The Wall Street Journal reported today that Citigroup and Bank of America have both been told that they must raise billions of dollars of extra capital. The stress tests conducted by the US government on 19 banks found that Citi and Bank of America both need more funds to cover future losses caused by the economic downturn.
This report therefore suggests the financial crisis is far from over.
For the last month various politicians have attempted to talk up the prospects of a recovery as both nationalization and continued stimulus packages have done little to stem the ‘great recession.’
Capitalist nations are finding that lying to the public about the debt and unemployment scenario is really the best way to deal with the little faith that is left after a decade of excess.
The problem fundamentally is down to the fact that Capitalist economies are not built upon anything real but contracts that are either derivatives of real assets or based upon future income streams. The boom of the last decade was built upon the real estate bubble, which was driven by debt – i.e. money that is built upon the prospect of future re-payments. The boom was also driven by a $500 trillion derivatives market built upon the illusion that the global economy will continue to grow.
Once such an illusion reached astronomical proportions and the financial industry realized that their future revenue streams were being defaulted upon on mass, the pack of cards came crumbling down.
Unless Western nations ditch such an approach to wealth creation, the global economy should expect another crisis – that’s if the global economy gets out of the current predicament. However the fact every thing can be commoditized, and that all participants of the ‘market’ can own whatever comes of the production line, whether real or not, means the current crisis is a result of idea’s that go right to the heart of Capitalism.
The way forward is not to lie to the public, but the discussion about alternatives based upon real wealth.
The International Monetary Fund’s latest Global Financial Stability Report has provided some conservative estimates of the potential global losses from bailing out the flawed capitalist financial system. According to the IMF, governments around the world will lose an estimated $4,400 billion on the loans and guarantees made to the financial sector over the last 18 months or so.
$4,400 billion is the total value of all the good and services produced in 2007 in Japan, the second largest economy in the world. Yet this is a conservative estimate as it only covers banks’ losses on loans and securities and does not include the flawed an inactive derivatives market.
Still this is an astonishing amount of expected loss that will need to be paid by ordinary taxpayers over decades. This is the price for bailing out capitalism. Despite governments’ committing nearly $9,000 billion in loans, asset purchase schemes and guarantees, with the justification of rescuing the real economy, the world economy is in the midst of a major global recession.
Driven by the venerated incentives of capitalism bankers took out huge loans to make colossal gambles which they lost. Rather than punishing this failure as capitalism espouses the bankers have been rescued with the world economy ending in deep recession. Private debt has been nationalised with the new debtors, taxpayers, unable to affect or influence the outcome of such a major catastrophe.
Proponents of democracy champion the role played taxpayers in accounting democratic governments. It is argued democracy needs taxpayers. Yet we see taxpayers and their democratic representatives utterly powerless in influencing the course of events in the last 18 months when the tax burden has risen exponentially.
The reality is political leaders are influenced more by rich bankers who can finance billion dollar election campaigns than ordinary citizens. This is demonstrated by the increasing role of bankers in government as detailed in “bankers own the congress.”
Thus this is not only a failure of capitalism but of democracy.
Martin Wolf, FT commentator, derides as absurd gold replacing the fiat currency standard. We certainly live in strange times when the pick of so-called intellectual thinkers in the west considers gold, a currency with stable intrinsic value that has stood the test of time over centuries, unsound in favour of valueless fiat currencies, which are propped up by little more than the confidence one has in the governments that print and issue them.
What’s more Zimbabwe is not an isolated example – there have been plenty of other fiat currency crashes: the Thai Bhat together with many other fiat currencies in the 1997/98 South East Asian crisis; the collapse of the Russian Ruble in 1998; Argentine Peso in 2001; Pound Sterling in 1992 etc.
What’s even more absurd is the idea that in the age of global finance with hundreds of millions in flight capital moving between financial centres with the ‘click of a mouse’ there will not be future fiat currency collapses or that such collapses may be averted by policymakers adjusting interest rates however loosely defined.
It their attempts to prolong the life of a fundamentally flawed capitalist financial model commentators like Martin Wolf have either lost sight of the obvious or are just deluded.
Today’s data from the UK’s Department of Works and Pensions confirmed what many have known since Capitalism’s foundation. The income and wealth gap in the UK has got worse in the post war era and poverty has increased, especially amongst children in spite of annual real GDP growth of near 3% per annum. Whilst various critics have blamed the Labour party for the latest figures, wealth inequality is a problem all capitalist free market economies face.
It should be remembered that until the downturn in the global economy politicians made many promises to eradicate and reduce poverty, however despite the supposed prosperity of the last decade a significant number of British society was not so fortunate.Statistics from HM Revenue and Customs show that the top 1% own over 21% of total wealth in the UK with the next 4% owning a further 18% of total wealth. The next 5% own a further 13% of the wealth generated in the UK. Thus 10% of the UK’s population own over 50% of total UK wealth! It is for this reason consumer debt in the UK is 1.4 trillion; the British economy itself is valued at £1.5 trillion.
Creating a level playing field where all of society can partake in wealth creation and circulation is the capitalism’s number one failure. This will always be the case since capitalism is only concerned with wealth creation; it pays little attention to the circulation of such wealth. Freedom of ownership, a revered principle underpinning capitalism, has only allowed the rich to get richer at the expense of the poor and no amount of tinkering with the free market will change this.
The capitalist baking model is flawed. Most intelligent commentators recognise that no bank is too big to fail. Banks create credit in multiples of actual Tier 1 capital such as cash and equity. By definition there will always be insufficient funds in banks if all depositors and borrowers came calling irrespective of the size of equity in a bank or how deep its pockets were. Indeed, attempting to rescue really big banks could potentially bring down national economies.
Why stress test banks then?
