The Global Financial Crisis

Ideas for Long Term Solutions

By Monzer Kahf , Ph.D.

The crisis began in the US real estate market; however, its indications had previously appeared in the end of 2007. The very reasons of this crisis lay in the funding of external wars. The Bush administration spent over 5 trillion dollars on the total military operations it conducted over 7 years. This gave rise to an increase in the public debt by more than 4.5 trillion dollars between 2002 and early 2008.

Hence, this crisis is one of accumulated debts that went beyond the capacity of the US financial system. This required inviting the European financial systems to offer help through securitization and alluring interest rates that continued for several years.

A process of rectification had to be conducted, and it began in the real estate market. This was due to the unbalanced burdens placed by funding contracts that consumers could not endure in the long run. These are funding contracts that provide short-term facilities. As a result, in the long run, consumers become unable to endure their burdens.

The structure of the real estate finance market (including loan guarantee contracts, securitization, debt securities trading, credit derivatives, and credit default swaps) led to the collapse of semi-wholesale finance institutions, such as the mortgage corporations Fannie Mae and Freddie Mac, and that was followed by the collapse of other banks. The crisis of confidence deteriorated. As a consequence, banks ceased giving short-term loans to companies and institutions, which resulted in reducing employment and laying off workers. It is most natural for this to begin in the housing market first, before it extended to other service and production sectors. It is no secret that diminishing incomes attributed to layoffs and diminishing fortunes due to the collapse in stock rates and other financial investments, caused a decline in demand, particularly for long-lived consumer goods deemed as the mainstay and indicator of any changes in the service and goods market. This added further and further to the negative indications, causing more decrease in employment in the US and European production markets.
Structural Causes That Aggravated the Crisis.

1. Large expansion in speculation transactions in financial markets, including those conducted through the Internet, until they overshadowed the real transactions, which are the very reason behind the establishment of financial markets. (They are intended to effect fluidity and facility in moving on from one investment to another). The nature of speculations makes them unproductive in the end, because they merely shift wealth from losers to winners.
2. The emergence of many transactions intended merely for speculations on prices. Ultimately, these transactions do not produce any added value in the market, yet huge amounts of money and great human capacities are invested in them.
3. The spread of the culture of quick profit (“if you can get away with it, then do it”), without any consideration of the long-term results of transactions. Added to this is the deficiency of laws, regulations, and administrative instructions aimed at following up the new methods for creating new forms of transactions and contracts (and this is what the Enron Corporation did). One has to note that this culture also emanates from capitalism as an idea and philosophy. Hence, so long as the law cannot control people’s behavior or get hold of them, why should they not appropriate maximum gains?
4. The shift of capitalism from the phases of service and production to the phase of financial capitalism and inflation of the financial sector’s profits, which caused people to believe that this is the way to quick gaining of wealth. Thus, layers of mere financial transactions that incessantly move away from the real production sector accumulated and increased in size. This brought about the so-called theory of the upside-down pyramid — a pyramid which is characterized by instability.
5. The dependence on interest-based loans given as a basis in funding, a process which does not produce any added value by itself.
6. The prevalence of securitization, which gave rise to an easy spread of.
7. The culture of “strike and place the burden on others.” This is also due to the fact that financial institutions accepted securitization with few and undeveloped restrictions, when, on the other hand, there were newly developed methods designed to protect those who made the first strike.
8. Securitization also created interconnection among financial institutions. Consequently, all of these institutions fell with the fall of the first piece of domino.
9. The system of exchange and trade of debts, and expansion in the transactions of selling debts. Enormous investments were attracted to such transactions, which in fact do not result in any real increase in social production. In addition, they are often quickly influenced by the media and political events. This would not happen, if interest was not adopted as a system of finance and refinance.
10. Investors’ natural trend of making financial investments directed toward exercising much caution. This led to an increase in the processes of derivatives. Which in turn , inflated the size of mere financial swaps and exchanges still further. Another consequence is the increased interconnection among institutions, something which accelerated the movement of the retrogressive impact from one institution to another.
11. Large dependence on public debt rather than taxes. This generated inflation in the processes of financial exchanges, local and international.
12. Big rise in the US military spending.
13. Although it increases labor and employment, it does not tend to improve the productive capacity of the economy. In consequence, the competitive capacity of US products in foreign markets diminished and the deficit in the balance of trade accumulated, thus undermining confidence in the US economy.

Short-Term Solutions

These are by all means usurious solutions. Rather, they cannot be but usurious, as they stem from the capitalist milieu and mentality.

