Dealing With The Financial Crisis

DEALING WITH THE FINANCIAL CRISIS---AN ISLAMIC APPROACH [email protected]

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. 1

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 2

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 3

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

4

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 5

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 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 6

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 7

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.

8