An edited version of this article was first published in Euromoney's Islamic Finance Information Service, 11 December 2007.
Tarek El Diwany, December 2007
The goldsmith bankers of seventeenth century England engaged in the seemingly innocuous practice of holding precious metal coins on behalf of their depositors. In return for each deposit of coins, a goldsmith would issue the depositor with a paper receipt that promised redemption on demand. If a particular goldsmith was well trusted, many merchants would be happy to accept his receipts in payment for goods and services. A large proportion of the public therefore came to see goldsmiths’ paper not as receipts for money, but as money itself. Accordingly, depositors came to seek redemption of their receipts in ever decreasing numbers. Why bother going to the goldsmith to withdraw gold coins, if shopkeepers would accept the paper in payment anyway?
The goldsmiths soon realised the incredible business opportunity implicit in their customers’ behaviour. Instead of acting as mere safe-keepers of gold, they now offered their services to the public as money lenders. But when the public came to borrow money, they would be loaned paper receipts not gold. From the perspective of these early bankers, such a policy had one great advantage. Unlike gold, paper money could be created in the back office at almost no cost.
Naturally, many businessmen wanted to join in this new game of banking. What easier way could one find of earning a living than creating money with a printing press, and then lending it at interest? "The Bank hath benefit of interest on all moneys which it creates out of nothing", said William Paterson upon founding the Bank of England.
In those early days of banking, some commentators argued that if a banker issued a receipt promising the payment of a certain amount of gold, then he should keep that amount of gold in his vault to honour the promise when so required. The bankers argued differently. They said that because the majority of depositors did not come to the bank to claim their gold in any one period, it would be safe to issue receipts in excess of their gold stock. With this argument, the bankers attempted to justify their creation of multiple legal claims of ownership for each unit of gold in their possession.
The reserve of gold to paper in issue came to be known as the "reserve ratio", and today many major banking organisations operate a reserve ratio of less than one twentieth. Hence "fractional reserve banking". For example, HSBC’s 2006 Annual Report shows that its customers held in aggregate some £168 billion of sight deposits, yet at the same time the bank held only £3.5 billion of cash to honour requests for withdrawal of those deposits. If all of HSBC’s customers asked for their money in cash on the same day, the bank would be in a rather similar position to that of Northern Rock. The same is true for all commercial banks because the holding of a fractional reserve is the essence of their business model. They survive only so long as depositors are sufficiently confident not to ask for their money back.
Realising that heavy withdrawals might bankrupt them, early bankers made arrangements to borrow reserves of coins from one another when necessary. However, these arrangements didn’t work well in times of crisis when every bank was in need of extra reserves. It would be so much more convenient if the money of the realm could be redefined as a piece of paper, rather than a piece of gold or silver. It could then be printed in whatever quantities were necessary to satisfy calls for reserves by the commercial banking system. The government duly obliged. In 1833, Bank of England notes were made legal tender for all sums above £5.
Today’s banking practices are of course more sophisticated, though the principles remain the same. Modern commercial banks create money by crediting the borrower with an electronic entry which shows up as a balance on an account statement. But as with the goldsmiths’ paper promises of old, if all of a bank’s customers try to convert these balances into cash, the bank will soon find itself in need of extra reserves.
There is another more important similarity between these modern and early forms of banking. Whether it is a goldsmith issuing a newly printed paper receipt to a borrower, or a high street bank crediting a customer’s current account with a ledger entry, money supply increases every time a banker makes a loan. Money has become the balance sheet counterpart of debt at the macro-economic level. Therefore, widespread attempts at reducing debt also cause reductions in the supply of money and lead directly to recession. In short, society cannot repay its debt and have a job.
Given that commercial banks have the power to create new money at zero cost, it is an obvious business strategy for them to maximise the amount of money created within the existing regulatory regime. The greater the amount of money created, the greater their interest revenue and the greater their profit. The overall trend is therefore for a growth in money supply (and hence debt) over time. As a result of this tendency, every modern nation suffers from inflation. In more recent times, this inflation has been disguised by various statistical techniques. For example, although houses are the most expensive item that most individuals ever buy, they are excluded from the common measures of UK inflation.
Monetary reformers argue that the legal privilege to create money should be removed from private entities such as commercial banks and placed instead in government hands. Others go further, citing the tendency of governments to issue money for their own political advantage, and propose a commodity money system based on precious metals. Put simply, this is a system in which money is created by those who dig for it.
The American founding fathers adopted exactly this approach. Their objective was to ensure that America would not fall prey to the money creating usurers of England, amply evidenced by Jefferson’s statement that "banking establishments are more dangerous than standing armies". Gold and silver were duly enshrined as the only lawful forms of money under the American Constitution, but the struggle with the banking lobby had only just begun. Soon, Jefferson felt compelled to warn the American people against giving the banks control over their currency. Then during an address to the American people in 1837, Andrew Jackson accused the Bank of the United States of having created a recession by contracting the money supply, and this in order to damage him politically. Almost thirty years later, President Lincoln proposed measures to ensure that democracy could rise above the "Money Power". But in the long run these efforts were insufficient against the power of the banking lobby. It was Woodrow Wilson who finally conceded to the demands for a central bank by signing the Federal Reserve Act into law in 1913, a manoeuvre that effectively passed control of the American monetary system to private interests.
Alas, the coup de bank is now global. It is the culmination of some three centuries of concerted effort by a small clique of men whose interests have never coincided with those of humanity at large. These are men who were once imprisoned for their usury, and who now rule over us from the comfort of their central banking boardrooms. From here they can change the value of our money with a single announcement, and there are few greater powers than that.
The dominance of the banks is all the greater because they can choose which entrepreneurs to finance and which to overlook, and because their immense profitability allows them to support ideologies that accord with their own political agenda. The defeat of the Christian prohibition of usury is one historical example, a strategy that is being repeated with astonishing similarity in the Islamic banking sector today. In this regard, semantic distortion has always been a favoured device. Money lenders don’t practice usury anymore, they "sell mortgages". Islamic banks don’t lend money at interest, they charge a "profit mark-up".
In recent weeks, semantics has been relied upon heavily in order to minimise public awareness of the black art of money creation. At first, we were led to believe that the money used to rescue Northern Rock is taxpayers’ money. It is nothing of the sort. It is new money, created in a few keystrokes by the Bank of England. Realising the impossibility of explaining how more than £20 billion of "taxpayers’ money" could be collected and disbursed in just a few weeks, the authorities soon amended their language. The rescue package is now referred to as a "taxpayer-backed loan", which implies that if Northern Rock cannot repay the money created out of nothing by the Bank of England then the British taxpayer will. Ironic, isn't it, that the people who may be required to pay the cost of saving the British banking system are the very ones who have been hopelessly indebted by it.
If this is what happens when just one bank is caught out on its promise to pay cash to its depositors, then the consequences of a wider bank run could clearly be catastrophic. The political pressures on media organisations to avoid an open discussion of fractional reserve banking are therefore substantial. It would be a brave editor who published the headline "The Bank Doesn't Have Your Money, Mrs. Smith" but no truer words could be written.
In the immediate present, the global economy stands on a knife edge between depression and hyperinflation. The pumping into circulation of hundreds of billions of dollars in new reserve money across the world may or may not be sufficient to rescue the banking sector from its own greed. And it may or may not be enough to prevent a global recession. But in the longer term, there looms a much weightier issue. The debts of the West have now become unrepayable except by means of an inflation that will cause its empire to weaken substantially. Such a development may force the dominant banking institutions of our time to shift their commercial and political focus into the Chinese banking space, and that would be a difficult migration. The Chinese leadership will surely know that control of the money supply brings with it control of the nation, and this is a power that they will not willingly place in foreign hands. Indeed, the founding fathers reasoned likewise.
Such is the story of paper money. That innocuous receipt has given us a world in debt, a world of huge power imbalances, of booms and busts, and now perhaps a transition of empire.
Sunday, June 1, 2008
Questions For The Scholars
Tarek El Diwany, September 2007
On the 31st of January of this year I attended a conference on Islamic banking and finance organised by Euromoney in London. In answer to a question from the floor, one of the scholarly panelists remarked that "we welcome constructive comments, but there are some people who only wish to be destructive and we ignore them". Later he asked "are Muslims not in need of home financing or car financing?" with the obvious implication that his critics think they are not.
Intentional or otherwise, this was a misrepresentation of the arguments that the inner circle of Islamic finance scholars face. And while each of us is entitled to develop his own economic theory, once the "Islamic" label is used the views of other professionals should not be dismissed too lightly. Islamic banking and finance is not a football that can be monopolised in the school playground. It is not an intellectual pet that belongs to any one group of people.
Because most of the world now sees usury as something normal, perhaps even necessary, Islam has become the last remaining line of defence among those religions and ideologies that once prohibited it. If the Muslims fail to promote a truly usury-free approach in finance, few others will do so. Unfortunately, in our rush to embrace the world of secular business and politics, vital matters of Islamic law and institutional substance have been passed over with almost casual arrogance. What makes this so dangerous is that business and politics are two of the least desirable forces for shaping the laws and institutions of a nation. It was their union that gave birth to the modern interest-based monetary system in London some three hundred years ago. William of Orange wanted power, the money lenders wanted a banking monopoly, and their creation was called the Bank of England.
Undoubtedly, powerful forces are now at work that seek to overturn the Islamic prohibition of usury. In many cases their tactics are identical to those that were deployed in Christendom. In the late Middle Ages and early Renaissance, the Scholastics argued against "retrovenditio" (known in Islam as bay al-`ina). They prohibited the exchange of a bottle of wine now for a bottle of the same wine several months later (a practice that has much in common with riba al-nasa) because wine became more valuable as it matured. Such contracts were recognised as covert forms of usury by the Church scholars, but it was the construction of a usurious loan through the combination of three permissible contracts (the "Contractum Trinius") that finally defeated them. Here was the door through which money lending at interest entered the daily practice of merchants in the Christian world, just as the practice of "murabahah-to-the-purchase-orderer" has done in the Islamic world.
The famous chronicler Matthew Paris describes a contract document from the year 1235CE, in which the bishops of the day had found a way of borrowing money at usury whilst keeping the appearance of staying within the Biblical law. Of the money lenders who were lending to the bishops, Paris writes: "... they circumvented the needy in their necessities, cloaking their usuries under the show of trade, and pretending not to know that whatever is added to the principal is usury by whatever name it is called". Cloaking their usuries under the show of trade? How depressingly familiar.
A few years ago, one occasionally heard scholars mentioning Michael Rowbotham on the subject of money creation by the commercial banking system. Although he does not believe that interest should be prohibited, the prominence of Michael's work was a hopeful sign because his thesis on the monetary system is essentially correct. Like me he believes that the business model of commercial banking involves the creation of money out of nothing (fraud) and its subsequent lending at interest (riba). For Muslims to focus on narrow issues of contractual structure when the monetary framework has been corrupted in this manner, is to guarantee the failure of the Islamic finance experiment. Islamic finance cannot succeed with un-Islamic money.
A key point in this connection is that no one, neither an individual nor a financial institution, should give a promise that is impossible to keep. If a bank promises to pay £100 in cash to a customer on demand, then the bank should keep £100 in cash in order to fulfil that promise when the customer requires it. This of course is not the case in modern commercial banking. For example, HSBC’s 2006 Annual Report shows that its customers held in aggregate some £150 billion of sight deposits, yet at the same time HSBC held only £3.5 billion of cash to honour requests for withdrawal of those deposits. If all of HSBC’s customers asked for their money in cash on the same day, HSBC would be forced to close its doors.
This practice of holding a fractional reserve is a classic case of gharar. It is also the misrepresentation that lies at the core of commercial banking. By lending out money that they are supposed to be holding for sight depositors, commercial banks increase the money supply. In the process they also increase their interest revenue, which is of course the point of the whole exercise. Inflation, indebtedness and the forced economic growth that Michael Rowbotham speaks of, become features of our economic landscape as a consequence of this practice.
In the West, the longstanding policy has been to regulate rather than abandon the fractional reserve system. Since commercial banks practice gharar by holding insufficient reserves to redeem their deposit liabilities, central banks offer a "lender of last resort" function in order to make extra reserves available to them in times of need. And since banks practice riba by promising in advance to pay depositors a percentage gain on their deposits, come what may, they must adhere to capital adequacy ratios. These require that each bank holds a cushion of capital to protect depositors from poor performance of the bank’s loan book.
The briefest of consideration would inform us that the lender of last resort function and the capital adequacy ratio, like many other features of the modern banking landscape, are a consequence of not implementing Shari`ah. This is why it is so utterly depressing to find Muslim executives and academics proclaiming the need for these very practices within an Islamic banking system. At the London conference, proud announcements were made of progress towards an "Islamic debt market", "adoption of the Bank for International Settlements framework" and "closer ties with the International Capital Markets Association". Our leaders do not seem to see that the structures with which they are trying to integrate could only grow in the soil of usury. Attempting to invent their Islamic equivalent is just as unreasonable as attempting the creation of an Islamic thief. Can we not have the vision to grow our own tree, in the soil of Islam, and harvest the pleasant fruit that would undoubtedly grow on it?
The impact of the interest-based money creation framework on the property market is well known in many countries. In the United Kingdom in 1963 the average house price was £3,160. Ten years later it was £9,942, ten years after that £26,471, and today it is some £200,000. Trying to save for a house under these circumstances is impossible for all but the highest earners in society. For the rest of us, by the time we have reached our savings target, the price of the house has doubled or trebled. The only practical option in these circumstances is to borrow the money in order to buy the house. But money borrowed from the bank is newly created money, and when that money is injected into the housing market, house prices rise. The act that allows one person to buy a house, causes house prices to become unaffordable for the next person. This is an awful trap, one that "Islamic" mortgages do nothing to solve because the banks that offer them are also creating money out of nothing. By promoting Islamic mortgages as a solution to our home financing needs, our problems only worsen in the long run.
In the model of home finance that I have promoted over the last decade or so, the financier buys a proportion of a property and the client buys the remainder. These two parties own the property as partners, and subsequently rent it to a tenant. The tenant in most cases is the home buying client. Over the years, the client can buy the financier’s share of the property, and if he does so he pays the market price for the share he buys. But the client doesn’t have to buy the financier’s share, and this is a vital feature because it means that the client is not in debt to the financier. At the end of the partnership term, if the client has not bought all of the financier’s share, the house will be sold on the open market and the sale proceeds will be divided between the partners according to the ratio of their partnership shares at that time. In this structure, the client can never be repossessed by the financier because he is never in debt to the financier. Neither can he find himself in "negative equity", the position that often occurs in interest-based mortgages where the debt owed on a property is greater than the value of the property. If the financier owns 80% of a property and the property falls in value to nothing, then the financier owns 80% of nothing and the client does not need to compensate him with a single penny.
Imagine if such a product existed in a Western country today. If the people of Britain or America knew that there was a way of buying a home and not being in debt, millions of them would go for it. And if they saw that it was the Muslims who were providing them with that solution, they would surely think more highly of Islam. Yet in almost every "Islamic" mortgage product available today, capital risk is shifted from the bank to the customer just as in a interest-based loan. The customer is in debt to the bank, just as in an interest-based loan. The monthly cash-flows are the same or higher than an interest-based loan. In many cases the rental rate can rise as unpredictably as the interest charge on a variable rate mortgage, because it is linked to LIBOR. And in a default, the customer may find himself in a position of negative equity, just as in an interest-based loan. Is it any surprise that non-Muslims who hear of the principles of Shari`ah, and are then confronted with its implementation, should mock us for what is happening?
So I do believe that Muslims need home finance. It’s just that my way of doing it accords with the spirit and tradition of our religion, while the ways of Islamic banking usually don’t. And I am not alone in my feelings. I speak to many financial executives who are equally disillusioned. Their feelings include guilt ("I feel like I just participated in the Manhattan Project and regret what I have helped to create"), derision ("... these instruments are pretty much a sham, and I still cannot believe that eminent scholars passed this product as Shari`ah compliant") and hostility ("... the more I practice Islamic finance, the more I hate it"). When practitioners within the industry make comments such as these, they cannot just be ignored. There is clearly a fundamental problem.
It is well known that Islamic banks cannot charge interest on a late payment of an installment due under a murabahah contract. We also know that tawarruq financing has been allowed by some scholars. Here, the client buys a commodity for delivery now against deferred payment, then sells the commodity into the market at a lower price for immediate cash payment. The bank arranges both transactions using various commodity dealers, and in this way maintains the fiction that it is trading commodities with its client. The substance of the transaction, of course, is that the client is borrowing money at interest from the bank. But to allow tawarruq and simultaneously prohibit the charging of a penalty for late payment of a debt is pointless in every sense and here is why, in the words of an Islamic banking lawyer: "We were told that banks couldn’t charge an interest penalty in event of late payment by the client. So we re-financed a late murabahah installment by entering into a tawarruq contract with the client. In that way the bank received its interest penalty, in effect".
Most of these practices rely heavily on the legal device of contract combination. A loan, a promise and a gift are each halal from the perspective of Shari`ah, yet their combination easily produces a "money-now for more-money-later" transaction. No scholar would permit such a transaction, yet the combination of two halal transactions produces precisely the same result in "murabahah-to-the-purchase-orderer". Why is the first combination seen as a form of riba, and the second not?
If the spirit of Shari`ah is being broken by means of contract combination, then so too is the letter of the law being broken by the practice of "benchmarking". In many modern lease contracts, the rental rate charged to the tenant is linked to LIBOR. Since LIBOR for any given period is not known until the commencement of that period, the tenant in a property cannot know what rent he will have to pay for its use in future periods. Rentals may therefore increase substantially and unexpectedly if market interest rates rise and, for many holders of Islamic mortgages, an increase of two or three percent can make the monthly payments unaffordable. There is an overwhelming consensus in Shari`ah that the price of an object of sale should be known at the time of contract signing, and rent is of course a price that is paid for the right to use a property. Yet this fundamental requirement is contradicted by linking rental payments to future measures of LIBOR. Clearly, many banks want to promote LIBOR linking in Islamic finance because the funds they use to finance their customers are themselves borrowed at an interest rate that is linked to LIBOR. Is it not therefore obvious that if the banks have financed themselves at interest, then the funds obtained thereby must be deployed in a way that mimics an interest-based loan? Wasn’t Islamic banking meant to challenge the interest-based model, rather than integrate into it?