They are as follows:

1. Rescuing the failing banks that can be rescued, with particular focus on retail banks, so that they can resume giving short-term loans to companies, in an attempt to alleviate the financial crisis in the production sector.
2. Applying income-increasing programs, particularly for the middle class, so as to enable debtors to overcome the crisis of bought houses and also to solve the problem of the diminishing demand for long-lived consumer goods, thus sending necessary indications to the production institutions that they should not decrease their productivity or continue to lay off workers. Furthermore, part of the solution focuses on increasing the spending on service sectors, including education and health sectors, which have large numbers of workers.
3. Stopping the increase in installments and interest rates for buyers of houses with changing interest rates. Interests should be decreased or canceled , even if for a short period of time, and respite should be granted to the debtors who took house loans. This has to be done through government decisions enabling the owners to continue their payments and preventing their loans from turning into bad debts. Accordingly, the house-market prices would enjoy stability and cease declining, and the process of restoring markets of real production to health would soon begin.
4. Avoiding resorting to an increase in public debt in a way that would aggravate the exhaustion of the market liquidity. Instead, taxes imposed on the wealthy — especially those who benefited from the immense military spending — should be increased.
5. Dealing in derivatives should be stopped, and what remains of them have to be gradually dissolved, particularly credit derivatives.

Long-Term Solution

These have to be based on reorganizing the financial markets for the rectification of their deficiency. The solutions include.

1. Laying down new rules aimed at curbing the expansion in finance beyond the capacity of the receivers of funds, particularly in the real estate market and with regard to the use of credit cards. These rules should curb the greed of retail finance banks and companies, in an attempt to force them to abide by strict standards. These later would hold these banks and companies responsible for the results of their leniency in alluring consumers to contracts whose burdens go beyond the consumers’ capacity, and would prevent them from achieving gains at the expense of consumers and semi-wholesale institutions.
2. Reconsidering the systems of money markets with the aim of banning or minimizing the deals based on mere speculations, given the fact that they produce no added value. Such deals are known as the “deals whose total equals zero.” These include the following deals:

• Index related deals.
• Contracts on differences.
• Credit derivatives.
• Short-term deals.
• Future deals.
• Restricting choices as a means of caution, in a way that is based on or linked to an existing situation in assets or liabilities.
• Limiting the transactions of currency trade on the Internet or completely banning them and canceling the licenses of platforms of currency speculations on the Internet.
• The same should be done with platforms of goods and stock speculations on the Internet.
• Generally, turning the financial markets back into markets that support service and goods production, not markets aimed at investments and profits involving speculations.

1. Limiting securitization (even through successive stages) until securitization of debts is completely banned and only taskik (financial documentation) is used. In taskik, the sukuk (financial documents) represent real assets excepting debts and money.
2. Reconsidering the laws that permit circulation of and trade in debts, given that these processes do not create an added value. Strict restrictions should be in place for banning the discounting and rediscounting of debts.
3. Developing institutional funding from banks and non-institutional funding from the market. This is to be bound by two main constraints:

• Establishing a direct connection with the real market of services and goods, so that funding in society does not go down the drain or transform into financial accumulations that go beyond the real market and turn away from it.
• Giving precedence to moral criteria in funding over the criteria of mere gains; that is, funding has to be withheld from goods and services that are unwanted by society or harmful to its environment and future.

6. And finally, respect ought to be shown to individual ownership as a fundamental right that is granted to humans by the Creator of the heavens and the earth. It is not proper for any individual to cede this right or any of its requirements, such as the right to free benefiting from one’s own possessions in all ways of benefiting , as well as the right to entitlement and so on, except if the individual wants to give voluntarily and consciously. It should also be stressed that contractual increase in debts and loans for deferred payment is an unjust increase that is wrongfully taken from the debtor’s money whilst there should be no increase in the creditor’s possessions that justifies it. Hence, contractual increase in debts and loans is not compatible with the requirements of the rights to property and entitlement. Debts should not be susceptible to increase, because no added value is generated from them.

Islamic Banks and the Current Crisis of Debts

First, it should be noted that Islamic banks were less affected by the crisis than traditional banks. This is because Islamic banks do not buy financial papers based on debts, let alone usurious debts. So, they are far from being affected by bad debts; there is no possibility that they might be affected by the traditional institutions that were led to bankruptcy.
However, one also has to note that the Islamic banks that dealt with traditional banks through goods murabahah (Islamic partnership) have in their budgets billions of dollars worth of debts to be paid by both international and regional traditional banks.

