Economy — 24 August 2013
Why Isn’t There a Demonstrably Correct Economic Theory?

An excellent question. Maybe there is a answer – Jamal Harwood

From Charles Hugh Smith oftwominds.com [website]

“Correspondent C.G.D. recently asked what I consider a very profound question: why isn’t there a demonstrably correct economic theory?

            “My wife has asked me a ‘simple’ question that I can not answer. After 2000 years, why do we not know which economic theory is correct: Keynesian or Hayek-Friedman? Surely, there is a demonstrably, statistically correct answer.”

Let’s add Marxism to the short list of contenders, and then consider why we have cargo-cult faiths (Keynesianism) instead of demonstrably correct models of economic behavior.”

Whilst the media onslaught against it is unrelenting and most are quite ignorant of history, it seems rather unfair to ignore in this debate the economic model from the dominant civilisation of the past 2 millenia. The model from which the first universities in the world were founded. Libraries, modern town planning, advanced architecture and medicine, great mathematicians flourished, scientific research was encouraged and whole populations enjoyed a high standard of living.

And although also suffering a period of decline, of intellectual torpor from which its application in society eventually disappeared, it would be remiss to ignore the widespread revival now being witnessed across continents. The ideology we refer to of course is Islam. It’s rather lacking to ignore Islam in this discussion of ideal economic theory, so let’s include it. And when we mention Islam we are not talking of some minor elements of “Islamic finance” where the banking industry has borrowed a few ideas and dressed them up in order to sell some capitalist financial products to a burgeoning Muslim population. We must include the Islamic theory and practice as espoused from the core Islamic doctrinal and legal basis (Quran and Sunnah of the Prophet (peace be upon him)) and as applied in the Caliphate for close to 1300 years until its demise in 1924, with some deference to incidents of misapplication over that time.

 

Demonstrably Correct?

Before presenting the case it is vital to at least lay out the groundworks of how we should compare and assess the alternatives laid at our table.

  • Successful management of the nations financial affairs is an extension of management of the home affairs, and means meeting the needs of each and every member of that household and society.
  • The basic needs including food, shelter, base education, security and healthcare should be achievable considering the vast resources at our disposal in this world.
  • A well defined and evenly applied rule of law.
  • The means to contribute in society via work in order to meet the needs of one’s family without unfair or burdensome taxation.
  • A representative leadership which is not beholden to corporate interests nor above the law.
  • And lastly a trusted and affordable means to look after the unfortunate that cannot work and require assistance to meet their basic needs.

 

It’s a little unfair to compare modern economic theories with only limited applicability or track records in economic practice, versus Islam with its vast corpus of thought not only economic but political, spiritual, social and personal, coupled with 1300 years of application. But if the fascination remains with Keynes, Adam Smith or Hayek and, despite these protagonists, the above aims of an effective economy are still absent, then why not examine Islam as the alternative? After all, there is still an enchantment with democracy in many regions despite its age.

 

Overview

  1. Economic Aim
  2. Property ownership and rights
  3. Gold Silver Currency
  4. Non Interest Economy
  5. Equity/Partnership rather than debt based financing
  6. Taxation policy
  7. Sustainable Welfare
  8. Flexible labour markets
  9. Regulatory framework
  10. Applying the rule of law

 

1. Islamic Economic Aim

It is of the extreme ironies that a large and growing proportion of western society is morbidly obese, yet millions die yearly in the southern hemisphere from a lack of basic food, water and basic sanitation/healthcare. Doubly criminal that it is these same regions which often have the most abundant of minerals, and resources for which the advanced societies crave and exploit. A society that is not concerned with the weakest of its peoples is not deserving of respect, and is destined for failure.

The Messenger Muhammad (peace be upon him) said “Whenever the people of an area wake up with a hungry person amongst them, then they have removed the covenant with Allah [God]”

He (pbuh) also instructed: “The son of Adam has no right to anything except these properties: a house to live in, a clothing to cover his ‘awrah (parts of body that must be covered in public), a chunk of bread, and water”

 

Food mountains accumulate in Europe, only to be trashed. The US with less than 5% of the population manages to consume 20% of the resources of the world, and still has 50 million of its own depending on foodstamps. Multinationals routinely exploit oil, gas and water resources without putting anything back to indigenous populations. Iniquity is rife.