And what of the forward sale of partnership shares? Let us imagine that two partners establish a business with contributions of 50 each in capital. These two partners share the profits in any way that they choose, and share losses in accordance with their share of the capital. It is therefore not permitted to agree at the outset that one partner will buy the other’s share, say at a price of 60 in one year’s time, since this would contractually guarantee a profit of 10 to the partner who sells his shares. Recent AAOIFI standards (3/1/6/2, 2003-2004) echo this point, but things are very different in practice.
For example, a forward sale of partnership shares was agreed in the USD3.5 billion sukuk issued by PCFC in UAE during 2006. The sukuk documentation requires that one musharakah partner buys the other’s share at a price that provides a pre-agreed gain of up to 10.125% per year. There are several clauses in the PCFC prospectus that achieve this, though one needs a forensic ability to identify them: "The Obligor shall execute a purchase undertaking (the Purchase Undertaking) in favour of the Issuer. Pursuant to the Purchase Undertaking, the Obligor shall undertake to purchase the Issuer’s Units at the Relevant Exercise Price"; "Relevant Exercise Price means ... a US Dollar amount equal to the aggregate of (i) the Outstanding Sukuk Amount and (ii) the Scheduled Accumulated Sukuk Return Amount"; "Scheduled Accumulated Sukuk Return Amount means an amount calculated as follows: Scheduled Accumulated Sukuk Return Amount = Outstanding Sukuk Amount x 10.125% x (n/360) where: n means the number of days for the period ..." PCFC Development FCZO, Offering Circular, January 2006
Is this not a shallow subterfuge in violation of industry standards? Certainly the terminology is typical of an interest-bearing bond, fixing in advance a positive return for investors in the sukuk. Yet look how it is portrayed by an executive at Dubai Islamic Bank: "Many readers may have been wondering as to how the PCFC Sukuk carries a pre-known profit rate whereas the Islamic Sharia is averse to the idea of fixing a return on investment at the outset. In order to substantiate that for all practical purposes, the above is a projected return based on a business plan prepared and submitted by PCFC to the investors, I would like to quote the gist of a relevant clause from the Musharaka agreement entered into between PCFC and the Special Purpose Co (SPC) representing scores of investors in the Sukuk: ‘PCFC acknowledges that it has prepared the business plan based on which the Musharaka is expected to yield a minimum profit of (say 15 per cent) per annum on its total equity. The Musharaka profit will be distributed between PCFC and the investors at the ratio of 30:70 respectively.’ " http://archive.gulfnews.com/articles/06/03/29/10028930.html
Nowhere in the above explanation does the fact of a purchase undertaking appear, something that is central to the PCFC structure. What do the profit-sharing arrangements matter, if one partner has undertaken to purchase the other’s share for a 10.125% profit on maturity?
If it becomes our culture to turn a blind eye to these various goings-on, then it will be more than just our jurisprudence that suffers. If Shari`ah violation is off-limits as a subject of discussion, why should the commercial performance of Islamic financial products come under any greater scrutiny? In all of the marketing buzz surrounding PCFC, for example, few people have asked why a government guaranteed organisation in the UAE should be raising funds at a pre-agreed financing cost that is several hundred basis points above US dollar LIBOR. If one is going to agree a financing cost on money at the outset, why not borrow at LIBOR instead and save tens of millions of dollars in the process? As another example, whilst researching for a client recently, I came across a fund that won the second place prize at an award ceremony in Saudi Arabia a couple of years ago. The fund focussed on North American equities and had lost some 16% of its value since inception, after fees. Over the same period, the market as a whole had risen by 3.3%. On average, initial investors in the fund would have done better by choosing their portfolio components at random from the Dow Jones Islamic Index.
An honest discussion of issues such as these is central to the long term credibility of the Islamic finance industry, but instead we get empty hype and a refusal to engage on the key topics. There has been a deliberate weeding out of traditionalists and plain speakers, with the result that too many of the people promoted to the conference platform are long on compromise or short on vision. All of this has been substantially encouraged by the secular banking lobby. It is they who are making a trillion dollars or more every year from the practice of usury. Why would they ever promote an industry that seeks to abolish it? And shouldn’t we be slightly concerned that so many of our leading scholars have achieved prominence through the patronage of these institutions?
Consider the consequences if we fail to defeat usury. The business model of many modern corporations is to borrow money from the bank at interest and then to invest that money into corporate operations yielding a higher rate of return on assets. Under this model, the more the firm borrows, the more profit it makes. So if the interest rate is 5% and the return on assets 20% then, for every extra dollar borrowed, another 15 cents in profit is generated. Firms therefore compete to borrow very large amounts of money from the banks, which as we know can create it out of nothing almost ad infinitum. Those that are able to borrow the most swallow up business opportunities that would otherwise have gone to smaller firms. The results of this can be seen everywhere. In the production process, owner-managers become disinterested lower-paid employees. In our landscape, characterful villages are encircled by anonymous housing estates and massive sheds. In our environment, intensive production puts stress on natural resources. And in countless communities, local influence over local affairs declines, as centres of control move to headquarters that are often thousands of miles away. These are some of the monuments to modern leverage.
In the Muslim world, leverage has traditionally been hard to achieve. If one cannot borrow at interest then how can one generate that 15 cents of profit on every dollar? If funds were raised on a profit-sharing basis, the entrepreneur would have to share the 15 cents with the investor and this would change the nature of financing activity entirely. The financier’s motive would be to choose the most profitable projects available, not necessarily the biggest ones. And since financiers could not charge interest, they would no longer be so concerned about the amount of collateral possessed by their clients. Under profit-sharing, what matters most to financiers is that their clients should have good management and profitable business opportunities. It is a system in which wealth begins to circulate among the poor once again, since profitable ideas and good management are not the sole privilege of the rich. Regrettably, in the Middle East today, debt financed mega-projects are announced on a regular basis. The marketing literature assumes that we will be proud of these projects, when in fact it is shameful that such huge resources are being centralised in the hands of so few people and organisations. Communities build societies, bankers and leverage don’t.
I know of many dedicated people who joined the Islamic finance movement in the hope that it would help to relieve the injustice of debt. But they have become mere tools by which debt can be spread more widely. Decades of marketing failed to convince the people of Saudi Arabia to borrow at interest. Tawarruq has achieved it in a couple of years. That is the legacy of modern Islamic banking and finance, and the interest-based establishment is laughing at us for having let it happen so easily. What good is our Shari`ah if it becomes a commodity for sale to usurers? Or if we exempt ourselves from its rules, in ignorance of their wisdom?
We believe that falsehood always destroys itself eventually. The Western financial system is no exception to this rule, and neither is our present "Islamic" banking system. If we had adopted a banking and finance strategy worthy of the word "Islamic", then in financial crises to come we could have demonstrated the superiority of our banking and finance model to the whole world. But we have adopted the interest-based system as our template, and so that opportunity has already been lost. Come the day, the Islamic banking system will be in just as much of a mess as its Western counterpart, its legal tricks swept away on a tide of financial distress. And I may just laugh more than I cry.
On the 31st of January of this year I attended a conference on Islamic banking and finance organised by Euromoney in London. In answer to a question from the floor, one of the scholarly panelists remarked that "we welcome constructive comments, but there are some people who only wish to be destructive and we ignore them". Later he asked "are Muslims not in need of home financing or car financing?" with the obvious implication that his critics think they are not.
Intentional or otherwise, this was a misrepresentation of the arguments that the inner circle of Islamic finance scholars face. And while each of us is entitled to develop his own economic theory, once the "Islamic" label is used the views of other professionals should not be dismissed too lightly. Islamic banking and finance is not a football that can be monopolised in the school playground. It is not an intellectual pet that belongs to any one group of people.
Because most of the world now sees usury as something normal, perhaps even necessary, Islam has become the last remaining line of defence among those religions and ideologies that once prohibited it. If the Muslims fail to promote a truly usury-free approach in finance, few others will do so. Unfortunately, in our rush to embrace the world of secular business and politics, vital matters of Islamic law and institutional substance have been passed over with almost casual arrogance. What makes this so dangerous is that business and politics are two of the least desirable forces for shaping the laws and institutions of a nation. It was their union that gave birth to the modern interest-based monetary system in London some three hundred years ago. William of Orange wanted power, the money lenders wanted a banking monopoly, and their creation was called the Bank of England.
Undoubtedly, powerful forces are now at work that seek to overturn the Islamic prohibition of usury. In many cases their tactics are identical to those that were deployed in Christendom. In the late Middle Ages and early Renaissance, the Scholastics argued against "retrovenditio" (known in Islam as bay al-`ina). They prohibited the exchange of a bottle of wine now for a bottle of the same wine several months later (a practice that has much in common with riba al-nasa) because wine became more valuable as it matured. Such contracts were recognised as covert forms of usury by the Church scholars, but it was the construction of a usurious loan through the combination of three permissible contracts (the "Contractum Trinius") that finally defeated them. Here was the door through which money lending at interest entered the daily practice of merchants in the Christian world, just as the practice of "murabahah-to-the-purchase-orderer" has done in the Islamic world.
The famous chronicler Matthew Paris describes a contract document from the year 1235CE, in which the bishops of the day had found a way of borrowing money at usury whilst keeping the appearance of staying within the Biblical law. Of the money lenders who were lending to the bishops, Paris writes: "... they circumvented the needy in their necessities, cloaking their usuries under the show of trade, and pretending not to know that whatever is added to the principal is usury by whatever name it is called". Cloaking their usuries under the show of trade? How depressingly familiar.
A few years ago, one occasionally heard scholars mentioning Michael Rowbotham on the subject of money creation by the commercial banking system. Although he does not believe that interest should be prohibited, the prominence of Michael's work was a hopeful sign because his thesis on the monetary system is essentially correct. Like me he believes that the business model of commercial banking involves the creation of money out of nothing (fraud) and its subsequent lending at interest (riba). For Muslims to focus on narrow issues of contractual structure when the monetary framework has been corrupted in this manner, is to guarantee the failure of the Islamic finance experiment. Islamic finance cannot succeed with un-Islamic money.
A key point in this connection is that no one, neither an individual nor a financial institution, should give a promise that is impossible to keep. If a bank promises to pay £100 in cash to a customer on demand, then the bank should keep £100 in cash in order to fulfil that promise when the customer requires it. This of course is not the case in modern commercial banking. For example, HSBC’s 2006 Annual Report shows that its customers held in aggregate some £150 billion of sight deposits, yet at the same time HSBC held only £3.5 billion of cash to honour requests for withdrawal of those deposits. If all of HSBC’s customers asked for their money in cash on the same day, HSBC would be forced to close its doors.
This practice of holding a fractional reserve is a classic case of gharar. It is also the misrepresentation that lies at the core of commercial banking. By lending out money that they are supposed to be holding for sight depositors, commercial banks increase the money supply. In the process they also increase their interest revenue, which is of course the point of the whole exercise. Inflation, indebtedness and the forced economic growth that Michael Rowbotham speaks of, become features of our economic landscape as a consequence of this practice.
In the West, the longstanding policy has been to regulate rather than abandon the fractional reserve system. Since commercial banks practice gharar by holding insufficient reserves to redeem their deposit liabilities, central banks offer a "lender of last resort" function in order to make extra reserves available to them in times of need. And since banks practice riba by promising in advance to pay depositors a percentage gain on their deposits, come what may, they must adhere to capital adequacy ratios. These require that each bank holds a cushion of capital to protect depositors from poor performance of the bank’s loan book.
The briefest of consideration would inform us that the lender of last resort function and the capital adequacy ratio, like many other features of the modern banking landscape, are a consequence of not implementing Shari`ah. This is why it is so utterly depressing to find Muslim executives and academics proclaiming the need for these very practices within an Islamic banking system. At the London conference, proud announcements were made of progress towards an "Islamic debt market", "adoption of the Bank for International Settlements framework" and "closer ties with the International Capital Markets Association". Our leaders do not seem to see that the structures with which they are trying to integrate could only grow in the soil of usury. Attempting to invent their Islamic equivalent is just as unreasonable as attempting the creation of an Islamic thief. Can we not have the vision to grow our own tree, in the soil of Islam, and harvest the pleasant fruit that would undoubtedly grow on it?
The impact of the interest-based money creation framework on the property market is well known in many countries. In the United Kingdom in 1963 the average house price was £3,160. Ten years later it was £9,942, ten years after that £26,471, and today it is some £200,000. Trying to save for a house under these circumstances is impossible for all but the highest earners in society. For the rest of us, by the time we have reached our savings target, the price of the house has doubled or trebled. The only practical option in these circumstances is to borrow the money in order to buy the house. But money borrowed from the bank is newly created money, and when that money is injected into the housing market, house prices rise. The act that allows one person to buy a house, causes house prices to become unaffordable for the next person. This is an awful trap, one that "Islamic" mortgages do nothing to solve because the banks that offer them are also creating money out of nothing. By promoting Islamic mortgages as a solution to our home financing needs, our problems only worsen in the long run.
In the model of home finance that I have promoted over the last decade or so, the financier buys a proportion of a property and the client buys the remainder. These two parties own the property as partners, and subsequently rent it to a tenant. The tenant in most cases is the home buying client. Over the years, the client can buy the financier’s share of the property, and if he does so he pays the market price for the share he buys. But the client doesn’t have to buy the financier’s share, and this is a vital feature because it means that the client is not in debt to the financier. At the end of the partnership term, if the client has not bought all of the financier’s share, the house will be sold on the open market and the sale proceeds will be divided between the partners according to the ratio of their partnership shares at that time. In this structure, the client can never be repossessed by the financier because he is never in debt to the financier. Neither can he find himself in "negative equity", the position that often occurs in interest-based mortgages where the debt owed on a property is greater than the value of the property. If the financier owns 80% of a property and the property falls in value to nothing, then the financier owns 80% of nothing and the client does not need to compensate him with a single penny.
Imagine if such a product existed in a Western country today. If the people of Britain or America knew that there was a way of buying a home and not being in debt, millions of them would go for it. And if they saw that it was the Muslims who were providing them with that solution, they would surely think more highly of Islam. Yet in almost every "Islamic" mortgage product available today, capital risk is shifted from the bank to the customer just as in a interest-based loan. The customer is in debt to the bank, just as in an interest-based loan. The monthly cash-flows are the same or higher than an interest-based loan. In many cases the rental rate can rise as unpredictably as the interest charge on a variable rate mortgage, because it is linked to LIBOR. And in a default, the customer may find himself in a position of negative equity, just as in an interest-based loan. Is it any surprise that non-Muslims who hear of the principles of Shari`ah, and are then confronted with its implementation, should mock us for what is happening?
So I do believe that Muslims need home finance. It’s just that my way of doing it accords with the spirit and tradition of our religion, while the ways of Islamic banking usually don’t. And I am not alone in my feelings. I speak to many financial executives who are equally disillusioned. Their feelings include guilt ("I feel like I just participated in the Manhattan Project and regret what I have helped to create"), derision ("... these instruments are pretty much a sham, and I still cannot believe that eminent scholars passed this product as Shari`ah compliant") and hostility ("... the more I practice Islamic finance, the more I hate it"). When practitioners within the industry make comments such as these, they cannot just be ignored. There is clearly a fundamental problem.
It is well known that Islamic banks cannot charge interest on a late payment of an installment due under a murabahah contract. We also know that tawarruq financing has been allowed by some scholars. Here, the client buys a commodity for delivery now against deferred payment, then sells the commodity into the market at a lower price for immediate cash payment. The bank arranges both transactions using various commodity dealers, and in this way maintains the fiction that it is trading commodities with its client. The substance of the transaction, of course, is that the client is borrowing money at interest from the bank. But to allow tawarruq and simultaneously prohibit the charging of a penalty for late payment of a debt is pointless in every sense and here is why, in the words of an Islamic banking lawyer: "We were told that banks couldn’t charge an interest penalty in event of late payment by the client. So we re-financed a late murabahah installment by entering into a tawarruq contract with the client. In that way the bank received its interest penalty, in effect".
Most of these practices rely heavily on the legal device of contract combination. A loan, a promise and a gift are each halal from the perspective of Shari`ah, yet their combination easily produces a "money-now for more-money-later" transaction. No scholar would permit such a transaction, yet the combination of two halal transactions produces precisely the same result in "murabahah-to-the-purchase-orderer". Why is the first combination seen as a form of riba, and the second not?
If the spirit of Shari`ah is being broken by means of contract combination, then so too is the letter of the law being broken by the practice of "benchmarking". In many modern lease contracts, the rental rate charged to the tenant is linked to LIBOR. Since LIBOR for any given period is not known until the commencement of that period, the tenant in a property cannot know what rent he will have to pay for its use in future periods. Rentals may therefore increase substantially and unexpectedly if market interest rates rise and, for many holders of Islamic mortgages, an increase of two or three percent can make the monthly payments unaffordable. There is an overwhelming consensus in Shari`ah that the price of an object of sale should be known at the time of contract signing, and rent is of course a price that is paid for the right to use a property. Yet this fundamental requirement is contradicted by linking rental payments to future measures of LIBOR. Clearly, many banks want to promote LIBOR linking in Islamic finance because the funds they use to finance their customers are themselves borrowed at an interest rate that is linked to LIBOR. Is it not therefore obvious that if the banks have financed themselves at interest, then the funds obtained thereby must be deployed in a way that mimics an interest-based loan? Wasn’t Islamic banking meant to challenge the interest-based model, rather than integrate into it?
And what of the forward sale of partnership shares? Let us imagine that two partners establish a business with contributions of 50 each in capital. These two partners share the profits in any way that they choose, and share losses in accordance with their share of the capital. It is therefore not permitted to agree at the outset that one partner will buy the other’s share, say at a price of 60 in one year’s time, since this would contractually guarantee a profit of 10 to the partner who sells his shares. Recent AAOIFI standards (3/1/6/2, 2003-2004) echo this point, but things are very different in practice.
