquire
when he received the money. This questions the reliability of the function of money as a store of
value after being used for exchange.

As a store of value, money must be subject to the criterions of custody. Honesty is the main
character of custody. The principle of honesty requires that:
 Money should be able to be reliably saved, stored, and retrieved.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Future value of money should equal its present value. Money should not gain extra value or
lose value in return to the lapse of time.
 Value of money, as something due to people, should not be devaluated or appreciated.

When money is viewed as a valueless medium of exchange, money which becomes legal tender
will not be available in a market until it will be exchanged again for a product. It will act as an
honest store of value.
 The currency unit will be retained with its value which derived at the date of exchange.
 The currency unit itself will not be subject to the market forces.

As a constant measure of value and honest store of value, money which becomes legal tender
will be able to protect the rights of its holder to obtain products of amount (future value) equals
the amount of the products he might acquire when he received the money (present value). If 1
Kilo of rice was sold for $1, the seller will be able to buy, in the future, the same 1 kilo of rice
for $1, unless the free interaction between demand and supply will determine a different market
price of rice.
As a result of equality of future value and present value, loaned money will not generate interest
or profit and the inflationary role of money will be avoided.

Protection of the rights of the money holders requires that:

1- A legal warranty is to be given to ensure confidence in money as a fair measure of value and
as an honest custodian of value. This warranty is necessary so that money does not lose its
public acceptability.
2- National product evaluated by a constant measure of value is to be sufficient for the rights of
money holders to be practically exercised.

Stability of the value of the currency unit is necessary to maintain the rights of
money holders.

Money in use for further exchange transactions

In practice, money is used in exchange for more than one time.

Velocity of money
Velocity of money refers to the number of times money is used in exchange processes. If the
national product equals 1 billion currency units, and quantity of money equals 0.5 billion
currency unit, it can be said that the velocity of money equals 2 times.
Velocity of money = National product / Quantity of money

Electronic copy available at: https://ssrn.com/abstract=1902705

Purchasing Power of Money
Economists use both terms “Value of money” and “Purchasing power of money” as synonyms,
but a distinction between the two terms is important. Value of money refers to the derivative
value in one exchange transaction. A currency unit may be used in more than one exchange
transaction.

The total sum of values derived by the currency unit in exchange transactions within a certain
period represents the purchasing power of the currency unit. If the national product equals 1
million currency units represents a production of 625,000 kilo of rice priced at 1.6 currency unit
per kilo, and quantity of money equals 0.5 million currency unit, it can be said that the
purchasing power of money equals 1.25 kilo of rice.
Purchasing power of a currency unit = Quantity of product / Quantity of money
In other words;
Purchasing power of a currency unit = Value of currency unit X Velocity of money
Purchasing power of currency unit is expressed in term of number of units of product.

In comparison between two countries (A , B) each of them has currency of value equals to 1.5
units of product, but different velocity which equals 2 for country A and 4 for country B, it
cannot be said that the purchasing power in each country equals 1.5 units of product. The
purchasing power of the currency of A equals 3, while the purchasing power of the currency of B
equals 6 because B used the same quantity of money to produce double the quantity produced by
A (Amount of national product of B equals double the amount of national product of B) .
Increased velocity increases the purchasing power. Similarly, increased value of currency unit
increases the purchasing power.

The purchasing power of the currency unit is dependent upon two variables; value of currency
unit and velocity of money;
 Value of currency unit is dependent upon different unstable prices of different products.
 Velocity of money is subject to many changeable factors such as product mix, production
processes, and marketing facilities in addition to personal behaviors.

These two variables are not controllable and cannot be stabilized, and also there is no way to
figure out the accurate amount of each variable.

Quantity of money
Since money is viewed as a valued commodity, the excess of quantity of money over the quantity
of money needed to pay returns to the real factors of production (rent, wages, and profits)
represents inflation charges (taxes, interests, speculative profits, and illegal earnings).

Electronic copy available at: https://ssrn.com/abstract=1902705

 Economists in charge monitor changes in money supply because of its possible effects on
price level. This leads to a lot of controversy about the concept of money and its value and
underlies reliance on fiscal and monetary policies as a means of controlling inflation.
 Fiscal and monetary policy controls quantity of money.
 Unused money, which includes saved money as liquidity, hoarded money, and money
invested abroad, constitutes a part of quantity of money because it has value.

When money is viewed as a valueless medium of exchange, the excess of quantity of money over
the quantity of money needed to pay returns to the real factors of production will not bring up
inflation or harmful impacts on a society.
 Economists in charge shall consider the shortage of quantity of money so that to avoid
economic recession. Unlike inflation, cure of recession is so simple. Quantity of money will
be increased as needed for productive activities.
 Value of national product will not be affected by the excess in quantity of money. Unused
money has zero value.
 Reliance on fiscal and monetary policies to control quantity of money will be avoided.
Economists shall not care about money supply as long as money will be invested in
productive activities.
 The inflationary role of money will be abolished because the equation of national accounts
will be :
National Money = Productive Money = National Product = National Income

Foreign Exchange
Since money is viewed as a valued commodity, foreign exchange process is regarded as a process of
buying and selling money.
 Exchange rate represents price of buying or selling a unit of a currency expressed by a
number of units of another currency.
 The difference between selling rate and buying rate represents trading profit or loss.
 Exchange rate is determined in foreign exchange markets.

When money is viewed as a valueless medium of exchange, foreign exchange process is regarded as a
process of exchanging a legal tender presented in form of a currency for a legal tender presented
in form of another currency.
 Exchange rate will represent a relative value of the legal tender of a currency to value of the
legal tender of another currency.
 The difference between selling rate and buying rate will be regarded a return for the
exchange service.
 Exchange rate is determined in foreign exchange markets.

Electronic copy available at: https://ssrn.com/abstract=1902705

At present, the US dollar is regarded as the medium of exchange of currencies. The exchange
rate of each currency for one unit of US dollar is used to calculate the cross exchange rate, which
represents the exchange rate of a currency for another currency.

A country may fix an exchange rate for the US dollar, otherwise, many factors are considered for
determination of exchange rates and its trend;
Basic economic indices:
 Value of a currency in comparison to the value of the currency which is considered as a
medium of exchange of currencies. A comparison between the values of similar basket of
products in different countries reflects the difference between the values of currencies.
 Balance of payment of a country reflects its ability to finance external liabilities.
 Balance of trade of a country reflects its ability to finance international trade.
 Interest rate in a country reflects the incoming flow of capital in the short run.
 Speculative activities in foreign exchange markets.
Other economic indices such as;
 Inflation rate, rate of output growth, rate of growth of consumption, and level of economic
activities.
Currency backing and reserves:
 Currency backing, local public debt, foreign public debt, and interest on public debts.
Factors related to the country such as:
 Level of trust in economy, level of political stability, monetary and fiscal policies, and
behaviors of individuals and entities.

Viewing money as a commodity is one of the main pitfalls in economic thinking

Electronic copy available at: https://ssrn.com/abstract=1902705

 CHAPTER 3

Prosperity
The main objective of a sound economic system

Economics is concerned with prosperity as the material aim that contributes to the nonmaterial
ultimate objective of welfare. On the national level, realization of prosperity requires an optimal
utilization of available resources, while on the individual level; it requires sufficiency of income
to meet living needs on acceptable standard of living.

While output growth is the basic problem of a less-developed country with a little output,
distribution of income is the main problem of a developed country that may be growing richer in
the sense of growth in total output without the people in the country growing any richer as
individuals.

Growth of output
The World Bank, World Development Indicators updated Jul 28,2011shows growth rate of world
gross product in comparison to world population growth rate for the period from 1985 to 2005 as
follows:
1985 1990 1995 2000 2005
Growth rate of world gross product 3.9% 3.0% 2.9% 4.3% 3.6%
Growth rate of world population 1.7% 1.7% 1.5% 1.3% 1.2%

The excess of the growth rate of world production over the growth rate of world population
provides evidence that scarcity of resources is not exist on the global level, and raises an issue of
overutilization of global resources. Overutilization of resources is made on account of increased
pollution and represents waste of resources that encourage recycling activities.

On the national level, economic possibilities of the society restrict its growth. Economic
possibilities of a society refer to the existing resources which include labor, capital goods, raw
materials, natural resources, knowledge, and skills. Economic possibilities of a society are not
limited to the available domestic resources. Resources that can possibly be imported from abroad
to compensate the shortage in raw material, technology, products and labor force are considered.

