THE GOLD STANDARD ANCHORED IN ISLAMIC FINANCE – Book Sample
Introduction – On the Necessity of a Gold Standard Anchored in Islamic Finance
The 2007–2008 global financial meltdown revealed a dangerous feature of the inconvertible reserve currency system that replaced the gold standard of the pre-1914 era. Reserve currency countries could do almost what they wished, with adverse fallouts for other countries.
Facing practically no foreign exchange restraint, reserve currency governments undertook one of the most expansive fiscal and monetary policies on record.
They forced interest rates toward zero, printed unlimited quantities of money, bailed out those among their institutions that had floated or acquired toxic debt, pushed more debt into the financial system, and attempted to re- inflate prices. Some of the real losses associated with the crisis were transferred from reserve to non-reserve countries, causing the most vulnerable people to suffer much of its consequences.
The reserve country banking system has, in turn, played the part of a wealth redistributor, with a historical pattern of over-indebtedness–crisis– bailout followed by over-indebtedness–crisis–bailout, a pattern that can become pervasive and endless as long as the reserve currency is widely accepted.
The reserve currency governments and central banks have prevented the liquidation of debt, which would not have been possible under a gold standard system.
Under this system, no country was able to issue unlimited quantities of cur- rency that amounted to a tax on other countries for the benefit of its debtors and speculators.
2 The Gold Standard Anchored in Islamic Finance
- M The crisis of the present inconvertible paper system
- M Brief history of the gold standard and the reasons (excessive monetary expansion) for its failure
- M Brief anatomy of financial crises (focusing on debt and leveraging)
- M Vulnerability of the gold standard under fractional and central banking systems
- M Restoration of gold based on the financial principles of Islam.
Undoubtedly, an inconvertible paper system enjoys tremendous support from politicians, financial groups, academics, the media, and profiteers as a class. Reforms are not imminent in the near future; it would never be a political decision; it would only come about under forced conditions, such as a total collapse of reserve currencies caused by the loss of trust.
Despite wide support from the political, financial, and busi- ness sectors, an inconvertible currency had opponents wherever it was introduced. These opponents formed what was called the sound money school. Such a school held that any reform of the monetary system at the domestic or international level could only be a gold standard; it rejected Adam Smith’s (1776) theory that called for substituting cost- less paper for gold so as to divert resources from gold mining to more socially useful sectors. Their principles can be summarized as follows:
M Money is a commodity that obeys the law of value, namely, cost in labor and other resources for producers and utility for the users. Although any commodity may serve as money, over centuries, gold and silver were found to be the most suitable form of money by most markets and countries.
M Fractional banking has to be abolished and replaced by a system of 100% reserve depository banking that does not create money, is confined solely to safekeeping, and is only used for the settlement of payments.
M The mandate of central banking has to be changed. Central banks often suspended the gold standard. In 1931, the Bank of England dealt it a fatal blow, and immediately thereafter, all the other central banks also stopped using the gold standard.
M Financial intermediation is confined to capital markets only. Investment banks intermediate between savers and users. They receive no deposit money and issue (create) no money. They only buy and sell debentures, bonds, and equities.
Islamic finance fully concurs with these principles, except that it strictly forbids any form of interest-based debt. Debt is not forbidden; it has to be in form of Quard al-Hassan, that is, an interest-free loan
The Crisis of the Present Inconvertible Paper System
Inconvertible paper money is, by definition, a piece of paper that is not convertible into any commodity by its issuer. It is a “thing in itself.” Since the cost of a bit of paper is negligible and can be assumed to be equal to zero, the issuer, whoever it might be, cannot resist issu- ing such paper at 100 percent seignorage until the purchasing power of the paper money reaches its actual cost, that is, zero. Inconvertible paper is not market money, but can circulate only with the force and backing of the state.1
Inconvertible paper fails to satisfy some basic properties of money; namely, a standard of value, a store of value, and a standard of deferred payments. The erosion of its value depends upon the speed at which the issuer, bank or government, wants to inflate. For instance, a barrel of crude oil was $0.8 in 1913 and it reached $147 in 2008, a multiple of 184 times. Gold was $18/ounce in 1913 and it reached
$1,744/ounce in 2012, a multiple of 97 times. In contrast, under the gold standard, the US consumer price index was 12.17 in 1800 and fell to 8.14 in 1900, that is, by 33 percent. Inflation is related to money supply; the more money is inflated, the higher will be the price level. With the ability to issue paper money, the size of governments has expanded.
