The Global Financial Crisis and Islamic Banking
Some of my earlier posts have cast doubt on the validity of free market fundamentalism: don’t worry, leave it to the market it will sort itself out! The fewer restrictions, the better! Any external interference with markets is harmful!
But are free markets (as practised in today’s capitalist world) really a universal and universally accepted mechanism driving economic progress?
Medieval Christian ethics did not accept usury, which is the basic tool of capitalism. Max Weber, in a famous essay, traced the origin of capitalism back to the Protestant ethic, especially its Calvinist (Pietist) variety. Islam still does not accept usury. So, how does the Islamic approach to finance do in the modern world?
Loretta Napoleoni: Rogue Economics. Capitalism’s New Reality. Allen&Unwin 2008 discusses the essentials of the Islamic banking system, which is based on sharia law and best developed in Malaysia. Its essentials are prohibition of any kind of ’speculation’ and of interest charges. ‘Immoral’ investments such as in casinos are also forbidden. Islamic banks have to make a profit. They do this by buying assets on behalf of the customer, who has to repay the ‘loan’ and a fee for using the asset. When the ‘loan’ is paid off, the asset’s ownership is transferred to the borrower. The advantage of this arrangement is that the bank shares not only the profit but the risk as well. For that reason, it will also have a very close look at the potential borrowers. For example, take as an example the case of a person or persons who want to buy a factory. They approach an Islamic bank which, after a thorough personal check, agrees to support the purchase. It buys the factory on behalf of the customer(s). Since it bears part of the risk, it has to make sure that this risk is not excessive. In toto, partnership (sharing risk and profit) and avoidance of excessively risky investments are characteristic of Islamic banking.
Napoleoni discusses the Asian financial crisis of the nineties. Several countries (Thailand, South Korea, Indonesia, Philippines) decided to accept financial support from the IMF and its restrictive conditions, which resulted in a worsening of the crisis. Malaysia, blaming international speculators for the crisis, refused to take the offer and relied on Islamic banking instead. It was the only country which survived the crisis without much damage.
In a recent article in the Sydney Morning Herald (October 11-12, 2008), Clancy Yeates (’Islamic finance rides the storm’) shows that the story is being repeated. Whereas we in the West are in a severe global crash, the Dow Jones’s Islamic financial index rose 4.75 per cent in the most recent September quarter and lost a modest 7 per cent in the previous years.
What does this teach us? I would say that, beside the immense debts accumulated particularly in the US, the almost unrestricted speculation (which is often connected with accumulation of debt) is at least to a large degree responsible for the present meltdown.
A propos speculation: The US-magazin Fortune reports that Credit Default Swaps (CDS’s) have doubled annually over the last decade. Trading in CDS’s is completely non-transparent, therefore the CDS volume can only be estimated. Such estimates arrive at US$ 54.5 trillion (compared with the global GNP of US$ 54.3 trillion). What would be the result if sellers default on their payments?
(Wikipedia: “A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the “buyer” makes periodic payments to the “seller” in exchange for the right to a payoff if there is a default or credit event in respect of a third party or “reference entity”.)
October 12th, 2008 at 10:03 pm
I am probably repeating myself, but the premise doesn’t work for me. I don’t think anyone believes in free market fundamentalism the way you state it in the first paragraph. One can believe that markets are in some ways not free enough (and perhaps too free in other ways). I would argue that the market as practised in the western world does not follow free market fundamentalism the way you state it. Every western country including the US has a raft of regulations that restricts what the natural flow of the free market. Some of these regulations have actually “enabled” the current crisis to go as bad as it has.
But if I rephrase your premise in a way that I could accept - > “Does Islamic Finance have a better mix of regulation and freedom the way it is practiced in Malasya compared to the way lending has been done in the US in the last few years?”
I would agree with you 100%.
In particular, the way that lenders have been able to pass on risk to unsuspecting entities is a classic case of moral hazard. Things would have been a lot better if the US banks that take loans were obliged to accept the risk of that loan until its full repayment.
There are definite lessons for regulators as to how to regulate loans, but I absolutely refute your premise that free market fundamentalism is the key evil.
I agree that CDS’s are absolutely mad, and their opacity goes against free market fundamentals that require transparency for free markets to be efficient.
October 13th, 2008 at 9:38 am
I don’t feel terribly competent to join in on this discussion, but here is my thrupenny ha’bit from three years back.
October 13th, 2008 at 9:58 am
Dr.Clam, see my comment in your blog.
October 14th, 2008 at 10:34 am
Marco, you are quite right that many (if not all) countries deviate in various degrees from the holy grail of market fundamentalism. Nevertheless, over the last decades at least there has bee a trend to enforce free market rules. See the advice the World Bank and IMF gave, for example, to Argentina in its crisis and to Asian countries in the Asian crisis, not to mention Russia before its rapid privatization. Now we see a backlash: the measures taken to stabilize the markets amount to nationalization of banks in Europe (and now apparently also in the US). Cynics would say we are well on the way to socialism, although I would not go that far. - Concerning persons: I know that quite a few economists and intelligent, well-informed non-economists believe that one should leave everything to the healing powers of free markets. Alan Greenspan in his autobiography refers again and again to Adam Smith; I did not see much reference to the usefulness of state interference in his recent autobiography.
But overall I think we agree: it all depends on the right mix. I would add: the rightness of the mix varies with time. Just now we need more state interference. Even big bankers (e.g., the head of The Deutsche Bank) want it.