In 1936 in the depths of a world-wide economic depression, John Maynard Keynes
described the decline of the world's financial markets as a result of playing
at a casino: "Short-term speculation with little regard to fundamentals." A
cursory examination of the current global financial crisis suggests little has
changed since Keynes' day - the conventional financial system, despite various
patches and fixes over the years, is still prone to periods of extreme
instability and abuse.
Unfortunately, the economics profession has provided little in the way of
constructive input in re-designing a more stable financial architecture.
Mainstream neo-classical equilibrium economic
analysis has not systematically incorporated elements that would account for
the conventional system's instability, let alone provide a framework for
predicting the occasional bouts of extreme instability.
Liberal-minded neo-Keynesians have done a bit better in identifying some
important precursors of the crisis, in particular, the destabilizing role of
huge private sector financial deficits in countries with large external
deficits, such as the US. The Keynesian view certainly played a big part in the
post-crisis response (fiscal stimulus) of many developed and emerging
On the conservative side, monetarists certainly raised doubts about the Federal
Reserve's abnormally low interest rates and expansive monetary creation in the
years preceding the crisis. Yet, at best, this line of analysis does not go
very far beyond the warning of an impending bubble and likely bout of
No doubt a leading monetarist, Milton Friedman, if alive today, would reaffirm
a firm belief in Say's Law of the smooth functioning of unimpeded (free)
markets. Those going down this road contend the current financial instability
is wholly the fault of too much government. As Friedman often observed, "The
Great Depression, like most other periods of severe unemployment, was produced
by government mismanagement rather than by any inherent instability of the
private economy". Lax money and credit policy of US Federal Reserve under Alan
Greenspan would be the focus of his ire today.
Monetarist offshoots such as the Rational Expectations School, while producing
good explanations of the stagflation experience of the 1970s, have not been
able to systematically incorporate irrational behavior into their models. The
lemming or investor-herd mentalities observed in recent years remain well
beyond their comprehension.
As Martin Wolf of the Financial Times has noted, of the Western interpretations
of the global financial crisis, it appears those economists working in the
Austrian tradition were more nearly right than anybody else. In particular,
they have argued that: central bank inflation-targeting is inherently
destabilizing; that fractional reserve banking creates unmanageable credit
booms; and that the resulting pattern of investment, linked not to the marginal
efficiency of capital but rather to financial returns, explains the subsequent
The best non-Western explanation of the global financial crisis is presented in
the book under review, The Stability of Islamic Finance: Creating a Resilient
Financial Environment for a Secure Future by Hossein Askari, Zamir
Iqbal, Noureddine Krichene and Abbas Mirakhor. However, this book is much more
than just an alternative explanation of the current depressed state of the
world economy - it is an elegant, sophisticated assessment of Islamic finance
as a viable, realistic alternative to the current conventional system. Perhaps
to the surprise of many, the author's assessment finds a number of similarities
between the core elements of Islamic finance and that of the Austrian School.
Certainly Islamic finance and banking institutions are thriving relative to
conventional finance. The Banker's 2009 survey of Islamic finance found the
volume of sharia-compliant assets of the Top 500 grew by an extremely healthy
28.6%, rising to US$822 billion from $639 billion, in 2008 (forecasts are that
this figure will top $1 trillion in 2010). At a time when asset growth in the
Top 1,000 world banks slumped to 6.8% from 21.6% the previous year, Islamic
institutions were able to maintain the 28% annual compound growth achieved in
the past three years.
The industry also continued to expand, with 20 new entrants bringing the number
of sharia-compliant institutions to 435, with a further 191 conventional banks
having sharia windows. The Islamic banking geographies are stretching beyond
the existing strongholds of Iran, Saudi Arabia, Bahrain, Malaysia and the UAE
to Europe, South Africa, Kenya and Indonesia.
Advocates claim Islamic finance has been immune because sharia-compliant
institutions are focused on the fundamentals, with simple products bearing
robust mechanisms for risk mitigation. Market analysts have stressed the
correlation between asset quality in Islamic institutions and their
conservative approach to risk as an insulating factor. Many conventional
bankers contend the success of Islamic finance in riding out the financial
storm can be attributed to the fact it is underpinned by tangible assets such
as real estate.
