The stability of islamic finance creating a resilient financial environment for a secure future

OUTLINE OF THIS BOOK In our quest to elaborate on the causes of fi nancial instability in the tional fi nancial system and to assess the stability of Islamic fi nance, we begin our analysi

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The Stability of Islamic Finance

Creating a Resilient Financial Environment for a Secure Future

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HOSSEIN ASKARI, ZAMIR IQBAL, NOUREDDINE KRICHENE AND ABBAS MIRAKHOR

John Wiley & Sons (Asia) Pte Ltd.

The Stability of Islamic Finance

Creating a Resilient Financial Environment for a Secure Future

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Foreword ix Acknowledgments xiii

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Over the past 25 years or so, Islamic (Shari’ah-compliant) ﬁ nance has made

impressive strides As of 2007, some $600 billion of assets were managed

in Shari’ah-compliant accounts around the world An additional substantial sum is represented by sukuk, or Islamic bonds Notably too, the develop-

ment of Islamic ﬁ nance is not limited to Islamic countries Global institutions

such as HSBC, JPMorgan, and others, have begun to offer

Shari’ah-compli-ant ﬁ nancial services through their worldwide networks

Moreover, the phenomenon of Islamic ﬁ nance seems likely to continue

to increase in importance Over recent years, Islamic fi nancial accounts and instruments have been growing twice as fast as conventional fi nance Given the size of the untapped market, and the growing wealth of Islamic countries, especially those that are major oil exporters, this trend seems set to continue Amid this ferment of practical activity, rigorous studies by well-trained economists have been relatively rare In this sense, this new book by a group of four Western-trained Islamic economists is greatly to be welcomed It builds on and extends their earlier work on the topic and will become essential reading for all those with an interest in the economic implications of Islamic fi nance.The book develops themes that link Islamic fi nance to existing tradi-tions in economics; that assess the stability properties of Islamic fi nancial instruments, and that explain some of the key Islamic concepts in econo-mists’ terms It will be an invaluable source for those who want to know more about the nature of the fi nancial instruments that go to make up an Islamic fi nancial system, and to understand how an Islamic fi nancial system might work in a twenty-fi rst century context

Everyone knows that a key concept of Islamic teaching is the avoidance

of interest payments that are ﬁ xed in advance (Interestingly, this tion is not different from that of other faiths at certain stages of their devel-opment.) But much less well-known to non-Muslims are the social teachings that lie behind the prohibition, and the variety of concepts that are permis-sible in economic transactions among Muslims

prohibi-Islamic ﬁ nance has its roots in the teachings of the Prophet Muhammad (himself a merchant) and is grounded in the social, moral and cultural pre-

cepts of the Qur’an Much has been written about the relationship of Islamic

ﬁ nance to Qur’anic teachings; but much less, until very recently, about how Islamic ﬁ nance is related to traditional economic doctrines, and how Islamic

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ﬁ nance might perform in a turbulent and unstable time like the present This volume therefore ﬁ lls an important gap.

The book begins with an overview of classical capital theory, pointing out its consistency with many of the concepts and limitations of Islamic ﬁ nance, once interest (the return to capital) and proﬁ t (the return to entrepreneur-

ship) are seen as a combined return to the provision of capital resources

Pursuing this theme, the authors analyze capital theory from Adam Smith and David Ricardo through William Stanley Jevons, Karl Marx, Eugen von Böhm-Bawerk, Knut Wicksell and others

This sets the scene for developing the central thesis of the book, namely that Islamic fi nance is potentially a more stable means of fi nancing capital accumulation than one that attempts to separate the functions of provid-ing capital and bearing risk Since Islamic fi nance requires a much greater relative role for equity capital, it is, the authors contend, better protected against the instability that can come from excess leverage

The authors seek to demonstrate how conventional ﬁ nance can generate cyclical instability in credit creation which in turn leads to economic booms and busts They describe the process we would now call “procyclicality” in the ﬁ nancial system and relate it to the Minsky hypothesis of endogenous

ﬁ nancial instability During a bubble, many assets become effectively etized and add to demand, while in a bust, liquidity evaporates and credit shrivels Central banks, while trying to offset these tendencies, have often added to them

mon-Focusing on the management of interest rates to manage the real omy, the authors argue, has in practice fuelled speculative booms, and the ensuing busts have proved impossible to prevent Central to all this is the process of credit creation generated by ability of banks to create money substitutes through issuing interest-bearing liabilities

econ-An interesting chapter deals with the current fi nancial crisis The book blames the internationalization of the crisis on excess money creation in reserve centers, and self regarding policies by individual countries Although not directly related to the theme of Islamic fi nance, the authors implicitly support the idea of a common reserve currency as the basis of a more stable international fi nancial system

Since Islamic fi nance avoids interest and interest-based assets, it is, the authors argue, inherently more stable than conventional fi nance, and need not inhibit the mobilization of savings and the effi cient allocation of invest-ment Islamic fi nancial instruments are more directly linked to the produc-tivity of the real investments they fi nance, and therefore not only promote the social objective of “sharing” risks and rewards, but cushion fi nancial intermediation against the inherent risks of excess, both in booms and slumps

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Doubtless, defenders of conventional fi nancial systems will say that better regulation and risk management can also protect fi nancial stability, and that a wider range of permitted fi nancial contracts can better achieve the completeness of markets It is not my purpose here to defend the specifi c claims made by the authors of the book Overall, however, it is a provocative and insightful assessment of the economic properties of Islamic fi nance that deserves to be read and refl ected on by Islamic and non-Islamic economists alike.

Andrew Crockett

President, JPMorgan Chase International Former General Manager, The Bank for International Settlements (BIS)

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We are grateful to Sir Andrew Crockett for taking the time from his busy schedule to write the Foreword to this book Sir Andrew is, without a doubt, among a handful of the most respected and experienced international bank-ers of the last quarter of a century—senior ofﬁ cial of the International Monetary Fund, executive director of the Bank of England, head of the Bank for International Settlements (BIS), member of the Group of Thirty, and the president of JPMorgan Chase International We are thrilled and honored by his contribution.

We are indebted to our editor, John Owen, for improving the script We also acknowledge the hard work of our production editor, Joel Balbin The support of John Wiley & Sons (Asia) for Islamic economics and

manu-ﬁ nance is greatly appreciated

Finally, none of this would have been possible without the love and support of our families; to them we will always remain grateful

xiii

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al - mal: Wealth or property

al - maysir: Gambling or any game of chance

al - Mu ’ minun/Mo ’ meneen: Those who believe with the heart

amanah: Trust

bay ’ al - salam: Sale in which payment is made in advance by the buyer and the

delivery of the goods is deferred by the seller

bay’ al - urbun/urbun: A sale in which the buyer deposits earnest money with the

seller as a partial payment of predetermined price in advance but agrees that if

he fails to ratify the contract he will forfeit the earnest money, which the seller can keep

bay ’ bithaman ajil (BBA) : Sales contract where payment is made in installments

after delivery of goods Sale could be for long term and there is no obligation to disclose proﬁ t margins

bay ’ mu ’ ajjal: Sale on credit; that is, a sale in which goods are delivered

immedi-ately but payment is deferred

faqih (pl fuqaha ’ ) : Jurist who gives rulings on various juristic issues in the light of

the Qur ’ an and the sunnah

fatwa: Religious verdict by the fuqaha ’

ﬁ qh: The whole corpus of Islamic jurisprudence In contrast to conventional law,

ﬁ qh covers all aspects of life — religious, political, social, commercial, and nomic Fiqh is based primarily on interpretations of the Qur ’ an and the sunnah and secondarily on ijma ’ (consensus) and ijtihad (individual judgment) by the fuqaha ’ While the Qur ’ an and the sunnah are immutable, ﬁ qhi verdicts may

eco-change in line with changing circumstances

ﬁ qhi: Relating to ﬁ qh

fuqaha ’ maqasid: The goals of a Shari ’ ah expert

gharar: Literally, deception, danger, risk, and uncertainty Technically, it means

exposing oneself to excessive risk and danger in a business transaction as a result of uncertainty about the price, the quality and the quantity of the coun- tervalue, the date of delivery, the ability of either the buyer or the seller to fulﬁ ll their commitment, or ambiguity in the terms of the deal — thereby, exposing either of the two parties to unnecessary risks

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hadith (pl ahadith ) : Saying, deed, or endorsement of the Prophet Muhammad

(peace be upon him) as narrated by his companions

hajj/umra: The pilgrimage to Mecca

hifz al - mal: Protection of wealth or property

hila (pl hiyal ) : Artiﬁ ce

ijarah: Leasing The sale of usufruct of an asset The lessor retains the ownership of

the asset with all the rights and the responsibilities that go with ownership

istisnah ’ (short form for bay ’ al - istisna h’ ) : A contract whereby a manufacturer