Capitalism faces not only a financial but a credibility crisis. The stress tests are aimed at persuading investors that these banks are viable businesses worth investing in in order to kick start flagging financial activity. The stress tests also suggest a kind of scientific approach to addressing the failure of banks as viable businesses. In actual fact the tests are half-baked attempts at concealing the systemic failure of the capitalist banking model.
Did the financial crisis stem from market failure or government failure? Anti-capitalists argue the market spectacularly failed while conversely capitalists contend that the regulatory framework was responsible for the collapse in financial markets.
Both opinions falsely assumes the so called regulatory framework exists to control the market. In reality this could not be further from the truth.
Increasingly the ‘regulatory framework’ has been about promoting deregulation: the ‘big bang’ in the UK that liberalised financial markets in the mid 1980s; removal of exchange rate controls in the 1990; privatisations of the 1980s and 1990s; and the Basel banking accords encouraging riskier banking models and the promotion lose controls or ‘market discipline’.
There is little doubt the market failed – banks stopped lending even though that’s their primary purpose or raison detre. To deny this is just dogmatic – no matter how elaborate the reasoning. This market failure was not due to government regulation but because of an absence of government regulation. The poachers became the gamekeepers.
This has wider implications for western democratic societies and their ability to look after the interests of all thier citizens over an above those of the capitalist elites who dominate business, government and policymaking.
BBC reported that the Japanese economy shrank by its quickest pace for the first three years for 2009 since records began due to a slump in exports caused by the downturn in the global economy.
“Output in the world’s second largest economy contracted by 4% during the period, or by 15.2% on an annual basis.”
The current downturn has in fact exposed the very weak nature of Japans economy as it highlights the vulnerability of having an export led economy which depends on exports as a primary source of growth.
We have come to realise that during the boom period the Western world consumed much of what come of the production lines of South East Asia, now that spending is being cut back – as many spent beyond their means during the bubble, Japan is finding that a problem that started on the other side of the world has dragged it down too.
Whilst Japan continues to be cited as a model to imitate, the fact that will never change is Japan will always be reliant upon the greed and consumption of the West to drive its economy.
In a report published recently by the TUC it states that those earning around the median income have seen a lower increase in their standard of living than higher earners.TUC General Secretary Brendan Barber says: “Those on middle incomes got left behind under the Conservatives, were left out of Labour’s boom that has now ended in recession, and are now fearing for their jobs and homes as unemployment bites.
“No wonder there is so much anger at a political system that has seen the super-rich soar away, while too many MPs look to be more interested in joining the wealthy rather than standing up to them.”
Despite being in a boom for the last decade it is the super wealthy that have prospered and taken the vast majority of generated wealth from these years which is highlighted by the fact that the top 25% of the UK population own around 75% of total UK wealth.
This report has highlighted the fact that under Capitalism wealth creation doesn’t mean more for all but rather more for the few who manipulate the system and maintain the status quo ensuring the rich get richer and everyone else runs after the carrot that is the capitalist dream.
US car giant General Motors (GM), who at one time had a massive 50% share of the US motor industry, has filed for bankruptcy.
The stricken firm whose fate is the biggest industrial failure in US history had been given a deadline of 1st June to come up with a viable recovery plan in order to secure emergency government funding.
GM’s sales have been hit hard by the financial crisis and the firm has already received $20 billion in state aid.
This most epic of catastrophes highlights the fact that bailouts are not the solution and only lead to a brief pause in the inevitability of failure.
We have seen many examples of how the so called boom years were fuelled by greed and excess and the concept of spending beyond ones means, with the motor industry benefiting from consumers taking out car loans to maintain the latest models on their driveways.
The credit crunch has exposed the reality of the growth of the motor industry of the past decade as a myth created by the debt culture that was promoted by capitalism.
It has been reported today by the BBC that the way banks were regulated needed to change in light of the failure of Northern Rock and other institutions.
The House of Lords Economic Affairs Committee said the so-called tripartite system had failed and must be reformed.
The report said the problem was that it was not clear who would be in charge in a crisis. It said the Bank of England should get a clear executive role.
What must be made clear is that until the credit crisis blossomed there was no questioning of the existent rules and regulations of conduct by banks.
In fact it was Gordon Brown who encouraged less regulation to enable the banking sector and financial institutions to make more money which ultimately contributed to the fiasco that we are currently in.
In the Capitalist mode of thinking rules and regulations are hindrances and obstacles in the way of the main goal of profit hence the super rich pay thousands of pounds to tax accountants to hide their earnings from the tax man.
Creating more stringent regulations of banking practices will never eradicate the philosophy of greed and profit from the minds of those who are part of the system and will ultimately continue the same practices and profit making tactics albeit with a new regulated face.
The Financial Times reported today that for Britain to recover from its current economic status it would have to return to the old fashioned custom of only spending and investing what the nation has in savings.
The UK has long suffered from the Capitalist disease of greed and consumption and living beyond ones means. This in turn contributed to the artificial economic boom and subsequent bust we now find ourselves in.
The implication is that a sustained economic recovery depends upon a major rebalancing of the economy - less consumption, more savings and more investment. But current economic policy is exactly the reverse: to try to boost consumption and borrow unprecedented sums: an even greater mortgage. This is what “crass Keynesianism” in economic policy amounts to - short-term consumption against long-term sustainability.
The problem that the UK finds itself in is that a large chunk of the economy is driven by the service sector as opposed to industry. The service sector itself is driven by finance.
Since decolonisation of its empire, the UK moved away from its industry based economy which at one time had a 60% share of world production and moved towards a service based economy, which led to increased manufactured imports and gave rise to the financial sector that we know is largely to blame for the economic situation at present.
Bailouts as we have seen are not the solution as they haven’t achieved their main aim of stimulating production nor is quantitative easing as this has merely devalued the pound further and reduced peoples real wealth and spending ability.
