What is the difference between a loan and Islamic debt?

Gassner's picture

This is one of the most often asked questions and probably among the least understood in the same time. Briefly I like to list a few of the points here:

  • Interest bearing loans causing interest being paid on interest. Currently at least 9 out of 10 states increasing their debt continously, repaying loans with new loans. That this cannot work indefinetely is known since long time and the immense effect of exponential growth is nicely explained in the parable about the invention of chess rewarded by a rice corn doubling for each square by Ibn Khallikan 1211 AD.
  • Islamic debt modes per se allow to finance assets, services and other real economic activities. However, running costs like wages and instalments are not suitable for Murabaha or Ijara and so on. They require to actually have some funds, e.g. equity through Musharaka for instance, which are not based on debt. Hence, Islamic finance properly applied would lead to a minimum equity protecting firms from insolvence due to short disruptions of debt financing.
  • Any financer has to take over some ownership rights, even if only for a legal second. This assumes responsibility and makes them liable. If there is fraud involved this can increase the risk of the financer as the item sold to the client on credit must be in the range of fair price without cheating. A clear case has happened in Germany, whereby sellers of apartments aligned with financers to offer a loan and sale of the apartments, which were highly overpriced. The court allowed to unwind the sale, with the bankrupt real estate company, but uphold the loan contract with the financer.
  • Last not least, the microeconomic equilibrity pricing gets negatively affected. If I can sell to clients wishing to pay deferred, this is a clear new market segment, for which a different optimal equilibrium price would apply. Through to the loans the market clearance function gets distorted in this regard.