Creation of Money and Islamic Banks
Dr. Asad Zaman
In ancient times, alchemists searched for the secrets of turning base metals into gold. In modern times, the fractional reserve banking system has turned the dreams of the alchemists into a reality. However, the secrets of credit creation by banks are kept hidden from the general public. For this reason, discussions and controversies about Islamic banking have not mentioned this crucial issue, even though rulings about the legitimacy or otherwise of financial transaction within Islamic law depend on it.
I am familiar with two extensive discussion of the status of modern money within Sharia:
1. PAPER MONEY, Its reality, history, value and legal ruling by ‘Abdullah b. Sulayman b. Mani’, Qadi in the Makkah Court and Member of the Council of Senior ‘Ulama, Saudi Arabia. 1st ed. 1391/1971, 2nd ed. 1404/1984 Abridgement, notes & translation by Usama Hasan
2. MONEY AND ITS USAGE: An Analysis in the Light of Shariah, by Moulana Dr. Asmatullah or Darul Uloom, Karachi. Translator: Omar Javaid
Neither of these books mentions credit creation by banks, which is a central element of modern fractional reserve banking. Modern money is of two types: high powered money which is created by the central bank, and credit which is created by private banks. The difference between the two is deliberately obscured in textbooks, in order to conceal the power of credit creation by banks. However, understanding the difference is crucial to arriving at the correct rulings concerning modern money.
What is the function of banks? How is money created? Both of these questions are given misleading answers in modern economic textbooks. As a result, certain myths are widely believed. Because correct information about the nature of banks and modern money did not reach the Ulema, they have issued un-informed rulings on the basis of these myths. The two myths are the following:
1. Government creates all the money, and controls the amount of money present in the economy.
2. Banks are financial intermediaries. They collect money from those with surplus, and provide this money to investors who are in need of money.
Before proceeding to debunk these myths, it is important to pause to explain the role of money in an economy. Although there is much dispute and controversy about the issue, Keynesian macroeconomics has common-sense appeal, and has substantial empirical support. We briefly describe this theory, without entering into debates and controversies regarding the matter.
It is widely believed that all the money that exists in the modern economy is created by the government. Furthermore, the government has the capability to increase or decrease the money stock according to its will. Monetary policy is conducted on this basis: the government attempts to control the quantity of the money in the economy.
According to Keynesian macroeconomic theory, if there is too little money in the economy, this will cause a recession – there will not be enough money to carry out normal business operations, and this will lead to unemployment and loss of production. If there is too much money, this will cause inflation, since people will want to buy more and more products with the excess money, but there will be no extra productive capacity to enable more production. Thus the extra money will cause a rise in prices. In accordance with this theory, the job of the government is to keep the money supply in exactly the right amount so as to have full employment but no inflation.
A monetary policy which creates full employment and controls inflation is highly desirable. However, in order to pursue such a policy it is essential that the government should be able to control the money supply. As we shall see later, governments do not have control over the money supply, and hence cannot rectify macroeconomic problems even when they desire to do so.
The role of banks within an economy is supposed to be financial intermediation. One group of people in the economy has surplus money. The excess is deposited as savings within banks. Another group of people have need of money. These are the investors, or consumers. These people who need money borrow the money from the banks as a loan with interest. Investors play a central role in economic growth, since they provide the buildup of the capital required to increase productive capacity in an economy. Investors do not generally have sufficient private funds to undertake investment on their own. They borrow required capital from the banks, and then repay the banks out of the profits they make on their investments. In this story, banks play a vital role in financing investment and providing for economic growth.
People place deposits with banks in order to earn interest. Banks lend to investors at interest. Both of these methods are not permissible within the rules of the Sharia. How can we make the system conform to Islamic law? When this problem was presented to scholars of Islamic law, they came up with the following solutions. The bank should lend to investors on the basis of Musharka – partnership in the business enterprise. Instead of interest on a loan, they should receive a share of the profits from the investors’ business activity. Similarly, depositor should not receive a fixed interest payment. Rather they should receive a share of the Profit or Loss that the banks make as partners in the investors’ business enterprises. As a practical matter, it became clear that banks do not like the uncertainty of return in Musharka, and depositors do not like the uncertainty of profit-loss sharing. Western banks are seen as purely financial institutions, which should not do any real trading. Thus partnership in business for banks is often prohibited by law. Even when law is not a barrier, it is not customary for banks to participate in business, or to take the risks of business.
The spirit of Islamic finance is captured in the saying “Al-Kharaj bil daman” – entitlement to profit comes from bearing the liability for potential business. This maxim is systematically rejected by the capitalist financial system, which has as a fundamental principle that money is entitled to make more money without risk. Banks are an embodiment of this spirit, and are based on transactions which provide high risk-free returns. This same is offered to depositors: risk free returns on their deposits. Islamic banking developed as an attempt to find a middle way between the two polar opposites. The Islamic principle insists on business risk as the source of entitlement of profit, and rejects the idea that money can earn money. Conventional Western banks are built on the principle that money is entitled to earn money without risk, and attempt to create methods of doing so for depositors and banks.
Purely Islamic models of finance are unacceptable in the western banking paradigm. Purely western banking transactions are unacceptable Islamically. Islamic banking is the attempt to find a middle way, low risk methods of making money from money which would compatible with conventional banking and acceptable in Islamic Law. There has been a lot of discussion and controversy about this issue, as to the extent to which these compromises are permissible within Islamic law. However, our contention in this paper is that the central problem with banking is not addressed by these debates. Both those who oppose and those who favor Islamic Banking argue without taking into account the central and vital role of credit creation by banks.
The modern banking system is called “fractional reserve banking”. To understand the system, it is necessary to understand the meaning of these words. We shall see that this system allows banks to create money at will, and profit from this created money by loaning it at interest. Only the very rich can create or own banks, and thereby benefit from this system. At the same time, those who are not very rich have need of money. They are often forced to borrow at high interest rates and thereby get into a debt-trap which allows the rich to have power over the poor. This system has created great inequality, which has become popularly known as the divide between the top 1% and the bottom 99%. In addition to inequality, this system also causes a large number of harms to the economy, and is subject to continual and recurring crises. Nonetheless, the rich and powerful benefit very much from this system, and hence they propagate myths that the system is highly beneficial to all. They also manipulate textbooks and politics to ensure that the truth does not get known, and to block policies to correct injustice and improve the system to a more equitable one.