(contractor) agrees to produce (build) and deliver well - described products (or premises) at a given price on a given date in the future The price need not be paid in advance and may be paid in installments in step with the preferences of the parties, or partly at the front end and the balance later on, as agreed

ju ’ alah: Performing a given task for a prescribed fee in a given period

khalifah: Vice -regent

kifala: Guarantee

manafaah al - ikhtiyarat: Variant of al - khiyar

manfaa maal/manfa ’ ah: Usufruct Beneﬁ t ﬂ owing from a durable commodity or

asset

maqasid al - Shari ’ ah: Basic objectives of the Shari ’ ah : the protection of faith, life,

progeny, property, and reason

masalahah: Public good as determined in the light of the rules of the Shari ’ ah maslahah: Literally, beneﬁ t Technically, it refers to any action taken to protect any

one of the ﬁ ve basic objectives of the Shari ’ ah

mudarabah: Contract between two parties — a capital owner or ﬁ nancier ( rabb al

mal ) and an investment manager ( mudarib ) Proﬁ t is distributed between the

two parties in accordance with the ratio upon which they agree at the time

of the contract Financial loss is borne only by the ﬁ nancier The investment manager ’ s loss lies in not getting any reward for his services

mudarib: Investment manager

murabahah: Sale at a speciﬁ ed proﬁ t margin This term, however, is now used to

refer to a sale agreement whereby the seller purchases the goods desired by the buyer and sells them at an agreed marked - up price, the payment being settled within an agreed time frame, either in installments or as a lump sum The seller bears the risk for the goods until they have been delivered to the buyer Also

referred to as bay ’ mu ’ ajjal

musharakah: Partnership Similar to a mudarabah contract, the difference being

that here both partners participate in the management and the provision of tal and share in the proﬁ t and loss Proﬁ ts are distributed between the partners

capi-in accordance with the ratios capi-initially set, whereas loss is distributed capi-in tion to each one ’ s share in the capital

niyyah: Intention

qard - ul - hassan (short form: qard ) : Loan extended without interest or any other

compensation from the borrower The lender expects a reward only from God

qimar: Gambling

kanz (pl konooz ) : Treasure(s) Refers to wealth held in the form of gold, silver,

and other precious metals

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Qur ’ an (also written as al - qur ’ an ): The Holy Book of Muslims, consisting of the

revelations made by God to the Prophet Muhammad (peace be upon him) Lays down the fundamentals of the Islamic faith, including beliefs and all aspects of the Islamic way of life

rabbul - mal/rabb al - mal: Capital owner or ﬁ nancier

riba: Literally, increase, addition or growth Technically, it refers to the “ premium ”

that must be paid by the borrower to the lender along with the principal amount

as a condition for the loan or an extension in its maturity Interest, as

com-monly understood today, is regarded by a predominant majority of fuqaha ’ to

be equivalent to riba

Shari ’ ah: The corpus of Islamic law based on Divine guidance, as given by the

Qur ’ an and the sunnah , and embodies all aspects of the Islamic faith, including

beliefs and practices

shirakah bai ’ /shirakah: Partnership Technically, is equivalent to musharakah sukuk (short form of sukuk al - ijarah ): Negotiable ﬁ nancial instrument issued

on the basis of an asset to be leased The investors provide funds to a lessor (say, an Islamic bank) The lessor acquires an asset (either existing or to be cre-

ated in future) and leases it out if it is not already leased out Sukuk al - ijarah

are issued by the lessor in favor of the investors, who become owners of the leased asset in proportion to their investment These entitle the holders to col- lect rental payments from the lessee directly Can also be made tradable in the stock exchange

sunnah: The second - most important source of the Islamic faith and law after the

Qur ’ an and refers to the Prophet ’ s (peace be upon him) example as indicated

by his practice of the faith The only way to know the sunnah is through the collection of ahadith

surah: A chapter of the Qur ’ an

takaful: An alternative to the contemporary insurance contract A group of

per-sons agree to share a certain risk (for example, damage by ﬁ re) by collecting a speciﬁ ed sum from each Any loss is met from the collected funds

tawarruq: Reverse murabahah Buying an item on credit on a deferred-payment basis

and then immediately reselling it for cash at discounted/prize to a third party

wa ’ d: A time - bound promise to deliver on terms contracted

wakalah: Contract of agency in which one person appoints someone else to

per-form a certain task on his behalf, usually for a ﬁ xed fee

zakah: Amount payable by a Muslim on his net worth, as a part of his religious

obligations, mainly for the beneﬁ t of the poor and the needy Obligatory duty

on every adult Muslim who owns more than a threshold wealth

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Introduction

be the worst since the end of the Second World War Representing the lapse of trillions of dollars of ﬁ ctitious credit derivatives and the meltdown

col-of uncontrolled credit growth, the scope and intensity col-of this crisis have kept increasing well into 2009 and could potentially continue on a downward path for some time to come

The crisis has crippled the fi nancial system of many advanced countries, and has claimed as victims long - established banking institutions that had been deemed “ too big to fail ” Large bailouts by governments and mas-sive liquidity injections by central banks may have only fanned the fl ames Capital markets have frozen, leading stock markets worldwide to crash, wiping out trillions of dollars in share values and retirement investment accounts The level of economic uncertainty prevailing in 2009 is unprec-edented over the last 80 years Has the crisis been correctly tackled or has it only been infl amed? Given the incredibly high liquidity injections by major central banks, is money supply out of control? How long will the crisis last? How many sectors and countries will it affect? What will be its impact

on growth and employment? What will be its fi scal and infl ationary cost? Will infl ation run out of control in the future? What are the lessons for the future? What steps need to be taken to prevent a similar episode?

While precise answers are not possible, the crisis has slowed down nomic growth in many industrial countries, increased unemployment to lev-els not seen in 25 years, triggered food riots and energy protests in many vulnerable countries, imposed extraordinary ﬁ scal costs with unprecedented government bailouts and ﬁ scal stimuli, and perhaps threatened the lives of more than a hundred million people around the world Notwithstanding its far-reaching and devastating consequences, the crisis has made the quest for

eco-ﬁ nancial stability a pressing and fundamental issue

Financial instability has been a recurrent phenomenon in contemporary economic history, affecting countries with varying intensity and resulting

in massive unemployment and lost economic output The most enduring

lived through that period fought to establish a banking system capable of

by Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor

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preserving long- term ﬁ nancial stability Their proposals became known as the Chicago Reform Plan, as it was economics professors at the University

natu-ral restatement of some basic pillars of Islamic principles and ﬁ nance The Chicago Plan basically divides the banking system into two components: (i) a warehousing component with a 100 percent reserve requirement, and (ii) an investment component with no money contracts and interest pay-ments, where deposits are considered as equity shares and are remunerated with dividends, and maturities are fully observed In the aftermath of the Chicago Plan and in the subsequent literature it has become clear that a

ﬁ nancial system along Islamic principles is immune to instability

Financial stability is a basic concept in ﬁ nance It applies to households,

fi rms, banks, governments, and countries It is an accounting concept veying notions of solvency, or equilibrium For an entity, fi nancial stability can be defi ned as a regular liquid treasury position, in which the sources of funds exceed the uses of funds The sources of funds are diverse and include income streams (salaries, transfers, taxes, interest income, dividends, profi ts, and so on), borrowing or loan recovery, and sales of real and fi nancial assets The uses of funds include current expenditures (including interest and divi-dend payments, rents, salaries, taxes, and so on), capital expenditures, pur-chase of assets, lending or debt amortization Accounts are separated into income or current accounts, and balance sheet or capital accounts Financial

Financial instability can be deﬁ ned as the opposite of ﬁ nancial stability It can be associated with payment defaults, payment arrears, or insolvency

It manifests itself through a regularly defi cient treasury position, in which the sources of funds fall short of uses of funds or payments obligations When fi nancial instability persists, access to borrowing becomes highly restricted The entity facing fi nancial instability may have to recapitalize, liquidate assets, restructure liabilities, seek a bailout, or, in extreme circum-stances, may be subject to merger or even liquidation

In banking, there is stability if the maturities of assets and liabilities are matched, if assets preserve their values and do not depreciate, and if the amount of IOUs is fully backed by gold or warehouse deposits that served for issuing these IOUs The excessive issuing of gold or warehouse certiﬁ -cates, or bank notes, may cause instability, as manifested in a run on a bank

the stock of gold or merchandise; under these conditions, conversion may

be suspended, bankruptcies may occur, or IOUs may be devalued Under a

ﬁ at - money system, the central bank may act as the lender of last resort to preserve stability by printing new money, which in turn may lead to cur-rency depreciation

