Sharia Economics: A solution to current crisis?

A growing trend of dissatisfaction with conventional economics has raised interests in finding an alternative paradigm leading to the revival of Islamic economics over the last few decades. On 8 August 2012, Dr Izzuddin Edi Siswanto explained how Islamic economics may provide solutions to existing problems in the financial markets as well as its contribution and potentials to address development challenges.

The conventional economics and financial systems have been put to a test following recent global financial crises. George Soros, a global financier and philanthropist, viewed:

“There is a super bubble that has been going on for 25 years or so that started in 1980 when Margaret Thatcher became Prime Minister and Ronald Reagan became President. That is when the belief that markets are best left to their own devices became the dominant belief. Based on that we had a new phase of globalisation and liberalisation of financial markets. The idea is false. Markets do not correct towards equilibrium.” “The whole construct, this really powerful financial structure, has been built on false grounds. For the first time this entire system has been engaged in this [economic] crisis.”

Prof Zubair Hassan, a prominent Sharia economics scholar, argued that current world situation has been a solid proof of the failure of capitalist economic systems to improve equality and welfare. The capitalist system has created massive capital accumulation in the last five decades since 1950, far bigger than the capital accumulated from the period of the prophet Adam to 1950.

 

Dr Siswanto argued that the capitalist system has caused excessive leverage and speculation leading to what is called as the inverted pyramid of wealth and debt positioning welfare at the bottom of the inverted pyramid and debt gaining the biggest portion at the top of the inverted pyramid. He further argued that debt  accumulates faster than wealth and minor shocks can make the system crash. The financial systems become fragile.  Crashes are needed to “clean up” the system. Then, debts start to accumulate again faster than wealth recurring crashes.

From an Islamic economics’ point of view, there are at least two sources of danger: Riba (usury and interest on loans) and Gharar (gambling and wagering). The danger of Riba are due to several reasons: it separates debt creation from wealth creation; debt grows faster than wealth; debt maturities shorter than assets; and debt services become unbearable. Riba also shrinks the real sector causing lower production and therefore increasing inflation which can lead to lower economic growth. The danger of Gharar or gambling are due to its high transaction costs. Gambling is also a zero-sum game where one’s profit causes the other party’s loss. Given this criterion, Islamic economics excludes derivatives as they are essentially zero-sum games.

In contrast, a Sharia-based system aims to improve wealth and income distribution as well as the development of real sectors. In Islamic economics, debt creation is integrated with wealth creation. Moreover, excessive risk and zero-sum games are excluded. Also, finance is integrated with real transactions. Since real sectors are less risky than financial markets, Islamic finance is less risky than conventional finance.

To meet the above objectives, Sharia financial products are developed based on three main strategies: (i) modification of conventional products; (ii) an innovative Sharia-based products; and (iii) products developed to respond demand from consumers. Those Sharia products must possess acceptable risk (ex ante) as indicated by high likelihood of success and inseparable from real activities. They must also have a clear payoff structure (ex post).

Islamic economics also acknowledges the importance of social safety nets. Non-profit safety-net is integrated into economic activities. Zakat or almsgiving as well as interest-free lending are common tools to help the poor access capital.

The development of Islamic economics must face a number of challenges. Pessimists often perceive that the difference between Islamic economics and conventional economics is not clear. Some view that it is simply a matter of ‘branding’. Other raise concerns about the competitiveness of Islamic banking because at the end of the day consumers always want to obtain profits. Sharia financial institutions must also keep looking for innovative products. This is often difficult considering the lack of human capital. Sharia supervisory boards are often filled with those whose expertise are only in Sharia laws but have limited knowledge of economics. Having said that, looking at positive trends since 2000 in the development of Islamic financial sectors in Indonesia as well as Indonesia’s growing middle income groups, Sharia financial products should have profitable markets in the country.

This article is written by Risti Permani.

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Filed under Economic development, Financial market, Income inequality, Indonesia, Islam, PPIA academic discussion

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