This paper earned the Award for Best Paper at Sharia Economics Conference 2013 , authored by Jamal Harwood and Sarfraz Wali. You can find Sarfraz Wali’s blog at http://www.breakthrougheconomics.blogspot.co.uk

This is Part 2 of the paper Part 1 can be found Here

Section 3) Monetary and Fiscal policy intervention mask Market Failure in the Capitalist Model

What the brief historical analysis demonstrates is the single mindedness of the mainstream and heterodox schools towards seeking growth albeit through some variation of two principle economic levers being monetary policy, including its non-conventional forms such as quantitative easing or expansionary fiscal policy

None of these schools however demonstrate any profound understanding of market failure and therefore rely on trying to treat the effects rather than eliminate the cause. As a result the growth paradigm is not met with any credible alternative in the mainstream discourse and growth as an imperative to keep the system afloat is treated as the only option.

As evidence of this inability to remain immune from market failure, even with the slightest disruption to growth, the effects are severe and massive intervention or patchwork is needed to prop the frail system up for a little while longer. This delays the moment of reckoning for economy which when governed along these lines, is on an unsustainable trajectory as the finite resources of the earth are a limiting factor to endless growth.  This was clearly demonstrated in the 1972 study called ‘Limits to Growth’ mentioned above.

This is not a justification for the Islamic Economic system not having at its disposal the lever of monetary policy due to the currency model being Gold and Silver based. Neither is there much scope for fiscal policy  with the exception of emergency taxation (with restricted limits), so neither does there exists any mechanism for Keynesian based deficit spending or stimulus programs as we know them.

Fundamentally, market failure explains why economies are unable to deal with falling or stagnating levels of GDP. When these failures affect the micro economy, the result can be less economic trade and hence output, than would otherwise have been the case. Or the effects can be more serious such as an economy wide recession which we all know as a downturn in the business cycle.

The question being asked is whether these failures are inevitable features of free market activity or due to certain factors unique to Capitalism. If it can be shown that the Islamic Economic system can work in an expanding, contracting or stable environment as far as GDP is concerned, then it can be concluded that there is far less propensity to market failure and by extension there is no growth imperative in the Islamic Economic system being presented.

If we focus of four types of market failure, this will help answer these questions:-

1)            Counterparty risk and price knowledge asymmetry

2)            Destruction of competition and Monopoly

3)            Trade restricting Regulation

4)            Labour Market inflexibility

Let us consider each in turn:-

1)                  Trade that would otherwise happen often does not happen, as trading parties often do not have trust in each other. Furthermore when there is knowledge asymmetry as far as knowledge of fair market prices between trading parties, exploitation may arise. The building industry is a prime example were so many potential building contracts especially in the domestic sector simply do not happen as there is so much fear of unscrupulous builders in the industry. A similar argument applies to financial trade where central counterparties such as investment banks who were considered on the door of insolvency due to holding toxic assets on their balance sheets were no longer able to satisfy their role of being financial intermediaries or central counterparties to trade and hence trade suffered.

2)                  Smaller companies are responsible for the bulk of job growth.  Despite the outwards             appearance of diversity, behind the scenes company consolidation has been occurring and this has destroyed competition. As an example the computer networking company Cisco has bought out close to 200 companies since the early 1990s.(1) This is a negative development as new business growth and innovation in the private sector is key for new job creation. Innovation by small business has been replaced by the acquisition of innovating firms by large firms. This trend has virtually destroyed the potential for new start-ups to survive and create new jobs. Historically the trend for large scale production was to allow the harnessing of information that would otherwise be more difficult to obtain in a flatter market structure. Accordingly, information key to decision making and product development was channelled up to the highest levels within the organisation and back into the production process. This analysis follows the work of Ronald Coase in his 1937 paper entitled “The Theory of the Firm”.

Now the potential to amass information exists without the macroeconomic baggage of large organisations so a fundamental rethink is required over why the economy needs such highly scaled up organisations. As far as natural monopolies where the argument is made that there is a need for large private sector companies via the PLC model to undertake the investment, these industries are publically owned in the Islamic model and run by the Islamic government on behalf of the public good. Fees can be charged for the upkeep of such services and this offsets the need for public wealth pooling via the stock markets.

3)                  Two aspects of regulation work as a significant means of market failure in Capitalism. Firstly regulation that is on balance useful in protecting the less powerful often gets bypassed through loopholes and other legislative oversight and secondly much regulation is hijacked by powerful economic actors and used to penalise the weaker market players, for example creating barriers to entry, resulting in it becoming a big impediment to growth and the development of trade.

