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Islamic Economics and the Global Financial Crisis

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0 Image by david_shankbone via Flickr by Dr. Asad Zaman, Modern financial institutions, instruments and their underlying philosophies clash with Islamic law in many areas. For some time, both critics and supporters have thought that these Islamic laws were in need of revision to bring them into conformity with the complexities of modern requirements of trade and industry. Critics have been content with ridiculing the archaic law. Supporters have made substantial efforts to provide Islamic equivalents of modern western financial institutions and instruments. Many have been uneasy with these efforts, which often seem pointlessly convoluted ways of imitating western ideas about finance. There is also the concern that Islamic laws are being stretched beyond the breaking point to accommodate western forms. The global financial crisis of 2008 has led to the radical realization that instead of being obstacles to progress, the Islamic laws provide barriers against financial disaster. Many western commentators have remarked that adherence to Islamic economic principles would have prevented this crisis. Challenges, a French magazine, went so far as to say that the 7th century text of the Quran offered better guidance than the Pope on financial matters. It is amazing that our sacred texts, from the days when even the simple financial innovation of paper currency did not exist, offer guidance on how to prevent the more than hundred big and small financial crises that occurred in the past century. Furthermore, they offer guidance on the architecture of a system that would both be proof against such crises and provide a more fair and equitable income distribution. The innovations which are the need of the hour are not in adapting Islamic law to modern institutions, but in changing these modern institutions to bring them into conformity with the ancient laws. Islamic law prohibits the trading of debt. It was the trading of collateralized debt obligations (CDOs) which triggered the global financial crisis of 2008. Islamic law insists on clarity regarding the product and the price as a condition for a valid sale. According to the famous financial wizard George Soros, complex instruments like CDOs are so esoteric that the risk involved may not be properly understood even by the most sophisticated investors. Islamic law prohibits interest. There is obvious injustice in a system which requires interest payments of billions of dollars annually to wealthy countries from the heavily indebted poor countries, which cannot afford to feed their own malnourished. The economic consequences of this injustice are apparent in the numerous financial crises resulting from debt defaults in both rich and poor countries. Islamic law prohibits gambling. An incredibly large proportion of financial transactions are pure gambles. For example, while real international trade is only about $100 billion daily, foreign exchange transactions amount to $ 4 trillion. Thus the vast majority of such transactions are purely speculative gambles about the freely floating exchange rates.

The global value of financial derivatives was more than ten times the total GDP of the entire world in 2008, when the crisis occurred. On a micro level, the stock value of firms can be more than twenty times the real on-the-ground value of the assets and revenues generated. The financial system creates an illusion of riches which often collapses, causing distress and misery to millions. In contrast, Islam requires every financial asset to be backed by a real asset. Western financial methods have created a topsy-turvy world where financiers juggling papers make tremendously more than the honest laborers who work hard to produce industrial or agricultural products. At the World Economic Forum in Davos, many remarked on the need for radical reforms to solve deepening global economic problems. Currently, producers of goods and services get only about 10% of the total output while 90% goes to bankers and financiers. Applying Islamic laws would channel a far bigger share in the output to the producers and laborers. It should be obvious that more incentives for producers would lead both to greater production and greater wealth for those most in need as well as most deserving of it. Islamic laws in the economic realm are explicitly designed to produce circulation of wealth, alleviation of poverty, and equitable income distributions. These ancient laws are the radical reforms needed to remove the massive injustices created by the current economic system designed to transfer wealth from the poor to the rich, both on an individual as well as the national level.

The Muslim Observer

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Current Economic Crisis: Causes and Cures