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BASIC ECONOMIC PRINCIPLES OF ISLAM

rules and laws, collectively referred to as Shari ’ ah , governing

eco-nomic, social, political, and cultural aspects of Islamic societies

Shari ’ ah originates from the rules dictated by the Qur ’ an and its

practices and explanations (more commonly known as sunnah )

rendered by the Prophet Muhammad (pbuh) Further elaboration

of the rules is provided by scholars in Islamic jurisprudence within

the framework of the Qur ’ an and sunnah

justice and equity The notion of justice and equity, from

produc-tion to distribuproduc-tion, is deeply embedded in the system As an aspect

of justice, social justice in Islam consists of the creation and sion of equal opportunities and the removal of obstacles equally for every member of society Legal justice, too, can be interpreted

provi-as meaning that all members of society have equal status before the law, equal protection of the law, and equal opportunity under the law The notion of economic justice, and its attendant concept

of distributive justice, is characteristic of the Islamic economic tem Rules governing permissible and forbidden economic behav-ior on the part of consumers, producers, and government, as well

sys-as questions of property rights and the production and tion of wealth, are all based on the Islamic concept of justice

that values human relations above material possessions In this way, it

is concerned not only about material needs but also establishes a ance between the material and spiritual fulﬁ llment of human beings

or community and appears as a mere aggregate having no dent signiﬁ cance, the Islamic system creates a balanced relationship between the individual and society Self - interest and private gains

indepen-of the individual are not denied, but they are regulated for the terment of the community Maximizing an individual ’ s pursuit of proﬁ t in enterprise or satisfaction in consumption is not the sole objective of society, and any wasteful consumption is discouraged

of society are the foundations of a stakeholder - oriented society, serving the rights of all and reminding them of their responsibilities

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BASIC PRINCIPLES OF ISLAMIC FINANCE

■ Prohibition of interest Prohibition of riba — a term literally

mean-ing “ an excess ” and interpreted as “ any unjustiﬁ able increase of capital whether in loans or sales ” — is the central tenet of the sys-tem More precisely, any positive, ﬁ xed, predetermined rate tied

to the maturity and the amount of principal (that is, guaranteed

regardless of the performance of the investment) is considered riba

and is prohibited The general consensus among Islamic scholars

is that riba covers not only usury but also the charging of “

inter-est ” as widely practiced This prohibition is based on arguments

of social justice, equality, and property rights Islamic law ages the earning of proﬁ ts but forbids the charging of interest because proﬁ ts, determined ex post, symbolize successful entre-preneurship and the creation of additional wealth, whereas inter-est, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth Social justice demands that borrowers and lenders share rewards

encour-as well encour-as losses in an equitable fencour-ashion and that the process of accumulating and distributing wealth in the economy be fair and representative of true productivity

■ Money as “ potential ” capital Money is treated as “ potential ”

capital — that is, it becomes actual capital only when it is joined with other resources in undertaking a productive activity Islam recognizes the time value of money, but only when it acts as capi-tal, not when it is “ potential ” capital

■ Risk-sharing Because interest is prohibited, suppliers of funds

become investors, rather than creditors The provider of fi nancial capital and the entrepreneur share business risks in return for a share of the profi ts The terms of fi nancial transactions need to refl ect a symmetrical risk - return distribution that each party to the transaction may face The relationship between the investors and the fi nancial intermediary is based on profi t/loss sharing principles, and the fi nancial intermediary shares the risks with the investors

■ Prohibition of speculative behavior An Islamic ﬁ nancial system

discourages hoarding and prohibits transactions featuring extreme uncertainties, gambling, and risks

■ Sanctity of contracts Islam upholds contractual obligations and

the disclosure of information as a sacred duty This feature is

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OUTLINE OF THIS BOOK

In our quest to elaborate on the causes of fi nancial instability in the tional fi nancial system and to assess the stability of Islamic fi nance, we begin our analysis by reviewing the nature of capital (through the seminal writings

conven-of Adam Smith, David Ricardo, William Stanley Jevons, Karl Marx, Eugen von Böhm-Bawerk, Knut Wicksell, and other giants of the ﬁ eld), explaining the concept of the rate of return, marginal productivity of capital, and the rate of interest

In Chapter 2 , we assess how ﬁ nancial instability leads to economic recession or depression Credit expansion and abundant liquidity, supported

by cheap money policy and low interest rates, lead to speculative booms and asset price bubbles Financial innovations, Ponzi fi nance, swindles, and fraud have invariably developed during speculative booms During a bubble many illiquid credit instruments become monetized — through securitiza-tion, for instance — and further fuel liquidity expansion Over - indebtedness erodes creditworthiness and causes defaults The sharp credit contraction, defl ation of asset prices, and bankruptcies that follow thereafter lead to economic recession or depression We examine Minsky ’ s hypothesis that the conventional fi nancial system is unstable and that instability is endog-enous in such a fi nancial system, which is apparently destined to experience periods of fi nancial instability However, Minsky ’ s endogeneity analysis, while integrating Keynes ’ views regarding instability of expectations and Schumpeter ’ s view on creative destruction adapted to fi nancial innovations,

is not fully supported by the facts

We deduce the common factors that led to ﬁ nancial turmoil in these sodes and examine the ordeal that followed instability The general pattern was

epi-intended to reduce the risk of asymmetric information and moral hazard

■ Shari ’ ah - approved activities Only those business activities that

do not violate the rules of Shari ’ ah qualify for investment For

example, any investment in a business dealing with alcohol, bling, or casinos is prohibited

■ Social justice In principle, any transaction leading to injustice

and exploitation is prohibited A ﬁ nancial transaction should not lead to the exploitation of any party to the transaction Exploita-tion entails the absence of information symmetry between parties

to a contract

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that each episode was preceded by rapid credit expansion, a speculative boom and excessive price volatility in one or more asset classes, such as common stocks, gold, commodities, land, housing, or foreign currencies The bursting

of the asset bubble(s) in turn led to asset price deﬂ ation and banking failure Each major ﬁ nancial crisis wiped out real income gains, setting real GDP and

In Chapter 3 , we establish that, in many episodes of fi nancial ity, monetary policy contributed directly to speculative booms and to their severe defl ationary or infl ationary consequences Central banks have often precipitated and amplifi ed fi nancial instability through liquidity injection that fuelled speculative booms and expanded risky lending In their quest to achieve full employment, central banks have relied on interest rate setting

instabil-to attain this objective while neglecting the moniinstabil-toring of monetary gates Such a mandate for some central banks, besides undermining long - term economic growth, has created an uncertain money framework and has

In Chapter 4 , we analyze the mechanics of the credit multiplier We show that conventional banks do create money substitutes by issuing liabili-ties With securitization, the credit multiplier becomes theoretically inﬁ nite

If uncontrolled by the monetary authorities, bank money creation can lead

to excessive credit and money growth in the economy, in turn becoming a source of instability

In Chapter 5 , we focus on and analyze the current (2007 – 09) episode of international fi nancial instability We show that its internationalization was caused by monetary expansion in reserve centers and beggar - thy - neighbor policies in pursuit of short- term economic growth gains, fl oating exchange rates, cross - border capital fl ows, increasing recourse to debt fi nancing and leveraging, lax fi nancial regulation and supervision, and pro - cyclical bank-ing regulation leading to a reduction in bank capital during an expansionary phase We also recall the notion of a common world currency or reserve

In Chapter 6 , we discuss the main theme of the book: the inherent

(1988) showed that an Islamic fi nancial system could be modeled asnon speculative equity ownership that is intimately linked to the real sec-tor and where demand for new shares is determined by real savings in the economy Many causes of fi nancial instability, such as money creation out of thin air, speculation, and interest - based fi nancial assets are absent in Islamic

ﬁ nance Banks have direct ownership of real assets and operate like an equity holding system Savings are redeployed into productive investment with no

ex - nihilo money creation

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Mirakhor (1988) showed that the rate of return on equities is determined

in a growth model by the marginal effi ciency of capital and time preference and is signifi cantly positive in a growing economy This implies that Islamic banking is always profi table provided that real economic growth is positive Mirakhor ’ s fi ndings establish a basic difference between Islamic banking, where profi tability is fully secured by real economic growth, and conven-tional banking, where profi tability is not driven primarily by the real sec-

banking for safekeeping, and banking for payment purposes This system operates on a 100 percent reserve requirement, and fees may be collected for this type of service In this system an investment banking system oper-ates on a risk/proﬁ t sharing basis, with an overall rate of return, which is positive and determined by the economic growth rate We show that Islamic banks do not create and destroy money; consequently, the money multiplier, deﬁ ned by Mirakhor as the savings rate in the economy, is much lower in the Islamic system than in the conventional system, providing a basis for strong

In Chapter 7 , we analyze theoretical models that deal with the inherent stability of Islamic ﬁ nance (Mirakhor 1985; Meltzer; Mohsin Khan; and

In Chapter 10 , we briefl y review the risk profi le of an Islamic fi cial intermediary and we demonstrate how a hypothetical Islamic fi nancial intermediary will be less exposed to asset - liability management risk

In Chapter 11 , we fi rst look at the positive and negative roles of tives and fi nancial engineering in the fi nancial system We then examine the role of structured fi nance and institutions that are operating exclusively in debt and speculative instruments We demonstrate that by their nature most speculative entities cannot survive in a stable fi nancial environment; that is;

deriva-in an Islamic fi nancial system We also discuss the types of fi nancial ties and instruments that are excluded from Islamic fi nance; in particular, interest rate - based bonds, securities, fi nance based on the securitization of

activi-fi ctitious assets, speculative activi-fi nance that is not backed by real commodities, and consumer fi nance that is not backed by real assets We then discuss the appropriate safeguards and regulatory framework to strengthen the stability

In Chapter 12, we examine the importance of corporate governance for

ﬁ nancial institutions We summarize lapses in governance during the current

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fi nancial crisis, outline governance rules in Islam and, fi nally, argue that the governance principles of Islam will strengthen overall governance and will lead to fi nancial stability.