To understand the system, it is useful to go back to the origins of paper currency. Although paper currency was first introduced in China, modern paper currency has its roots in goldsmiths of England. This story is crucial to understanding the fractional reserve system, so we describe it in some detail. In fact the modern banking system is almost identical to the ancient goldsmith system to be described below.
6.1 Goldsmiths and Money Creation
Merchants and traders had amassed huge hoards of gold and entrusted their wealth to the Royal Mint for storage. In 1640 King Charles I seized the private gold stored in the mint as a forced loan (which was to be paid back over time). Thereafter merchants preferred to store their gold with the goldsmiths of London, who possessed private vaults, and charged a fee for that service. In exchange for each deposit of precious metal, the goldsmiths issued receipts certifying the quantity and purity of the metal they held in trust. Gradually these certificates became promissory notes, which would be payable to the bearer of the note (instead of being payable only to the depositor).
As long as there was confidence in these goldsmith-bankers, their certificates were just as good as gold. Instead of withdrawing gold and paying with gold, people started to use these certificates to trade. Because of the convenience of this form of trade, people started asked for bearer certificates in small denominations, and these became widely used. These certificates eventually became the paper currency that we have today. So far, there is nothing wrong with this type of trading, since every certificate is backed by gold. But now we come to the crucial twist in the story.
Once the certificates started circulating widely, the goldsmiths noticed that the gold remained with them most of the time. As a rule of thumb, they noted that the maximum demand during one year would be at most 20% of the total amount that they had on deposit. Thus they realized that they could loan out 80% of the amount without any serious risk, and make profits on it. Thus this practice was started – the goldsmith-bankers would loan out the gold on deposit to borrowers on interest. Because the gold was not theirs to begin with, they made sure that they would get it back with some profit. This required an interest-based loan. They could not use the gold to become partners in a business, since they could not tolerate any loss – the gold they were loaning did not belong to them, and had to be returned to the original owner. Thus the mode of lending was interest based loans backed by collateral. If the lender paid back, the interest would belong to the bank, and the original gold would be returned to the depositor. If the lender could not pay back the loan, the bank would seize the collateral and make even more money. In either case, the bank would make profits by loaning gold belong to others.
Taking advantage of the fact that they need only 20% of the amount of notes in circulation, the goldsmiths can create four times the amount of deposits they have in fake money. Suppose each goldsmith-banker has deposits of 100 Kg of gold. Based on the rule that they only need 20% of the amount of notes in circulation, it follows that they can create 400 Kg of credits to give as loans to borrowers. If they do so, then there will be a total of 500 Kg of notes in circulation, backed by 100 Kg of gold in reserve. This is precisely the meaning of fractional reserve: only a fraction (20%) of the gold in circulation in the form of currency notes is available on reserve with the goldsmith-bankers. Another very important thing to note about this situation is the following. ALL of the money loaned to borrowers by the goldsmith-bankers is actually created by the goldsmiths. The 100 Kg on reserve is actually the deposits of the original borrowers which remains exactly the same as before the act of credit creation. However, using these deposits as reserves, the goldsmiths created 400 Kg of credits in the form of currency notes which are promises to pay gold. This money created by the goldsmiths is what has been lent to borrowers. Thus the goldsmiths are NOT financial intermediaries – they do not take money from those with surplus and loan to those with deficits. Rather, they create money which is then lent to borrowers.
Next, we turn from ancient history to modern banking. The process by which the transition took place to get from the goldsmiths to modern banking institutions is a tangled and complex story. This story has a lot of vital insights to offer, and is important in its own right. Details can be found in Web of Debt, by Ellen Brown, and Stephen Zarlenga, The Lost Science Of Money. Nonetheless, we omit these details for the sake of brevity, and move straight to modern banking
It may surprise the reader to learn that the goldsmith system for lending out non-existent gold is identical to modern fractional reserve banking. Understanding one is the same as understanding the other. There is difference in that today the practice of creating money out of nowhere and lending it on interest enjoys the protection of laws and the government, and every effort is made to prevent the crises that it regularly leads to. Despite these efforts, banking crises continue to occur frequently.
7.1 Government Authorized Fiat Currency
There is no longer any gold behind currencies, which are now “fiat” money. They circulate because the government guarantees them and legally enforces and ensures the use of this money in all national transactions. This has been the subject of a great debate among the Ulema; does the withdrawal of gold backing affect the Sharia status of currency? What has been completely missing from this debate is the status of credit created by banks, which is of an entirely different nature. We now turn to the description of how money is created in the modern fractional reserve banking system.
In the first place, the government creates money. However, for complex reasons, the government does not directly print money. Rather the job is assigned to the Central Bank of the country. Furthermore, efforts are made to guarantee the independence of Central Banks. That is, the government cannot simply order the bank to print money according to desire and needs of the government. Central Banks decide on the amount of money there should be in circulation according to their own mandate and agenda. Typically this is done on the basis of Keynesian macroeconomic ideas. That is, there is an optimal quantity of money which will create full employment and growth, but prevent inflation. The job of the Central Bank is to print enough money to prevent recessions, but not so much as to cause inflation. Since the government cannot print money according to its needs, it has to borrow money from the Central Bank. Often it does so by taking a loan at interest. This is really strange, since the government has created the Central bank and the government has the authority to print money. The argument given for this is that if governments could print money at will, they would print huge amounts and cause money to lose all its value, in a hyper-inflation. Thus, they must be given the budgetary discipline imposed by taking loans and paying interest on these loans. This reasoning is questionable because the interest payments forward the major expenses of borrowing to the next government. The discipline is imposed by putting direct limits on borrowing by governments; this limit can also be imposed in a system where the Central Banks print money under strict rules. Central Bank independence has to be maintained and money creation has to be left to monetary experts rather than the discretion of the government.
A number of authors have recently stated that the ban on government to print money for its needs is a trick which is used by powerful private sector financiers to give private banks the privilege of printing money. It is not our intention here to go into this complex debate, which does not directly affect our topic of concern. The point of mentioning this here is that money and interest based loans are tied on a one-to-one basis in the modern economy. Central Banks print money and give it to the government or to private banks as interest based loans. Central Banks also issue Treasury Bonds which are sold to the public in order to reduce the money stock in the hands of the public. These Treasury Bonds allow the Central Bank to decrease or increase money supply buy selling or buying the Bonds from the public and private banks. This is also an interest based operation. In other words, all of the methods by which money goes into circulation are intimately tied to interest based debt. Under modern banking systems, the money issued by the Central Bank takes the place of gold. The other type of money in the system is the credit created by banks. We now turn to the role of private banks.