February 12, 2009 by TMO

By Dr. A. S. Nakadar, Publisher & CEO of TMO

John Maynard Keynes, 1883 1946. Time Magazine cover, 1966 On June 8, 2006; I wrote an article entitled: The Crumbling American Might. I said, The world fears American might while America fears its own crumbling might, the dollar. And the American dollar is the US Achilles Heel. About 15 months later the American dollar tumbled. The cumulative effect of many years of fickle fiscal policies, especially of the last 7 years, is responsible for the present economic crisis. Many fear that we are on the brink of depression should the current severe recession continue. Since the Second World War, the US has adopted two economic policies. One is Keynesian economic theory, proposed by the British economist John Maynard Keynes in 1930, and later in 1970s the US adopted the supply side theory proffered by Milton Friedman and others. According to Keynesian economics, the state should stimulate economic growth and improve stability in the private sector through, for example, adjusting interest rates, taxation and funding public projects. The basic premise of the Keynesian economic policies is: for economic wellbeing, the state should stimulate economic growth through the private sector. And, by adjusting the interest rates, the Fed maintains the stability of the private sector (i.e. you and me). The Fed fine-tuned the money supply as and when it caused inflation or deflation. If inflation raised its head, it restricted the money supply by increasing the interest rates. And it would loosen the credit supply by lowering the interest rates, as an when economic activity slowed down or deflated. The stagflation of the 1970s, (the awful combination of high inflation and slow growth) and the oil crisis of 1973 bedeviled policy makers in 1970s. It sowed the seeds for the end of the dominance of Keynesian policies, as it had failed to stabilize the demand management. This bought the Austrian school of thought, supply-side economics, to the fore. The intellectual roots of supply-side economics have also been traced back to various early economic thinkers such as Ibn Khaldun and many others, especially Nobel laureates Robert Mundell, Milton Friedman, and James Buchanan. Supply-side economy basically propagates tight money to stop inflation, cut in marginal taxes to stimulate growth, and lower capital gains tax to encourage entrepreneurs. The supply side economist typically argues to achieve the proper level of marginal tax rates, (tax cuts). According to them, maximum benefits are achieved by optimizing the marginal tax rates of those with high incomes. And hence it is termed as trickle down economics. Reduction in capital gains will most likely increase supply and thus spur growth. Thus it came to be known as supply side economics. The Keynesian economist, by contrast, contends that tax cuts should be used to increase demand, not supply, and thus should be targeted at cashstrapped, lower-income earners, who are more likely to spend additional income. What it means in simple terms is this: supply side economists target higher income brackets, while Keynesians target lower income brackets. In both these theories, the critical word personal savings is missing, and both theories advocate spending either through borrowing directly from bank, via credit cards or money saved from lowered taxes.

The industrial prosperity of a country is measured by its Gross National Product (GNP) and not by Gross National Consumption (GNC). Although GNC may help increase GDP, but by default. It is a historical fact that for more stable economies, individual savings plays a strengthening role. Thus, encouragement of personal savings is paramount in creating more stable economies. Depending upon his savings, an individual buys goods after careful consideration of each purchases pros and conseven if it is a leveraged buy or on installments. Essentially what it means is when an individual uses his savings or in combination with the borrowing he will be more prudent in his purchases or investments. In the next few articles, I will discuss: the causes of the present economic crisis, that has little to do with Keynesian or supply side economics; whether the present proposed stimulus is enough or not and will it work or not; its long term impact and as an individual what you should do to protect your assets. I hope you are reading Bob Woods weekly articlesmany readers appreciate his articles and have benefited from his advice. 11-8

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The Muslim Observer

The Current Economic Crisis: Causes & Cures (Contd)
February 19, 2009 by TMO By Dr. A. S. Nakadar, CEO and Publisher of TMO Last week I discussed the the Keynesian and supply-side economic theories. This week I will attempt to show the factors that have contributed to our current economic crisis. These are multiple factors at work, rather than any single economic theory discussed earlier. Factors include the lack of financial accountability, a lack of understanding of the working mechanisms of economics, internal degeneration at a moral or socio-political level or at the economic level (corruption and greed) and external aggression, or wars. Accountability The classical example is the debacle of the Savings and Loan banks of the 1980s. The S&Ls original purpose was to help homeowners obtain mortgages. As the interest rate rose in the late 70s (following the Vietnam war) they could not afford to continue their prior commitments of low interest loans. To help the S&Ls, congress deregulated the industry by removing the restrictions on loans they could make. The scammers took over. Just over a decade later, at the end of the 80s, the collapse was imminent and congress had to bail out the industry with taxpayer money. As the saying went, Why rob a bank when you can own one. Another example is the uncounted billions spent on the Iraq and Afghanistan wars. Lack of understanding of current economic situation