For example, a forward sale of partnership shares was agreed in the USD3.5 billion sukuk issued by PCFC in UAE during 2006. The sukuk documentation requires that one musharakah partner buys the other’s share at a price that provides a pre-agreed gain of up to 10.125% per year. There are several clauses in the PCFC prospectus that achieve this, though one needs a forensic ability to identify them: "The Obligor shall execute a purchase undertaking (the Purchase Undertaking) in favour of the Issuer. Pursuant to the Purchase Undertaking, the Obligor shall undertake to purchase the Issuer’s Units at the Relevant Exercise Price"; "Relevant Exercise Price means ... a US Dollar amount equal to the aggregate of (i) the Outstanding Sukuk Amount and (ii) the Scheduled Accumulated Sukuk Return Amount"; "Scheduled Accumulated Sukuk Return Amount means an amount calculated as follows: Scheduled Accumulated Sukuk Return Amount = Outstanding Sukuk Amount x 10.125% x (n/360) where: n means the number of days for the period ..." PCFC Development FCZO, Offering Circular, January 2006
Is this not a shallow subterfuge in violation of industry standards? Certainly the terminology is typical of an interest-bearing bond, fixing in advance a positive return for investors in the sukuk. Yet look how it is portrayed by an executive at Dubai Islamic Bank: "Many readers may have been wondering as to how the PCFC Sukuk carries a pre-known profit rate whereas the Islamic Sharia is averse to the idea of fixing a return on investment at the outset. In order to substantiate that for all practical purposes, the above is a projected return based on a business plan prepared and submitted by PCFC to the investors, I would like to quote the gist of a relevant clause from the Musharaka agreement entered into between PCFC and the Special Purpose Co (SPC) representing scores of investors in the Sukuk: ‘PCFC acknowledges that it has prepared the business plan based on which the Musharaka is expected to yield a minimum profit of (say 15 per cent) per annum on its total equity. The Musharaka profit will be distributed between PCFC and the investors at the ratio of 30:70 respectively.’ " http://archive.gulfnews.com/articles/06/03/29/10028930.html
Nowhere in the above explanation does the fact of a purchase undertaking appear, something that is central to the PCFC structure. What do the profit-sharing arrangements matter, if one partner has undertaken to purchase the other’s share for a 10.125% profit on maturity?
If it becomes our culture to turn a blind eye to these various goings-on, then it will be more than just our jurisprudence that suffers. If Shari`ah violation is off-limits as a subject of discussion, why should the commercial performance of Islamic financial products come under any greater scrutiny? In all of the marketing buzz surrounding PCFC, for example, few people have asked why a government guaranteed organisation in the UAE should be raising funds at a pre-agreed financing cost that is several hundred basis points above US dollar LIBOR. If one is going to agree a financing cost on money at the outset, why not borrow at LIBOR instead and save tens of millions of dollars in the process? As another example, whilst researching for a client recently, I came across a fund that won the second place prize at an award ceremony in Saudi Arabia a couple of years ago. The fund focussed on North American equities and had lost some 16% of its value since inception, after fees. Over the same period, the market as a whole had risen by 3.3%. On average, initial investors in the fund would have done better by choosing their portfolio components at random from the Dow Jones Islamic Index.
An honest discussion of issues such as these is central to the long term credibility of the Islamic finance industry, but instead we get empty hype and a refusal to engage on the key topics. There has been a deliberate weeding out of traditionalists and plain speakers, with the result that too many of the people promoted to the conference platform are long on compromise or short on vision. All of this has been substantially encouraged by the secular banking lobby. It is they who are making a trillion dollars or more every year from the practice of usury. Why would they ever promote an industry that seeks to abolish it? And shouldn’t we be slightly concerned that so many of our leading scholars have achieved prominence through the patronage of these institutions?
Consider the consequences if we fail to defeat usury. The business model of many modern corporations is to borrow money from the bank at interest and then to invest that money into corporate operations yielding a higher rate of return on assets. Under this model, the more the firm borrows, the more profit it makes. So if the interest rate is 5% and the return on assets 20% then, for every extra dollar borrowed, another 15 cents in profit is generated. Firms therefore compete to borrow very large amounts of money from the banks, which as we know can create it out of nothing almost ad infinitum. Those that are able to borrow the most swallow up business opportunities that would otherwise have gone to smaller firms. The results of this can be seen everywhere. In the production process, owner-managers become disinterested lower-paid employees. In our landscape, characterful villages are encircled by anonymous housing estates and massive sheds. In our environment, intensive production puts stress on natural resources. And in countless communities, local influence over local affairs declines, as centres of control move to headquarters that are often thousands of miles away. These are some of the monuments to modern leverage.
In the Muslim world, leverage has traditionally been hard to achieve. If one cannot borrow at interest then how can one generate that 15 cents of profit on every dollar? If funds were raised on a profit-sharing basis, the entrepreneur would have to share the 15 cents with the investor and this would change the nature of financing activity entirely. The financier’s motive would be to choose the most profitable projects available, not necessarily the biggest ones. And since financiers could not charge interest, they would no longer be so concerned about the amount of collateral possessed by their clients. Under profit-sharing, what matters most to financiers is that their clients should have good management and profitable business opportunities. It is a system in which wealth begins to circulate among the poor once again, since profitable ideas and good management are not the sole privilege of the rich. Regrettably, in the Middle East today, debt financed mega-projects are announced on a regular basis. The marketing literature assumes that we will be proud of these projects, when in fact it is shameful that such huge resources are being centralised in the hands of so few people and organisations. Communities build societies, bankers and leverage don’t.
I know of many dedicated people who joined the Islamic finance movement in the hope that it would help to relieve the injustice of debt. But they have become mere tools by which debt can be spread more widely. Decades of marketing failed to convince the people of Saudi Arabia to borrow at interest. Tawarruq has achieved it in a couple of years. That is the legacy of modern Islamic banking and finance, and the interest-based establishment is laughing at us for having let it happen so easily. What good is our Shari`ah if it becomes a commodity for sale to usurers? Or if we exempt ourselves from its rules, in ignorance of their wisdom?
We believe that falsehood always destroys itself eventually. The Western financial system is no exception to this rule, and neither is our present "Islamic" banking system. If we had adopted a banking and finance strategy worthy of the word "Islamic", then in financial crises to come we could have demonstrated the superiority of our banking and finance model to the whole world. But we have adopted the interest-based system as our template, and so that opportunity has already been lost. Come the day, the Islamic banking system will be in just as much of a mess as its Western counterpart, its legal tricks swept away on a tide of financial distress. And I may just laugh more than I cry.
A Soil of Our Own
An edited version of this article appeared in the December 2006 edition of Business Islamica magazine.
Tarek El Diwany, February 2006
In Summer 2005, Michael Chussodovsky wrote an article on LIVE 8 and its campaign to reduce global poverty (http://www.globalresearch.ca). Here is a short extract from that article:"The concerts are totally devoid of political content. They concentrate on simple and misleading cliches. They use poverty as a marketing tool and a consumer-advertising gimmick to increase the number of viewers and listeners worldwide. Live 8 creates an aura of optimism. It conveys the impression that poverty can be vanquished with the stroke of the pen. All we need is good will. The message is that G8 leaders, together with the World Bank and the IMF, are ultimately committed to poverty alleviation. In this regard, the concerts are part of the broader process of media disinformation. They are used as a timely public relations stunt for Prime Minister Tony Blair, who is hosting the G-8 Summit at Gleneagles, Scotland. Tony Blair is presented as stepping up his campaign to convince other G8 nations 'to take action on poverty' ".
Chussodovsky has identified a methodology here. It is used by the establishment to weaken a potentially threatening movement from within and, because it is a methodology, it can be identified elsewhere. For example, with a few minor alterations, Chussodovsky's words suddenly become relevant to the Islamic banking industry:
"The Islamic banking industry concentrates on simple and misleading cliches. It uses Islam as a marketing tool and a consumer-advertising gimmick to increase its following among Muslims worldwide. Islamic bankers create an aura of optimism. They convey the impression that usury can be vanquished with the launch of more financial products. All we need is to set up more Islamic banks. The message is that Western bankers, together with their friends at the World Bank and the IMF, are ultimately committed to providing an Islamic paradigm. In this regard, Islamic banking conferences are part of the broader process of media disinformation. Leading establishment figures are often presented as stepping up their campaign to convince others 'to level the playing field for Islamic finance' ".
The platitudes and gloss of LIVE 8 are repeated in the award ceremonies at Islamic banking conferences. Interest-based loans with Islamic labels win the top prizes but few people stop to ask who exactly is glorifying this trash. Could it just be that these awards are a means of promoting the type of Islamic finance that the interest-based establishment wants? A type that doesn't threaten the existing financial paradigm? In the UK last year, the banking sector made USD 40 billion equivalent in profit. It will try to guard this profit-making machine against all possible threats, whether commercial or ideological. So what if it costs them a few hundred million to do so? To co-opt Islamic banking and influence it from within may in fact be the cheapest strategy available. A member of the design team that won a recent industry award told me privately that the product "is a sham", that he "can't believe the scholars approved it". I can believe it. The methodology is working.
One of the main factors that has propelled us to this low point is, I believe, a lack of vision and confidence among leading Muslims to develop and implement a distinctively Islamic framework for modern financial activity. It is as if critical sections of Muslim academia and business have been intellectually colonised by the West. Hence one finds little difference in the material used to teach finance courses in the Gulf as compared to universities in London or New York, and the symptoms of this malaise have spread well beyond academia. A suit and tie still seems to earn the kind of respect that a thobe and beard cannot, even in the Islamic banking industry.
During my first week of employment in Islamic finance, I suggested to a director of an Islamic housing organisation in London that we should develop together a diminishing partnership home financing product. I told him we could prove a concept together. My firm's financing know-how plus his operational knowledge would fit together nicely, I thought. We would share capital risk together. His clients need no longer fear negative equity, no longer suffer from debt stress. (This was a true diminishing partnership by the way, not at all like the interest-based loans that were to appear in the name of diminishing partnership a few years later.) After maybe fifteen minutes, the director proudly informed me that he'd recently agreed a 5 year loan at 7.5% through Barclays Bank and wasn't interested in Islamic finance. Looking back I realise the extent of my naivety, imagining that a Muslim director of an Islamic housing organisation would be interested to develop an Islamic financing paradigm. But at the time, the thought uppermost in my mind was that my firm's business plan was in real trouble. If this was the state of the Muslim community, what hope Islamic finance?
The story repeated itself as the years went by. On a visit to a Gulf-based Islamic bank in 1996, I proposed the issuance of bonds with coupons linked to project revenues and redeemable at net asset value. A client of mine needed several million dollars to finance an infrastructure project in a stable Muslim country. I saw this as a great opportunity to launch a genuinely halal financial instrument that could act as a template for years to come. This particular institution had a balance sheet in the billions of dollars, but once again I found myself speaking with men who wanted to do "money-now for more-money-later" transactions, men who seemed incapable of thinking beyond the confines of a McGraw Hill textbook. The idea of tradable revenue bonds switched them off entirely, but when an executive from a big Western bank visited this same institution to propose a commodity cash-and-carry with a limp LIBOR related return, then this was a breakthrough! Truly innovative! Soon a variety of technical sounding product names sprouted in the literature. "Revolving murabahahs" and "notes issuance facilities" became the flavour of the day. Often, there would be a feature in some trade magazine, accompanied of course by the obligatory sentence to inform us that the Islamic banking industry is an exciting niche market worth $150 billion, growing at 15% per year.
In those days, commentators were still arguing that murabahah was just a temporary phase in Islamic banking, something to get by with until a truly Islamic product could be found. People were saying "yes, I know, it's not ideal, but it's a start", "one step is better than no step", and so on. But it is quite possible that no step would have been better than that step because, in the formulation of modern murabahah, principles were established that have led us to tawarruq and a whole new selection of excuses. I am thinking in particular of the use of contract combination in the design of Islamic financial products but also, at a more general level, of the promotion of legal form over substance in so much of what the industry does. The resultant transformation has been remarkable. For decades in the Middle East, much of the Muslim public resisted tempting offers of interest-bearing loans from the banking system. The sinful connotations were sufficiently strong to block the borrowing impulse. But the emergence of tawarruq has changed all of this by providing a convenient fig-leaf for borrowing at interest. This largely explains why, for example, consumer borrowing in Saudi Arabia has leapt by more than 50% over the last year. It is therefore rather ironic to find a scholar who was for many years a leading voice in favour of those questionable legal principles now warning his ex-clients that their products are becoming indistinguishable from interest. The time to warn and prohibit passed long ago, Sheikh. Your fatawa commanded such a high price not because you were more capable than other scholars, but because you were willing to permit what others would not, and because your opinions suited what the bankers wanted to do. The result is that the money-now for more-money-later transaction has become a cornerstone of the Islamic banking business model, just as it is in interest-based commercial banking. The least we can do now is to make sure that those who opened the legal flood gates, so to speak, are not given responsibility for closing them again.
It is rather worrying that the collapse of the Christian prohibition of usury has left behind a similar story, one of jurisprudence and intellectual thought influenced by a powerful banking establishment. That influence has continued up to the present day. For example, the London Business School is a creation of the major British commercial banks and the Citibank Foundation spends much of its funds on financial education. A powerful anti-banking thesis is most unlikely to emerge under the patronage of such institutions, and the executives who grow up on that theoretical diet will know little of the interest-free economic paradigm. Yet such men are invited to develop and manage Islamic banking departments across the world.
The Western range of instruments (overdrafts, fixed income bonds, home mortgages, derivatives) are a fruit that can only grow upon a certain tree (the institutional framework of fiat money, a central bank, fractional reserve banking and so on) and that tree can only grow in a certain soil (the concepts of riba, gharar, speculation). We cannot Islamise this tree or its fruit any more than we can Islamise theft, but I am not advocating that we "go back to the Stone Age" or regress in some other way as orthodox economists occasionally suggest. We must simply plant our seed in a soil of our own, let the tree grow, and harvest whatever fruit results. Dr. Daud Bakar, who has spent many years researching the matter, finds no record of deposit-taking banks in the early centuries of Islam yet the Islamic Empire was advanced in every way given the technological limits of the time. Why then has the Western model of commercial banking been so unquestioningly adopted by the modern pioneers of Islamic banking? Did we really think that we could transplant a model that grew so uniquely in the soil of usury to the soil of Shari`ah? The scheme should have been a non-starter, but it lives, sustained by the smoke and mirrors of the Islamic banking community, producing ever more absurd semantics as the years go by.
I have believed for a long time that the Muslim world can only solve its problems if it first understands what those problems are. This seems an obvious idea to me, in Islamic banking and finance especially, but apparently not so to others. The continuing suspicions and legal confusions in Islamic banking have only reinforced the fact that something is badly wrong in the industry. It is especially sad that the industry has never seriously investigated the theory of fractional reserve banking, or recognised that it consistently predicts the development of the economic landscape around us. Without this vital re-appraisal of the raison d'etre of commercial banking, its Islamic variant will in due course be absorbed by the interest-based sector and disappear entirely. This will happen because there will be no substantive difference between the two. Already those who pull the strings at the conferences are debating whether the word "Islamic" should be dropped from the industry's marketing effort, and Harvard's 2006 conference has the integration of Islamic finance into the mainstream as its theme. Stephen Green, CEO of HSBC, goes so far as to suggest that the success of Islamic banking products "will be their acceptance in the mainstream financial community" (Islamic Banking and Finance Magazine #4, UK, 2004). No Stephen, it's precisely the opposite. The failure of Islamic banking and finance will be measured by the degree to which it is accepted in the mainstream. If such a dreadful thing should happen it will be a victory for usury and a defeat for Islam and for the suffering people of this world.
But if we are to Islamise modern day Islamic banking and finance, a number of radical policy changes are required. Where these policies cannot be implemented immediately, they should at least be put on the agenda for discussion. I do not care whether it is in the Muslim world or the non-Muslim world that such a debate takes place for they are reforms that will benefit all of mankind, as indeed Islam is meant to. Here are some of those ideas in brief:
Tarek El Diwany, February 2006
In Summer 2005, Michael Chussodovsky wrote an article on LIVE 8 and its campaign to reduce global poverty (http://www.globalresearch.ca). Here is a short extract from that article:"The concerts are totally devoid of political content. They concentrate on simple and misleading cliches. They use poverty as a marketing tool and a consumer-advertising gimmick to increase the number of viewers and listeners worldwide. Live 8 creates an aura of optimism. It conveys the impression that poverty can be vanquished with the stroke of the pen. All we need is good will. The message is that G8 leaders, together with the World Bank and the IMF, are ultimately committed to poverty alleviation. In this regard, the concerts are part of the broader process of media disinformation. They are used as a timely public relations stunt for Prime Minister Tony Blair, who is hosting the G-8 Summit at Gleneagles, Scotland. Tony Blair is presented as stepping up his campaign to convince other G8 nations 'to take action on poverty' ".
Chussodovsky has identified a methodology here. It is used by the establishment to weaken a potentially threatening movement from within and, because it is a methodology, it can be identified elsewhere. For example, with a few minor alterations, Chussodovsky's words suddenly become relevant to the Islamic banking industry:
"The Islamic banking industry concentrates on simple and misleading cliches. It uses Islam as a marketing tool and a consumer-advertising gimmick to increase its following among Muslims worldwide. Islamic bankers create an aura of optimism. They convey the impression that usury can be vanquished with the launch of more financial products. All we need is to set up more Islamic banks. The message is that Western bankers, together with their friends at the World Bank and the IMF, are ultimately committed to providing an Islamic paradigm. In this regard, Islamic banking conferences are part of the broader process of media disinformation. Leading establishment figures are often presented as stepping up their campaign to convince others 'to level the playing field for Islamic finance' ".
The platitudes and gloss of LIVE 8 are repeated in the award ceremonies at Islamic banking conferences. Interest-based loans with Islamic labels win the top prizes but few people stop to ask who exactly is glorifying this trash. Could it just be that these awards are a means of promoting the type of Islamic finance that the interest-based establishment wants? A type that doesn't threaten the existing financial paradigm? In the UK last year, the banking sector made USD 40 billion equivalent in profit. It will try to guard this profit-making machine against all possible threats, whether commercial or ideological. So what if it costs them a few hundred million to do so? To co-opt Islamic banking and influence it from within may in fact be the cheapest strategy available. A member of the design team that won a recent industry award told me privately that the product "is a sham", that he "can't believe the scholars approved it". I can believe it. The methodology is working.
