Wednesday, January 29, 2014

Exploitative Profit Sharing: On the incoherence of all contract-based approaches to "Islamic finance"

I am writing a paper for a conference, and after my usual criticism of the modus operandi of Islamic finance (using degrees of separation such as trading partners and assets to separate lender from borrower to disguise interest on debt), which is shared by many, I wanted to make sure also to criticize the misplaced drive for finding an "Islamic finance" in other contract forms. Toward that end, I wrote the following example:

Some supporters of “Islamic finance” have long suggested that profit sharing (in silent partnership, or mudaraba) or profit-and-loss sharing (in full partnership, or musharaka) is the ideal Islamic alternative to riba. However, the reason for the prohibition, which Ibn Rushd imputed to be the potential for extreme injustice, can be just as present there. 
Consider, for example, a silent partnership whereby a capitalist approaches a worker with no capital. Instead of hiring the worker at the market wage, let’s say it is $100 per day, he tells the worker that he wants to engage him as a mudarib (entrepreneur), while he himself will serve as rabb al-mal (capitalist). Let’s say that the capital invested for one day is $1,000 and it is expected to produce a profit of $200 plus or minus $10, depending on market conditions. The mudarib will do the same work for which he could have earned a guaranteed $100 market wage, but the capitalist insisted on “risk sharing.” That may be argued to be somewhat fair if he is offered a 50% share of the profit, in which case, he would earn $100 plus or minus $5. 
Putting aside the relative risk tolerances of the capitalist and the worker/entrepreneur for the moment, which presents problems of its own, there is nothing in the Islamic rules of mudaraba that prevents the capitalist from offering the worker a 25% share of profits, which is grossly unfair relative to his market wage. If the worker has no access to other work, severe exploitation is thus allowed by this ostensibly “Islamic” partnership model, whereby the worker is forced to earn half his market wage on average, with unwanted risk to boot! That is the very same extreme injustice (ghubn fahish) for which riba is but one vehicle.
(Note: This is not an entirely novel idea: many classical jurists had classified mudaraba as ijara bi-l-gharar; hire with (forbidden if excessive) uncertain wage. My example suggests that it may also include an element of riba, in the sense that the profit share is not commensurate with the work done, fairness being determined by the market wage, as many classical jurists would also have determined.)

The message is clear: to call a transaction "Islamic," it must be fair in some clear sense. The paper will include a section on a "unified theory of riba and gharar" to which I have hinted in earlier writings, including on this blog.

My point has been, and continues to be, that there is no amount of juristic (fiqhi) analysis of contract forms that will help you determine whether or not there is injustice in the exchange, and that is the crux of the matter for calling something "Islamic," because the first requirement is Justice (عدل):

(Al-Nahl 16:90 [Asad translation]; 
Behold: God enjoins justice, and the doing of good, and generosity towards one's fellow men,
and he forbids all that is shameful and all that runs counter to reason, as well as all envy,
and He exhorts you repeatedly so that you might bear all this in mind.)

I love, in particular, how Muhammad Asad translated al-munkar (المنكر) as "all that runs counter to reason." I often translate it as "blameworthy activity." But, of course, these are one and the same, and explains my attitude towards so-called "Islamic finance," it runs counter to reason, and is, therefore, blameworthy!


Blogger Parvez said...

Asak Dr. Gamal

I think the problem you identified with the Mudarib offering a 25% share for $50 as apposed to $100 in wages would be non-existent in a free market. And if the worker has no access to work then the wage for that job would likely not be $100/ day. Forces of demand and supply would take care of that I guess. And I believe that Islamic Economics is not entirely opposed to free markets except in some special circumstances. Your thoughts?

11:06 AM  
Blogger Mahmoud El-Gamal said...

Aha, very good point. This same logic suggests that an interest bearing loan to the client cannot be at usurious (exploitative) rates, because competition would drive down the interest rate to the proper measure of time value + credit risk. However, riba was forbidden, according to scholars (more listed in the paper) because of the potential for exploitation. I am merely pointing out that if the market conditions were such that exploitation is possible in interest-based loans, it is equally possible in partnership finance, which has been hailed for decades as a "truly Islamic" alternative, for reasons that I cannot understand.

11:16 AM  
Blogger Parvez said...

