Menu
Home
Log in / Register
 
Home arrow Business & Finance arrow The art of RF (riba-free) Islamic banking and finance
< Prev   CONTENTS   Next >

CHAPTER 6. Towards an RF Monetary Discipline: The RF Commodity Indexation Discipline

In the first five chapters of this book, the reader was introduced to the Judeo- Christian-Islamic foundations of the RF finance and its two pillars: the RF Commodity Indexation Discipline and the Marking-to-Market Discipline. Chapter 5 reviewed the history of money and the evolution of fiat (paper) money and the current monetary system, which is based on paper money. In this chapter, the RF Commodity Indexation Discipline and its use to detect price, economic bubbles, and market excesses will be applied and explained in detail. A call for a new beginning for an RF Monetary Discipline is made.

THE CYCLICAL NATURE OF THE FIAT MONEY ECONOMY

Professor Ahmad Kamal Meera[1] authored an insightful book on the economics of fiat money, bank fractional reserves, and interest, in which he concluded that the fiat money interest-based system causes asset bubbles, particularly after the potential gross domestic product (GDP) levels of an economy have been reached. He described a five-stage process to the creation of cycles in a fiat money-based economy. It is important to state here that the purpose of this discussion is not to criticize the current monetary system or advocate changing it — that is not our goal or the purpose of this book — but rather to throw more light on how the system works, in order to coexist with it and to allow for it — in the short term — while designing, implementing, and operating the RF banking, finance, and monetary system in a world that uses fiat (paper) money. It is believed that this can be done to a high degree of success (as experienced in our operations at LARIBA since 1987 and the Bank of Whittier in the United States since 2003) by applying the screens of the Commodity Indexation Discipline and the Marking-to-Market Discipline. If we know the way the riba-based fiat money monetary, financial, and banking system works, we definitely can — in the short run until a fair RF commodity-based monetary system is developed and implemented — to a better extent and with a great level of success, identify the formation of a pricing bubble earlier, before it grows larger to create a serious economic problem. It is hoped that using this RF discipline will allow those of us who aspire to live by the RF rules and lead an RF lifestyle to have the proper and well-defined early warning signals and the decision-making tools that will allow for the avoidance of or the timely exit from that economic bubble before it bursts and causes everyone in the RF banking and finance system in particular and the society at large a great loss of assets, economic damage, and the loss of stability, reputation, and credibility of the system's financial and banking institutions as experienced during the 2008 financial meltdown. Following are the five stages:

1. A Period of Money Creation without significant inflation. In this phase, the central bank or the Feds would allow the creation of more money through the tools at its disposal — for example, lowering interest rates (the Fed Funds rate) and/or reducing the statutory reserve requirements at the banks as explained in Chapter 5. As money becomes available, people begin borrowing money and buying things. This situation creates a period of economic prosperity without inflation, because the excess production and services capacity of the economy goes into an absorption process through that increase in demand.

2. An Inflationary Period of excess money supply with cheap (low interest rate) funds. This stage follows the full utilization of available production capacities and the subsequent drying up of supply of inexpensive products, services, homes, and commercial real estate. People still can borrow at low interest rates, which causes demand to rise further and outpace the available supply from the productive capacity of the economy. This situation causes a period of inflation of prices. Excess money in the hands of the public begins going into higher salaries, which means more excess cash in the hands of the public, more savings for retirement, and, in the end, excess cash pouring into the stock market, causing it to heat up and rise sharply. Of course, those in the money market and stock market will always give the impression that there is no end in sight to this spectacular growth. It is the responsibility of a wise central bank or Federal Reserve Board to arrest the money creation machine at this stage to avoid the growth of this economic bubble.