As the role of paper money increased, central banks were given the conflicting mandate of securing full-employment and moderat- ing inflation to achieve sustained prosperity, and the role of govern- ments increased. Much of the classical economics of Adam Smith’s invisible hand, Say’s law of the markets, David Ricardo’s free trade, and Bohm-Bawerk’s capital theory were thrown out and replaced by government intervention and management.
The creation of paper money out of thin air is, by definition, a redistribution of wealth in favor of the beneficiaries of its creation. There is a forced saving imposed on the victims of paper creation, which could be the workers, the annuitants, and the poor in general. Often, the victims of inflation pay three inflation taxes: one tax for the state, one tax for the speculators, and one tax for the debtors. The wealth concentration becomes exacerbated.
The 2007–2008 meltdown unmasked the dangerous nature of a dominant reserve currency. The central bank holding the issuance power of the dollar can bankrupt the whole banking system of the United States as well as the Eurozone. The central bank can bail out the entire banking sector with the stroke of the pen and make the general citizenry, who are the victims, pay for crimes they did not commit, and transfer some bank losses to the poor in the vulnerable countries.
The central bank can be a Plutus who drowns speculators and debtors into abundant wealth and opulence at the expense of those who lose real income and wealth. Milton Friedman, long before 2007–2008, feared the power of the Federal Reserve.2 A monetary chaos took hold after 2007: zero interest rates; massive money cre- ation; unlimited wealth gains in stock markets and in debt; highly unstable exchange rates; large monetized fiscal deficits; unjust rise in income inequalities; and wealth concentration. A worker who labors all day gets poorer; a speculator or a debtor gets rich with little or no contribution toward a real output, thanks to zero-interest rates. At the same time, leading industrial economies were plagued by intrac- table and high unemployment; meager growth; and declining real incomes. Practically, governments blocked the liquidation of the crisis and forced re-inflation of assets and commodity prices in an effort to recover from the crisis. Government and private debt has far exceeded the pre-2008 levels. It is likely that much of this debt can never be paid except by more debt, inflation, or general bankruptcy.
Taking a long view, the future will only be as chaotic as the past. Too much uncertainty prevails with deranged domestic investment and international trade and capital flows. Sound economic calcu- lations are practically impossible in the context of such uncertain- ties. Another major financial meltdown is very likely to follow soon. An inconvertible paper money system imposes no discipline on the issuers of the reserve currency and lacks many of the properties of sound money. In 1971, the then US Secretary of the Treasury, John Connally said to Europeans, “The dollar is our money, but it is your problem.”
Brief History of the Gold Standard and the Reasons (Excessive Monetary Expansion) for Its Failure
The gold standard made gold the basis for measuring and transacting all other commodities. Trade was settled in gold among domestic and international traders. For centuries gold circulated as a commodity in form of coins, bullion, or raw metal (gold dust). It circulated by weight or by tale, that is, number of coins to be paid in a transac- tion. When gold was the standard of value, silver was a commodity as any other commodity such as wheat or tea.
When silver was a standard of value, gold became a commodity as any other commod- ity. In large transactions within and across countries, gold was subject to an assay and was used according to its true weight and fineness. In small transactions, gold coins were rarely used. Silver, copper, and nickel were used instead of gold.
Credit instruments existed as mean for circulating commodities and settling trade; they were promises to settle debt at maturity in terms of gold. There were also bills of exchange, checks, compensation, and clearing mechanism among traders within or across countries that economized on the use of gold. Bills of exchange offset the payments concerning exports and imports without necessarily importing or exporting gold.
Originally, gold circulated without interruption; there were no paper substitutes as there were no printing presses. Adding more alloys to sovereigns, or clipping and sweating by people debased gold coins. Occasionally, sovereigns raised the value of the coin in terms of the units of account.3 Then, goldsmith houses and a small number of banks appeared; banks multiplied; and governments promoted central banking.
Banks, goldsmith houses, and central banks emitted notes convertible in gold against deposits. These deposits were either gold deposited by depositors at the depository institutions, or credit created by the banking institutions in favor of their debtors.
Besides banks of issues, governments occasionally resorted to issuing paper money redeemable in gold through their treasury departments. As it were, often-issuing institutions, such as goldsmith houses, banks, central banks, or states, were compelled to suspend the conversion of their paper into gold for excess of issuance; that is, liabilities far exceeded gold reserves. The government, as in the case of the Bank of England in 1797, might order the suspension of gold payment. The Parliament ordered the bank not to redeem bank notes.
