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21st Century Islamic State - Economic Model

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Economic Model


Glossary of terms used is provided at the end of the book.

Economic System

The fundamental viability of any state is its economic system. The inability of the Muslim world in creating viable economic models that are not cheap replicas of Western economies is perhaps the biggest challenge that we face. Riba (interest) is central to the western economy and for Muslims this is unacceptable. Any models we develop on the lines of their system is therefore fundamentally un-Islamic. We have to be brave in breaking new ground, in finding a viable alternative framework rather than conniving the latest trick in the book to put another name for riba, and somehow guise it as “rent” or “fee” or the many other terms we play with. Riba is wrong; there is no going around this.

Impact of Interest

If one looks at economies where banking dominates to a greater extent, it is my hypothesis that you will find that economic cycles are more volatile. Banking is responsible for much of the money supply in the economy and this money supply tends to fluctuate to a greater extent precisely because of its connection to banks; they accentuate the volatility of the money supply, which in turn emphasize the volatility in demand.

Removing fractional reserve banking and an interest-based economy is likely to make booms and busts far less of a problem as the money supply in the economy is less likely to fluctuate. Research could conclusively prove or disprove this thesis by doing a comparative study of economies where banking plays a greater role versus a lesser role and matching this to see how it correlates with the volatility of booms and busts in each group. Of course, holding everything else constant in an absolute puritanical sensewill be difficult but this exercise may still be useful.

Not only is interest (riba) wrong, but it is also not the be all and end all of a discussion of Islamic economics. There are many other fundamental issues that are intrinsically linked and are of great importance. For instance, fractional reserve banking and the concept of limited liabilityare also key elements of the Western economic model, but are again essentially non-Islamic. Fractional reserve banking allows money to be created out of no real economic activity but virtually out of thin air. Limited liability allows businesses to exist without proper assignment of risk to the constituents of the business. We cannot be blind to these elephants in the room.


Savings-Investment

The fundamental question for an Islamic economy, or perhaps any economy for that matter, is in defining how savings-investment will work in an alternative framework. That is, how may savings in an economy be effectively transformed into investments? By taking out both interest-based banking and limited liability (thus corporations as we know them, stock flotation and leverage), we appear to be taking out this important link between savings and investment. In the Islamic state, this function can be taken over by creating an alternative venture capital centered investment economy and by redesigning the corporation as we know it to incorporate liability.

Today western economies subsidize loans over investment in equity because interest payments are not taxable while dividends are. This puts investors at a disadvantage and gives banking a leg up. There does not seem to be any real rationalization for this without going into a “conspiracy theory”, but suffice it to say for intended or unintended reasons, this is the case. Venture capital and angel funds are also restricted to only receive fundings from accredited investors, effectively barring the public. Thus, restrictions on investors in private equity are stringent and constricting. As a result, venture capital and other forms of private investing suffer a double jeopardy. We see that venture capital is greatly marginalized in western economies both in quantity and in quality, focusing narrowly on the highest yield opportunities which also involve the highest risk.

Within investments in equity, corporations created in limited liability (and the concept of the corporation as a legal entity) and by extension the stock market, dominate because of their access advantage to funding and limitation of liability. The public is also practically barred from investing in non-publicly traded companies, i.e. companies that are not large enough, not limited corporations and are not willing to pay the typical 30% of their stock value to investment middlemen (say, from Wall Street), to gain access to public flotation of company stock.

This monopoly is maintained by law, meaning it is illegal to bypass this greasy and shady process to directly sell shares to the public. While theoretically it may be possible to start your own exchange, the bureaucratic and regulatory burden is enough to ensure that any such enterprise by an outsider to the vested financial institutions is practically doomed to fail. This essentially is the other handicap that small companies have to face in addition to the well-known preference of banks to finance large firms.

These disadvantaged categories of firms are then left to raise money informally from friends and family, mortgaging their personal assets and / or to seek venture capital which itself is restricted to “accredited investors” as mentioned earlier.

If we want to imagine an alternative, the best alternative is to set the market free – disable the handicaps to private equity and enable handicaps on unfair money creation through the interest-based banking system. Let us imagine an alternative savings-investment framework. Our savings-investment vehicles could include:

1.    Venture capital firms;
2.    Investment banks;
3.    Restructured corporations; and
4.    Restructured stock market.

