[31 October 2008]
The current crisis emanating from US financial markets and spreading to other developed and fast developing countries like China, India and Brazil, is threatening a global meltdown leaving the entire world poorer and full of forebodings regarding future .It started as a credit crunch due to highly over-stretched leverage, was aggravated by the complexity of the products and reached its zenith due to moral failure generating conflicts of interest and mismatch between incentives of the various groups and individuals involved in the saga.
Islamic economics stands for
abolition of riba and maysir in financial dealings as well as on
a regard for the interest of others in one’s pursuit of material gains.
The purpose of this brief
note is to examine the relevance of Islamic economics today. Does it have a
message for humanity insofar as its current financial problems are concerned?
In what follows we first
outline the broad features of the crisis under the four headings noted above,
trying to establish the thesis that most of them are rooted in a moral failure
that leads to exploitation and corruption. This would be followed up by an
explanation of riba and mysir
that equates them to bank interest and
gambling-like speculation based on risk shifting as distinct from risk sharing.
It will be argued that debt-finance coupled with speculative products whose
intricacies defy understanding provide ample opportunities to greedy
profit-maximizing agents to exploit the aspirations of ordinary investors and
for goading home owners and consumers into living beyond their means and
chasing untenable dreams. Even the calls for more and more deregulation, and
the philosophy of non interference with financial markets have [im]moral
dimensions. There is a hidden agenda behind this call [Joseph Stiglitz and
Bruce Greenwald, Towards a New Paradigm in Monetary Economics (2003), p.
206]. Though they swear by the name of efficiency and innovation, the champions
of deregulation and laissez faire have their self interest in view, not the
social weal. In conclusion a world of banking and finance without riba
and maysir will be suggested as the best alternative to the current
scenario. In this new environment risk sharing will replace risk shifting and
morality, advising people to be moderate in their material pursuits and
considerate about public good in their private decisions, coupled with realism,
will serve as the corrective to self- destructive outgrowths of current
financial capitalism. It will be noted that for this alternative model to be
robust and resilient, morality has to be rooted in spirituality. This will
provide a basis for willing acceptance of social norms, state supervision,
regulation and intervention in the market based on values rather than
interests.
We begin with the fourth
element of the crisis noted above, i.e. moral failure and a mismatch between
the incentives of various players in the financial arena. The reason: some of
the other elements of the situation described above are partly a product of
this factor. Currently, financial institutions include banks, investment
companies, insurance companies etc., managed by hired professionals. Those who
govern financial conglomerates by virtue of owning enough shares have motives different
from ordinary shareholders. Almost the entire population in developed countries
is involved in supplying capital through purchase of stocks, bonds, insurance
policies, pension funds, etc. While these ‘principals’ are interested in
profits they care about many other things too, among them stability, jobs,
social justice, and anxiety free communities. Not so the hired managers who
consider profit maximization to be their mission as it earns them maximum bonus
and continued employment. There are those amongst middlemen who earn fees. They
earn more when transactions multiply. In an environment where no one cares
about others, focused as everyone is on his or her own interest, public
interest is supposedly guarded by regulators. How can the same self-focused
assembly of individuals throw up regulators who would work to protect and
promote public good remains a moot question for neo-classical economics. An
answer to this question is, however, provided by the public choice school:
public servants too, elected as well as appointed, seek to maximize private
gain!
Without committing myself to
this rather bleak view of man in society, I suggest that we embark upon a
discussion of the first three factors from the vantage point provided by this
very view. It means I regard maysir- infested financial products[ like
CDS, Credit Default Swaps], the inverted pyramid of debts[with a slender base
of real assets] and the dearth of
liquidity…,all the remaining three features of the current situation, to
be rooted in the moral failure briefly described above. It could have been
different. The reason it is what it is can be found in the denudation of
economics from morality after the secularization of society in the wake of
enlightenment. Islamic civilization has the instruments to pre-commit man in
society to certain values leading to rules
[abolition of interest and gambling, for example] that guard the society
from falling prey to shortsighted predators. I proceed to elaborate taking the
above-mentioned elements of the crisis one by one.
What is wrong with gambling?
Firstly, gambling does not create additional wealth. Games of chance only
transfer wealth from its (losing) owners to new (winning) ones. Considering the
human resources consumed in the process, wealth transfers through games of
chance cannot be considered to be efficient. They do not serve any social
purpose. The satisfaction and thrill they provide to the players do not justify
the opportunity cost involved. Other exonerating circumstances like the revenue
to state in form of taxes or employment
generated by casinos, lotteries, etc. cannot be considered as
‘advantages’ until the acceptability of gambling itself is established.
