Prepared For: Bro Mustafa Omar

Global Economic Crisis from Islamic Economics Perspective

Group Assignment 1

Prepared By Aizul Fiteri Bin Mastor (G0927247) Nurain Shaharudin (G0831786) FIN 6620 Economics, Al-Shariah and Society Masters of Business Administration Graduate School of Management, IIUM 8th October 2010

Abstract
In recent decades, the world has witnessed few financial and economic crises which have put the Free Market Economy a.k.a Capitalism to trial and their fundamentals questioned. We have witnessed the 1998 Asian Financial Crisis, the 2000 Dot.Com Bust and the most recent and by far the worst, the 2008 Sub-Prime Crisis, labeled as The Great Recession putting it straight into comparison with the Great Depression of 1930s. A crisis which began in the USA, the heart of Capitalism, has swept across the global in no time and left tens of millions of people around the world jobless as well as homeless. This paper will describe how the crisis unfolded and developed from American Sub-Prime crisis into a huge global crisis. The main factors causing the crisis will be examined and addressed from the Islamic Economics perspective. The question whether Islamic Economics would be able to prevent such crisis, and ultimately replacing Capitalism as the new world economic system will also be discussed.

The Crisis Unfold

In the aftermath of the Great Depression of 1930s, John Maynard Keyness idea has been widely accepted as a required adjustment to the Market Economy and had effectively redefined the modern economics. He is in the opinion that the government should assume greater role to balance the market force and most importantly preventing market failure. Hes idea was timely as the world was just recovering from the Great Depression and the eminent and growing threat of Communism and Socialism which argue Command Economy as the ultimate answer to the problematic market economy. However, as the influence of Command Economy diminishes due to its failure to create prosperity in even the most ardent communist states such as the former USSR and the East Germany. Even China has started to liberalize its economy to some extent and embraced a toned-down capitalism all as an effort to stay

relevance and to survive the onslaught of Globalization. The Market Economy has since then lost its biggest rival and started to neglect Keyness idea and reverting back to its fundamentals, restoring Market force as the ultimate power with zero government intervention. This seemingly concerted effort of reducing Government role as a counterpart to the market was spearheaded by the worlds biggest economy namely the USA. As Stiglitz (Stiglitz, 2010) has rightly put it In the last twenty-five years, America lost that balance, and it pushed its unbalanced perspective on countries around the world. The current crisis which stemmed from America can be traced back to the 2000-2002 dot-com burst. During which the United States was controlled by the right-wing Republican under the leadership of President George W. Bush. The Bush administration took the opportunity during the short recession to lower the tax rate which benefits the rich. By applying such fiscal policy, he believes the tax cuts will motivate the rich to reinvest back their surpluses into the economy and thus restore employment rate to a healthy level. Unfortunately, the tax cuts had failed to stimulate the economy as intended, since the rich chose to limit their domestic investment and prefer to keep the cash. Consequently, the Federal Reserve under the leadership of Alan Greenspan decided to undertake the expansionary monetary policy strategy by lowering interest rate as an attempt to spur the economy by allowing easy access to cash. The low interest rate, coupled with significant inflow of funds and hot money from the oil producing countries (the middle-east region was in the midst of Afghanistan and Iraq War in 2003 thus not conducive for investment) and other emerging economies in Asia has created a very high liquidity in the American economy. This has encouraged American banks and other financial institutions to embark on predatory marketing activities and competing with each other in giving out credits and loans to maximize consumption which translate to huge profit. These consumption are mainly driven by home mortgages, credit cards and