Corporations may be restructured to include liability. In that case however, it may be reasonable to pass responsibilitythat information is provided accurately to the top management. If the company fails because the management was hiding information in any way then the shareholders should not be held liable for the losses beyond the value of the stocks. Any stocks that are showing poor balance sheets, income statements and cash flow statements could be de-listed from the stock exchange mechanism and moved to pink sheets. Investors investing in these pink sheet companies will be fully cognizant that they are dealing with companies that could default and fail, resulting in them being held liable for losses. This is but one possible solution to restructuring corporations as we know them.

Derivatives need to be severely restricted and regulated by the markets to ensure that speculation does not reign. This is important to ensure that the financial system is subservient to the "real economy". Derivatives could be restricted to forwards and swaps of real assets, rather than fiat paper. The Islamic state would need Muslim thinkers and economists who can further analyze where else and how else this can be applied.

Derivatives inherently do not appear to be wrong when connected with real assets rather than paper assets and provides fundamental value for economic activity. They are particularly important in today's times when production activities are highly synchronized and dependent on a vast network of supply activity, all of which have to be made available within complex long-term planning and procurement.

Venture capital firms would need to play a key role in the economy, a role that will be far less restricted by regulation and would also not be restricted by the opportunity costs created by interest (riba) in Western countries. They will therefore need to be structured differently from the VC firms in western markets. They will be larger, more “bank-like” in their investment decisions and willing to take on lower yield investments.

We must note that banks cannot play the role of a venture capital firm because they lack the skills, training, organization structure and basic mindset. It is therefore not surprising that our attempts to turn banks into investment firms have met with limited success if not abject failure.

For VC firms becoming larger and taking more of the lower risk spectrum of the market should be a natural adaptation and evolution for them given that there will be no competing interest-based system to take the lower yield and lower risk side of the market. The financial system will not subsidize interest based lending (as in the west and discussed earlier) and there will be no "risk-less interest" to artificially raise yield requirements for risk-sharing investing.


Land and Property

By and large, the vast majority of humanity lives today as tenants to property owners. The rents they pay (or their mortgage payments) are a substantial portion of their income. It is small wonder that buying a house is such a major facet of people’s lives. It is also an important salient that property booms and busts are of such critical importance to economies today. When the house of cards comes down, newspapers speak of this salient as defining their downturn: homelessness.

Yet, Islam does not allow man to claim property for himself perpetually. All land belongs to Allah, and according to Islamic shariah, man cannot claim land that he has not been using productively. The land does not belong to some remotely located land owner; neither does it belong to a “nation state” or “government”.

An application of this Islamic law alone would liberate the populace. It would allow citizens of our Islamic state to live outside the oppression of either earning a wage or to live “homeless”. It would drastically bring down property prices. Simultaneously, it would introduce new workers into the work force who are the unproductive landowners and government stewards. For an economy where a portion of the populace originally makes no effort to earn a wage, the productivity of the economy would increase.

Those owning the land would also more likely be users of the land; this could further increase productivity as long as regulation is in place to ensure that agricultural land-holding size is adequate for economies of scale.

While Maududi has spelled out that any land not in use for 3 years is open for people to make use of or in fact a duty upon government to allocate efficiently, very few if any Muslim economists consider how critically different our economy will be when people are freed from the oppression of the landed and propertied classes, how much less financing would be required for acquiring housing and how this would impact the stability and dynamics of the economy as a whole.

Economics is the study of supply and demand, imagine an Islamic economy where a man owns a piece of land and is not productively utilizing it:

1)      He is afraid that it may be taken and is thus more pressured to sell.
2)      In the market, people do not have banks and mortgages to fall back on, thus the bidding prices are significantly lower.

Bottom line: Property and housing will be significantly more affordable. The barriers to entry are low; one can simply find a piece of unused land, build a simple hut and own his own residence.

Ignoring the economic revolution behind reformulating today's property rights is perhaps the biggest crime Muslim economists are doing today.

Money Supply

In an Islamic state, money supply may be maintained at a rate that would approximately keep prices constant. Some leeway that is practical may be allowable. However, the aim of the Islamic State would be to maintain the value of money to its best ability. We have seen the negative impact of inflation coupled with loose government spending and an exploitative banking system, a sure recipe for disaster.

