Global
finance today dominates the world economy. Western economies are characterised
with financial sectors which generate billions for the economy. Stock Markets,
multinationals, companies raising billions, initial public offerings (IPO) and
so on, all symbolise the apparent success of Capitalism. Finance is important
in any economy for two fundamental reasons:
1. Whatever is produced in any economy can
only be bought and sold through the use of money.
2. Society is looking to increase its
wealth through investment. The financial sector exists today primarily to bring
those with money, and those who need it together.
Finance:
Past and present
Capitalism
has dominated the financial scene for over 300 hundred years. The initial
development of the stock markets took place in Europe to fund expeditions to
Latin America, where merchants went to gain riches. Most of the developments in
finance have taken place in the post WW2 era.
The
purpose of finance is to bring those with money and those that need it together
in the market place. The first time the world's largest economies got together
to discuss global finance was at the Breton Woods conference in 1944, this was
the first attempt at unifying the terms of global finance. There were two
important outcomes from the conference:
The
pegging of the worlds currencies to the dollar which in turn was pegged to Gold
and the blueprint to remove all barriers to finance so financial transactions
could take place freely. Financial dealings increased twenty fold and reached
astronomical proportions. When the US abandoned the dollar peg to Gold, this
brought even more money into the financial markets. The explosion in finance
meant more and more money was being invested in the financial markets, the need
to keep pace with such a development required ever more money to fund such
investments and with the absence of a peg to Gold this period witnessed an
astronomical rise in the printing of money.
The
deregulation drive during the Thatcher-Reagan era brought even more
participants into the financial markets including individual investors looking
for riches. This also saw the development of the derivative markets in the
1990's where money was speculated on the movement in the shares of companies,
currencies and interest rates. For the first time traders were allowed to
speculate in a commodity without actually buying or selling the actual
commodity.
Over
a period of 300 hundred years the emergence of fiat currencies (i.e. currency
without an intrinsic value), the role of compound interest and the development
of limited liability company structures have shaped western finance.
Such
developments have also been the sole reason why the West has come to be
characterised with regular financial crises. The developments in finance since
WW2 brought to an end industrial dominance and created duel economies. This is
because the financial sector moved away from raising finance to fund business
start-ups and projects to speculating on company share prices and the movement
of currencies. In this way trading in the financial sector ceased to be about
purchasing currency or buying shares in the hope of receiving a dividend to
purchasing financial commodities in the hope they could be sold for a higher
price.
Due
to this it became possible for a company to be in financial difficulties but
have a rising share price, or as was seen during the dot.com bubble, new
start-up's witnessed astronomical rises in their share prices even though they
were forecasted not to make a profit for 20 years.
The
financial sector dominated by the financial markets actually does not produce
anything real. Speculators trade in shares, bonds, and currencies that move
around from trader to trader, in the hope that slight price changes will yield
profits. This process has led to speculation reaching levels unheralded in
history. It also means the price of commodities could be moving in the complete
opposite direction to the supply and demand situation of a commodity. A good
example of this was the rise in oil prices in 2008. Oil prices in less than a
year reached $150 a barrel. Throughout history Oil prices rarely went above $35
a barrel, this huge surge in price completely contradicted the fundamentals. No
new oil fields were discovered, no new technology was invented that could
extract or refine oil quicker. Mark Lewis from Energy Market Consultants
explained at the time in a BBC interview: "We
really don't know what the fundamentals are doing at any point in time; the
markets are looking for signals from the fundamentals. Some of them are
irrelevant, some of them are wrong, some of them are meaningless, but they
affect prices nevertheless." Sean Cronin, editor of Argus
Global Markets explained at the time: "When
the New York oil price broke through $100 a barrel for the first time at the
start of 2008, one of the factors cited as being behind it was the
assassination of Benazir Bhutto in Pakistan on 27 December 2007, that didn't
strike us as making any sense at the time."
The
financial economy that doesn't produce anything has become so sophisticated
that various products have been created which allow an investment in a paper
with no real asset represented. This side of the economy is valued more then
the real economy, the size of the worldwide bond market is estimated at $45
trillion. The size of the world's stock markets is estimated at $51 trillion.
