Thursday, November 19, 2009

Developing the Theoretical Foundations of Economics in Islam

Abbas Mirakhor

From New Issues in Islamic Economics & Finance

• 2 approaches to the systematic development of Islamic economic theory
o to start with Western approach to consumer theory and the theory of the firm and then proceed with the analysis by imposing a series of Islamic constraints on the solution
o to ignore Western assumptions regarding consumer and firm behaviour and assume behaviour that would be compatible with Islamic doctrines, not accepting man as he is but as he should be
• efforts to formulate a coherent foundation for Islamic economics have been disputed by 2 grps of thinkers:
o the group that expresses dissatisfaction with the pace and direction of progress made thus far in Islamic economics and disagrees with the concept, methodology and objective of the discipline
o the group that expresses a strident New Weberian critique of islam, in general, and Islamic economis, in particular, and views Islamic institutions and thought as contrary to the growth and development of Muslim societies (he refers to Kuran a lot)
• a problem is for all Muslim economists to reach a consensus-
o with respect to vocabulary
• so far the only 2 fundamental propositions agreed on are
• interest is riba
• risk-sharing and profit-sharing is the Islamic alternative
• also agreement on 2 fundamental issues
• “Justice and Equity” as the focus of the prophetic message
• the Quran, hadith and fiqh as the sources of Islamic law
o with respect to naming the emerging discipline
o with how to define it
• “means-end” characterization satisfactory?
• The unacceptability of the notion of “scarcity” in the Quran
o New institutional economics
• To do more research on Islamic economic institutions and their operation at present in Muslim societies.
• To create an incentive structure for the establishment of new institutions compatble with Islamic objectives
• He suggests that along with an Islamic economic vocabulary, 2 other sources are useful in order to develop a common language-
o History of thought-
• That its ok to borrow the results of investigation from others, That ideas developed belong to all humanity
• “…,moral philosophy gave birth to political economy, out of which grew the present discipline of economics. And moral philosophy from the Middle Ages to the time of Adam Smith was influence by the scholarship of Muslims. While the historians of economic thought generally ignore Muslim contributions, they emplhasize the Aristotelian thought fo the Middle Ages. However, the latter arrived in Europe already influenced by Muslim intermediation and was as Aristotelian as present day neoclassical economics is classical.” (p 224)
• on Hicks model of mercantile behaviour (1986) , Adam Smith and Theory of Moral Sentiment
o Economic hermeneutics – which as used by Abbas Mirakhor does not mean tafseer but rather the process of extracting economic meaning from the first order of interpretation done by fuqaha (see Ali Khan and Chapra in The Future of Economics)
o Relating Hermeneutics to the Islamic Economic History – see Hasanuz Zaman in The economic Funcitons of the Early Islamic State (International Islamic Publishers, Karachi 1981)

Tuesday, November 10, 2009

Strengthening the Islamic Financial System: Lessons from the Crisis

Public Lecture
Dr Abbas Mirakhor
29 September 2009
Securities Commission Malaysia

1997 Asian crisis gave rise to policy recommendations by IMF which included-
• avoid debt dependence
• rely mostly on equity investments
• if must have debt, shld not be more than 25% GDP
• countries’ obligations should not be geared to short term
• must have enough strength in economy
• shld ensure sovereign bonds include certain clauses to ensure risks are shared equally between creditors and debtors
• transparent balance sheet, marked to market financing, not heavily leverage
• domestic institution must be regulated
• shld establish orderly bankruptcy procedures and restructuring mechanism for workouts
• periodic audits of the soundness and stability of the economy, “financial sector assessment report”

Majority of IMF members accepted this, but major economies incl the US did not implement them eg they refused to have financial sector assessment

The recent subprime crisis occurred and 2 possible explanations:-
Conventional and non conventional