auto loans. As the market demand-supply theory dictates, surge in demand for property has in return, caused dramatic increase in both price and production of property to an unprecedented level. This in return, created a bubble waiting to burst. In the pursuit of profit maximization, the banks turned their head in selling the home mortgages to the sub-prime borrowers, those who have weak credit rating and low repayment ability. The subprime borrowers were offered Adjustable Rate Mortgage (ARMs) so that they could enjoy lower repayment at the time. This encourages them to buy more houses as investment since they believe the house value will keep appreciating. As of March 2007, the subprime mortgage market volume has grown to an estimated of USD$1.3 trillion (Associated Press, 2007). The banks were able to churn out more and more home mortgages since their loans and mortgages were sold as a security in the form of Mortgage Base Security (MBS) to both local and global financial institutions including foreign pension funds. By end of 2007 the combined outstanding home loan of the two major US MBS sponsors Freddie Mac and Fannie Mae has reached USD$5.1 trillion (over 30% of Americas 2007 GDP) (Koya, 2009) . The lucrative MBS industry has lured investment banks in the Wall Street to innovate a more sophisticated asset backed security product called Collateral Debt Obligations (CDOs) The MBS and CDOs became a much celebrated investment product, since now its possible for local and global investment funds to chip into a booming US property market. The MBS and CDOs were also given favorable rating by prominent rating agencies despite the fact that these products were just a repackage of high risk subprime mortgage loans. Some investors who hold these securities require some kind of protection to prevent huge losses in the event of default. Thus they bought insurance policy in the form of Credit Default Swap (CDS) issued by giant insurer like AIG, MBIA and FORTIS. Another fact to note is these CDS can be bought and sold by parties who never own a security in the first place! Since the CDSs are tradable in secondary market, this led to speculative activities on debt issues and credit

worthiness of the reference entities. As of November 2008, the debt covered by CDS estimated to range between US$33 to $47 trillion. The crisis started when the US housing market began to peak in mid 2006. The housing market has started to be over supplied which then later caused the home price to peak and then decline significantly. The subprime borrowers who were counting on home value appreciation started to unable to serve their mortgages since the banks has revised the ARM to a higher rate. This has led to high rate of foreclosure and non-performing loan. Banks cash flow then became stressed since they were highly leveraged in the first place, which force them to increase the AMR even higher. This in results has caused downward pressure on consumer consumption since their income surplus diminishing in serving the growing mortgage payment. Coupled with the crash of construction industry, the reduction in consumer spending has caused several domino effects pressuring the general economy and forcing businesses to close down which eventually led to a surge of unemployment rate. Consequently, the financial industry has also started to suffer huge losses via their investment in the MBSs and the CDOs which were pegged to the subprime mortgages. The insurance companies who had sold the CDS also started to suffer huge losses. The housing market burst has caused the CDS worthless and at the same time had to compensate their clients who had their MBS and CDOs defaulted. The losses due to exposure on these asset backed products were quite significant for some investment banks which in returns depleted their net worth and capital level. In the case of Lehman Brothers and Wachovia this has led to their downfall. The inability of banks and financial institutions to provide liquidity and loans for genuine business needs had made the overall economy slumps even further. The whole chain of events had negative impact for banks and financial market around the world, hampering liquidity and hurting the global economy. The next discussion will be revolved on the four main elements namely Riba (Interest), Gharar (Uncertainty), Maysir

(Gambling) as the main factors causing the crisis, and Ruyat al-Islam lil-wujud (Islamic Worldview) as to understand how Islamic economics could have prevented such crisis.

The Prohibition of Riba (Interest)

Interest is the engine of capitalism. It essentially is a concept which allows money to grow itself overtime through the increase in loan repayment. Banks charge interest via AMR on the disbursed mortgages. They then securitized the loan in the form of MBS and CDOs and sell them as interest bearing investment products in return for cash. And when the crisis broke out, the interest rate of the AMR was increased by the banks so that they could honor the interest promised to the investors. This had triggered the vicious cycle of foreclosure and cash flow stress to the banks and the homeowners, which then paralysed the economy. Islam prohibits riba as clearly stated in the Quran 2:275 Allah has permitted trade and has forbidden riba. The rationale is clear as Islam regards interest based loan is unjust to the borrower and add no real values to the economy. In an interest based system, the rich will always have the upper hand over the poor and this kind of oppression is against Islamic principle. Islamic economics propose Qard Hassan (Benevolent loan) as the solution where borrower only pay the amount he borrowed. However its permissible for the debtor to pay more as a sign of appreciation. Islam instructs creditors to be lenient when asking for repayment and encourage them to write-off portion of the debt or prolong the repayment term when the borrower is having difficulty. This would be handy when the crisis hit, therefore preventing foreclosure and bankruptcy which would be a lost to both parties. However, some argues that this concept is impractical. Therefore Islamic economics has other alternatives for conventional mortgages through Bai biThamin Ajil (deferred payment sale) where the profit rate is fixed thus hedging the homeowner from the risk of volatile economic cycle and a better concept of Musyaraqah Mutanaqisah (diminishing partnership) where the home is

