In the Name of Allah, the Most Gracious, the Most Merciful
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Economic Model - 21st Century Islamic State

Economic Model

Economic System

The fundamental viability of any state is its economic system. The inability of the Muslim world in creating viable economic models that are not cheap replicas of Western economies is perhaps the biggest challenge that we face. Riba (interest) is central to the western economy and for Muslims this is unacceptable. Any models we develop on the lines of their system is therefore fundamentally unislamic. We have to be brave in breaking new ground, in finding a viable alternative framework rather than finding the latest trick in the book to put another name for riba, and somehow guise it as “rent” or “fee” or the many other terms we play with. Riba is wrong, there is no going around this.

Impact of Interest

If one looks at economies where banking dominates to a greater extent, it is my hypothesis that you will find that economic cycles are more volatile. Banking is responsible for much of the money supply in the economy and this money supply tends to fluctuate to a greater extent precisely because of its connection to banks; they accentuate the volatility of the money supply, which in turn emphasize the volatility in demand.

Removing fractional reserve banking and an interest-based economy - this is likely to make booms and busts far less of a problem as the money supply in the economy is less likely to fluctuate. Research could conclusively prove or disprove this thesis by doing a comparative study of economies where banking plays a greater role against economies where banking plays a lesser role and matching this to see how it correlates with the volatility of booms and busts in each group. Of course, holding everything else constant in an absolute, puritanical sense, and will be difficult but this exercise may still be useful.

Not only is interest (or riba) wrong, but it is also not the be all and end all of a discussion of Islamic economics. There are many other fundamental issues that are intrinsically linked and are of equally greater importance. For instance, fractional reserve banking as well as the concept of limited liability are also key elements of the Western economic model, but are again essentially unislamic. Fractional reserve banking allows money to be created out of no real economic activity, but virtually out of thin air. Limited liability allows businesses to exist without proper assignment of risk to the constituents of the business. We cannot be blind to these elephants in the room.


The fundamental question for an Islamic economy, or perhaps any economy for that matter, is in defining how savings-investment will work in an alternative framework. That is, how would savings in the economy be turned into effective investments? By taking out both interest-based banking and limited liability (thus corporations as we know them, stock flotations and leverage) we seem to be taking out this important link between savings and investment. In the Islamic state, this function can be taken over by creating an alternative venture capital based investment economy and by redesigning the corporation as we know it to incorporate liability.

Today western economies subsidize loans over investment in equity because interest payments are not taxable while dividends are. This puts investors at a disadvantage and gives banking a leg up. There does not seem to be any real rationalization for this without going into a conspiracy theory, but suffice it to say for intended or unintended reasons, this is the case. Within investments in equity, corporations created in limited liability (and the concept of the corporation as a legal entity) and by extension the stock market, dominate.

In addition, restrictions on investors in private equity and venture capital are also stringent and constricting. As a result, venture capital and other forms of private investing suffer a double jeopardy. we see that venture capital is greatly marginalized in western economies both in quantity and in quality, focusing narrowly on the highest yield opportunities which also involve the highest risk.

Our savings-investment vehicles would include:

1. Venture capital firms
2. Investment banks
3. Restructured corporations
4. Restructured stock market

Corporations would be restructured to include liability. However, it would be the responsibility of the top management to make sure that information is provided accurately. If the company fails because the management was hiding information in any way then the shareholders will not be held liable for the losses beyond the value of the stocks. Any stocks that are showing poor balance sheets, income statements and cash flow statements could be de-listed from the stock exchange mechanism and moved to pink sheets.

Investors investing in these pink sheet companies will be fully cognizant that they are dealing with companies that could default and fail, resulting in them being held liable for losses.

Derivatives need to be severely restricted and regulated by the markets to ensure that speculation does not reign. This is important to ensure that the financial system is subservient to the "real economy". Only derivatives allowed will be forwards and swaps of real assets, rather than fiat paper. The Islamic state would need Muslim thinkers and economists who can further analyze where else and how else this can be applied.

Foreign exchange for instance, comes to mind as a point where forwards and swaps may need to be applicable for the smooth operation of international trade, although they fail our benchmark of being real assets. Derivatives inherently do not appear to be wrong when connected with real assets rather than paper assets and provides fundamental value for economic activity. They are particularly important in today's times when production activities are highly synchronized and dependent on a vast network of supply activity, all of which have to be made available within complex long-term planning and procurement.

Venture capital firms would need to play a key role in the economy, a role that will be far less restricted by regulation and the opportunity costs created by interest (riba) in Western countries. They will therefore need to be structured differently from the VC firms in western markets. They will be larger, more “bank-like” in their investment decisions and willing to take on lower yield investments.