Conventional explanation-
1. policy failure
a. to undertake strengthening regulations, lax monetary policies and fiscal policies
b. refusal to deal with asset and actual incentives of policy makers towards highly risky and complex instruments.
c. These are premised on the interllectural idea o the policy maker which drives his policies.
i. In Greenspan’s idea, he believes in “perfect markets”. If this is true, the risks in the economy will be distributed efficiently. 2 issues affect any economy- (a) what is the total aggregate risk in the economy (b) how do you distribute this risk among the participants of the economy. If you believe in perfect markets, you will want as many instruments to spread the risks efficiently;
ii. The idea that the value of the firm relates to its marginal profitability. So it does not matter how it is financed, ie whether debt or equity. MM model. If you believe in this idea, instruments can be derived based on payoff which is interest rate;
iii. EMH- were the prices of the security includes all the information that a decision maker requires. So if the price increases, it means demand increases and later with over demand supply increases which leads to prices falling again. Thus, Asset Bubbles will never occur
d. The conclusion is that Greenspan will never interfere in policy and regulate markets as you don’t believe that either monetary policy or regulatory measure will affect asset bubbles.
e. But in Dec 2008 Greenspan concluded that he was following a flawed model.
2. regulatory failure – hands off policy, segmentation of economy
3. governance failure – internal and external idea that profit seeking did not create a systemic risk – too complex, too big instruments and institutions resulted
4. globalization failure- increase the vulnerability of the world system, becos there was no institution to overlook the global system. An excess in sovereign funds of some countires , invested in the debt instruments of the US – treasury bills – created a huge inflow into the US – no regulation – debt imbalance

Non conventional explanation

• crisis cannot be avoided in a financial capitalist society where it is based on interest and debt contracts
• 2 components to this-
o capitalism is vulnerable and fragile due to the Fractional Reserve banking system (refe Morris Alais or Holbern) – the fragility sets in because once the banks can create credit, they can also create “shadow banking” ie leverages without taking deposits
o this is the money multiplier of the conventional banks and the leverage of the shadow banks. The fragility is due to the ease in contraction and expansion
• so the “Chicago Plan” during the Depression years came about, but was not adopted as the banking lobby was so strong – the suggestion of that school being that the banking system that operates on 100% reserve
• also mismatching – banks borrow short and lend long. If this does not occur, there won’t be ny need for banking deposit insurance. James Token proposed this system which would anchor the market economy
• Keynes says that capitalism and market economies are inherently fragile because the system interferes with surplus / shortfall of supply of funds. Even in a market economy, there can be no perfect balance, cos savers and investors have different motivations. So consumption in 1 period cannot validated investment in a previous period. So you also cannot guarantee full employment situation.There is also rentier class (interest rate system). If you don’t have this class, saving will find its way into a project and the payoff will be the profit. With interest, it creates a wedge in the economy that make the system fragile. So he says get rid of interest and the rentier class.
• Minsky, a student of Keynes – repeated Keynes ideas and he says financing must be done based on equity financing – “Financial Stability Hypothesis” – during prosperity, firms see investment opportunities, use equity to finance it with little debt. When prosperity picks up momentum, the businessman decides that he want to take advantage by undertaking debt in order to grow. Then begins interest payments, asset bubbles leading to financial distress – “rolling bubbles”
• Soros – “super bubble” which takes magnitude fromt eh bursting of smaller bubbles within it.
• So there must be equity financing and risk sharing to stabilize an economy

What are the lessons for Islamic Finance?

Since they exist side by side with conventional system

-how do you cushion the system from price shocks, so that they can adjust very rapidly in such events
-islamic mathematical models of finance before this assumed that they were bank based, but this cannot be relied on to create stability
also regulatory frameworks is important. The major lesson from the crisis is reulation. We are not assured, because there is no quality control. So a stong enough regulation must be in place acceptable in all jurisdiction and an authority with enough mandate to implement. Otherwise the system can be destroyed. – reputationa damage of sukuk failures

with 100% reserve system, there is no money created. Only the State will create money.

A Short Outline of the Foundations of Islamic Economics

Usama Uthman
2nd Harvard University Forum on Islamic Finance 1998

He defines Islamic economic system as one that constitutes 3 aspects:-
moral values
economic policy
economic theory

The Challenge of Poverty and the Poverty of Islamic Economics

by Mohammad Omar Farooq
SSRN eLibrary 2008

Islamic economics is suffering from "poverty of substance" . As a discipline it is just a "context of post colonial Islamic resurgence." He finds that Islamic economics is focussed on the alleviation of poverty (why? because poverty leads to kufr) rather than achieving affluence. He calls this "economics of poverty".