While there is no country that has adopted a pure Islamic fi nancial tem, over the last 35 to 40 years a number of Islamic fi nancial institutions and fi nancial products have come on the market In Chapter 13 , we survey the recent fi nancial performance of these institutions and the fi nancial prod-ucts that they issue

To round everything off, we then summarize our conclusions, focusing

on the inherent stability and resilience of the Islamic ﬁ nancial system and how

it may be better implemented in the future We turn to the social cost of fi cial instability; namely, that when the central bank tries to socialize losses from a speculative boom through large bailouts, it sets in motion an infl ation-ary process This penalizes the public for policy mismanagement, and causes large wealth redistribution from fi xed income wage earners, and creditors in favor of banks and debtors Moreover, high infl ation causes a defl ation of real output and may degenerate into stagfl ation if infl ationary expectations become fully embedded in the price and wage system Last resort bailouts are tantamount to validating uncontrolled money creation by fi nancial institu-tions An Islamic system avoids such an outcome The absence of last resort lending in an Islamic system means there can be no uncontrolled liquidity creation or, therefore, infl ation based on monetary policy

As the current fi nancial crisis and previous episodes of fi nancial ity were in large part caused by overly expansionary monetary and credit policies in many industrial and developing countries, there may be a need for a Basel III agreement to regulate the regulators — that is, the central banks — and set guidelines for safe central banking aimed at fi nancial sta-bility and not at full employment Without such a regulatory framework, the existing Basel I and II arrangements, even if fully implemented, would not be suffi cient to prevent future episodes of severe international fi nancial instability 13

ENDNOTES

1 Henry Simons, Frank Knight, Aaron Director, Garﬁ eld Cox, Lloyd Mints, Henry Schultz, Paul Douglas, and A G Hart elaborated the Chicago Plan Professor Irving Fisher from Yale University was a strong supporter of the Plan His book,

100% Money, was an attempt to win support among academics and

policymak-ers for the Plan

2 The consolidated account can be compared to the overall ﬁ scal account of the government or to a country ’ s balance of payments Each account comprises two components: a current account and a capital account The overall balance of the consolidated account should be sustainable for ﬁ nancial stability to be maintained over time

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3 For instance, following a run on its gold reserves the United Kingdom suspended the gold standard in September 1931 Similarly, the United States suspended the gold standard in August 1971 when its gold reserves fell criti- cally below the level of dollars held by foreign central banks that had the legal right to convert dollars into gold at the rate of $35 per troy ounce of gold

4 For instance, US real GDP was reported to have fallen by over one - third ing the period 1929 – 33 and did not return to 1929 levels until 1939 In Japan,

dur-ﬁ nancial instability, caused by the collapse of stock and real estate prices ing an asset boom during the period 1985 – 89, was responsible for the economic stagnation of 1990 – 2001, commonly referred to as the “ lost decade ”

5 Simons (1948) considered the central bank to be almost solely responsible for

ﬁ nancial instability for allowing multiplication of money substitutes by banking institutions and for failing to strictly control monetary aggregates and credit Allais (1999) held a similar view, and considered uncontrolled money expansion and destruction by the banking system to be a major cause of ﬁ nancial instability

6 Although we refer to this crisis as the ﬁ nancial crisis of 2007 or, alternatively, as the ﬁ nancial crisis of 2007 – 09, we in no way intend to imply that the crisis was limited to these years

7 We discuss the stability of Islamic banks at a theoretical level Deviations from basic Islamic banking precepts could expose Islamic ﬁ nancial institutions to the same instability as conventional banking In many instances, troubled Islamic banks were found to be applying the same principles as conventional banking

8 Hassan and Lewis (2007) offered a comprehensive description of Islamic modes

of fi nancing, which are based on profi t/loss sharing investment; the types of risks in Islamic banking; and fi nancial innovations, including access to capital markets and securitization, introduced by Islamic banks

9 Speculation may create a disconnect between the market price of an asset (such as common stock, house, and so on) and its true economic value or fundamentals For instance, the construction cost of a house may decrease, due to productivity gains; however, because of speculation, its market price may increase two, three,

12 A penetrating treatment of regulatory and supervision challenges in Islamic banking can be found in Archer and Abdel Karim (2007)

13 In October 2008, failing to force banks to resume lending to borrowers, major central banks bypassed banks and decided to lend directly to these borrowers at negative real interest rates

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CHAPTER 1 The Nature of Capital and the Rate of Return

of population, defying Malthusian pessimism, would not have been sible without capital accumulation, increased productivity and signifi cant advances in science and technology The use of all forms of capital, including energy, and advances in all fi elds of endeavor have resulted in productivity levels beyond anything that Malthus could have dreamt of, promoting mass production, faster and faster communication, expansion of urbanism, better health and nutrition, dramatically higher standards of living and increasing life expectancy The leaps in capital and labor productivity are undeniable Economic growth models have demonstrated the role of capital accumula-tion and technical change in enhancing economic growth Economic growth depends on savings, which are transformed into investment Savings are defi ned as consumer goods, essentially food and necessities that are spent

pos-on employed labor in producing capital goods New capital goods serve to replace amortized capital and add to existing capital New investment incor-porates innovations and new technology (technical change) that enhance productivity and hence economic growth In the Harrod model, economic growth depends on investment and capital productivity, or on the capital - output ratio More generally in most economic models of growth, economic growth is determined by capital (both physical and human), technology (or technical change), labor and natural resources

Two different strands of thought have dominated the deﬁ nition of tal: capital as physical goods or real assets; and capital as a pool, or fund,

capi-of money or ﬁ nancial assets Both concepts are intimately related and are essential to capital theory and ﬁ nancial stability A pool of money is the money counterpart of physical commodities, and vice - versa In a barter econ-omy, capital is a set of commodities In a money economy, money serves as

a medium of exchange and a store of value Commodities are exchanged for money capital through trade; and, in turn, money is exchanged for

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commodities The capital of a nation includes social and economic structure such as ports, airports, hospitals, schools, and housing; it also includes machinery, plant, raw materials, and inventories of consumer goods (mainly food and necessities) Human capital is generally included under labor input Land, mining (mineral resources), rivers, and sea are classiﬁ ed under land and natural resources Although capital is a set of heterogeneous goods of varying durability, it is collectively measured and assessed in money terms The balance sheet of a ﬁ rm or a household shows capital assets in money terms and not in physical terms The money value of capital changes with the market prices of goods Capital may increase in value without a physical increment if asset prices appreciate It may increase in volume with-out an increase in value when asset prices depreciate

Capital is also a pool of money or, in other words, ﬁ nancial assets Financial intermediation and banking use the notion of capital as a pool of money and not as a set of physical goods or objects Money can be in gold, any other commodity that is accepted as a medium of exchange, or ﬁ at money

It serves as a medium of exchange and a store of value Banks mobilize ings and receive deposits in money They disburse loans in money Similarly, capitalists own pools of money and loan money capital to borrowers Money funds change in value as fi nancial assets change in price or valuation Financial stability could be undermined when banks issue more money claims than are backed by the stock of real capital, or when there is a misalignment between money interest rates and the real return to capital When fi nancial capital multiplies independent of real capital, infl ation results and speculative bubbles

sav-in real assets and commodities accelerate All bubbles eventually burst They lead to ﬁ nancial instability, real economic recession, and a forced and unjust redistribution of wealth from savers to debtors and speculators

In this chapter, we review the deﬁ nition of capital, focusing on the notion of capital as a pool of money or a fund, as opposed to the idea of capital as a set of heterogeneous physical goods Ricardo regarded capital as

a wage fund — namely, food and basic necessities, which are vital to enhance labor input and enable production B ö hm - Bawerk regarded capital as a sub-sistence fund, which is a larger concept than wage fund, as capital would be required not only to support labor, but also landlords, entrepreneurs, and money capitalists

The distinction between physical and money capital has its counterpart

in the concepts of profi t and the rate of interest Thus, in the same vein, we review the debate regarding the nature of interest and profi ts Different the-ories were advanced to explain interest in terms of the productivity of capi-tal, abstinence, and time preference A distinction was made between money interest rate, which can be directly infl uenced by monetary authorities and the availability of loanable funds, and the natural rate of interest, which

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equates savings with investment The natural rate of interest is also called the “ free ” interest rate and is determined by capital productivity, abstinence, and time preference The notion of interest rate overlapped with the notion

of proﬁ t While interest could be considered unequivocally as contractual income from loan capital, applicable both to a consumption loan yielding

no additional product and a production loan yielding additional product, profi t is an ex - post concept that applies only to an enterprise in trade or production Defi ned as a residual concept, profi ts arise to the owners of the enterprise and may be seen to reward factors which are not accounted for in the computation of cost, such as entrepreneurship, risk, and uncertainty Finally in this chapter we discuss the theory of capital as detailed in the