The Islamic principle is to provide a minimum of food, shelter and clothing for each and every citizen (coupled with security, basic healthcare and education). This is achieved not through blanket income and consumption taxes (on the poor and middle classes) or forced distribution of wealth in some vague aim for equality, but rather via levying a tiny portion (2.5%) of unused wealth yearly (Zakat) to be collected and used specifically for the poor and those unable to support themselves. The commitment to poverty eradication is serious and the Zakat moneys are ring-fenced and cannot be spent on the general budget of the state. If in the very unusual circumstance that Zakat was insufficient to meet the basic needs then the state will levy based on the wealth of the citizens (and not income), and levies are all strictly proportional to unused wealth (1%, 2% and so on) so that no class of people from the wealthy to the modestly endowed is unfairly taxed. Alongside this policy there is no restrictions on the scale of earning the individual or properly founded companies can generate provided they operate fairly within the law.

 

2. Property Ownership and Rights

Property law is based on a clear distinction between Public, Private and State property with oil, gas, minerals, large mines, water resources, electricity resources and public road/rail/byways/waterways all within the definition of public property which is managed on behalf of all the population by the state, and cannot be privatised into private or company hands. Public property is widespread (excluding state property such as government buildings) and uniquely includes the requirement for farm and grazing lands to be used continuously by its owners (over 3 year periods) or to face confiscation and re-allocation to anyone that will use them. Land cannot be monopolised, and anyone can own dead lands which are unused. Consequently the Islamic economy within the Caliphate is characterised by protection of vital public properties/lands and widespread encouragement for use of land by the masses. The taxing of agricultural land on the basis of productive capacity (a small percentage thereof) rather than actual production further encourages utilization of land.

 

3. Gold Silver Currency

The only system of governance that unequivocally insists upon Gold and Silver as its currency is the Islamic economy as applied by the Islamic State (Caliphate). No fiat money will be issued by the state, and any paper currency must be 100% backed by bullion which is subject to public audit. The key features of the Islamic state’s management of currency are the following:

 

1.  The State will not issue any currency that is not 100% backed by gold and silver. Fractional reserve banking is not practiced and not allowed.

2.  Citizens may hold and use fiat currencies from any country, but the official currency of the State is gold and silver.

3.  All interest is forbidden, hence creation of credit beyond existent resources is curtailed.

4.  Credit/money creation by banks including the State Treasury (Beit al Mal) is forbidden this includes quantitative easing and other forms of open market operations.

5. Futures trading of bullion is strictly forbidden and all trades must be exercised in the spot market for immediate delivery.

 

There is no restriction on the ownership of gold and silver and no fixed exchange rate between the two. A key element of the success of the Islamic currency system is Islamic rules forbidding the hoarding of wealth.

“And let those who hoard gold and silver and do not spend them in the way of Allah know that a severe and painful punishment is awaiting them”

[Translated Meaning Quran 9:34]

This injunction coupled with a taxation system focused upon wealth rather than income tax encourages the circulation of wealth and investment. When wealth is not hoarded or left within a restrictive banking system (that fluctuates in lending policies as the business cycle fluctuates). The impact is a tremendous velocity of investment across all sectors of the economy.

The combination of prohibiting banks from trading with interest, and acting as the sole middle man in effectively controlling the money markets, together with the incentive for investment (Zakat is raised on unused assets together with the prohibition of hoarding) has meant that the Islamic society benefited from high and consistent investment. These disincentives to take wealth out of circulation have consistently been applied over hundreds of years and massively softened the impact of business downturns, which usually resulted from natural shocks such as climactic disasters. The current liquidity crisis post the 2008 financial crisis is as much about those that are taking their cash and wealth out of circulation as the high levels of losses that banks have experienced and credit de-leveraging which have caused massive retrenchment.

Fiat currency systems are at the mercy of the banking system which will determine the flow of cash according to their estimation of demand and risk. In times of greatest need for investment and loans, we have often seen the banks in a period of retrenchment and hence the available cash is restricted. Islam in contrast to this provides a consistent non interest environment in which there is no incentive to take money out of circulation.

 

“In order that it does not merely make a circuit amongst the wealthy”

[Translated Meaning Quran Al-Hashr 59: 7]

 

Stability in the economy is built upon investments only being permitted in real products or business which makes wealth generation a result of work and profits, not debt. The currency system also reflects this with money (gold and silver) being also tangible and real.

