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Prof Mohammad Nejatullah Siddiqi
Dr Mohammad Nejatullah Siddiqi is an internationally renowned name in Islamic economics. Recipient of several awards such as theKing Faisal International Prize for Islamic Studies in 1982, American Finance House Award in 1993, Award for Life-long Contributions to Islamic Insurance and Banking, Takaful Forum, New York in 2000 and decades of teaching experience at the renowned institutions of King Abdulaziz University, Saudi Arabia and Aligarh Muslim University, India and holder of several editorial and advisery positions, Dr Siddiqi has contributed immensly to the development and understanding of Islamic finance for the last four decades. IFER wishes to thank Dr Siddiqi for allowing us to publish some of his works on our website for the benefit of our readers.
April 2009
In this paper I try to note the main causes of the current financial crisis
that is leading the world into an economic disaster of unprecedented proportions.
This is followed by a discussion on how can we get out of this undesirable
situation and move towards a better world. In between I shall also comment
on why some of the conventional strategies of crisis management are proving
to be ineffective. I conclude indicating the systemic changes that should
accompany economic strategies in order to move towards an enduring solution.
What Happened
The story is by now well known. Debt financing grew to an extent the repayment
capacity of the borrowers could no longer sustain. This was most visible
in the housing sector in the United States of America. But it pervaded
all sectors of the economy almost all the world over. With so much debt
floating in the market, securitization and repackaging took the debts
to the common man and those managing their savings. The easiest way to
make money grow became, not productive enterprise, but manipulating other
people’s debts. Complex derivatives and risk absorbing products
like Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs)
attracted the financial institutions entrusted with investing people’s
monies for profit. Monetary authorities also obliged financial markets
with supply of cheap money. Higher and higher leverage became order of
the day. When the inevitable bursting of the bubble occurred and defaults
became endemic financial institutions failed to fulfill their obligations.
Liquidity dried up. Things stopped moving. Globalization ensured that
these effects reached everywhere.
Role of Debt
A modern economy is built around debts that bear interest. Monetary management
as well as financial intermediation is effected through interest bearing
debts. This makes the system crisis prone. It also makes the system unfair
and inequitable. Let us take the monetary system first.
The amount of fiat money the monetary authority decides to float in the
economy finds its way to people mostly through banks and other financial
institutions. Whatever monies are given to people directly as salaries,
wages and grants etc., also find their way to banks and other financial
institutions as deposits and investments. The monies that go out from
banks and other financial institutions mostly do so as debts carrying
interest. Some of these debts are repaid and that much new money is cancelled,
but the interest paid remains as revenue for the bank. Some debts are
renewed on maturity, often with accrued interest added to the principal.
Bank loans are part of an economy’s money supply. To the extent
the volume of interest bearing loans increases, the money supply also
increases.
Parallel to this stream of debts runs another stream and in the same direction.
It is bonds issued by the government; Central, State and Local; as well
as bonds floated by private sector corporations. Government bonds’
supply has had a tendency to increase over time.
As time passes the volume of debts in the economy goes on increasing.
Obligations to pay interest due and/or return the principal can be met
from wealth newly created or already existing. In case debt financed productive
enterprises fail to produce additional wealth large enough to meet obligations
of repayment with interest, a dip unto old wealth already existing before
the debt-financed projects were started becomes necessary. Wealth redistribution
in favor of lenders is an inalienable feature of an economy in which debt
financing predominates.
In money terms, there is not sufficient money to meet all payment obligations,
in view of the interest added to the principal that came out as newly
created money. The only way out is to renew some of the outstanding debt
or monetize it (by exchanging newly printed currency for debt papers).
The debt based system of creating new money and financing productive enterprises
necessitates ever increasing volumes of debts. It is difficult to imagine
how these debts can ever be paid. To lighten the burden of debt a severe
bout of inflation will be necessary with all its unhealthy consequences.