One of the main factors that has propelled us to this low point is, I believe, a lack of vision and confidence among leading Muslims to develop and implement a distinctively Islamic framework for modern financial activity. It is as if critical sections of Muslim academia and business have been intellectually colonised by the West. Hence one finds little difference in the material used to teach finance courses in the Gulf as compared to universities in London or New York, and the symptoms of this malaise have spread well beyond academia. A suit and tie still seems to earn the kind of respect that a thobe and beard cannot, even in the Islamic banking industry.
During my first week of employment in Islamic finance, I suggested to a director of an Islamic housing organisation in London that we should develop together a diminishing partnership home financing product. I told him we could prove a concept together. My firm's financing know-how plus his operational knowledge would fit together nicely, I thought. We would share capital risk together. His clients need no longer fear negative equity, no longer suffer from debt stress. (This was a true diminishing partnership by the way, not at all like the interest-based loans that were to appear in the name of diminishing partnership a few years later.) After maybe fifteen minutes, the director proudly informed me that he'd recently agreed a 5 year loan at 7.5% through Barclays Bank and wasn't interested in Islamic finance. Looking back I realise the extent of my naivety, imagining that a Muslim director of an Islamic housing organisation would be interested to develop an Islamic financing paradigm. But at the time, the thought uppermost in my mind was that my firm's business plan was in real trouble. If this was the state of the Muslim community, what hope Islamic finance?
The story repeated itself as the years went by. On a visit to a Gulf-based Islamic bank in 1996, I proposed the issuance of bonds with coupons linked to project revenues and redeemable at net asset value. A client of mine needed several million dollars to finance an infrastructure project in a stable Muslim country. I saw this as a great opportunity to launch a genuinely halal financial instrument that could act as a template for years to come. This particular institution had a balance sheet in the billions of dollars, but once again I found myself speaking with men who wanted to do "money-now for more-money-later" transactions, men who seemed incapable of thinking beyond the confines of a McGraw Hill textbook. The idea of tradable revenue bonds switched them off entirely, but when an executive from a big Western bank visited this same institution to propose a commodity cash-and-carry with a limp LIBOR related return, then this was a breakthrough! Truly innovative! Soon a variety of technical sounding product names sprouted in the literature. "Revolving murabahahs" and "notes issuance facilities" became the flavour of the day. Often, there would be a feature in some trade magazine, accompanied of course by the obligatory sentence to inform us that the Islamic banking industry is an exciting niche market worth $150 billion, growing at 15% per year.
In those days, commentators were still arguing that murabahah was just a temporary phase in Islamic banking, something to get by with until a truly Islamic product could be found. People were saying "yes, I know, it's not ideal, but it's a start", "one step is better than no step", and so on. But it is quite possible that no step would have been better than that step because, in the formulation of modern murabahah, principles were established that have led us to tawarruq and a whole new selection of excuses. I am thinking in particular of the use of contract combination in the design of Islamic financial products but also, at a more general level, of the promotion of legal form over substance in so much of what the industry does. The resultant transformation has been remarkable. For decades in the Middle East, much of the Muslim public resisted tempting offers of interest-bearing loans from the banking system. The sinful connotations were sufficiently strong to block the borrowing impulse. But the emergence of tawarruq has changed all of this by providing a convenient fig-leaf for borrowing at interest. This largely explains why, for example, consumer borrowing in Saudi Arabia has leapt by more than 50% over the last year. It is therefore rather ironic to find a scholar who was for many years a leading voice in favour of those questionable legal principles now warning his ex-clients that their products are becoming indistinguishable from interest. The time to warn and prohibit passed long ago, Sheikh. Your fatawa commanded such a high price not because you were more capable than other scholars, but because you were willing to permit what others would not, and because your opinions suited what the bankers wanted to do. The result is that the money-now for more-money-later transaction has become a cornerstone of the Islamic banking business model, just as it is in interest-based commercial banking. The least we can do now is to make sure that those who opened the legal flood gates, so to speak, are not given responsibility for closing them again.
It is rather worrying that the collapse of the Christian prohibition of usury has left behind a similar story, one of jurisprudence and intellectual thought influenced by a powerful banking establishment. That influence has continued up to the present day. For example, the London Business School is a creation of the major British commercial banks and the Citibank Foundation spends much of its funds on financial education. A powerful anti-banking thesis is most unlikely to emerge under the patronage of such institutions, and the executives who grow up on that theoretical diet will know little of the interest-free economic paradigm. Yet such men are invited to develop and manage Islamic banking departments across the world.
The Western range of instruments (overdrafts, fixed income bonds, home mortgages, derivatives) are a fruit that can only grow upon a certain tree (the institutional framework of fiat money, a central bank, fractional reserve banking and so on) and that tree can only grow in a certain soil (the concepts of riba, gharar, speculation). We cannot Islamise this tree or its fruit any more than we can Islamise theft, but I am not advocating that we "go back to the Stone Age" or regress in some other way as orthodox economists occasionally suggest. We must simply plant our seed in a soil of our own, let the tree grow, and harvest whatever fruit results. Dr. Daud Bakar, who has spent many years researching the matter, finds no record of deposit-taking banks in the early centuries of Islam yet the Islamic Empire was advanced in every way given the technological limits of the time. Why then has the Western model of commercial banking been so unquestioningly adopted by the modern pioneers of Islamic banking? Did we really think that we could transplant a model that grew so uniquely in the soil of usury to the soil of Shari`ah? The scheme should have been a non-starter, but it lives, sustained by the smoke and mirrors of the Islamic banking community, producing ever more absurd semantics as the years go by.
I have believed for a long time that the Muslim world can only solve its problems if it first understands what those problems are. This seems an obvious idea to me, in Islamic banking and finance especially, but apparently not so to others. The continuing suspicions and legal confusions in Islamic banking have only reinforced the fact that something is badly wrong in the industry. It is especially sad that the industry has never seriously investigated the theory of fractional reserve banking, or recognised that it consistently predicts the development of the economic landscape around us. Without this vital re-appraisal of the raison d'etre of commercial banking, its Islamic variant will in due course be absorbed by the interest-based sector and disappear entirely. This will happen because there will be no substantive difference between the two. Already those who pull the strings at the conferences are debating whether the word "Islamic" should be dropped from the industry's marketing effort, and Harvard's 2006 conference has the integration of Islamic finance into the mainstream as its theme. Stephen Green, CEO of HSBC, goes so far as to suggest that the success of Islamic banking products "will be their acceptance in the mainstream financial community" (Islamic Banking and Finance Magazine #4, UK, 2004). No Stephen, it's precisely the opposite. The failure of Islamic banking and finance will be measured by the degree to which it is accepted in the mainstream. If such a dreadful thing should happen it will be a victory for usury and a defeat for Islam and for the suffering people of this world.
But if we are to Islamise modern day Islamic banking and finance, a number of radical policy changes are required. Where these policies cannot be implemented immediately, they should at least be put on the agenda for discussion. I do not care whether it is in the Muslim world or the non-Muslim world that such a debate takes place for they are reforms that will benefit all of mankind, as indeed Islam is meant to. Here are some of those ideas in brief:
[1] Serious moves should be made to reform the present interest-based monetary system. It should be replaced over time with a commodity based currency issued under the supervision of the state.
[2] A 100% reserve requirement should be imposed on the sight deposit accounts of deposit-taking institutions and the payment of returns on these accounts should be prohibited by law.
[3] As a transitionary step, securitisation and tradability of real assets should be encouraged so as to provide holders of money with an alternative liquid investment that does not suffer longer term devaluation due to the operation of credit creation by the commercial banks. With the elimination of fractional reserve banking, the need for such securities will diminish substantially.
[4] Investment accounts should be operated as off-balance sheet items, and should be legally segregated from the payment transmission operations of deposit takers. The investment accounts would carry a 0% reserve requirement, and returns to investors as well as withdrawal rights from the accounts would be subject to the performance and liquidity of the underlying portfolio of assets.
[5] Interest-based forms of finance should be phased out over time by statute, and incentives put in place to encourage genuine alternatives such as operating leases and installment payment facilities.
[6] Revenue bonds should be promoted to finance infrastructure projects where an identifiable revenue stream exists (a toll road project for example). These will be easier to administer than profit sharing securities since project revenues can be directly observed, whereas profits can be distorted through creative accounting.
[7] Diminishing partnership financing (of the kind in which capital risk is genuinely shared) should be promoted for capital investment and financing of large ticket items, in property and transport for example. Insolvency due to an unequal apportionment of risk between the user and provider of funds will then be a far less frequent occurrence, but a legal and financial framework should be established to minimise the negative social and economic consequences of those cases in which investments do fail. I am thinking here of good corporate governance, proper regulation of the financial sector, the establishment of mutual insurance funds, the promotion of good portfolio management practices, and so on.
[8] Interest-free loans should be provided to lower income groups for home purchase, car purchase and education through a public sector agency. This would be the lowest cost option for society to fund many such purchases, and has been operated successfully in the past. For example, until recently, interest-free loans from the government were a major source of home finance in Saudi Arabia.
[9] The use of margined transactions on financial markets should be restricted in accordance with Shari`ah such that at most only one counterparty can defer delivery of a countervalue to a future date. This policy will help to reduce speculative dealing in key areas.
[10] Contract combination in Islamic banking should be explicitly prohibited under industry standards because it allows the synthesis of interest-based loans in the name of Islam. This would include a prohibition on the use of mutual promises for achieving the same ends.
[11] A wealth tax should be instituted where it has not already been put in place in order to address issues of wealth inequality, and to address the harmful impact of monopolistic control over mineral and other resources in certain countries of the Muslim world. Zakat upon mineral extraction is a right of the Ummah.
Away from the purely financial arena, there is a more general reform that urgently needs to be implemented. Many Muslim countries desperately need a legal framework that an honest businessman can trust, a framework that operates speedily and impartially. The benefits of such a reform for economic and social progress are hard to underestimate. When one sees counterparties based in the Muslim world choosing English law and English courts to mediate their financial disputes, this really says something about the present condition of the Ummah. To think, lands under Islamic rule were once renowned as a place of justice for all. Now, in many cases, they are not even a place of justice for the Muslims.
To move forward we must have the vision to strike out in our own direction, upon our own methodology, to grow our own tree. We should know that the way to achieve a truly interest-free paradigm is to practice Islamic finance for the sake of Allah, not for the sake of profit, not even for the sake of economic development. Then, when that paradigm has been built, the profit-seeking businessmen can join the party and play by the new set of rules. The strategy we see now, however, is the precise opposite of this. The rules are being set by the profit-seeking businessmen and the paradigm builders are being ignored. The longer we travel on this road, the harder it will be to find our way back when the time comes. But let us not be disheartened by the task ahead. Many of the problems we face are the result of an un-Islamic framework. Derivative products are a cause of volatility, not the cure for it. Interest is not a recompense for inflation, it is a cause of it. Take away that which is haram, instead of re-labelling it, and many of our economic problems will simply disappear.
I'm told that Brazil, the world's most indebted country, is cutting down its rainforest at the fastest ever rate in order to meet its debt repayments. The Amazon rainforest produces a large proportion of the world's oxygen supply, and at this rate of deforestation it will almost disappear within three generations. Where have we heard that interest might be the cause of such ecological disasters? Not in many places. It is the truth that dare not speak its name, the one the media doesn't discuss very much. In its present condition Islamic banking will not restrain this monster. Its clients will still have to repay debt at interest, in all but name. They will still have to cut down the rainforest to satisfy their repayment schedules. So it has become a matter of global ecological importance that Islamic banking adopts a different paradigm, that it becomes more of a solution and less of a get-rich-quick bandwagon.
Saturday, May 10, 2008
Holding Back the Tide
Nadine Marroushi interviewed Tarek El Diwany in London during Summer 2007.
Q. What are your reasons for thinking that "Islamic banking isn't Islamic"?
A. "My point is a little more refined than that. I am saying that Islamic commercial banking is not Islamic, and this is because commercial banking is a combination of usury and misrepresentation. The practice of usury is obvious and involves the advancing of money now in return for more money later, while the misrepresentation is less obvious and involves the creation of money out of nothing. Most of the time, the money that commercial banks lend is money that they themselves have created. Since neither usury nor misrepresentation can be Islamised, and since the business model of commercial banking requires both, there cannot be such a thing as Islamic commercial banking. For the same reason, there cannot be such a thing as an Islamic central bank. Historically, the Muslim world has had neither commercial banks nor central banks, though of course it did have institutions that fulfilled permissible functions such as payment transfer. In our rush to create an Islamic banking and finance industry, we have forgotten to ensure that the money we are using is itself Islamic. Islamic finance cannot be practiced with money that is un-Islamic. We therefore need a very fundamental reform of the institutional framework in Islamic banking and finance, but unfortunately the industry is simply refusing to address the issue."
Q. Why?
A. "Globally, the banking and finance sector is earning as much as two trillion dollars of gross profit a year. A lot of this profit arises from the receipt and payment of interest within the financial system. Since Islam is the only major ideology to challenge that practice in today's world, the interest-based institutions face two basic choices. Either they openly oppose the Islamic banking and finance movement, or they try to neutralise it from within. I believe they have chosen to do the latter. This helps to explain why critical issues are being swept under the carpet, and why the core practices of Islamic banking and finance are beginning to look indistinguishable from interest. Then there are the financial realities of life to contend with. Graduates in London are more likely to choose to work for a major global financial institution on a starting salary of 60,000 pounds a year, than with Tarek El Diwany for 10,000 pounds a year. They're not necessarily bad people, but money talks and can often change a person's outlook on life. This is one reason that the modern system of usury is so difficult to overturn. Too many of the world's most influential people are earning a good living out of it. So the issue remains that we need to reform the system, and we can't rely on existing commercial forces to do that for us. Why would the dominant financial institutions of today want to change a system that has made them so profitable? Would institutions that depend upon interest for their continued success help to establish a paradigm that aims for the abolition of interest?"
Q. Is anyone listening, and doing anything about it?
A. "Many people, and a few institutions, are beginning to listen and campaign for financial reform in various ways. These include the members of other religions, for example the Christian Council for Monetary Justice in London, which has been campaigning for four decades against usury and the creation of money by the banking system. One also occasionally finds mainstream politicians supporting some key policies of monetary reform. American Congressman Dennis Kucinich has argued for the adoption of interest-free finance in public projects, and the former prime minister of Malaysia Dr. Mahathir Mohammed has promoted the use of gold in international monetary transactions. Vincent Cable, the Liberal Democrat Shadow Chancellor in the UK, has argued for controlling inflation by raising bank reserve ratios instead of raising interest rates. All of these are policies that I have argued for."
Q. What do the well-known scholars in Islamic banking and finance think of your ideas?
A. "Naturally, the scholars who are promoting the current version of Islamic banking and finance won't agree with what I'm saying. How could they? I think that much of what they are doing is a gigantic mistake. But I don't say that they are bad Muslims. One must presume that they are sincere in their thinking, and everyone is entitled to his own opinion of course. If we could only discuss our opinions on a level playing field, we might start to make some progress in this industry. Unfortunately, what has happened is that a rather narrow set of opinions from a small group of scholars has been used to define the nature of modern Islamic banking and finance, when in many cases there is little or no consensus to support those views. Some of the scholars that I work with, and many of the bankers and lawyers, say that the Islamic banking game is a scam."
Q. Can you name some of the scholars that share your views?
A. Shortly before he died, Sheikh Ibn Uthaymeen in Saudi Arabia called Islamic banking "the usury of deception". For this reason he regarded it as worse than interest-based banking. At least the latter doesn't pretend to be anything other than what it is. Even Mufti Taqi Usmani, a father of the modern Islamic banking movement, is reported to have said that what the industry is doing now is not so much the jurisprudence of Islamic transactions as the "jurisprudence of Islamic legal tricks". Here in London, Sheikh Haitham al-Haddad has argued consistently that most of the current range of retail Islamic banking products contains riba. And traditional scholars such as ibn Taymiyyah were arguing against tawarruq centuries before Islamic banks adopted it as the basis of their loan facilities.
Q. In practical terms, what is wrong with the product range of Islamic banking today?
A. "Two basic types of contract that can be used in trade and finance are contracts of investment and contracts of exchange. The current Islamic banking industry has based almost all of its products on contracts of exchange such as sale on a deferred payment basis, or the leasing of some kind of asset. These contracts are not controversial on their own, though their purpose is easily distorted when several of them are combined into a single transaction. For example, I might buy some metal from an Islamic bank for one hundred and ten pounds payable next year, and then sell it to someone else for one hundred pounds payable in cash now. If the bank organises these two transactions for me, then I am effectively borrowing cash at 10% interest. Reading through the detailed contractual documents for some of these products makes one wonder what connection they have with all the lofty talk of risk sharing that one hears on the conference circuit. In the event of a big recession, we'll quickly see that the financiers are sharing little or no risk in most of these deals. The bottom line is that contracts of exchange are intended for use by traders of goods and services, not by banks. If a bank wishes to trade cars, let it become a car dealer. If it wishes to rent property, let it become a landlord. And if it wishes to lend money for a profit, let it not use the word 'Islamic' to describe the process."
Q. You say Islamic finance is now mainly based on contracts of exchange, but what about the Islamic investment products emerging like private equity and hedge funds? Isn't Islamic finance also based on investment products?
A. "Of the two main contract types, it is the contract of investment that is the more suitable basis for funding businesses in Islam since it involves a sharing of risks and rewards that cannot be achieved with a contract of exchange. Profit sharing securities issued by individual companies, or funds comprising such securities, are much more in line with the principles of risk sharing that Islamic commercial law proposes. This is the kind of product that Islamic investment managers should develop and build upon. There is a whole world of genuinely Islamic products to develop if we stick to our principles here. Why not develop revenue sharing securities? Or true property partnerships between investors and developers? Why not launch an Islamic education fund to develop Muslim schools and colleges in the private sector? There is so much we can do if we have some vision and confidence in ourselves. The alternative is that we continue to copy the methodologies and product ranges of interest-based finance, and that will lead us nowhere in the long run."
Q. Do you work with these principles at Zest Advisory? And if the money being used in Islamic finance is un-Islamic, how can your company participate in product development?