That the value of money should be maintained does not also somehow mean that a gold standard should be necessarily sought. A gold standard implies that the value of the currency remain constant to the value of gold, which has its own negative implications, as the value of gold can fluctuate independently to that of the goods and services bought and sold in an economy. Gold prices today can also be highly fluctuating. Instead, the approach may be to keep the value of the currency dependent on:

1)      A basket of goods and services that is reflective of the economy as well as;
2)      The value of a basket of currencies that would be represented by their level of trade with the Islamic state.

Of these two factors, the former (a basket of goods and services reflective of the economy) should be weighted more than the latter (basket of currencies being traded with), given the importance of the Islamic state's own real assets and value to its citizens. This ratio of decision-weighting would need to be determined and could perhaps be in the region of a 80:20 ratio, heavily in favor of maintaining the value of the currency for the local consumers.

Alternatively, the ratio could perhaps be equal to the proportion of foreign trade to domestic consumption, a more classical way to address the issue and something discussed in conventional Western economic thought.

For this to work in practice, a completely independent monetary authority would be needed. If the US constitution has three branches that are independent of each other, the Islamic State need many more than three. The central bank may be one such independent authority that maintains the value of the currency. Another independent institution will deal with statistical data and this may also need to be completely independent of the other arms of the state. This is important and is mentioned here because it would be less useful to have an independent central bank if it depended on data that was manipulated by governments as a means to sway the central bank.

We have seen how Western governments have played with key statistics such as inflation and unemployment. The Islamic State may not repeat that mistake. An independent statistical arm of the state will provide statistics for all independent arms of the government to base their decisions on, including data needed by the independent monetary authority of the state.
Money Supply Expansion with Population

There is still the problem that a naturally increasing population would mean that keeping money supply per person constant would require a natural increase in the money supply. In the Western economy, monetary expansion principally and in its first incidence benefits the banking institution and the government rather than the people who are only benefited indirectly.

One possible alternative is for each individual that comes of age, he/she would be given an endowment equal to the amount that would result in keeping the economy in equilibrium (a value dependent on the consumption rate). This could also simultaneously be a source of financing for young men and women entering the economy needing an initial investment to get them going (i.e. for education, buying a starter home, etc). In addition, such an endowment would strengthen the meritocratic nature of the state, evening the playing field for all future generations.

The nature of the state however must remain fundamentally that of an open economy based on private enterprise
 and competition. We may not take the route of ever increasing government regulation and government supported welfare projects that take on a political power-base of their own. The low tax rate of an Islamic economy will perhaps prove to be a counter to such state-creep. Regulatory creep however needs to be watched and guarded against far more extensively. The importance of having a financial regulatory body, completely independent from the government of the day, is thus of vital import to the model we are attempting to develop.

Fiat Money versus Precious Metals

The present Muslim world is in a heated debate concerning the Gold Dinar. The best argument in favor of those opposed to a fiat currency is that all the mediums of exchange referred by the Prophet (peace be upon him) have in common the quality of having intrinsic value. On the other hand, the best argument against such a monetary shift is the present circumstances of the Muslim Ummah were we do not have enough precious metals to replace fiat currency or that precious metal prices today are volatile.

The best possible solution in the given circumstance is perhaps to allow both to exist side-by-side. The problem then becomes one of Gresham’s Law, that bad money will drive out good money. The solution is to ensure that the price of gold/silver/precious metal currency is exchanged at market rate with fiat currency. The problem encountered with Gresham’s Law was with the government determining the value of the precious metal coins, which is circumvented by allowing the market to determine its true value.

Sheikh Imran Hossein is also of the view that a free market should exist between various standards of dinars and dirhams available in the Muslim world at present, rather than attempting to force everyone to agree on one set standard. In transition, it would be hoped that we, over time, increasingly move away from fiat currency and towards currencies that have intrinsic value. This will not only be superior from a theological perspective, but will also act as a check and balance against the central bank and foot-loose monetary policy.

In Transition

In the event of the establishment of an Islamic state, abolishing banking outright would be catastrophic. Money supply would shrink rapidly. Demand and investment would collapse and spiral the economy into recession. The knee-jerk reaction from the populace would be to increase savings, further reducing consumption and compounding the problem.

The correct solution perhaps would be to gradually impair banking. Just as the Communists created a socialist state to achieve Communism, so too must the Islamic state act in staging itself through a transition. Staggered increase in the reserve ratio of banks and gradually changing the regulatory framework can go hand-in-hand in transforming today's banks from caterpillars to butterflies. 

