Rent-Seeking Behavior and Islamic Finance


Rent-Seeking: Understanding and Awareness

In 2007 an important voice in the field of Islamic economics and finance, Prof. Mahmoud El-Gamal characterized Islamic finance as “rent-seeking Shariah arbitrage.” His statement found a prominent place in the discourse, even though many were shocked and became detractors. Since then the concept of rent-seeking shows up here and there. Unfortunately, understanding and awareness about the concept and theory of rent-seeking is not that common, even though it is highly relevant in the context of Islamic economics and finance and beyond. It is further important in connection with the prohibition of riba and Islam’s fundamental concern regarding zulm (injustice/exploitation).

The Qur’an’s sternness in riba prohibition (2:279) indicates that it’s not something ordinary. Riba in financial transaction is a life-ruining experience; it often puts a weaker party in such transaction on the path of ruin. That’s why riba prohibition must be taken seriously and indeed Islamic finance emerged to provide alternatives to help Muslims to avoid riba. However, not properly understanding it or its scope can lead to legalistic or mechanistic avoidance of riba, without avoiding the ruinous impact of non-riba sources. This author’s research paper “Exploitation, Profit and Riba-Interest Reductionism” (2013) elaborately deals with this subject.

Unearned Income

What is often glossed over in riba related discourse is that besides being exploitative, it also has a dimension of unearned income or wealth. One can see in works on Islamic finance reference to riba and interest as “unearned income”, “unearned wealth”, “unearned gain”, “unearned capital”, etc. Also, in defining riba, the concept of counter-value is important. Riba is often defined as “stipulated excess in a financial transaction without any counter-value”. That’s why interest is generally equated with riba, because interest is understood as a stipulated excess extracted by the lender (surplus unit) for which the borrower (deficit unit), arguably, does not get any benefit or value.

While the unearned dimension is commonly mentioned, neither its scope nor its implication is properly identified, appreciated and delineated. Rent-seeking behavior primarily relates to this unearned dimension of wealth, income, gain, etc. In the modern world of increasing complexity, the widespread and powerful presence of rent-seeking behavior calls for better understanding of it, if we really care about injustice and exploitation in general than simply reducing injustice/exploitation to riba/interest.

The term rent as in rent-seeking behavior is not the ordinary sense in which it is used; for example, rent charged for renting any property, whether home, automobile or equipment. It is also not in the sense of payment for land as one of the four factors of production. Rent in this context is used in a special economic sense.

In economic literature rent-seeking is defined as “attempt to obtain economic rent (i.e., portion of income paid to a factor of production in excess of what is needed to keep it employed in its current use) by manipulating the social or political environment in which economic activities occur, rather than by creating new wealth.”

Economic Profit vs. Economic Rent

In this brief article I will try to shed light on the concept by sharing a number of examples, so that those who are interested can further study this phenomenon.

An important concept in economics, with no conflict with Islamic economics, is economic profit or above average profit. In a competitive market economic profit serves as a signal to attract new entry, while economic loss causes losing firms to exit the market, so that the long-run outcome of the competition is zero economic profit or normal profit (earned on average by the participating firms). In a dynamic, competitive, entrepreneurial economy, economic profits are generated by creating new products or methods through discovery, innovation or improvement that allows the contributing firm to earn economic profit. This is legitimate and fair for the entrepreneurial value and wealth creation as part of the real economy.

Economic rent is different from economic profit. While competition can reduce or eliminate the economic profit for the advantage of the consumers and the broader society, and thus also create more incentive for real value creation (value creators will earn economic profit for a while), economic rents are protected by various institutional and legal means preventing its elimination or reduction. This is unjust and unearned, thwarting legitimate competition by artificially stifling the market. Whether Prof. El Gamal’s observation about rent-seeking through Shariah arbitrage is questionable, the fact remains that the robust presence of Islamic finance industry is in many rentier states or economies, where rent-seeking behavior and culture are rampant, and the industry is vulnerable to such behavior and culture.