I understand the point you are making but the injunctions in Islam are not entirely based on logic and reasoning for the wisdom of the Allah is beyond human comprehension. Clearly if they had based on logic, we would be eating pork and consuming alchohol for the reasons I do not think we need to eloborate further.

Now, I know you will not agree with the above because of what I have seen you post off late - The Mutazilite v/s Asharite positions and your preference for the Mutazilite position. Correct me if I am mistaken.

1:11 PM  
Blogger Mahmoud El-Gamal said...

One does not need to invoke theological schools on matters of financial transactions. In this domain, all schools agree with the juristic rule that what matters in contracts is substance and not form.

The argument from dietary rules to financial transactions is a classical bait and switch, exploited by the likes of Taqi Usmani. The primary differences are (1) that pork has not changed since 1 A.H., but finance has changed dramatically, and (2) that all schools of jurisprudence agree that the default in financial transactions is permissibility, and that the objective is human benefit.

One does not need to stick to one school or the other across the board. On matters of creed, I find the Ash`arite position (Tahawi creed, in particular) to be quite familiar and comfortable. Combining that with neo-Mu`tazilite approaches, especially in Fiqh, like many 20th centuries jurists, is also very appealing.

Especially when you can prove definitively that the illogical adherence to certain juristic positions can only result in the impoverishment of Muslims with all the ills of, say, riba still intact, then that position is untenable.

No scholar can claim to have definitive proof for the prohibition of any modern financial transaction in the same way that we have definitive proof of the prohibition of pork in the Qur'an. The Qur'an, the Sunnah, and the practice of the first generations, all have very little to say about modern finance without a lot of reasoning by analogy. In this domain, I trust my fellow contemporary lawyers' and economists' abilities to make analogies than jurists trained in medieval methods.

2:13 PM  
Blogger Parvez said...

Fair enough. However, I would argue that substance and form are equally important in all matters of faith and not just for financial contracts. Therefore, substance of a transaction has to follow a permissible form i.e they go hand in hand.

for e.g. one can argue that the substance of a common law relationship (contract) is the same as a marriage contract in western law for spouses share the same rights and responsibilities. But clearly one form is permissible and the other is not. On the other hand if we were to consider a contract of Mutah (contractual marriage) versus a casual relationship, the substance would be impermissible yet the contractual form of Mutah would be acceptable at least under certain circumstances.

Further, I would argue that the substance of ribawi finance (modern or medieval) has not changed substantially. What has changed is the form primarily as a result of the advancement in technology (computing power).

We can assign a variety of reasons that has resulted in the impoverishment of Muslims and I do not think you can assign that blame on jurists alone. I firmly believe that it is the global monetary system based on fractional reserve banking deeply rooted in the system of Riba that is at the heart of this problem. This ails a large population of the world and not just Muslims alone.

I agree that we need jurists who understand the contemporary system to be able to make coherent judgments. But are you sure that you trust your fellow contemporary lawyers' and economists (neo classical), the very same people who are responsible in giving us the present system?

9:15 AM  
Blogger Mahmoud El-Gamal said...

I agree that contract forms are useful, if only for standardization of use and regulation.

The funny thing is that mudaraba itself would have been deemed impermissible as a matter of form (hire with random wages). However, it was ubiquitous, so classical jurists found a way to approve it in analogy to sharecropping.

Then, there was a debate on leasing agricultural land for a fixed rent. Part of the debate was canonical, about the Hadith of Rafi` ibn Khadij, but part of it was at least implicitly substantive: once you allow the fixed price rental of capital in the form of land, why not allow rental of capital in other forms? (Ultimately, the majority approved renting land, again because of its ubiquity).

So, we come to the modern era, and have a number of very highly qualified scholars who say that modern interest-based finance should not be looked at as interest on loans, but rather as an investment with fixed profit margin. That is merely rejoining the old classical debate and accepting what is now ubiquitous. However, the "Islamic finance" advocates reject that solution, and introduce an even more controversial alternative based on credit sales. We forget today how controversial so called murabaha was in the 1970s when first introduced. It was really murabaha for the one who ordered the deferred sale (lil-'amir bi-l-shira' ma`a bay` bithaman 'ajil). Because the last part of the name had already been condemned by Arab and Pakistani jurists (despite its ubiquitous use in Malaysia), they just shortened the name to murabaha!!