I argue that risk shifting is gambling. One who
buys risk exchanges a definite amount of money (the price) for an uncertain
amount of money, whose delivery itself is not certain. Credit Default Swaps are
an appropriate example. The millions of loans made by a bank are each subject
to the risk of default (credit risk) in various degrees. As Joseph Stiglitz and
Bruce Greenwald have rightly pointed out credit is not homogenous like money [Towards
a New Paradigm in Monetary Economics (2003), page 271]. The risks
attached to each loan are unique. The institution undertaking to pay for all
defaulters among, say a million borrowers has no scientific basis for measuring
the risk it is taking. There is no long history to fall back on. The law of
large numbers does not apply. It is just taking chances, gambling. The banks
that so protect themselves against credit risks are emboldened to give more and
more loans. That is how aggressive lending policy gained an impetus. The
sub-prime mortgage crisis would not have occurred without the speculative deals
like CDS. Aggressive lenders offered to refinance mortgages on the basis of
rising home prices, virtually converting owned homes into ATM machines, sending
people on a buying spree, some of it on installment purchase basis, encouraging
an expansion that had little basis in the fundamentals: earning powers,
disposable incomes and savings and investments.
The Islamic approach to risk
is realistic but cautious. It does not allow deals involving excessive
uncertainty (gharar kathir). It encourages sharing arrangements
for facing risks. The additional wealth created with the use of existing wealth
through risky ventures should be shared between fund users and fund owners
while both bear the risks involved and the resulting losses. Differences in the
participants’ perception of risks involved will be decisive in determining the terms of bargain between
those sharing risk. Even though the motive of each party is making profits, it
is very different from taking chances in gambling. There is real wealth to be
created, real gain to be reaped. It is different in case of risk shifting [as
in CDS]. Neither the buyer nor the seller of risk has any stakes in real wealth
creation. As in gambling only one party actually gains, either the seller of
risk or the buyer. It is different in risk sharing in which both parties gain
(or lose). Like gambling, risk shifting is a zero sum game.
Risk sharing fits in with a
system that integrates risk management with value creation. The Islamic
institutions of musharakah, and mudarabah, for example target
value creation and are good ways of managing risk. In a healthy venture fear of
loss works to counter-balance hope for gain. When a system allows shifting the
risk (at a cost) the fear factor becomes inoperative insofar as the seller of
risk is concerned. It is worse when the government takes over the risk (as in
case of Fannie Mae and Freddie Mac in USA). Such a system is heavily tilted
towards the rich and leads to greater inequality as it protects the lenders but
leaves the borrowers to fend for them selves. This is the feature of the
current system that lead to an almost universal cry that it amounted to
privatizing gain and socializing pain---profits go to the corporations, losses
are borne by the taxpayers.
As an aside take a minute to
ponder over the Islamic approach as encapsulated in verse 278-281 of the second
chapter of Quran:
Believers! Have fear of Allah and give up
all outstanding interest if you do truly believe. But if you fail to do so,
then be warned of war from Allah and His Messenger. If you repent even now, you
have the right of return of your capital; neither will you do wrong nor will
you be wronged. But if the debtor is in straitened circumstances, let him have
respite until the time of ease; and whatever you remit by way of charity is
better for you, if only you know.[2:278-81]
In effect the above is
advising how to handle a crisis caused by default. A crisis like the sub-prime
crisis in US (if it ever occurred in an Islamic interest free system based on
risk sharing) would be handled not by extending credit to lenders but by giving
more time to borrowers and writing off some of the debts.
Over extended leverage,
outstanding credits amounting to an ever-increasing multiple of existing
capitals of the relevant institutions, is a direct result of financing through
interest bearing debts. The business of lending to thrive requires continued
expansion of credit. After all, the primary concern of the lending institutions
is making money that comes in the form of interest on loans outstanding. Every
loan recovery kills an existing income stream,
every loan extension generates a new income stream. With credit defaults
swaps available and insurance companies like AIG supposedly providing cover,
sub-prime lending looked attractive. The rest of the story is well known.
