DEALING WITH THE FINANCIAL CRISIS---AN

ISLAMIC APPROACH
mnsiddiqi@hotmail.com

In this paper I try to note the main causes of the current financial crisis that
is leading the world into an economic disaster of unprecedented
proportions. This is followed by a discussion on how can we get out of this
undesirable situation and move towards a better world. In between I shall
also comment on why some of the conventional strategies of crisis
management are proving to be ineffective. I conclude indicating the
systemic changes that should accompany economic strategies in order to
move towards an enduring solution.

What Happened

The story is by now well known. Debt financing grew to an extent the
repayment capacity of the borrowers could no longer sustain. This was most
visible in the housing sector in the United States of America. But it pervaded all
sectors of the economy almost all the world over. With so much debt floating in
the market, securitization and repackaging took the debts to the common man and
those managing their savings. The easiest way to make money grow became, not
productive enterprise, but manipulating other people’s debts. Complex derivatives
and risk absorbing products like Collateralized Debt Obligations (CDOs) and
Credit Default Swaps (CDSs) attracted the financial institutions entrusted with
investing people’s monies for profit. Monetary authorities also obliged financial
markets with supply of cheap money. Higher and higher leverage became order of
the day. When the inevitable bursting of the bubble occurred and defaults became
endemic financial institutions failed to fulfill their obligations. Liquidity dried up.
Things stopped moving. Globalization ensured that these effects reached
everywhere.

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Role of Debt

A modern economy is built around debts that bear interest.

Monetary management as well as financial intermediation is
effected through interest bearing debts. This makes the system
crisis prone. It also makes the system unfair and inequitable. Let us
take the monetary system first.

The amount of fiat money the monetary authority decides to float

in the economy finds its way to people mostly through banks and
other financial institutions. Whatever monies are given to people
directly as salaries, wages and grants etc., also find their way to
banks and other financial institutions as deposits and investments.
The monies that go out from banks and other financial institutions
mostly do so as debts carrying interest. Some of these debts are
repaid and that much new money is cancelled, but the interest paid
remains as revenue for the bank. Some debts are renewed on
maturity, often with accrued interest added to the principal. Bank
loans are part of an economy’s money supply. To the extent the
volume of interest bearing loans increases, the money supply also
increases.

Parallel to this stream of debts runs another stream and in the same
direction. It is bonds issued by the government--- Central, State
and Local---- as well as bonds floated by private sector
corporations. Government bonds’ supply has had a tendency to
increase over time.

As time passes the volume of debts in the economy goes on

increasing. Obligations to pay interest due and/or return the
principal can be met from wealth newly created or already
existing. In case debt financed productive enterprises fail to
produce additional wealth large enough to meet obligations of

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repayment with interest, a dip unto old wealth already existing
before the debt-financed projects were started becomes necessary.
Wealth redistribution in favor of lenders is an inalienable feature of
an economy in which debt financing predominates.

In money terms, there is not sufficient money to meet all payment

obligations, in view of the interest added to the principal that came
out as newly created money. The only way out is to renew some of
the outstanding debt or monetize it ( by exchanging newly printed
currency for debt papers) . The debt based system of creating new
money and financing productive enterprises necessitates ever
increasing volumes of debts. It is difficult to imagine how these
debts can ever be paid. To lighten the burden of debt a severe bout
of inflation will be necessary with all its unhealthy consequences.

When the economy is not growing fast enough defaults occur (as
happened in the US recently). Insurers step in to capitalize on the
fear of default by offering to buy risk of default from dealers in
debt. Speculation in the market for buying and selling risk is
detached from speculation in the market for real goods and
services. It is not based on relevant information in the real sector,
nor do actuarial tables exist to make any kind of scientific
calculation possible. Speculating in the market for risks is a zero
sum game relying on chance. On the other hand the ability to sell
risk of default to a third party makes the lending institutions
reckless. They tend to make more loans to less creditworthy clients
and fail to monitor their behavior for ensuring repayment. At the
same time the distance between people whose monies are lent and
those who are supposed to repay them goes on increasing. The
long chain of anonymous intermediation separating lenders and
borrowers coupled with transfer of risk to specialist institutions
creates a make believe world in which nothing but profit margins
and leverage matters. Some of this attitude spills over to the stock
markets too as dividends and share prices are manipulated with a
view to attracting more savings. An increasing proportion of

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society’s real resources---men, machines and other material---
engages, not in producing real goods and services but in
manipulating numbers and creating complex new financial
products which enable more bets on already existing profit
opportunities.

Two consequences inevitably follow. Firstly, it is impossible for

all debt obligations to be met making default endemic at some
stage. The impossibility is rooted in the twin phenomena of interest
added on all debt to be repaid and in the uncertain nature of
productive enterprise financed by debt. The system cannot survive
without destroying some obligations to repay the outstanding
debts. Secondly the distribution of income and wealth tends to
become more unequal over time. This consequence is rooted in the
transfer of some of the existing wealth from the borrowers to the
lenders as the legal system obliges even those debt –financed
entrepreneurs who failed, to repay the sum borrowed with interests
added. A second factor contributing to enhanced inequality is the
banks keeping a lion’s share of the seigniorage resulting from
money creation in a fractional reserve system. The competitive
mechanism needed to channelize a major part of seigniorage to
common man---depositors, clients and other users of banking
services---does not function. The reason competition fails to bring
down real interest rates to levels in sync with proper sharing of the
benefits of money creation, the seigniorage, with people is that
interest rates are treated as a policy tool, determined
administratively rather than by the market forces. The central bank
has to take into consideration the requirements of the country’s
external balance of payments and the domestic needs for money
supply, etc., in deciding upon the key rate at which it would lend
money to commercial banks, which rate in turn forms the basis of
the other interest rates in the economy.