Qu r’an and the sunnah The notion of capital as a physical asset, whether

produced or a natural resource, and the notion of capital as a money fund apply to Islamic fi nance where money capital is fully anchored by real capital and where overlap between profi t and interest is non existent because inter-est is forbidden Profi ts in Islamic fi nance stand unequivocally as reward to capital after allowing for capital amortization They are distributed in the form of dividends to shareholders The role of capital in economic growth

is fully recognized Capital is to be invested and not lent for consumption

or speculative fi nance The most effi cient use of capital and the admonition against the wasting of capital are the basic principles of Islamic fi nance The literature on capital theory is vast It would be impossible to do it justice in one short chapter However, the defi nition of capital as a set of real assets and as money funds and the distinction between interest and profi t are necessary for appreciating what lies at the core of fi nancial stability

ON THE NATURE OF CAPITAL

Factors of production have been classifi ed essentially as a triad: land and natural resources; labor (with embedded human capital); and capital (with embedded technology) The remuneration for owners of each factor is another triad: rent; wages; and interest and profi ts, respectively While inter-est was seen as the return to capital, profi ts (defi ned as a residual between total revenues and costs) have been either subsumed with interest or treated intrinsically as non interest income Savings and capital accumulation could

be derived from all income categories However, the propensity to save could vary according to income class; namely, the savings propensity out

of wages could be low, whereas the savings propensity out of non - wage income could be high

Among all factors of production, capital has been the subject of the most debate Even before Adam Smith, there had been two broadly different ways

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of thinking about capital: one was to view it as concrete physical goods, such as tools and machines; the other, was to see it as a sum of money, or the market value of the capital goods that it represents In this vein, Smith formulated two concepts of capital: capital as a means of acquisition for the individual, and capital as a means of social production He deﬁ ned capital

by its contribution to a nation ’ s wealth Individual or acquisitive capital increases the wealth of an individual owner and not necessarily a nation ’ s national output Social capital, however, is deployed in the production pro-cess and increases a nation ’ s real product Ricardo deﬁ ned capital as that part of the wealth of a country that is employed in production, and con-sists of food, clothing, tools, raw materials, and machinery as the means to enhance the contribution of labor Hence, according to Ricardo, the notion

of capital is intimately related to his labor theory of value , which considers

labor as the foundation for the value of commodities Capital may increase

in quantity by additions made to food and necessities

The notion of capital as a wage fund — namely, food and necessities to sustain labor in the production process — dominated early classical capital theory In particular, the notion of savings was identiﬁ ed with the availability

of food and necessities for sustaining workers in investment activities For instance, labor engaged in building roads would require food surplus made available by farmers over and above their own use If the labor employed

in the production of consumer goods absorbs its entire product, then there are no savings that can be used to free labor and redeploy it in investment activities Savings are transformed through production processes into capi-tal goods and lead to capital accumulation

B ö hm - Bawerk reviewed many deﬁ nitions of capital in his classic treatise

The Positive Theory of Capital Although he opted for a deﬁ nition of capital

as a subsistence fund that encompasses the Ricardian wage fund, he also saw capital as supporting landlords and money capitalists In essence, B ö hm - Bawerk ’ s deﬁ nition is an extrapolation of the Robinson Crusoe model to a general economy Robinson consumes less from his product to keep Crusoe employed in making capital goods Hence, capital is a set of physical goods; namely, food and other consumer goods made available prior to the start of the production process to enable the survival of labor, landlords, and entre-preneurs during the time interval required for the production process until

ﬁ nished goods are produced, or crops harvested

John Bates Clark treated capital as a fund rather than as an array of heterogeneous capital goods and offered a general deﬁ nition of rent as the income from all capital goods, rather than just the income from land There

is a permanent fund of productive wealth, expressible in money but not embodied in money, and it is this which businessmen designate as capital Clark deﬁ ned capital as economic wealth whose quantity is expressed in

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general value units There is no place in this defi nition for a distinction between individual and social capital, or between consumption and pro-duction goods All valuable things of more than momentary duration are intermediate goods and can be defi ned as capital, in that they are valuable because they are designed to satisfy future wants While this defi nition sweeps away any limitation on the content of capital because of a difference in future use, it likewise sweeps away any limitation because of a difference

in its origin or in source of its value Capital is considered only as goods whose value is the result of labor The prevailing distinction between “ natu-ral agents ” and “ produced agents ” of production involves radical defects of logic and is not maintained in practice In regard to the contending views —

fi rst, that capital consists of concrete goods, and, second, that it is the value of goods — the defi nition harmonizes them by defi ning capital as consisting

of concrete things, but only when considered as homogeneous and rable units of value

Jevons considered economics not solely as the science of exchange or value, but also as the science of “ capitalization ” His view of capital theory was in fundamental agreement with those adopted by Ricardo He regarded capital as the aggregate of those commodities that are required for sustain-ing laborers of any kind or class engaged in work A stock of food is the main element of capital; but supplies of clothes, furniture, and all the other articles in common daily use are also necessary parts of capital The current means of sustenance constitute capital in its free or un - invested form The single and all - important function of capital is to enable a laborer to

the beginning and the end of an enterprise It is evident that when men make their livelihood from the soil, with output only once a year, their subsistence needs for the whole year must be provided for in advance The ﬁ rst and most obvious setting where capital is directly used as an input in industry

is to enable production that requires considerable time to come to fruition

A man, when aided by capital, can afford to remain at his work until it is

ﬁ nished, and is not compelled to leave it unﬁ nished while he searches for the necessary means of subsistence If there were no accumulated fund to sup-port the laborer, no man could remain for a single day exclusively engaged

in any occupation other than that which would supply his primary wants Capital allows the employment of labor before labor ’ s output is produced Jevons believed that the deﬁ nition of capital and the explanation of capital theory must rely on the distinction between free and invested capital Free capital was deﬁ ned as the wages of labor, either in its transitory form of money, or in its real form of food and other necessities of life The ordinary sustenance required to support laborers of all ranks to be engaged in their work is the true form of capital This is quite in agreement with the ordinary

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language of businessmen when they refer to a factory, dock, railway, or ship

not as capital, but as representing so much capital sunk in their enterprise To

invest capital is to spend money, or the food and maintenance which money purchases, upon the completion of some work Capital remains invested

or is sunk until the work has returned a proﬁ t, equivalent to the input or sunk - capital cost plus interest Accordingly, a railway would not be seen as

ﬁ xed capital , but that capital is ﬁ xed in the railway The capital is not the

railway, but the food of those who made the railway An abundance of free capital in a country means that there are copious stocks of food, clothing, and every article which people insist upon having — that, in short, everything

is so arranged that abundant subsistence and conveniences of every kind are forthcoming without the labor of the country being taxed to provide them Under such circumstances, it is possible that some of the labor force can be employed in production activities that will yield output only in the distant future while no one feels scarcity at the present

National income accounts are fully consistent with the classical deﬁ tion of capital They measure aggregates in money values and apply the

ni-concept of resources (sources) and their uses Savings S is deﬁ ned simply

as national income Y less consumption C Savings can be expressed as:

identity can be formulated as equality of resources (sources of income) and

If the saving - investment gap is negative, the country is importing capital through depleting gold reserves or borrowing If it is positive, the country is exporting capital through acquiring gold reserves or lending

The dichotomy of the deﬁ nition of capital — real commodities versus money fund — is of paramount importance in the conduct of macroeco-nomic policy, growth and ﬁ nancial stability The object of economic growth

is to increase the quantity of real capital and output An overriding goal of macroeconomic policy is to achieve fi nancial stability Real capital may face constraints on its expansion because of limits to savings, natural resource availability or entrepreneurship However, money capital can lose contact and association with real capital and may expand disproportionately in rela-tion to real capital when fi scal and monetary policies are unduly expansion-ary If fi scal defi cits are fi nanced through bank credit (that is, monetization), there will an infl ationary expansion of money capital that is inconsistent with the stock of real capital Similarly, central banks or the banking system may expand credit in an uncontrolled manner, leading to an infl ationary expansion of money capital accompanied by slow growth or even a contrac-tion of real capital In the same vein, fi nancial innovation can lead to the creation of instruments that are pure debt trading instruments and have no

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connection to real capital For instance, through securitization or credit atives, money capital can expand at phenomenal rates that bear no relation-ship to the stock and availability of real capital A disproportionate increase

deriv-of money capital has deriv-often ﬁ nanced speculative booms in real assets and modities, with the burst of speculative bubbles resulting in banking bankrupt-cies and large redistributions of wealth from savers in favor of debtors