This should be a natural adaptation and evolution for them given that there will be no competing interest-based system to take the lower yield and lower risk side of the market, the financial system will not subsidize interest based lending (as in the west and discussed earlier) and there will be no "risk-less interest" to artificially raise yield requirements for risk-sharing investing.

Money Supply

Money supply should be maintained at a rate that would approximately keep prices constant. Some leeway that is practical should be allowable. However, the aim of the Islamic State would be to maintain the value of money to its best ability. We have seen the negative impact of inflation, coupled with loose government spending and an exploitative banking system, a sure recipe for disaster.

That the value of money should be maintained does not also somehow mean that a gold standard should be sought. A gold standard implies that the value of the currency remain constant to the value of gold, which has its own negative implications, as the value of gold can fluctuate independently to that of the goods and services bought and sold in an economy. Gold prices today can also be highly fluctuating. Instead, the value of the currency will be dependent on a basket of goods and services that is reflective of the economy as well as the value of a basket of currencies that would be represented by their level of trade with the Islamic state. Of these two factors, the former (a basket of goods and services reflective of the economy) should be weighted more than the latter (basket of currencies being traded with), given the importance of the Islamic state's own real assets and value to its citizens. This ratio of decision-weighting would need to be determined and could perhaps be in the region of a 80:20 ratio, heavily in favor of maintaining the value of the currency for the local consumers.

Alternatively, the ratio could perhaps be equal to the proportion of foreign trade to domestic consumption, a more classical way to address the issue.

For this to work in practice, a completely independent monetary authority would be needed. If the US constitution has three branches that are independent of each other, the Islamic State will need many more than three. The central bank will be one such independent authority that will be in charge of maintaining the value of the currency. Another independent institution will deal with statistical data and this will also need to be completely independent of the other arms of the state. This is important and is mentioned here because it would be less useful to have an independent central bank if it depended on data that was manipulated by governments as a means to sway the central bank.

We have seen how Western governments have played with key statistics such as inflation and unemployment. The Islamic State should not repeat that mistake. An independent statistical arm of the state will provide statistics for all other parts of the government to base there decisions on, including data needed by the independent monetary authority of the state.

Money Supply Expansion with Population

There is still the problem that a naturally increasing population would mean that keeping money supply per person constant would require a natural increase in the money supply. In the Western economy, monetary expansion principally and in its first incidence benefits the banking institution and the government rather than the people, who are only benefited indirectly.

One possible alternative is for each individual that comes of age, he/she would be given an endowment equal to the amount that would result in keeping the economy in equilibrium (a value dependent on the consumption rate). This could also simultaneously be a source of financing for young men and women entering the economy needing an initial investment to get them going (i.e. for education, buying a starter home, etc). In addition, such an endowment would strengthen the meritocratic nature of the state, evening the playing field for all future generations to.

The nature of the state, however, must remain fundamentally that of an open economy based on private enterprise and competition, we must not take the route of ever increasing government regulation and government supported welfare projects that take on a political power-base of their own. The low tax rate of an Islamic economy will perhaps prove to be a counter to such state-creep. Regulatory creep however, needs to be watched and guarded against far more extensively. The importance of having a financial regulatory body, completely independent from the government of the day, is thus of vital import to the model we are attempting to develop.

In Transition

In the event of the establishment of an Islamic state, abolishing banking outright would be catastrophic. Money supply would shrink rapidly. Demand and investment would collapse, spiraling the economy into a recession. The knee-jerk reaction from the populace would be to increase savings, further reducing consumption, compounding the problem even further.

The correct solution perhaps would be to gradually impair banking. Just as the Communists created a socialist state to achieve Communism, so too must the Islamic state act in staging itself through a transition. Staggered increase in the reserve ratio of banks and changing the regulatory framework can go hand-in-hand in transforming today's banks from caterpillars to butterflies.

The aim, eventually, is to move banking towards a theoretical 100% reserve ratio; depositors would have to give the bank consent to invest their money. One option would be that such banks would offer liquidity options with time horizons such as 3 days, 1 week, 1 month, etc. Investments would not have a fixed guaranteed return but rather a risk sharing return. Because of the nature of the investments, greater liquidity options would still generally yield lower returns and thus still maintain those natural patterns of investment that economists have come to consider almost equal to the law of gravity.

For those depositors seeking 100% reserve and complete liquidity, the banks should be allowed to charge a service fee for holding the money in safety. After all, such a service would represent a clear service to the bank's customers with clearly identifiable costs to the bank.