A society must be able to utilize its resources, so that to produce at least a certain minimum
amount of all goods required for attaining at least a minimum level of prosperity. Prosperity is a
relative term. It is limited to the economic possibilities of the country.

Electronic copy available at: https://ssrn.com/abstract=1902705

A society may succeed to attain even higher level of growth needed for realization of prosperity,
but the collection of goods produced by using the available resources may differ from the
collection needed for prosperity. If the difference between the two collections can be
overcompensated through international trade, the goal of prosperity will be attainable; otherwise
a problem of product mix will come up;
 The difference may be a result of giving priority to development on account of consumption.
More resources are devoted to produce capital goods such as factories, machineries,
railroads, and dams.
 The difference may be a result of giving priority to produce goods necessary for war or
natural disasters.
 The difference may be a result of giving priority to luxuries on account of necessities. More
resources are devoted to produce luxury goods such as pyramids and fancy squares.
 The difference may be intentionally made by giving priority to produce goods of higher
profits such as goods required for war in case of peace without expectation of wars.

A society may fail to achieve its goal of prosperity because resources are not fully employed or
inefficiently employed.
 Unemployment of resources may be a result of lack of technology to discover or extract
resources or because of a shortage of funds needed for discovery or extraction processes.
 Resources which can be utilized may not be employed because the decision of utilization is
still not yet taken for political reasons or for a decision made for increasing reserves even on
account of reasonable consumption.
 Inefficient utilization of resources may be a result of low productivity, scarcity of skilled
labors or lack of technology necessary for production.

An economy may be growing in the wrong direction. Growth may be achieved on account of
increased pollution or depletion of available stock of natural resources.

It is the responsibility of a government to plan for efficient utilization of available resources so

that to realize full employment and best product mix, and to avoid pollution and faster
exhaustion of resources.

Optimal growth requires best utilization of available resources

Distribution of income
Present economies are characterized by growth in the rate of poverty and expansion of the
income gap amongst people. A study by the World Institute for Development Economics
Research at United Nations University reports that the richest 1% of adults alone owned 40% of

Electronic copy available at: https://ssrn.com/abstract=1902705

global assets in the year 2000, and that the richest 10% of adults accounted for 85% of the world
total assets. The bottom half of the world adults owned 1% of global wealth.

Economic inequality has existed in a wide range of societies and historical periods; its nature,
cause and importance are open to broad debate. For example;
 Marxists believe that economic equality is necessary for political freedom. They favor
distribution process based on an individual‟s needs.
 Libertarians argue that it is natural to reward some vastly more than others because men are
born unequal.
 The Capabilities Approach looks at income inequality and poverty as form of “capability
deprivation”. When a person‟s capabilities are lowered, they are in some way deprived of
earning as much income as they would otherwise.

In its attempts to eliminate the income gap, governments use different income redistribution
policies. Policies used by governments differ according to its economic system.
 Capitalists adopt some welfare systems. Welfare systems include all forms of public
assistance, such as unemployment compensation, housing, food stamps, free services,
subsidies and cash aid in addition to social security and retirement systems. Present welfare
systems increase public expenditures and labor cost. In general present socioeconomic
systems result in inflation and failed to ensure financial security for the public.
 Socialism failed to realize its objective of equality because labors lose their incentive for
work and because strong dictatorship of the proletariat class is established.

In both capitalism and socialism, redistribution policies are based on extensive growth in the
function of government. This helps concentration of power in addition to wealth in few hands.
Socialism neglects private property rights of public, and capitalism allows rich to legally steal
properties of consumers through inflation.

Causes of inequality
There are many reasons for economic inequality within societies. The factors affect individuals‟
capabilities to accumulate wealth, no matter his work ethic, include natural factors and inflation.
1- Natural factors
Natural factors refer to the natural differential in personal capacities. They include;
 Innate ability:
People are naturally born unequal with different innate ability, such as intelligence,
motivation, strength, or charisma. Some has disability as a result of a birth defect.
 Life-style:
People grow in different living conditions. A child may grow in a poor, dangerous
neighborhood with poor schools and little access to healthcare. Some has disability as a
result of an accident or disease. Rich tend to provide their offspring with a better

Electronic copy available at: https://ssrn.com/abstract=1902705

 education, healthcare, and safe neighborhood. Those who already hold wealth have the
means to invest in new sources to create more wealth.
 Life-cycle:
Normally, neither a child nor an old can earn income from work.
 Society:
Cultures, customs, genders, races, religion and diversity of preferences within a society
affect wealth-acquiring behavior.
2- Inflation
Intentional inequality is the direct result of inflation which allows an oppressive operation to
legalize making private gains on account of public losses. This operation is against values of
all religions, constitutional rights, traditional values and human rights.

Redistribution of income
While inflation allows an oppressive operation, natural factors have its justification because of its
role in generating social cooperation which is necessary for civilization. Should people are
identical, every one of them will have equal role in the society. Different roles are necessary for
people to live in the way they are living. Labors in addition to engineers are necessary to build a
dam. Doctors are not needed unless there are patients. Without social cooperation there will be
no rich. Social cooperation brings up the differentiation in individuals‟ contributions in building
the society and results in different wealth-acquiring behaviors which explains the existence of
poor and rich. .

Therefore, redistribution of wealth is not a matter of applying welfare policies, social security
systems, or giving alms to poor or even looking for absolute equality, but it is a matter of need
and interest of the rich to continuously acquire social cooperation in addition to maintain social
stability. From a Meritocratic point of view, economic inequality is beneficial inasmuch as it
reflects individual skills and effort, and detrimental inasmuch as it represent inherited or
unjustified wealth or opportunities.

ٍ ocial justice requires recognition of the right of poor to be compensated for the natural
S
differential in personal capacities and for stealing their properties by inflation. A sound
redistribution policy should be based on giving the right to every individual, old or young,
disabled or healthy, male or female, to live, at least, on an acceptable standard of living.

Because only the rich benefit from inequality, it is their responsibility, not the government
responsibility, to compensate poor.

A sound redistribution policy gives the right to every individual, to live, at least, on an
acceptable standard of living.

Electronic copy available at: https://ssrn.com/abstract=1902705

 CHAPTER 4

Inflation-free economic system

The Natural Economy

Prosperity, as the ultimate goal of a sound economic system, may not be realized unless there
will be an economic system that ensures economic stability, optimal growth and recognizes the
right of everybody to live on, at least, an acceptable standard of living. These goals can be
achieved by applying an inflation free economic system.

Proposed inflation free economic system requires getting rid of the inflationary role of money
and avoidance of all inflation charges. Inflation charges are the result of the expansion of
economic activities to include non-productive activities.

In order to avoid inflation charges (taxes, interests, speculative profits, and illegal earnings),
interest-based financial activities, speculative activities and illegal activities should be
eliminated, and taxation policy should be reviewed.

Transformation into the proposed inflation free economic system requires;

 Replacement of present monetary systems by a closed monetary system. This will help
avoidance of the inflationary role of money and eliminating illegal earnings.
 Replacement of present interest-based financial systems by a profit-sharing financial
system. This will help eliminating interest charges on credits granted to finance productive
activities.
 Replacement of present public financial markets by trading markets. This will help
eliminating the negative impacts of speculative profits on society and getting rid of interest
charges on credits provided to finance non-productive activities.
 Replacement of present financial equality and welfare systems by a financial security
system based on direct redistribution of income between rich and poor. This will help
avoidance of government dependency on taxes as a source of revenue.

Electronic copy available at: https://ssrn.com/abstract=1902705

 1- Presentation of a closed monetary system

Objectives of closed monetary system

 Avoidance of the inflationary role of money
The inflationary role of money is the result of the use of money to pay inflation charges. For
the government, as guarantor, to be able to ensure that money is used just as a medium of
exchange of products, all money with individuals, government, public sector, private sector,
and banking sector should be circulated within a governmental monetary authority (or central
bank) in form of unrestricted interest free current account deposits. Lending and settlement of
debts are regarded as internal transfers.
 Elimination of illegal earnings
A government should have a complete record of all monetary activities of every individual,
so that it can eliminate illegal earnings and financial corruption and prevent hoarding of
money.

Present money in circulation takes two forms; cash money and banking deposits. Banks and
some financial institutions collect deposits and retain records for them in form of current
accounts, checking accounts, saving accounts, or term deposits. For easy reference, the word
“bank” is used to refer to any financial institution that retains deposits.