7.2 Credit Creation By Private Banks
Different economies have different levels of “financial penetration”. We will use this term to talk about the spread of banking institutions within the economy. In the rich countries, banking institutions are widespread, and most people keep most of their money in banks. The vast majority of people have bank accounts. In contrast, in most Islamic countries, most people do not have bank accounts, so the penetration of banking is low. Most money is kept as cash holdings in homes and stores, instead of in bank accounts.
In countries with high financial penetration, most of the money in circulation is kept in banks – much like people used to keep most of their gold on deposit with the goldsmiths. Money issued by the Central Bank is called High-Powered Money, or the Monetary Base, or Narrow Money. This money is actually backed by notes issued by the Central Bank, even though notes are only printed on an “as needed” basis. Consider now a situation where a private bank – say Mozoon Bank -- acquires PKR 400,000 as deposits. Currently the cash reserve requirements in Pakistan are 4% daily. This means that banks are required to have 4% of the amount that they give out as a loan to borrowers in their daily cash reserves. This means that Mozoon bank can give a loan of PKR 10,000,000 (!) on the basis of its meagre reserves of 400,000 which it has in the form of cash deposits. To consider what this means, suppose that Mr Dawood, a rich businessman comes in and asks for a loan of 10,000,000 from the bank. Note that Mozoon bank has only 400,000 in cash available. Nonetheless, the bank will happily oblige, and open an account in the name of Mr. Dawood, and create a book-entry (or a computer entry these days) stating that Mr Dawood has a credit of 10,000,000 which Mozoon Bank. It will provide Mr Dawood with a checkbook, and he will be able to write checks on this account to pay any third party he wishes to pay. In this transaction, the bank has created the money PKR 10,000,000 in the process of making the loan. Note that the bank is not lending money it has, as financial intermediation required. Rather the bank creates money for loans. Suppose that the bank charges 10% per year interest. Then it will make a risk free profit of PKR 1,000,000 without any basis for justifying this profit – the bank did not even have the money it lent to Dawood! We note here that Islamic banks also operate within the fractional reserve banking system, so that they also follow exactly the same process. If the bank gives Mr. Dawood the loan as a Murabaha, Mudaraba, or Musharka transaction, it is still the case that the bank manufactures the money lends out of thin air, by the stroke of a pen. This aspect of Islamic banking has not been taken into account by the Islamic jurists who have considered these issues.
7.3 How does this system work?
Next the question immediately arises as to how this is possible? How can such a system work? Will not the system collapse immediately when Mr Dawood demands his 10,000,000 in cash, while Mozoon bank only has 400,000 available to give him? We now provide the complex answer to this question. Note that the system has evolved for centuries, and bankers have developed a lot of strategies to prevent such problems. We will just discuss the simplest and most basic of them. Nonetheless, all such strategies fail from time to time, because such a system is inherently unstable. There have been hundreds of banking crises in the past thirty years or so.
Firstly the ratio of reserves kept by the bank varies from country to country, depending of the level of financial penetration. In countries where financial penetration is high, and banking is widespread, the ratio can be very small, even 1% or less. This means that with $1000, the bank can make a loan of $100,000. In Pakistan, financial penetration is low, so banks will in general keep a lot more in the way of reserve ratio. The 4% is the legally required minimum cash reserve ratio, but the bank will generally keep much more than that in Pakistan. In June 2015, the reserve money in Pakistan is listed as PKR 3.14 Billion, while Broad Money is listed as PKR 11.3 Billion. Thus the reserve ratio is about 28% which is very high, far above the minimum 4% required. In general, in countries where most of the money is kept in banks, banks can work with very low reserve ratios, while in countries where people keep a lot of cash, and relatively little money is kept in banks, banks need to maintain high reserve ratios.
Suppose that the required reserve ratio is 5%, and there are 10 banks in the country. Suppose that each bank has PKR 500 in form of cash deposits from customers. Since the bank needs to keep only 5% cash against demand deposits, it can create demand deposits upto PKR 10,000. Thus, it can give loans of upto 9,500 while only having demand deposits of 500 in cash! After all ten banks have given loans of 9,500, there will be 95,000 of bank created money in the economy, and 5000 of real cash money in reserve in the banks. So now the real money (created by central bank) is PKR 5000, while the fake money created by private banks is PKR 95,000. I am calling this “fake money” because it has no real existence except as entries on the books of bankers. At first sight, this seems impossible, just like the alchemists task. How can the banks manage to service loans of PKR 100,000 when they have cash reserves of only 5,000?