Askari et al incorporate all of these considerations into their demonstration
of the advantages of the Islamic alternative, but they also go several steps
further than most previous assessments. Prior examinations of Islamic finance
have devoted most of their attention to its ethical side - prohibition of
interest and the ban on lending for certain activities - gambling, alcohol
production and so forth. As its title suggests, The Stability of Islamic Finance
demonstrates, in addition to Islamic finance's usual virtues, its relative
stability with regard to the conventional system.
As the authors note (p 209), conventional banks fail to meet inherent stability
conditions even in the presence of prudential regulations. First, credit losses
from debt default to the depreciation of assets may create a large divergence
in relation to the liabilities that remain fixed in nominal value. Second, bank
credit has no fixed relation to real capital in the economy and bears no direct
relation to the real rate of return. Unbaked credit expansion through the
credit multiplier and further leveraging is a fundamental feature of
conventional banks. Cash flow could fall short of expectations and force large
income losses on banks, especially when the cost of funds is fixed through a
predetermined interest rate.
Third, banks caught in a credit freeze, with a drying up of liquidity. may
default on their payments. Fourth, banks are fully interconnected with each
other through a complex debt structure; in particular, the assets of one bank
instantaneously become liabilities of another, leading to fast credit
multiplication. A credit crash causes a dramatic contagion and a domino effect
that may impair even the soundest banks.
While their analysis is much too rich to detail here, suffice to say they
demonstrate that an Islamic system overcomes many of these limitations. In
particular, in an economy governed by the principles of Islamic finance, the
rate of return on equities is determined by the marginal efficiency of capital
and time preference, and is positive in a growing economy. This implies that
Islamic banks are always profitable provided that real economic growth is
positive. This establishes a basic difference between Islamic banking where
profitability is fully secured by real economic growth and conventional banking
where profitability is not driven primarily by the real sector.
A critical feature noted by the authors, and one consistent with the Austrian
ideal for banking, is the fact that the Islamic system operates on a 100%
reserve requirement. In this system, investment banking operates on a
risk/profit sharing basis, with an overall rate of return that is positive and
determined by the real economic growth rate.
Islamic banks do not create and destroy money; consequently, the money
multiplier, defined by the savings rate in the economy, is much lower in the
Islamic system than in the conventional system, providing a basis for strong
financial stability, greater price stability and sustained economic growth.
In short, the requirements of Islamic finance - lower proportions of debt to
equity, a condition that the lender share profits and losses with the borrower,
and a focus on transactions based on tangible assets - mean that Islamic banks
have not become entangled in the toxic-debt instruments that have laid waste to
many of the conventional banking giants.
In sum, The Stability of Islamic Finance has many strengths. Perhaps the
greatest one is the ability of the authors to bridge the gap between the
conventional and increasingly sophisticated global financial system and that
represented by Islamic finance. Previous attempts at contrasting the systems
largely failed because authors were strong in one area but lacked the expertise
to provide an in-depth critique of the other system. Professor Askari is an
acknowledged world-class expert in both systems and combined with his three
co-authors anchors an analytical team uniquely capable of integrating the
workings of an Islamic system into the increasingly complex global context.
Still, there are many problems confronting a wider based adoption of Islamic
financial systems. In addition to the usual West-Islamic differences over
interest, ethical roles of business etc, a number of fundamental changes would
have to take place in the way Western governments manage their economies. For
one thing, the adoption of popular Keynesian stimuluses during recessions would
be much more difficult than is currently the case. Central bank discretionary
policy would have to be abandoned for strict rules on monetary expansion.
Reserve requirements of 100% on banks would fundamentally alter the banking
business - the list goes on.
Having shown its inherent advantages over the current system, hopefully the
authors will collaborate on a follow-on book detailing how the Islamic
financial system can transition outside of its current narrow confines to be a
viable alternative to the conventional system.
The Stability of Islamic Finance: Creating a Resilient Financial Environment for
a Secure Future by Hossein Askari, Zamir Iqbal, Noureddine Krichene and
Abbas Mirakhor. John Wiley & Sons, Singapore (2010). ISBN:
978-0-470-82519-80. Price US$49.95, 256 pages.
Robert Looney is a professor of national security affairs, and associate
chairman of instruction, Department of National Security Affairs, at the Naval
Postgraduate School, California.