Requirements of closed monetary system

 The process of transferring cash money to the monetary authority requires that all paper
money and coins will be recalled and equivalent amount will be retained as deposits with the
monetary authority.
 The process of transferring banking deposits to the monetary authority requires gradual
liquidation of banking credits and investments. Since most of banking deposits is not retained
in cash, the difference between the total deposits and available cash will be debited to a loan
account with the monetary authority. During a transitional period, the balance of the loan
account will be gradually reduced by collected principals until becomes zero. A bank will be
liable to pay predetermined interest on the balance of the loan account.

Transformation into closed monetary system

 All money will be replaced by units of account translated into accounting entries.
 All payments shall be made through transfers between accounts using available banking
withdrawal instruments. Withdrawals shall not be restricted, but they shall represent
transfers within the monetary authority. Depositors shall use available banking withdrawal
instruments.
 For sundry expenses, cash money will be replaced by prepaid electronic cards in several
denominations issued by the monetary authority on the request of the account holder.

Electronic copy available at: https://ssrn.com/abstract=1902705

 To encourage consumption, free of interest credit cards can be issued for buying consumer
goods on credit base. Reasonable service fee may be collected from sellers.
 Total deposits shall be gradually reduced until getting rid of all inflation money.
 Credits expanded by present commercial banks will be replaced by investment money
provided by the monetary authority to be invested by banks in productive activities on
profit/loss sharing base.
 Currency backing shall be used to settle foreign public debts (if any). Surplus will be used
for development. During a transitional period, deficit will be gradually settled.
 Cash money, in papers and coins, will be recalled for cancellation. During a transitional
period, local public debt will be gradually settled.
 Only the monetary authority will handle all banking services in local and foreign currencies.
 After the transitional period, assets of the monetary authority shall include investment with
banks, and credit cards, while liabilities shall include deposits and capital. Inflation money
will be abolished.
 Foreign investments in local market shall be based on profit-sharing contracts.
 A government may invest abroad in productive projects based on profit-sharing contracts.
 Prices of imports and exports are determined by the international markets regardless of the
exchange rate of the domestic currency or the local price of products.
 Currencies are exchanged at the valid market exchange rate determined by the international
foreign exchange markets.
As a result of considering the dollar, any other currency, or a basket of some currencies as a
medium of exchange of currencies, the exchange rate of a currency is affected by the changes
in the value of the currency as well as the changes of the value of the currency which is
regarded as the medium of exchange of currencies.
In order to avoid the impact of the changes in the value of the currency which is regarded as
the medium of exchange of currencies, an imaginary unmarketable constant international
currency may be regarded as a medium of exchange of currencies. At a certain moment, the
basic exchange rates of currencies for one unit of the nominated international currency will
be equal to the exchange rates of currencies for one unit of US dollar. Afterward, the basic
exchange rate of a currency unit will equal its value.

Advantages of the closed monetary system

 There will be no need for monetary policies to control quantity of money because the
inflationary roll of money will be abolished.
 Utilization of resources in productive activities shall be at maximum.
 A government shall not be in need to borrow money. Quantity of money can be increased to
satisfy the increase of output. National output is the real currency backing.
 A government will not be liable to retain currency reserve.
 Interest on loans provided to banks by the monetary authority will be used to pay interest on
public debt (if any). Surplus will increase public revenue.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Each deposit account will provide a complete record of income and payments of the account
holder. The records help creditability studies and combating financial corruption. Illegal
operations, tax evasion and procrastination in paying debts by a wealthy man will be
eliminated.
 Since currency reserve will not be needed, the impacts of the fluctuation of foreign
currencies on local economy will be avoided.
 As cashless system, closed monetary system prevents stealing of money.
 Closed monetary system is in compliance with the present trend, especially in developed
countries, toward replacement of cash money by substitute money such as electronic cards,
payments through internet, checks, and banking transfers.
 US dollar may be used as a medium of exchange of currencies. Also another currency or a
basket of currencies or an imaginary international currency may be used as a medium of
exchange of currencies.

Electronic copy available at: https://ssrn.com/abstract=1902705

 2- Presentation of profit-sharing financial system

Objectives of profit-sharing financial system

 Avoidance of the role of financial system as money issuer.
 Financing productive activities.
 Avoidance of interest, or any other type of returns to lending productive sector, as an element
of inflation charges.

Requirements of profit-sharing financial system

 Gradual liquidation of present banking credits and investments.
 Transformation of present banks into investment banks.

Requirements of gradual liquidation of present banking credits and investments

 All credits granted by the bank shall be scheduled for payment on due dates within a
transitional period. Due credits together with accrued interests or profits shall be collected by
debiting accounts of debtors with the monetary authority. The monetary authority loan
account with the bank will be gradually reduced by collected principals until becomes zero.
Received interest will be used to pay accrued interest on the monetary authority loan account.
 The bank will be liable to liquidate any other investments or debts and to pay off any other
liabilities within a certain transitional period.
 Only the owners of the bank shall be responsible for bad debts and shall benefit from the
profit, or bear the loss, resulted from the liquidation process.

Transformation of present banks into investment banks

 A bank may be in form of a private, public, or semi public company.
 A bank will not be involved in, or benefit from, lending or speculative transactions, and will
not provide banking services.
 A bank will manage productive investment projects in local currency, alone or with other
partners on profit/loss sharing companionship agreement. A project may be a business deal.
A bank may not invest in a project managed by the bank or by another bank.
 A bank will act as a financier. Projects will be financed in favor of private sector, public
sector, or consumers. A companionship agreement will be simple or reducible. A project
established by a bank will be sold to others otherwise a new shareholding company will be
established to run the business. For selling a project, a bank may grant credit facilities in
form of credit sales or capital lease for sale.
 A partner, as an investor, will invest in the project in form of tangible or intangible assets in
local or foreign currency. Invested capital in foreign currency will be evaluated in local
currency at valid exchange rate. Monetary authority will bear the currency risk related to
invested capital.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Investments shall be made for the interest of the whole society according to the governmental
plans and shall be subject to the supervision and approval of the governmental monetary
authority. A bank will present a comprehensive visibility study of the project.
 A bank will maintain a completely separate accounting set for each project, and financial
reports will be fairly disclosed. All receipts and payments of the project will be made through
the account of the project with the monetary authority.
 Investors shall invest in a specific project of their choice in local currency. Amount of
invested money will not be subject to a minimum or maximum limit. Invested money will be
transferred from investor‟s account to the project account within the monetary authority.
Withdrawal of invested money will not be restricted and will not affect the right of sharing
profit/loss.
 Monetary authority, as an investor, will cover the deficit in the cash flow of the project.
 The relationship between the bank and investors will be based on profit/loss sharing
contracts.
 Amount of profit (or loss) will be recognized by liquidation of the project in case of a simple
companionship or when it is realized on cash base in case of reducible companionship.
 Predetermined declared portion of profit (if any) will be allocated as a return to management.
Expenses of the bank and the partners other than direct cost of material and labor related to
the project shall be considered as part of the return to management.
 Unlike distribution of profit in Islamic banks which is based on a company with fixed capital,
a current companionship with variable capital will be considered. Like distribution of interest
by traditional banks and distribution of profit by Islamic banks, net profit (or loss) will be
distributed amongst investors in proportion to invested capital. Invested capital will be
calculated on the daily balance of money invested by the investor.
 For a certain premium paid to the monetary authority and charged to each project as a
percentage of its amount, the monetary authority will act as an insurance company in order to
recover any loss may be charged to investors other than partners.

Advantages of the profit-sharing financial system

 The system will provide alternative investment opportunities that will help reversal shift from
financial and speculative activities to productive activities.
 The system will provide better investment opportunities. Rate of profit on investment is
normally higher than interest rate. Risk of productive investments is not higher than the risk
of financial investments because of the existence of underlying assets. For investors other
than partners, there will be no risk because losses will be recovered by the monetary
authority.
 Profit share of the monetary authority, as an investor, will represent a new source of public
revenue.
 Through free competition, banks will play an important role to prevent greed.
 The system encourages needed foreign investments without initiating public debt.

Electronic copy available at: https://ssrn.com/abstract=1902705

 The system suits cash flows related to different projects and different investors. Capital share
of partners is changeable but with respect to the companionship agreement. Capital share of
the monetary authority is limited to the deficit in cash flow of the project. Capital share of
other investors is changeable.

Electronic copy available at: https://ssrn.com/abstract=1902705

 3- Presentation of trading markets

Objectives of trading markets

 Avoidance of lending for generating interest or profit.
 Avoidance of speculative activities.