To solve this puzzle, it is best to start with a highly financialized economy, where people keep most of their money in banks. Suppose that people who receive these loans, use them up to make payments to various clients. But the payments are all made in the form of checks, which are now deposited in some other banks. So at the end of the day, when all the borrowed money has been spent, PKR 95,000 of fake money is now lying in different banks from the ones which originated the loan. For example, suppose that Mozoon Bank made created an account worth PKR 95,000 for Saith Dawood. Saith Dawood wrote checks on the account and these were deposited in different banks by those who received the checks. So at the end of the day, PKR 95,000 was divided up among ten banks as credits payable at Mozoon Bank. Some portion of this money would be deposited at Mozoon Bank itself – this portion can simply be cleared by transferring an electronic entry from Saith Dawood’s account to someone else’s account, without needing any cash. Other portions would be at other banks. Now note that all ten banks have created money, and all the customers have written checks on their accounts. Thus all of this credit is being re-deposited from one bank to another bank. At the end of each day, something called “Inter-Bank Clearing” takes place, where all the transactions between banks are totaled up. Suppose that there are several checks totaling 50,000 written on Mozoon Bank which have been deposited at Mahboob Bank. Similarly, there are checks totaling 80,000 written on accounts in Mahboob Bank which have been deposited at Mozoon bank. So the net result is that Mahboob Bank owes 30,000 to Mozoon Bank. All of the thousands of transactions are totaled at the end of the day to come up with a total figure for each Bank. For example, Mozoon Bank has a credit of 30,000 receivable from Mahboob Bank, and another credit of 20,000 from Masroof Bank, but it owes 25,000 to Majboor Bank, and 60,000 to Mashghool Bank and so on. The sum total of all credits and debits at Mozoon bank will be the total credit or liability of Mozoon bank. This can be positive or negative. Let us consider the extreme case where all of the money in the account flowed out of Mozoon and nothing came back. In this case, Mozoon Bank will end up being liable to pay 95,000 Rupees which it has created to the other nine banks in the system. Each of the other banks has some portion of this 95,000 as credit entries in their accounts, payable by Mozoon Bank. Now there is regular and routine Inter-Bank Borrowing. If the cash amounts held at Mozoon Bank (only 5000 Rs.) are not enough to pay for the 95,000 it owes the other banks, it can borrow this amount from the other banks at standard fixed inter-bank borrowing rates, which are always lower than the rate of interest being charged on loans. Thus Mozoon Bank has given loans of 95,000 to different people at 10%. Now it borrows this amount from the banks where the money was deposited at 5%. This is called over-night borrowing, because this amount is borrowed only for one night. The Mozoon Bank still makes a handsome 5% profit on an initial investment of nothing – since it created the 95,000 Rupees it lent out of nothing. Usually, money will flow in different directions on a daily basis. If Mozoon Bank did not receive any deposits today, it will receive many deposits tomorrow. What it borrowed at 5% on one night will be lent out to other banks at 5% on other nights. In any case, the system will function because as long as the artificial money created by banks remains within the banks, and the banks have an easy automatic inter-bank borrowing system, they can trade electronic entries with each other, and have no need of cash. Thus this magical money creation from nothing works fine as long as all the money remains within the family, in a highly financialized economy.
What happens if there are leakages? Some of the money flows out of the banking system? There are three different levels of such leakages. For small day to day cash withdrawals, the cash reserves on deposit are enough. In fact, they are meant for this purpose. People withdraw cash, make cash payments to others, and eventually the cash may get re-deposited into the bank. For larger cash withdrawals, there is the mechanism of inter-bank borrowing. Banks may borrow cash reserves from other banks. Because of random flows of cash into and out of the system, some banks have excess reserves while others have shortfalls. Those with surplus can lend to those with shortfalls. But the worst cases cannot be handled in this way. For example, suppose that Mozoon Bank creates an account of PKR 95,000 for Saith Dawood in order to give him a loan. Saith Dawood walks into the bank and demands the full amount in cash. The bank has only 5000 in cash available, and all ten banks have total cash of 50,000 between them. So this demand cannot be met by inter-bank borrowing.
This is where the Central Bank comes in. The Central Bank is the lender of the last resort, and is legally required to provide liquidity to banks in crisis situations like this one. Thus Mozoon Bank will borrow the money from the Central Bank as an overnight loan, payable at a low rate of interest. Central Bank is authorized to print money as required for these loans, so Mozoon can actually get cash amounts in order to give to Saith Dawood. Now this cash money comes into circulation, and goes out of the banks. Eventually, this money will be put back into the banks, enabling the banks to repay the cash loans to each other and to the Central Bank. The interest rate paid on these loans is much lower than the interest being charged to Saith Dawood. So when Dawood repays the original loan in cash, together with interest, the bank can easily repay all of the loans that it took to finance cash payments to cover its deficits in the interim period. Mozoon Bank will keep borrowing overnight, from other banks and the Central Bank, until the time that incoming cash payments from loans with interest cover up its deficits.
There have been two important reasons which have motivated Muslims to create Islamic Banking. One is that many Muslims keep their money in Western style banks and earn interests. There are no convenient alternatives available. So the Ulema thought that we should provide them with an alternative in order to prevent them from falling into the Haraam. However, we have seen that Islamic Banks also operate on the fractional reserve banking principle. The business of the bank is the creation of money and the giving of it on loan to earn a profit. Whether the profit comes in form of interest, or in the form of Musharka shares, this does not change the fact that the bank loans money which it does not have. It borrows money to pay for this loan on an as needed basis. This does not appear to be a legitimate Islamic method.
The second reason why many Muslims have sought to construct an Islamic Banking system is the supposition that financial institutions are an important reason and basis for the economic strength of the west. In fact, many in the West have made such claims and argued that banking and financial institutions have enabled the advances in the West, and that Muslim countries have remained poor and backwards because they lacked such institutions. Muslims believed these arguments and became motivated to create an Islamic alternative to banks.
The Banking system has been extremely harmful to western economies. It has created an extreme concentration of wealth in the hands of a very few people. According to recent calculations, the top 80 wealthiest people now own half of all the wealth on the planet. This number keeps getting smaller as the concentration of wealth increases. With so much wealth, the wealthy have been able to buy up newspapers, politicians, other types of media, and ensure that only news favorable to the system is published, and that only policies favorable to the continuation of the system are carried out. So the reality of the system is very different from what is commonly written about it and widely believed. Below we list briefly some of the major problems with the system.
8.1 Income Inequality, Financialization & Secular Stagnation
As we have shown in figures above, banks can make a lot of risk free money with very little cash, by using the process of credit creation. With fractional reserve requirement of 5% cash deposits of PKR 500,000, banks can make loans of PKR 10,000,000 at 10% interest, and make 1,000,000 in one year. In Pakistan, banks hold reserves of 30%, so they can only create credit about twice what they have. So a bank with 500,000 can give loans of 1,000,000 and make 100,000. Still, a 20% return with zero money invested is wonderfully easy earnings. Note that these earnings are only available to the wealthy, who have enough money to open up a bank. This requires about 70 crores of Rupees in Pakistan, and even larger amounts in rich countries. Thus the wealthy have access to a means to create money, while the poor must borrow money and become indebted to the rich. The effects of this highly unjust and inequitable system have been traced by several leading authors in the recent times, because it has led to massive and increasing inequality over the last three decades. For example, Piketty has documented increasing concentration of wealth in his famous and extremely popular book: “Capital in the Twenty First Century. “ Similarly Stiglitz has written about the rising inequality and its harmful effects in “The Prices of Inequality.”
