There has been much discussion during the on-going financial crisis, on how to initiate a sustained recovery and the consensus shown by the mainstream commentators has been through returning to sustained economic growth.
Such is the focus in the capitalist order towards growth, that any program or strategy that is not able to demonstrate how compounding levels of growth can be achieved is not given credibility and hence many, such as the Turkish economics professor Timur Kuran, have written extensively showing how the Shariah has rules which limit the ability of economies to grow and hence are an impractical alternative to the current order.
It is the aim of this paper to demonstrate that the current capitalist economic paradigm with its fractional reserve banking model has within it a destructive growth imperative which is on an unsustainable trajectory and to present Islam’s alternative approach to the subject.
Section 1: What is economic growth and how is it measured
Economic output is the volume of goods and services produced over a financial year. The measure is called GDP or Gross Domestic Product. Other measures such as the Gini Coefficient have been developed to measure the distribution of wealth among the population.
A coefficient of 0 suggests a completely even distribution and 1 suggests totally uneven distribution where a small number of market participants own the majority of wealth. It is worth noting that this figure is moving towards 1 in the states which adopt the growth strategy and is something the Occupy movement has tapped into.
The disruption in continual growth in output for 2 successive quarters is defined as a recession and this is regarded as a severe harm to the economy necessitating economic management to minimize the duration of the slowdown in output. This is the essence of the business cycle which is the alternating phases of growth and contraction which have been witnessed for hundreds of years under capitalism.
What then are the stated outcomes sought from economic growth?
According to all mainstream schools of Capitalist economic thought, growth in production is the solution to the fundamental economic problem facing society due to the coupling of the unlimited wants of man in relation to the limited resources available to satisfy such wants. This definition includes both needs and wants and not just basic needs.
The thinking of the founders of the first modern economic school of thought argued that increasing production was the key to maximizing happiness for the individual.
Adam Smith, the founder of modern Capitalism, considered that if the society focused on maximizing production, this would equate with distributing wealth to the greatest number of individuals. His focus was not on targeting distribution as he felt that distribution would be a natural by-product of materialistically driven individuals all seeking their self-interest. In his book “The Wealth of Nations” Smith quotes:
“By pursuing his own interest he frequently promotes that of the society more effectually (sic) than when he intends to promote it”.
Soon it became clear that the unregulated free market approach of the Classical school of Adam Smith was good at increasing production but deficient as far as the distribution of the gains of higher rates of production.
The next development was the neoclassical school, which emerged at the end of the 19th Century, proposing new ideas relating to value. As far as the breakthrough in the view of value and exchange, its input was to bring in a more accurate way of price formulation as far as considering both demand and supply and at the micro economic level. This had some positive impact on wages being more likely to be linked to the value that the labourer’s service provided, however no distinct policy changes were associated at the macro-economic level with the emergence of the neoclassical school as far as formal re-distribution of wealth.
Since then, new thinking came in the latter part of the 20th Century through works such as the 1956 book entitled ‘The Future of Socialism’ which argued for a new way of breaking the disparity between rich and poor by not focusing on the size of the slice but the size of the pie. The argument being the same slice of a bigger pie would give more wealth to the less privileged classes.
We shall now turn to a discussion on the schools of modern capitalist economic thought relating to growth and demonstrate the single minded attitude of the mainstream approaches towards endless and exponential growth. These schools fundamentally differ over key factors that hinder growth through the mechanics of what is called the business cycle. It is of no surprise that much focus is thus placed on the business cycle by all capitalist schools of thought.
A key argument is that if a theory can help minimize the slowdown in growth that occurs during a downturn in the business cycle, its policy proscriptions should be adopted by nations seeking endless growth.
However there are some non-mainstream schools, which reject the paradigm of growth. Rejection of growth as an endless strategy was in fact advocated by the mainstream schools including Adam Smith himself and Keynes given the obviously limited capacity of the earth to sustain growth indefinitely. Renewed interest in this area was spurred by a study by a think tank called Club of Rome whose study in 1972 called ‘Limits to Growth’ argued that the ecosystem imposes limits to growth. From this have arisen branches such as those who argue for a steady state economy that plateaus after a period of exponential growth, and Welfare Economics who differentiate between good growth and bad growth, the latter being termed uneconomical growth. More extreme movements have also arisen such as the De-growth movement who argue for downscaling production. However these are considered fringe ideas and we now turn to the mainstream view which advocates continual growth.