As the concept and theory of rent-seeking developed in the western, conventional economy, it is helpful to understand that context first. In modern states, lobbying by various business entities or constituencies to influence government’s policies is an important example of rent-seeking behavior. An article in Harvard Business Review (May 26, 2016) makes the case “Lobbyists are behind the rise in corporate profits.” Shouldn’t corporate profits be from their business activities? Before proceeding further, let’s note that we are not talking about riba or interest, rather profit, which is otherwise halal (permissible). The article identifies non-financial corporations in five industries that had the most concentrated lobbying effort and impact: pharmaceuticals/chemicals, petroleum refining, transportation equipment/defense, utilities, and communications. Indeed, in the US context these industries together are known as “rent-seeking sector”.

In 2016 lobbyists in USA spent $3+ billion on lobbying. This is not charitable contribution. So, what do they get out of it? According to the HBR article cited earlier, a good part of lobbying is to seek regulations that “provided them sheltered markets—rather than competing on innovation.” In such sheltered or protected market, profits are higher than it otherwise would be. The study shows that Regulation and lobbying has contributed to corporate profit (1.2%) close to the contribution of capital (1.4%). Thus, profit is halal. But when profits are boosted by activities or actions that are not productive (e.g., lobbying) as part of the profit, the companies get economic rent (unearned gain, without any additional productivity or value creation).

In absence of economic rent, costs would have been lower, price would have been lower, and therefore these rent-boosted profit is a massive transfer of wealth from consumers (regardless of rich or poor) to the company shareholders. For those with interest in Islamic economics and finance can note that riba is defined as “stipulated excess without any counter value”, where this stipulation is a key aspect of riba. In case of economic rent, with probably much bigger negative impact on the economy and society, the unearned gain is without any stipulation, and it should not be difficult to understand and appreciate that in this kind of “unearned gain”, it is unstipulated. In another word, wealth or value transfer occurs without even knowledge of common people and consumers who ultimately are the source of extracting such economic rent.

Public Sector Corruption

A major rent-seeking problem area is public sector corruption. In many countries it is all too common, more so in Muslim-majority countries, to award contracts to privileged parties based on bribes (euphemistically, kickback or even gift): that’s economic rent earned by public officials. Also, often these contracts are at inflated cost, yielding rent for contract winning parties. Such inflated cost covered by taxpayers’ money is a transfer of wealth from people, without addition to the real economy. In many developing countries the poor are more vulnerable to the consequences of corruption, and the rich and powerful has an interest in perpetuation of poverty, so that instead of legitimate profit they can earn economic rent. In many countries even the law enforcement agencies are involved in extortion of common people. Such unearned income is not just illegitimate, but also immoral, constituting unjust enrichment at the expense of others.

Let us consider an oil rich Muslim-majority country, which earns most of his revenue from its natural resource. The country has a ruling elite and business oligarchs that control the vast resources of the country. The rich and powerful get mega projects for which they are willing to spend large sum as “gifts”. No one can get any such contract without the favor of the ruling elite. Foreign companies also pay large sum in their international competition to get contracts. Most of these contracts are also at inflated costs. All of these are examples of economic rent, which constitute transfer of wealth from that otherwise would have been available to the people in general.

One might make the argument that one can see the presence of rent-seeking behavior in this activities, but where does Islamic finance fit in? Well, in several ways. The members of the ruling elites are also in the boards and/or management of the Islamic financial institution (consider an Islamic bank or an Islamic investment bank). The members of the ruling elites can also be majority shareholders or in the management. All of these aspects can lead to scenarios or rent-seeking can occur, even though the projects or activities can be Shari’ah-compliant at the transaction level. These scenarios can become more possible where the ownership of these financial institutions is highly concentrated, as it happens to be in many Muslim-majority countries. What is important is to recognize that injustice and exploitation of individuals or the public can and does occur that is much more widespread in impact than merely riba or interest. Furthermore, even though the financial transactions are Shari’ah compliant, in the kind of scenarios described above Islamic finance, just like any kind of finance, can be an enabler for rent-seeking.

Now let’s take a look at another kind of rent-seeking. In many oil-rich Gulf countries labor visas are sold, even though that should not be the case. Local sponsors and their agents often pocket the price of visa, an example of unproductive, unearned income. Similarly, in these countries for expatriates to engage in business, there must be local sponsors or locals with commercial license, who earn “rent” on their license.

