Posted: 21 Dhul Hijjah 1429, 20 December 2008
The meltdown of the global financial system has raised profound
questions of its fundamental structural reform. The downward spiral
in the US and Western Europe is described by financial experts as
deleveraging : the forced reduction of accumulated debt by households
and financial institutions. As more assets get dumped into the market,
prices are driven down further, which in turn necessitates more
deleveraging. This vicious cycle has gained such momentum that even
the massive bailout packages may not be sufficient to stop it. The
bursting of the debt-fuelled property bubble in the US, together with
the crippling losses suffered by banks, has set in motion a
chain-reaction that, in a worst-case scenario, (according to Prof Niall Ferguson of Harvard) could lead to a 21st century version of the Great Depression (1).
The immediate cause of the current financial crisis appears to be
the excessive and imprudent lending by banks (2). This in turn is
attributed to the unbridled power of private bankers to create money
out of nothing, and then to loan this bank-created money on interest
(described as fractional reserve banking). In this present monetary
framework, money is traded as a commodity, instead of performing its
true function of operating as a medium of exchange. This system
favours the rich against the industrious poor. Despite the fact that
deposits are sourced from a broad cross- section of the society, their
benefit goes mainly to the rich. James Robertson in “Transforming
Economic Life”(3) states that:
“Today’s money and finance system is unfair, ecologically
destructive and economically inefficient. The money – must – grow
imperative … skews economic effort towards money out of money, and
against providing real services and goods”.
A substantial proportion of this privately created bank-money is
invested in speculative wagering instruments, such as derivatives based
on futures, swaps, and options. Such betting instruments are not
connected with transactions in the real economy. According to Prof John
Gray of Oxford University, (4) derivatives have created a “virtual
financial economy” which “has a terrible potential for disrupting the
underlying real economy as seen in the collapse in 1995 of Barings,
Britain’s oldest bank”. It is therefore no surprise that George Soros has described derivatives as “hydrogen bombs”. Warren Buffet described them as “financial weapons of mass destruction”.
The Bank for International Settlements (BIS) currently estimates the
notional amount of all outstanding derivatives (including credit
default swaps) to be a staggering 600 trillion dollars, more than 10
times the size of the world economy. (BIS, September 2008, pg 20).
Although debt-financing cannot be ruled out, the solution lies in a
shift to equity-based financing, posited on profit and loss sharing,
which is the primary characteristic of Islamic Finance. In this
equitable manner, economic effort would be directed at providing useful
goods and services, instead of simply making money out of money. At
the same time, the wide gap between the supply of money and the supply
of real goods and services would be decisively narrowed. The
distinguishing features and benefits of Islamic Banking were aptly
summarized by the Islamic Development Bank, based in Jeddah,
(established 1975) in the following words:
“Islamic banking is distinctive in two respects: concentrating
on the real sector of the economy, it imparts tremendous stability to
the economic system by achieving an identity between monetary flows and
goods and services, and by operating on a system of profit and loss
sharing in its evolved state, it insulates the society from the
debt-mountain on the analogy that if the economies enter into
recessionary or deflationary phases, the principles of profit and loss
sharing protects the states and economic operators from the evils of
accumulation of interest and minimizes defaults and bankruptcies.” (5)
--
1. See generally the article entitled “The End of
Prosperity” by Prof. Ferguson of Harvard, published in Time, October
13, 2008, at pages 18 to 21.
2. Dr M Umer Chapra, economics advisor to the Islamic
Development Bank of Jeddah in a paper entitled “The Global Financial
Crisis”. (Can Islamic Finance Help? (5/11/2008) (shorter version).
3. James Robertson, Transforming Economic Life : A Millennial Challenge, Green Books, Devon, 1998.
4. John Gray, False Dawn : The Delusions of Capitalism, Grunte Books, London, 1998, p62.
5. See the written submission of the Islamic
Development Bank to the Supreme Court of Pakistan in 1999 in connection
with its landmark judgment declaring all prevailing forms of interest
as unlawful according to Islamic Law. The judgment was delivered on
the 23 December 1999.
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