Section 2: Current Approaches to Economic Growth
The main schools can be broadly grouped into the following camps:
3. Neo Classical which includes Monetarists and Rational Expectations
4. New Keynesian/New Classical
The formulation of the classical school as stated was the overwhelming belief in the efficiency of free markets to self-regulate themselves. It was felt that the laws of supply and demand were sufficient to ensure the allocation of resources would always flow to the most worthy projects and temporary gluts would be short lived as unemployed workers would easily accept lower paid jobs to regain employment.
It became clear very early on that in reality many market imperfections would act as impediments to this idealistic model and some type of interventionist approach by the state would be required to ease the market mechanism along to achieve this level of efficiency. Such intervention takes the form of monetary and or fiscal policy as the primary means of perpetuating the boom phase and minimizing the bust phase of the business cycle.
The period from the work of Adam Smith in 1776 with the publication of his famous book “The Wealth of Nations” to the onset of the Great Depression following the 1929 stock Market crash in the US was the golden era of the neoclassical school which deemed there to be a minimal role for the state. It became clear after a short while that the market was unable to recover by itself and needed active governmental efforts to kick start a recovery.
Prices were declining and unemployment was rising and the market was unable to self-correct from this situation. The saviour was the British economist John Maynard Keynes who entered the debate with his influential book “The General Theory of Employment, Interest & Money” published in 1936.
The central concept from the work of Keynes was that markets when in a downward spiral would not recover and the government needed to act as a catalyst to reinvigorate demand for goods and services through increased spending when the private sector was saving. This would however increase government deficits, nevertheless the argument was put that when times are good, taxes could be used to pay for such emergency spending for when times are bad.
This approach, adopted by the 1933 Roosevelt administration, was so instrumental in ending the Great depression that Keynes ideas ruled supreme until the 1970’s when new phenomena called stagflation baffled economists on both sides of the Atlantic. This reality threw into question the policy proscription devised by the Keynesian revolution and the new saviour was the Chicago School economist named Milton Friedman whose ideas formed the Monetarist school which remained popular from the late 70’s until the high inflation induced after the end of Bretton Woods was reigned in.
Stagflation saw the simultaneous upward climb of unemployment and inflation. Prior to this, as depicted by the Philips curve, there was always perceived to be an inverse relationship between the two where governments could bring down unemployment at the cost of some inflation and vice versa. As far as unemployment and the supply of money, if there is inadequate money in circulation to sustain trade requirements, then traders will be unable to trade at current prices as they lack the means to conduct their transactions. This would cause unemployment as traders would be unable to trade and be forced to start laying off staff due to the lack of sales for their production.
Therefore Friedman argued that the supply of money should be kept at an optimal level to avoid either extreme. Furthermore, he advocated that there was a `natural rate of unemployment’ which the government shouldn’t take action to reduce and instead the government should try to control the money supply so that it was in line with the level of economic activity. This theory was implemented through aggressively raising interest rates to soak up the excess money supply which brought the hyperinflation of the 1970’s to an end.
Other schools such as the Rational Expectations School lead by Robert Lucas came to prominence since the mid 1980’s that added that people could no longer be tricked by the government policy tools and that they would anticipate the actions that the state’s economists would try to do and by so doing would be able to negate the intended aim of such governmental policies. For example when the government would increase the money supply economic agents would tend to bargain for higher wages ahead of time and firms would increase prices, so the effect of lowering unemployment which would otherwise have occurred, is not realised.
This insight was not new in that Friedman also used expectations to explain stagflation by arguing that economic agents anticipate the actions of the government when the government increase the money supply and the effect of lowering unemployment does not occur as economic agents would tend to bargain for higher wages ahead of time and similarly firms would increase their prices ahead of time and this would fuel inflation above the level intended by government policy and hence would render the attempt to reduce unemployment ineffective.
Regarding the development in ideas related to rational expectations, both Keynesians and neoclassical schools reinvented themselves with new and post prefixes.
Other schools such as the Austrian School are variations of these themes and more recent contributions have come from what is known as behavioural economics which try to incorporate the physiological disposition of individual behaviour to explain the un-coordinated and often irrational behaviour of economic agents which prevents markets behaving in an optimal self-adjusting manner.
The final question to ponder is the issue of what the Policy differences are between the major schools. The preceding discussion is quite abstract as far as how theorists such as Keynes and Hayek, who is popularly characterised as the extreme end of the spectrum of mainstream thought, see the economic fundamentals necessary to prolong boom and minimise the bust phase of the business cycle. As far as policy, this difference manifests in the form of monetary and fiscal policy and which instrument is favoured to help return an economy that was in growth, towards growth in a downturn.
Other ways of framing this difference are also well known such as big government vs. small government or whether to regulate or ‘get out of the way of business’ a game cry of the right popularised by the ‘tea party movement ‘ in the US. Ultimately these labels all point back to the fundamentally different views presented by the schools mentioned above.