In all cases of a disproportionate increase of money capital, inﬂ ation

in the price of food and consumer necessities would intensify and could be regarded as an increase in the price of capital and a contraction of real capi-tal Suppliers of commodities generally reduce real supplies in an infl ation-ary environment and hoard commodities Infl ation reduces real wages It also reduces real savings and depresses demand for capital goods as well as the demand for non - necessities Such an infl ationary effect acts as a depres-sant for the real economy and triggers an economic recession

It will be shown later that in Islamic ﬁ nance money capital is fully anchored by real capital and maintains full and direct connection to it There

is no inﬂ ationary pressure on capital prices and therefore there is full economic stability Real supplies of commodities remain always forthcoming

macro-in a competitive manner Real wages are not depleted Savmacro-ings remamacro-in high macro-in real terms, as do investment and capital accumulation

ON THE NATURE OF INTEREST AND PROFIT

The confl ict over the nature of interest and profi t has been pervasive in the literature through time The confusion arises when interest is thought to be profi t, and vice - versa For instance, Adam Smith suggested the use of mar-ket interest rate to form an opinion on the rate of profi t and to look at the history of the evolution of interest rates as a way of assessing the behavior

of proﬁ ts Ricardo considered the rate of interest to be ultimately and manently governed by the rate of proﬁ t B ö hm - Bawerk, Irving Fisher, and Alfred Marshall perhaps best exemplify the notion of interest rate as a rate

per-of proﬁ t in the theory per-of productivity per-of capital For instance, B ö hm - Bawerk explains interest rates by the greater productivity of roundabout produc-tion processes Wicksell developed the notion of a natural rate of interest

as a measure of the proﬁ t rate and proposed to analyze the deviation of the money - market rate from the natural interest rate as explaining booms and contractions in bank credit and commodity prices

Frank Knight deﬁ ned proﬁ t as a residual after inputting rent, wages, and interest for land, labor, and capital, respectively Hence, Knight considered that interest remunerates capital and, in contrast to classical capital theory,

he did not confuse proﬁ t with interest The primary attribute of competition

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is the tendency to eliminate proﬁ t or loss, and bring the value of economic goods to equality with their cost Or, since costs are in the large part identical with distributive shares other than proﬁ t, the competitive principle may be expressed as saying that the tendency is toward a remainder less distribution

of products among the agents contributing to their production But in reality, cost and value only tend towards equality; it is only by an occasional accident that they are precisely equal; and they are usually separated by the margin of proﬁ t The key to the whole tangle will be found to lie in the notion of risk or uncertainty and the ambiguities concealed therein Knight believed that a sat-isfactory explanation of proﬁ t would highlight the distinction between perfect competition (in theory) and its remote resemblance to competition in practice, with the difference explained by a thorough examination and criticism of the concept of uncertainty, and its bearings upon economic processes

Frank Fetter pointed to a major contradiction in B ö hm - Bawerk ’ s theory

of interest Namely, B ö hm - Bawerk ’ s initial ﬁ nding that interest stems from time preference for present over future goods was contradicted by his later claim that the greater productivity of roundabout production processes is what accounts for interest However, when criticizing B ö hm - Bawerk ’ s pro-ductivity theory of interest, it was not necessary for Fetter to dismiss the important conception of roundaboutness or the period of production Roundaboutness is an important aspect of the productivity of capital goods However, while this productivity may increase the rents to be derived from capital goods, it cannot account for an increase in the rate of interest; that is, the ratio between the annual rents derived from these capital goods and their present price For Fetter, this ratio is strictly determined by time preference

In discussing the relations between rent and interest, Fetter pointed out the confusions and inconsistencies of previous writers on the theory of rent and interest In place of the classical distinction between rent as income from land and interest as income from capital goods, Fetter proposed that all fac-tors of production, whether land or capital goods, be considered either as yielding services and thus earning rent, or as saleable at their present worth calculated as a discounted sum of rents, as wealth or capital

As a corollary, rent must be conceived of as an absolute amount (per unit

of time), whereas interest is a ratio (or percentage) of a principal sum called capital value Rent becomes the usufruct from any material agent or factor But then there is no place for the idea of interest as the yield of capital goods Rents from any durable goods accrue at different points in time, at different dates in the future The capital value of any good then becomes the sum of its expected future rents, discounted by the rate of time preference for present over future goods, which is the rate of interest In short, the capital value of

a good is the capitalization of its future rents in accordance with the rate

of time preference or interest Therefore, marginal utility accounts for the

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valuations and prices of consumer goods; the rent of each factor of duction is determined by its productivity in eventually producing consumer goods; and interest arises in the capitalization, in accordance with time pref-erence, of the present worth of the expected future rents of durable goods Such was Fetter ’ s vision of the relative place of rent, interest, and capital value in the theory of distribution

In sum, Fetter wanted to separate the concept of marginal productivity from that of interest Marginal productivity explains the height of a factor ’ s rental price, but another principle is needed to explain why and on what basis these rents are discounted to get the present capitalized value of the factor: whether that factor be land, or capital goods That principle is time prefer-ence, the social rate at which people prefer present goods to future goods

in the vast interconnected time market (present/future goods market) that pervades the entire economy

In many economies, interest rates are set by the central bank via a

between money interest rate and natural rate of interest and has been seen

as a serious cause of ﬁ nancial instability More speciﬁ cally, it allows money capital to multiply independently of real or physical capital The dichotomy

of interest rates inevitably led to the theory of two interest rates in the ings of such as Thornton, Ricardo, Marx, and Wicksell: a market rate set by the central bank, and a non - observed natural rate corresponding to capital market equilibrium If the market rate is below the natural rate, there will be bank credit expansion and a commodity price boom A speculative bubble invariably reaches a bursting stage and when the bubble bursts ﬁ nancial instability is the end result If the market rate is above the natural rate, there will be bank credit contraction and falling commodity prices In pro-longed economic crises, a considerable loss in efﬁ ciency and a misallocation

writ-of resources have been caused by distortionary monetary policies

CAPITAL THEORY IN THE QUR’AN AND SUNNAH

Economics, ﬁ nance, social equity, and economic justice are treated

exten-sively in the Qur’an and the sunnah Islamic economics is designed for

society to attain human prosperity, economic growth, social equity, and nomic justice A main foundation of Islamic capital theory is the enduring

eco-presence of Allah as the sole creator of everything: “ And He has subjected

to you, as from Him, all that is in the heavens and on earth: behold in that are signs indeed for those who reﬂ ect ” (45:13)

Allah has endowed mankind with faculties and knowledge: “ it is He

who has created you (and made you grow) and made for you the faculties of

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hearing, seeing, feeling and understanding ” (67:23) These faculties, without which a man would be handicapped, are indispensable for survival and for exploiting material resources and building civilizations Scientiﬁ c advances are emphasized as a means for the betterment of life and economic prosperity (see, for example, 20:114)

The notion of capital is discussed extensively in both Qur’an and sunnah

Allah warns against loving “ wealth with inordinate love ” (89:20) and against

appropriating unjustly the capital of other people, including the wealth of orphans Private wealth is fully protected but, ultimately, wealth belongs to

Allah and men are only temporarily empowered to enjoy it during their

life-time (see 24:33) Besides condemning extortion, cheating, and theft, which is punishable by the cutting off of hands, the misuse of capital is also discour-aged For instance, Surat 3:5 says: “ And give not unto the foolish your prop-

erty which Allah has made a means of support for you, but feed and clothe

them therewith, and speak to them words of kindness and justice ”

The classical distinction between land and capital is not essential to Islamic capital theory Land and real commodities could be easily treated

as wealth or capital The distinction between labor and capital, however, is made explicit Besides designating capital in terms of commodities, capital also has been deﬁ ned in money terms In both domestic and international trade, commodities are sold for money In turn, money reserves are used to acquire commodities Money eliminates the double coincidence of wants and thus saves considerably on transaction costs Because of its wide accep-tance and its real purchasing power, money is considered as wealth Money

capital is referred to under the general name quanz or qunuz , and includes

gold, silver, other precious metals and jewelry Capital can be used in trade, production and for lending

The notion of capital as a roundabout production process and advances

in knowledge and technologies are inherent to Islamic capital theory Capital accumulation sustains economic growth, increases output and enhances human comfort It expands cities and enriches people However, classical capital theory ’ s emphasis on capital productivity as an explanation for inter-est is irrelevant in Islamic capital theory Loan transactions are perfectly

legitimate; however, they have to be qard - ul - hassan — free of interest A loan

has to be written by a notary in the presence of two witnesses, irrespective

of its amount The real value of the loan has to be preserved in terms of quantity, quality and time The debtor should never fail to repay his debt The repayment of a loan has priority over other spending such as perform-

ing the pilgrimage of hajj or umra It also has priority before an inheritance

is passed on to heirs Thus trust is stipulated as a fundamental element of

Islamic ﬁ nance and economics and of how well economics and ﬁ nance tion in practice

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Distribution and redistribution theory is complete in Islamic economics The remuneration of different factors of production is clearly deﬁ ned in

the Qur’an and sunnah The remuneration of labor is called “wage” ( ajr)