The point is that new forms have been introduced over and over again, starting in the classical era. Nobody has sacred authority in this arena, so the criteria to use must be legal and economic efficiency, using the best tools available today.

Yes, of course, today's system is not perfect, but the commodity money model was also far from perfect. The great depression was not possible to avoid in part because there was no monetary policy. "Tyranny of gold," many called it in the early twentieth century. It was a system whose time had passed. We keep trying to find better economic and legal systems, just like we keep looking for better medicine, better science and engineering, and so on.

In that search, there will be beneficiaries of particular systems that will tilt the field of search in their favor, and I admit that this has indeed been the legacy of modern capitalism and its neoclassical justification. Pointing out the system's flaws is one thing, but looking for alternatives among those that were already discarded for obvious reasons, let alone basing that on some abstract sacred authority of "scholars" in areas where there are no sacred foundations, is a tragedy. It is a tragedy for Muslims in many many fields, and finance is just the tip of the iceberg.

12:24 PM  
Blogger Parvez said...

Let me be honest and say that I do really learn a lot through your blogs.I think we are in agreement on most issues but I do want to raise two issues

1)Without going into the causes of the great depression, the gold system was still built on the system of Riba and it failed but the same commodity money flourished during the Islamic era. Correct me if I am wrong.

2)Do you really consider money "capital" and therefore can be rented ?. In the islamic understanding, the role of money is restricted to its use as a means of exchange and a measure of value. Acccording to Imam Ghazali who put in quite eloquently when he said " the nature of money is like a mirror which does not have any color but reflects all colors.

Have you ever read Taqi Usmani's The Text of the Historic Judgment on Interest
Given by the Supreme Court of Pakistan.

You can read it here

Your thoughts

3:09 PM  
Blogger Mahmoud El-Gamal said...

It is unhealthy to think that "the Islamic era" was some Utopian heaven without financial and economic problems. Nothing could be further from the truth. Moreover, there was nothing "Islamic" about that system; it was merely a hodge podge of Byzantine and Sassanid systems. It is well documented how `Umar relied heavily on literate Persians, and later Caliphs relied heavily on literate Christians and Jews to run the affairs of the growing empire, because Arab Muslims still lacked literacy, mathematical, and administrative talents for many decades after the death of the Prophet (p).

The issue of what is money is a very complex one (Narayana Kocherlakota, currently president of the Minneaplis Fed, has a famous paper "money as memory").

Your reference is to the typical "Islamic economics" anachronism which takes the Keynesian taxonomy of uses of money and superimposes it on Al-Ghazali's writings. Keynes is now antiquated, and Al-Ghazali is by no means an expert on economic matters, let alone theories of money.

I am trying my best to limit my public criticism of Islamic finance "scholars," so if you wish to discuss a specific fatwa spearheaded by a particular person, we should probably take the discussion offline.

3:59 PM  
Anonymous Anonymous said...

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5:50 AM  
Anonymous Anonymous said...

Thank you very much Professor for this extremely beneficial and, as always, thought provoking post. I eagerly anticipate the draft of the paper. Your simple example highlights very clearly that it is impossible for contracts in themselves to ensure justice - you could provide an infinite number of numerical examples of how an 'islamically approved' contract can be more exploitative than a 'haram' interest based contract (even, as you say, ignoring the other not-insignificant elements of the Islamic contract e.g greater risk/variance of returns, legal protection / clarity of terms etc).

You raise a fascinating point about earning a fixed rate of return on Agricultural land and its implications for allowing rent of other forms of capital (the definition of which has changed significantly over time). It just highlights the fact that at some point in our history we just decided to close the doors on innovation in so many things.

I personally get really tired of hearing people claim that we should return to the use of gold and silver (implying this is the ‘prophetic currency’. I believe this kind of argument that we should link everything to the demand/supply idiosyncrasies of some (arbitrary) commodity (an argument weak in terms of economic theory of currency regimes and historical evidence) stems from some utopian dream which is probably based on good intentions from these people to return to the times of the prophet s.a, but essentially reflects a lack of appreciation of what elements of the life of the prophet s.a were context specific (adopting existing financial systems of the time) and which true core principles we should extract from those. Without making too simple an argument, just as very few people are calling for us to return to the use of camels and donkeys as a mode of transportation (subsequently replaced by more technologically efficient means), we should not be calling for a return to linking our world economies to the value of some arbitrary piece of metal (similarly, commodity based regimes have been subsequently replaced by more electronic money systems which most definitely have their flaws and need to be reformed but that is no reason to completely get rid of them).