Requirements of transformation into trading markets

 Money and capital Markets will be liquidated.
 Setting a certain transitional period for everyone or entity to be in conformity with the
disciplinary regulations.
 Setting disciplinary regulations to prevent speculative activities.

Disciplinary regulations of trading markets

Stock markets
 Setting minimum period for retaining stocks before being sold.
 Setting maximum range for the difference between the market price of a stock and its real
value declared in financial reports.
Real estate markets
 Setting rules to ensure that real estate are bought for living, renting or development.
 Setting maximum period for utilization of privately owned lands within urban areas.
Commodities markets
 Setting rules to ensure physical delivery of goods bought through national markets of
commodities. Goods will be marketable but contracts will not be marketable.
Foreign exchange markets
 Setting rules to prevent forward deals.
Derivatives
 Replacement of option contracts by insurance contracts issued by the monetary authority
to cover volatility of foreign currencies.

Advantages of trading markets

 Avoidance of inflation resulted from making private gains on account of public losses.
 Avoidance of financial crisis.
 Avoidance of foreign currency risks.

Electronic copy available at: https://ssrn.com/abstract=1902705

 4- Presentation of financial security system

Objectives of financial security system

 To avoid dependency of government on taxes as a source of revenue.
 To ensure sufficiency of individual‟s income to meet living expenses on an acceptable living
standard.

In general cost of living includes:

1. Cost of consumables
Cost of consumables refers to the cost of living necessities and cost of utilities. Living
necessities include housing, food, drink, clothing, marriage, and death. Utilities include all
services that can be billed on consumption base, such as electricity, water, communication,
transportation, property insurance, and accident insurance.
2. Cost of general services
Cost of general services refers to the total cost of services provided by a society to
individuals regardless of the volume of consumption. It includes cost of private services,
public services, and governmental services. Private services include all services directly
provided to individuals, such as health care, medication, obligatory education and emergency
services. Public services are not directed to specific person, such as roads, dams, and bridges.
Governmental services include all services provided by government such as defense, internal
security and judicial service. Cost of governmental services, includes liabilities of public debt
(if any).

A government will estimate an individual‟s standard cost of consumables with consideration

given to age, gender, and living standard in the community.
Cost of general services will be distributed evenly among individuals. A government will
determine an individual‟s share in the cost of general services. Shares will be paid by individuals
to be distributed among the providers of services.
An individual‟s standard cost of living represents the total of an individual‟s standard cost of
consumables in addition to his/her share in the cost of general services. Standard cost of living is
not a stable figure. It can be changed according to the changes in development needs, service mix
and living standard in the community. It can be increased in emergency cases such as war and
natural catastrophes.
An individual may enjoy personal services of higher standard provided that he/she pays
providers the difference in cost.

The standard cost of living of a family equals the sum of the standard cost of living of the
household, the spouse, and all dependants in the family taking into consideration the number of
the family members.

Electronic copy available at: https://ssrn.com/abstract=1902705

The income of a family equals the sum of the income of the household in addition to the amounts
paid by the spouse and dependants to the household as contribution to family expenses. Income
includes capital gains.
Financial security system will recover the shortage of the income of each family to pay for the
standard cost of living of the family.

Transformation into financial security system

 A member of the labor force will be liable to work within his/her capacity. Regulations will
be set to prevent dependency on the recovery system.
 A household will be responsible for paying the cost of consumables provided to his family in
addition to the family‟s share in the cost of general services (Nothing for free). Payments will
be made by transfers from his/her account within the monetary authority to the accounts of
the providers of the services or goods with the monetary authority.
 A government will not provide services beyond the scope of its main duties to realize
security and justice. It will provide the services that cannot be provided by others due to
security reasons or because they are not profitable such as defense, internal security, judicial
services, national planning, controlling, protection of environment, scientific researches for
development, and protection of market freedom by encouraging free competition,
discouraging monopoly, and ensuring transparency. As a result, public expenditure will be
reduced.
A government may be involved in other productive activities through fully or partially owned
independent for-profit establishments.
A government will have sufficient financial resources for recovery. The primary source of
public revenues includes profits from investments made by the government using public
properties, earnings generated by the monetary authority, and payments received in return for
the governmental services.
In case of insufficient revenues, the shortage will be collected by the government through
imposing a progressive wealth duty. Wealth duty will be levied on the excess of the family
income over the family standard cost of living, and also on the excess of the income of the
spouse or the dependent over his/her contribution to the family expenses.
Unlike present taxes, wealth duty is not public revenue. It will be transferred from the
accounts of those who are liable to pay the duty to the accounts of those who deserve
recovery.

Advantages of the financial security system

 Income recovery will ensure fair living standard for all people.
 Reduction of public expenditure results in avoidance of public debts and financial corruption.
 The system will replace present welfare systems, social security systems, and governmental
retirement programs.
 Avoidance of taxes which represent an element of inflation charges.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Putting all together

Unlike present economic systems, proposed inflation free system introduces pure productive
economy, cashless system, interest free system and tax free system. The inflationary role of
money will be discarded, inflation charges will be abolished, and the government duties will be
limited to provide security and justice, and to ensure best utilization of resources and appropriate
implementation of the system.

The proposed inflation-free system will result in economic stability, steady optimal growth and
full employment. Private property will be protected with consideration given to the right of all
people to enjoy fair living standard. Prices will decline, value of currency unit will increase,
national output valued at fair prices will rise, exports will increase, and imports will decrease.

The proposed economic system is fair, integrated, and dynamic in such a way to comply with
present complex requirements of societies and accelerated technological improvements. It
introduces a self-correcting system and prevents the harmful interventions in the natural
economic system.

The proposed inflation-free economic system benefits all people and provides better investment
opportunity, but it is not in favor of corruptors and will be confronted by those who dominate
both economic and financial markets.

The views expressed here are undoubtedly drastically different from the views of other
researchers. However, financial distress is increasing and people will, sooner or later, realize the
truth and make concert efforts to gradually embrace an alternative system that would reflect fair
economy, and advance the needs of humanity as a whole.

Electronic copy available at: https://ssrn.com/abstract=1902705

 CHAPTER 5

Islamic Economy
In light of the verses of the Holy Qur‟an

In general, all religions handled economic issues, but Islam has set constant comprehensive rules
as guidelines for establishment of a fair economic system which suits all people in different
times and places.
 In the first chapter of the Holy Qur‟an named Al-Fatihah, Muslims ask for guidance; ―Guide
us to the straight way‖. In reply to their request, the second chapter named Al-Baqarah starts;
―This is the book, where is no doubt, a guidance to those who are the pious believers‖.
 The Holy Qur‟an is in conformity with both Christianity and Judaism;‖We did send down the
Taurat (Torah), therein was guidance and light … And whosoever does not judge by what
Allah (God) has revealed, such are the disbelievers.‖(Al-Ma‘adah 5:44).
―and We gave him the Injill (Gospel), in which was guidance and light and confirmation of
the Taurat …. Let the people of the Injill judge by what Allah has revealed therein. And
whosoever does not judge by what Allah has revealed therein, such are the rebellious.‖ (Al-
Ma‘adah 5:46,47).
―And this (Qur‘an) is a blessed book which We have sent down, confirming the Revelations
which came before it‖ (Al-An‘am 6:92).
 The Holy Qur‟an introduces a message for all people regardless of their beliefs.
―We have sent down to you the book (Qur‘an) for mankind in truth‖(Az-Zumar, 39: 41).

Taking into consideration the complexity of recent economies, different approach has been taken
to identify economic topics and to understand the verses of the Holy Qur‟an which controls
present macroeconomic issues. This explains the different presentation of Islamic economy in
comparison with what was introduced by other researchers.

An introduction to Islamic beliefs related to economy will be followed by a presentation of the

main topics of economics; Economic activities, Market and Prices, Money, and Distribution of
wealth, based on the ideological viewpoints of Islam and supported by the verses of the Holy
Qur‟an and the sayings (Hadith) of the Prophet ((Pbuh).