jointly owned by the bank, together with all the risk attached to the ownership. In the later, since the risk of owning the home will be borne together, the bank would practice a higher level of due diligence in assessing credit worthiness of a potential client. Thus the whole issue of subprime lending can be avoided.

Gharar (Uncertainty)
Gharar (excessive uncertainty or ambiguity) is a relative concept as oppose the riba which is very definitive. As Siddiqi has put it The Islamic approach to risk is realistic but cautious. It does not allow deals involving excessive uncertainty (Siddiqi, 2008). Most if not all of the financial products involved in the crisis namely the MBS, CDO and the CDS are tainted with excessive uncertainty. The MBS and the CDO for instant is just a repackage of high risk subprime mortgages. The selling of such products will earn the bank with a definite amount of cash, which is then pumped again to the consumer in the form of more loans and mortgages. On the other hand, the return to the investor is uncertain since the risk attached to the actual subprime mortgages, were made ambiguous. In this instance, the rating agencies were also at fault since their approval of such products would clamor the real risk and would affect investors judgment. Islam will never allow a bias and asymmetric information such as this and would require seller to be honest and layout all the relevant risk before any venture or transaction could commence. In principle, Islam does not allow the selling of debts and receivables because this would constitute a riba transaction. Furthermore selling loan presented excessive uncertainties to the investor. However Islam has the alternative of Sukuk al-Ijara which allows partial partnership of a tangible asset. In this kind of venture, both parties the sukuk issuer and the investor will share the risk of owning the asset and therefore has the common interest to ensure the venture success. In this situation, gharar can be eliminated since both

parties for their best interest, will share the risk analysis on the venture and would have a common understanding on what at stake. In the case of selling of CDS, as protections against securities default were provided by insurer, the element of gharar is quite obvious. Especially, when the insurers themselves were not too sure where they will get the money to compensate their clients in the event of the house market crashes. To make things worse, the insurer also sells the CDS to those who are not the buyer of those CDOs and allow them to be traded in the secondary market. This brings us to the third element, which is Maysir (Gambling).

Maysir (Gambling)
Maysir essentially is a risk shifting activity. Islam promotes risk sharing and risk management in return for economic gains but not just a mere risk shifting. The trading of CDS in the secondary market is purely speculative and tantamount to maysir (gambling) which is strictly prohibited by Islam. As awkward as it may sounds, the trading of CDS may lead into a situation where a party is putting a bet hoping another party to default in serving the securities. It is a zero sum game where the winning party takes all and leaving the loser with none. This speculative product does not create any real value to the economy but rather just transferring wealth from one hand to another. Even though, theres no real economic value offered; resources are still used in the process of CDS trading. Therefore this activity brought inefficiency in the economic system. Furthermore, when the CDS issuers were having trouble paying out to their clients and were in the verge of bankruptcy, they received a bail-out from the American government. It seems that the capitalist economic system is cultivating new philosophy whereby profit is privatized whilst losses are borne by the public.