The world derivatives market has been estimated at $1000 trillion, more than 60
times the size of the US economy and 24 times the size of the entire world
economy.
Disaster
Capitalism
Western
theories on finance have dominated the discipline of economics for over a
century. Economic textbooks argue the ‘time value of money' theory which states
that the value of money (the quantity of goods that can be bought) is falling
hence a mechanism is needed to fill the difference. Hence £100 will purchase a
fixed amount of goods today, however a year later £100 will not get you the
same amount of goods, interest rates in theory are equal to the difference. The
ability to invest in investment products and financial markets allows one to
hedge his/her wealth.
The
fundamental problem with such Capitalist theory is that on many issues there is
a wide discrepancy between theory and practice. Interest rates in today's
global economy in no way represent the change in the value of money. Interest
rates in many economies across the world outstrip prices changes enormously.
Such views of money have in fact created an economy which is not real. The
global financial economy has turned into one big casino where traders bet on
what will happen in the real economy.
Islam
and the Financial Economy
The
Islamic economy is built upon the real economy this is where the process of
production of tangible goods and services, Islam has designated a role for
finance in the economy - due to Islam's focus on the real economy which is the
wealth creating aspect of any economy finance in Islam is not an end in itself
as there is no interest (Riba). Wealth in Islam is created through each stage
of industry i.e. mining, refining, manufacturing and sales' All of this adds
value at each stage and creates wealth for the economy.
"That is because they say: ‘Trading is only
like Riba,' whereas Allah has permitted trading and forbidden Riba."
[Al-Baqarah: 275]
Finance
in Islam is intrinsically tied to the real economy and is not an industry in
itself. Due to this finance takes a shape in an Islamic economy very different
to what is seen in Capitalist economies.
1. Money in Islam was designated by Prophet
Muhammad (saw)
as representative money. This is where the notes and coins in the economy are
representing a commodity. Through the actions of Prophet Muhammad (saw)
in terms of collating tax, penalties and prices in the economy, money represents
gold and silver. By restricting the legal tender to such metals inflation is
contained as any increase in the supply of money requires additional metal, in
this way the Islamic economy has restricted the central government from freely
printing currency (paper money must be 100% backed by gold or silver). This
brings the much needed stability to money which in turn brings stability to the
overall economy.
2. The Bait-ul Mal - the central treasury
plays a key role in an Islamic economy. It regulates Money supply by monitoring
production and ensuring sufficient currency exists in the economy so that trade
and transactions can take place. The role of the state has been clearly defined
in the Islamic texts. It has been designated with the responsibility of
ensuring the circulation of wealth and supervising the public properties.
3. The removal of interest has a huge
impact in the economy. For many it is difficult to envisage economic life
outside the capitalist framework which relies so much on interest. The absence
of interest actually allows for more wealth creation. To appreciate this we
need to understand the role played by interest in investment decisions. This is
because the challenge all people face is one of investment. Simply put, people
will only invest their money if the rate of return of a business venture
measured against the risk of the venture is offset by the interest that can be
gained from leaving the money in a bank account to accrue interest. Thus, if
the risk of the rate of return on an investment is less than the rate of
interest, then one would leave their wealth in a bank account rather than
actually invest it. Hence the incentive would be to save the money rather than
to use (invest) it. Interest in other words restricts investment and hence is
an impediment to the distribution of wealth. By removing interest from the
economy it incentivises wealth circulation in the economy through investing in
real goods and business ventures. This brings added stability as all
participants participate in the same sphere - the real economy.
4. Any individual wanting to begin a
business venture needs finance. One could wait for years to accumulate the
necessary profits to expand or start a new business or borrow the money today.
For this purpose banks were created. Islam has permitted the creation of banks
and views them as institutions that aid wealth circulation. This is because
banks collect the population's deposits and then invest the money across the
economy in new business ventures. In this way banks become like venture capital
bodies who invest in real business. With the absence of speculative financial
markets banks only have one sphere to invest customer wealth, the real economy.