Electronic copy available at: https://ssrn.com/abstract=1902705

 1- ISLAMIC BELIEFS

Unlike present living systems which are based on man-made constitutions, living systems in
Islam are based on Islamic beliefs. In economy, main Islamic beliefs can be summarized as
follows:

Allah is the only Creator

Allah creates all things such as the heavens, the earth, natural resources, plants, and animals.
―Such is Allah, your Lord! non has the right to be worshipped but He, the Creator of all things‖
(Al-An‘am 6:102).
Allah creates people ―O mankind! Be dutiful to your Lord, Who created you from a single person
and from him He created his wife, and from them both He created many men and women‖ (An-
Nisa 4:1).
Allah creates the systems that organize the movement of creatures ―Verily, in the creation of the
heavens and the earth, and in the alternation of night and day, and the ships which sail through
the sea with that is of use to mankind, and the water which Allah sends down from the sky and
makes the earth alive therewith after its death, and the moving creatures of all kinds that He has
scattered therein and in the veering of winds and clouds which are held between the sky and the
earth are indeed signs for people of understanding.‖ (Al-Baqarah 2:164).
Allah creates the systems that facilitate living of people on earth ―And do not do mischief on the
earth, after it has been set in order‖ (Al-A‘raf 7:56).
Allah is the only Owner
Allah is the only Owner of all creatures, ―Unto Allah belongeth the Sovereignty of the heavens
and the earth and whatsoever is therein.‖ (Al-Maeda 5:120).
Allah is the only Provider
Allah provides people with their living needs. ―And how many an animal there is that beareth
not its own provision! Allah (God) provideth for it and for you.‖(Al-Ankaboot 29:60). On the
international level, scarcity does not exist. Statistics show that the rate of the increase in
international output is much greater than the rate of the increase in world population. On the
national level, a shortage in resources may be imported from other nations. ―and have made you
nations and tribes that ye may know one another‖(Al-Hujraat 49 :13).
People are trustees
Allah authorizes people to utilize available resources. ―and spend of that whereof He hath made
you trustees;‖ (Al-Hadid 57: 7).
People have to follow rules of trust
For utilization of resources, people, as trustees, are required to follow the rules and conditions
that set by the only Owner, ―And whosoever disobeys Allah and His Messenger, and
transgresses His limits, He will cast him into the fire‖ (An-Nisa 4:14).

Electronic copy available at: https://ssrn.com/abstract=1902705

 2- ECONOMIC ACTIVITIES

Productive Activities
Economy in Islam is a pure productive economy.

Legality of productive activities

―Eat not up your property among yourselves unjustly except it be a trade amongst you‖
(An-Nisa‘. 4:29)
In general, the word “Trade or Trading” in the Holly Qur‟an refers to any form of investment in
productive activity. Eating propriety results in an increase of one‟s wealth on account of a
decrease in another‟s wealth. The principle is to respect private property. The case of trade is an
exception. Exchange of properties based on its real values does not involve eating of properties.
If a seller bought a product for $4 and sold it for $4, the exchange transaction would has no
effect on the wealth of the buyer or on the wealth of the seller. Normally, trade involves profit or
loss. If the seller sold the product for $5, his wealth would has been increased by $1 on account
of an equal decrease in the wealth of the buyer who paid $5 to acquire a product worth $4.

Regulations of Productive activities

Regulations of productive activities may be classified into three principals; mutual consent,
justice, and avoidance of prohibited acts.
1- Principle of mutual consent
―except it be a trade amongst you, by mutual consent‖. (An-Nisa‘. 4:29).
2- Principle of justice
 Fair evaluation of wages and rights of others
―The way is only against those who oppress men‖ (Ash-Shura, 42:42).
 Fair evaluation of properties of others
―and reduce not the things that are due to the people‖ (Hud, 11:85).
 Fair terms between partners in a company
“And, verily, many partners oppress one another, except those who believe and do
righteous good deeds, and they are few‖ (Sad. 38: 24).
3- Principle of avoidance of forbidden acts
 Environmental mischief such as pollution
―And when he turns away, his effort in the land is to make mischief therein and to
destroy the crops and the cattle, and Allah likes not mischief‖ (Al-Baqarah 2:205).
 Mischief on natural systems
―And do not mischief on earth, after it has been set in order‖ (Al-A‘raf 7:56).
 All types of corruption
―and do not commit mischief in the land causing corruption.‖ (Hud. 11:85).

Electronic copy available at: https://ssrn.com/abstract=1902705

Legality of production of consumer goods
―O mankind! Eat of that which is lawful and good on the earth‖ (Al-Baqarah. 2:168)
 Prohibition of some products such as:
Intoxicants
―Intoxicants and….., So avoid that‖. (Al-Ma‘idah. 5:90).
Specific kinds of meat
―Forbidden to you are: the dead animals, blood, the flesh of swine, and that on which
Allah‘s name has not been mentioned while slaughtering, and that which has been killed
by strangling, or by violent blow, or by headlong fall, or by the goring of horns, and that
which has been partly eaten by a wild animal unless you are able to slaughter it before
its death, and that which is slaughtered on stone-alters.‖ (Al-Ma‘idah, 5:3).

Legality of production of capital goods

―And remember when He made you successors after ‗Ad people and gave you habitations in the
land, you build for yourselves places in plains, and crave out homes in the mountains.‖
(Al-A‘raf.7:74).

Legality of international trade

“(And with all those Allah‟s Grace, and Protections, We cause) the (Quraish) caravans to set in
winter and in summer” (Quraish 106: 2)

Factors of production
The Holly Qur‟an legalizes the use of material which comes out of natural resources, hiring
people for work, and being involved in investment risk.
1- Material
―And We have given you (mankind) power in the earth, and appointed for you therein
livelihood. Little give ye thanks!‖ (Al-Araf 7:10).
2- Labor
Manual labor
“And he was building the ship” (Hud 11 :38).
Intellectual labor
―He said: Set me over the storehouses of the land. Lo! I am a skilled custodian.‖
(Ysuf 12 :55).
3- Risk
―except it be a trade‖ (An-Nisa 4 :29).
Trade involves investment risk.

Electronic copy available at: https://ssrn.com/abstract=1902705

Financial activities
From the Islamic view point, both usury and speculation are prohibited, while interest-free
lending and capital finance are legalized.

Prohibition of usury
The word “Usury” is used here to refer to the practice of lending money for generating profit or
interest even if the interest rate is very low. According to the Holly Qur‟an, the word “Riba”
refers to any direct or indirect return for lending.
―Those who eat Riba will not stand except like the standing of a person beaten by Satan leading
him to insanity. That is because they say: ―Selling is only like Riba,‖ whereas Allah has
permitted selling and forbidden Riba‖ (Al-Baqarah. 2:275)
―But if you repent, you shall have your capital sums‖ (Al-Baqarah. 2:279)

In addition to Islam, Christianity and Judaism forbid usury.

―Give back to them immediately their fields, vineyards, olive groves and houses, and also the
usury you are charging them—the hundredth part of the money, grain, new wine and
oil."(Nehemiah 5:11)
―who lends his money without usury and does not accept a bribe against the innocent. He who
does these things will never be shaken.‖(Psalm 15: 5)
―He withholds his hand from sin and takes no usury or excessive interest.‖(Ezekiel 18:17)
"But love ye your enemies, and do good, and lend, hoping for nothing again; and your reward
shall be great". (Luke 6:35)
―If thou lend money to any of My people, even to the poor with thee, thou shalt not be to him as a
creditor; neither shall ye lay upon him interest.‖ (Exodus, 22:24 [14])- Hebrew Bible
―Thou shalt not give him thy money upon interest, nor give him thy victuals for increase.‖
(Leviticus, 25:35-37)- Hebrew Bible
―but unto thy brother thou shalt not lend upon interest; that the LORD thy God may bless thee in
all that thou puttest thy hand unto, in the land whither thou goest in to possess it.‖
(Deuteronomy, 23:20-21)- Hebrew Bible

Difference between Usury and Selling

―Those who eat riba... they say: Selling is only like riba‖ (Al-Baqarah. 2:275)
The argument stated in this verse of the Holly Qur‟an indicates the importance of understanding
the difference between usury and selling.
The logic behind the argument is that the increase in profit from credit sale over cash sale is
considered as time value of money. Similarly, riba is the time value of money. This type of
similarity may be true to an extent, but the discrepancies should be considered.
 Usury represents a transaction of exchanging money for debt, while credit sale refers to a
transaction of exchanging real product for debt.
 Riba may be considered as the time value of money, while profit, from sale, represents the
return to investment risk which increases in case of credit sale.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Profit is the investor‟s reward for increasing national product and national supply and
therefore helps price reduction, while riba is added to cost of products and hence causes
inflation.
 Selling is the base of the real productive economy which results in prosperity, while usury is
the base of present financial economy which causes havoc in society.