There are many statistics and graphs to show how inequality has become extremely high, and has been increasing in since 1980’s. There is an interesting question of why did this start in the 1980’s. Very briefly, unregulated excessive money creation by the banks led to the Great Depression of 1929, which cause great damage to all the wealthy nations of Europe and USA. After the Great Depression, very strict and stringent banking regulations were created to prevent mis-behavior by banks. This led to about 50 years of increasing equality. The wealth and income shares of the top 1% started to decrease, and that of the bottom 90% started to increase. The wealthy did not like this, and plotted to eliminate the restrictions on banks. In 1980’s they got the chance to do so; some have said that this became possible only because those who have lived through the Great Depression had died out by this time.
There were some minor economic disturbances caused by an oil crisis in the 1970’s. The economic problems were blamed on regulations, and Reagan in USA and Thatcher in UK started to de-regulate the banking industry. For 50 years there had been no banking crises because of the regulations. As soon as de-regulation started, banking crises started to occur, and income inequality started to increase. In 1999 and 2000 two major laws were passed which removed all of the restrictions on banks that had been created in 1935 Banking Regulation Act following the Great Depression. Very soon afterwards, in 2007, we had the Global Financial Crisis, which has been followed by the Great Recession. However, there is one big difference between the two. This time, the wealthy elites were very well prepared. They knew that a crisis was coming and they managed it so that after the crisis, no new banking regulations were passed. They bought out key politicians, and passed bills so that the Congress paid for all the losses of the banks in trillions of dollars, but did not help the ordinary people who lost their life savings, homes and jobs following the crisis. As a result, the Global Financial Crisis actually helped the super rich, instead of hurting them.
According to recent figures, the amount of wealth in the hands of the top 0.1% ( top 1 out of 1000 people) is more that the total in the hands of the bottom 900. The massive and increasing inequality is due to the banking system which allows the wealthy to earn very high returns on their money without any risk and without doing anything of value, or contributing to the society. At the same time, those who are not among the very wealthy must work for a living. The returns to working are not as high as the return to wealth, so in the race for accumulation, the wealthy keep getting richer, while those who provide services or produce things of value keep lagging behind. This accounts for what has been called “secular stagnation” over the past thirty years. This is a great mystery to economists, who ignore the inequality as a factor in the explanation. When the real sector has low returns and the financial sector has high returns than the money flows to the rich, solely on the basis of their ownership of wealth. When money is not given to reward productive activities, than productivity stagnates, as has happened in western economies over the past thirty years or so.
8.2 The Debt Weapon
Debt has been used as a weapon to enslave people for a long time. There is a narration by Bilal R.A. that a Jew gave him loans until they mounted to a large amount, and then threatened to capture him as a slave unless repayment was made very quickly. One of the reasons for the downfall of the Ottoman Empire was the huge debt that was contracted from Europe for building an extremely expensive palace – the Dolmabahce Palace. When the debt could not be repaid, the Europeans demanded and obtained taxation privileges within the Ottoman Empire, effectively making them rulers within certain areas. The same systems continue to the present day, both on an individual and personal level, and also on an international level to enslave entire countries.
Everyone needs money. However, according the method by which money is created, especially in advanced economies, money is only available from banks. Furthermore, banks only give money on interest based loans. The product manufactured by banks is money, and sales are made as interest based loan. Therefore it is in the interest of banks to popularize interest based loans, and to make people take such loans. Previously, people used to save up money to buy consumer goods. However, banks have popularized installments sales and credit cards, by which people take loans to buy goods, and pay bank in installments with interest. Similarly, banks give loans to students, who have to pay back when they get jobs. Currently the students are under a trillion dollar debt obligation in the USA, while the job markets have collapsed. Effectively, the banks have enslaved the students, who will work to pay off their loans for the rest of their lives. In the lead-up to the Global Financial Crisis, the banks offered loans to people to buy houses with, knowing that the people would not be able to pay the installments. After putting up their life savings as down-payment to the banks, their homes were seized when they found that they could not pay the installments. People lost their life-savings and their homes, and banks ended up with the possession of the homes and the money.
Atif Mian and Amir Sufi in their book called The House of Debt have explained how the expansion of debt, caused by banks, led to the Global Financial Crisis, and also explained the tremendous injustice of the interest based debt contract, which puts all the burdens on the weaker party and none on the stronger party. On purely economic grounds, they have recommended the elimination of debt from the system.
8.3 International Trade & Debt
The same system which works to enslave the poor people within a country is also used to enslave entire countries. For international trade, fiat currency does not work. A country can enforce legal acceptance of its currency within its own territory, but it cannot purchase products of other countries by giving them just paper. Something valuable is required for exchange. The Gold Standard was used for international trade prior to World War I for this purpose. Currencies were backed by gold. Even when internally, people were not allowed to use gold (they were required legally to use currency instead), foreigners could cash currency for gold under certain conditions. After World War I, the UK and many European countries became heavily indebted; they had spent huge amounts of money in the War. As a result, it was impossible for them to pay Gold for their currencies and they went off the Gold Standard. An effort was made to return to the gold standard but that did not work well, and the Second World War destroyed all possibilities of a return to Gold. As a result, the Bretton-Woods agreement was made, which created a new architecture for stabilizing currency values, without gold backing. At that time, the US had the largest economy, untouched by the World Wars, and the US Dollar was officially backed by gold. The dollar then became the reserve currency. Countries started using dollar in place of gold to back up their currencies. One reason for this was that dollars could be created by private banks and loaned to countries, unlike gold. This situation was enormously favorable for the USA. Effectively, the USA acquired the capacity to print gold from nothing. This led to global dominance of the USA.
The USA started printing dollars in great excess to finance the Vietnam War. It banned internal use of gold by USA citizens, requiring them to use dollars only. However, foreign holdings of dollars became so great that the USA was forced to announce that it was going off the gold standard in 1971. This led to a breakdown of the Bretton-Woods system. The new system is now dollar based, but dollars do not have any gold backing. This system is tremendously favorable to the US. Unlike any other country in the world, the USA can print dollars without any limit, and purchase real goods and services from the rest of the world. It can also print dollars and give them as loans, and collect interest from the rest of the world.
The Iraq war could not have been carried out by the USA if it did not have the ability to tap nearly an unlimited source of funds, since the war cost several trillion dollars. The sum is so large, it is hard to imagine it. It is equivalent to five years of income of the bottom billion, the poorest people on the planet. It is enough to feed, house, clothe, educate and take care of health needs of the entire planet for one hundred years. This was free money, creating just by printing it. This printing of paper allows the USA to purchase real and valuable commodities, such as oil, minerals, farm products, and others from all over the world. They can also purchase human beings, paying the highest salaries to employ those with valuable skills and abilities in order to create products of high value within the US economy. Malaysian ex-president Mahathir Mohammad stated that if the Oil Economies would refuse to accept dollars in payment for their oil, and demand payment of something of real value instead, this would strike a great blow at the international political power of the USA. Of course, this power is precisely what prevents the oil economies from taking such a step.