Investment in industry would stimulate the real recovery as it would lead to increased production and creation of jobs in the process, however the problem the UK faces is that whilst its financial sector dominates the economy this has led to the creation of hyper finance products where no real trade takes place but where money is circulating in a virtual world where the aim is to make money from money.
The Islamic economic model views the financial sector in a completely different way. Rather that seeing it as a sector in itself Islam views it as an outlet supplying money into the real economy stimulating real production and growth. This leads to a true circulation of wealth and would prevent boom and bust cycles as growth would be real and not artificially created via greed and an over debt products.
Global finance today dominates the world economy. Western economies are characterised with financial sectors which generate billions for the economy. Stock Markets, multinationals, companies raising billions, initial public offerings (IPO) and so on, all symbolise the apparent success of Capitalism. Finance is important in any economy for two fundamental reasons:1. Whatever is produced in any economy can only be brought and sold through the use of money.
2. Society is looking to increase its wealth through investing, the financial sector exists today primarily to bring those with money, and those who need it together.
Finance: Past and present
Capitalism has dominated the financial scene for over 300 hundred years, the initial development of the stock markets took place in Europe to fund expeditions to Latin America, where merchants went to gain riches. Most of the developments in finance have taken place in the post WW2 era.
The purpose of finance is to bring those with money and those that need it together in the market place. The first time the worlds largest economies got together to discuss global finance was at the Bretton Woods conference in 1944, this was the first attempt at unifying the terms of global finance. There were two important outcomes from the conference:
The pegging of the worlds currencies to the dollar which in turn was pegged to Gold and the blueprint to remove all barriers to finance so financial transactions could take place freely. Financial dealings increased twenty fold and reached astronomical proportions. When the US abandoned the dollar peg to Gold, this brought even more money into the financial markets. The explosion in finance meant more and more money was being invested in the financial markets, the need to keep pace with such a development required ever more money to fund such investments and with the absence of a peg to Gold this period witnessed an astronomical rise in the printing of money.
The deregulation drive during the Thatcher-Reagan era brought even more participants into the financial markets including individual investors looking for riches. This also saw the development of the derivative markets in the 1990’s where money was speculated on the movement in the shares of companies, currencies and interest rates. For the first time traders were allowed to speculate in a commodity without actually buying or selling the actual commodity.
Over a period of 300 hundred years the emergence of fiat currencies (i.e. currency without an intrinsic value), the role of compound interest and the development of limited liability company structures have shaped western finance.
Such developments have also been the sole reason why the West has come to be characterised with regular financial crises. The developments in finance since WW2 brought to an end industrial dominance and created duel economies. This is because the financial sector moved away from raising finance to fund business start-ups and projects to speculating on company share prices and the movement of currencies. In this way trading in the financial sector ceased to be about purchasing currency or buying shares in the hope of receiving a dividend to purchasing financial commodities in the hope they could be sold for a higher price.
Due to this it became possible for a company to be in financial difficulties but have a rising share price, or as was seen during the dot.com bubble, new start-up’s witnessed astronomical rises in their share prices even though they were forecasted not to make a profit for 20 years.
The financial sector dominated by the financial markets actually does not produce anything real. Speculators trade in shares, bonds, and currencies that move around from trader to trader, in the hope that slight price changes will yield profits. This process has led to speculation reaching levels unheralded in history, it also means the price of commodities could be moving in the complete opposite direction to the supply and demand situation of a commodity. A good example of this was the rise in oil prices in 2008. Oil prices in less than a year reached $150 a barrel. Throughout history Oil prices rarely went above $35 a barrel, this huge surge in price completely contradicted the fundamentals. No new oil fields were discovered, no new technology was invented that could extract or refine oil quicker. Mark Lewis from Energy Market Consultants explained at the time in a BBC interview “We really don’t know what the fundamentals are doing at any point in time; the markets are looking for signals from the fundamentals. Some of them are irrelevant, some of them are wrong, some of them are meaningless, but they affect prices nevertheless.” Sean Cronin, editor of Argus Global Markets explained at the time “When the New York oil price broke through $100 a barrel for the first time at the start of 2008, one of the factors cited as being behind it was the assassination of Benazir Bhutto in Pakistan on 27 December 2007, that didn’t strike us as making any sense at the time.”
The financial economy that doesn’t produce anything has become so sophisticated that various products have been created which allow an investment in a paper with no real asset represented. This side of the economy is valued more then the real economy, the size of the worldwide bond market is estimated at $45 trillion. The size of the world’s stock markets is estimated at $51 trillion. The world derivatives market has been estimated at $1000 trillion, more then 60 times the size of the US economy and 24 times the size of the entire world economy.
Disaster Capitalism
Western theories on finance have dominated the discipline of economics for over a century. Economic textbooks argue the ‘time value of money’ theory which states that the value of money (the quantity of goods that can be bought) is falling hence a mechanism is needed to fill the difference. Hence £100 will purchase a fixed amount of goods today, however a year later £100 will not get you the same amount of goods, interest rates in theory are equal to the difference. The ability to invest in investment products and financial markets allows one to hedge his/her wealth.
The fundamental problem with such Capitalist theory is that on many issues there is a wide discrepancy between theory and practice. Interest rates in today’s global economy in no way represent the change in the value of money. Interest rates in many economies across the world outstrip prices changes enormously. Such views of money have in fact created an economy which is not real. The global financial economy has turned into one big casino where traders bet on what will happen in the real economy.
Islam and the Financial Economy
The Islamic economy is built upon the real economy this is where the process of production of tangible goods and services, Islam has designated a role for finance in the economy - due to Islam’s focus on the real economy which is the wealth creating aspect of any economy finance in Islam is not an end in itself as there is no interest (Riba). Wealth in Islam is created through each stage of industry i.e. mining, refining, manufacturing and sales’ All of this adds value at each stage and creates wealth for the economy
“That is because they say: “Trading is only like Riba,” whereas Allah has permitted trading and forbidden Riba” [Surah al-Baqarah]
Finance in Islam is intrinsically tied to the real economy and is not an industry in itself. Due to this finance takes a shape in an Islamic economy very different to what is seen in Capitalist economies.
