The role of the state in Islam is modelled on the way that the early companions implemented the affairs of state. Islam requires the authority of the state to act in the public interest, to maintain justice, to promote Islam internationally, and to redistribute wealth. The extent to which the state should rule peoples affairs depends on the needs of the people. Sometimes large government involvement may be needed and sometimes only a little. Islam does not prescribe any thing like a state with huge control over industry but it is responsible for taking control of such basic utilities such as water rights if it is necessary to ensure that the basic needs of the population are met. The Islamic economy is a very free market economy restricted by the morals of the Muslims involved in the trading and general concerns over distortions to that freedom to trade. For example the existence of monopolies or other forms of attempts to deceive people as to the would-be free market prices is something an Islamic government would attempt to eradicate. One key aspect of Islamic economics is the prohibition of interest. Discussing this brings out a number of the moral teachings of Islam with regard to economics.
This has to be taken into consideration along with the prohibition of gambling and discouraging of hoarding supplies or money. These things are all closely related. An efficient economy is characterised by a swift and general balance of supply and demand. Hoarding distorts the free flow of goods if it is done for the purpose of storing wealth. (Keeping collections of things that are used in some way for benefit doesn't have that effect.) Hoarding is also a kind of speculation based on the idea that what is hoarded will go up in value or at least stay constant in value. Speculation is wrong to the extent that it is like gambling. Let us consider the market for wheat. In an efficient market, the buyers of wheat are the people who will then make bread and other foods and sell it, the price will adjust depending on the supply and demand and will reflect what people are willing to pay for it in order to use it. Hoarding amounts to betting on an increased value. Speculation on an increased value would mean buying the wheat in order to sell it at a time in the future with the expectation that its price is going up. This kind of action distorts the matching of real demand (for the use of some product) and real supply. In the most extreme circumstances where most of the trade is speculative then most purchases are because people expect an increase in price. The act of buying pushes the price up and so encourages more people to buy. This positive feedback is the opposite of what should happen in an efficient economy where the rules of supply and demand are a negative feedback and push prices to a dynamic equilibrium.
If I expect the price to change I can, however, make a contract in which future liabilities are clearly fixed which may well take this expected change into account. Such contracts have inherent risks in them built into the liabilities. However, in dealing with the risk we have a contract between a user and a supplier and these are the people best suited to mitigate that risk by finding ways around it. What shouldn't be done is to begin trading risk to people who have little or no ability to mitigate it, for example insuring the risk. To do any such trading in risk is essentially a form of gambling. In general Islam therefore tackles risks by strategies for risk mitigation rather than insurance. For example for risks where short-term temporary loss can be damaging what is needed is short-term loans or payouts from an organisation with considerable liquidity. Such mitigation can be achieved by collective mutual assistance groups. In these groups people deposit funds according to their abilities and on the basis of mutual assistance. This fund is then given out to those in the most need if the dangers come to pass. Such a mechanism removes the connection between the amount put in to the fund and the amount paid out and is therefore no longer a form of gambling. These collectives should ultimately be the responsibility of the state to implement as acting in the interests of the public good. A fine example of such a scheme in practice is the universal health cover provided by governments in various countries including the UK. Such organisations acting for the collective are then in a position to mitigate related common risks much more effectively.
Interest is explicitly forbidden in Islam. The essential problem with interest is that interest divorces the lender from any moral responsibility for the use of money lent. The return is guaranteed no matter what the changed circumstances of the borrower are. The possession of money doesn't of itself cause any increase. It is only when the money is put to some use that it can yield a profit. By divorcing the lender from any responsibility over the use of the money what is introduced is a problem called a moral hazard. The lender doesn't care where the money is lent so long as the returns are guaranteed. This encourages not merely immoral lending (e.g. . lending to encourage a build up of weapons for a war), but it also encourages continually more reckless lending. The real profitability of the use of the borrowed money is hidden from the financial system.
We consider an analogy here: The financial system is like a farmer living through the productivity of the physical economy - the man's farm. The man takes some of the produce from the farm for his own needs. However, the farmer should also consider the needs of the farm and must not overwork the land or act carelessly about the potential of the land to carry on producing. Carelessness will inevitably cause problems, in the worst case the farm will be destroyed and so will the farmer. The existence of interest in an economy amounts to the same thing as the farmer (financial system) not caring about the farm (the physical economy) and it is bound to lead to problems. On a microcosm we see the problem in the case when money is lent to people who then find themselves in difficulty are pushed ever further into debt because they are unable to pay the debt - eventually they are ruined.