Rent-seeking behavior encourages pursuing income and wealth without work or contribution to the value creation in the economy. The behavior can be understood as people being interested in getting a larger share of the pie without making an effort or contribution to make the pie larger.

Rent-seeking behavior can happen even in the presence of Islamic finance, where prohibitions such as riba, gharar, maysir are respected, and they should be, but rent-seeking is also pursued. Part of the problem is that Islamic finance and Islamic commercial law is focused on transactions, without understanding, taking into account or exploring the institutional or systemic behavior and dynamics.

Islam and the Qur’an are categorically and firmly against zulm (injustice, exploitation). If our concern as Muslims is to have a world based on justice and free from zulm, the starting point for our approach has to be unjust behavior, like unearned income, which includes riba, one of the fundamental cases of unearned income/wealth as part of rent-seeking behavior. Narrow focus on riba/interest may lead us to have a riba/interest-free world, and Muslims need to insist on it, but we may not have a world free of zulm, if our understanding, concern and policy frameworks and tools do not take into consideration rent-seeking behavior.

(This article was originally published in Islamic Finance News, August 2018. An annotated, expanded version of this paper is available at https://ssrn.com/abstract=3197653. The author is an associate professor of Economics and Finance and an Islamic finance expert, University of Bahrain; [email protected])


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  2 Comments   Comment

  1. DrMohammad Omar Farooq

    Author's comment:
    Salaam and thanks to osakaali for reading the article and sharing his pertinent thoughts. Sometimes going too far in a brief article makes the message more vulnerable to misunderstanding.

    Once someone recognizes, understands and appreciates the rent-seeking behavior and the concomitant unearned gains, it creates the context for delving into it further.

    One clarification. "Professor Farooq defines 'Riba' as “stipulated excess in a financial transaction without any counter-value.” Actually, it is not my definition. I was just quoting the traditional definition. My approach to understanding riba is substantively different. Specifically, on the issue of this "stipulated excess", please refer to "Stipulation of Excess in Understanding and Misunderstanding Riba: The Al-Jassas Link" (link: https://ssrn.com/abstract=1412753).

    Also, for more on understanding Riba, see "Exploitation, Profit and the Riba-Interest Reductionism". https://ssrn.com/abstract=1995142. Fi amanillah.

  2. osakaali

    It is gratifying to witness IslamiCity publishing an article on this most important topic, not only to Muslims, but all people who value effort and enterprise while simultaneously valuing honor and justice. Professor Farooq frames the issue in a thought-provoking way, a commendable accomplishment.

    If anything, I would only protest that the thesis doesn't go far enough. It is even debatable if the notion of Islamic 'Finance' is a concept that really serves the imperatives of the Deen of Islam. Really, why do we need to shoe-horn Islam into a framework of custom and terminology which is derived from very suspect sources, i.e., the world of western commerce? In other words, who needs the 'science' of economics or 'banking' itself when Al-Muamalat, the vast (and unfortunately neglected) portion of the Fiqh that instructs us in the absolute best way to conduct our affairs, to include commerce and the management and disposition of our wealth?

    Additionally, the article may have been intended for a professional or academic readership, but could a simpler, more direct and more honest terminology be utilized when describing the concepts involved in these issues as well as the problems our community faces? For example, Professor Farooq defines 'Riba' as “stipulated excess in a financial transaction without any counter-value”. This term, 'stipulated' is too vague to be applied to a definition of such grave implications. The author seems dissatisfied with the conventional definitions of riba that include terms such as 'unearned'; maybe it is right that they don't suffice. To me, riba as 'any unjustified gain or profit' is simpler, more accessible and appropriately palpable. Perhaps such a description would cause discomfort if mentioned in a meeting of, say, a financial regulatory body, but would such a reaction signify a bad thing?

    I hope more readers will share their honest views in this comments section, and that Islamicity.org will be encouraged to revisit and further the discussion on these kinds of topics in the future through upcoming articles and features.