Islamic Finance

A System To Defeat Inflation: Islamic Finance

Written by
Published on
June 25, 2023

Inflation - the specter that haunts economies worldwide, impacting rich and poor alike, has been a growing concern as we navigate through the turbulent waters of the post-pandemic world. As the cost of living escalates, families find it increasingly difficult to make ends meet, while businesses struggle to maintain profitability.

But what if we were overlooking extraordinarily relevant set of principles that could help us combat this economic menace? What if the solution to our problems is embedded in the teachings of the Holy Quran and the principles of Islamic Finance? In this blog post, we dive deep into the wealth of wisdom enshrined in Islamic Finance and explore how it can help the world fight the rising tide of inflation.

The Emergence of Inflation and Its Impact

Before we delve into the solutions, let’s first examine the problem. The global inflation rate rose from 3.2% in 2019 to an estimated 3.6% in 2022 (IMF), illustrating a worrying trend. Inflation impacts people in many ways - it erodes purchasing power, discourages savings, and can even fuel social unrest.

The Pillars of Islamic Finance

Islamic Finance, derived from the Holy Quran and Hadith, presents a unique framework centered around equitable wealth distribution, risk-sharing, prohibition of interest (riba), and transactions grounded in real economic activities. The principles of Islamic Finance could potentially offer some solutions to rising inflation.

Prohibition of Riba (Interest)

One of the core tenets of Islamic Finance is the prohibition of interest, termed as Riba. The Quran (2:275-280) unequivocally forbids it, emphasizing that trade is permitted while usury is not. Economists like Keynes and Friedman have shown that monetary expansion, when not corresponding to economic growth, can lead to inflation. The global debt has soared to over 356% of GDP in 2020, up from 320% in 2019, as per the Institute of International Finance (IIF). This massive borrowing, often accompanied by interest, contributes to monetary inflation without necessarily correlating with real economic growth. Thus, the prohibition of interest in Islamic Finance can play a significant role in curbing inflation.

Risk Sharing

Islamic Finance promotes the sharing of risk between parties rather than transferring it, as seen in conventional finance. This approach dissuades speculative activities, which often exacerbate economic volatility and inflation. A study published in the Journal of Economic Behavior & Organization (2014) found a direct correlation between speculation in financial markets and inflation volatility. By promoting shared risk, Islamic Finance can potentially reduce speculative trading, thereby creating a more stable economic environment less prone to inflation.

Asset-Backed Financing

Another cornerstone of Islamic Finance is the requirement for all financial transactions to be tied to tangible assets and real economic activities. This principle discourages the creation of wealth out of thin air, a practice that can inflate the money supply and lead to inflation. A 2018 study by the Bank of England showed that up to 97% of money in circulation was created by banks when they provided loans - not backed by real assets. The practice of asset-backed financing in Islamic Finance would thus serve as a check on this unrestricted money creation.

Profit and Loss Sharing

Profit and Loss Sharing (PLS), an intrinsic part of Islamic Finance, promotes a system where borrowers and lenders share both profits and losses from financial transactions. This sharing of outcomes discourages reckless lending and borrowing practices, which can lead to economic instability and inflation. A 2020 study by the National Bureau of Economic Research (NBER) highlighted the role of reckless lending practices in the 2008 financial crisis, which subsequently led to severe inflation in many economies. By ensuring lenders also share the risk, PLS provides a natural check and balance system that can potentially control inflation.

Prohibition of Gharar (Uncertainty) and Maysir (Gambling)

The Quran strongly discourages transactions that involve excessive uncertainty (Gharar) or gambling (Maysir). Excessive uncertainty and speculative trading can significantly contribute to inflation, as they distort the balance between the money supply and real economic activities. By discouraging these practices, Islamic Finance can potentially mitigate these inflationary forces.

Zakat (Charity)

Zakat, one of the five pillars of Islam, mandates the giving of a portion of one's wealth to the poor. This principle helps reduce income inequality and increase the purchasing power among the lower-income demographics, thereby stimulating economic activity. A 2021 report from the World Bank showed that nations with high income inequality tend to experience more frequent and severe economic shocks, often leading to inflation. Thus, by promoting wealth redistribution, Zakat can contribute significantly to inflation control.

Ethical Investing

Islamic Finance encourages investment in sectors that are ethically and socially responsible, steering clear of industries such as alcohol, tobacco, and gambling. Such an ethical approach to investing may lead to more stable economic growth and less inflation. A 2019 study in the Journal of Business Ethics found a positive relationship between ethical investment and economic stability.

Fiscal Discipline

Last but not least, the teachings of the Quran encourage fiscal discipline and avoiding excessive consumption. Quran (17:29) warns against wasteful spending: "And do not make your hand [as] chained to your neck or extend it completely and [thereby] become blamed and insolvent." Such fiscal discipline at the individual and societal level can be instrumental in controlling inflation.

The Road Ahead

It's high time the world takes a serious look at Islamic Finance's principles in the quest to fight inflation. While the path is complex, these principles provide a blueprint that can be adapted to specific economic circumstances worldwide. As we grapple with the challenge of inflation, the wisdom of the Quran and Islamic Finance offer a beacon of hope, highlighting the importance of real economic growth, equity, and financial discipline.

However, implementing these principles requires the collaborative effort of policymakers, financial institutions, and individuals worldwide. As we step forward, let's bear in mind the essence of these principles - a more equitable and sustainable economic system for all.

As the Quran (2:219) says, "They ask you about wine and gambling. Say, 'In them is great sin and [yet, some] benefit for people. But their sin is greater than their benefit.' And they ask you what they should spend. Say, 'The excess [beyond needs].'" In these trying times, let us strive to eradicate the 'great sin' of economic instability and create a world where wealth serves its true purpose - to benefit all of humanity.

Latest posts

Join our newsletter

Sign up for the very best tutorials and the latest news.
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.