The aim, eventually, is to move banking towards a theoretical 100 percent reserve ratio; depositors would have to give the bank consent to invest their money. One option would be that such banks would offer liquidity options with time horizons such as three days, one week, one month, etc. Investments would not have a fixed guaranteed return but rather a risk sharing return. Because of the nature of the investments, greater liquidity options would still generally yield lower returns and thus still maintain those natural patterns of investment that economists have come to consider almost equal to the law of gravity.

For those depositors seeking 100 percent reserve and complete liquidity, the banks should be allowed to charge a service fee for holding the money in safety. After all, such a service would represent a clear service to the bank's customers with clearly identifiable costs to the bank. 

Monetary and Fiscal Impact of Transition

We have already touched upon how liquidity would dry up in transition. Even with the most gradual transition it would result in recession, and the more gradual it would be the longer the recession would last. Let us consider three possible policy options: increasing the reserve ratio, curtailing interest-based banking through regulation and restricting and regulating the stock market. All would result in a rapid reduction in the money supply, and a rapid downward projection of the economy towards an inevitable crash; ceteris paribus, deflationary pressures would reduce investment and consumption expenditures and reduce national income

Is this a necessary pain to create an Islamic state? One, impoverished and destitute already, would he or she be willing to dip even deeper into unimaginable poverty and hopelessness? No. Insh’Allah there is a solution. It may in fact be an ideal opportunity. Let us consider the possibilities.

Keynesian economics dictates that a (read non-Islamic) economy can be revived by public spending to boost consumption and thus inject the system with new demand and new money.

Y=C+I+G+X-M
C▼ and I▼ is counteracted by G▲
Where:
Y is National Income
C is Consumption
I is Investment
G is Government Expenditure
X is Exports
M is Imports

Because an interest-based Western economy is inherently cyclical and dependent on an ever increasing GDP & Money Supply, the Keynesian solution is often the last resort when all monetary and information options have failed. That is, for instance, when simply expanding credit and the money supply either becomes ineffective or becomes untenable.

The great downside of Keynesian fiscal expansion is inflation. Yet, this may not be a downside in deflationary times. Here is the opportunity within our framework of a transitioning Islamic state: if we attempted fiscal expansion during our earlier described banking and stock market transition, we would be ideally placed to carry out our expansionary fiscal policies without paying the price of inflation!

However, as with anything in life, timing and proportion is crucial. A cricketer (or a baseball player) perhaps understands this better than an economist. Yet for the economist, that mistimed ball would result in far more damage than the cricketer can fathom. It is perhaps for a reason that Alan Greenspan played the violin; dreamers must be good and timely executioners, if their dreams are to succeed.

Post Transition

This period of fiscal expansion should not however go beyond the period of transition. Governments cannot be allowed foot-loose monetary and fiscal policies. Balanced budgets may be hardwired into the constitution. Division of powers would ensure that monetary policy is conducted by an independent arm of the government that is autonomous of the political and administrative authority. This will ensure that the money supply is not abused and inflation is kept at or near zero percent. Combined with a hardwired balanced budget, this will ensure the stability of macroeconomic conditions in the country.

On the surface, such a setup appears grossly flawed. When a Western economy faces recession, not only does consumption decrease but so does government revenue. As a result, balanced budgets would do great harm in actually advocating reduced government spending during a recession. However, in our economic model we believe that the economy will be far less cyclic given the elimination of interest and fractional-reserve banking and the expected higher level of civic duty within the community. Secondly, we can add a provision that the monetary authority will have the final say as to the amount and extent of any fiscal intervention in the case of a recession. Since in our form of government the central bank / monetary authority is a completely independent arm of government, the conflict of interest issue is perhaps resolved.

Yet another possible supplemental solution is a delayed effect and weighted budget that looks to match revenue earned X years ago and is an average of a few years thence.

Insh’Allah this solution effectively eliminates perhaps the greatest quandary of Western economies - the conflict of interest between political government and vested interests on the one hand, and the higher intellectual goals of managing booms and busts.

Our model makes a trade-off that enables us to have a more stable and less cyclic economic model at the expense of being able to inject massive liquidity relatively quickly. This implies that such an economy, while more stable, will be unable to grow at spectacular rates as was observed with such countries as Japan, South Korea, China, etc. This represents the downside of the model, but within a Solow Growth model context, would become less important as we reach nearer saturation levels of income in the long-run.