Rental and leasing property, be it land or a physical asset such as a house

or a machine, earns a contractual rent ( ijar) , which is perfectly legitimate in

Islam

Interest is deﬁ ned as an income on a loan, be it in kind or in money terms Interest is totally forbidden in Islam, and all arguments advanced in classical theory for interest as rewarding capital productivity, abstinence,

or measuring time preference are irrelevant for Islamic capital theory The confusion of interest with proﬁ t is totally forbidden: “ They say trade is

like interest, but Allah has permitted trade and forbidden interest ” (2:275)

With interest ruled out in an Islamic economy, the confusion of interest with proﬁ t is fully resolved: only proﬁ t can be the reward for capital

Profi t is a basic element of Islamic fi nance It is a residual that arises to the owner of the enterprise once all costs associated with labor, capital amor-tization, raw materials, and taxes are deducted Profi t also rewards risk and entrepreneurship In the absence of loans and interest rates, an economy based

on shareholding and profi t is always in equilibrium and is immune from bility and infl ation Distortions created by interest rates and undue expansion and contraction of money capital cannot take place in an Islamic economy The rate of profi t is related to the real economic growth rate The rate of profi t

insta-is much higher than various interest rates For instance, for the US over the period 1926 – 2000 the average annual rate (nominal) of return on T bills was 3.9 percent, long term T - bonds 5.7 percent, large stocks 13.0 percent, small

In an Islamic economy, consumer loans are negligible or non existent Capital is used effi ciently and productively in investment and to enhance economic growth It is not lost in bankruptcies or in speculation Savings will be higher than in an interest - based economy The capacity of an Islamic economy to generate labor employment and growth is substantially greater than that in an interest - based economy Speculative fi nance, based on interest loans, is non existent in Islamic fi nance The economy is, therefore, immune from unjust appropriation of wealth by speculators and from economic and

ﬁ nancial dislocation stemming from speculation

ENDNOTE

1 http://74.125.93.104/search?q cache:HV6TkxlDnLEJ:web.mit.edu/15.407/

ﬁ le/Ch07.pdfhistoric+rates+of+returnonstocksandT bills & cd2 & hl

en & ct clnk & glus

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CHAPTER 2 The Origins of Financial Panics and Recessions

deep contraction in economic output, large scale unemployment, ruptcies, a dramatic fall in real incomes, and social hardships In view of these devastating effects, there has been considerable research into under-standing the causes of ﬁ nancial instability and to developing remedies to reduce its risk and likelihood Financial instability has often been caused

bank-by war or large fi scal defi cits, and frequently fi nanced bank-by printing money Financial instability has also been caused by ill - designed monetary policies, abundant liquidity and excessive and imprudent credit expansion, by market forces endogenous to the fi nancial system, by monetary policy targeting infl a-tion, by cross - border fl ows of capital or by inadequate and badly designed regulatory and supervisory regimes

In the fi rst section of this chapter, we discuss the role of over - indebtedness and defl ation as a cause for instability We then discuss Minsky ’ s theory of endogenous instability; namely, that a fi nancial system evolves from stability

to instability In the third section, we examine the role of central banks in ing instability More speciﬁ cally, a central bank may support un backed credit expansion and the creation of money out of thin air with a view to stimulat-ing consumption and employment Besides being inﬂ ationary, the creation of

caus-money ex - nihilo was found to be a cause for bankruptcies in many episodes

of fi nancial instability In the fourth section, we look briefl y at the impact of the cross - border fl ows of capital and exchange rate regimes (which are examined

in more detail in Chapter 4 ) In the ﬁ nal section, we look at the important role

of ﬁ nancial regulation and supervision in preserving ﬁ nancial stability

OVER - INDEBTEDNESS AND DEFLATION

Fisher (1933) reviewed many possible causes of ﬁ nancial instability He argued that two dominant factors were responsible for each boom and

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depression: the boom fueled by over - indebtedness in relation to equity, gold,

or income is followed by deﬂ ation, consisting of a fall in asset prices or a fall in the price level igniting a recession or even a depression He noted that over-investment and over - speculation are often important, but they would have far less serious results if they were ﬁ nanced by equity, as opposed to

ﬁ nancing from borrowed money and leveraging That is, over - indebtedness may reinforce over-investment and over - speculation Disturbance in these two factors — debt and the purchasing power of a unit of money — will have

an adverse impact on all other economic variables If debt and deﬂ ation were absent, other disturbances would be much less likely to bring on crises comparable in severity to those of 1837, 1873, or 1929 – 33

Fisher found that easy money was the great cause of over - borrowing When an investor thinks he can earn high returns by borrowing at low rates, he will be tempted to borrow and to invest or speculate with bor-

indebtedness in 1929 The low interest rate policy adopted by the US to help England return to the gold standard in 1925 contributed to unchecked credit expansion Brokers ’ loans, with very small margins and low interest rates, expanded very fast and fueled stock - market speculation Inventions and technological improvements created investment opportunities leading

to large debts Other causes were the burden of domestic and foreign war debts and the cost of reconstruction loans to Europe

To Fisher, the Depression was triggered by debt liquidation, which led to distress selling and to a contraction of deposit currency as bank loans were paid off, and to a slowing down in the velocity of the circulation of money The contraction of deposits caused a fall in the level of prices There followed

a greater fall in the net worth of businesses, precipitating bankruptcies and a fall in profi ts and leading to a reduction in output, trade, and employment, which in turn led to hoarding and a slowing of the circulation of money Fisher ’ s analysis showed that fi nancial instability of the scale of the Great Depression is preventable if over - indebtedness is avoided He empha-sized the important corollary of his debt - defl ation theory that great depres-sions are curable through refl ation and stabilization He maintained that the government could refl ate the price level through printing money to fi nance the defi cit needed to kick - start economic recovery The central bank can also refl ate through open market operations or lending as a lender of last resort Referring to Sweden, where economic policy achieved economic stability during the period 1929 – 33, he believed that price level was controllable through appropriate policy instruments

Friedman and Schwartz (1963) and Friedman (1959, 1969, 1972) ceived of ﬁ nancial instability as a monetary phenomenon — described as faster money expansion resulting from unchecked credit expansion — and

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con-signifi cantly downplayed real factors In each fi nancial crisis, banks pended conversion of deposits into currency, and a wave of bank failures ensued The analysis of the causes of the Great Depression by Friedman and Schwartz (1963) sheds light on the causes that led to the present fi nancial crisis, characterized by a meltdown of sub prime loans and the bursting of the housing bubble They argued that fi erce competition among banks and

susﬁ nancial innovation that evaded prudential regulations contributed to over borrowing for speculation in housing and stock markets and a deterioration

-of the quality -of loans They noted that fi nancial instability -of the scale -of the Great Depression did not happen prior to the creation of the Federal Reserve System (Fed) in 1913 The founders of the Fed expected that fi nan-cial instability that had been a feature of the nineteenth and early - twentieth centuries would be thwarted, contained or signifi cantly reduced by the cre-ation of a central bank

With regard to the Great Depression, Friedman and Schwartz held the view that the Fed was responsible for two policy errors: it was reluctant to prevent a speculative boom at an early stage and it was not able to move fast enough to prevent massive bank failures and deep depression Based

on their study of US monetary history, they observed that ﬁ nancial stability prevailed only when money supply was increasing at a stable and moderate rate of 2 – 3 percent In line with Simons (1948), Friedman strongly rejected discretionary and unpredictable monetary policy and prescribed the rule of setting ﬁ xed targets for the growth of monetary aggregates in line with the

The setting of low interest rates by the Fed during the period 1926 – 29

to help Britain restore the gold standard at a pre - 1914 parity level was found to have led to speculative booms in housing and stock markets and

to high economic growth The reluctance of the Fed to raise interest rates with a view to protecting farmers, builders, and the rest of the economy con-tributed to uncontrolled credit growth during the period 1927 – 29, which ended with the Great Depression Interest rate setting by central banks has been sharply criticized throughout contemporary economic history by a number of economists, including Thornton (1802), Wicksell (1898) and Friedman (1968, 1972), who opposed discretionary policy on the grounds that it creates both excessive credit and market risks for ﬁ nancial institu-tions Interest rate setting can be seen as a form of price control that causes considerable distortions and inefﬁ ciencies Besides creating monetary uncer-tainties, it leads to excessive credit expansion, speculation and, therefore, to

By targeting interest rates, a central bank abandons monetary gates and signiﬁ cantly reduces its direct contacts with individual banks For instance, in the United States the role of district banks has been curtailed and

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aggre-liquidity operations have been concentrated in the New York Fed 4 The tral bank wants only to control interest rates and stands ready to supply any amount of money required to maintain an interest rate pegged at a fi xed tar-get rate, regardless of creditworthiness, and to support the price of govern-ment bonds and fi nance fi scal defi cits, essentially by using open market operations Furthermore, as the general price level increases or asset prices rise, the central bank stands to accommodate higher money demand for transactions or for fueling credit expansion, which in turn increases liquid-