Prohibition of speculative activities

 Speculative activities involve unlawful eating property
―And eat up not one another‘s property unjustly‖ (Al-Baqarah. 2:188).
Speculative activities cause inflation. Speculators gain profits on account of public in form of
hidden inflation tax.
 Speculative activities involve intervention into the natural price system
―And do not do mischief on the earth after it has been set in order‖(Al-A‟araf, 7:56).
The price of an asset in financial markets does not reflect free interaction of real demand and
supply on the asset itself. It reflects the interaction of artificial demand and supply on
contracts of selling or buying assets. In most cases, prices reflect interests of large capitalists
who dominate the speculative markets.
 Speculative activities involve unfair valuation of assets and commodities
―And O my people! Give full measure and weight in justice‖ (Hud. 11:85).
In speculative markets, prices do not reflect fair value of underlying assets. Optimistic
speculations raise market prices, while pessimistic speculations cause price decline.
 Speculative activities involve gambling
―Intoxicants and maisir, and animals that are slaughtered as a sacrifice for idols, and
arrows for seeking luck are an abomination of Satan‘s handiwork, So avoid that‖. (Al-
Ma‘idah. 5:90).
The word used by the Holy Qur‟an for gambling is „maisir‟ which literally means „getting
something too easily‟ or „getting a profit without working for it‟. Speculative activities
represent a sort of gambling. Also Christianity and Judaism forbid gambling.
 Speculative activities involve Riba
―Yahya related to me from Malik that he had heard that receipts were given to people in the
time of Marwan ibn al-Hakam for the produce of the market at al-Jar. People bought and
sold the receipts among themselves before they took delivery of the goods. Zayd ibn Thabit
and one of the Companions of the Messenger of Allah, may Allah bless him and grant him
peace, went to Marwan ibn al-Hakam and said, "Marwan! Do you make usury halal?" He
said, "I seek refuge with Allah! What do you mean?" He said, "These receipts which people
buy and sell before they take delivery of the goods." Marwan therefore sent a guard to follow
them and to take them from people's hands and return them to their owners.‖ (The Muwatta
of Imam Malik).

Electronic copy available at: https://ssrn.com/abstract=1902705

 Speculative activities involve unlawful bargain sale
―Ibn 'Umar (Allah be pleased with them) reported Allah's Messenger (peace be upon him) as
having said this: One amongst you should not enter into a transaction when another is
bargaining‖ (Sahih Muslim).
 Speculative activities involve unlawful sale before taking possession
―Ibn Abbas (Allah be pleased with them) reported Allah's Messenger (peace be upon him) as
saying: He who buys foodgrain should not sell it until he has taken possession of it‖ (Sahih
Muslim).
 Speculative activities involve unlawful forward sale of currency
―The prophet (Pbuh) prohibited the sale of silver for gold on credit.‖(Muslim).
 Speculative activities which are based on interest are forbidden
―whereas Allah has permitted selling and forbidden Riba‖ (Al-Baqarah. 2:275).

Legality of interest-free lending

―O you who believe! When you contract a debt‖(Al-Baqarah, 2:282)
If lending does not involve riba, it will not cause inflation. Interest-free lending is regarded as a
social financial aid.
Regulations of interest-free lending
Term
―O you who believe! When you contract a debt for a fixed period‖(Al-Baqarah, 2:282)
Writing
―O you who believe! When you contract a debt for a fixed period, write it down. Let a scribe
write it down in justice between you……. (Al-Baqarah, 2:282
Witnesses
―And get two witnesses out of your own men.‖(Al-Baqarah, 2:282)
Collaterals
―then let there be a pledge taken, then if one of you entrusts the other, let the one who is
entrusted discharge his trust‖(Al-Baqarah, 2:283)
No return
―you shall have your principal sums‖ (Al-Baqarah, 2:279)
Collection
―And if the debtor is in a hard time, then grant him time till it is easy for him to repay; but if
you remit it by way of charity, that is better for you if you did but know.‖ (Al-Baqarah,
2:280)

Legality of capital finance

In Islam, legalized capital finance refers to a companionship based on sharing profit and loss.
―And , verily, many partners oppress one another, except those who believe and do righteous
good deeds, and they are few‖ (Sad 38 :24)

Electronic copy available at: https://ssrn.com/abstract=1902705

Regulations of profit-sharing company
 Method of finance must be in form of a company.
―And , verily, many partners‖ (Sad 38 :24).
 Subject of finance must be a type of productive activities.
―except it be a trade‖ (An-Nisa 4 :29).
 Terms of the company must be based on the regulations of productive activities; principles of
mutual consent, justice, and avoidance of prohibited acts.
―And whose obey Allah and the Messenger, then they will be in the company of those on
whom Allah has bestowed His Grace …‖ (An-Nisa 4 :69)
 Return to finance must be in form of profit not riba
―whereas Allah has permitted selling and forbidden Riba‖ (Al-Baqarah. 2:275).

Summary
In light of the verses of the Holy Qur‟an regarding economic activities, the following main
principles must be followed:
1. Economic activities must be limited to productive activities.
2. Usury must be abolished.
3. Speculative activities must be eliminated.
4. Finance must be based on profit/loss sharing companionship.
5. Productive activities must be based on principles of mutual consent, justice, and avoidance of
prohibited acts.

Electronic copy available at: https://ssrn.com/abstract=1902705

 3- MARKET AND PRICES

Selling
In general the word “Selling or Sale” refers to the last stage of any investment transaction in
which the seller hands over one or more of his property rights through cash sale, credit sale,
renting, leasing, rental sale, giving right to use in return for toll or service fee, or any other legal
way of alienation.

Legality of selling
― except it be a trade‖ (An-Nisa 4 :29). Trade involves sale of products.

Legality of credit sale

―That is because they say: ―Selling is only like Riba,‖ whereas Allah has permitted selling and
forbidden Riba‖ (Al-Baqarah. 2:275)
The similarity between selling on credit and riba is that usury generates profit in return for time
and credit sale generates excess profit for delay in payment. Cash sale does not generate profit
for time.

Prohibition of some methods of sale such as:

 Gharar sale
―On the authority of Abu-Hurayra (mAbwh) that: The prophet (Pbuh) prohibited the pebble
sale and the Gharar sale‖ (Muslim, Abu Dawud).
The word “Gharar” refers to the sale of products whose existence or characteristics are not
certain such as the sale of fish in the sea, unborn calf in its mother‟s womb, birds in the sky,
runaway animal, and un-ripened fruits on the tree.
 Sale of what is not in possession
―Hakim-bin-Hezam reported: The Messenger of Allah prohibited me to sell what is not in my
possession.‖ (Tirmizi).
 Forced sale
―Ali reported that the Messenger of Allah forbade the (forced) purchase from a needy person,
and purchase from the inconsiderate and purchase of fruit before it reaches maturity.‖ (Abu
Daud).
 Deceiving Sale
―Waselah-bin-Asqa‘a reported: I heard the Messenger of Allah say: Whoso sells a defective
thing without disclosing it continues to be in the wrath of Allah or angels continue to curse
him.‖ (Ibn Majah).

Market Price
Market prices represent the total of returns to factors of production.
 Rent
Investors have to pay for material. In return rent (or share in depreciation) will be included in
market prices.
―O ye who believe! Fulfill your undertakings.‖ (Al-Maeda 5:1).

Electronic copy available at: https://ssrn.com/abstract=1902705

 Wages
Investors have to pay for labor in cash or other benefits. In return wages will be included in
market prices.
―She said: Verily, my father calls you that he may reward you for having watered (the flocks)
for us.‖ (Al-Qasas 28 :25).
―He said: I intend to wed one of these two daughters of mine to you, on condition that you
serve me for eight years‖ (Al-Qasas 28 :27).
 Profit
Profit represents a return given to investors for taking investment risk. Investors are entitled to
include profit in market prices.
―except it be a trade‖ (An-Nisa 4 :29). Trade involves investment risk.

Islamic conceptual framework of pricing

Natural price system is one of many natural systems created by Allah to organize movement of
creatures and to facilitate life on earth. It refers to the ability of the market to correct itself with
no external intervention. In the natural price system demand and supply, as the market forces,
freely interact until they reach an equilibrium point where fair price is determined.