1. Money in Islam was designated by Prophet Muhammed (saw) as representative money, this
is where the notes and coins in the economy are representing a commodity. Through the actions of Prophet Muhammed (saw) in terms of collating tax, penalties and prices in the economy, money represents gold and silver. By restricting the legal tender to such metals inflation is contained as any increase in the supply of money requires additional metal, in this way the Islamic economy has restricted the central government from freely printing currency (paper money must be 100% backed by gold or silver). This brings the much needed stability to money which in turn brings stability to the overall economy.
2. The Bait-ul Mal - the central treasury plays a key role in an Islamic economy. It regulates Money supply by monitoring production and ensuring sufficient currency exists in the economy so that trade and transactions can take place. The role of the state has been clearly defined in the Islamic texts. It has been designated with the responsibility of ensuring the circulation of wealth and supervising the public properties.
3. The removal of interest has a huge impact in the economy. For many it is difficult to envisage economic life outside the capitalist framework which relies so much on interest. The absence of interest actually allows for more wealth creation. To appreciate this we need to understand the role played by interest in investment decisions. This is because the challenge all people face is one of investment. Simply put, people will only invest their money if the rate of return of a business venture measured against the risk of the venture is offset by the interest that can be gained from leaving the money in a bank account to accrue interest. Thus, if the risk of the rate of return on an investment is less than the rate of interest, then one would leave their wealth in a bank account rather then actually invest it. Hence the incentive would be to save the money rather then to use (invest) it. Interest in other words restricts investment and hence is an impediment to the distribution of wealth. By removing interest from the economy it incentivises wealth circulation in the economy through investing in real goods and business ventures. This brings added stability as all participants participate in the same sphere - the real economy.
4. Any individual wanting to begin a business venture needs finance. One could wait for years to accumulate the necessary profits to expand or start a new business or borrow the money today. For this purpose banks were created. Islam has permitted the creation of banks and views them as institutions that aid wealth circulation. This is because banks collect the population’s deposits and then invest the money across the economy in new business ventures. In this way banks become like venture capital bodies who invest in real business. With the absence of speculative financial markets banks only have one sphere to invest customer wealth, the real economy. The absence of interest in the Islamic banking industry as well as speculative and dubious financial markets is the discerning line between modern banks and Islamic banking. This means Islamic banks can only make money from investing wealth across the economy in projects and new start ups, the impact on the wider economy is huge as banks will stimulate the economy through such acts. Modern banking wealth finds its way primarily into the financial markets creating a speculative bubble if investments do not materialise.
5. Although Islam is built upon the real economy and the financial sector is based upon providing finance for the real economy, Islam has allowed a few purely financial transactions. Islam has permitted currency exchange as this was a common practice amongst the people of Mecca and Madina and Muhammed (saw) did not object to it. Islam permitted some forward contracts - this is where payment is taken before the actual delivery of goods or before the final transfer of ownership of the goods. However the items that can be sold before ownership is undertaken must be of a defined nature where they can be counted, measured or weighed, this is due to what is established in the hadith of ibn Abbas, that the Messenger of Allah (SAW) said: “Whoever pays in advance in dates, let him pay in advance for a known price and a known weight for a known period.” And in another narration of ibn Abbas who said: The Messenger of Allah (SAW) said: “Whoever pays in advance in something then (it should be) in a known measure and a known weight for a known period” (narrated by Al-Bukhari). Islam has categorically prohibited purely financial transactions where one lends money in the hope of receiving more in repayment. All trade and transactions are linked to the real economy as they are built upon construction, manufacture, services, or the production of goods and so on.
6. The Islamic company structure also complements an economy without interest. This is because Islamic law does not allow companies to operate on the basis of limited liability, which allows one to only have a financial stake in a company which is restricted to the amount invested. In the event of bankruptcy a shareholder would only lose the initial capital of the company no matter how large the debts. The key feature in an Islamic company is all shareholders are responsible for company debts in proportion to their investment, rather than just their monetary amount. Islamic company shareholders also partake in the running of the business not merely just remain a shareholder in the hope that share prices rise. Stock markets exist primarily to cater for such investors, who do not directly participate in running or management of the company.
7. Whilst the Capitalist finance industry offers investors an array of products and many opportunities, it also brings much harm to the wider economy. This is because such debt based products are betting on the future and reliant upon a certain outcome, when this doesn’t occur the inevitable bust occurs. The Global, credit crunch was built upon future real estate prices continuing to rise, when this was not forthcoming it brought the global economy down, as many had invested in debt based products which themselves were dependent on rising house prices.
8. Western theorists have always argued that an economy without interest removes the incentive to invest. They argue there would be no investment unless there was a guaranteed rate of return. The Islamic economy however is dynamic enough to encourage investment without the need for interest. The prohibition of hoarding wealth has been addressed directly by Allah (swt), the Islamic creed has forbidden the hoarding of wealth. Hence spending is seen as an act of worship alongside the fulfilment of ones needs. At the same time the Islamic economy has designated a 2.5% tax (Zakat) on any wealth held for a year above a fixed threshold. Hence holding onto wealth aside from being rebuked by the Islamic texts faces taxation at the of the Islamic tax year - all this gives citizens in the Islamic economy the incentive to spend and invest, stimulating the economy.