The absence of interest in the Islamic banking industry as well as speculative
and dubious financial markets is the discerning line between modern banks and
Islamic banking. This means Islamic banks can only make money from investing
wealth across the economy in projects and new start ups, the impact on the
wider economy is huge as banks will stimulate the economy through such acts.
Modern banking wealth finds its way primarily into the financial markets
creating a speculative bubble if investments do not materialise.
5. Although Islam is built upon the real
economy and the financial sector is based upon providing finance for the real
economy, Islam has allowed a few purely financial transactions. Islam has
permitted currency exchange as this was a common practice amongst the people of
Mecca and Medina and Muhammad (saw) did not object to it. Islam permitted some
forward contracts - this is where payment is taken before the actual delivery
of goods or before the final transfer of ownership of the goods. However the
items that can be sold before ownership is undertaken must be of a defined
nature where they can be counted, measured or weighed, this is due to what is
established in the hadith of ibn Abbas (ra), that the Messenger of Allah (saw)
said: "Whoever pays in advance in dates, let him pay
in advance for a known price and a known weight for a known period."
And in another
narration of ibn Abbas (ra) who said:
The Messenger of
Allah (saw)
said: "Whoever pays in advance in something then (it
should be) in a known measure and a known weight for a known period." (narrated by Al-Bukhari)
Islam has
categorically prohibited purely financial transactions where one lends money in
the hope of receiving more in repayment. All trade and transactions are linked
to the real economy as they are built upon construction, manufacture, services,
or the production of goods and so on.
6. The Islamic company structure also
complements an economy without interest. This is because Islamic law does not
allow companies to operate on the basis of limited liability, which allows one
to only have a financial stake in a company which is restricted to the amount
invested. In the event of bankruptcy a shareholder would only lose the initial
capital of the company no matter how large the debts. The key feature in an
Islamic company is all shareholders are responsible for company debts in
proportion to their investment, rather than just their monetary amount. Islamic
company shareholders also partake in the running of the business not merely
just remain a shareholder in the hope that share prices rise. Stock markets
exist primarily to cater for such investors, who do not directly participate in
running or management of the company.
7. Whilst the Capitalist finance industry
offers investors an array of products and many opportunities, it also brings
much harm to the wider economy. This is because such debt based products are
betting on the future and reliant upon a certain outcome, when this doesn't
occur the inevitable bust occurs. The Global, credit crunch was built upon
future real estate prices continuing to rise, when this was not forthcoming it
brought the global economy down, as many had invested in debt based products
which themselves were dependent on rising house prices.
8. Western theorists have always argued
that an economy without interest removes the incentive to invest. They argue
there would be no investment unless there was a guaranteed rate of return. The
Islamic economy however is dynamic enough to encourage investment without the
need for interest. The prohibition of hoarding wealth has been addressed
directly by Allah (swt),
the Islamic creed has forbidden the hoarding of wealth. Hence spending is seen
as an act of worship alongside the fulfillment of one's needs. At the same time
the Islamic economy has designated a 2.5% tax (Zakat) on any wealth held for a
year above a fixed threshold. Hence holding onto wealth aside from being
rebuked by the Islamic texts faces taxation at the of the Islamic tax year -
all this gives citizens in the Islamic economy the incentive to spend and
invest, stimulating the economy.
Conclusions
The
Islamic economy is intrinsically tied to the real economy, this means wealth is
created at each stage of the production line, be it mining, refining,
manufacturing, marketing or sales. Each of these sectors will need companies
and finance to contribute towards the economy and it is here Islamic finance
plays a role. Due to finance being tied to the real economy participants engage
only in the real economy which creates stability as there is no way for
national income to leave the economy - as such a parallel economy does not
exist. The aim of the Islamic economy is to remove barriers to wealth
circulation, Islam achieved this through the removal of the barriers that act
as obstacles such as interest, speculative financial markets and income based
taxation and fiat currency. Boom and bust will not exist in an Islamic economy
as the Islamic economy is about ensuring wealth continually changes hands so
all can profit from it, the aim of the Islamic economy is not perpetual
economic growth, which has proven to be mission impossible.
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