President Bush maintained till his last days in office that The fundamentals of our economy are sound, and this refrain was repeated by John McCain. When a giant century-old financial institution, Lehman Brothers, failed and filed for bankruptcy he said. There is tremendous turmoil in our financial markets and Wall Street. People who bore the brunt understood how deep was the recession, with a precipitous decline in employment, business activity almost coming to a stop, falling housing market, and the overall situation pointing to a deep depression. Amazingly, it took a full year of economic distress, from December 2007, when economic activity last peaked, to declare that a recession had actually been taking place. When Obama became president he realized the severity of the recession. That prompted him to say: I didnt know I was going to inherit this, and he declared the economy would be his top priority. Internal Degeneration Moral and socio-political degeneration is on rise. The recent episodes of NYs Governor Eliot Spitzers prostitution scandal, or Portlands Mayor Sam Adams affair with an intern are just the tips of the iceberg. Unethical involvement of the two U.S. senators, Christopher Dodd, (Chairman of the banking committee), and Kent Conrad, (Chairman of the Budget and member of the finance committee), are also well known. They both are former cabinet members and the latter is a former ambassador to the United Nations. They received loans from financial institutions that waived fees, points, lender fees, etc; through a little known program for prominent people. The recent corrupt practices of Governor Blagojevich and the Ponzi scheme run by Bernard Lawrence Bernie Madoff are still fresh in our minds. Madoff was once Chairman of the NASDAQ stock exchange and founded his Wall Street firm, Bernard L. Investment Securities LLC, in 1960. His investment fraud (about $8 billion) was carried out by a single person. Greed of some of the executives of big corporations, like Enron, Lehman Brothers, Washington Mutual, Fannie Mae and Freddie Mac, AIG, Merrill Lynch and others have been equally guilty in corruptive procedures and greed by awarding themselves big payoffs, some even after receiving government bail outs. The greed of companies like Halliburton and Blackwater are inexcusable; they are only concerned with their profit, irrespective of human lives. These are some of the examples of privileged people fighting hard to keep their privileges instead of privileges of the common people. This kind of moral, degeneration on all its levels, is partly to blame for our present economic chaos. Wars The Roman Empire fell because their leader bankrupted it. Look at the red ink now! A huge national debt that has tripled since George W Bush took power. External wars of Roman Empire with Attila the Hun and other non-Roman barbarians started the empires decline in the 5th century. The Ottoman Empire fought many wars with Russia. But it was the Crimean War that weakened the Empire. From 1897 to 1907, the sun didnt set on the British Empire. From 1899 to 1902, it fought a war against the independent Boer republic of South Africa. It was longer and costlier than Britain expected. Although the British won the dirty little war, it became so expensive in terms of finance and human resources that the war eroded its position in the world. That was the beginning of the sun set for that empire. From 1965 to 1973, America fought a long and unpopular war in Vietnam. Apart from the human lives lost (58,000 Americans and appalling Vietnamese deaths) there was incalculable suffering and sorrow for millions. The financial cost was $1.5 billion; accounting for inflation it would be more. This led to the monetary debacle of the late 70s and early 80s, with high unemployment, high inflation and productivity at a standstill, leading to stagflation. Rising oil prices added to the trade deficit, creating a situation in which the dollar had no value against the gold that supposedly backed it. Because of this huge disparity, the US in 1975 floated the dollar with respect to gold and other currencies. This act signaled a loss of confidence in the dollar and consequently in the US. The price of gold rose from $35 an ounce in 1969 to $900 in 1980. From 1979 to 1989, the Soviets invaded Afghanistan. This left the Soviet economy in tatters. The ruble fell to its lowest point against other currencies and became worthless. It weakened the whole USSR, ultimately leading to its dismemberment. The US invaded Afghanistan on October 7, 2001, and Iraq on March 20, 2003, on the pretext of removing WMD. What an irony, we used WMD to remove nonexistent WMD. Both wars have proved costly in money and lives. The US has spent over a trillion dollars to sustain its war machines. This has undermined our credibility worldwide and has weakened the dollar. Our national debt has tripled, almost surpassing $12 trillion. In a recent article in the Wall Street Journal, a Russian professor Igor Panarin predicted the end of the US by the end of 2010. He says America will disintegrate into six countries. According to him a moral and an economic collapse will trigger a civil war and eventual breakup of the US

(andrew.osborn@wsj.com). We know it is nonsense but it does give you an insight of the world thinking and the magnitude of the problem we face. Financial insecurity is most dreaded, especially in the developed countries, and yet no economist or politician dares to discuss the role of the Iraq and Afghan wars as primary reasons for our present economic mess. Causes and Cures of our economic mess will continue next week. I will discuss the creation of the economic bubble, why it was necessary, and what caused it to burst. What, in my opinion, we should do to guard ourselves. I hope you are reading Investment page of Bob Wood. If you have been following his advice, I am sure you have benefitted from it. 11-9