Ruyat al-Islam lil-wujud (Islamic Worldview)

Islam views human being as representative of Allah in the world with responsibility to manage the resources in such a way that the five maqasid (objectives) of syariah are preserved with the ultimate aim to obtain Allahs pleasure. The main objectives of syariah are to preserve the following elements Religion, Life, Lineage, Intellect and Property. In fulfilling these responsibilities, human are guided by a divine value system which promotes fairness, justice and putting priority of public interest over personal interest. These elements of value bound system are what missing from the market economy. In the market economy theory, human is relegated and regarded as just a mere factor of production. As a factor of productions, human is expected to behave rationally and what they meant is for a human to choose an option which has higher benefits over cost. This assumption has been embedded in the very fabric of society living within the capitalist, market driven economic system. So much so that maximizing profit has become the only objective whilst others are secondary including modesty, fairness and justice. In every sequence of events leading to the crisis, the greed of maximizing profit can be identified, from the hard selling of mortgages, abandoning due diligence in risk assessment, risky subprime loans securitization, misguided rating of securities by the rating agencies and lastly the speculative CDS market. To make it worse, the government has failed to protect the public interest by allowing these activities to occur unchecked. In fact, the government was responsible for prolonging the low interest rate, which served as catalyst for these activities to flourish. Islamic Economics regards government as the protector of public interest and in actual facts are responsible in ensuring basic needs of the people are fulfilled. In Islamic economic system, government has the responsibility to regulate and protect the market from the elements discussed earlier namely riba, gharar and maysir. Market economy argues that,

government intervention is not required since the market will realign itself via the demand and supply control mechanism. However, from this crisis we learnt that the market can be distorted by predatory marketing, information asymmetries driven by vested interest which then created artificial demand and consumption. These unchecked, has caused the market to fail. All are emanated from human rational behavior guided by pure self interest. Ironically, the same proponent of zero government intervention, call for governments help in bailing out them from the mess utilizing tax payer fund. Instead of protecting the public interest, the government in this instance has put the public in the losing end while the capitalist are reaping the profits.

Conclusions
The subprime crisis which is one of the worst since The Great Depression of 1930s has exposed the weaknesses of the current market economy systems adopted globally. The market self-regulation proposition has led to the destruction of the market itself. The banking and financial institutions which main functions are to ensure liquidity and efficiency in the economy by mobilizing savings and capitals within a well managed risk environment had miserably failed. On the contrary, they have created excessive risk by utilizing their creative and innovative talents that their hands possessed in coming up with dangerous financial products. All were done in the name of rational behavior of profit maximization. Concurrently, the government had also failed to play its role in introducing active fiscal and monetary policies in stabilizing the market. At the end of the day, the society had to bear huge economic losses. Islamic economic system had all the qualities and potentials to alleviate this pain from the society. Promoting a just, fair and equitable system within a value based framework which acknowledge that theres more to life than profit maximization. At any time, public interest has to be protected while at the same time the right for individual to own property

and accumulate wealth is also recognized. However critics may argue that Islamic financial and banking system which is a part of the Islamic economic system is prone to boom and bust as shown in the recent 2010 Dubai Sukuk Crisis. For once, Islamic Economic system shouldnt be blame for the mishap, but rather the diversion of the Islamic financial products from the Islamic economic objectives should. In other word, as long as the core Islamic economics purposes and intents are being adhered, theres no doubt that Islamic Economic will be the best candidate to substitute the incumbent capitalist system.

Bibliography
1. Associated Press. (2007, 3 13). Retrieved 10 6, 2010, from www.msnbc.com: http://www.msnbc.msn.com/id/17584725 2. Koya, M. (2009). Global Economic Crisis, An Islamic Perspective. Australia: Idialogue Magazine. 3. Siddiqi, M. N. (2008, 10 31). Current Financial Crisis And Islamic Economics. Retrieved 9 27, 2010, from www.siddiqi.com. 4. (2010). In J. E. Stiglitz, Freefall. New York : W. W. Norton & Co. 5. Wikipedia. (n.d.). Subprime_mortgage_crisis. Retrieved October 7, 2010, from www.wikipedia.org: http://en.wikipedia.org/wiki/Subprime_mortgage_crisis