Conclusions
The Islamic economy is intrinsically tied to the real economy, this means wealth is created at each stage of the production line, be it mining, refining, manufacturing, marketing or sales. Each of these sectors will need companies and finance to contribute towards the economy and it is here Islamic finance plays a role. Due to finance being tied to the real economy participants engage only in the real economy which creates stability as there is no way for national income to leave the economy - as such a parallel economy does not exist. The aim of the Islamic economy is to remove barriers to wealth circulation, Islam achieved this through the removal of the barriers that act as obstacles such as interest, speculative financial markets, income based taxation and fiat currency. Boom and bust will not exist in an Islamic economy as the Islamic economy is about ensuring wealth continually changes hands so all can profit from it, the aim of the Islamic economy is not perpetual economic growth, which has proven to be mission impossible.
Virtual Economy - Root Cause Analysis of The Current Financial Crisis
In a statement made to a congressional committee on April 3, 2008, the Chairman of the Federal Reserve Bernanke said that "if Bear Stearns had been allowed to fail, it would have led to a "chaotic unwinding" of Bearn Stearns investments held by individuals and other financial institutions. Moreover, the adverse impact of a default would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability"[1].
In an article published by Newsweek, October 11, 2008, Daniel Gross writes [3]: "Back in 2002, Apple's stock was trading far below the level of cash on its books, ascribing a value of zero to its brands and products, compared with several billion at the height of the boom".
Both statements refer to the existence of two views of the economy: a real economy which is reflected by the level of cash on corporate books, and an inflated, exaggerated view which is reflected in the current stock values of the market. The second view of the economy will be referred to as a virtual economy in this article. Virtual economy, in this context, differs from what is being called virtual economy commerce [2], where customers trade in a virtual imaginary product with certain specifications and an imaginary value. However, this will not be the subject of this study.
The second type of virtual economy (VE) is the one that is important and is strongly related to the failure of the financial capitalist system as is being witnessed today. VE allows the economy to appear much larger than its real size. This economy is based on the assumption that the real money will not be tapped into and therefore, it is possible to deal with an assumed larger (virtual) value for the money.
A good example of this scenario is the case with Donald Trump. He ran projects worth billions of dollars, while being more than 50 million dollars in debt. He was about to file for personal bankruptcy in 1989 when he was pressed to pay some of his debts.
A parallel concept to virtual economy exists in computer systems, where the concept of virtual memory is used. Virtual memory is a special type of organisation which allows the memory in the system to appear much larger than the real size of the memory. With this type of organisation, it is possible to execute program applications which require much larger memory than the system actually has. Virtual memory organisation in computer systems remains a smart way of running applications. However, there are some cases where an application may break the limits of virtual memory and cause the system to thrash, i.e. to fail. This happens when an application insists on using more than the size of real memory instantly, at one given time.
In a similar manner, virtual economy (organisation) provides two views of the economy. One is the real value of commodities and services in a given economy which corresponds to the real economic growth and production. The second view of the economy represents the imaginary value of stock prices and the accumulation of interest (usury) in the banks. A virtual economy system, similar to a virtual memory systems, is bound to crash (thrash) at any point when the instant demand for finance at any given time exceeds the real value of the real economy. The current financial crisis in the US and the world at large is a striking example of a virtual economy crashing (or thrashing).
The phenomenon of a virtual economy, where the money in transactions appears much larger than the real money, began to surface at the level of state economies at the end of the 19th century when financial markets began to take shape in New York. This phenomenon grew to be an integral part of capitalist economies, especially in the US and in Europe due to three major reasons, namely: stock markets, interest based economy, and the removal of gold as a basis for the monetary systems. At the political front, the cold war between the capitalist and socialist camps in the 2nd half of the 20th century further strengthened the virtual economies in the west. We will examine these three factors in some detail in the next few sections. 1. Stock Markets and the Virtual Economy
Stock market activities at the start of the 20th century created a new phenomenon in the economy, where the wealth associated with stock values grew at a much higher rate than the wealth associated with the real economy. When the stock market collapsed in New York in 1929, economists attributed the crash to the great difference between the inflated values of stocks and the values of the real assets of the economy.
The Economist magazine reported on 2/11/1929 that "there is warrant for hoping that the deflation of the exaggerated balloon of American stock values will be for the good of the world." To understand this aspect it has been found that the prices of financial market increased during the preceding period from 1925 to 1929 by 120%, while economic growth for the same period did not exceed 17%. And when the market collapsed, it lost over 93% from its value, which means that the market returned to its real value which was obviously much lower than what the stock market indicated. The same scenario repeated itself in 1987 when the market collapsed again, and as observers again noted financial market had been grossly inflated compared with the real size of the economy, such that the difference between the virtual economy and the real economy was more than 200%. And by the end of the twentieth century the virtual economy was again three times the size of the real market value and this scenario came to be known as the Internet (or DOT COM) Bubble.
The result is that the nominal values of stocks do not reflect the reality of economic production. It is possible to increase the value of the shares of a given company without any real increase in production or profit achieved by that company; this was the case with Amazon, where its stock value exceeded $300 at a time when the company had not achieved any profits. Enron is another example, where the rising value of their stock was based on false information about fictitious profits.
These kind of financial activities, transactions and dealings create two faces for the economy: a real face linked to the economic growth and production which indicates the real strength of the economy. And an imaginary side, that reflects the image seen and observed by the local and global community. When the difference between the two sides is small, there does not appear to be a serious problem in the economy. When the difference, however, is vast as is the case now, in 1987 and in 1929 it is dangerous and may lead to devastating consequences for many years, as happened with the Asian Tiger economies in the late 1990's.
The capitalist countries are aware of the magnitude of the problem, and its seriousness, and keep developing plans and alternatives to prevent or delay an inevitable devastating collapse, to mitigate the effects of the collapse, or to exit quickly in case a collapse happens. A good example of such plans is the recent bail out of the Bear Stern Bank, which almost collapsed after the drastic decline of its stock prices. (The most recent bailout of more than a trillion dollars in US and Europe occurred few months after this article was written).