This is achieved through a "caring society" and via a reliance on the zakat mechanism to alleviate poverty. He cites the situation of roaming zakat payers that cannot find any zakat beneficiaries during the rule of Hadrat Umar and Umar Ibn Abdul Aziz (2nd khalifa). However he questions the extent of effectiveness of zakat, and speculates that the affluence of the times came from redistribution of wealth obtained through conquests and not thru zakat.

Farooq observes that "Islamic economics" is torn between those that want to "Islamize" the current body of conventional economic thought and those that reject conventional economics outright. But neither focuses on poverty. Even Choudhury (of hte Tawhidi economics) does not tackle poverty head-on. Farooq opines that poverty is not caused by shortage, but by failure in distribution/ redistribution.

Islamic Economics and Finance - a Fiasco

by Masudul Alam Choudhury
Middle East Business and Economic Review Vol 20 Issue 1 page 38

Islamic economics as based on a Tawhidi epistemology. Takes it on a completely different paradigm, based on Principle of Pervasive Complementaries. Based on this principle, assumption of scarcity cannot exist in Islamic resource allocation plan as resources flow occurs over three time dimensions, as oppose to linear. Therefore, there would be no such thing as production possibility curve, opportunity cost, marginal substitution, competition.

Monday, November 9, 2009

A THEORY OF SOCIAL INTERACTIONS

NBER WORKING PAPER SERIES

Gary S. Becker*
Working Paper No. 42
CENTER FOR ECONOMIC ANALYSIS OF HUMAN BEHAVIOR AND SOCIAL INSTITUTIONS
National Bureau of Economic Research. Inc.
261 Madison Avenue, New York, N.Y. 10016
June1974


Therefore, charity is a form of self—insurance that is a substitute
for market insurance and government transfers. Presumably, the rapid
growth of these latter during the last 100 years discouraged the growth of
charity.

CIVIL SOCIETY, SOCIAL ENTREPRENEURSHIP, AND ECONOMIC CALCULATION: TOWARD A POLITICAL ECONOMY OF THE PHILANTHROPIC ENTERPRISE

Peter J. Boettke and Anne Rathbone∗
The Philanthropic Enterprise Working Paper 8
2002

State and Civil Society

But, the view that conceives of civil society as the foundation for the effective operation of the state is flawed on several grounds in our opinion. We do not deny that a vibrant democratic society is grounded in a healthy civil society and institutions of self-governance. This is so mainly because it limits government from expanding its scope of activities. Such a limiting constraint on the scope of government is necessary to ensure that government is restricted to those because of the important distinction between finance through voluntary means and finance through the coercive means of taxation.

State- activities it can do well and avoids those tasks, which in fact it lacks the knowledge and incentives to accomplish effectively. The attempt to conceptualize the market as contrasted with civil society also commits two errors of commission and one error of omission. First, it underestimates the coercive nature of state action. The state, as Max Weber emphasized, is a geographic monopoly on coercion. The state is a powerful instrument through which some parties can gain by exploiting others. Second, it underestimates the role of civil society as an opposition force of self-governance against the coercive power of the state. It was this aspect of 19th century America that so captured the imagination of Alex de Tocqueville. Tocqueville saw America=s propensity for selfgovernance as opposed to reliance on the formal structures of state action as a defining characterization of that society. Self-governance was seen as alternative to the state, not as a prerequisite for a working state sector. Third, the contemporary juxtaposition omits a discussion of the importance of the self-enforcing norms and bonds of trust, which are evident in everyday economic life. Formal contracts and various less formal alternative institutional facilitators of voluntary cooperation are at work in the day-to-day operation of a market society. Benson (1990) suggests that in the United States, seventy five percent of commercial disputes are settled privately through arbitration and mediation. Rubin (1997) points out that in developed economies businesses have learned methods of doing substantial amounts of business without relying on contracts and the threat of legal enforcement makes private arrangements easier.