Debt financing of productive
enterprise amounts to preferring risk shifting to risk sharing. This is immoral
as well as counterproductive. The environment in which productive enterprise
takes place does not guarantee creation of additional wealth. It is only a
probability. The lender’s demand for a guaranteed positive return to the sum
lent is unfair. Actually it cannot be met at the macro [i.e., society’s] level
in the long run. Some enterprises do fail. Some others end up without any
positive return to capital invested. Repayment in these cases can come only
from old wealth already existing when the debt financed new projects were
launched. Repayment of the borrowed sum with interest added, by those whose
ventures failed to create wealth, causes a transfer of wealth from the
entrepreneurs to the owners of money capital who would not share risk yet want
a return. Putting producers/innovators at a disadvantage as compared to those
having money to spare does not bode well for society. Easy money for those who
have contributes to a life style at the top of the wealth pyramid that creates
problems at its bottom. Society can continue meeting its debt obligations as
long as there is growth at an accelerated rate. But the planet earth, its
ecology, environment and resources are not designed for limitless growth.
Deterioration in environment, increase in inequality, and social tensions are
direct results of heavy reliance on debt finance.
The problem is aggravated when monetary
expansion too takes place in the form of interest bearing debts, as is the case
with the current monetary system. In order for new money to come in circulation
a loan must be given, a new debt must be created. For every loan to be paid
back with interest, borrowers need more money than they have. This additional
money leads to additional debts, and so on. As pointed out in the previous
paragraph the debt imperative creates a growth imperative that contributes to
the destruction of the ecosystem.
Selling Debts
Some debt financing has
always been part of the financial markets. Even in hey day of Islamic
civilization trade credit, a form of debt financing , thrived. Islam has no
problem with that as it fits in with prohibition of exchanging money now with a
larger amount of money after a period of time. The problem starts with sale of
debt, whether created by a money loan or owed as a price of goods sold on
credit. Sale of debt is allowed at par or face value. But there can hardly be a
market for exchanging debts at par. You have a market for debt when bond [i.e.,
debt] prices are determined by supply and demand. Sale of debt implies selling risk [or
shifting risk]. A thriving market for debts at prices determined by supply and
demand [as in conventional bond markets] is vulnerable to gambling like
speculation as there exists no objective basis for measuring risks of default.
The changing prices reflect changing subjective perceptions of the risks
involved. As is well known these perceptions can sometimes be manipulated
through planting stories in the media.
Remarkably, a ban on selling
debts would drastically reduce the outstanding volume of debt. In effect it
would scale down the volume of outstanding debts to the level of existing real
assets. The inverted pyramid of debts, standing on a slender base of real
wealth, would be replaced by a rectangular column of debts, owed against an
equal amount of real goods and services acquired. The volatility in the bond
market is directly related to the total volume of bonds. The larger the volume
of debts, the weaker its connection with real wealth, and the more the scope
for gambling-like speculation.
Derivatives
Derivatives also involve excessive uncertainty. They facilitate managing certain market risks (related to prices, rates of exchange, etc.). Chance remains the basic element in the situation, however, expectations being based on pure speculation. Derivatives too are a zero sum game: you lose what I gain, unlike the win-win situations in trade or risk sharing. The claim that they increase liquidity and improve operational market efficiency in financial markets remains unsubstantiated. What can be empirically established is that, whatever the initial benefits for a certain class of investors, availability of derivatives invites speculative activity. This is evidenced by the fact that currently the volume of derivatives being traded stands at many times the world GDP. The market for derivatives literally becomes a casino.
The demand for liquidity increases with expansion of credit. The current liquidity shortage is rooted in over extended leverage. Unbridled risk taking as in sub prime mortgage, results in lack of trust in the stability of the current prices as well as in defaults leading to strains on bank liquidity. The situation leads to a decrease in peoples’ confidence in the banks, resulting in widespread withdrawals. Pouring in more cash in the system could be more effective if it were to be given to the ultimate debtors---consumers, small businesses, poor home owners, etc.--- who would then use it to meet their financial obligations or engage in new purchases. As it works in the current system it is given to the banks and insurance companies. It enters the market as loans, creating another chain of debt obligations. This amounts to solving a crisis by methods that sow seeds for another crisis.
CONCLUSION
I wish I could go on. But there is already a wealth of material available on the subject. I seek the readers’ response to my central point: All the technical flaws and tactical mistakes leading us to the current crisis are rooted in a moral failure.
Given a society in which individuals care about public good and cooperate with one another to promote it, even though after securing their self-interest in order to ensure survival, we could escape much of the troubles currently facing us. Only such a society of individuals who care for public good can opt for the right mix of state intervention and private initiatives. Such a society is possible. Let us first shed the illusion that we have been living for decades now under the best of all arrangements, social, political, economic and financial. We have not. Let all join the search for an alternative.