As a final point, from my own personal experience, the use of many Islamic contracts to replicate existing simple ‘haram’ contracts with a number of ‘halal’ contracts with Arabic words, resulting in exactly the same net cash flows and substance as ‘haram’ contracts yet a higher price, really does not reflect well on Islam and Muslims. I have worked for a number of years in conventional western financial markets, where I witnessed the use of ‘Islamic’ commercial paper on trading desks who viewed these exactly the same as any other paper issued by the same issuer (because the cash-flows are identical! Who care about the Arabic name!). Since ‘Islamic’ paper has higher rates of interest (sorry ‘profit’), its easy to make a relatively risk free arbitrage and buy one while selling the other (the only thing preventing even greater profits for the desk was the relative illiquidity of the islamic contracts, so 'developing' the Islamic markets would allow even more of these rents to be extracted! (naturally, rates will decrease as the liquidity premium decreases but I think the relative contractual complexity of an islamic instrument will on average ensure a slightly higher price always)). Many people in financial markets think it’s really funny that Muslims are so easily fooled; quite sad really. We lose a lot of credibility by putting the word ‘Islamic’ on these pathetic contracts, and we damage the name of Islam with this.

5:51 AM  
Anonymous Anonymous said...

This is why we need individuals such as yourself to continue doing what you are doing despite the whole industry being against them. Allah knows best, maybe you wont have the impact you want in your lifetime but you can sow the seeds for change in the future inshAllah when we hopefully have more scholars with both an appreciation of classical fiqh as well as modern finance / economics. Barak Allahu feek.

5:51 AM  
Blogger Mahmoud El-Gamal said...

Thank you for the pep talk, Muhammad. I once was talking to Dr. M. Nejatullah Siddiqi and admitting that my style of argument has antagonized too many people, and that I wish I could be more diplomatic... His response was that one should only try to be authentic to oneself, and hope that good will come out of it.

7:11 PM  
Blogger Parvez said...

Asak Dr. Gamal

The reason I asked you to look into the fatwa was to seek your opinion on it as it addresses some of the topics we have discussed here i.e. definition of Riba, nature of money, resource allocation, market structures etc.

It is a landmark fatwa and perhaps one of the most comprehensive as it covers a wide range of issues. I thought it would be beneficial for all of us if you were to provide your take on it. But if you prefer to take it offline in e-mails, that would be fine as well. Can I write to you on Rice University e-mail address?

I also wanted you to take a look at another fatwa - this one is on equity investments in Joint Stock Companies which appeared on authored by a student of Mufti Ibrahim Desai of South Africa who also approved it.

I found it very enlightening and logical in its conclusions and wanted to get your perspective.

By the way, I did go back to my notes and books and did realize that the concept of Mudaraba is not supported by any firm evidence from the Quran. Also, there are no reliable proofs in the Sunnah according to Ibn Hazm whereas Ibn Taymiyyah asserts that the Prophet (PBUH) approved it. I gather this from Tarek El Diwany's Book - Islamic Banking & Finance - What it and What it could be - Page 162

Do you also find similar issues with the concept of "Musharika" ?.

This is the last straw on which we can hang on :-)

5:51 PM  
Blogger Mahmoud El-Gamal said...

You are right, we should discuss that Pakistani fatwa in public. I'll plan to start the discussion under a separate posting, isA.

Musharaka is just a generalization of mudaraba, where the capital contributed by both parties is positive (it is zero for one party in mudaraba). It is just as vulnerable to abuse, for the same reason as mudaraba: profit rates can be set at any level.

We do not need contract form straws. The Mawdudist school was looking in the wrong place when they thought that partnership forms are in some way superior Islamically to debt instruments. There was absolutely no basis for this in classical jurisprudence.

More soon, isA.

8:55 PM  
Blogger Kareem said...

Dr. El-Gamal. I am eagerly awaiting your conference paper. Are you planning to post it (if so, do you know when?)? Jazak'Allahu Khairun

10:35 AM  

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