Loaning the money to others traps them in debt, ensuring that they obey policies dicated to them. For example, ex-Nigerian president Obasanto said in 2000 that “we had borrowed only about 5 billion upto 1985. Since then we have paid $16 billion, but $28 billion still remains in interest on the original debt.” Today the poorer countries of the world pay around $1 trillion in repayments of debts contracted by them earlier. The Pakistani budget for the year 2015-16 is around PKR 14 billion. Of this amount, around 7 billion is for repayment of debt, or interest on debt. The expansion of debt is an essential feature of the current financial system. This system continues to operate because most people are ignorant about the nature of the system: how it works, who is helped by it, and who is hurt by it. The powerful take advantage of this ignorance to present this system as the only possibility and as an excellent and useful system with many benefits. Many alternative systems which provide much greater justice, and much better results for the poor are available. However, our ignorance blinds us to the existence of alternative, and we quietly acquiesce to the workings of the system without any real knowledge of the effects, because we swallow the propaganda being made in its favor.
We provide some historical details of the major crises produced by the fractional reserve banking system, to show how badly it works. There have been hundreds of banking crises all over the world, and they share common features. By learning the true history of the banking system, we will understand that this banking system is not something that we want to Islamize. We will also understand why the laws of Allah were designed to protect us from using such harmful and unjust systems. We will also understand why no such institution existed in the course of Islamic history, even though Muslims carried out international trade and had an excellent global economy which produced tremendous wealth and prosperity for all.
The system of capitalism based on investments financed by bankers leads to a regular cycle of booms and busts; these have been called business cycles and are the subject of study in economic theory. The basic reason for these cycles is simple. Banks create credit in large quantities in a booming economy, which eventually causes a crash. Among many books devoted to the study of this phenomena, one with a great deal of historical detail is Kindleberger’s Manias, Panics, and Crashes: A History of Financial Crises. The shows the important role played by expansion of credit given to finance speculation in leading to panics and crashes.
9.1 The Great Depression of 1929
After the USA Civil War in the 1860’s destroyed the semi-feudal agricultural economy of the South. This created an economic expansion led by the industrial states of the North. Wealthy Europeans started investing heavily in railroads in the USA, leading to rapidly increasing investment and stock prices. The boom created a mania of further speculation financed by easy money created by European and American banks. This was followed by a panic, leading to a financial crash in 1873. Similar pattern of activities led to repeated crises and recessions in 1893, 1900, 1902, 1907, and 1911. In this era, there were only private banks, and no central bank. From our discussion of fractional reserve banking, the private banks cannot handle very large demands for cash withdrawals without a central bank. This mean that they are forced to keep fairly large reserves, which limits their power of money creation. Regardless of this cautionary measure, the basic principle of fractional reserve means that if there is a panic, and all people demand their money from banks, the banks will never have enough to fulfill their demands. This is why there are frequent panics and crises in the capitalist financial system.
The private banks wanted to create a central bank, on the pattern of England, which would provide them with needed cash in emergencies. According to Congressional testimony, the banking panic of 1911 was engineered to frighten people into supporting the creation of the Federal Reserve Bank. This was successful, and the Central Bank was created in 1914. The hope was that a central bank would be able to prevent banking crises in the future. However, exactly the opposite happened. The story is of great importance.
Creation of the Federal Reserve Bank in 1914 created confidence in banks that they could now expand credit without limits. In case of emergency needs for cash, the Federal Reserve Bank was required by law to provide them with loans. The product of the banks is interest based loans, and the banks set out to create an environment where more and more people took loans on interest. The concept of installment sales was invented and popularized so that people could buy expensive consumer items like automobiles by taking a loan and repaying it with interest in installments. Credit easily available at low interest rates was used to buy property, stocks, consumer goods etc. This led to a period called the roaring 20’s where prices of land and stocks went up greatly. This further contributed to the attraction of taking a low interest loan to buy, because large profits could be made due to rapidly rising prices. Eventually stock prices increased far beyond sustainable levels, and some people decided to cash out. When many people started selling stocks, there was a crash in prices. The Dow-Jones Industrial Average, an average overall measure of stock values based on the stock prices of thirty leading U.S. companies, was at an all-time high of 353 on October 10, 1929. It then dropped for the next four years, reaching a low of 41 on July 8, 1933. Not until 1954 did the Dow-Jones average again climb to 353. Many of the banks had invested in these stocks directly, and were forced to declare bankruptcy.
The stock market crash of 1929 set off a worldwide chain of bankruptcies and defaults. Factories and businesses closed, workers plunged into poverty in millions, houses and farms were repossessed, crops which could not be sold were dumped into the sea. By late 1932, 11,000 of the United States’ 25,000 banks had collapsed, manufacturing output had fallen to half its 1929 level, and some 30% of workers searched in vain throughout the country for jobs to support their families. Farmers unable to sell their produce, unable to repay their bank loans were evicted and with their families joined the human flood of misery. John Steinbeck’s moving novel, The Grapes of Wrath, provides a vivid depiction of the era.
9.2 The Consequences of the Great Depression
In the aftermath of the Great Depression (GD 29), many people understood the problem with credit creation by banks. Leading Economists created the “Chicago Plan” which would bank fractional reserve banking and create a system based on 100% reserve banking. The power of money creation was to belong to solely to the government. This is very much in line with Islamic principles. As Moulana Asmatullah has described in detail, it is unanimously agreed that only governments have legal rights to create money. For individuals to do so would be considered as an unlawful act (fasad fil arz). This plan was created and circulated in 1933. It was a very radical reform of the system, and was successfully blocked by the bankers and financiers, because it completely eliminate their powers of creating money. However, in 1935 a Banking Reform Act was passed which did put a lot of restrictions on banks. In particular the Glass-Steagall Act prohibited banks from buying stocks or doing any other kind of speculation.
