Articles on Islamic Economics

Intertemporal Consumption in Islamic Economic Framework

Salman Ahmed Shaikh

A typical lifecycle pattern of humans shows that the need to consume basic necessities exists throughout the lifetime, while the capacity to earn incomes is present mostly during the working years of life. In childhood and old-age, one usually does not provide as much labour supply in the labour market or none at all as compared to the youth and mature age. In working age periods, when consumption in a period is less than income in the period, people save so that they can continue to maintain their consumption levels even when they stop earning any income from labour supply after they retire. Thus, consumption decisions are intertemporal keeping in view consumption today and consumption tomorrow. Households save and seek financing in an effort to ensure consistent consumption throughout their lifetime in spite of having irregular income streams over time. Financial institutions enable people to save and invest and thus achieve smooth consumption in the wake of no or volatile incomes during the various stages of the lifecycle. Financial investments with financial institutions or in financial markets make the lifetime resources grow in periods when they are not needed for current consumption.

Furthermore, by living in society and extended families, one often also gets support from immediate relations in times of need. Parents bring up children and then children grow up, enter the labour force and gain financial independence. Eventually, the children look after their parents in their old age. Parents often leave bequests so that their children can continue to consume even if they do not earn any income in early non-working years of their lives. Finally, the social and redistributive institutions complement the commercial financial institutions by providing necessary public goods and transfer payments. Thus, these institutions provide valuable income support and skill enhancement for increasing the chances of market-based employment for the poor and needy.

Broadly speaking, the Muslim consumer would also want to smooth consumption throughout the lifecycle in a typically similar fashion. A Muslim consumer with surplus endowments would look to invest and earn income on investments for the possibility of higher consumption in future. Investment decision making requires a careful analysis of risk and return. The objective of financial investments is to achieve highest returns for a given level of risk or to minimize the risk of achieving a given target level of return. The difference in an Islamic framework would come with the normative distinction between investments which are declared as prohibited in the ethical injunctions of Islamic faith and other investments which are deemed as permissible. A Muslim consumer with net surplus endowments has to abide by certain restrictions in intertemporal consumption choices. For instance, Islamic principles prohibit the use of Ribā (interest), Gharar (uncertainty), Maysir (gambling) and certain sale transactions which do not fulfil the requirements of delivery, possession or price specification of assets. Hence, this Muslim consumer would have a relatively constrained choice set of investible assets and trading strategies for fulfilling the objective of lifetime consumption smoothing.

Furthermore, other factors may restrict the individuals to achieve consumption smoothing. For instance, if the income itself is not smooth and the financial services are not accessible to the masses; then, despite having the desire to achieve lifetime consumption smoothing, it may remain elusive for people with binding liquidity constraints. Low levels of income leave little surplus and savings. Hence, consumption may remain dependent on current incomes which can be highly volatile for informal industrial workers and farmers.

On the brighter side, social norms could provide significant motivation for actions. There is strong incentive mechanism for pure altruism in Islamic worldview. Islamic principles make every wealthy Muslim liable to share a portion of his wealth with the poor in society. In this regard, altruism and philanthropic endowments provide a social cushion to the endowment deficient consumers. Thus, some of the liquidity constrained poor consumers could find necessary support from social finance as social finance primarily focuses on promoting prosperity and higher living standards of the lower income segments of the society. Even if endowment deficient consumers are unable to access the formal financial institutions and remain underserved by weakly funded public support programs, they can obtain ease in liquidity constraints through social finance.

To facilitate households and firms to meet different financial objectives in compliance with Shari’ah principles, the field of Islamic finance was conceived as an alternate financial system in the early part of the twentieth century. In the last quarter of the twentieth century, several Islamic financial institutions were established in banking, insurance and asset management sectors. In the area of asset management and investments, the Islamic scholars had devised certain screening criteria to identify and classify Shari’ah compliant equity investments. As per these screens, the core business of the firm should be Shari’ah compliant. Secondly, there are certain financial screens that are used in order to discourage involvement in interest based borrowings, investments and earnings. Consequently, a Muslim consumer with net surplus endowments can invest in bank deposit schemes of different maturities, Islamic mutual funds with varying investment styles, Shari’ah compliant stocks and Sukuk.

On the other hand, it is known that more than a billion people on earth live in poverty and approximately half of the global poor are Muslims. That is why; it is realistic to expect that a significant number of Muslim consumers might experience net endowment deficiency even in the working age period of life. People in labor force who are unemployed and who have limited accumulated savings and assets remain vulnerable to be excluded from the formal financial sector credit services. For such individuals, Islamic microfinance provides a useful way to access funds for their small enterprise and livelihood expenses. Besides that, the redistributive institutions like Zakāt and Waqf can provide non-market based assistance. Zakāt transfers wealth from people having wealth above Nisāb (a minimum threshold value of wealth) to the poor people directly or through the causes and organizations working for the welfare of the poor. On the other hand, Waqf is an Islamic institution which provides perpetual dedication of liquid and illiquid assets to particular social causes.

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