Prohibition of humanity disruption into the natural price system

―And do not do mischief on the earth after it has been set in order …‖ (Al-A‘araf, 7:56)
The verse prohibits all types of humanity Interventions that may result in a fall or a rise in prices.
Intervention into the natural price system takes two forms. A government may fix prices or set a
minimum wage. Inflationary economic systems allow intentional increase in prices.
 Prohibition of fixing prices
Prices may not be fixed. Greed may be avoided by encouragement of clean competition
through investment banks or establishments owned by the government.
―Anas reported that the current price once became dear at the time of the Messenger of
Allah. They asked: O Messenger of Allah! Fix a rate for us. The Holy Prophet replied: Verily
Allah is One who controls price, curtails, gives amply and provides sustenance; and
certainly I hope that I should meet my Lord while there will be none amongst you who will
hold me responsible either for blood or for property.‖(Tirmizi, Abu Daud, Ibn Majah).
 Prohibition of inflationary charges
Natural price system is a free-of-inflation system. Islam prohibits taxation, usury, speculative
activities, and financial corruption.
Prohibition of taxes
 Present direct and indirect taxes
―And eat up not one another‘s property unjustly nor give it to the rulers that you may
knowingly eat up a part of the property of others sinfully ….‖ (Al-Baqarah. 2:188).
On one hand, taxes reduce disposable income. On the other hand taxes are paid in form of
increase in prices.

Electronic copy available at: https://ssrn.com/abstract=1902705

  Hidden inflation tax
―and reduce not the things that are due to the people…‖ (Hud. 11:85).
Inflation money reduces the value of the currency unit. Suppliers have to pay higher
prices for material and labor. Consumers have to pay higher prices for products.
Prohibition of interest
―whereas Allah has permitted selling and forbidden Riba‖ (Al-Baqarah. 2:275).
Prohibition of profits from speculative activities
―Intoxicants and maisir…. are an abomination of Satan‘s handiwork, So avoid that‖. (Al-
Ma‘idah. 5:90)
Prohibition of profits from financial corruption
―and do not commit mischief in the land causing corruption.‖ (Hud. 11:85).
The verse prohibits all forms of financial corruption such as
 Deceiving:
―And give full measure when you measure, and weigh with balance that is straight‖ (Al-
Isra‘, 17:35).
 Bribery:
―Abdullah-b-Amr reported that the Messenger of Allah cursed the bribe-taker and the
bride-giver.‖(Abu Daud, Ibn Majah).
 Theft:
―And, the male thief and the female thief, cut off their hands‖ (Al- Ma‘idah 5:38).
 Embezzlement:
―Verily, Allah commands that you should render back the trusts to those, to whom they
are due‖ (An-Nisa, 4: 58).
 Monopoly
Ma‘mar reported that the Messenger said: Whoever monopolizes is a sinner. (Muslim).
 Greed
“And O my people! Give full measure and weight in justice” (Hud. 11:85).

Summary
In light of the verses of the Holy Qur‟an regarding markets and prices, the following main
principles must be followed:
1. Humanity disruption into the natural price system must be avoided.
2. Inflationary charges must be abolished.
3. Freedom of markets must be respected.

Electronic copy available at: https://ssrn.com/abstract=1902705

 4- MONEY

Money was a product made of precious metal, or fully backed, directly or indirectly, by precious
metal, but it is no longer a product. Present money is not a commodity. It includes paper money
or coins made of material of negligible cost and issued by the monetary authority, substitute
money such as checks, or credit money created by financial institutions. Economists define
money as anything that is widely used as means of exchange and agree that money is not in itself
wealth and that money has no intrinsic value. Money is just a social invention introduced to
facilitate the process of exchanging products. As a medium of exchange, money has to act as a
measure of value. When it is acquired as a result of the exchange process, money becomes a
legal tender in order to gain its public acceptability. Afterward, money acts as a store of value.

Money as a measure of value

The Holy Qur‟an introduces the evaluation concepts.
 Prohibition of appreciation
―Allah has permitted selling and forbidden Riba‖ (Al-Baqarah. 2:275)
Prohibition of riba requires that money should not gain extra value in return to lapse of time.
In other words the future value of money should not exceed its present value.
 Prohibition of devaluation
―and reduce not the things that are due to the people‖(Hud, 11:85)
The word “Things” in this verse refers to properties and any other dues. Money is something
due to people. This principle requires that value of money should not be intentionally
devaluated through excessive expansion of money.
 Principle of fair valuation
―And O my people! Give full measure and weight in justice….‖ (Hud. 11:85).
Money acts as a measure of value of products. This principle requires that the value of a
product should be fairly measured and the money should express the exact value of the
underlining product.
 Prohibition of humanity disruption into the natural market system.
―And do not do mischief on the earth after it has been set in order‖ (Al-A‘araf, 7:56)
Products are priced in term of money. This principle requires that prices of products should
not be affected by the use of money as a measure of value.

Money as a legal tender

Unlike like a commercial paper which represents a legal right that can be claimed by the creditor
through following some legal procedures, money, as legal tender, represents an obligation
guaranteed by the government that should be fulfilled upon request by the owner without
following legal procedures. As long as money is a legal tender the principle of guarantee will
apply.

Electronic copy available at: https://ssrn.com/abstract=1902705

 Principle of guarantee
Hadith ―Al kharaj bel Daman‖ (Abu Daud, Ibn Majah)
The Arabic word “Al kharaj” refers to any type of revenue as a result of investment and the
Arabic word “Daman” refers to the guarantee. The meaning is that the profit of guaranteed
money is for the guarantor.

Money as a store of value

As a store of value money acts as a trustee. The Holy Qur‟an introduces the rule of trust.
 Principle of trust
―Verily, Allah commands that you should render back the trusts to those, to whom they are
due‖(An-Nisa, 4: 58).
This verse requires stability of the value of the currency unit so that the owner can obtain
products of future amount equals the amount of the products he might acquire when he
received the money. As a result of equality of future value and present value, the inflationary
role of money will be avoided.

Currency backing
From the Islamic viewpoint, Currency backing is regarded as a sort of unlawful hoarding of
money, gold, and silver.
 Prohibition of hoarding precious metal as currency backing
―And those who hoard up gold and silver and spend them not in the way of Allah, announce
unto them a painful torment‖ (Al-Taubah. 9:34)
 Prohibition of hoarding money as currency reserve
―Woe to every slanderer and backbiter. Who has gathered wealth and counted it. He think
that his wealth will make him last forever. Nay! Verily, he will be thrown into the crushing
Fire.‖ (Al-Humazah.104: 1-4)

Foreign currency exchange

 Legality of spot exchange
Narrated Abu Al-Minhal: I used to practice money exchange, and I asked Zaid bin 'Arqam
about it, and he narrated what the Prophet said in the following: Abu Al-Minhal said, "I
asked Al-Bara' bin `Azib and Zaid bin Arqam about practicing money exchange. They
replied, 'We were traders in the time of Allah's Apostle and I asked Allah's Apostle about
money exchange. He replied, 'If it is from hand to hand, there is no harm in it; otherwise it is
not permissible." (Sahih Al-Bukhari).
 Prohibition of forward exchange
―The prophet (Pbuh) prohibited the sale of silver for gold on credit.‖(Muslim).

Summary
In light of the verses of the Holy Qur‟an regarding money, the following main principles must be
followed:

Electronic copy available at: https://ssrn.com/abstract=1902705

1. The inflationary role of money must be abolished.
2. Currency backing must be avoided.
3. Value of money must be stable.
4. Foreign currency exchange must be based on spot deals.

Electronic copy available at: https://ssrn.com/abstract=1902705

 5- REDISTRIBUTION OF WEALTH

Islamic approach to distribution

 Legality of natural differential in wealth
―Say (O Muhammad): Verily, my Lord enlarges the provision to whom He wills and
restricts‖ (Saba 34: 36).
 Prohibition of intentional differential in wealth
―And eat up not one another‘s property unjustly‖ (Al-Baqarah. 2:188).
 Legality of redistribution of wealth
―in order that it may not become a fortune used by the rich among you‖(Al-Hashr. 59:7).

Islamic conceptual framework of redistribution

The Holy Qur‟an introduces the rules which people have to follow so that wealth can be fairly
distributed among people. The rules of redistribution are set in a form of rights and duties of
individuals.

Rights of individuals
1- Right of legal private property
―Eat not up your property among yourselves unjustly‖ (An-Nisa‘. 4:29).
2- Right of earning legal income
Legal income can be earned through rendering personal services or property services or
bearing investment risk.
 Income from sale of personal services (Wages)
―She said: Verily, my father calls you that he may reward you for having watered (the
flocks) for us.‖ (Al-Qasas 28 :25).
 Income from sale of property services (Rent or fee)
―O ye who believe! Fulfill your undertakings.‖ (Al-Maeda 5:1).
 Income from investment (Profit)
―except it be a trade‖ (An-Nisa 4 :29). Trade involves investment risk.
3- Right of heirs (law of inheritance and bequest)
―There is a share for men and a share for women from what is left by parents and those
nearest related, whether the property be small or large – a legal share‖(An-Nisa, 4:7).
Several verses in Surat An-Nisa show the distribution rules of an estate among different
heirs.
4- Right of living means
―Verily, you have that you will never be hungry therein nor naked. And you will suffer not
from thirst therein nor from the sun‘s heat‖ (Taha, 20: 118-119).