Galbraith (1954), Kindleberger (2005) and Soros (2008) found that speculative manias gather speed through expansion of money and credit, and are supported by ﬁ nancial de regulation During periods of speculative euphoria, many credit instruments become “ monetized, ” fueling specula-tion The Radcliffe Commission in Britain in 1959 claimed that in a devel-oped economy there is a wide range of ﬁ nancial institutions and many highly liquid assets which are close substitutes for money These are equally good

to hold, and only inferior when the actual moment for payment arrives Call money — more specifi cally, brokers ’ loans — combined with small margins and low interest rates, fi nanced stock market speculation in 1929 Credit instruments can be monetized during a speculative boom; these instru-ments include bills of exchange, negotiable CDs, installment credit, NOW accounts, credit cards, mortgages, and student loans Uncontrolled fi nancial

de regulation provides the supportive environment for euphoria and tion When a speculative boom collapses, these credit instruments become illiquid and there is a rush to liquidity and safety

In sum, looking at the history of ﬁ nancial panics, there are two features common to all panics Panics are invariably preceded by a period of rapid monetary expansion followed by a mania, whether for tulips, tea, housing, technology stocks or something else The rapid monetary expansion drives down the cost of money, sometimes in the negative range in real terms, encouraging individuals and companies to borrow and speculate The herd instinct takes over Speculation takes over in the belief that the price — of housing, tulips or whatever may be prized — will keep on increasing A bub-ble develops but is not seen for what it is

When the bubble bursts, which it always does, banks and other lenders become insolvent In the Western banking model, banks have lent multiples

of their capital (leveraged) and become insolvent when a fraction of their

customers become insolvent (Compare this with Islamic banks, which are

not leveraged and would only fail if all of their customers defaulted.) As a

result, following the bursting of the bubble, there are massive bank failures and an implosion of debt in the Western model The de leveraging process

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is painful and affects both insolvent and solvent institutions Consumers feel poorer because of a decline in perceived wealth as asset prices — stocks, bonds, housing and the like — decline Some of the panic is psychological Consumers lose faith in ﬁ nancial institutions In the recent panic, in

2008, consumers lost a great deal of conﬁ dence when money - market funds broke the buck (a decline in asset value below par) after the collapse of Lehman Brothers and its effect on the commercial paper market dried up funding for business Financial panics and recession are two different sto-ries How a country handles the ﬁ rst affects the outcome of the second Economic contractions can be brought about by external shocks and

by internal factors A capitalist economy is prone to recessions from these sources through such things as a cut - off in oil supplies; a spike in energy prices; wars; ﬂ uctuations in investment; changes in government spending; attempts by central banks to bring inﬂ ation under control; and a freezing of credit Given the importance of credit to the real economy in the Western

ﬁ nancial and economic model, if credit is unavailable or available at a high price (high interest rate), then consumption and investment growth slows down and inventories build up, resulting in a slower growth in national output, followed by a fall in employment If the decline in employment is sufﬁ ciently large, consumption and investment decline, and thus national output declines If the decline in national economic output continues for at least two consecutive quarters, then an economic recession is upon us

MINSKY: STABILITY IS UNSTABLE

Minsky (1986, 1992) considered ﬁ nancial instability to be endogenous to

a conventional fi nancial system His core model is known as the Financial Instability Hypothesis (FIH), which simply declares that stability is inherently unsustainable A fundamental characteristic of a conventional fi nancial sys-tem, according to Minsky, is that it swings between robustness and fragility and these swings are an integral part of the process that generates business cycles His “ stability is unstable ” theory was infl uenced by Keynes ’ notion

of the fundamental instability of market expectations, and by Schumpeter ’ s notion that capitalism renews itself through competition and innovation — “ creative destruction ” — that chucks out the bad and ushers in the good But while Schumpeter focused on the role of technology in driving capitalism, Minsky ’ s focus was on banking and fi nance He contended that nowhere is evolution, change and Schumpeterian entrepreneurship more evident and the drive for profi ts more clearly the reason for change than in the conven-tional banking and fi nance system Financial innovation as a destabilizing infl uence becomes evident with the bursting of a speculative boom

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Minsky looked at all participants in the economy — households, panies and ﬁ nancial institutions — in terms of their balance sheets and cash

com-fl ows Balance sheets are composed of assets and liabilities, while cash com-fl ows validate the liabilities Minsky ’ s economy comprises what he calls a “ web of interlocking commitments ” — a vast and complex network of interconnected balance sheets and cash fl ows that is always changing and evolving During periods of stability people feel more confi dent According to Minsky, they respond by increasing their liabilities relative to income; and the “ margin of safety ” declines

Minsky classiﬁ ed borrowers into three distinct categories, according to their balance sheet and ability to make interest and principal payments

fi nancing units are those which can fulfi ll all of their contractual payment obligations through their cash fl ows According to Minsky ’ s defi nition, the greater the weight of equity fi nancing in the liability structure, the greater the likelihood that the unit is a hedge fi nancing unit Speculative fi nance units are those that can meet their commitments on interest payments, even

as they cannot repay the principal out of income cash ﬂ ows Such units need

to roll over their liabilities — that is, to issue new debt to meet commitments

on maturing debt For Ponzi units, the cash fl ows from operations are not suffi cient to fi ll either the repayment of principal or the interest on outstand-ing debts Such units can sell assets or borrow Borrowing or selling assets

to pay interest (and even dividends) on common stocks lowers the equity of

a unit The key feature of a Ponzi scheme is its need to attract ever - greater sums of money To survive, Ponzi units must re ﬁ nance, either by selling assets or by raising more debt For this to happen, asset prices must continue

to rise Ponzi ﬁ nance typically emerges during a speculative bubble, a time when the margin of safety has been undermined

Minsky stated that if hedge ﬁ nancing dominates, then the economy could be in an equilibrium - seeking state In contrast, the greater the weight

of speculative and Ponzi ﬁ nance, the greater the likelihood that the economy

is in a deviation - amplifying state The ﬁ rst theorem of the instability esis is that the economy has ﬁ nancing regimes under which it is stable and

ﬁ nancing regimes in which it is unstable The second theorem of the esis is that over periods of prolonged prosperity, the economy transits from

hypoth-ﬁ nancial relations that make for a stable system to hypoth-ﬁ nancial relations that make for an unstable system

Minsky observed that ﬁ nancial institutions compete furiously, both when investing and when providing credit to others Inspired by Schumpeter ’ s notion of “ creative destruction, ” he described the proliferation of ﬁ nancial innovations as a means to attract more borrowers and to bypass existing regulations The level of product innovation has run far in advance of the

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capacity to utilize these products and the ability to understand the teristics of risks and long term consequences Recent instruments — based on the idea of “ originate and distribute, ” instead of “ originate and hold, ” as well as securitization models — include mortgage - backed securities (MBS), collateralized debt obligations (CDO), and CDO tranches, not to mention CDO squared (tranches from CDO tranches), CDO cubed (tranches on top

charac-of CDO squared) or the most abusive credit default swaps (CDS) The more layers of derivatives there are on top of each other, the more sensitive (a cas-cading effect) they are to even small changes in the underlying variables and assumptions Thus it should be no surprise that in 2009 many AAA - rated CDOs have only a 50 percent rate of recovery, and everything else, includ-ing AAs and single As, are pretty much wiped out

Banks are not the only fi nancial institutions competing fi ercely with one another for profi ts As Ponzi fi nancing dominates, swindles, fraud, theft, embezzlement, and deceptive credit ratings multiply and make large gains

in the process When their liabilities become valueless, losses are borne by banks, and massive bankruptcies erupt Present - day hedge funds, as con-trasted with Minsky ’ s notion of hedge units, play an increasingly impor-tant role in the credit markets, providing liquidity to the housing market

by buying mortgage - backed securities and fueling the growth of leveraged buyouts and structured fi nance As hedge funds have not been regulated, little is known about the true extent of their leverage or the positions they take However, their capacity to leverage is potentially enormous By bor-rowing fi ve times its assets and investing in the riskiest part of a structured security such as collateralized mortgage obligations, a credit hedge fund could in theory become lender of $ 850 million - worth of residential securi-ties by committing just $ 10 million of its own funds Credit hedge funds rely on short term fi nancing to pursue leveraged strategies A synchronous

de leveraging of credit hedge funds could become a new risk element in the credit markets

Following the teachings of Irving Fisher, Minsky held that a fi nancial crisis has a defl ationary impact as people seek to pay off debts His pre-scription was conventional: more government spending and lower inter-est rates from the central bank could prevent debt defl ation His view on the consequences of these actions was, however, less conventional Minsky contended that successful interventions during crises discouraged fi nancial conservatism If the boom is unwound with little trouble, it becomes quite easy for the economy to enter a new phase of instability Financial institu-tions respond to the fact that the authorities are protecting them from fi nan-cial catastrophe by plunging anew into risky activities; hence an increase

of moral hazard risk The successful resolution of a crisis further ens moral hazard Moreover, large government deﬁ cits combined with low

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