The direct cause of a stock market collapse is the attempt made by some investors to transfer what they own from fictitious money to real money. As an example, let's assume that the real money is 10% of the total virtual money. This means the amount that can be turned into real money, is no more than 10% of total capital, and the rest is equal to none. So when the owners of the shares notice that a major investor started selling his possessions (to convert them to real money), they panic and start selling their possessions hoping to cash in some real money before the collapse. Then a collapse takes place and brings everything to the foundation (real money).
Let's work through the example more thoroughly. Assume that there are 1000 shares in a company. Also, assume that each share is worth $100. So the total stock value of the company is $100,000. For the sake of argument, assume that the real value of the company is $10,000. In other words, the real value of the company is 10% of the virtual value. Now assume that a major investor sells 50 stocks at $100 and cashes $5000. If the rest of the share holders start selling their shares hoping to get real money from the company, they will be able to get no more than $5000 at best, which translates into $5 per share. Now if one more person was able to sell 50 shares at say $50 and cashes $2500, then the rest of the crowd will have to share the remaining $2500 at $2.5 a share. Eventually when all $10,000 are gone, the share will go to zero. This is how the stock values of Enron and Martha Stewart companies collapsed.
The danger of the virtual economy is that it creates a state of delusion in the economy, which can deceive senior economists and politicians, and drives them to undertake projects larger than their real wealth. There could be a temporary positive effect from this delusion, especially when competing with others for large projects. America has benefited greatly while in a conflict with the Soviet Union during the cold war era, where the Soviet Union used real money to finance its projects, and America used the virtual economy for its own projects. But when a state is exposed to a financial or political crisis larger than the size of its real economy, the illusion may push the state into a losing gamble. The current wars in Iraq, Afghanistan, Somalia and the devastating effects of hurricanes in the US must have contributed to the recent financial crisis in the west. Some countries may sometimes intentionally create real crisis for other countries that depend on the virtual economy, in an attempt to push them to the limits of their real economies. Note also that a sudden collapse of the virtual economy brings the economy to levels much lower than the real value of the economy. 2- The Usury and the Virtual economy
The objective of the financial policy in the capitalist economy, as stated by the bylaws of the Federal Reserve Bank in the USA, is to maintain the highest return on production and labour and to sustain price stability. This objective will be achieved through a mechanism that controls the value of usury (interest rate). During a recession in the economy, the state reduces the value of usury in order to encourage borrowing and increase the demands on goods and services. Conversely, the value of usury would be increased to curb inflation. The point here is to recognize the importance of usury for the capitalist economy as the most important tool to control the ups and downs of the economy. This explains the wide spread of financial institutions that offer loans to individuals, companies, institutions and even governments themselves.
Within this usury based economy, the money flows in two directions. In one direction, the money flows from the investors towards the bank in a form of deposit payments. The other direction is from the banks to the investors in a form of loan payments. Except for cases where the inflation rate is higher than the interest rate during the repayment period, the amount of money going towards the bank is steadily more than the amount of money going towards the investors. If the real money is the money which the investors deal with to increase production and to maintain price stability as required by the fiscal policy, this money will certainly be less than the money that accumulates in the banks. This is the main reason for the difference between the real money and the virtual money. And there are two cases that lead to this phenomenon.
The first case is when the bank performs the lending process. Let's assume that the bank provided a loan of 100 million dollars with 5% usury for 1 year. Let's assume also that the inflation during this period was 2%, the real interest rate becomes 3%. Now presume as well that the borrowed money (100 million) was spent on profitable projects and the total profit was 2%. Now the total value to be paid back to the bank = 103 million dollars, while the real money which is the sum of the initial money and the profit is equal to $102 million. This means that (1) $million accumulates in the bank account which does not correspond to actual value in reality. This surplus is the usury which is described in the Qur'an (That, which ye lay out by usury for increase through the property of (other) people, will have no increase with Allah). Note that the biggest borrowers in the world are governments which borrow money to pay for their operations and not for profit production. Consequently, the accumulated pure usury will be much higher than the ratio of (1%) in the above example. That is why usury money can reach during a specific period of time hundreds of billions of dollars and up to twice the amount of real money. It is worthwhile to know that the real economic growth rate in the US was no more than 3.5% during the last (30) years, while the actual interest rate was more than (8%). This means that virtual money over (30) years was (135%) of the actual value of money. So if the actual value of the US economy was 5 trillion dollars, the value of usury excess of the true value will be $6.75 trillion dollars. This makes the virtual money value (11.75) trillion dollars.
The second case that leads to an increase in the virtual money is when investors deposit their money in the banks for investment in usury. If investors deposit in the bank (100) million with (5%) interest after taking into account inflation, and for a period of (10) years. The value of the money invested becomes (150) million. For the bank not to lose money, it in turn invests the (100) million. Let's say the bank gains (7%) by investing its money ($ 170 million); if (5%) of that investment was part of productive investment by the bank and the rest was pure usury, we will have (20) million usurious money which has no real value in reality. The reality is that most banks do not invest their money in production processes, but rather by investing in other banks and by recycling the loans to other borrowers. This makes the virtual money increase repeatedly and multiple times.