Civil Society – Market and non Market

In short, market activity is embedded within a larger context of rule-governed behavior. We suggest instead of the distinction that sees the profit motive as contrasted with civil society, that the more appropriate contrast would be the traditional state versus civil society dichotomy, where civil society is divided into non-market and market activity.

Market

In short, what spurs entrepreneurship is the lure of profit, and what disciplines entrepreneurs is the penalty of loss. The property rights structure provides the incentives and establishes the issue of the residual claimant, and the price system provides economic actors with the information to act on the bases of those incentives to utilize resources effectively.

State

But can we say anything in alternative contexts? First, lets consider the state sector and in particular because it is considered responsive let us consider the effectiveness of democracy in assuring that agents act in the interest of the principals. In this example the agents are elected officials, and the principals are the voting public. Is the vote mechanism as effective in disciplining the behavior of the agents in relation to the demands of the principals, as what we argued was the case in the market setting?

The voting mechanism is governed by the logic of concentrated benefits and dispersed costs. The interaction in democratic politics is one characterized by rationally ignorant voters, specially interested votes, and vote seeking politicians. The bias of this interaction is for the politician to concentrate benefits on the well-organized and well-informed special interest voters and to disperse the costs on the unorganized and ill-informed mass of voters.

Non profits

Does the non-profit sector avoid the pitfalls of the state sector? The non-market component of civil society certainly avoids the pitfall of coercion, but it does not have recourse to the institutions of property, prices and profit and loss to the same extent as the market component does. Instead, the non-market sector relies on face-to-face interaction and the disciplinary devices most appropriate for that sort of interaction, namely reputation.

Social Entrepreneurship

Our concern goes to the disciplining of the conjectures of social entrepreneurs. How does the social entrepreneur know if they are doing the right thing in their choice of project A, or project B? How does he calculate the use of scare time and financial resources? We contend that he can do this only by limiting those initiatives to those, which can be directly monitored and disciplined on the basis of face-to-face mechanisms of self-governance. The social entrepreneur does not have recourse the anonymous mechanisms of self-governance that exist in a market economy.

The problem faced by these entrepreneurs was twofold. The social entrepreneurs have to acquire capital from private organizations and must convince the donors that the money is necessary and will be directed to the goal of putting the neediest students through college. What makes this problem especially difficult is that United Student Aids Fund, Inc. was attempting to privately provide a service that the government was already in the business of providing. This makes the problem of convincing private donors to donate money all the more difficult. Thus the notion of reputational collateral is the method by which the social entrepreneur must attain capital. The social entrepreneur must convince the private donors that the government provided service has failed to meet the needs of low-income students to attain loans and additionally that the money donated to the United Student Aid Fund, Inc.would better enable the needy students to attain student loans and that the students would complete their education. Yet, the nature of any nonprofit is that it operates under the structure of a bureaucracy and as such is subject to “soft budget constraints” (Kornai, 1980). The private donors must be convinced that their money is necessary even though the government already provides such a service but also must be convinced that the money will not be misused in the traditional bureaucratic fashion but that it is making society better off or is reaching the neediest students in a manner that was previously
lacking.

The second problem is giving the money to the students who not only need the money the most but that desire the assistance thus the social entrepreneur must engage in not only establishing his own reputational collateral in an effort to acquire capital from private donors but must identify and acquire reputational collateral from the students who are receiving the assistance. This all occurs in the philanthropic arena under which there is no price mechanism because the market has been unable to facilitate exchange in the face of government provision of such services and thus assessing willingness to pay through the price mechanism is not possible. Market prices convey information among buyers and sellers. Without the price mechanism there are proxies for the exchange of information and the determination of willingness to pay. It then becomes the task of United Student Aids Fund, Inc. to assess which students want to go to college and which among them are most likely to finish. This is the only way to ensure future private donations. The government program need not prove the value added in the final product

The Kalamazoo Promise: A study of philanthropy’s increasing role in the American economy and education

Shelley Strickland
WORKING PAPER FOR ASHE 2008 CONFERENCE

Philanthropy is an indirect catalyst for economic development,particularly to improve the greater Kalamazoo community.