Treatment of Uncertainty

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 Risk and uncertainty are inalienable features of life. The society’s
interest lies in mitigating and minimizing uncertainties. Two things
greatly contribute towards minimizing uncertainties rooted in
human behavior as distinguished from those rooted in nature, like
earthquakes, floods, etc. One is behavioral norms or rules every
economic agent adheres to. For example telling the truth, keeping
promises and honoring contracts contribute immensely towards
efficiency. Second is cooperation in facing uncertainties that takes
the form of sharing risks that cannot be eliminated. This feature
contributes to efficiency as well as equity and fairness. In both
cases the crucial factor is incentives, the answer to the question
why would one do this rather than do that?

In the conventional system as exposed by the current crisis we

have failed on both counts. Lies have been told, norms have been
breached, rules violated and contracts ignored. Most economic
agents tended to shift risks to others (who in many cases would
gamble with them) rather than share risks equitably. Looking at the
incentives there is little else than the desire to get rich quickly with
little regard for any societal considerations. Contradicting the
claims that somehow the culture of unabashed greed will also
ensure the survival of the weak and the uninformed, the world has
landed into a morass of unprecedented difficulties. The
conventional system lacks proper incentives for economic agents
adhering to rules and/or cooperating to minimize risks (through
information dissemination, for example) and sharing risks
equitably.

What Is To Be Done?

I suggest that a comprehensive solution requires attention towards

all the three factors highlighted above: role of interest based debt,
speculative and exploitative approach towards risk and an
incentive structure focused on maximization of private gain. But

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before arguing in favor of this approach it is necessary briefly to
look at the other efforts currently being made to check the disaster.

Current efforts at amelioration can broadly be summed up under

three heads: Pouring more liquidity into the system; more strict
regulation of the financial markets; and nationalizing parts of the
financial system that cannot be fixed in the two above ways. There
is no intention anywhere of changing the role of interest bearing
debt, adopting a radically different stance towards risk
management or restructuring incentives by influencing peoples’
motivation.

I submit that as a result of the above measures currently being

taken to fix the situation the economy will someday regain its feet
on the ground but it will be laden with new problems and will
certainly carry the seeds of a new crisis to appear sooner or later.
Meanwhile the distribution of income and wealth may become
more unequal and the level of confidence in the suitability of the
system may fall further.
At the international level the rehabilitation of world’s developed
economies will not mean an end to endemic poverty in Africa and
South Asia, nor shall it bring promise of enduring peace as the
current ways of solving the crisis fail to touch the fundamental
causes of hegemonic policies of the rich towards the poor.

Enduring Solutions

Humanity needs a change of heart. The philosophy of greed and

individualism must give way to a cooperative approach to living.
This necessitates disabusing minds from the unfounded premises
of neoclassical economics that extolled individualism and
maximization of private gain as the surest way to societal felicity.
It also requires bringing ethics and morality back into economics
and finance. That is the only way the loss of people’s trust into the
banks and other financial institutions can be reversed. People trust

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each other when they perceive they are pursuing mutually
reconcilable goals. The current loss of confidence is born of the
opposite perception, each fearing the other is out to exploit and
take advantage of him.

Ethics and morality are not luxury goods a society can dispense
with. The very fabric of social living is built around them. An
exchange economy, especially its financial system is very sensitive
to loosening of that fabric. Reinforcing that fabric brings customers
closer to their managers. When the reverse happens people stop
trusting their managers and withdraw into their cocoons, to great
disadvantage of society. An enduring solution to the current crisis
calls for restoration of trust between people by replacing the
tendency to treat others as mere instruments for promoting the
interests of the self with a relationship rooted in universal human
brotherhood. It is only such a revitalized society that can throw up
an administration that can protect public interest from being
pulverized by vested interests. Writing tougher rules and tighter
regulations cannot remedy a situation in which many of the
regulators happen to be former or potential future employees of
vested interests.

Absence of ethics and morality from the public square is also

responsible for the dangerous situation at the international level.
Almost all international financial institutions—the IMF and the
World Bank included--- have lost the trust of poor countries. Most
international organizations are perceived as tools for serving
hegemonic designs of the rich and powerful nations.

Reform Agenda

An alternative to debt financing from which interest is absent is the

first step towards change. Parallel to this we need a way of creating
money in which interest plays no role. Equity can easily replace
debt as the basis for issuing new money by the monetary authority

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and/or by other financial institutions. There are viable schemes of
monetary management without involving interest but this is not the
place to go into details. As regards finance various sharing
schemes offer ways of equity financing that suit different sectors of
the economy. Leasing and cost plus financing also offer viable
alternatives in some sectors.

Once the menace of interest is banished from the economy keeping

speculation within reasonable limits would become easier. Society
should insist on transparency wherever other people’s money is
involved. It should also arrange for dissemination of information
that would help minimize uncertainty. It will be easier to eliminate
gambling on the stock market and/or betting on un-measurable
risks in such an environment. Given respect for other people’s
interests within and outside the country, hegemonic policies may
gradually be replaced by international covenants based on
mutuality.

Last but not the least is the newly gained awareness of ecological
imbalances caused by man’s pursuit of unlimited growth.
Conventional system has no inbuilt mechanism to limit growth to
sustainable levels, based as it is on individualism and pursuit of
private gain. A new approach requires not only new regulations but
a move away from individualism and pursuit of private gain
towards socially conscious decision making and cooperation in
realization of common interests. Man must learn to live in
moderation in view of the limits our environment imposes.
Moderation in pursuit of material gains and in consumption has
been part of the teachings of religions in general and Islam in
particular. It is time to bring them in.