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DEALING WITH THE FINANCIAL CRISIS--

ISLAMIC APPROACH mnsiddiqi@hotmail.com

In this paper I try to note the main causes of the current financial crisi

is leading the world into an economic disaster of unprecedented

proportions. This is followed by a discussion on how can we get out o

undesirable situation and move towards a better world. In between I sh

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

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 mostvisible in the housing sector in the United States of America. But it pervaded

sectors of the economy almost all the world over. With so much debt floating

the market, securitization and repackaging took the debts to the common man

those managing their savings. The easiest way to make money grow became,

productive enterprise, but manipulating other peoples debts. Complex deriva

and risk absorbing products like Collateralized Debt Obligations (CDOs) and

Credit Default Swaps (CDSs) attracted the financial institutions entrusted wit

investing peoples monies for profit. Monetary authorities also obliged financmarkets with supply of cheap money. Higher and higher leverage became ord

the day. When the inevitable bursting of the bubble occurred and defaults bec

endemic financial institutions failed to fulfill their obligations. Liquidity dried

Things stopped moving. Globalization ensured that these effects reached

everywhere.

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Role of Debt

A modern economy is built around debts that bear interest.

Monetarymanagement as well as financial intermediation iseffected 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 tobanks 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 economys 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

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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 boutof 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 andborrowers 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

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societys 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 tobecome 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 lions share of the seigniorage resulting from

money creation in a fractional reserve system. The competitive

mechanism needed to channelize a major part of seigniorage tocommon 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 countrys

external balance of payments and the domestic needs for money

supply, etc., in deciding upon the key rate at which it would lendmoney to commercial banks, which rate in turn forms the basis of

the other interest rates in the economy.

Treatment of Uncertainty

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Risk and uncertainty are inalienable features of life. The societys

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 everyeconomic 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 theclaims 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

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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 heads: Pouring more liquidity into the system; more strictregulation 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 beingtaken 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 worlds developed

economies will not mean an end to endemic poverty in Africa andSouth 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 premisesof 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 peoples trust into the

banks and other financial institutions can be reversed. People trust

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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 thetendency 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 institutionsthe 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

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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 viablealternatives 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 peoples 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-measurablerisks in such an environment. Given respect for other peoples

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 mans pursuit of unlimited growth.

Conventional system has no inbuilt mechanism to limit growth tosustainable 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.

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