Taking the first point, in the Secular marketplace, the disposition of market participants is to maximise profit as a means and an ends and this places them in direct confrontation with regulatory frameworks which are designed to protect all market participants especially the more vulnerable. As evidence of this, one needs to look no further than the amount of financial innovation being targeted towards bypassing financial regulation. For example the Repo 105 fraud undertaken by Lehman brothers (2) to conceal the bankrupt state of its Balance Sheet allowing Lehman brothers to take on more debt and risk exposure.

As for the second problem, countless examples exist of how regulation is devised to aid the powerful by for instance creating barriers to entry into the marketplace for small start-ups that help consolidate the power of the few firms that become dominant in the market.(3) This leads to an obstacle to new job creation and lost demand as there is less diversification and competition needed that would have helped create more employment and stronger aggregate demand which fosters trade in a market less prone to market failure.

4)                  Labour market inflexibility is another major impediment to achieving sustainable growth. When the economy is in recession, firms usually fire workers rather than drop salaries to the level they can afford. This increase in unemployment results in less demand which causes further layoffs as products are not being sold. In an efficient labour market, salaries and wages would need to fall until all workers could be employed and the market would clear i.e. surplus labour would be allowed back into the labour market. Due to factors unique to the Capitalist models, this failure is inbuilt into the workings of markets and the recessionary phase is needlessly prolonged and the impact on growth which benefits all citizens is severe and avoidable as will be made clear in the Islamic solution section.

The unique factors referred to above include, but are not limited to, the following:-

• Constant fear of monetary inflation which isn’t a reality under the Islamic based Gold and Silver currency.

• Employer fear of workers sabotaging production associated with worker grievance when wages are reduced. When the mind set of citizenry is changed from the utilitarianism advocated by the champions of Capitalism such as Smith and Jeremy Bentham, for accountability to a creator of mankind namely Allah (SWT), the potential for this behaviour is significantly minimised and hence less of a factor under the Islamic model.

• Money illusion is a phenomenon that leads workers to see the nominal wage above the real wage and this fuels the reluctance to accept lower wages despite the lower wage having the same purchasing power and the overall positive effect on the level of aggregate demand in the macro economy associated with a higher employment level. Money illusion is prevalent in all societies that see constantly rising prices as the norm with central bank intervention to avoid deflationary effects in the market. This is not the norm in the Gold Silver based system and the Islamic system is exempt from this phenomena.

Section 4: The destructive Growth Imperative within Capitalism

The current model of economics in the secular capitalist tradition is not robust enough to tolerate periods of slowdown or reduction in growth unlike the Islamic model which can flourish in a deflationary and equity finance environment due to a number of unique factors.

Another primary cause of this growth imperative is the fractional reserve based monetary system which imposes an imperative on the expansion of the M1 money supply so that debt service is possible on the current loans in circulation. In this monetary system, all money is loaned into existence and therefore all money exists as debt. Therefore the monetary base needs to constantly grow along with the underlying growth in goods and services so as to avoid rampant monetary inflation when the money supply outstrips the growth in goods and services, and to meet interest payments, or a debilitating deflation when the money supply fails to grow in the form of new loans. This deflation is debilitating under the Capitalist system due to certain factors unique to it such as the fact that monetary policy becomes ineffective when prices are declining as low interest loans intended to increase the money supply are unattractive when prices are falling and the low interest rate cannot offset the inflating money. Also debtors are penalised in a deflationary climate. The former is not a reality and the latter as shall be shown is less of a concern in an equity financing environment unlike the debt based finance model prevalent in Capitalism. Therefore to avoid a deflation, there must be a constant increase in money supply and a corresponding increase in production. The final argument of the anti-deflation camp is that deflation causes consumers to delay purchasing goods and this leads to contraction. This view is not held by all the Capitalist schools, for example the Austrian school is pro-deflation. This argument fails to convince when one considers the growth in industries that have seen falling prices over the last few years such as the TV industry. Furthermore the question of whether consumers would delay the purchase of goods when there is the equal possibility of their wages deflating prior to their intended purchase, rules out any positive correlation between deflation and a downward spiral in economic transactions.

This race to produce more than is needed, under the umbrella of consumerism, as started by mind manipulators such as Edward Barnays and his ‘Torches of Freedom’ campaign, ensure that the practice of endless consumption endures. Furthermore practises such as ‘planned obsolescence’ where time bombs are built into products so as to ensure consumption and demand is constantly being recycled to sustain the fragile system, become the norm as far as manufacturing methodologies. This is very destructive as far as the Earths finite resources and is tantamount to stealing from the future to consume irresponsibly in the present.

In contrast, the Islamic model is immune to the effects of crazed consumption and deflation and is thus immune from the growth imperative. The Islamic economy can yield output at variable levels to achieve the objective of providing the necessary goods and services for its citizens in a much more robust and independent way.

See Also
The Economic Growth Imperative within Capitalism and the Islamic Viewpoint (Part 1)