In the same vein, the Parliament ordered the Bank of England to resume gold pay- ments in 1819. Private banks failed to pay gold. Some were able to regain solvency while others disappeared following bankruptcy. In every country, the gold standard was terminated by decrees of the government. It was not the private market that ended the gold stan- dard. It was a legislation forced by the government that made it a felony to use gold money. Governments eliminated gold as the stan- dard and stood against it restoration.
With the advent of modern fractional reserve banking in the sev- enteenth century, and the substitution of banknotes, particularly starting from the seventeenth century, the gold standard came under increasing stress and frequent suspensions.
Governments could not resist printing paper money and expanding their power, military force, and expenditures. Bankers could not resist expanding loans and earning interest and commissions.
There were two sources of paper emissions: the government and banks of issue emitted notes convertible into gold. Often, each institution of issue emitted notes in excess of its gold reserves. Particularly, banks practiced leveraging; a bank realized that depos- ited gold was withdrawn on average only up to a small fraction. For instance, on a deposited amount of 100 coins, only 10 coins were withdrawn during a given period. The bank decided to lend 90 coins in banknotes. It realized that it could increase its loans to an amount of 1,000 coins in banknotes.
However, if depositors decided to pull more than 100 in physical coins to pay for foreign goods, the bank was not able to redeem all demands of withdrawals. It found itself in an illiquid, but not necessarily insolvent, position. It was not able to convert into gold the notes presented to it. A panic developed. The suspension of convertibility lasted for few months, or even few years. It happened that banks failed completely, and therefore depositors lost all their gold. The history of the period is replete with financial crises and suspensions. Examples of suspen- sion of gold payments were the Bank of England during 1797–1821 and US banks in 1907. The causes of the suspension were low inter- est rates, high expansion of credit, high degree of leveraging, high speculation, and default.
Brief Anatomy of Financial Crises:
Debt and Leveraging
Economic history shows that gold and silver where most widely used metals in minting monies from time immemorial until 1914. Gold was the standard value in some countries; silver was the standard of value in other countries. Nonetheless, both metals were used as monies in almost all countries; one metal is standard, and the other is an auxiliary metal for fulfilling certain needed money functions. For instance, in the United Kingdom, gold was the standard of value from 1816 to 1914 and silver was auxiliary money for fulfilling small payments such as wages. In France, silver was the standard of value during 1803–1870. However, gold coins were used as money, particu- larly in settling international transactions.
With the advent of modern banking and the depository system beginning in the fourteenth century, banknotes were issued by banks of issues and circulated along metallic money at a nominal fixed rate with metallic money, called par value of the bank note.
The issuing bank promised to redeem its paper money into metallic money at the request of the holder of the banknote. Moreover, with the genesis of modern banking and the development of industry and commerce, credit instruments such as discounts, advances, bills of exchange, promissory notes, and book credit became instruments of payment and fulfilled the same functions as metallic money in circulating com- modities and assets. Banks, the state, the merchants, and corpora- tions issued the instruments of credits.
An inherent feature of the modern banking and credit system was the recurrence of financial crises. These crises were characterized by panics during which holders of banknotes rushed to respective issuing banks and asked for redemption in metallic money. Often, these panics led to suspension of redemption by issuing banks facing deficiencies in metallic reserves. The financial crisis did not lead to a suspension of the gold standard. Only banking institutions, or governments facing a mismatch between gold and notes, suspended the redemption of their respective notes. The mints continued to operate with gold bullion minted into coins according to the prevailing laws of weights and fineness. Suspending institutions were either in temporary deficiency in gold and restored cash payments following a strengthening of their gold reserves or disappeared completely, inflicting losses on their creditors. The notes of suspending institutions might have circulated during the suspension period at a discount in relation to their par value.
The financial crises of the eighteenth and early nineteenth centuries led eminent philosophers to ponder on the causes of these crises and to prescribe reforms for preventing their recurrence or attenuat- ing their severity. Many reforms were aimed at ensuring the convert- ibility of the paper currency into gold and controlling the issuance of paper money.
John Stuart Mill (1826) studied the financial crises of 1814–1815 and 1824–1825. He attributed these crises to speculation and over- trading. In fact, many investment opportunities, such as the new trade opportunities with newly independent Latin American states—which led to the formation of new companies, the floating of new shares, and to high prices of the new shares. Speculation led to rapid price increases. Banks accommodated the new demand for credit.
