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Challenges in Economic and Financial Policy Formulation pdf

Challenges in Economic and Financial Policy Formulation: An Islamic Perspective

  • Book Title:
 Challenges In Economic And Financial Policy Formulation
  • Book Author:
Abbas Mirakhor, Hossein Askari, Zamir Iqbal
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In any economic system, there is a role for the state and for government policy. While the specifics of this role, its mandate, and its extent would differ from one economic system to another, a legitimate government and its policies are, at a minimum, essential for the preservation of security, social harmony, the legal system, and sustained economic prosperity. In the realm of economics and finance, the role of the state is multifaceted and can be minimal to dominant, depending on the system and societal goals.

In Islam, the Creator has given humankind the rules by which they should live their lives on this plane of existence. He demands much of humans, but if humans follow His rules, they could achieve the ideal social and economic system. If humans follow His path, although there would be minimal need for government intervention in the economic system, macro-economics would help in preserving a stable growth trajectory. Thus, there is an important role for the state in an Islamic economy, but this role may be increasingly reduced as an economy transitions to what might be called the “ideal” economy, where there is full compliance with the prescribed rules of behavior.

In this book we explore when, why, and how a government should inter-vene in a society and what policies it should use to improve economic and social conditions as recommended in Islam.

Economic Goals and Priorities

In every society and nation state, economic prosperity is the overriding goal. However, policies to achieve this goal are very different from one society to another. As a result of differing priorities, the target, focus, and the nature of government policies vary significantly across countries.

While the level of GDP and its growth rate are quick and useful indica-tors of a country’s economic success and power, they are dependent upon a country’s size, resources, and population, making cross-country com-parisons almost meaningless. For comparative purposes, and with humans always making comparisons, per capita GDP or per capita income and its growth rate provide a more meaningful basis for comparisons. However, adopting the highest level of per capita income and its growth as the goal in any society is also quite meaningless.

Humans do not live by national economic success alone. They cannot starve while the per capita GDP keeps on growing. They cannot eat the nation’s economic success. In short, there are many other dimensions that matter. While a people may take pride in their society enjoying the highest level of per capita GDP on earth, it matters whether an individual’s income is above, at, or below the prevailing average.

 To give an extreme example, it does not make for a flourishing and healthy society if it enjoys the highest per capita GDP in the world but that GDP is only because a few individuals possess an unimaginable income while the rest of society living at a subsistence level! So yes, while income distribution must also be a goal or a priority, societies view its details very differently and government policies can affect and determine the outcome.

Even a high level of per capita GDP and a more or less equitable distri-bution does not reflect and indicate a society’s welfare. Humans are born with dreams. Does society provide those people with the environment and freedom to realize those dreams?

 Are there real opportunities, with equal access to high quality education, social mobility, and good employment prospects in order for all members of society to realize their full potential? Moreover, what about the disadvantaged members of society who cannot readily avail themselves of existing opportunities? Are the interests of future generations—generations that have no vote or say today—protected when it comes to the environment, the availability of natural resources, and future economic growth rates and prospects? Government and government poli-cies, both directly and indirectly, affect all of these outcomes. But again, the role of the state and its policies are perceived very differently from one society to another, and our focus is the role of public policy in Islam.

The Role of the State

In most states, where you are born becomes the state of your nationality. States, however, change as a result of both internal and external political and military forces. However, if you are born a Muslim, you are a member of all Muslim countries, at least that is the way it was some 1,300 years ago. In those early days, up until some century and half ago, a Muslim could travel throughout the Muslim world with no papers and expect to be treated as if he or she had been born in the land where they happened to be. How things have changed!

States have monopoly over the levers of coercive power to force compli-ance. In Islam, Muslims are expected to comply because they are answerable to Allah. Yes, in Muslim societies, states do also have a coercive power, but the expectation is that the state should use its coercive powers sparingly and only when individuals are rule violators or when the use of coercion is in the interest of society. Those interests are, however, not arbitrary; they are defined clearly by the Creator.