3. A Period of Destruction of Money Supply, causing an economic downturn with financial distress and bankruptcies. Here, prices keep rising, but prudent investors start looking at their positions and discover that the price-to-earnings ratio of certain stocks is too high to be real and the price of real estate is so high that the debt service is much higher than the potential rent. This is where applying the RF Commodity Indexation Discipline and rules and the RF Marking-to-Market Discipline (detailed in Chapters 3 and 5) will be extremely useful to those who lead an RF lifestyle and believe in and apply the RF disciplines and rules of the Judeo-Christian-Islamic Shari'aa law. Many decide to go to cash. This reduces demand and increases supply, causing prices to decline and, in most cases, sharply signaling the bursting of the economic bubble. In most cases, the price of a real estate property, for example, may be lower than the loan the owners obtained to finance it (Americans use the expression “under water” meaning that the value of the home or property is under the level of the loan taken against it) — as many experienced during the 2008 economic meltdown. In most cases, especially in today's culture, that prompts many to declare bankruptcy to run away from their debt responsibility, and the banks proceed to go through the mechanical steps to repossess the properties. Because banks are not allowed by regulators to carry real estate direct ownership on their books for an unnecessarily long time, they are required by the regulators to sell these properties as soon as possible. This causes prices to decline further in a process of capital destruction. The same process happened on the stock market, especially with portfolios that use margin financing (borrowing money against the market value of the stock portfolio). Market losses in the Dow Jones Industrial Average — in one day — can reach more than $1 trillion (that is, $1,000 billion). During this process, we witness the destruction of the fiat (paper) money created at the printing press, as described earlier in stages 1 and 2.

4. A Period of Transfer of the Crisis from the Financial Sector (Wall Street) to the Real Sector (Main Street). As the recession sets in, businesses, in their pursuit to cut expenses and overhead, resort to reducing employment and begin laying off employees and reducing production (in industries such as home construction and auto manufacturing, which are the backbone of the economy of an industrialized country such as the United States), with a resulting deep impact on local economies because workers in the backbone industries in the economy — home construction and automobile manufacturing — are laid off in a massive way. This process results in massive economic dislocations and price reductions.

5. A Period of Recovery that Takes the Economy Back to the First Period described in stage 1. At this phase, the government starts a recovery program with the help of monetary authorities, and we head back toward the first stage; money creation begins anew.

The five-stage process that ends with the bursting of the bubble has been witnessed during the inflation of the stock market from 1987 to the year 2000 and from 2003 to 2008. The reduction in interest rates that followed the September 11, 2001, attacks caused inflation of real estate prices for a long time, resulting in the 2008 meltdown and the near-collapse of the financial system, not only in the United States but in the whole world.

It is important to note here that one of the responsibilities of the central bankers of the world — including the Federal Reserve of the United States — is to try their best to timely stop the “bubblization” of assets by bursting these bubbles before they become so large that they create a heavy burden on the economy and the whole population when they collapse. It is interesting to note that former Fed Chairman Alan Greenspan (1987-2006) preferred to allow the housing bubbles in the United States to fester for a long time. The bubbles eventually burst a short time before his retirement, causing the huge damage of financial markets worldwide. Unfortunately, in the 2008 experience we have seen that such a laissez-faire approach and policy adopted by the Federal Reserve Board invited corruption and fraud (witness the persistent regulatory and legal violations of many of the investment bankers and mortgage bankers). The outcome can be devastating in depth and extent, as we saw in 2008.

The big question is: how can an average citizen or an RF financial institution avoid participating in this bubble-creating banking and finance behavior? The answer is that participation in the bubble can be avoided by applying the following two important RF disciplines and finance rules:

1. Use the RF Commodity Indexation Discipline.

2. Apply the RF Marking-to-Market Discipline.

These RF finance rules make certain that we are investing prudently and not participating in a bubble. True, we may be premature in quitting and exiting a certain market, and we do not participate in some spectacular speculative (gambling) returns, but as RF bankers we are certain that we deliver the most important value of RF banking to our customers who decided to live an RF lifestyle: the preservation of capital and the realizing of prudent returns that, in the long run, will be much higher than such “bubble” and gambling-based returns.

  • [1] Ahmad Kamal Mydin Meera, The Islamic Gold Dinar, (Kuala Lumpur: Pelanduk Publications, 2002).
 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >
 
Subjects
Accounting
Business & Finance
Communication
Computer Science
Economics
Education
Engineering
Environment
Geography
Health
History
Language & Literature
Law
Management
Marketing
Philosophy
Political science
Psychology
Religion
Sociology
Travel