Money is treated as a medium of exchange and consequently is not a monetary tool for banking interests. With monetary supply dependent upon wealth within the state, currency induced inflation is minimal and cannot reach levels seen for example during the 1970’s when the US took the world unilaterally away from the gold standard in 1971. Historically the level of inflation and deflation under the gold standard was low and within a 2% variation (not more than 2% inflation or deflation) (1)

Maintaining currency stability and the absence of high levels of inflation is a key requirement for business. The volatility of fiat/paper based currencies, particularly where governments engage in aggressive monetary easing due to excessive spending runs directly against the needs of business.

The passing of power to central banks to enable manipulation of the money supply in recessionary times risks uncontrollable inflation. The recessionary business cycle in which a fiat currency/fractional reserve banking environment is a factor through inflation risk, adds to business uncertainty and can delay the growth cycle (2).

 

4. Non Interest Economy

Islam forbids all usurious (interest) based transactions.

“Whereas Allah has permitted trade but forbidden usury (interest)” [TMQ Al-Baqarah 2:275]

 

Rather than equity/partnership based investment the interest/debt model popular in western economies has meant that banks and finance providers can not only create money from nothing (fractional reserve banking) but can charge unlimited levels of interest (expense). Furthermore via collateral lending, lenders can guarantee virtually risk free returns, with the final insult being “too big to fail” gambling backed by government protection (at the publics expense).

As most fiat money exists as debt, then the need for interest payments on debt necessitates an ever increasing expansion of the money supply to keep the system afloat. This drives a corresponding increase in the growth in the production of goods to avoid hyperinflation resulting from too much money in relation to goods. In the ten years prior to the financial crisis of 2008 over 100 Trillion dollars of money (debt) was created (3), the deleveraging of this debt is continuing to this day and acts as an anchor against economic recovery and growth.

Despite steadily decreasing interest rates in the Japanese economy – an indication that policy makers recognise that interest is injurious to growth – growth has been been elusive over the past 20 years. Current attempts by the US and other central banks (for example the UK) to steadily reduce interest rates to generate growth through lowering the costs of borrowing clearly show that interest is costly to the economy. It is strange that governments now are close to a zero interest rate policy – given to some banks – whereas a zero interest rate policy for all borrowers is not adopted.

Having brought significant numbers of investors into government bond markets who depend upon interest to provide investment returns including significant pension assets, those investors are now suffering with tiny returns as interest rates have been reduced to close to zero for government bonds (and are less than inflation – negative real rates). If the whole system was based upon equity/partnership returns rather than interest as advocated by Islam, then the consistency of investment approach would provide greater certainty and stability based on business profitability rather than variable interest rate returns including Central bank manipulation of the market.

 

5. Equity/Partnership rather than debt based financing

Capital markets in the Islamic state are dominated by partnership and company formation in which the key features are: offer and acceptance, defined profit and loss sharing between investors/partners, a specific corporate body (not anonymous share ownership), and no limited liability. Additionally there is no organised share trading market (stock market), as transfer of ownership must be agreed between owners on a case by case basis. As a consequence the ownership and management of companies is tightly controlled and all partners/investors have specific responsibilities rather than the often anonymous and opaque ownership structures in western markets (4).

Whilst large companies can form under Islamic company governance rules, most of the largest projects including management of public resources such as oil, gas, water and electricity are administered by the state. With no corporation tax or business taxes and only Zakat payable on certain of the business inventories (including livestock) there is strong incentives for business formation and growth, many of which are in the small and medium enterprise sector. The requirement for all partners/owners to agree in the formation, objectives, profit disposition and other major decision making ensures direct accountability and closer association with the running of business, rather than that detached ownership model driven in the secular stock markets, where employees (company Directors) can take decision largely separate from day to day review and the active oversight of shareholders.

 

6. Taxation policy

Islam maintains a wealth and productive capacity of the land based taxation system which encourages full investment and a rapid circulation of wealth.

The plethora of taxes imposed on the public in western economies is a great oppression. Islam has a simplified approach, which is predominantly based on wealth as opposed to income tax. By focusing upon accumulated wealth which is not invested (Zakat at 2.5% per annum), taxes on the productive capacity of the land (Kharaj) and head taxes (Jizya) for those who can afford them, the State is encouraging work/enterprise and investment, and discouraging the withdrawal of wealth from circulation, exactly the conditions which bank/debt dominated western economies are suffering most from. Inevitably, the consequence is a smaller footprint for the state which coincides with the general perception that governments in the western world have taken on too much responsibility (and high budget deficits) and are stifling recovery with ever higher taxes—taxes which fall unevenly on the poorer via income and consumption taxes.