A. "We develop financial products that avoid controversial legal techniques and that promote the core principles of Islam. We do this as far as is possible given the legal and economic environment around us. Here in England we designed and developed a commercially viable home finance scheme in which the financier and the homebuyer own a property as partners. The homebuyer buys portions of the financier's share of the property as the years go by, and in the meantime he rents the financier's share in order to live in the property. Crucially, the homebuyer is not forced to buy the financier's share of the property during the life of the contract, therefore he is never in debt to the financier, cannot be repossessed by the financier, and cannot find himself in negative equity. Imagine if that product was widely available today. Millions of people would want it. And they would respect the Muslims for making it available. As it is, non-Muslims look at the Islamic home finance products offered by banks and often they say "that's interest, and you people aren't fooling anyone."
Q. How do you go about achieving the larger changes that you say are necessary?
A. "In the past, the state put money lenders into prison for practicing usury. Now, those money lenders call themselves bankers and in many cases governments have put them in charge of the economy. They call it "central bank independence" which is a polite way of saying the same thing. Semantic distortions of this type are to be found everywhere in modern finance. Banks don't practice usury anymore, they "sell you a home mortgage". To make any meaningful change, we must first recognise that our idea of what is normal in matters of banking and finance have been very heavily influenced by the interest-based establishment. The volume of "research" being produced by the central banks, the World Bank and investment banks is truly enormous, but the underlying value system is very narrow in scope. Students who grow up with this kind of material might think they're being educated, but I would argue that the process has more in common with brainwashing. So we have to allow much greater openness and breadth of thought in our education and in our industry dialogue. We need to discuss the core issues calmly and sensibly, and not allow commercial or political forces to tempt the discussion one way or other. Then we need to hope that Allah gives us political and commercial leaders who are willing and capable of implementing the recommendations that emerge from the new thinking. Most importantly, the people should want the change and we will therefore need to help them understand the seriousness of the financial situation that faces them. The Americans failed to prohibit alcohol consumption because the people didn't believe it was the right thing to do. Contrast that with the prohibition of alcohol consumption in Medina. The streets were flowing with discarded wine as soon as the prohibition was announced. Likewise, if the Muslims of today are not interested in change, then we probably won't succeed in making a genuine reform. We certainly can't put the onus of change entirely on the banks."
Q. Can you make a comment about what you think the role of banks, and the state, should be with the above idea in mind (no money creation by private enterprises)?
A. The money creation function should be returned to the system that worked so well in the era of commodity money. New money is pumped into circulation when the mining companies produce gold or silver (for example) and take it to the mint for conversion into coinage. If the amount of precious metal expended in paying the costs of mining exceeds the amount of metal so produced, then no new metal will enter circulation in the form of coinage. And vice versa. That is a truly fair, market-based mechanism for allowing changes in money supply to occur. It is not based upon interest or debt, and neither the state nor the banking system retain any power to arbitrarily change money supply. It is also the traditional monetary system of the Islamic world. Commercial banks can continue as providers of payment transmission services, they can become financial advisors and arrangers, and investment managers, but they must not retain the right to create money out of thin air. That is far too great a power to place into the hands of any profit-motivated company.
This interview was originally published in Islamic Finance Today March 2008
Q. What are your reasons for thinking that "Islamic banking isn't Islamic"?
A. "My point is a little more refined than that. I am saying that Islamic commercial banking is not Islamic, and this is because commercial banking is a combination of usury and misrepresentation. The practice of usury is obvious and involves the advancing of money now in return for more money later, while the misrepresentation is less obvious and involves the creation of money out of nothing. Most of the time, the money that commercial banks lend is money that they themselves have created. Since neither usury nor misrepresentation can be Islamised, and since the business model of commercial banking requires both, there cannot be such a thing as Islamic commercial banking. For the same reason, there cannot be such a thing as an Islamic central bank. Historically, the Muslim world has had neither commercial banks nor central banks, though of course it did have institutions that fulfilled permissible functions such as payment transfer. In our rush to create an Islamic banking and finance industry, we have forgotten to ensure that the money we are using is itself Islamic. Islamic finance cannot be practiced with money that is un-Islamic. We therefore need a very fundamental reform of the institutional framework in Islamic banking and finance, but unfortunately the industry is simply refusing to address the issue."
Q. Why?
A. "Globally, the banking and finance sector is earning as much as two trillion dollars of gross profit a year. A lot of this profit arises from the receipt and payment of interest within the financial system. Since Islam is the only major ideology to challenge that practice in today's world, the interest-based institutions face two basic choices. Either they openly oppose the Islamic banking and finance movement, or they try to neutralise it from within. I believe they have chosen to do the latter. This helps to explain why critical issues are being swept under the carpet, and why the core practices of Islamic banking and finance are beginning to look indistinguishable from interest. Then there are the financial realities of life to contend with. Graduates in London are more likely to choose to work for a major global financial institution on a starting salary of 60,000 pounds a year, than with Tarek El Diwany for 10,000 pounds a year. They're not necessarily bad people, but money talks and can often change a person's outlook on life. This is one reason that the modern system of usury is so difficult to overturn. Too many of the world's most influential people are earning a good living out of it. So the issue remains that we need to reform the system, and we can't rely on existing commercial forces to do that for us. Why would the dominant financial institutions of today want to change a system that has made them so profitable? Would institutions that depend upon interest for their continued success help to establish a paradigm that aims for the abolition of interest?"
Q. Is anyone listening, and doing anything about it?
A. "Many people, and a few institutions, are beginning to listen and campaign for financial reform in various ways. These include the members of other religions, for example the Christian Council for Monetary Justice in London, which has been campaigning for four decades against usury and the creation of money by the banking system. One also occasionally finds mainstream politicians supporting some key policies of monetary reform. American Congressman Dennis Kucinich has argued for the adoption of interest-free finance in public projects, and the former prime minister of Malaysia Dr. Mahathir Mohammed has promoted the use of gold in international monetary transactions. Vincent Cable, the Liberal Democrat Shadow Chancellor in the UK, has argued for controlling inflation by raising bank reserve ratios instead of raising interest rates. All of these are policies that I have argued for."
Q. What do the well-known scholars in Islamic banking and finance think of your ideas?
A. "Naturally, the scholars who are promoting the current version of Islamic banking and finance won't agree with what I'm saying. How could they? I think that much of what they are doing is a gigantic mistake. But I don't say that they are bad Muslims. One must presume that they are sincere in their thinking, and everyone is entitled to his own opinion of course. If we could only discuss our opinions on a level playing field, we might start to make some progress in this industry. Unfortunately, what has happened is that a rather narrow set of opinions from a small group of scholars has been used to define the nature of modern Islamic banking and finance, when in many cases there is little or no consensus to support those views. Some of the scholars that I work with, and many of the bankers and lawyers, say that the Islamic banking game is a scam."
Q. Can you name some of the scholars that share your views?
A. Shortly before he died, Sheikh Ibn Uthaymeen in Saudi Arabia called Islamic banking "the usury of deception". For this reason he regarded it as worse than interest-based banking. At least the latter doesn't pretend to be anything other than what it is. Even Mufti Taqi Usmani, a father of the modern Islamic banking movement, is reported to have said that what the industry is doing now is not so much the jurisprudence of Islamic transactions as the "jurisprudence of Islamic legal tricks". Here in London, Sheikh Haitham al-Haddad has argued consistently that most of the current range of retail Islamic banking products contains riba. And traditional scholars such as ibn Taymiyyah were arguing against tawarruq centuries before Islamic banks adopted it as the basis of their loan facilities.
Q. In practical terms, what is wrong with the product range of Islamic banking today?
A. "Two basic types of contract that can be used in trade and finance are contracts of investment and contracts of exchange. The current Islamic banking industry has based almost all of its products on contracts of exchange such as sale on a deferred payment basis, or the leasing of some kind of asset. These contracts are not controversial on their own, though their purpose is easily distorted when several of them are combined into a single transaction. For example, I might buy some metal from an Islamic bank for one hundred and ten pounds payable next year, and then sell it to someone else for one hundred pounds payable in cash now. If the bank organises these two transactions for me, then I am effectively borrowing cash at 10% interest. Reading through the detailed contractual documents for some of these products makes one wonder what connection they have with all the lofty talk of risk sharing that one hears on the conference circuit. In the event of a big recession, we'll quickly see that the financiers are sharing little or no risk in most of these deals. The bottom line is that contracts of exchange are intended for use by traders of goods and services, not by banks. If a bank wishes to trade cars, let it become a car dealer. If it wishes to rent property, let it become a landlord. And if it wishes to lend money for a profit, let it not use the word 'Islamic' to describe the process."
Q. You say Islamic finance is now mainly based on contracts of exchange, but what about the Islamic investment products emerging like private equity and hedge funds? Isn't Islamic finance also based on investment products?
A. "Of the two main contract types, it is the contract of investment that is the more suitable basis for funding businesses in Islam since it involves a sharing of risks and rewards that cannot be achieved with a contract of exchange. Profit sharing securities issued by individual companies, or funds comprising such securities, are much more in line with the principles of risk sharing that Islamic commercial law proposes. This is the kind of product that Islamic investment managers should develop and build upon. There is a whole world of genuinely Islamic products to develop if we stick to our principles here. Why not develop revenue sharing securities? Or true property partnerships between investors and developers? Why not launch an Islamic education fund to develop Muslim schools and colleges in the private sector? There is so much we can do if we have some vision and confidence in ourselves. The alternative is that we continue to copy the methodologies and product ranges of interest-based finance, and that will lead us nowhere in the long run."
Q. Do you work with these principles at Zest Advisory? And if the money being used in Islamic finance is un-Islamic, how can your company participate in product development?
A. "We develop financial products that avoid controversial legal techniques and that promote the core principles of Islam. We do this as far as is possible given the legal and economic environment around us. Here in England we designed and developed a commercially viable home finance scheme in which the financier and the homebuyer own a property as partners. The homebuyer buys portions of the financier's share of the property as the years go by, and in the meantime he rents the financier's share in order to live in the property. Crucially, the homebuyer is not forced to buy the financier's share of the property during the life of the contract, therefore he is never in debt to the financier, cannot be repossessed by the financier, and cannot find himself in negative equity. Imagine if that product was widely available today. Millions of people would want it. And they would respect the Muslims for making it available. As it is, non-Muslims look at the Islamic home finance products offered by banks and often they say "that's interest, and you people aren't fooling anyone."
Q. How do you go about achieving the larger changes that you say are necessary?
A. "In the past, the state put money lenders into prison for practicing usury. Now, those money lenders call themselves bankers and in many cases governments have put them in charge of the economy. They call it "central bank independence" which is a polite way of saying the same thing. Semantic distortions of this type are to be found everywhere in modern finance. Banks don't practice usury anymore, they "sell you a home mortgage". To make any meaningful change, we must first recognise that our idea of what is normal in matters of banking and finance have been very heavily influenced by the interest-based establishment. The volume of "research" being produced by the central banks, the World Bank and investment banks is truly enormous, but the underlying value system is very narrow in scope. Students who grow up with this kind of material might think they're being educated, but I would argue that the process has more in common with brainwashing. So we have to allow much greater openness and breadth of thought in our education and in our industry dialogue. We need to discuss the core issues calmly and sensibly, and not allow commercial or political forces to tempt the discussion one way or other. Then we need to hope that Allah gives us political and commercial leaders who are willing and capable of implementing the recommendations that emerge from the new thinking. Most importantly, the people should want the change and we will therefore need to help them understand the seriousness of the financial situation that faces them. The Americans failed to prohibit alcohol consumption because the people didn't believe it was the right thing to do. Contrast that with the prohibition of alcohol consumption in Medina. The streets were flowing with discarded wine as soon as the prohibition was announced. Likewise, if the Muslims of today are not interested in change, then we probably won't succeed in making a genuine reform. We certainly can't put the onus of change entirely on the banks."
Q. Can you make a comment about what you think the role of banks, and the state, should be with the above idea in mind (no money creation by private enterprises)?
A. The money creation function should be returned to the system that worked so well in the era of commodity money. New money is pumped into circulation when the mining companies produce gold or silver (for example) and take it to the mint for conversion into coinage. If the amount of precious metal expended in paying the costs of mining exceeds the amount of metal so produced, then no new metal will enter circulation in the form of coinage. And vice versa. That is a truly fair, market-based mechanism for allowing changes in money supply to occur. It is not based upon interest or debt, and neither the state nor the banking system retain any power to arbitrarily change money supply. It is also the traditional monetary system of the Islamic world. Commercial banks can continue as providers of payment transmission services, they can become financial advisors and arrangers, and investment managers, but they must not retain the right to create money out of thin air. That is far too great a power to place into the hands of any profit-motivated company.
This interview was originally published in Islamic Finance Today March 2008
Silent Culprit of Our Decline
An edited version of the following article was first published in Resurgence Magazine, Issue No. 248, May/June 2008.
Tarek El Diwany, April 2008
If a money lender from the time of Christ had loaned an ounce of gold at 5% annual compound interest, it would today require an amount of bullion weighing several planet Earths in repayment. Early bankers knew the profound implications of this fact: a system in which commodity money is loaned out at interest is physically unsustainable in the long term.
With paper money things are different. When the exponents begin their inevitable work, the issuer of such money can simply print a larger face value on his banknotes. In acquiring the legal privilege to create money in this way, the early banks side-stepped a critical failsafe in the financial processes that drive economic activity, though the consequences were slow to emerge.
Other problems with interest could not be resolved so easily. In the real world things experience compound decrement, which is to say they rot and become useless. Meanwhile, interest allows money to grow at compound increment towards infinity. Herein lies the fundamental conflict between interest-based finance and the environment. Money loaned at interest does not obey the same laws as the physical assets that money buys.
Hence Michael Lipton's example of a hypothetical plantation farmer who faces a choice of land use. He can farm his trees on a sustainable basis and produce 1000 units in profit annually for ever. Or he can move to intensive farming and produce 1250 units of profit annually for twenty years, after which his land turns to desert. With interest rates of more than 9% per annum, a standard discounted cash flow analysis recommends that the farmer chooses the intensive option. Unfortunately, this 'killing of the golden goose' is not confined to theory. The world's top deforesting nations are among its most indebted partly because saving trees is less of a priority than servicing international debt.
Lord Hanson once said that his job was to "appropriate tomorrow's value today" and although such business logic may be familiar to an MBA student, future generations are unlikely to thank us for it. The great monuments of the world were built because their progenitors took precisely the opposite attitude. They cared more about creating value for the future than the present. But when infrastructure is financed with loans at interest, caring about the future becomes a rather expensive habit. One reason that we find it so difficult to build the likes of St. Paul's Cathedral nowadays, or even the London Underground, is that we have forgotten how to fund projects without resorting to bank loans.
Unfortunately, a powerful commercial logic called financial leverage is preventing change in these matters. The business model of most modern corporations is to borrow money at a rate of interest that is below the rate of return earned when investing that money. For example, by borrowing £100 at 5% and investing it in a one year project that yields 20%, the executive manager can earn £15 for his firm. And the banker will earn £5 of interest on his newly created money. It is a rather cosy symbiosis, but its logical consequence is that firms will grow increasingly large over time. Instead of borrowing £100 in order to make £15 of profit, why not borrow £100 million and make £15 million of profit instead?
In this manner, financial leverage has enabled a relatively small number of corporations to achieve market dominance, while their bankers collect interest on an ever-growing pile of debt. And because the commercial banking system has the ability to create new money almost without limit, there is correspondingly nothing to restrict the extent of financial leverage. The result is that economic growth of a highly aggressive kind is being forced upon humanity.
Nowhere is this better illustrated than in the changing face of Britain today. A charming landscape of ages past is gradually being scarred by the characterless housing estates that financial leverage imposes on us. Large corporations are beginning to monopolise business and cultural activity, removing decision-making power from local communities and passing it in increasing measure to distant centres of control. This is the system that put the butcher, the baker and the candlestick-maker out of business, and then employed them at a nearby supermarket on the minimum wage. And if you think that Top Shop, Burton, Miss Selfridge, Dorothy Perkins, Wallis, Richard Shops and BHS represent healthy competition in the fashion sector, think again. All these companies are controlled by one businessman, obligingly empowered with bank debt. Is this what passes for market competition in the twenty-first century?
Given the amount of profit at stake, it is understandable that the connection between interest-based leverage and matters of environment is rarely mentioned in political discourse. Mr. Stern's voluminous report on global warming and Al Gore's documentary barely touch upon it. But there is another way, and that is the way of equity in both its financial and social sense.
Imagine a world in which holders of surplus wealth invested with entrepreneurs only on a profit and loss sharing basis. Here the investor gains or loses according to the entrepreneur's business fortunes. Under this kind of finance, the interests of both parties are closely aligned. The investor will be more careful when examining the entrepreneur's project plan and personal history before investing. This contrasts with the attitude of many interest-based lenders who attach greater importance to the borrower's collateral than to his business plan. This is because collateral can be repossessed and sold on the market in order to repay the original loan plus interest. Bank loans therefore tend to be directed towards those members of society who already have wealth, not necessarily to those with the best projects. A poor man may have a good business idea but, without collateral, few banks will finance him. Interest-based finance therefore tends to increase wealth inequality, whereas pure profit and loss sharing tends to reduce it.
In Islam, any benefit accruing to a lender of money is regarded as a form of usury and is prohibited. There is no such thing as a "usurious" rate of interest in Islamic law, because all rates of interest are usurious. And although the prohibition of usury is not a cure-all for the maladies of modern life, where it has been implemented as part of a wider regime of Islamic regulation the historical precedents are excellent. The universities, hospitals, welfare systems and infrastructure of Iraq, Spain and the Ottoman Empire were funded without resort to interest-bearing loans. Within twenty years of the institution of Islamic law, the Arabian peninsula was transformed from a scene of poverty to one in which deserving recipients for welfare payments could not be found. The lesson is clear. Interest-based finance is not a pre-requisite for society's material advancement.
In today's context, the prohibition of interest would yield immediate benefits to the majority of the world's poor. If the developing countries were to cease their debt service repayments today, they would find themselves richer by more that a billion dollars a day. That would make a very real difference in a world where as many as three billion people are each living on less than two dollars a day. Their hunger is our luxury, and usury makes it so.
1400 years ago the Prophet Muhammad (peace be upon him) told his followers, "though usury be much, it always leads to utter poverty". When such words are uttered by a Prophet, they carry the force of an economic law. They warn us that even the wealthy nations of the world are in a race against time. If we do not defeat usury, usury will defeat us too.