Section 3: Monetary and Fiscal policy intervention mask Market Failure in the Capitalist Model
What the brief historical analysis demonstrates is the single mindedness of the mainstream and heterodox schools towards seeking growth albeit through some variation of two principle economic levers being monetary policy, including its non-conventional forms such as quantitative easing or expansionary fiscal policy
None of these schools however demonstrate any profound understanding of market failure and therefore rely on trying to treat the effects rather than eliminate the cause. As a result the growth paradigm is not met with any credible alternative in the mainstream discourse and growth as an imperative to keep the system afloat is treated as the only option.
As evidence of this inability to remain immune from market failure, even with the slightest disruption to growth, the effects are severe and massive intervention or patchwork is needed to prop the frail system up for a little while longer. This delays the moment of reckoning for economy which when governed along these lines, is on an unsustainable trajectory as the finite resources of the earth are a limiting factor to endless growth. This was clearly demonstrated in the 1972 study called ‘Limits to Growth’ mentioned above.
This is not a justification for the Islamic Economic system not having at its disposal the lever of monetary policy due to the currency model being Gold and Silver based. Neither is there much scope for fiscal policy with the exception of emergency taxation (with restricted limits), so neither does there exists any mechanism for Keynesian based deficit spending or stimulus programs as we know them.
Fundamentally, market failure explains why economies are unable to deal with falling or stagnating levels of GDP. When these failures affect the micro economy, the result can be less economic trade and hence output, than would otherwise have been the case. Or the effects can be more serious such as an economy wide recession which we all know as a downturn in the business cycle.
The question being asked is whether these failures are inevitable features of free market activity or due to certain factors unique to Capitalism. If it can be shown that the Islamic Economic system can work in an expanding, contracting or stable environment as far as GDP is concerned, then it can be concluded that there is far less propensity to market failure and by extension there is no growth imperative in the Islamic Economic system being presented.
If we focus of four types of market failure, this will help answer these questions:-
1) Counterparty risk and price knowledge asymmetry
2) Destruction of competition and Monopoly
3) Trade restricting Regulation
4) Labour Market inflexibility
Let us consider each in turn:-
1) Trade that would otherwise happen often does not happen, as trading parties often do not have trust in each other. Furthermore when there is knowledge asymmetry as far as knowledge of fair market prices between trading parties, exploitation may arise. The building industry is a prime example were so many potential building contracts especially in the domestic sector simply do not happen as there is so much fear of unscrupulous builders in the industry. A similar argument applies to financial trade where central counterparties such as investment banks who were considered on the door of insolvency due to holding toxic assets on their balance sheets were no longer able to satisfy their role of being financial intermediaries or central counterparties to trade and hence trade suffered.
2) Smaller companies are responsible for the bulk of job growth. Despite the outwards appearance of diversity, behind the scenes company consolidation has been occurring and this has destroyed competition. As an example the computer networking company Cisco has bought out close to 200 companies since the early 1990s.(1) This is a negative development as new business growth and innovation in the private sector is key for new job creation. Innovation by small business has been replaced by the acquisition of innovating firms by large firms. This trend has virtually destroyed the potential for new start-ups to survive and create new jobs. Historically the trend for large scale production was to allow the harnessing of information that would otherwise be more difficult to obtain in a flatter market structure. Accordingly, information key to decision making and product development was channelled up to the highest levels within the organisation and back into the production process. This analysis follows the work of Ronald Coase in his 1937 paper entitled “The Theory of the Firm”.
Now the potential to amass information exists without the macroeconomic baggage of large organisations so a fundamental rethink is required over why the economy needs such highly scaled up organisations. As far as natural monopolies where the argument is made that there is a need for large private sector companies via the PLC model to undertake the investment, these industries are publically owned in the Islamic model and run by the Islamic government on behalf of the public good. Fees can be charged for the upkeep of such services and this offsets the need for public wealth pooling via the stock markets.
3) Two aspects of regulation work as a significant means of market failure in Capitalism. Firstly regulation that is on balance useful in protecting the less powerful often gets bypassed through loopholes and other legislative oversight and secondly much regulation is hijacked by powerful economic actors and used to penalise the weaker market players, for example creating barriers to entry, resulting in it becoming a big impediment to growth and the development of trade.
Taking the first point, in the Secular marketplace, the disposition of market participants is to maximise profit as a means and an ends and this places them in direct confrontation with regulatory frameworks which are designed to protect all market participants especially the more vulnerable. As evidence of this, one needs to look no further than the amount of financial innovation being targeted towards bypassing financial regulation. For example the Repo 105 fraud undertaken by Lehman brothers (2) to conceal the bankrupt state of its Balance Sheet allowing Lehman brothers to take on more debt and risk exposure.
