Islamic Banking and Friedman's Rule

The recent resurgence of Islamic scholarship has revived the ancient controversy concerning the legitimacy of interest payments. It has also fueled a debate about whether a modern economy can exist without interest. In this paper, we review the arguments against interest presented both in Islam and in the West. It is then suggested that there are two ways to achieve a zero interest rate: impose a zero price ceiling in the credit market and suffer the consequences of the resulting market distortions, or conduct monetary policy so as to reach a zero interest rate through the market itself. This latter approach, derived from Friedman's Rule, suggests that Islamic bankingif done properly, may allow Islamic societies to have the best of both worlds, i.e. they can follow their religious precepts without creating serious distortions in their economies. Finally, the recent performance of Islamic Banking in Iran and Pakistan is briefly reviewed.