Tarek El Diwany, April 2008
If a money lender from the time of Christ had loaned an ounce of gold at 5% annual compound interest, it would today require an amount of bullion weighing several planet Earths in repayment. Early bankers knew the profound implications of this fact: a system in which commodity money is loaned out at interest is physically unsustainable in the long term.
With paper money things are different. When the exponents begin their inevitable work, the issuer of such money can simply print a larger face value on his banknotes. In acquiring the legal privilege to create money in this way, the early banks side-stepped a critical failsafe in the financial processes that drive economic activity, though the consequences were slow to emerge.
Other problems with interest could not be resolved so easily. In the real world things experience compound decrement, which is to say they rot and become useless. Meanwhile, interest allows money to grow at compound increment towards infinity. Herein lies the fundamental conflict between interest-based finance and the environment. Money loaned at interest does not obey the same laws as the physical assets that money buys.
Hence Michael Lipton's example of a hypothetical plantation farmer who faces a choice of land use. He can farm his trees on a sustainable basis and produce 1000 units in profit annually for ever. Or he can move to intensive farming and produce 1250 units of profit annually for twenty years, after which his land turns to desert. With interest rates of more than 9% per annum, a standard discounted cash flow analysis recommends that the farmer chooses the intensive option. Unfortunately, this 'killing of the golden goose' is not confined to theory. The world's top deforesting nations are among its most indebted partly because saving trees is less of a priority than servicing international debt.
Lord Hanson once said that his job was to "appropriate tomorrow's value today" and although such business logic may be familiar to an MBA student, future generations are unlikely to thank us for it. The great monuments of the world were built because their progenitors took precisely the opposite attitude. They cared more about creating value for the future than the present. But when infrastructure is financed with loans at interest, caring about the future becomes a rather expensive habit. One reason that we find it so difficult to build the likes of St. Paul's Cathedral nowadays, or even the London Underground, is that we have forgotten how to fund projects without resorting to bank loans.
Unfortunately, a powerful commercial logic called financial leverage is preventing change in these matters. The business model of most modern corporations is to borrow money at a rate of interest that is below the rate of return earned when investing that money. For example, by borrowing £100 at 5% and investing it in a one year project that yields 20%, the executive manager can earn £15 for his firm. And the banker will earn £5 of interest on his newly created money. It is a rather cosy symbiosis, but its logical consequence is that firms will grow increasingly large over time. Instead of borrowing £100 in order to make £15 of profit, why not borrow £100 million and make £15 million of profit instead?
In this manner, financial leverage has enabled a relatively small number of corporations to achieve market dominance, while their bankers collect interest on an ever-growing pile of debt. And because the commercial banking system has the ability to create new money almost without limit, there is correspondingly nothing to restrict the extent of financial leverage. The result is that economic growth of a highly aggressive kind is being forced upon humanity.
Nowhere is this better illustrated than in the changing face of Britain today. A charming landscape of ages past is gradually being scarred by the characterless housing estates that financial leverage imposes on us. Large corporations are beginning to monopolise business and cultural activity, removing decision-making power from local communities and passing it in increasing measure to distant centres of control. This is the system that put the butcher, the baker and the candlestick-maker out of business, and then employed them at a nearby supermarket on the minimum wage. And if you think that Top Shop, Burton, Miss Selfridge, Dorothy Perkins, Wallis, Richard Shops and BHS represent healthy competition in the fashion sector, think again. All these companies are controlled by one businessman, obligingly empowered with bank debt. Is this what passes for market competition in the twenty-first century?
Given the amount of profit at stake, it is understandable that the connection between interest-based leverage and matters of environment is rarely mentioned in political discourse. Mr. Stern's voluminous report on global warming and Al Gore's documentary barely touch upon it. But there is another way, and that is the way of equity in both its financial and social sense.
Imagine a world in which holders of surplus wealth invested with entrepreneurs only on a profit and loss sharing basis. Here the investor gains or loses according to the entrepreneur's business fortunes. Under this kind of finance, the interests of both parties are closely aligned. The investor will be more careful when examining the entrepreneur's project plan and personal history before investing. This contrasts with the attitude of many interest-based lenders who attach greater importance to the borrower's collateral than to his business plan. This is because collateral can be repossessed and sold on the market in order to repay the original loan plus interest. Bank loans therefore tend to be directed towards those members of society who already have wealth, not necessarily to those with the best projects. A poor man may have a good business idea but, without collateral, few banks will finance him. Interest-based finance therefore tends to increase wealth inequality, whereas pure profit and loss sharing tends to reduce it.
In Islam, any benefit accruing to a lender of money is regarded as a form of usury and is prohibited. There is no such thing as a "usurious" rate of interest in Islamic law, because all rates of interest are usurious. And although the prohibition of usury is not a cure-all for the maladies of modern life, where it has been implemented as part of a wider regime of Islamic regulation the historical precedents are excellent. The universities, hospitals, welfare systems and infrastructure of Iraq, Spain and the Ottoman Empire were funded without resort to interest-bearing loans. Within twenty years of the institution of Islamic law, the Arabian peninsula was transformed from a scene of poverty to one in which deserving recipients for welfare payments could not be found. The lesson is clear. Interest-based finance is not a pre-requisite for society's material advancement.
In today's context, the prohibition of interest would yield immediate benefits to the majority of the world's poor. If the developing countries were to cease their debt service repayments today, they would find themselves richer by more that a billion dollars a day. That would make a very real difference in a world where as many as three billion people are each living on less than two dollars a day. Their hunger is our luxury, and usury makes it so.
1400 years ago the Prophet Muhammad (peace be upon him) told his followers, "though usury be much, it always leads to utter poverty". When such words are uttered by a Prophet, they carry the force of an economic law. They warn us that even the wealthy nations of the world are in a race against time. If we do not defeat usury, usury will defeat us too.
Tuesday, May 6, 2008
The Reality of Money and the Banking System
Before reading this, please read the article “Modern Economy: Progress or Destruction” on this website (I have added some video links and if you have time please watch them too, as they further illustrate the points made in the article).
I got this interesting article from the internet. It is a must read to understand the economic system we are living under today.
Please also watch the video “Money as Debt” (the link for the video is at the end of the article). I highly recommend it.
MONEY & BANKS ….
THE HIDDEN TRUTH BEHIND GLOBAL DEBT .
1) What is money... how is it created and who creates it?
2) Why is almost everyone up to their eyeballs in debt... individuals, businesses and whole nations?
3) Why can’t we provide for our daily needs - homes, furnishings cars etc. without borrowing?
4) How much could prices fall and wages increase if businesses did not have to pay huge sums in interest payments which have to be added to the cost of goods and services they supply...?
5) How much could taxes be reduced and spending on public services such as health and education be increased if governments created money themselves instead of borrowing it at interest from private banks…?
"If you want to be the slaves of banks and pay the cost of your own slavery, then let the banks create money…" Josiah Stamp, Governor of the Bank of England 1920.
WHAT IS MONEY....?
It is simply the medium we use to exchange goods and services.
Without it, buying and selling would be impossible except by direct exchange.
Notes and coins are virtually worthless in their own right. They take on value as money because we all accept them when we buy and sell.
To keep trade and economic activity going, there has to be enough of this medium of exchange called money in existence to allow it all to take place.
When there is plenty, the economy booms. When there is a shortage, there is a slump.
In the Great Depression, people wanted to work, they wanted goods and services, all the raw materials for industry were available etc. yet national economies collapsed because there was far too little money in existence.
The only difference between boom and bust, growth and recession is money supply.
Someone has to be responsible for making sure that there is enough money in existence to cover all the buying and selling that people want to engage in.
Each nation has a Central Bank to do this - in Britain, it is the Bank of England, in the United States, the Federal Reserve.
Central Banks act as banker for commercial banks and the government - just as individuals and businesses in Britain keep accounts at commercial banks, so commercial banks and government keep accounts at the Bank of England.
TODAY’S "MONEY"... CREATED BY PRIVATE INTERESTS FOR PRIVATE PROFIT.
"Let me issue and control a nation’s money, and I care not who writes its laws." Mayer Amschel Rothschild (Banker) 1790
Central banks are controlled not by elected governments but largely by PRIVATE INTERESTS from the world of commercial banking.
In Britain today, notes and coins now account for only 3% of our total money supply, down from 50% in 1948.
The remaining 97% is supplied and regulated as credit - personal and business loans, mortgages, overdrafts etc. provided by commercial banks and financial institutions - on which INTEREST is payable. This pattern is repeated across the globe.
Banks are businesses out to make profits from the interest on the loans they make. Since they alone decide to whom they will lend, they effectively decide what is produced, where it is produced and who produces it, all on the basis of profitability to the bank, rather than what is beneficial to the community.
With bank created credit now at 97% of money supply, entire economies are run for the profit of financial institutions. This is the real power, rarely recognised or acknowledged, to which all of us including governments the world over are subject.
Our money, instead of being supplied interest free as a means of exchange, now comes as a debt owed to bankers providing them with vast profits, power and control, as the rest of us struggle with an increasing burden of debt....
By supplying credit to those of whom they approve and denying it to those of whom they disapprove international bankers can create boom or bust and support or undermine governments.
There is much less risk to making loans than investing in a business. Interest is payable regardless of the success of the venture. If it fails or cannot meet the interest payments, the bank seizes the borrower’s property.
Borrowing is extremely costly to borrowers who may end up paying back 2 or 3 times the sum lent.
The money loaned by banks is created by them out of nothing – the concept that all a bank does is to lend out money deposited by other people is very misleading.
MONEY CREATED AS A DEBT
We don’t distinguish between the £25 billion in circulation as notes and coins (issued by the government) and £680 billion in the form of loan accounts, overdrafts etc. (created by banks etc,).
£100 cash in your wallet is treated no differently from £100 in your current account, or an overdraft facility allowing you to spend £100. You can still buy goods with it.
In 1948 we had £1.1 billion of notes and coins and £1.2 billion of loans etc. created by banks – by 1963 it was £3 billion in cash and £14 billion bank created loans etc.
The government has simply issued more notes and coins over the years to cover inflation, but today’s £680 billion of bank created loans etc. represents an enormous increase, even allowing for inflation.
This new "money" in the form of loans etc, which ranks equally with notes and coins – how has it come into existence?
"The process by which banks create money is so simple that the mind is repelled." Professor. J. K. Galbraith
This is how it’s done…. a simplified example...
Let’s take a small hypothetical bank. It has ten depositors/savers who have just deposited £500 each.
The bank owes them £5000 and it has £5000 to pay out what it owes. (It will keep that £5000 in an account at the Bank of England – what it has in this account are called its liquid assets).
Sid, an entrepreneur, now approaches the bank for a £5000 loan to help him to set up a business.
This is granted on the basis of repayment in 12 months - plus 10% interest – more on that later.
A new account is opened in Sid’s name. It has nothing in it, nevertheless the bank allows Sid to withdraw and spend £5000.
The depositors are not consulted about the loan. They are not told that their money is no longer available to them– The amounts shown in their accounts are not reduced and transferred to Sid’s account.
In granting this loan, the bank has increased its obligations to £10,000. Sid is entitled to £5000, but the depositors can still claim their £5000.
If the bank now has obligations of £10,000, then isn’t it insolvent, because it only had £5000 of deposits in the first place? Not exactly…
The bank treats the loan to Sid as an ASSET, not a liability, on the basis that Sid now owes the bank £5000.
The bank’s balance sheet will show that it owes its depositors £5000, and it is now owed £5000 by Sid. It has created for itself a new asset of £5000 in the form of a debt owed by Sid where nothing existed before - this on top of any of the original deposits still in its account at the Bank of England. - it is solvent - at least for accounting purposes!
(At this stage the bank is gambling that as Sid is spending his loan, the depositors won’t all want to withdraw their deposits!)
The bank had a completely free hand in the creation of this £5000 loan which, as we shall see, represents new "money", where nothing existed before. It was done at the stroke of a pen or the pressing of a computer key.
The idea that banks create something out of nothing and then charge interest on it for private profit might seem pretty repellent. Anyone else doing it would be guilty of fraud or counterfeiting!
New "money" into the economy...
Sid’s loan effectively becomes new "money" as it is spent by him to pay for equipment, rent and wages etc. in connection with his new business.
This new "money" is thus distributed to other people, who will in turn use it to pay for goods and services - soon it will be circulating throughout the economy.
As it circulates, it inevitably ends up in other people’s bank accounts.
When it is paid into someone’s account which is not overdrawn, it is a further deposit - Sid pays his secretary £100 and she opens an account at our hypothetical bank – it now has £5100 of deposits.
If we assume for a moment that the remaining £4900 ends up in the accounts of the original depositors of our hypothetical bank, it now has another £4900 in deposits - £10000 in total if the depositors have not touched their original deposits. In practice much of it would end up in depositors accounts at other banks, but either way there is now £5000 of new "money" in circulation.
Thus in reality, all deposits with banks and elsewhere actually come from "money" originally created as loans – (except where the deposits are made in cash – more on cash very shortly).
If you have £500 in your bank account, the fact is someone else like Sid went into debt to provide it.
The key to the whole thing is the fact that :-
[1] Cash withdrawals account for only a tiny percentage of a bank’s business.
[2] Bank customers today make almost all payments between themselves by cheque, switch, direct debit or electronic transfer etc. Their individual accounts are adjusted accordingly by changing a few figures in computer databases – just book keeping entries. No actual money/cash changes hands. The whole thing is basically an accounting process that takes place within the banking system.
THE ROLE OF CASH
The state is responsible for the production of cash in the form of notes and coins.
These are then issued by the Bank of England to the high street banks - the banks buy them at face value from the government to meet their customers’ demands for cash.
The banks must pay for this cash and they do so out of what they have in the accounts which they hold at the Bank of England – their liquid assets. Their accounts are debited accordingly.
The state (through the Treasury) also keeps an account at the Bank of England which is credited with the face value of the notes and coins as they are paid for by the banks. (This is now money in the public purse available for spending on public services etc.)
This is how all banks acquire their stocks of notes and coins, but the cash a bank can buy is limited to the amount it holds in its account at the Bank of England – its liquid assets.
As this cash is withdrawn by banks’ customers, it enters circulation in the economy.
Unlike bank created loans etc, cash is interest free and can circulate indefinitely.
NON CASH PAYMENTS - Book keeping entries
With so little cash being withdrawn, and from experience knowing that large amounts of deposits remain untouched by depositors for reasonable periods of time, banks just hope that their liquid assets will be sufficient to enable them to buy up the cash necessary to meet the relatively very small amounts of cash that are normally withdrawn.
A bank has serious problems if demands for cash withdrawals by depositors, and indeed borrowers who want to draw some of their loans in cash, exceed what the bank holds in its account at the Bank of England.
In practice it would probably try to get a loan itself from the Bank of England or another bank, to tide itself over. Failing that it would have to call in some loans and seize the property of borrowers unable to pay.
DEPOSITORS’ CLAIMS AGAINST BANKS …
Once you have made a deposit at the bank (in cash or by cheque), all you then have is a claim against the bank for the amount in your account. You are simply an unsecured creditor. Your bank statement is a record of how much the bank owes you. (If you are overdrawn, it is a record of what you owe the bank). It will pay you what it owes you by allowing you to withdraw cash, provided it has sufficient cash to do so.
If customers are trying to withdraw too much cash, this is a run on the bank, which will soon refuse further withdrawals. So it’s first come first served!
Should you want to make a payment by cheque, this is less likely to be a problem – you are simply transferring part of your claim against the bank to someone else – the person to whom your cheque is payable - just a book keeping entry.
If the person to whom your cheque is payable has an account at the same bank as you do, the deposit stays with that bank – overall the bank is in exactly the same position as it was before.
I give you a cheque for £50 – we both have accounts in credit at Barclays – what Barclays owes me is reduced by £50, what Barclays owes you increases by £50 – but nothing has left Barclays – the total deposits or claims against Barclays remain the same…..
BANKS’ CLAIMS AGAINST EACH OTHER
….BUT if you keep your account at Lloyds, deposits at Barclays are reduced by £50, whilst deposits at Lloyds increase by £50.
Millions of transactions like this take place every day between customers of the various banks, using switch cards, direct debits, electronic transfers as well as cheques – deposits are therefore constantly moving between the banks.
All these cheques and electronic transfers pass through a central clearing house (which is why we refer to a cheque being "cleared").
The transactions are set off against one another, but at the end of each day, a relatively small balance will always be owed by one bank to another.
A bank must always be ready to settle such debts.
To do this, it makes a payment from its account at the Bank of England to the creditor bank’s account at the Bank of England.
Thus a bank faces claims from two sources (which it meets out of its liquid assets) – its customers wanting cash, and other banks when it has a clearing house debt to settle.
Unless all the banks are faced with big demands for cash at the same time, the banking system as a whole is safe, although an individual bank is vulnerable, should a large number of depositors for some reason withdraw their deposits in cash or transfer their deposits to other banks.
We now see how today the whole system is basically a book keeping exercise where millions of claims pass between the banks and their borrowers and depositors every day with relatively very little real money or cash changing hands – backed by tiny reserves of liquid assets.
The system is known as FRACTIONAL RESERVE BANKNG and banks are sometimes accurately referred to as dealers in debts.
Barclays Bank’s 1999 accounts illustrate the whole thing very well - it had loans owing to it of £217 billion, it owed £191 billion to its depositors – backed by just £2.2 billion in liquid assets!
A bank’s level of lending is geared to the amount of cash it has or can buy up – its liquid assets - rather than the amount of its customers’ deposits.
But if a bank can attract customer deposits from other banks, it will add to its liquid assets, as other banks settle the resulting clearing house debts in its favour – hence there is tremendous competition between banks to attract deposits.
INTEREST …. BIG PROFITS FOR THE BANK...
Let’s now return to Sid – he has to pay our bank 10% interest on his loan - £500. These interest payments are money coming into the bank, they are profits and they end up in its account at the Bank of England - additional liquid assets for the bank.
It now has an extra £500 to meet its depositors’ withdrawals. If Sid manages to repay the original loan as well, it will have an extra £5500.
Our bank created for itself out of nothing an asset of £5000 in the form of a loan to Sid. It is no longer owed anything by Sid, but in repaying his loan with interest, Sid turned a mere debt into £5500 of liquid assets for the bank – a tidy profit for the bank…. and the basis on which more loans can be made.