The state is the guardian of the legal system and the rule of law. In the absence of laws, their monitoring, and enforcement, a nation-state becomes a veritable jungle—with risk that overwhelms all rational decision-making.

The resulting constraints on management of economic, financial, and politi-cal risk would in turn impede social and economic progress. In the absence of a supportive legal system and the rule of law, economic actors are unlikely to entertain long-term decisions. Going beyond the legal system, the state can be seen as society’s risk manager, especially in the absence of private sector insurance against idiosyncratic risks.

Beginning with the obvious—that include external threats, internal security and violence, and unforeseen natural disasters—and stretching to the not-so-obvious—that include broad economic and financial collapse, loss of all employment opportunities, and impairment of the ability to work or losses of asset values beyond the control of individuals—there is an undeniable role for the government in managing society’s risk profile. Chapters 5 and 6 will address these issues.

The state plays an important regulatory role that cannot be entrusted to private parties. Sound regulations are at the foundation of business con-fidence. All economic systems—from any form of market arrangement to command systems—need regulations or rules of the game (or institutions, as we will discuss in Chapters 2 and 3).

 In the absence of carefully con-structed regulations, markets cannot transmit correct signals to consumers and producers for their decision-making. Markets can fail for a number of reasons that include price and output collusion, monopolistic power, asym-metric information, moral hazard, unfair foreign competition and trade practices, and even outright fraud. An important area for government inter-vention and policy is in dealing with the issue of externalities—negative fallouts, or by-products, of economic transactions.

Chemical companies, as a by-product of their industrial processes, emit dangerous pollutants into the air and into the waters. In the normal course of events, they would not install expensive pollution controls. The companies would invariably prefer to maximize their profits by not paying for the external diseconomies that they cause.

The government can establish rules and force companies to clean up their environmental damage and install pollution control equipment. Even in non-market systems, participants must have rules and guidelines for what they can and cannot do. However, regulations and rules are only as effective as their supervision and unbiased enforcement. Again, both super-vision and enforcement are difficult to privatize and should be entrusted to a fair and just government.

The government’s regulatory role goes further. The state stands to protect society and individuals from predictable harm. Licensing of professionals is important in numerous areas—medicine (doctors and nurses), business, financial institutions, etc.

A government agency, such as the Food and Drug Administration (FDA) in the United States, tests and monitors the safety of drugs before they are sold to the public. Accreditation of hospitals and schools is another role for the government. The government plays an impor-tant role in certifying the safety of the food chain and the origins and con-tent of whatever is consumed. The government plays a key role in developing safety standards that businesses might not adopt on their own—for cars, airlines, household equipment, etc.

The state has a crucial role in ensuring expansion of economic activ-ity and prosperity. As the world witnessed during the Great Depression and, more recently, in the Great Recession, there is no reason to believe that the economy will be operating at full employment (the natural rate or later restated as NAIRU, the non-accelerating rate of unemployment by Modigliani and Papademos in 1975).

 In fact, it is highly unlikely that the economy will be humming along at NAIRU for any length of time. There will be periods when aggregate demand is too low (when the aggregate sup-ply is high) and others when it is too high (or when the aggregate supply is low), requiring government intervention to nudge the economy back to the NAIRU level of activity.

Stabilization policies—monetary and fiscal (dis-cussed in more detail in Chapter 7)—are crucial in moderating economic fluctuations and maintaining employment, something that is critical to avoid economic hardships for families, and for society in general. However, government’s role in stabilization goes beyond monetary and fiscal policies to include industrial policies, trade policy, exchange rate policy, and income policies (such as healthcare and education, that affect incomes).

While government can adopt policies to support economic activity and nudge the economy towards its NAIRU level, it could play an important role in enhancing growth. Sustained economic growth needs supportive poli-cies and institutions to encourage businesses to invest for the long term, for

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