Moreover, the banks that dealt in tawarruq (securitization) with their clients and holders of credit cards (which are based on transforming debts through tawarruq) also have in their budgets lots of inflated debts to be paid by ailing clients whose investments in the local and global financial markets have collapsed.

These tawarruq debts are also strictly financial accumulations that are far from the real market. The reason for this is twofold: First, finance through tawarruq is based on creating many debts with no real movement of goods (because goods are not sought in themselves). Second, tawarruq, by its very nature, contributes to the accumulation of layers of debts, one above the other, just like an upside-down pyramid. Tawarruq is nothing but finance that aims at repaying debts by more large debts.

Still, the Islamic banks that had invested large amounts of money in global stock markets have also been affected by the crisis, owing to the collapse of these markets. The clients of these banks have been affected as well. They lost large sums in stock investment funds. It should also be noted that it was fortunate that these funds had been far from the stocks of the traditional financial sector and other sectors more influenced by the crisis.

Finally, it is worth mentioning that Islamic banks are subject to the same impacts traditional banks were subjected to. This is due to the financial difficulties that face their clients because of the decrease in incomes and wealth as a result of diminishing employment and declining value of financial investments.

Lessons from and for Islamic Finance

In light of the financial crisis, some lessons of utmost significance can be derived from Islamic finance and banking:-

1. There is deep-seated confidence in the correctness of Islamic finance in terms of its adherence to funding by sales, leases, and partnerships, and in terms of its avoidance of loans of all types, given that they are a method of finance that takes finance away from the real market of production and exchange. Likewise, there is ingrained confidence in the principle of rejection of circulation or securitization of debts. These are the most important guarantees that a financial system will not slip into a crisis.
2. It is necessary to stop the attempts aiming at imitating the Western forms and practices of finance, which are devoid of the reality of goods, particularly those contracts that produce no added value but only result in shifting wealth from one hand to another. The point is that these contracts belong to the type of contracts whose total equals zero, including the so-called funds of Islamic caution, contracts of compound promises, imaginary contracts of investment, and other nominal practices that are founded upon no real production or exchange.
3. It is necessary to reevaluate certain financial dealings adopted by some Islamic banks — namely, those dealings that separate finance from the real market and avoid relying on the production of an added value. These dealings rely on the accumulation of debts that are not accompanied by any movement in services and goods. Such dealings do not effect generation of wealth; they widen the gap between the real market and the financial market and contribute to inflation of debts in a way that leads to financial instability.
4. Also, the debts that are not based on real exchange of goods (but rather on overlapping contracts) result in illusory financial accumulations not reflecting the true identity and goal of Islamic finance. As a consequence, Islamic finance would fail to maintain its moral purity and would fail to apply its moral standards to the measures it follows. Here, one may make special mention of the transactions of tawarruq and murabahah for local and international commodities.
5. There is a need for reviewing the systems of financial markets in Muslim countries, with the aim of limiting financial speculations by laying down restrictions on their different types and also by banning the transactions that do not involve real investment. It is to be known that the systems applied in some Arab and Muslim markets do not allow many derivatives, which is one of the most important causes of the crisis.
6. It is necessary to revise many views and opinions, especially those practices falsely labeled “Islamic,” such as the so-called short-term sale, derivatives and dealings on the same day, markets of caution, mudawalat (speculations) via the Internet using currency, and so forth. These practices facilitate the prevalence of the mentality of quick profit and encourage — albeit implicitly — the spirit of selfishness and financial speculations that do not increase production or create any added value.
7. Principles of Islamic finance should be presented to the world as part and parcel of the true image of Islam, whose message is directed to all humankind — a mercy for the worlds. These principles are not specific to Muslims; they are principles of Islam, which is a universal religion. In fact, throughout the ages, these principles have always been known and practiced in all communities in their exchanges and transactions, though some financial dealings and speculations have marred them. Above all, these Islamic principles are required by the scientific, logical analyses of economic and financial systems and by the principles of human rights, notably the right to reaping the fruits of one’s own property and the right to protection against encroachment upon the personal property of those benefiting from funding. This is the meaning of justice and elimination of oppression. It is the meaning that is constantly stressed by all the rulings and branches of Islamic Shari`ah.
8. There is a need for reevaluating — from the perspective of Islamic Shari`ah — the current systems of Islamic sukuk (financial documents), in an attempt to perfect their rules and lay down organizational and jurisprudential regulations that would ensure they will not slip into the forms of securitization that dominated the Western financial markets.
9. From the standpoint of Islamic finance, a firm stance should be taken against selling debts (a practice found in Malaysia) and against discounting and rescheduling them, even under false names.