Electronic copy available at: https://ssrn.com/abstract=1902705

Duties of individuals
1- Duty of work
―There is nothing for man but what he strives for‖ (An-Najm, 53:39).
2- Duty of paying for products and services (Nothing for free)
―There is nothing for man but what he strives for‖ (An-Najm, 53:39).
3- Duty of spending for living
 For personal living
―And surely, We gave you authority on the earth and appointed for you therein
provisions‖ (Al-A‘raf, 7:10).
 For living of the wife
―Men are the protectors and maintainers of women … because they spend from their
means‖ (An-Nisa, 4: 34).
 For living of the family
―They ask you what they should spend Say: Whatever you spend of good must be for
parents and kindred and orphans and the poor and the wayfarer‖ (Al-Baqarah, 2: 215).
4- Duty of spending surplus of income
 Rights of others
―An in their properties there was the right of the beggars and the poor‖(Adh-Dhariyat,
51: 19).
 Rights of the community
―Spend your wealth for the cause of Allah‖ (Al-Baqara 2:195).

Limits of duties
 Limits of duty of work
―Allah burdens not a person beyond his scope‖ (Al-Baqarah. 2:286).
 Limits of spending for living
 Without miserliness
 ―Those who are miserly and enjoin miserliness on other men and hide what Allah has
bestowed upon them of his Bounties. And We have prepared for the disbelievers a
disgraceful torment.‖ (An-Nisa‘. 4:37).
 Without extravagance
 ―and waste not by extravagance― (Al-An‘am. 6:141).
 Within financial capacity
 ―There is no blame on those who are weak or ill or who find no resources to spend‖(Al-
Taubah, 9:91).
 Limits of spending of surplus of income
 Within financial capacity
―Let the rich man spend according to his means; and the man whose resources are
restricted, let him spend according to what Allah has given him. Allah puts no burden on
any person beyond what He has given him‖ (At-Talaq, 65 :7).

Electronic copy available at: https://ssrn.com/abstract=1902705

 "And We ask not any person except according to his capacity‖ (Al-Muminun, 23:62).
 Up to full financial capacity
―And they ask you what they ought to spend. Say: that which is beyond your needs‖ (Al-
Baqarah, 2:219).

Methods of redistribution
 Zakat
―Take Sadaqah from their wealth in order to purify them and sanctify them with it‖
(Al-Taubah. 9:103).
―The alms are only for the poor and the needy, and those who collect them, and those whose
hearts are to be reconciled, and to free the captives and the debtors, and for the cause of
Allah, and (for) the wayfarer; a duty imposed by Allah.‖(Al-Tawba 9 : 6).
The word “Sadaqah” in this verse refers to the “Zakat” which is a duty imposed on wealthy
people only. Zakat is regarded as wealth protection duty. It protects rich from the reactions
of envy and hate. It also purifies the human soul of vices like greed and selfishness. Zakat is
an obligatory tax allocated for distribution among the needy to meet their right of living
means.
 Fighting by properties
―Go forth, light-armed and heavy-armed, and strive with your wealth and your lives in the
way of Allah‖ (Al-Taubah, 9:4)
―Verily, Allah has purchased of the believers their lives and their properties for that theirs
shall be the paradise. They fight in Allah‘s Cause‖(Al-Taubah, 9:111)
 Charities and alms
―As for him who giveth and is dutiful (toward Allah) And believeth in goodness; Surely We
will ease his way unto the state of ease‖ (Al-Lail 92 : 5-7)
―If ye publish your almsgiving, it is well, but if ye hide it and give it to the poor, it will be
better for you‖ (Al-Baqara 2 : 271)
 Spending for good deeds
―And spend in the cause of Allah ..‖ (Al-Baqarah, 2:195)

Summary
In light of the verses of the Holy Qur‟an regarding redistribution, the following main principles
must be followed:
1. A member of labor force must work within his/her capacity.
2. Everyone has the right of living means.
3. Everyone has to pay for his/her needs of products and services (Nothing for free).
4. Those who have surplus of income must recover the shortage of income of others to meet
cost of living.
5. Spending surplus of income in the cause of Allah is up to full financial capacity.

Electronic copy available at: https://ssrn.com/abstract=1902705

 CONCLUSION

A comparison between Islamic economy, as in The Holy Qur‟an, and present economies shows
following main discrepancies:

Subject Islamic economy Present economies

Economic activities Productive economy. Inflationary economies.
Market and Prices Natural price system. Inflationary systems.
Money Stable medium of exchange. Inflationary commodity.
Redistribution Recognition of right of living means. Equality or welfare policies.

It is obvious that avoidance of interest is just one of the Islamic rules that must be respected.
Present Islamic economic systems and Islamic banks may represent attempts to introduce an
interest free economic systems and banks. Presentation of the inflation free economic system is
an attempt to introduce an Islamic economic system in compliance with the rules of Holy
Qur‟an.

While the Holy Qur‟an governs all macroeconomic issues, the Sayings of the Prophet (Pbuh) and
Islamic Fiqh controls commercial transactions under what is known as Kitab Al-Buyu.
Presentation of the inflation free economic system raises the microeconomic issue of profit/loss
sharing companionship with banks.

In order to be in conformity with the principles of mutual consent, justice and avoidance of
prohibited acts, old Fiqh introduced rules of fixed capital company between individuals or
entities, and controls over the issue of capital mix. According to old Fiqh, main companionship
rules may be summarized as follows:
 Investment must be made in a certain business in order that profit or loss can be accurately
computed. An independent company is allocated for each business.
 Capital must be invested in the specified business. Investment is the reason for generating
profit or bearing loss. A partner may not use capital of another partner in other than the
specified business in order to avoid eating up property unjustly.
 Profit must be recognized on cash base or liquidation, and distributed as agreed.
 Loss must be recognized on cash base, and distributed as per capital shares.

In order to solve the problem of the differential in dates of deposits, investments, and accounting
in banking business, contemporary Fiqh introduced an approach named “Common Mudarabah”
to govern the companion relationship between an individual investor (or entity) and a bank.
Implementation of the common companionship approach contradicts the principle of justice and
involves eating up properties unjustly:
 Profit does not represent an accurate return to invested capital in specific business. An
investor generates part of profit (or bear loss) related to investments made by use of capital

Electronic copy available at: https://ssrn.com/abstract=1902705

 paid by others. In return he is not given his fair share in profit (or is not charged for fair loss)
related to investments in which his capital is invested.
 Rules of capital mix are not respected. An independent company is not allocated for each
business. Over and above, investors‟ money is mixed with bank‟s money.
 Profit and loss are calculated according to accounting principles.
 A bank determines amount of distributable profit. Profit is reduced by reserves and
provisions.

Presentation of “Current Companionship” approach is an attempt to introduce an applicable

companionship with a bank based on old Fiqh;
 Investment is made in a specific business.
 An independent company is allocated for each business.
 Invested capital is calculated on daily base.
 Invested capital is the base of distribution of net profit or loss.
 Net Profit (or loss) is recognized on cash base or liquidation.

Murabaha was not introduced as a banking product because it involves a lot of doubt about its
legality.
―Nu'man b. Bashir (Allah be pleased with him) reported: I heard Allah's Messenger (may peace
be upon him) as having said this (and Nu'man) pointed towards his ears with his fingers): What
is lawful is evident and what is unlawful is evident, and in between them are the things doubtful
which many people do not know. So he who guards against doubtful things keeps his religion
and honor blameless, and he who indulges in doubtful things indulges in fact in unlawful things,
just as a shepherd who pastures his animals round a preserve will soon pasture them in it.
Beware, every king has a preserve, and the things God his declared unlawful are His preserves.
Beware, in the body there is a piece of flesh; if it is sound, the whole body is sound and if it is
corrupt the whole body is corrupt, and hearken it is the heart.‖ (Sahih Muslim).

“And whatsoever you differ, the decision thereof is with Allah”

(Ash-Shura 42:10)

Electronic copy available at: https://ssrn.com/abstract=1902705