When the economy is not growing fast enough defaults occur (as happened
in the US recently). Insurers step in to capitalize on the fear of default
by offering to buy risk of default from dealers in debt. Speculation in
the market for buying and selling risk is detached from speculation in
the market for real goods and services. It is not based on relevant information
in the real sector, nor do actuarial tables exist to make any kind of
scientific calculation possible. Speculating in the market for risks is
a zero sum game relying on chance. On the other hand the ability to sell
risk of default to a third party makes the lending institutions reckless.
They tend to make more loans to less creditworthy clients and fail to
monitor their behavior for ensuring repayment. At the same time the distance
between people whose monies are lent and those who are supposed to repay
them goes on increasing. The long chain of anonymous intermediation separating
lenders and borrowers coupled with transfer of risk to specialist institutions
creates a make believe world in which nothing but profit margins and leverage
matters. Some of this attitude spills over to the stock markets too as
dividends and share prices are manipulated with a view to attracting more
savings. An increasing proportion of society’s real resources; men,
machines and other material; engages, not in producing real goods and
services but in manipulating numbers and creating complex new financial
products which enable more bets on already existing profit opportunities.
Two consequences inevitably follow. Firstly, it is impossible for all
debt obligations to be met making default endemic at some stage. The impossibility
is rooted in the twin phenomena of interest added on all debt to be repaid
and in the uncertain nature of productive enterprise financed by debt.
The system cannot survive without destroying some obligations to repay
the outstanding debts. Secondly the distribution of income and wealth
tends to become more unequal over time. This consequence is rooted in
the transfer of some of the existing wealth from the borrowers to the
lenders as the legal system obliges even those debt –financed entrepreneurs
who failed, to repay the sum borrowed with interests added. A second factor
contributing to enhanced inequality is the banks keeping a lion’s
share of the seigniorage resulting from money creation in a fractional
reserve system. The competitive mechanism needed to channelize a major
part of seigniorage to common man; depositors, clients and other users
of banking services; does not function. The reason competition fails to
bring down real interest rates to levels in sync with proper sharing of
the benefits of money creation, the seigniorage, with people is that interest
rates are treated as a policy tool, determined administratively rather
than by the market forces. The central bank has to take into consideration
the requirements of the country’s external balance of payments and
the domestic needs for money supply, etc., in deciding upon the key rate
at which it would lend money to commercial banks, which rate in turn forms
the basis of the other interest rates in the economy.
Treatment of Uncertainty
Risk and uncertainty are inalienable features of life. The society’s
interest lies in mitigating and minimizing uncertainties. Two things greatly
contribute towards minimizing uncertainties rooted in human behavior as
distinguished from those rooted in nature, like earthquakes, floods, etc.
One is behavioral norms or rules every economic agent adheres to. For
example telling the truth, keeping promises and honoring contracts contribute
immensely towards efficiency. Second is cooperation in facing uncertainties
that takes the form of sharing risks that cannot be eliminated. This feature
contributes to efficiency as well as equity and fairness. In both cases
the crucial factor is incentives, the answer to the question why would
one do this rather than do that?
In the conventional system as exposed by the current crisis we have failed
on both counts. Lies have been told, norms have been breached, rules violated
and contracts ignored. Most economic agents tended to shift risks to others
(who in many cases would gamble with them) rather than share risks equitably.
Looking at the incentives there is little else than the desire to get
rich quickly with little regard for any societal considerations. Contradicting
the claims that somehow the culture of unabashed greed will also ensure
the survival of the weak and the uninformed, the world has landed into
a morass of unprecedented difficulties. The conventional system lacks
proper incentives for economic agents adhering to rules and/or cooperating
to minimize risks (through information dissemination, for example) and
sharing risks equitably.
What Is To Be Done?
I suggest that a comprehensive solution requires attention towards all
the three factors highlighted above: role of interest based debt, speculative
and exploitative approach towards risk and an incentive structure focused
on maximization of private gain. But before arguing in favor of this approach
it is necessary briefly to look at the other efforts currently being made
to check the disaster.