Either way, the resultant quantity of the money accumulated in the banks is much more than the quantity of the initial real money that represents the (real) production. However, what encourages and motivates the continuation of the increase in virtual money is the absence of the urgent need to withdraw large amount of funds from many banks at once. When one of these banks gets exposed to pressure from investors and depositors to withdraw amounts of money (Run On The Bank) that exceed the amount of the real money, the bank soon collapses for the lack of ability to meet customer needs, as happened with the Bank of Boston in the early eighties of the last century. If the Government does not intervene to save the bank and back it up by its funds, a collapse of the bank becomes imminent. When the problem becomes severe and has the potential of affecting several financial institutions, the big countries such as the US begin to print and pump money that could match the amount of the virtual money. This leads to massive inflation, decline in prices and weak production and may lead to a huge financial disaster. Sometimes a disaster may occur by withdrawing large amounts of investors' money at the same time from the banks (similar to the real estate and credit crisis in the US - this occurred few months after writing this article). 3- Breaking away from the Gold Standard
The virtual economy would have not become a genuine trend, if the main currency (i.e. Dollar) remained linked to the gold standard as per the Bretton Woods Agreement in 1944. The agreement established a clear base of exchange into gold within a fluctuation rate of not more than (1%); it also set the bases on how to convert currencies into gold. The existence of such a law can not permit any State economy to appear much larger than its real size. That would cost its stockpile of gold to deplete. There will not be sufficient gold to match the fictitious numbers of the virtual economy. But when the US turned against the Bretton Woods Agreement (in the early 1970's) and broke the link between the dollar and the gold standard, it freed its economy from the rein of the market prices without any restrictions. The US was not satisfied with breaking the linkage between the dollar and the gold, but it also broke the link between the value of its currency and the economy. It made it possible for money to grow more rapidly and at much higher rates than the growth of the economy. It was this separation between money and gold on one hand, and between money and economic growth on the other that enabled the existence of the virtual economy and its tendency to grow at an alarming rate. (Recently the Prime Minister of Britain Gordon Brown called for the reconstruction of the Bretton Woods agreement - Report on Business.com Oct. 14-2008) 4- Conclusions
Is the presence of a virtual economy a matter of strength or weakness for the State? There is no doubt that the presence of a virtual economy leads to the emergence of the state as a powerful state with an ability to manoeuvre, threaten and impact other countries. A virtual economy and strength may allow one country to destroy the economies of other countries especially if those countries rely on a real economy or have less ability than the attacking state. America is still using the virtual economy to influence Europe, Japan, China and others. However, the virtual economy is like an Achilles' heel for these States. While it appears as a point of strength, it also could be a potential point of destruction for the state. When a state is exposed to real crisis, whether caused by disasters or wars, the crisis would drain up what is equivalent of the real economy of that State which in turn may lead to the bankruptcy of the State economy.
Today, the major capitalist countries in Europe and the US have built their enormous economies on the basis of the virtual economy. Most importantly, these countries cannot go back to rebuilding a more realistic economy. The financial politics are based on usury and exorbitant wealth, and the steady increase of the money has become the only goal of their economic and financial policies. And from here we cannot imagine rebuilding the economy in the capitalist countries to become closer to reality, and therefore they will remain vulnerable to destruction and collapse.
And Allah says:
"Those who devour usury will not stand except as stands one whom the Evil One by his touch hath driven to madness. That is because they say: "Trade is like usury," but Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (the offence) are Companions of the Fire; they will abide therein (forever)." [Quran Chapter 2; verse 275]
How political decision can be a cause of economic problem is found in the base of current US financial crisis. This financial crisis indeed started with the advent of a decision by the Clinton administration in 1994. In 1996, there would be a public election for electing president. Being a democrat, Clinton wanted to get the vote bank of 25% people of USA who didn’t possessed houses of their own. Clinton was definitely successful in achieving his political goal, but failed in terms of a economic manager if we consider the long run effect of that decision. Here in this article we are going to discuss the whole agenda in full detail to understand the situation better and we shall try to relate the phenomenon with the reality of Bangladesh.
STEP 2
The big flaw: Creating a Sub-prime Market
The sub-prime market differs from the prime market as it comprises all those people who do not meet the criteria for a mortgage in the mainstream markets. The adoption of the Depository Institution Deregulatory and Monetary Control Act in 1980 was part of the deregulation drive that eliminated many restrictions to lending, this resulted in loan reaching unprecedented levels which led to the mainstream mortgage market becoming saturated and reaching its peak of profitability. Those with patchy credit histories and of low income were turned away from mainstream mortgages at a time when the market was buoyant due to consumer spending and borrowing. The sub-prime market was carved out after this point as 25% of the US population fell into this category and represented a market opportunity. Hence US lenders gave mortgage to people who had little means to pay for a mortgage and charged them a rate of interest much higher than the commercial rate due to the increased default risk. They issued these mortgages sage in the knowledge that if the buyer defaults, then they would be able to repossess the property, and sell in a buoyant property market. By the start of 2007, the sub-prime market was valued at more then $1.3 trillion.
Traditional banks stayed away from this risky market and instead remained focused on prime lending and questioned some of the business practices of sub-prime companies such as their aggressive lending and accounting practices. Between 1994 and 1997 the number of sub-prime lenders tripled, gong from 70 to 210. because such institutions were not banks they possessed no customer deposits and in order to expand many lenders turned to the stock market for funding.
Companies such as Money Store, AMRESCO Inc, Dallas and Aames Financial Corporation, all raised capital through placing some of their companies on the stock market. Relatively young lender such as Long Corporation, Delta Funding Corporation, Irvine, California based New Century Financial Corporation, Delta Funding Corporation and Cityscape Financial all took their companies 100% public. By the end of 1997, the top 10 lenders accounted for 38% of all sub-prime lending.
STEP 3
Securitization
Most sub-prime lender then invented another of making money in a sector which was already highly risky. Many lender wanted to ensure they didn’tlose out at possible money making opportunities in the sub-prime market and developed a number of complex products; this was achieved by breaking down the value of the sub-prime mortgage market and various home loans in to financial sausage meat- just as wholesome as the real world equivalent- and selling them on to other institutions. Debt was sold to a third party, who would then receive the loan repayments and pay a fee for this privilege. Thus debt becomes tradable just like car. Hence the ability to securitize debt provided a way for risk to be sliced and diced and spread, thereby allowing more mortgages to be sold. Since 1994, the securitization rate of sub-prime loans increased from 32% to over 77% of total sub-prime loans. This process effectively increase the number of financial institutions with a stake in the sub-prime market. This was allowed to happen to the manner in which the original sub-prime loans were securitized.
