The End of Prosperity: Can Islamic Finance Help?
By Mahomed Shoaib Omar (Specialist Corporate & Islamic Finance Attorney)
Posted: 21 Dhul Hijjah 1429, 20 December 2008The 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.
2. Dr M Umer Chapra, economics advisor to the Islamic Development Bank of
Jeddah in a paper entitled “The Global Financial Crisis”. (Can Islamic Finance
Help? (5/11/2008) (shorter version).
3. James Robertson, Transforming Economic Life : A Millennial Challenge,
Green Books, Devon, 1998.
4. John Gray, False Dawn : The Delusions of Capitalism, Grunte Books, London,
1998, p62.
5. See the written submission of the Islamic Development Bank to the Supreme
Court of Pakistan in 1999 in connection with its landmark judgment declaring
all prevailing forms of interest as unlawful according to Islamic Law. The
judgment was delivered on the 23 December 1999.
