Economic Rationale of the Prohibition of Interest

A New Aspect

Abstract

Conventional economist, in particular neo-classical, assumes that self-interest is the guiding principle of economic behaviour and there exist no fallacies of composition. That is, whatever is in the interest of an individual is also in the interest of a society. Keynesian school of thought, on the other hand, though admits fallacies of composition such as “paradox of thrift” and “liquidity trap,” but they believe that such anomalies can be resolved by appropriate government intervention. History has, however, shown that government intervention, on average, worsens the issues of an economy instead of resolving it. One such issue which could not be resolved through government intervention is of “interest.” In this paper we investigate that why interest requires divine intervention for its prohibition. After explaining the economic rationale of prohibition of interest from Islamic perspective, we show through numerical illustration that how interest-based investment project, on one side, allows individual lenders to shift risk to borrowers and on the other side, generates a negative externality in the shape of financial and bankruptcy risk, which is an addition to the investment risk for the stakeholders of interest based investment. This might be one of the reasons that all divine religion including Islam give more weight to the societal or other stakeholders’ interests than the interest of lenders only and prohibit interest based lending completely. We conclude that Islam not only admits the existence of fallacies of composition, as do Keynesian school of thought, but also takes steps to resolve such fallacies through divine rules.