With little or no disincentive from taking wealth out of circulation, banks, large corporations, and wealthy individuals will hold onto wealth and perpetuate the dis-investment cycle. Contraction in business, fewer jobs and further declines in government taxes results.

 

7. Sustainable Welfare

Western economies are rapidly approaching the state where they can no longer fund their future liabilities whether pension, healthcare or other welfare requirements. Austerity programmes are providing shock responses with the “individualistic” public attuned to rebelling against cutbacks to what the public purse can no longer support. It is ironic that eventually these societies may be forced to adopt the Islamic model in which the individual capable males are expected to work to support themselves and dependents, followed by families who must support those within the family circle which fall on hard times, and only the state acting as a final support for the truly deserving whose families are non existent or unable to meet the basic requirements.

 

8. Flexible labour markets where wages are able to adjust to deflationary environments

A significant factor in explaining why recessions occur is due to market pricing failure. Employers do not drop wages and salaries to levels necessary to ensure that they can keep their existing staff employed. Instead they prefer to preserve fewer staff at current wage levels. However this increases unemployment and is very damaging for the wider macroeconomic environment due to a decrease in aggregate demand at current price levels.

The reason why dropping prices or deflation is considered a great evil under Capitalism is due to unique factors which do not exist in Islam. Firstly, monetary policy becomes ineffective during deflationary times as banks would need to pay interest on the loans they issue to incentivise borrowers to borrow money, which means borrowing declines and monetary policy becomes ineffective. Secondly, existing debtors are penalised in deflationary environments as the value of their debts increase in real terms. This reality also does not exist in Islam as borrowing is not the norm instead equity investment is the prevalent mode of finance.

Money illusion is additionally a key reason why workers are averse to pay cuts despite their not being any worse off in real terms as lower wages in an environment where prices are falling does not equate with a lower standard of living. In this regard, the Capitalist theorists failed to capture the real essence of the meaning of value as far as separating it from money as a gauge and this has led to a disconnect from seeing value, in this case the value of wages, away from the prism of the nominal amount and hence this irrational attachment to the nominal amount of wages and salaries being the paramount consideration in wage negotiation. Furthermore the fear of monetary inflation is never far from the fear of deflation and this further de-incentivises workers from accepting pay cuts.

As these factors do not exist in the Islamic model, there is no reason to suspect that workers will be averse to having flexibility in wage negotiation and hence offers a much more versatile and robust feature to the economy.

 

9. Regulatory framework In Islam

Regulation in Islam aims to foster a safe and productive environment where wealth that is generated can be more equitably distributed than the current Capitalist economy. It is not a means of creating entry barriers for small business or allowing favours to be granted by the political structure in response to lobbying and other underhand means.

One may argue that the goals of regulation, namely to curtail open trade, are inherently in conflict with the goals of traders who are profit seekers and as such they will always have a limited ability to achieve their desired aims. In Islam, as wealth procurement is not the ultimate aim in life, as is earning the pleasure of Allah, such frictions have no reality as both the wealth and the means to obtain it lie firmly under the domain of the individuals desire to adhere to the Shariah rules which manifest this goal in life.

As far as the second concern highlighted above, there is no possibility of lobbyists creating a biased agenda for regulation to protect the few dominant players as the rules are clearly defined by the Shariah injunctions. Furthermore many rules are aimed at aiding traders to enter markets to create a healthy competitive environment for sustainable growth unlike the regulations which penalise small businesses and lead to substantial barriers for entry. (5)

 

10. Applying the rule of law

Responsibility for management of the affairs of state fall to the Caliph who is accountable to the elected “Majlis” with representatives from all regions of the state, and the Caliph is responsible for the economic well being of each and every citizen. In accordance with the words of the Messenger: “The Imam is a guardian, and he is questioned over his responsibility”

Perhaps more controversially the Caliph (provided he upholds the law scrupulously) is not subject to a fixed 4 or 5 year term of office. Many were in office for much longer. The key elements of accountability in this scenario is that if the rule of law is not fully or correctly applied the Caliph can be removed from office (and several were over the years) by the Court of the Acts of Injustice (the highest court in the land), and to which every citizen has the right to challenge the Caliph for any perceived wrongdoing on his part. These provisions coupled with bans on political lobbying and political party bias (the Caliph once elected can no longer be part of a political party) mean the interminable struggle between corporate interests and the Executive are removed and the gridlock and gross inefficiency of lame duck Presidents and continuous election cycles minimized.