Banks today risk creating loans 100 times or more in excess of their liquid assets as Barclays Bank’s 1999 accounts show – (see above).
Thus our bank will soon be making many more loans. Thus, the deposits it receives back will increase and so will interest payments and therefore profits.
With more loans and more deposits, there will be a greater demand to withdraw cash – but increasing profits means more cash can bought by the bank. (This is how the amount of cash in circulation has been increasing to reach £25 billion by 1997.)
It is a myth to think that when you borrow money from a bank, you are borrowing money that other people have deposited – you are not – you are borrowing the bank’s money which it created and made available to you in the form of a loan.
MORE DEBT FOR THE REST OF US....
Sid’s interest payments and any repayment of the loan itself to the bank means, however, that this "money" is no longer circulating in the economy.
Any payment into an overdrawn account reduces that overdraft. It operates as a repayment to the bank and the "money" is lost to the economy.
More money must be lent out to keep the economy going. If people don’t borrow or banks don’t lend, there will be a fall in the amount of money circulating, resulting in a reduction in buying and selling - a recession, slump or total collapse will follow depending on how severe the shortage is.
The increase in bank created loans over the years is additional conclusive proof that banks do create "money" out of nothing - £1.2 billion in 1948 up to £14 billion by 1963 up to £680 billion by 1997.
Today’s supply of notes and coins after taking inflation into account, has similar buying power to the supply in 1948 (£1.1 billion) but since then, there has been a tenfold plus increase in real terms in money supply made up of credit created by banks.
This has enabled the economy to expand enormously, and as a result living standards for many people have improved substantially.... but it has been done on borrowed money! What is credit to the bank is debt to the rest of us.
The banks are acquiring an ever increasing stake in our land, housing and other assets through the indebtedness of individuals, industry, agriculture, services and government - to the extent that Britain and the world are today effectively owned by them.
THE REPERCUSSIONS OF OUR DEBT BASED MONEY SYSTEM...
1) Goods and services are much more expensive...
The cost of borrowing by producers, manufacturers, transporters, retailers etc. all has to be added to the price of the final product.
2) Consumers’ have much less money to spend...
They are burdened by the cost of mortgages, overdrafts, credit cards, personal loans etc. As a result of 1) and 2) there is...
3) A surplus of goods and services...
...because the population overall can’t afford to buy up all the goods and services being produced. This in turn creates.....
4) Cut throat competition...
Businesses try to cut prices and costs to grab a share of this limited purchasing power in the economy, as illustrated by:
(i) Wages being held down as much as possible.
(ii) Shedding of jobs.
(These both reduce people’s spending power even more.)
(iii) Retailers importing cheap products from abroad where wages are much lower.
(iv) Production of cheaper goods that don’t last as long.
(v) Protection of the environment a low priority.
(vi) Mergers and takeovers - corporations get bigger and bigger, driven to search out new markets.
(vii) Big companies shifting production to poorer countries which have cheap non-unionised labour and the least stringent safety and environmental laws or....
(viii) Demanding large government subsidies and tax free incentives as the price for setting up new production or not relocating abroad.
5) Ever increasing indebtedness...
When a bank creates money by making a loan, it does not create the money needed to pay the interest on that loan.
The bank lent Sid £5000, but it demands £5500 back. Sid has to go out into the business world and compete and sell to get that extra £500 from his customers. It can only come from money already circulating in the economy - made up of loans other people have taken out – so soon someone will be left short of money and have to borrow more.
Thus the only way for interest payments to be kept up is for more loans to be taken out.
Although a few individuals and businesses may pay off their debts or get by without additional borrowing, OVERALL people and industry must keep borrowing MORE AND MORE to provide the money in the economy needed to keep up interest payments on the overall volume of debt.
The present level of debt at £680 billion means we are borrowing about £60 billion of new "money" into existence each year to pay the interest on it.
But people and industry can’t go on borrowing indefinitely - they will no longer be able to afford to, and will gradually stop borrowing more money into existence. When this happens, the economy will go into decline. The system thus contains the seeds of its own destruction.
When loan repayments and interest payments are made to banks, this is money taken out of circulation. If it went on indefinitely, in an economy where the money supply is largely made up of loans etc. created by banks, there would eventually be almost no "money" left in circulation and with it no economy.
Under the present system, if the economy is to be kept going, money must be constantly lent out again. It would be possible simply re-circulate the existing money supply without creating new money were it not for the fact that extra money is needed to cover interest payments and also to enable the economy to grow.
6) Inflation....
is guaranteed because producers constantly have to borrow more, and must add the cost of that increased borrowing to the price of the goods produced.
Why is it that when the moneylenders hike their prices (i.e. put up interest rates) this is supposed to reduce inflation?
It doesn’t....
It’s just that there is a delay in industry putting up prices.
Initially industry is forced to hold or even reduce its prices with profits down, or even sustaining losses in a desperate bid to sell its products in an economy where money available for spending is reduced because of higher interest payments being made to the banks.
Inflation may be held in check or even reduced temporarily, but eventually industry must put its prices up in order to recover these higher costs.
This most readily happens when interest rates come down, more people borrow, and money supply and consumer spending increases. Inflation then races ahead.
The fact that levels of borrowing/money creation have to keep on rising as already explained, adding to the overall burden of interest payments, guarantees that inflation will be present as long as we have an economy based on an increasing burden of debt.
EFFECTS ON INTERNATIONAL TRADE
Surplus goods in the national economy have to be disposed of somehow. The obvious way to do this is to try to export them!
The absurdity is that every nation is trying to do this, because of the same fundamental problem at home.
This creates frenzied competition in world markets and masses of near identical goods madly criss-crossing the globe in search of an outlet.
Instead of international trade being based on reciprocal mutually beneficial arrangements where nations supply each others’ genuine needs and wants, the whole thing becomes a cut-throat competition to grab market share in order to stay solvent in a debt based economy.
Big corporations demand unrestricted access to every nation’s market – so called "free" trade.
The European Union "single market", the North American Free Trade Agreement and the World Trade Organisation are the best examples of the drive to open up all national markets.
Exporting is good for a nation’s economy...
because when exported goods are paid for, this brings money into the exporting nation’s economy free of debt.
The money to pay for them was borrowed from banks in the importing nation.
That money is lost to the importing nation’s economy, but the debt that created that money still has to be repaid by the importer out of the remaining money in the importing nation’s economy.
If a nation can become a big net exporter, for a time it’s economy will boom with all the interest free money coming in - a trade surplus will exist.
Importing is not so good for a nation’s economy...
If some nations are building up trade surpluses in this way, others must be net importers and building up trade deficits.
Ultimately, those with big deficits can no longer afford to import, since so much money is sucked out of their economies leaving a proportionally increasing burden of debt behind.
THIRD WORLD DEBT AND THE INTERNATIONAL MONETARY FUND (IMF)
The IMF was set up to provide an international reserve of money supposedly to help nations with big deficits.
In practice it makes matters worse.
A nation with a big deficit has to seek a bail out from the IMF.
BUT this comes in the form of a loan, repayable with interest.
Like loans from a commercial bank, IMF loans are money created out of nothing, based on a cash reserve pool, which is provided by western nations who go into debt to provide it (see National Debt).
The nation with the deficit goes even more heavily into debt.
It will however be able to carry on trading and importing goods from the wealthier nations.
As a result, much of this borrowed IMF loan money flows into the economies of wealthier western nations.
However, the repayment obligation including the interest payments remains with the debtor nation.
This is the true horror of third world debt - the poorest nations borrow money to bolster the money supply of the richer nations.
In order to secure income to pay the interest, and redress the trade balance, these poorest nations must export whatever they can produce. Thus they exploit every possible resource - stripping forests for timber, mining, giving over their best agricultural land to providing luxury foodstuffs for the west, rather than providing for local needs.
Today, for nations in Africa, Central and South America and elsewhere, the revenue from their exports does not even meet the interest payments on these IMF loans (and other loans from western banks).
The sums paid in interest over the years far exceed the amounts of the original loans themselves.
The result is a desperate shortage of money in their economies - resulting in cutbacks in basic health and education programmes etc.
Grinding poverty exists in nations with great wealth in terms of natural resources.
Structural Adjustment Programmes - these are now attached to IMF loans and include conditions that recipient countries will reduce or remove tariff barriers and "open up their markets to foreign competition" - in other words take surplus goods off another country that can’t be sold at home.
NATIONAL DEBT
British national debt now stands at £400 billion - the annual interest on that debt is around £25 -30 billion. The government can only pay it by taxing the population as a whole, so we pay! National debt is up from £26 billion in 1960 and £90 billion in 1980.
Successive governments have borrowed this money into existence over the years.
Instead of creating it themselves and spending it into the economy on public services and projects boosting the economy and providing jobs, they get banks to create it for them and then borrow it at interest.
It all started in 1694 when King William needed money to fight a war against France.
He borrowed £1.2 million from a group of London bankers and goldsmiths.
In return for the loan, they were incorporated by royal charter as the Bank of England which became the government’s banker.
Interest at 8% was payable on the loan and immediately taxes were imposed on a whole range of goods to pay the interest.
This marked the birth of national debt.
Ever since then the world over, governments have borrowed money from private banking interests and taxed the population as a whole to pay the interest.
How the Government Borrows Money
When governments borrow money, in return they issue to the lender, exchequer or treasury bonds - otherwise known as government stocks or securities.
These are basically IOU’s - promises by government to repay the loan by a particular date, and to pay interest in the meantime.
They are taken up chiefly by banks, but also by individuals with money to spare including very wealthy ones in the banking fraternity and, in more recent years, pension and other investment funds.
When government securities are taken up by banks, this is money creation at the stroke of a pen by the banks out of nothing.
Banks are creating money as loans out of nothing by lending it into existence to the government in very much the same way as they do to individuals and companies.
The government now has new money in the form of loans to spend on public services etc.
If this money was not borrowed into existence in this way, there would be that much less economic activity as a result.
Under this system NATIONAL DEBT IS CREDIT ISSUED TO THE GOVERNMENT AND AS SUCH HAS BECOME A VITAL PART OF THE TOTAL MONEY SUPPLY OF ANY MODERN NATION.
The government constantly tells us that there isn’t enough money for this that and the other, because it knows that the cost of borrowing any money it needs has to be passed on to the taxpayer.
Instead, it sells off state assets and now gets the private sector to fund public services instead.
War…...
enormous increases in national debt...
enormous profits for the banks...
Massive government borrowing and money creation by banks is required to fund a war effort.
The same international bankers have covertly funded both sides in both world wars and many other conflicts before and since.
Having profited from war leaving nations with massive debts and more beholden than ever to them, the banks then fund reconstruction.
Bankers have even helped bring wars about. The calling in of loans to the German Weimar republic largely created the conditions for the rise of Hitler.
The pattern was well established by the mid 19th. century - by then international banker and speculator Nathan Rothschild could boast a personal fortune of £50 million.
The Constant Increase in National Debt
In the same way that under the present system, industry and individuals must keep borrowing more and more to enable interest payments to be kept up on their existing loans, so government must constantly borrow more and more to keep up interest payments on its existing loans.
Furthermore, when a particular government stock is due for repayment, the government simply borrows more by issuing new government stocks.
Phasing out of National Debt
"If the government can issue a dollar bond, it can just as easily issue a dollar bill." Thomas Edison.
Government could stop borrowing money at interest, and start creating it itself by spending it into the economy on public projects and services, at the same time creating jobs and stimulating the economy.
It already does this to a very limited extent – the amount it receives from the banks when it sells cash to them is added to the public purse and is available for spending on public services and projects.
Please watch this informative video to gain further insight into the modern banking system: Money as Debt http://video.google.com.au/videoplay?docid=5352106773770802849&hl=en
In addition, for history of the banking system and analyses of our modern economy please watch The Money Masters Part 1 http://video.google.com/videoplay?docid=-1583154561904832383 and The Money Masters Part 2 http://video.google.com/videoplay?docid=-7336845760512239683
I would also recommend that you read the book "The Final Crash" by Hugo Bouleau http://www.finalcrash.com/. In addition, please read "The Web of Debt" By Ellen Hodgson Brown" (http://www.webofdebt.com/)
I got this interesting article from the internet. It is a must read to understand the economic system we are living under today.
Please also watch the video “Money as Debt” (the link for the video is at the end of the article). I highly recommend it.
MONEY & BANKS ….
THE HIDDEN TRUTH BEHIND GLOBAL DEBT .
1) What is money... how is it created and who creates it?
2) Why is almost everyone up to their eyeballs in debt... individuals, businesses and whole nations?
3) Why can’t we provide for our daily needs - homes, furnishings cars etc. without borrowing?
4) How much could prices fall and wages increase if businesses did not have to pay huge sums in interest payments which have to be added to the cost of goods and services they supply...?
5) How much could taxes be reduced and spending on public services such as health and education be increased if governments created money themselves instead of borrowing it at interest from private banks…?
"If you want to be the slaves of banks and pay the cost of your own slavery, then let the banks create money…" Josiah Stamp, Governor of the Bank of England 1920.
WHAT IS MONEY....?
It is simply the medium we use to exchange goods and services.
Without it, buying and selling would be impossible except by direct exchange.
Notes and coins are virtually worthless in their own right. They take on value as money because we all accept them when we buy and sell.
To keep trade and economic activity going, there has to be enough of this medium of exchange called money in existence to allow it all to take place.
When there is plenty, the economy booms. When there is a shortage, there is a slump.
In the Great Depression, people wanted to work, they wanted goods and services, all the raw materials for industry were available etc. yet national economies collapsed because there was far too little money in existence.
The only difference between boom and bust, growth and recession is money supply.
Someone has to be responsible for making sure that there is enough money in existence to cover all the buying and selling that people want to engage in.
Each nation has a Central Bank to do this - in Britain, it is the Bank of England, in the United States, the Federal Reserve.
Central Banks act as banker for commercial banks and the government - just as individuals and businesses in Britain keep accounts at commercial banks, so commercial banks and government keep accounts at the Bank of England.
TODAY’S "MONEY"... CREATED BY PRIVATE INTERESTS FOR PRIVATE PROFIT.
"Let me issue and control a nation’s money, and I care not who writes its laws." Mayer Amschel Rothschild (Banker) 1790
Central banks are controlled not by elected governments but largely by PRIVATE INTERESTS from the world of commercial banking.
In Britain today, notes and coins now account for only 3% of our total money supply, down from 50% in 1948.
The remaining 97% is supplied and regulated as credit - personal and business loans, mortgages, overdrafts etc. provided by commercial banks and financial institutions - on which INTEREST is payable. This pattern is repeated across the globe.
Banks are businesses out to make profits from the interest on the loans they make. Since they alone decide to whom they will lend, they effectively decide what is produced, where it is produced and who produces it, all on the basis of profitability to the bank, rather than what is beneficial to the community.
With bank created credit now at 97% of money supply, entire economies are run for the profit of financial institutions. This is the real power, rarely recognised or acknowledged, to which all of us including governments the world over are subject.
Our money, instead of being supplied interest free as a means of exchange, now comes as a debt owed to bankers providing them with vast profits, power and control, as the rest of us struggle with an increasing burden of debt....
By supplying credit to those of whom they approve and denying it to those of whom they disapprove international bankers can create boom or bust and support or undermine governments.
There is much less risk to making loans than investing in a business. Interest is payable regardless of the success of the venture. If it fails or cannot meet the interest payments, the bank seizes the borrower’s property.
Borrowing is extremely costly to borrowers who may end up paying back 2 or 3 times the sum lent.
The money loaned by banks is created by them out of nothing – the concept that all a bank does is to lend out money deposited by other people is very misleading.
MONEY CREATED AS A DEBT
We don’t distinguish between the £25 billion in circulation as notes and coins (issued by the government) and £680 billion in the form of loan accounts, overdrafts etc. (created by banks etc,).
£100 cash in your wallet is treated no differently from £100 in your current account, or an overdraft facility allowing you to spend £100. You can still buy goods with it.
In 1948 we had £1.1 billion of notes and coins and £1.2 billion of loans etc. created by banks – by 1963 it was £3 billion in cash and £14 billion bank created loans etc.
The government has simply issued more notes and coins over the years to cover inflation, but today’s £680 billion of bank created loans etc. represents an enormous increase, even allowing for inflation.
This new "money" in the form of loans etc, which ranks equally with notes and coins – how has it come into existence?
"The process by which banks create money is so simple that the mind is repelled." Professor. J. K. Galbraith
This is how it’s done…. a simplified example...
Let’s take a small hypothetical bank. It has ten depositors/savers who have just deposited £500 each.
The bank owes them £5000 and it has £5000 to pay out what it owes. (It will keep that £5000 in an account at the Bank of England – what it has in this account are called its liquid assets).
Sid, an entrepreneur, now approaches the bank for a £5000 loan to help him to set up a business.
This is granted on the basis of repayment in 12 months - plus 10% interest – more on that later.
A new account is opened in Sid’s name. It has nothing in it, nevertheless the bank allows Sid to withdraw and spend £5000.
The depositors are not consulted about the loan. They are not told that their money is no longer available to them– The amounts shown in their accounts are not reduced and transferred to Sid’s account.
In granting this loan, the bank has increased its obligations to £10,000. Sid is entitled to £5000, but the depositors can still claim their £5000.
If the bank now has obligations of £10,000, then isn’t it insolvent, because it only had £5000 of deposits in the first place? Not exactly…
The bank treats the loan to Sid as an ASSET, not a liability, on the basis that Sid now owes the bank £5000.
The bank’s balance sheet will show that it owes its depositors £5000, and it is now owed £5000 by Sid. It has created for itself a new asset of £5000 in the form of a debt owed by Sid where nothing existed before - this on top of any of the original deposits still in its account at the Bank of England. - it is solvent - at least for accounting purposes!
(At this stage the bank is gambling that as Sid is spending his loan, the depositors won’t all want to withdraw their deposits!)
The bank had a completely free hand in the creation of this £5000 loan which, as we shall see, represents new "money", where nothing existed before. It was done at the stroke of a pen or the pressing of a computer key.
The idea that banks create something out of nothing and then charge interest on it for private profit might seem pretty repellent. Anyone else doing it would be guilty of fraud or counterfeiting!
New "money" into the economy...
Sid’s loan effectively becomes new "money" as it is spent by him to pay for equipment, rent and wages etc. in connection with his new business.