Use the logic model developed by public affairs and philanthropy scholar Peter Frumpkin (2006). He contends that while external factors and broader economic and political forces are also considerations, three primary interrelated elements factor into the logic model (see Figure 1).
First, the theory of leverage considers the tactics a donor might employ. These tactics take two forms. One is the type of grant-making technique (project grants, short-term, grants, matching grants, loans, large grants to a few select recipients, issuing requests for proposals, high-engagement levels, funding overseas, joint ventures, and capacity-building grants). The second tactic is the programmatic technique (funding in communities, not program areas; new initiatives and pilot programs; support for nonprofit collaboration, not isolated work; private funding for public programs; funding of commercial ventures within nonprofits; funding for organizations created by grantmakers; and funding for independent evaluations). The combination of tactics informs the theory of leverage, which determines the philanthropic inputs.

The theory of change can be considered the core of the logic model. Frumkin contends that five possible change theories exist in philanthropy. Donors attempt to train individuals for leadership in a field, build stronger organization, create new networks, influence political channels, and generate new ideas and programs “with the goal of shaping the underlying paradigm and conversation.” The theory of change affects the activity, outputs and outcomes of a gift. Scholarly and media attention on the Promise has primarily focused on these elements.

Finally, the theory of scale determines the broad public impact. This can be measured in terms of financial strength, program expansion, comprehensiveness, multisite replication and the acceptance of a new doctrine within a field.

Current scholars, then, are not discounting pioneering concepts; they instead claim that economic concepts on philanthropy are incomplete, inconclusive or incorrectly prioritized.

Rather than either a public goods explanation of philanthropy or a focus on private consumption, Duncan (2004) advances a third model: “impact philanthropy.” He claims this model will predict philanthropic behavior because it captures the ways philanthropy interrelates with other aspects of giving, such as the relationship of a charitable organization to its donors or fundraising activities. His model accounts for negative gift externalities in ways previous research does not. For example, an “impact philanthropist” who seeks pleasure from seeing the measurable result his or her own personal giving alone makes on a charitable organization could actually have that charitable fulfillment decreased by others’ gifts. Duncan’s previously noted concept of “impact
philanthropy,” a new alternative to economic theories, helps account for explanations of why donors such as those to the Promise did not provide operating support. An impact philanthropist, as opposed to a public goods or private consumption philanthropist, perceives a greater impact by targeting a specific part of the production process that can be measured (Duncan, 2004).

Tax deductions do not fully explain motivations for the ultra rich. “The mega giver takes every advantage of the tax laws. But tax savings isn’t the primary force behind giving. And for many, tax isn’t a factor at all” (Panas, 2005, p. 162). With an estimated $250 million endowment established (Lydersen, 2006) for the Promise in particular, the donors were not likely motivated by taxation implications.

The remarkable resources of such donors, exemplifying the concentration of wealth in a select few, present the opportunity to alter our society and our marketplace, especially as they bring creative approaches to philanthropy

RELIGION, CULTURE, AND ECONOMIC PERFORMANCE

Marcus Noland
Institute for International Economics

“Whatever the sins of Western imperialists, Islam was developing more slowly than the
West during a period of Islamic conquest and geographical expansion into Europe. “

3 possible reasons offered-

Intellectual roots – “closing of the doors of ijtihad” (just follow , no need to inquire attitude) prevented a critiques of current practices “a la Protestant Christianity”

Sociological roots – earlier – warrior tribe with plunder method for amassing wealth, later coalescing into socially dominant town tribes with slave owning economic structure – with sedentary bureaucratic – does not lead to “development through intensive means”

Institutionally – eg inheritance laws with concentration on redistribution prevented long term corporate institutions that can amass wealth

However, the writer found that there is no evidence that Islam inhibits economic growth.

Economics of Philanthropy

Entry in the Encyclopeadia of the Social and Behavioral Sciences
2001 Elsevier Science Ltd
ISBN 0080430767

Individuals are sensitive to the tax deductions allowed by the US tax system. Tax deductions increase the giving by private sector. There is crowding out effect of government grants on private charitable giving.