Meritocracy as the Central Theme of our Model

Let us consider the central principles of our Economic Model. Centrally, we seek free enterprise within the constraints of Islam making it philosophically an effort towards a meritocracy and simultaneously a welfare state within that which has been prescribed in Islam given the Muslim obligations of zakat and alms giving.

We observe the salient of removing riba, fractional reserve banking and inflation as a tax imposed by government. We find a defanged savings-investment system built around equity investing and freed from the injustices of regulation, double taxation and unfair competition that equity investments face today in the West, and an independent state bank to have complete control over the money supply with the central purpose of maintaining a stable value of money.

A central theme of meritocracy inevitably plays out, given Muslim requirements for alms giving and zakat (which incidentally is a wealth tax), Islamic redistribution laws on death, and if we are to pursue an endowment policy for the young, as outlined earlier. Linked with free education and a meritocratic political model, we see that the theme for meritocracy would become intrinsic to the Islamic state, politically, economically and spiritually; the Day of Judgment too will be meritocratic, each soul being rewarded by what it earned. That will be a Day of Perfect Justice. Our meritocracy on the other hand, is a human meritocracy and flawed by our human limits, we must never forget that.

Economic Modeling & a New Science of Muslim Economics

Economic modeling will need to be rethought as many of the key models have interest (riba) as a key element in the models. Perhaps Tobin's Q
 could be a replacement for riba when the profit rate is insufficient or problematic. “Islamic Economics” needs to look beyond Microeconomic discussions of interest-free banking. We need to fundamentally rethink utilitarianism as an ideology and perhaps replace it with the conceptual foundations of Imam Shatibi’s Maslahah. We need to see if GDP measurements make sense to the world, let alone to a non-materialistic Muslim state. We need to find alternative measures that make more sense. This author is presently investigating suicide rates as a better guide to measuring welfare. We need pioneers to create the building blocks of Islamic econometrics.

Where we stand today intellectually is yet underdeveloped. Much more needs to be done yet. We must build on the works of such men as Kurshid Ahmad, Anas Zarqa, Abbas Mirakhor and Nejatullah Siddiqi, among others.

What started off as a pioneer spirit has, over the last 30 years fizzled into mimesis and small minded intellectualism; mindless reworking of Western economic models into “Islamic” frameworks. The central problem is structural – our universities as they stand today are not meant to create Islamic scholars, their structure inherits a legacy that is fundamentally un-Islamic. Consider for instance that students essentially come to universities to get certificates and find a better job. This materialist paradigm cannot create the quality of scholarship we need.

Professors work to meet research specifications which often mean they have to publish their work in Western journals, having to measure up to their expectations and thinking patterns. Again, they are living within a materialist paradigm of professional progression rather than altruistic intellectual jihad.

Endless conferences where the scholars of our time present yet another notch on their resumes; another conference: to condemn riba yet again or to claim again that there is no other option and that 'this is the best we can do'. Mindless chatter from men of speech-without-actions, men of no consequence: Such men are only to be pitied or reviled for their hypocrisy. Curious still – many such 'academics' are not to be seen in masjids at the times of prayer.

Let us ask ourselves how many conferences the Prophet (peace be upon him) attended and from what university did he gain his PhD? When the very venue, the people, the method and the motives are non-Islamic, do we still wonder that 30+ years hence, we have still failed at the 'Islamization of Knowledge'?

Another issue is of the life-cycle of the science of economic theory. Adam Smith’s landmark work would not have earned him a PhD in Economics today, for it lacked the manner of writing, the methodology and the emphasis on mathematics and statistics. A research supervisor would potentially laugh at his work and say “it’s too broad, focus on something specific” or “it needs quantitative rigor”. This is because the Western intellect is at a different stage of their journey, we cannot hope to find help in their present model of education to answer our quandaries, and rather, we would end up stuck in the minute, which is only relevant when the broader picture has been clearly established. Scientific fields develop from the broad to the specific, but with the present paradigms of mimeses, we are stuck on the minute, myopically copying the West.

We complain that we do not have the means to do jihad. Yet, no nation is stopping us from doing the intellectual jihad. Why then are we this way? Perhaps someday we will stop producing mindless trash and move to the actual work of developing a real alternative model.


"Because Allah will never change the Grace which He hath bestowed on a people until they change what is in their (own) souls: and verily Allah is He Who heareth and knoweth (all things)."
(Al-Quran, 8:53. Translation: Yusuf Ali)
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