At some point, many of the projects turned out to be less remunerative than initially expected by speculators; the latter rushed to sell shares before they collapsed; debtors defaulted on their loans; there was a sudden credit freeze, forced sales and, therefore, a general financial and eco- nomic crisis. John Stuart Mill downplayed the role of banknotes issu- ance as a cause of a crisis, simply because banknotes were not the main instruments for circulating commerce and stocks.
He showed, based on data, that credit instruments, such as bills of exchange, dis- counts, advances, and book credit settled more than 90 percent of the trade. Hence, the cause of the crisis might not be necessarily the circulating banknotes.
However, banks and merchants had unlimited capacity for issuing credit and therefore fueled speculation and over- trading until the speculative mania burned itself out. The panic was very quick and the collapse of prices was fast. John Stuart Mill also analyzed interest rate determination and its pattern over the business cycle. He noted that the interest rate depended on the rate of profit and on the demand for credit. High expected rate of profit and high demand for credit might have caused the interest rate to rise; however, as banks extended credit, they kept interest rates at a moderate rate. He criticized the British usury laws, which prevented the interest rates from rising above a fixed ceiling of 6 percent.
Among the most celebrated attempts to analyze financial crisis and find their remedy was the Sir Peel’s 1844 Act. Noticing the severity of the 1825 and 1837 crises, legislatures and professionals wanted to study the causes of business cycles and find a remedy for them. Two opposing schools of thought developed: the Currency School, which originated in the 1810 Bullion Report as well as in the writing of David Ricardo, versus the Banking School, which was influenced by Henry Thornton and Thomas Tooke. The Currency School maintained that over-issuance of notes in relation to gold reserves was the source of gold suspension.
The Currency School wanted to secure the payment of gold and decided to follow the models of the Bank of Amsterdam (1609) and the Bank of Hamburg (1619), where notes were 100 percent backed by metal. Hence, beyond an amount backed by government securities, banknotes were on the margin, 100 percent backed by gold reserves. The Banking School emphasized the convertibility principle of banknotes; however, based on the real bill doctrines, it maintained that credit would not expand beyond business needs.4 Credit accommodated business expansion and was self-liquidating.
Juglar (1862) studied both the theory and the statistical facts of financial crises. He examined annual banking data for France, the
United Kingdom, and the United States spanning 1800–1860. In France, commercial crises recurred during 1804, 1810, 1813, 1818, 1826, 1830, 1836, 1839, 1847, and 1857. In the United Kingdom, they recurred in 1803, 1810, 1815, 1818, 1826, 1830, 1836, 1839, 1847, and 1857. In the United States, they recurred in 1814, 1818, 1826, 1837, 1839, 1848, and 1857.
Juglar noted that financial crises were rarely local and spread to industrial countries inter-related by trade and capital markets. He selected four indicators for his study; these were: (i) discounts and advances; (ii) metallic reserves and their counterparts; (iii) circulation (paper and coins); and (iv) deposits and checking accounts. Juglar showed that credit and metallic reserves displayed an immutable pattern in each episode. Prior to the crisis, credit increased rapidly and metallic reserves decreased to low levels in each of the three countries.
During the liquidation phase, credit contracted sharply and metallic reserves rose considerably; interest rates rose significantly; and prices fell sharply. Juglar noted that the liquidation phase was very brief; its severity depended on the intensity of the prior boom. Powerful boom was followed by a severe contrac- tion, whereas a moderate boom was followed by a moderate contraction. Juglar stressed the high leverage of the banking institutions; he called the credit structure an inverted pyramid built on a diminishing metalling reserves; it was very vulnerable to the smallest disturbance, such as the inability of a bank or commercial corporation to meet its liabilities.
Juglar also described the symptoms that preceded the crises. There were signs of high prosperity, new enterprises, and speculations of all kinds. Juglar showed, using available data, that there were rapid price increases of all commodities, securities, and houses. There was full- employment and very high increases of wages; there was a significant decline in interest rates; there was the credulity of a number of people who wanted to become rich as instantaneously as in a lottery.
Juglar mentioned the high level of luxury spending, based not on income earnings, but on the tremendous appreciation of securities as quoted in stock markets. He stated explicitly that investment exceeded real sav- ings and credit was in large part fictitious, exerting pressure on prices. All the newly created enterprises found credit almost immediately and were able to fund all capital requirements; investors rushed to buy new securities and raised their prices with overwhelming confidence in the future!5 He mentioned that both fictive shares as well as fictive credit caused bankruptcy. In his statistical analysis of financial crises during 1800–1860, he claimed that financial crises were an inherent
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