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Islamic Banking Can Save Capitalism (Part 1)

Posted on 18th July 2012 by Camille Paldi,

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Excerpt from Iraj Toutounchian’s Islamic Money & Banking: Integrating Money in Capital Theory

“It was once believed that the capitalist economy would be self-regulating and self-correcting, but the intensity and frequency of economic fluctuations have made even the most ardent of economists withdraw from such claims.  The greed and selfish consumption that underlies the system has disturbed the ecological balance in a way that poses a massive threat to all mankind, a threat whose magnitude could have never been imagined by the great architects of the Scientific Revolution.  Despite the scientific community’s repeated warning about the vast potential for catastrophe, the irresponsible exploitation of natural and human resources is perpetuated by a system which secures the benefit of a few at the expense of the overwhelming majority of the planet’s population. There is a rising tide of public dissatisfaction and disgust with such behaviour.  The “Greed is good” mentality, which has predominated in the capitalist world, particularly since the 1980’s, is under challenge.

The United States represents the prototype of a purely capitalist country.  While the sheer size, power, and complexity of its economy put it in a category of its own, this does not mean that its manifold problems are confined within its shores.  Quite the opposite, in fact – to which the worldwide ramifications of the recent U.S. sub-prime crisis will attest.  Nevertheless, the uniqueness of the American economy requires that a few specific comments be made about it.

There is endless discussion among economic theorists and experts of America’s federal budget deficit, its negative current account balance, its lack of investment, and the bursting of the financial bubble.  But for all the talk, these theorists fail to acknowledge that the capitalist economy intrinsically tends toward recession.  They may admit that the economic growth rate has been falling since the 1960’s, but they attribute this to bad policy, rather than seeing it as a reflection of a general process of modern capital accumulation.

The rapid growth of the 1950’s and 60’s was the result of people saving during World War II and the second wave of industrialization in such things as steel, glass, and rubber for the automobile industry, in the construction industries and in the interstate freeway network.

Added to these were the economic stimuli created by two regional wars in Asia, and the extraordinary increase in sales related to modern marketing techniques.  Most of these factors have either completely vanished (along with people’s savings) or have reached the point where they can no longer be considered as major stimulants for economic growth.

During the 1980’s, the main economic stimulant was the expansion of the financial superstructure of theU.S.economy through huge advances in the electronics and computer technologies that gave birth to the Internet.  These factors, too, have weakened following the bursting of the stock market bubble and a decrease in investment in these industries.

Unemployment, too, is a continuing source of concern in the U.S.  During the economic downturn in the early years of this century, the New York Times reported in February 2003 that employment was at its lowest for 20 years and, since the beginning of the crisis two years earlier, had lost more than 20 million job opportunities.  Given that the official statistics – which for January 2003 showed 6.5 percent unemployment – do not include those who, confronted with the prospect of prolonged unemployment, stop looking actively for jobs, or those who work part-time yet want full-time work- the real level of unemployment was probably closer to 11 percent.  By October 2007, the corresponding figure provided by the Bureau of Labor Statistics was around 5 percent, which again emphasizes the cyclical volatility that characterizes the system.

In spite of lowering interest rates to historically low levels on several occasions in recent years, the Federal Reserve has failed to stimulate investment.  This is not surprising since, as we saw earlier, what determines investment volume in the new output capacity is the prospect of gaining investment profit in the future.  Recent events should help persuade Western Economists (both Keynesians and Monetarists) that investment is not a function of interest rate and should stimulate them to search for another factor, a factor that is responsive in normal as well as in risk conditions.

This search should direct them toward interest-free (Islamic) Banking, where interest rates are replaced by profit rates and attention is given to both the supply side and the demand side simultaneously.  We should bear in mind that business cycles are rooted in money and are related to interest, which is the result of speculation.

As we saw in earlier chapters, the two main issues that should concern all economists are those of equity (Justice) and efficiency.  Between the two lies a trade-off area.  Under capitalism, the emphasis on efficiency and equity is a spill over that will somehow emerge in the process of economic growth.  But consider the position in the United States, where ‘the richest 1 percent of households owns 36 percent of all the wealth …[and] wealth inequality has a Gini coefficient of 0.82, which is pretty close to inequality.’ (Wolff 2003: 1-2)  Where is the equity in that, and why is it that after the passage of more than 200 years justice has not yet emerged?

The socialist system claims to have justice as its goal and regards efficiency as a by-product.  Yet, it has a mistaken image of justice.  The socialists’ error is that they do not respect private property.  Proudhon’s famous assertion that ‘property is theft’ is used to justify the belief that ownership is always obtained through theft.  However, he did not attack private property as such.  ‘On the contrary,’ argues Eric Roll ‘…he regarded property as an essential condition of liberty’ and saw justice – ‘the supreme principle of human life’ – as an equilibrium of opposing forces.  (see roll 1961: 242).

The issue of equity is the issue of rights, including the right of the owner of capital (not money) to possess and enjoy the results gained through the utilization of that capital.  Neither is the issue of a given society.  Even when economists talk about efficiency they implicitly consider equity.  Specifically, the welfare cost of inflation, which has occupied a considerable volume of economic literature, is mainly targeted toward ensuring the least damage to society.  This is nothing other than justice (equity).

In Islamic economics, the rights of people and those of ‘things have been defined prior to and after the distribution of wealth and justice as an uncompromising goal for all members of the community.  Where there is justice as people like Rawls and Gauthier interpret it, all things are in their proper places and it is not difficult to demonstrate that this produces optimality.  The resulting corollary is that simultaneous access to both stable prices and full employment is attainable.  Meanwhile, the natural course of affairs, which results from the application of justice, will create a state of equilibrium between human psychological needs and the surrounding environment (something the capitalist economy has been unable to attain).

History shows that ever since mankind achieved this understanding of justice, he has struggled against interest – a struggle that pre-dates Christ by hundreds of years.  (In this regard, note that usury was repugnant to Aristotle.)  The economic literature throws up many examples of serious thinkers who rejected interest.  Rolls tells that Proudhon believed that ‘interest being abolished, exploitation through property is abolished, too” (Roll 1961: 244).  In the serious scientific discussions of zero interest in the 1930’s, Gesell came up with the idea of ‘stamped money’ as a means of omitting interest from the economy (Gesell 1934: 129-41).  In 1947, Maurice Allais reached the conclusion that the optimum real interest rate is zero.

Professors Pesek and Saving (1967) argued that if money were to bear interest, it would cease to be used as money.  Professor Friedman (1969), too, reached the conclusion that zero nominal interest rate is a necessary condition for efficient resource allocation.  Later, economists working for the U.S. Federal Reserve showed that zero interest is both a necessary and sufficient condition for efficient resource allocation (Cole and Kocherlakota 1998:2-10).

These results come as no surprise to Muslim economists.  Yet, the question remains as to how banks would operate under these circumstances.  If Friedman’s proposal (Friedman 1966:339) of a legal reserve ratio of 100 percent for the purposes of economic stability is adopted, what form will banking assume?  Despite their efforts, none of these economists has yet found an answer to this vital question and mankind has paid a heavy price for this failure.

This book has argued that the Islamic model of economics, which shows the way to those who believe in the unity of Almighty God, is the safest and least costly of all, a view that is perhaps reinforced by the fact that an increasing number of capitalist economies are now turning their attention to Islamic economics and, in particular, to Islamic banking.” (325 – 329) – Iraj Toutounchian


Posted on 18th July 2012 by Camille Paldi


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