By banning interest, Islam forces the linking of lending with the moral responsibility for its use.
The role of financing organisations is crucial to an economy, ideally they distribute the wealth from those who don't know how to put it to productive use to those who do know. This is essentially the role of investment agencies and it requires some knowledge of how to invest effectively in productive enterprises. This input of knowledge is (in our analogy) like the farmers work to make the land productive. The current banking system however started on quite a different way of making money which required no specific investment skills - only rigid enforcement that interest be paid on their loans.
A brief history and prediction of the life of banks:
Banks started life not as vehicles for investment but as secure places to store wealth. At some point some one noticed that only very rarely did people take out all their money and there was always money locked away in their bank. The banker decided to lend out some of the money, which belonged to the depositors on interest. The loan would be repaid with interest and the depositors would never have noticed. The profit is the interest on the loan. This practice became established and is used globally as the basic way banks make their money. This is known as fractional reserve banking and has proven extremely lucrative for the banks.
Firstly it is clear from Islam that fractional reserves are wrong because they are a deception. However, using fractional reserves circumvents some of the bad effects of hoarding money and releases it instead for use in the economy. This is initially a good thing - it is similar to the depositor stopping to hoard money and instead investing it. However, all deceptions eventually have their cost. Fractional reserve banking exacerbates the moral hazard problem mentioned above since it inevitably involves hiding the risk of investment, which is taking place with the depositors money. Moreover, for every unit of currency deposited a bank may be able to lend out much more than is deposited. The effect of this wrenches up the moral hazard problem by increasing the risk of banks. This works as following:
I deposit $100 in the bank. The bank then lends $90 to someone who uses the money to buy something from a third person. This person then puts his money in the bank. The bank is then able to lend out $81 of this deposit, and so on around the cycle. Thus for an initial deposit of $100 and a reserve level of 1/20 the bank can effectively lend out $2000. The lower the level of reserves needed the higher the potential profits of the banks. The problem only arises when people think that the Bank doesn't have enough money to give them their money back. This is true- the bank doesn't have the money and is quite unable to return it.
In order to overcome this problem, banks clubbed together so that if one bank lost the confidence of its depositors the others would lend it enough money to return the deposits until the confidence returned. This worked for a while but banks operate in a competitive environment and to make more profit there was great pressure to lower the level of reserves needed and therefore increase the profits. The use of state power was the next required step to add strength to the assertion that people would get their guaranteed interest and their guaranteed deposits back. When people got worried about their deposits being unsafe, the government would declare a "bank holiday" allowing the banks to close and reopen only when the 'panic' subsided. This use (abuse) of state power led to the creation of national central banks which in exchange for this power enabling more effective guarantees of the deposits in the banks, lent to the government with guaranteed returns. This step gave greater credibility to the guarantee of deposits. This guarantee though just exacerbates further the moral hazard problem of interest. The government has to maintain the confidence of the depositors and is therefore heavily involved not only in distributing cash to banks in trouble but also making as sure as possible that people don't lose confidence in the system generally. For if one bank collapses it damages (potentially fatally) the confidence in another bank and a domino effect is feared. This lead then to international co-operation to establish the International Monetary Fund and World Bank to try to save national central banks when investors/ depositors lost confidence in that country's economy. This worked for a while however, this is still not enough for the bankers now deep in to the moral hazard problem. Banks that were deregulated and able to trade internationally were able to make more profits than those who were in heavily regulated markets. Over the last few decades the regulation of banking has been dismantled to allow the banks to make yet more profits. A new market has been introduced where risks are traded in a myriad of forms and is the ultimate in giving banks liquidity to pay back depositors. The volume of trade on this "Futures" market is huge and dwarfs the size of whole national economies. The moral hazard problem is also getting larger and larger as the financial world demands ever more returns from the physical economy. The problem isn't just like one farmer not caring what his land can produce; it is a global situation. If it isn't stopped, it will result in the global physical economy being wrecked - sooner or later. The financial system must be reformed to prevent this - the reform is to introduce Islamic economics, the heart of which is the ban on interest.