Monetary and Fiscal Impact of Transition

We have already touched upon how liquidity would dry up in transition. Even with the most gradual transition would result in recession, and the more gradual it would be the longer the recession would last and the worse would be its consequence. Let us consider three possible policy options: increasing the reserve ratio, curtailing interest-based banking through regulation and restricting and regulating the stock market. All would result in a rapid reduction in the money supply, and a rapid downward projection of the economy towards an inevitable crash; ceteris paribus, deflationary pressures would reduce investment and consumption expenditures and reduce national income.

Is this a necessary pain to create an Islamic state? One, impoverished and destitute already, would he or she be willing to dip even deeper into unimaginable poverty and hopelessness? No. For sure there is a solution. It may in fact, be an ideal opportunity. Let us consider the possibilities.

Keynesian economics dictates that an (read non-Islamic) economy can be revived by public spending to boost consumption and thus inject the system with new demand and new money.

C▼ and I▼ is counteracted by G▲
Y is National Income
C is Consumption
I is Investment
G is Government Expenditure
X is Exports
M is Imports

Because an interest-based Western economy is inherently cyclical and dependent on an ever increasing GDP & Money Supply, the Keynesian solution is often the last resort when all monetary and information options have failed. That is, for instance, when simply expanding credit and the money supply either becomes ineffective or becomes untenable.

The great downside of Keynesian fiscal expansion is inflation. Yet, this may not be a downside in deflationary times. Here is the opportunity within our framework of a transitioning Islamic state: If we attempted fiscal expansion during our earlier described banking and stock market transition, we would be ideally placed to carry out our expansionary fiscal policies without paying the price of Inflation!

However, as with anything in life, timing and proportion is crucial. A cricketer (or a baseball player) perhaps understands this better than an economist. Yet for the economist, that mis-timed ball would result in far more damage than the cricketer (or baseball player) can fathom. Neither is it for no reason that Alan Greenspan played the violin; dreamers must be good and timely executioners, if their dreams are to succeed.

Post Transition

This period of fiscal expansion should not however go beyond the period of transition. Governments should not be allowed foot-loose monetary and fiscal policies. Balanced budgets would be hardwired into the constitution. As we shall see in the section on the constitution, division of powers would ensure that monetary policy is conducted by an independent arm of the government that is autonomous of the political and administrative authority. This will ensure that the money supply is not abused and inflation is kept at or near zero percent. Combined with a hardwired balanced budget, this will ensure the stability of macroeconomic conditions in the country.

On the surface, such a setup appears grossly flawed. When a Western economy faces recession, not only does consumption decrease, but so does government revenue. As a result, balanced budgets would do great harm in actually advocating reduced government spending during a recession. However, in our economic model, we believe that the economy will be far less cyclic, given the elimination of interest and fractional-reserve banking. Secondly, We can add a provision that the monetary authority will have the final say as to the amount and extent of any fiscal intervention in the case of a recession.

This solution effectively eliminates perhaps the greatest quandary of Western economies - the conflict of interest between political government and vested interests on the one hand, and the higher intellectual goals of managing booms and busts.

Meritocracy as the Central Theme of our Model

Let us consider the central principles of our Economic Model. Centrally, we seek free enterprise within the constraints of Islam, making it philosophically an effort towards a meritocracy. A welfare state within that which has been prescribed in Islam given the Muslim obligations of zakat and alms giving.

Removal of riba, fractional reserve banking and inflation as a tax imposed by government. A defanged savings-investment system built around equity investing and freed from the injustices of regulation, double taxation and unfair competition that equity investments face today in the West. An independent state bank to have complete control over the money supply, with the central purpose of maintaining the money supply.

A central theme of meritocracy inevitably plays out, given Muslim requirements for alms giving and zakat (which incidentally is a wealth tax) Islamic redistribution laws on death, and if we are to pursue an endowment policy for the young. Linking with free education and a meritocratic political model, we see that the theme for meritocracy would become intrinsic to the Islamic state, politically, economically and spiritually.

The Day of Judgment too will be meritocratic, each soul being rewarded by what it earned. That will be a Day of perfect Justice. Our meritocracy on the other hand, is a human meritocracy and flawed by our human limits.

Economic Modeling & a New Science of Muslim Economics

Economic modeling will need to be rethought as many of the key models have interest (riba) as a key element in the models. Perhaps Tobin's Q could be a replacement for riba. We would need pioneers to create the building blocks of Islamic econometrics. Thus far, “Islamic Economics” has largely meant Microeconomic discussions of interest-free banking. This is a poor picture of what we need and perhaps reflective only of where we stand today.

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