Dealing With the Financial Crisis

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  • 8/14/2019 Dealing With the Financial Crisis



    ISLAMIC APPROACH [email protected]

    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



    mailto:[email protected]:[email protected]
  • 8/14/2019 Dealing With the Financial Crisis


    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


    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


    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


    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


    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


    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.