The End of Prosperity: Can Islamic Finance Help?

By Mahomed Shoaib Omar

The meltdown of the global financial system has raised profound questions of its fundamental structural reform.  The downward spiral in the US and Western Europe is described by financial experts as deleveraging : the forced reduction of accumulated debt by households and financial institutions.  As more assets get dumped into the market, prices are driven down further, which in turn necessitates more deleveraging.  This vicious cycle has gained such momentum that even the massive bailout packages may not be sufficient to stop it.  The bursting of the debt-fuelled property bubble in the US, together with the crippling losses suffered by banks, has set in motion a chain-reaction that, in a worst-case scenario,(according to Prof Niall Ferguson of Harvard) could lead to a 21st century version of the Great Depression (1).

The immediate cause of the current financial crisis appears to be the excessive and imprudent lending by banks (2).  This in turn is attributed to the unbridled power of private bankers to create money out of nothing, and then to loan this bank-created money on interest  (described as fractional reserve banking).  In this present monetary framework, money is traded as a commodity, instead of performing its true function of operating as a medium of exchange.  This system favours the rich against the industrious poor.  Despite the fact that deposits are sourced from a broad cross- section of the society, their benefit goes mainly to the rich.  James Robertson in “Transforming Economic Life”(3) states that:

“Today’s money and finance system is unfair, ecologically destructive and economically inefficient.  The money – must – grow imperative … skews economic effort towards money out of money, and against providing real services and goods”.

A substantial proportion of this privately created bank-money is invested in speculative wagering instruments, such as derivatives based on futures, swaps, and options.  Such betting instruments are not connected with transactions in the real economy. According to Prof John Gray of Oxford University, (4) derivatives have created a “virtual financial economy” which “has a terrible potential for disrupting the underlying real economy as seen in the collapse in 1995 of Barings, Britain’s oldest bank”.  It is therefore no surprise that George Soros has described derivatives as “hydrogen bombs”.  Warren Buffet described them as “financial weapons of mass destruction”.  The Bank for International Settlements (BIS) currently estimates the notional amount of all outstanding derivatives (including credit default swaps) to be a staggering 600 trillion dollars, more than 10 times the size of the world economy. (BIS, September 2008, pg 20).

Although debt-financing cannot be ruled out, the solution lies in a shift to equity-based financing, posited on profit and loss sharing, which is the primary characteristic of Islamic Finance.  In this equitable manner, economic effort would be directed at providing useful goods and services, instead of simply making money out of money.  At the same time, the wide gap between the supply of money and the supply of real goods and services would be decisively narrowed.  The distinguishing  features and benefits of Islamic Banking were aptly summarized by the Islamic Development Bank, based in Jeddah, (established 1975) in the following words:

“Islamic banking is distinctive in two respects:  concentrating on the real sector of the economy, it imparts tremendous stability to the economic system by achieving an identity between monetary flows and goods and services, and by operating on a system of profit and loss sharing in its evolved state, it insulates the society from the debt-mountain on the analogy that if the economies enter into recessionary or deflationary phases, the principles of profit and loss sharing protects the states and economic operators from the evils of accumulation of interest and minimizes defaults and bankruptcies.” (5)

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1. See generally the article entitled “The End of Prosperity” by Prof. Ferguson of Harvard, published in Time, October 13, 2008, at pages 18 to 21.