In addition to strong regulation of banking, economic theory was also radically changed by the GD of 29. Prior to GD 29, economists believed that best results are obtained by leaving free markets alone, without any interference from the government. However, it became obvious that free markets could lead to widespread and persistent unemployment for more than a decade. Newly invented Keynesian economic theory provided a justification for government interference in the labor market. In particular, the government was made responsible for providing jobs, and unemployments benefits to ease the difficulties of common people in the labor market. The regulation of banking, and provision of support for laborers worked very well. For about fifty years from 1930 to 1980 there were no banking crises in the USA. There was general and widespread prosperity. The distribution of income improved as the wealth shares of the poor improved. The graph below shows the trends of the income distribution for the rich and the poor.
The wealthy elites were unhappy with this state of affairs, especially since the wealth share of the rich was declining over this period of time. They formulated a deep and insightful strategy to change the system. Milton Friedman was one of the key architects of this strategy. His view was that “Only a crisis – actual or perceived – produces real change. When that crisis occurs, actions that are taken depend on ideas that are lying around.” The group of free market economists generated research to favor free markets and oppose Keynesian ideas, and also wrote books and created societies of people who would be in favor of de-regulating the banks. They did not try to implement change quickly, but patiently waited for a crisis. Detailed analysis of the strategy pursued by the free market economists is provided by Alkire and Ritchie in “Winning Ideas: Lessons from Free Market Economics”. In addition, Naomi Klein in The Shock Doctrine: The Rise of Disaster Capitalism provides a historical analysis of the adoption and impact of free market ideas all over the world. She also make the same point, that adoption of free market ideas depends upon a crisis – a shock – which temporarily disturbs and disorients people, and allows the implantation of radically different ideas.
The opportunity to create change occurred when the Oil Crisis in the 1970’s created the phenomenon of stagflation – high inflation combined with high unemployment. This was not possible according to Keynesian theory, and Milton Friedman provided alternative theories which could explain the phenomena. The group of free market economists exploited the opportunity created by the economic crisis to blame everything on regulation of banks and Keynesian economics. Contemporaries remarked that success of the free market economists was partly due to the fact that the generation which had lived through the Great Depression had died out, and the memories had faded from view. Friedman and his group offered quick and easy answers to the economic problems created by the oil crisis, by blaming all problems on big government and regulation of banking and business. They succeeded in convincing the public of their views, and as a result, Reagan in the USA and Thatcher in England were voted into office. This is known as the Reagan-Thatcher era because both had similar platforms. They were for free markets and deregulation. This is what set the stage for the first new banking crisis after the Great Depression.
9.3 The Savings and Loan Crisis of 1980’s
Reagan announced that he would take major step toward the de-regulation of America's financial institutions. The first step was the Garn-St Germain Act of 1982, which de-regulated the Savings and Loan (S&L) Industry. This was a specialized sub-sector of banking which provided financing for home purchases. Reagan believed that outmoded regulations left over from the era of the Great Depression, were preventing thrifts from competing in the complex, sophisticated financial marketplace of the 1980s. According to him, the Garn-St. Germain bill was "the most important legislation for financial institutions in 50 years," he said. It would mean more housing, more jobs and growth for the economy.
As a matter of fact, the de-regulation of S&L led to the biggest banking crisis since the Great Depression. The Depression-era regulations had created barriers to prevent speculative behavior by banks. Barriers to sales and purchases, and to the entry of new S&L’s were removed. Upon removal of these barriers, many old fashioned S&L’s were bought out, new S&L’s entered the market, and managers of many existing S&L’s were changed. The idea was that this would bring dynamism into the industry. This is indeed what happened. The cash reserves available at the S&L were used to create large amounts of credit according the standard fractional reserve banking principles. The dynamic new industry started speculating heavily with newly created credit. This is a standard problem with credit creation by banks. The banks are gambling with money created by themselves, backed by reserves belonging to depositors. They lose nothing if the gambles fail, but the depositors lose their money. Alternatively, they keep all the winnings if they succeed. In this case, for various reasons, a lot of the gambles failed, which led to a huge financial crisis.
Almost one third of the S&L institutions (1,043 out of the 3,234) failed in the period from 1986 to 1995. In 1996, the General Accounting Office estimated the total cost to be $160 billion, including $132.1 billion taken from taxpayers. Nassim Nicholas Taleb (in his book entitled The Black Swan: The Impact of the Highly Improbable) has calculated that the loss was more than the total profits of the entire banking industry in the fifty year period from the Great Depression onwards.
9.4 The Vital Role of Disinformation
The Garn St Germain Act was the first step in a comprehensive plan of de-regulation of the entire banking and finance industry. It went wrong very badly, creating a disaster. Documenting the fact that de-regulation of the Savings and Loan industry led to disaster is not difficult. Several books provide details of how this happened:
Pizzo, Stephen, Mary Fricker, and Paul Muolo. Inside job: The looting of America's savings and loans. McGraw-Hill Companies, 1989.
Mayer, Martin. The greatest-ever bank robbery: the collapse of the savings and loan industry. C. Scribner's Sons, 1990.
Black, William K. The best way to rob a bank is to own one: How corporate executives and politicians looted the S&L industry. University of Texas Press, 2013.
Scheer, Robert. The Great American Stickup: How Reagan Republicans and Clinton Democrats Enriched Wall Street While Mugging Main Street. Nation Books, 2010.
Day, Kathleen. S & L Hell: The People and the Politics Behind the $1 Trillion Savings and Loan Scandal. WW Norton & Company, 1993.
What is extremely important to note is that the mainstream accounts do not make any mention of the de-regulation and the Garn St Germain act as the cause of the S&L crisis. Even the Wikipedia article, which usually manages to present a neutral point of view, provides a long list of causes for the S&L crisis, without mentioning Reagan or de-regulation of the industry.
This kind of re-writing of history is crucial to the success of free market economists. If the link between de-regulation of S&L and the S&L catastrophe had been clearly seen by the public, the moves for further de-regulation would have been prevented. However, by blaming S&L crisis on other forces, the free marketeers could pursue their agenda of enriching the wealthy. This is one of the key lessons from Naomi Klein. The free market creates disaster after disaster, but the media portrays these disasters as great successes.
