ACC 103 Economics for Management

ACC 103 Economics for Management

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Islam and the Future of Economics
Ishrat Husain

The topic that has been assigned to me today is Islam and the future of Economics. As a practitioner I would hesitate from indulging in pure abstractions and would illustrate my viewpoint with the help of application to Pakistan. There are many protagonists in Pakistan who are pushing the country towards adopting this system. Western analysts and observers view such a move with apprehension and feel that this will lead to Pakistan’s decoupling from the global economic system and its isolation from mainstream economic thinking. In their minds such behavior will create greater instability and amplify risks for the rest of the world. I believe these apprehensions are totally misplaced and the assumptions and premises on which the hypothesis about the Islamic economic system have been constructed are seriously flawed.

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Pakistan is a moderate and progressive Islamic country and any suggestion that it will adopt policies that may be risky for the rest of the world is untenable. Pakistan is and will remain a responsible member of international community and is committed to utilize the vast opportunities provided by globalization and financial integration of world markets for the benefit of its population. There is no suggestion whatsoever by any significant group of people or political parties in favour of isolation or withdrawal from international economic system. Secondly, the pre-conditions for a robust and well functioning Islamic economic system are missing in Pakistan. The Islamic moral values that emphasize integrity, honesty, truthfulness and full disclosure and transparency are not yet widely practiced by Pakistani businesses. Once these pre-conditions are established the adoption of a real Islamic economic system will lead to superior welfare outcome for the majority of Pakistani population.

How can the Islamization of the economy affect the future direction of Pakistan economy and improve the welfare of its people compared to the present system? Before that, let me recapitulate the basic principles upon which Islamic economic system is built upon.

Unlike positive economics the entire edifice of Islamic economy is built upon a set of objectives or maqasid. In other words, Islamic economics is normative in nature with the objective of the Shariah being to promote the well being of all mankind which lies in safeguarding their faith, their human self, their intellect, their posterity and their wealth.

Keynote address delivered at the Conference on Islamic banking and Finance held at Karachi on June 26, 2010. At the micro level, the precepts of profit maximization and utility maximization are retained intact but are supplemented by a set of interlinked objective functions. Islamic system tries to promote a balance between market, family, society and the state. It does so by promoting both the material and the spiritual urges of the human self, foster peace of mind, enhance family and social solidarity. Some western thinkers and anti-globalization activists decry the western economic model as being suppressive of collective human rights, community and social well being, disruptive of family values and too much focused on selfish individual interests. Behavioral economists were already challenging the assumption of rationality in the choices and preferences an individual makes in day-to-day life. The 2008-09 global financial crisis has put to serious question the rationality assumption that underpins the modern capitalist system. Thus, the merit of Islamic economic model therefore lies not only in its extension but also in overcoming weaknesses and deficiencies of the western model in fundamental and beneficial ways. It introduces into the objective function an additional argument which keeps self interest within the bounds of social interest by limiting individual preferences to conform with social priorities and eliminating or minimizing the use of resources for purposes that frustrate the realization of the social vision. This may help promote harmony between self-interest and social interest and put at rest the current tension between individual utility maximization and achievement of collective good.

This second argument complements the market mechanism by making the allocation and distribution of resources subject to a double layer of filters. It attacks the problem by first changing the behavior and preference scale in keeping with the demands of the normative goals. Claims on resources are then exposed to the second filter of market prices. In this process, the influence that initial resource endowments are able to exercise in the allocation and distribution of resources may be reduced substantially. Faith tries to accomplish this by giving self-interest a longer-term perspective – stretching it beyond the span of the world to the Hereafter. This interest in Hereafter cannot be served except by fulfilling his or her social obligations. This may induce individuals to voluntarily hold their claims on resources within the limits of general well being and thus create harmony between self-interest and social interest even when the two are in conflict.

The promotion of simple living and the reduction of wasteful and conspicuous consumption may help reduce excessive claims on resources and thereby release a greater volume of resources for need-fulfillment by others who are not so well off. It may also help promote higher savings and investment and thereby raise employment and growth.