As for the second problem, countless examples exist of how regulation is devised to aid the powerful by for instance creating barriers to entry into the marketplace for small start-ups that help consolidate the power of the few firms that become dominant in the market.(3) This leads to an obstacle to new job creation and lost demand as there is less diversification and competition needed that would have helped create more employment and stronger aggregate demand which fosters trade in a market less prone to market failure.
4) Labour market inflexibility is another major impediment to achieving sustainable growth. When the economy is in recession, firms usually fire workers rather than drop salaries to the level they can afford. This increase in unemployment results in less demand which causes further layoffs as products are not being sold. In an efficient labour market, salaries and wages would need to fall until all workers could be employed and the market would clear i.e. surplus labour would be allowed back into the labour market. Due to factors unique to the Capitalist models, this failure is inbuilt into the workings of markets and the recessionary phase is needlessly prolonged and the impact on growth which benefits all citizens is severe and avoidable as will be made clear in the Islamic solution section.
The unique factors referred to above include, but are not limited to, the following:-
· Constant fear of monetary inflation which isn’t a reality under the Islamic based Gold and Silver currency.
· Employer fear of workers sabotaging production associated with worker grievance when wages are reduced. When the mind set of citizenry is changed from the utilitarianism advocated by the champions of Capitalism such as Smith and Jeremy Bentham, for accountability to a creator of mankind namely Allah (SWT), the potential for this behaviour is significantly minimised and hence less of a factor under the Islamic model.
· Money illusion is a phenomenon that leads workers to see the nominal wage above the real wage and this fuels the reluctance to accept lower wages despite the lower wage having the same purchasing power and the overall positive effect on the level of aggregate demand in the macro economy associated with a higher employment level. Money illusion is prevalent in all societies that see constantly rising prices as the norm with central bank intervention to avoid deflationary effects in the market. This is not the norm in the Gold Silver based system and the Islamic system is exempt from this phenomena.
Section 4: The destructive Growth Imperative within Capitalism
The current model of economics in the secular capitalist tradition is not robust enough to tolerate periods of slowdown or reduction in growth unlike the Islamic model which can flourish in a deflationary and equity finance environment due to a number of unique factors.
Another primary cause of this growth imperative is the fractional reserve based monetary system which imposes an imperative on the expansion of the M1 money supply so that debt service is possible on the current loans in circulation. In this monetary system, all money is loaned into existence and therefore all money exists as debt. Therefore the monetary base needs to constantly grow along with the underlying growth in goods and services so as to avoid rampant monetary inflation when the money supply outstrips the growth in goods and services, and to meet interest payments, or a debilitating deflation when the money supply fails to grow in the form of new loans. This deflation is debilitating under the Capitalist system due to certain factors unique to it such as the fact that monetary policy becomes ineffective when prices are declining as low interest loans intended to increase the money supply are unattractive when prices are falling and the low interest rate cannot offset the inflating money. Also debtors are penalised in a deflationary climate. The former is not a reality and the latter as shall be shown is less of a concern in an equity financing environment unlike the debt based finance model prevalent in Capitalism. Therefore to avoid a deflation, there must be a constant increase in money supply and a corresponding increase in production. The final argument of the anti-deflation camp is that deflation causes consumers to delay purchasing goods and this leads to contraction. This view is not held by all the Capitalist schools, for example the Austrian school is pro-deflation. This argument fails to convince when one considers the growth in industries that have seen falling prices over the last few years such as the TV industry. Furthermore the question of whether consumers would delay the purchase of goods when there is the equal possibility of their wages deflating prior to their intended purchase, rules out any positive correlation between deflation and a downward spiral in economic transactions.
This race to produce more than is needed, under the umbrella of consumerism, as started by mind manipulators such as Edward Barnays and his ‘Torches of Freedom’ campaign, ensure that the practice of endless consumption endures. Furthermore practises such as ‘planned obsolescence’ where time bombs are built into products so as to ensure consumption and demand is constantly being recycled to sustain the fragile system, become the norm as far as manufacturing methodologies. This is very destructive as far as the Earths finite resources and is tantamount to stealing from the future to consume irresponsibly in the present.
In contrast, the Islamic model is immune to the effects of crazed consumption and deflation and is thus immune from the growth imperative. The Islamic economy can yield output at variable levels to achieve the objective of providing the necessary goods and services for its citizens in a much more robust and independent way.
Source: new civilization.com