Current efforts at amelioration can broadly be summed up under three categories:
Pouring more liquidity into the system; more strict regulation of the
financial markets; and nationalizing parts of the financial system that
cannot be fixed in the two above ways. There is no intention anywhere
of changing the role of interest bearing debt, adopting a radically different
stance towards risk management or restructuring incentives by influencing
peoples’ motivation.
I submit that as a result of the above measures currently being taken
to fix the situation the economy will someday regain its feet on the ground
but it will be laden with new problems and will certainly carry the seeds
of a new crisis to appear sooner or later. Meanwhile the distribution
of income and wealth may become more unequal and the level of confidence
in the suitability of the system may fall further.
At the international level the rehabilitation of world’s developed
economies will not mean an end to endemic poverty in Africa and South
Asia, nor shall it bring promise of enduring peace as the current ways
of solving the crisis fail to touch the fundamental causes of hegemonic
policies of the rich towards the poor.
Enduring Solutions
Humanity needs a change of heart. The philosophy of greed and individualism
must give way to a cooperative approach to living. This necessitates disabusing
minds from the unfounded premises of neoclassical economics that extolled
individualism and maximization of private gain as the surest way to societal
felicity. It also requires bringing ethics and morality back into economics
and finance. That is the only way the loss of people’s trust into
the banks and other financial institutions can be reversed. People trust
each other when they perceive they are pursuing mutually reconcilable
goals. The current loss of confidence is born of the opposite perception,
each fearing the other is out to exploit and take advantage of him.
Ethics and morality are not luxury goods a society can dispense with.
The very fabric of social living is built around them. An exchange economy,
especially its financial system is very sensitive to loosening of that
fabric. Reinforcing that fabric brings customers closer to their managers.
When the reverse happens people stop trusting their managers and withdraw
into their cocoons, to great disadvantage of society. An enduring solution
to the current crisis calls for restoration of trust between people by
replacing the tendency to treat others as mere instruments for promoting
the interests of the self with a relationship rooted in universal human
brotherhood. It is only such a revitalized society that can throw up an
administration that can protect public interest from being pulverized
by vested interests. Writing tougher rules and tighter regulations cannot
remedy a situation in which many of the regulators happen to be former
or potential future employees of vested interests.
Absence of ethics and morality from the public square is also responsible
for the dangerous situation at the international level. Almost all international
financial institutions; the IMF and the World Bank included; have lost
the trust of poor countries. Most international organizations are perceived
as tools for serving hegemonic designs of the rich and powerful nations.
Reform Agenda
An alternative to debt financing from which interest is absent is the
first step towards change. Parallel to this we need a way of creating
money in which interest plays no role. Equity can easily replace debt
as the basis for issuing new money by the monetary authority and/or by
other financial institutions. There are viable schemes of monetary management
without involving interest but this is not the place to go into details.
As regards finance various sharing schemes offer ways of equity financing
that suit different sectors of the economy. Leasing and cost plus financing
also offer viable alternatives in some sectors.
Once the menace of interest is banished from the economy keeping speculation
within reasonable limits would become easier. Society should insist on
transparency wherever other people’s money is involved. It should
also arrange for dissemination of information that would help minimize
uncertainty. It will be easier to eliminate gambling on the stock market
and/or betting on un-measurable risks in such an environment. Given respect
for other people’s interests within and outside the country, hegemonic
policies may gradually be replaced by international covenants based on
mutuality.
Last but not the least is the newly gained awareness of ecological imbalances
caused by man’s pursuit of unlimited growth. Conventional system
has no inbuilt mechanism to limit growth to sustainable levels, based
as it is on individualism and pursuit of private gain. A new approach
requires not only new regulations but a move away from individualism and
pursuit of private gain towards socially conscious decision making and
cooperation in realization of common interests. Man must learn to live
in moderation in view of the limits our environment imposes. Moderation
in pursuit of material gains and in consumption has been part of the teachings
of religions in general and Islam in particular. It is time to bring them
in.
[This article has been retrieved with permission from www.siddiqi.com/mns]