At the macro level, Islamic economic model in its ideal form tends to combine the positive aspects of the capitalist economy and socialist economy while minimizing their negative consequences. Capitalist economy based on private property and market mechanism allocates resources efficiently but as it takes initial resource endowment as given, equity considerations do not figure in this system. Socialist system is very much concerned with equity and welfare of its population and ensures benefits from cradle to grave for its citizens. But as it relies on state ownership and bureaucracy it is poor in allocating resources thus creating inefficiency, waste and value subtraction. Islamic System overcomes the deficiencies of both the systems as it is solidly based on private property and market mechanism but has also explicitly built in equity and distribution through compulsory deduction of Zakat i.e. transfer payments from the asset holders to the poor segments of the population. The western economic model is criticized today as it is unable to address the issues of unemployment, poverty and income inequities in developing countries. Islamic economic model addresses the distribution issues explicitly after market has allocated the gains. It does so by a compulsory deduction of 2.5 percent of tangible wealth and net asset holdings from the incomes generated by the market mechanism for transfer among the vulnerable, sick, handicapped, indigenes and poor segments of the society. Although the deduction is compulsory the transfers are made voluntarily by the well-to-do to their poor relatives, neighbours and other whom they know to have legitimate needs. Thus the leakages, waste and corruption that are inherent in a state administered system of welfare payments are conspicuous by their absence under this system. Only really deserving persons and families or mustahaqeen receives these payments. In Pakistan, it is estimated that private transfers made voluntarily to the poor account for 2 percent of GDP annually. These welfare payments are a potent force in reducing poverty, helping the vulnerable to earn their own livelihoods and lower income disparities.

At the sectoral level, the introduction of Islamic banking should result in deepening of the financial sector. There are believers in Islamic Faith who do not use the Conventional banking system because of their strongly held views that his system is based on riba. They will willingly deposit their savings into Islamic banks and borrow from these banks for expansion of their businesses or new investment. Thus a significant segment of population that is currently outside the organized financial sector will be brought into its fold deepening financial markets. .

The primary principle of Islamic Banking is the prohibition of Riba (usury), which is believed to be a means of exploitation of the masses. Trade is the preferred mode of business in Islam. The goal of the banking is the general economic improvement of the public at large rather than of few groups.

What are the characteristics of the Islamic bank?

• One of the most distinguishing features of Islamic banking is that being part of a faith-based system, it is obligatory on Islamic banks that they do not pursue activities that are detrimental to the society and its moral values. Thus Islamic banks are not allowed to invest in casinos, nightclubs and breweries, etc. It is pertinent to note that casinos are one of the prime vehicles used for money laundering and dealing with them could expose the conventional banks to such risk. • The second distinguishing feature of the Islamic banking is that in addition to the rules and regulations applicable to the conventional banks, the Islamic banks have to go through another test, i.e. fulfill exhaustive requirements to be Shariah compliant. This requires that the clients of Islamic banking must have business that should be socially beneficial for the society creating real wealth and adding value to the economy rather than making paper transactions. Therefore, a stringent Know Your Customer (KYC) policy is inherently an inbuilt requirement for an Islamic bank since the Islamic bank has to know the customer and his business before getting into a socially responsible Shariah compliant transaction. KYC is the first line of defense against money laundering in any banking system.

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• Third, by their very nature, Islamic mode of financing and deposit taking discourages questionable/undisclosed means of wealth that form the basis of money laundering operations. The disclosure standards are stringent because the Islamic banks require the customers to divulge the origins of their funds in order to ensure that they are not derived from un-Islamic means e.g. drug trade, gambling, extortion, subversive activities or other criminal offences. On the financing side, the Islamic banks must ensure that funds are directed towards identifiable and acceptable productive activities. Most Islamic financing modes are asset backed, i.e. they are used to finance specific physical assets like machinery, inventory, equipment, etc.

• Fourth, the role of the bank is not limited to a passive financier concerned only with timely interest payments and loan recovery. The bank is a partner in trade and has to concern itself with the nature of business and profitability position of its clients. In the case of loss in business, the Islamic financier has to share that loss. To avoid the loss and reputational risk, the Islamic banks have to be extra vigilant about their clientele.

It can be said that banks that judiciously follow Islamic banking principles are less likely to engage in illegal activities such as money laundering and financing of terrorism than conventional banks. However, the existence of rogue elements cannot be ruled out in any type of organization. It is the duty of the state and the regulators to ensure that despite these in-built safeguards, there are adequate pieces of legislation, regulations, and enforcement mechanisms to take action against the potential offenders.

To sum it up, Islamization, if adopted and practiced in its true form, at any time in the future will strengthen the economy particularly income distribution and poverty alleviation which have proved elusive under the present western economic model. This will, in fact, eliminate the sources of instability, violence and propensity towards terrorism arising from a sense of deprivation.