Yes there were instances of corruption and misapplication of the law, but for every Sultan living in the lap of luxury there were other Caliphs/Rulers like Abdur-Rahman an Nasser [6] who died penniless after a full life of committed scrupulous public service. Nevertheless in search of the ideal economic policy we should not be side-tracked into debating the merits of those that applied/misapplied the economy in practice but the system itself which is to be applied, particularly when we may be soon needing to pick up the pieces of this debt fuelled, fiat based, banker driven capitalist anarchy.

 

Concluding

Some rather shallowly believe that Islam lacks economic clarity or deals only in spiritual matters, and after its decline in application during the 19th century and early part of the 20th century that it will not return. Yet opinion surveys in the Muslim world overwhelmingly point the way to the return of Islamic rule. The Center for Strategic Studies at the University of Jordan undertook a comprehensive survey of the key Middle Eastern countries in a 2005 report entitled “Revisiting the Arab Street” finding that two thirds of respondents in central Arab countries felt that Shariah should be the sole source for legislation (a key requirement for an Islamic State) and the remaining third feeling that Shariah should be a source of law.  A study by the University of Maryland published on www.worldpublicopinion.org in April 2007 also confirmed this trend towards Shariah:

“Large majorities in most countries support the goals of requiring a strict application of sharia, keeping out Western values, and even unifying all Islamic countries into a single Islamic state.”

In addition to greater than 70% support for Shariah and a unifying Caliphate the respondents overwhelmingly rejected that the change would come via violence:

“Large majorities in all countries oppose attacks against civilians for political purposes and see them as contrary to Islam. Attacks on civilians are seen as hardly ever effective. Politically motivated attacks against civilian infrastructure are also rejected”.

An independent accountable ruler, a rule of law which is not changed at the whim of corporate lobbyists, a sound monetary system not open to manipulation and a dynamic economy in which property ownership and tax policy encourage the widespread circulation of wealth. These are the pillars which the Muslim world will again apply as a beacon of light for those brave enough to follow.

 

Jamal Harwood Is a lecturer in Finance, UK based and a regular contributor at Newcivilisation.com

 

(1)  http://www.thegoldreport.co.uk/publications/gold-standard-the-future-for-a-stable-global-currency     (pages 9 and 10)

(2)  Are we the next Japan?

http://money.cnn.com/2011/09/27/news/international/US_Japan_recession.moneymag/index.htm

(3)  ATCA, Asymmetric Threats Contingency Alliance

http://www.siliconvalleywatcher.com/mt/archives/2008/10/the_size_of_der.php

(4)  The Economic System in Islam, Taqiuddin an-Nabhani, Sixth Edition, 2008

(5)  http://www.management-issues.com/2006/8/24/research/a-good-place-to-do-business-but-too-much-red-tape.asp

(6)  Abdur-Rahman an Nasser was an Amir in Andalus (Spain). As the Wali (Governor) he appointed officers to look after the erection of new buildings (town planners) in accord to the Prophet (pbuh) command: “The neighbor has the right over his neighbor in two things, firstly, to be free from bad cooking smells, and secondly for him not to build higher than his house.” He also assigned officers to look after the milk, to ensure that the milk was not watered down. He appointed environmental health officers to inspect meat and other foodstuffs on sale, ensuring that the produce was well protected from flys and insects, etc. He built hostels for the travellers and constantly busied himself with the affairs of state, such that on his death when the people read his personal diaries they found that throughout his entire rule of 55 years, 7 months, and 3 days in office, he had only 14 days free from affairs of state. And on his death he had nothing to leave, he died poor.

 

 

 

 

 

 

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  1. “But if the fascination remains with Keynes, Adam Smith or Hayek and, despite these protagonists, the above aims of an effective economy are still absent, then why not examine Islam as the alternative? ”

    Sounds good. It all depends on what Egypt is doing and can Save and Produce in the Economy. That is because the old Economy Methodology is not working anywhere including Egypt.

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