In fact, it appears that the free market economists and their backers, the wealthy businessmen, had learned their lessons from the Great Depression. Anticipating that their policies would lead to a popular backlash, they had created research institutes, funded scholarships for bright students to ideologically oriented universities, and bought out the media. All this was easy to do because of the power of creating money. In particular, concentration of ownership of the media increase greatly in the era of de-regulation so that at the moment, only about seven companies own the vast majority of media in USA and Europe. This permits fairly complete control over the public opinion, at least in the USA. Similarly, heterodoxy has been stamped out of the universities so that views of economists which are different from the mainstream orthodox theories are not available to the vast majority of students of economics.
9.5 The Global Financial Crisis of 2007
The third major crisis cause by banking and the financial industry was the Global Financial Crisis (GFC) of 2007. This followed the typical pattern of banking crises all over the world, not just the two big ones described above. The first step was additional de-regulation. Without learning any lessons from the S&L crisis following the de-regulation done by the Garn St Germain act, the effort to remove all restrictions from banking continued. A landmark success was achieved in 1999 with the repeal of the Glass-Steagall act which prohibited banks from making speculative investments. A further great step was taken in 2000 with the Commodity Futures Modernization Act, which put many types of transactions out of the purview of legislators. In effect, the banks were permitted to gamble, and also they were not accountable to anybody for this gambling. The results were exactly what one would expect.
The banks started extending credit for mortgages. Also, they started selling these mortgages as “collateralized debt obligations” to other financial institutions. This new type of financial instrument proved to be very popular on the market. Many buyers were available. As a result, billions of dollars poured into the purchase of mortgages. It became very easy to get a loan to buy a house. When everybody started buying houses, the prices started increasing rapidly. This made purchases even more attractive, and attracted even more money into the market. Because of de-regulation of banks, vast amounts of money could be created and made available to borrowers.
Many people who did not have proper qualifications in terms of wealth and assets also started to buy houses. In the regulated industry this would not have happened. This is because banks would not have given loans to people who were risky prospects for repayment of the thirty year mortgages. However, in the new de-regulated market, this became easily possible. First there was the insurance industry, which would provide insurance upon payment of a small premium. In return, they promised to pay on behalf of the mortgagor. This made it safe to give loans to risky borrowers. Secondly, the mortgage itself could be sold to third parties, and so it did not matter whether or not the borrower could pay in the long run. Thus banks started to use deceptive practices to overlook problems with home buyers, and would sell houses to almost anyone who could put a down-payment and an insurance payment. Ultimately the market collapsed because many people were unable to pay the installments and defaulted on the loans.
This is the typical pattern where excess money creation leads to wild speculation, increasing prices and ultimately collapse. An important element in this pattern is the ability of banks to create money from nothing. This allows rapid increases in money to pour fuel on the fires of speculation.
The Global Financial Crisis caused massive damage to the world economy which continues to this day. In the USA millions of people lost their homes and their life savings when their homes were re-possessed by the banks. The levels of homelessness and hunger in the USA rose to levels not seen since the second World War. Because millions lost jobs and income, the demand for consumer goods declined, and many factories had to close down. As a result many people not involved in buying or selling homes also suffered. High levels of unemployment continue because assets of middle class and lower class have been wiped out, and this has substantially reduced the aggregate demand, leading to low levels of production and employment. At the same time, the wealthy elite were very well prepared for the crisis. They prevented the Congress from enacting any restrictions on the banking industry. In fact, the opposite was done. Trillions of dollars was given to the failing banks to make up for their losses due to the crisis. As a result, while the crisis caused great damage to the bottom 99%, the top 1% only gained from it. The banking system continues unchanged, without any restrictions to prevent future problems. As a result many economists have said that the next crisis is only a matter of time, since no changes have been made to the system.
In the previous section we discussed three major banking crises which destroyed the lives and the life savings of millions of people, while enriching the rich. Ever since the de-regulation movement started in the 1980’s, there have been hundreds of banking crises all over the world. All of these crises have the same cause: fractional reserve banking. When the bank issues credits upon money that it does not have, then situations arise when it cannot pay the demands that are made upon it. If we look at the benefits from banking, and compare them to the costs, it is very clear that on the whole the Western world has come to a great deal of harm as a result of this banking system. It is very clear that we would not want to have an Islamic Banking system that works in a way similar to the Western one.
The question arises: why does the Western world continue to use the system, and to advocate it forcefully, and to sing its praises, when it has suffered so much harm from it? To answer this question we must clearly differentiate the interests of the top 1% from the bottom 99%. While the bottom 99% is very much harmed by the system, the top 1% benefits tremendously. All of the money created goes to the wealthy, without any work at all, since that is the capitalist principle that money earns money without risk. The impoverishment of the bottom 99% is also to the advantage of the rich. This allows them to provide debt to them and thereby enslave them in chains of interest repayments. Today, the entire third world (the poorer countries) owe a tremendous debt to the richer countries. Every year, money in the amount of about a trillion dollars goes from the poorest countries to the richer countries of the world as repayments of interest on previous debt. At the same time, it is said that the rich countries provide “foreign aid” to the poor countries and help in their development. This is just one illustration of how the capitalist system systematically deceives people into believing things which are the exact opposite of the truth. One of the leading capitalists, Henry Ford said that “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
So far, the Islamic countries have been saved from this system by a strict adherence to Islamic laws, which prohibit banking in its pure form. The vast majority of Muslims do not have bank accounts, mostly because they are too poor. However, the invention of Islamic Banking makes it possible for the tiny wealth elite to exploit the population of the Islamic countries in the same way that the bottom 99% are exploited in the West. Thus this methodology has been eagerly adopted by Western Banks. It is estimated that about 75% of the current volume of business of Islamic Banks is in the hands of Western Banks – about 15 Billion Dollars out of 20 Billion. London has announced its ambition to become the center for Islamic Banking and many European countries are eager to encourage this development. Obviously these people are not motivated by the idea of service to the Ummah, but by the profits that they can make from exploiting the Ummah.
We may end this article with the following quotation from an experience Central Banker at the heart of the Western banking system. Lord Mervyn King, who was the governor of the Bank of England from 2003 to 2013 said the following about the banking system:
“Of all the many ways of organising banking, the worst is the one we have today. ... Change is, I believe, inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crisis. This crisis has already left a legacy of debt to the next generation. We must not leave them the legacy of a fragile banking system too.”
Outlines of an alternative to this system have been sketched in my paper on An Islamic Version of the Iceland Plan for Monetary Reform. This is available from: http://ssrn.com/abstract=2593863