This new "money" is thus distributed to other people, who will in turn use it to pay for goods and services - soon it will be circulating throughout the economy.
As it circulates, it inevitably ends up in other people’s bank accounts.
When it is paid into someone’s account which is not overdrawn, it is a further deposit - Sid pays his secretary £100 and she opens an account at our hypothetical bank – it now has £5100 of deposits.
If we assume for a moment that the remaining £4900 ends up in the accounts of the original depositors of our hypothetical bank, it now has another £4900 in deposits - £10000 in total if the depositors have not touched their original deposits. In practice much of it would end up in depositors accounts at other banks, but either way there is now £5000 of new "money" in circulation.
Thus in reality, all deposits with banks and elsewhere actually come from "money" originally created as loans – (except where the deposits are made in cash – more on cash very shortly).
If you have £500 in your bank account, the fact is someone else like Sid went into debt to provide it.
The key to the whole thing is the fact that :-
[1] Cash withdrawals account for only a tiny percentage of a bank’s business.
[2] Bank customers today make almost all payments between themselves by cheque, switch, direct debit or electronic transfer etc. Their individual accounts are adjusted accordingly by changing a few figures in computer databases – just book keeping entries. No actual money/cash changes hands. The whole thing is basically an accounting process that takes place within the banking system.
THE ROLE OF CASH
The state is responsible for the production of cash in the form of notes and coins.
These are then issued by the Bank of England to the high street banks - the banks buy them at face value from the government to meet their customers’ demands for cash.
The banks must pay for this cash and they do so out of what they have in the accounts which they hold at the Bank of England – their liquid assets. Their accounts are debited accordingly.
The state (through the Treasury) also keeps an account at the Bank of England which is credited with the face value of the notes and coins as they are paid for by the banks. (This is now money in the public purse available for spending on public services etc.)
This is how all banks acquire their stocks of notes and coins, but the cash a bank can buy is limited to the amount it holds in its account at the Bank of England – its liquid assets.
As this cash is withdrawn by banks’ customers, it enters circulation in the economy.
Unlike bank created loans etc, cash is interest free and can circulate indefinitely.
NON CASH PAYMENTS - Book keeping entries
With so little cash being withdrawn, and from experience knowing that large amounts of deposits remain untouched by depositors for reasonable periods of time, banks just hope that their liquid assets will be sufficient to enable them to buy up the cash necessary to meet the relatively very small amounts of cash that are normally withdrawn.
A bank has serious problems if demands for cash withdrawals by depositors, and indeed borrowers who want to draw some of their loans in cash, exceed what the bank holds in its account at the Bank of England.
In practice it would probably try to get a loan itself from the Bank of England or another bank, to tide itself over. Failing that it would have to call in some loans and seize the property of borrowers unable to pay.
DEPOSITORS’ CLAIMS AGAINST BANKS …
Once you have made a deposit at the bank (in cash or by cheque), all you then have is a claim against the bank for the amount in your account. You are simply an unsecured creditor. Your bank statement is a record of how much the bank owes you. (If you are overdrawn, it is a record of what you owe the bank). It will pay you what it owes you by allowing you to withdraw cash, provided it has sufficient cash to do so.
If customers are trying to withdraw too much cash, this is a run on the bank, which will soon refuse further withdrawals. So it’s first come first served!
Should you want to make a payment by cheque, this is less likely to be a problem – you are simply transferring part of your claim against the bank to someone else – the person to whom your cheque is payable - just a book keeping entry.
If the person to whom your cheque is payable has an account at the same bank as you do, the deposit stays with that bank – overall the bank is in exactly the same position as it was before.
I give you a cheque for £50 – we both have accounts in credit at Barclays – what Barclays owes me is reduced by £50, what Barclays owes you increases by £50 – but nothing has left Barclays – the total deposits or claims against Barclays remain the same…..
BANKS’ CLAIMS AGAINST EACH OTHER
….BUT if you keep your account at Lloyds, deposits at Barclays are reduced by £50, whilst deposits at Lloyds increase by £50.
Millions of transactions like this take place every day between customers of the various banks, using switch cards, direct debits, electronic transfers as well as cheques – deposits are therefore constantly moving between the banks.
All these cheques and electronic transfers pass through a central clearing house (which is why we refer to a cheque being "cleared").
The transactions are set off against one another, but at the end of each day, a relatively small balance will always be owed by one bank to another.
A bank must always be ready to settle such debts.
To do this, it makes a payment from its account at the Bank of England to the creditor bank’s account at the Bank of England.
Thus a bank faces claims from two sources (which it meets out of its liquid assets) – its customers wanting cash, and other banks when it has a clearing house debt to settle.
Unless all the banks are faced with big demands for cash at the same time, the banking system as a whole is safe, although an individual bank is vulnerable, should a large number of depositors for some reason withdraw their deposits in cash or transfer their deposits to other banks.
We now see how today the whole system is basically a book keeping exercise where millions of claims pass between the banks and their borrowers and depositors every day with relatively very little real money or cash changing hands – backed by tiny reserves of liquid assets.
The system is known as FRACTIONAL RESERVE BANKNG and banks are sometimes accurately referred to as dealers in debts.
Barclays Bank’s 1999 accounts illustrate the whole thing very well - it had loans owing to it of £217 billion, it owed £191 billion to its depositors – backed by just £2.2 billion in liquid assets!
A bank’s level of lending is geared to the amount of cash it has or can buy up – its liquid assets - rather than the amount of its customers’ deposits.
But if a bank can attract customer deposits from other banks, it will add to its liquid assets, as other banks settle the resulting clearing house debts in its favour – hence there is tremendous competition between banks to attract deposits.
INTEREST …. BIG PROFITS FOR THE BANK...
Let’s now return to Sid – he has to pay our bank 10% interest on his loan - £500. These interest payments are money coming into the bank, they are profits and they end up in its account at the Bank of England - additional liquid assets for the bank.
It now has an extra £500 to meet its depositors’ withdrawals. If Sid manages to repay the original loan as well, it will have an extra £5500.
Our bank created for itself out of nothing an asset of £5000 in the form of a loan to Sid. It is no longer owed anything by Sid, but in repaying his loan with interest, Sid turned a mere debt into £5500 of liquid assets for the bank – a tidy profit for the bank…. and the basis on which more loans can be made.
Banks today risk creating loans 100 times or more in excess of their liquid assets as Barclays Bank’s 1999 accounts show – (see above).
Thus our bank will soon be making many more loans. Thus, the deposits it receives back will increase and so will interest payments and therefore profits.
With more loans and more deposits, there will be a greater demand to withdraw cash – but increasing profits means more cash can bought by the bank. (This is how the amount of cash in circulation has been increasing to reach £25 billion by 1997.)
It is a myth to think that when you borrow money from a bank, you are borrowing money that other people have deposited – you are not – you are borrowing the bank’s money which it created and made available to you in the form of a loan.
MORE DEBT FOR THE REST OF US....
Sid’s interest payments and any repayment of the loan itself to the bank means, however, that this "money" is no longer circulating in the economy.
Any payment into an overdrawn account reduces that overdraft. It operates as a repayment to the bank and the "money" is lost to the economy.
More money must be lent out to keep the economy going. If people don’t borrow or banks don’t lend, there will be a fall in the amount of money circulating, resulting in a reduction in buying and selling - a recession, slump or total collapse will follow depending on how severe the shortage is.
The increase in bank created loans over the years is additional conclusive proof that banks do create "money" out of nothing - £1.2 billion in 1948 up to £14 billion by 1963 up to £680 billion by 1997.
Today’s supply of notes and coins after taking inflation into account, has similar buying power to the supply in 1948 (£1.1 billion) but since then, there has been a tenfold plus increase in real terms in money supply made up of credit created by banks.
This has enabled the economy to expand enormously, and as a result living standards for many people have improved substantially.... but it has been done on borrowed money! What is credit to the bank is debt to the rest of us.
The banks are acquiring an ever increasing stake in our land, housing and other assets through the indebtedness of individuals, industry, agriculture, services and government - to the extent that Britain and the world are today effectively owned by them.
THE REPERCUSSIONS OF OUR DEBT BASED MONEY SYSTEM...
1) Goods and services are much more expensive...
The cost of borrowing by producers, manufacturers, transporters, retailers etc. all has to be added to the price of the final product.
2) Consumers’ have much less money to spend...
They are burdened by the cost of mortgages, overdrafts, credit cards, personal loans etc. As a result of 1) and 2) there is...
3) A surplus of goods and services...
...because the population overall can’t afford to buy up all the goods and services being produced. This in turn creates.....
4) Cut throat competition...
Businesses try to cut prices and costs to grab a share of this limited purchasing power in the economy, as illustrated by:
(i) Wages being held down as much as possible.
(ii) Shedding of jobs.
(These both reduce people’s spending power even more.)
(iii) Retailers importing cheap products from abroad where wages are much lower.
(iv) Production of cheaper goods that don’t last as long.
(v) Protection of the environment a low priority.
(vi) Mergers and takeovers - corporations get bigger and bigger, driven to search out new markets.
(vii) Big companies shifting production to poorer countries which have cheap non-unionised labour and the least stringent safety and environmental laws or....
(viii) Demanding large government subsidies and tax free incentives as the price for setting up new production or not relocating abroad.
5) Ever increasing indebtedness...
When a bank creates money by making a loan, it does not create the money needed to pay the interest on that loan.
The bank lent Sid £5000, but it demands £5500 back. Sid has to go out into the business world and compete and sell to get that extra £500 from his customers. It can only come from money already circulating in the economy - made up of loans other people have taken out – so soon someone will be left short of money and have to borrow more.
Thus the only way for interest payments to be kept up is for more loans to be taken out.
Although a few individuals and businesses may pay off their debts or get by without additional borrowing, OVERALL people and industry must keep borrowing MORE AND MORE to provide the money in the economy needed to keep up interest payments on the overall volume of debt.
The present level of debt at £680 billion means we are borrowing about £60 billion of new "money" into existence each year to pay the interest on it.
But people and industry can’t go on borrowing indefinitely - they will no longer be able to afford to, and will gradually stop borrowing more money into existence. When this happens, the economy will go into decline. The system thus contains the seeds of its own destruction.
When loan repayments and interest payments are made to banks, this is money taken out of circulation. If it went on indefinitely, in an economy where the money supply is largely made up of loans etc. created by banks, there would eventually be almost no "money" left in circulation and with it no economy.
Under the present system, if the economy is to be kept going, money must be constantly lent out again. It would be possible simply re-circulate the existing money supply without creating new money were it not for the fact that extra money is needed to cover interest payments and also to enable the economy to grow.
6) Inflation....
is guaranteed because producers constantly have to borrow more, and must add the cost of that increased borrowing to the price of the goods produced.
Why is it that when the moneylenders hike their prices (i.e. put up interest rates) this is supposed to reduce inflation?
It doesn’t....
It’s just that there is a delay in industry putting up prices.
Initially industry is forced to hold or even reduce its prices with profits down, or even sustaining losses in a desperate bid to sell its products in an economy where money available for spending is reduced because of higher interest payments being made to the banks.
Inflation may be held in check or even reduced temporarily, but eventually industry must put its prices up in order to recover these higher costs.
This most readily happens when interest rates come down, more people borrow, and money supply and consumer spending increases. Inflation then races ahead.
The fact that levels of borrowing/money creation have to keep on rising as already explained, adding to the overall burden of interest payments, guarantees that inflation will be present as long as we have an economy based on an increasing burden of debt.
EFFECTS ON INTERNATIONAL TRADE
Surplus goods in the national economy have to be disposed of somehow. The obvious way to do this is to try to export them!
The absurdity is that every nation is trying to do this, because of the same fundamental problem at home.
This creates frenzied competition in world markets and masses of near identical goods madly criss-crossing the globe in search of an outlet.
Instead of international trade being based on reciprocal mutually beneficial arrangements where nations supply each others’ genuine needs and wants, the whole thing becomes a cut-throat competition to grab market share in order to stay solvent in a debt based economy.
Big corporations demand unrestricted access to every nation’s market – so called "free" trade.
The European Union "single market", the North American Free Trade Agreement and the World Trade Organisation are the best examples of the drive to open up all national markets.
Exporting is good for a nation’s economy...
because when exported goods are paid for, this brings money into the exporting nation’s economy free of debt.
The money to pay for them was borrowed from banks in the importing nation.
That money is lost to the importing nation’s economy, but the debt that created that money still has to be repaid by the importer out of the remaining money in the importing nation’s economy.
If a nation can become a big net exporter, for a time it’s economy will boom with all the interest free money coming in - a trade surplus will exist.
Importing is not so good for a nation’s economy...
If some nations are building up trade surpluses in this way, others must be net importers and building up trade deficits.
Ultimately, those with big deficits can no longer afford to import, since so much money is sucked out of their economies leaving a proportionally increasing burden of debt behind.
THIRD WORLD DEBT AND THE INTERNATIONAL MONETARY FUND (IMF)
The IMF was set up to provide an international reserve of money supposedly to help nations with big deficits.
In practice it makes matters worse.
A nation with a big deficit has to seek a bail out from the IMF.
BUT this comes in the form of a loan, repayable with interest.
Like loans from a commercial bank, IMF loans are money created out of nothing, based on a cash reserve pool, which is provided by western nations who go into debt to provide it (see National Debt).
The nation with the deficit goes even more heavily into debt.
It will however be able to carry on trading and importing goods from the wealthier nations.
As a result, much of this borrowed IMF loan money flows into the economies of wealthier western nations.
However, the repayment obligation including the interest payments remains with the debtor nation.
This is the true horror of third world debt - the poorest nations borrow money to bolster the money supply of the richer nations.
In order to secure income to pay the interest, and redress the trade balance, these poorest nations must export whatever they can produce. Thus they exploit every possible resource - stripping forests for timber, mining, giving over their best agricultural land to providing luxury foodstuffs for the west, rather than providing for local needs.
Today, for nations in Africa, Central and South America and elsewhere, the revenue from their exports does not even meet the interest payments on these IMF loans (and other loans from western banks).
The sums paid in interest over the years far exceed the amounts of the original loans themselves.
The result is a desperate shortage of money in their economies - resulting in cutbacks in basic health and education programmes etc.
Grinding poverty exists in nations with great wealth in terms of natural resources.
Structural Adjustment Programmes - these are now attached to IMF loans and include conditions that recipient countries will reduce or remove tariff barriers and "open up their markets to foreign competition" - in other words take surplus goods off another country that can’t be sold at home.
NATIONAL DEBT
British national debt now stands at £400 billion - the annual interest on that debt is around £25 -30 billion. The government can only pay it by taxing the population as a whole, so we pay! National debt is up from £26 billion in 1960 and £90 billion in 1980.
Successive governments have borrowed this money into existence over the years.
Instead of creating it themselves and spending it into the economy on public services and projects boosting the economy and providing jobs, they get banks to create it for them and then borrow it at interest.
It all started in 1694 when King William needed money to fight a war against France.
He borrowed £1.2 million from a group of London bankers and goldsmiths.
In return for the loan, they were incorporated by royal charter as the Bank of England which became the government’s banker.
Interest at 8% was payable on the loan and immediately taxes were imposed on a whole range of goods to pay the interest.
This marked the birth of national debt.
Ever since then the world over, governments have borrowed money from private banking interests and taxed the population as a whole to pay the interest.
How the Government Borrows Money
When governments borrow money, in return they issue to the lender, exchequer or treasury bonds - otherwise known as government stocks or securities.
These are basically IOU’s - promises by government to repay the loan by a particular date, and to pay interest in the meantime.
They are taken up chiefly by banks, but also by individuals with money to spare including very wealthy ones in the banking fraternity and, in more recent years, pension and other investment funds.
When government securities are taken up by banks, this is money creation at the stroke of a pen by the banks out of nothing.
Banks are creating money as loans out of nothing by lending it into existence to the government in very much the same way as they do to individuals and companies.
The government now has new money in the form of loans to spend on public services etc.
If this money was not borrowed into existence in this way, there would be that much less economic activity as a result.
Under this system NATIONAL DEBT IS CREDIT ISSUED TO THE GOVERNMENT AND AS SUCH HAS BECOME A VITAL PART OF THE TOTAL MONEY SUPPLY OF ANY MODERN NATION.
The government constantly tells us that there isn’t enough money for this that and the other, because it knows that the cost of borrowing any money it needs has to be passed on to the taxpayer.
Instead, it sells off state assets and now gets the private sector to fund public services instead.
War…...
enormous increases in national debt...
enormous profits for the banks...
Massive government borrowing and money creation by banks is required to fund a war effort.
The same international bankers have covertly funded both sides in both world wars and many other conflicts before and since.
Having profited from war leaving nations with massive debts and more beholden than ever to them, the banks then fund reconstruction.
Bankers have even helped bring wars about. The calling in of loans to the German Weimar republic largely created the conditions for the rise of Hitler.
The pattern was well established by the mid 19th. century - by then international banker and speculator Nathan Rothschild could boast a personal fortune of £50 million.
The Constant Increase in National Debt
In the same way that under the present system, industry and individuals must keep borrowing more and more to enable interest payments to be kept up on their existing loans, so government must constantly borrow more and more to keep up interest payments on its existing loans.
Furthermore, when a particular government stock is due for repayment, the government simply borrows more by issuing new government stocks.
Phasing out of National Debt
"If the government can issue a dollar bond, it can just as easily issue a dollar bill." Thomas Edison.
Government could stop borrowing money at interest, and start creating it itself by spending it into the economy on public projects and services, at the same time creating jobs and stimulating the economy.
It already does this to a very limited extent – the amount it receives from the banks when it sells cash to them is added to the public purse and is available for spending on public services and projects.
Please watch this informative video to gain further insight into the modern banking system: Money as Debt http://video.google.com.au/videoplay?docid=5352106773770802849&hl=en
In addition, for history of the banking system and analyses of our modern economy please watch The Money Masters Part 1 http://video.google.com/videoplay?docid=-1583154561904832383 and The Money Masters Part 2 http://video.google.com/videoplay?docid=-7336845760512239683
I would also recommend that you read the book "The Final Crash" by Hugo Bouleau http://www.finalcrash.com/. In addition, please read "The Web of Debt" By Ellen Hodgson Brown" (http://www.webofdebt.com/)
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