The Muslim Observer

Tell me honestly, would you have been happy to see a stimulus package of $786 billion rather than $787 billion? Since the approval of this stimulus package by both houses, we have heard endlessly from all the sides of the political aisle, from people of different hues and so called experts discussing its advantages and disadvantages. Republicans oppose it and Democrats favor it. The plan provides for increased government spending. More funding for unemployment benefits, increases food assistance and increases health insurance for the poor. It also calls for higher taxes on people who earn more than $250,000/year. The package includes construction and repair of high ways and bridges. Reduction in homeowners mortgage payments to prevent foreclosures. Schools and childrens education funding have received a priority in the stimulus packages. Huge amounts will be spent on development of alternate energy sources, and so forth. The Senate package also includes two costly but popular tax breaks not in the House bill, an $11.5 billion measure that would encourage the purchase of autos by allowing buyers a write-off for local sales taxes and interest on loans and a $35.5 billion measure creating new tax credits that would equal 10% of a primary-home purchase, up to $15,000. The prevention of a prolonged recessionor even a depressionrequired the injection of huge amounts of money into the system. Inaction would have been the worst course of action. The recession would have continued to spiral without an end in sight. Republicans suggested that cutting taxes would have been better. The situation is different. The people who paid the bulk of the taxes are either unemployed, or working on a lowered salary, or their assets have dwindled. There is nothing to gain by reducing capital gain taxes further, when there are very little gains but more losses. How many rich people pay taxes anyway? They have enough legal loopholes so as to avoid paying taxes. Some argue that without the stimulus package the economy and the dollar would self-adjust and emerge strong; in all probability no action would wreck the economy further, with internal turmoil and havoc. It is anyones guess how long the economy would take to correct itself. Moreover, during this period of inaction, it could put the global economies at risk. And hence it could usher in an unbearable shift in world power. The stimulus package will result in direct payments to individuals, through unemployment compensation or tax credits, and through purchases of goods and services by the Federal government or indirectly in the form of grants to states and local governments. The stimulus package will take time to work its way through. Its effect may become visible by the end of this year or early next year. It is likely to create jobs, roads, bridges and other services, stabilize the housing price slide, and tax incentives may help reduce mortgage foreclosures by lowering mortgage payments and restructuring the loans and by easing the credit crunch by injecting money into the banks. The primary movers of the economy are the banks, the housing industry, and the auto industry. The bank, through its lending activities, keeps the economy moving. The toxic mortgages choked off its prime lending activity. It bought the economy to a standstill. To keep it functioning, the Bush administration approved $700 billion under TARP (the Troubled Asset Relief Program), and this year the Obama administration asked for a $750 billion infusion into the banking system. Last year European governments put $2.3 trillion on the line in guarantees and other emergency measures to save their banking system. Bailing out the banks, and bringing back confidence in the banking system, required infusions of huge amounts of capital. Hank Paulson, the former treasury secretary, initially started to buy banks (nationalization) but soon learn its enormous problem and advised to give money to the bank with relative bank ownership (short of nationalization). The other most important factor in moving the economy is the housing market. A house, especially a new house, supports number of industries by providing demand for lumber, electrical services, plumbing services, carpeting services, household appliances and so forth; it also supports your district

schools and other city services through city taxes, thus the collapse of the housing market is considered a most significant risk to the economy. Once the housing market starts moving, it will impact the total economy. Similarly, the auto industry provides employment to hundreds of thousands of people through its manufacturing plants, and supports hundreds of other smaller industries that manufacture its various components. Keeping the above factors in mindhow one can protect his asset or what is in store for the future? An infusion of money will effectively devalue the dollar. Prices of all commodities, utilities and goods and services will start rising after a year or so, especially after the dust settles. During the period of recession, cash will be king. So remain liquid. Be prudent in your purchases. If you are in a stock market, a certain portion of your portfolio must be in a Bear fund or hedged funds (20-30% or more depending upon your strategy). Keep 20-30% in cash. Divide the rest of the money between domestic shares and the overseas market. TMO columnist Bob Wood, who predicted this bear market and mess before anyone else did, thinks it is headed lower, maybe below the 5000 level or so. Here is what he says, An interesting item in Barron yesterday showed that the Dow has lost half of what it gained since the Depression. I can go that one better. The Dow has lost one half of its gains since 1900! The Dow began the last century at 66. It peaked in October of 2007 at about 14,300. It is now at under 7,100. What that means to us is that it took 107 years for the Dow to rise to over 14,000, and 16 months to give half of those gains away! According to him, the PE ratio is still very high, about 25, and has to fall about 10 or lower, before the stock market will show life. The housing market: There is surplus inventory of 13 months supply. This provides an excellent buy opportunity, especially for those who are looking for a house to live. Not only are the prices at bargain levels, but the mortgage financing is low and the tax incentives are great. The time for real estate investment, land, apartments, shopping centers, etc; is good too, but you must have a holding capacity of at least 3-4 years without any significant income coming from that property. Gold, silver, and other commodities: Gold prices and the U.S. Dollar are inversely proportional. If the value of the dollar goes down, gold prices will go up. Gold will soar higher because it is and has always been the worlds hard currency. The current price of gold is around $900-$930/oz. It may rise to $1500 in the near term, and may reach $2000 in the long term. Every portfolio must have at least 5-10% in gold, either in shares or in actual bullion, as an insurance against any monetary catastrophe. Taxes: Individual taxes and capital gains tax will ultimately go up after 2010. The astronomical trillion dollar deficits have to be financed. This is important in future tax planning, especially for tax shelters. No matter what you do, you must have an investment strategy based on your age and income. If you develop a sound strategy, you will be prepared for the eventualities. This is the last article from a series.