Many institutions including mainstream Wall Street investment banks became owners of Collateralized Debt Obligation (CDOs). These are bonds created by a process of deconstructing and re-engineering asset-backed securities. This essentially works by proving investors with access to the regular payments received from debt payers in return for paying to have access to the CDO as well as management fees. Thus Wall Street investment banks made investment in the cash flown of the assts, rather than a direct investment in the underlying assets.
Many institutions also became owners of mortgage-backed securities (MBS), which were created out of the repackaging of sub-prime loans. In simple terms this is where a bank sells a set of debts as one product. In return for a fee, the new holder of this debt obligation receives the regular loan repayments. In most cases such a debt forms part of a pool of mortgage based debts lumped together into a form of asset or bond, each with different degrees of risk attached to them. Thus owners of MBS’sactually do not know the source of where the payments are coming from or even which sectors they’re being exposed to. The MBS market is worth $6 trillion currently, even more then US treasury bonds. The difference between CDOs and MBSs is in the later the property is placed as collateral. In any event of a downturn in the housing market, it would not only be the sub-prime providers who would lose out, but now all those who purchased collateral products would also be exposed.
STEP 4
The Role Of Credit Rating Agencies
Most debt carry ratings which indicate the amount of risk they entail, such a task is undertaken by credit rating agencies as an independent verification of credit worthiness. US home loans had been pooled and packaged into tradable securities by Wall Street banks, before being sold on to financial institution around the world. as they were bought and sold, these mortgage-backed securities were valued according to ther ratings given to them by the credit rating agencies. Credit agencies (dominate4d by the big three: Moody’s, S & P and Fitch) classify the risk of these repackaged securities according to their exposure to risky markets. CDOs were classified into tranches, the highest tranche was perceived to be very low risk and was often given an AAA rating- the same rating as high grade US Treasury Bonds. This is because in the even of default, the first to incur the loss would be the lower tranches and not the top tier. The mathematical models and simulations that the banks relied upon didn’t predict a scenario where defaults would become so numerous that even the top tier AAA-rated tranches would be affected.
STEP 5
Sub-prime Market Collapse & Effect On World Economies
As the housing sector continued to inflate due to the appetite for housing by Americans, the sub-prime sector continued to also grow. Commercial banks entered what they considered a buoyant market that could only rise, many Americans refinanced their homes by taking out second mortgages against the added value to use the fund for consumer spending. The first sign that the US housing bubble was in trouble was on the 2nd April, 2007, when New Century Inc., the largest sub-prime mortgage lender in the US declared bankruptcy due to the increasing number of defaults from borrowers.
The crisis then spread to the owners of collateralized debt who were now in the position where the payments they were promised from the debt they had purchased was being defaulted upon. By being owners of various complex products, the constituent elements of such products resulted in many holders of such debt to sell other investments in order to balance losses incurred from exposure to the sub-rime sector or what is know as ‘covering a position’. This second round of selling to shore up funds and meet brokerage margin requirements is what caused the collapse in share prices across the world in August 2007, with the market getting into a vicious circle of falling prices leading to the further sales of shares to shore up losses.
What made matters worse was many investors caught in this vicious spiral of declining prices did not just sell sub-prime and related products, they sold anything that could be sold. This is why, share prices plummeted across the world and not just in those directly related to sub-prime mortgage. International institutes, who poured their money into the US housing sector realized they will not actually receive their money that they loaned out to investors as individual sub-prime mortgage holders were defaulting on mass on such loans; this resulted in all those who took positions in the housing sector not being able to pay the institutes they borrowed money from. It was for this reason central banks across the world intervened in the global economy in an unprecedented manner providing large amounts of cash to ensure such banks and institutes did not go bankrupt.
Major Sub-prime Losses (June, 2008)
Citigroup
$40.7 billion
UBS
$38 billion
Merrill Lynch
$31.7 billion
HSBC
$15.6 billion
Bank of America
$14.9 billion
Morgan Stanley
$12.6 billion
Royal Bank of Scotland
$12 billion
JP Morgan
$9.7 billion
Washington Mutual
$8.3 billion
Deutsche Bank
$7.5 billion
Wachovia
$7.3 billion
Others
$24.8 billion
The European Central Bank, America’s Federal Reserve and Japanese and Australian central banks injected over $300 billion into the banking system within 48 hours in a bid to avert financial crisis. They stepped in when banks, such Sentinel, a large American investment house, stopped investors from withdrawing their money, spooked by sudden and unexpected losses from bad loans in the American mortgage market, other institutions followed suit and suspended normal lending. Intervention by the world’s central banks in order to avert crisis cost them over $800 billion after only seven days.
STEP 6
Credit Crunch Across The World
Banks across the world fund the majority of their lending by borrowing from other banks or by raising money through the financial markets. As the realization dawned that sub-prime mortgage backed securities existed across the banking sector in the portfolios of banks and hedge funds around the world, from BNP Paribas to Bank of China. Many lenders stopped offering loans, some only offered loans at very high interest rates and most banks stopped lending to other banks to shore up their books. As no bank really knew how much each bank was exposed to the sub-prime crisis, many refused to lend to other banks, this led to credit crunch whereby those banks who made the majority of their loans from borrowed money found credit was drying up.
Northern Rock, the 5th largest mortgage lender in UK, funded its lending by borrowing 80% from the financial markets. As the credit markets froze, it requested the Bank of England, as lender of last resort, for liquidity support facility due to problems in raising funds in the money markets. This created a run on the bank as depositors lost all confidence in the bank leading to queues developing across the nation as depositors withdrew their cash in panic. The British governmenttook the controversial decision to nationalize Northern Rock as its collapse would have inevitably spread to other banks as panic stricken depositors attempted to withdraw their savings- the whole banking sector would have collapsed.
