Recession: When casino economy meets real economy
Falling economic activity in one or more industries or sectors is not uncommon even during more general periods of sustained economic growth. As an example manufacturing employment in the UK fell from 4.5 million to 3.2 million (1) between 1997 and 2007 – a 10 year period over which UK-wide economic growth rose by a robust 3% per annum on average in real terms (2).
It is however rare for a sub sector to cause the whole economy to go into recession. However, this is exactly what’s happened during the current financial crisis and subsequent recession. The collapse of high risk ‘sub-prime’ lending in the USA exposed the fragility and global interdependence of financial markets.The failure of this specific area of finance initiated a chain reaction that resulted in, until recently, highly profitable century-old global financial institutions filing for bankruptcy, sometimes, overnight. In the UK, Northern Rock, a bank from the North East of England, went bankrupt, after which other banks were kept afloat only as a result of Government bail-outs and guarantees.With domestic and international financial sectors in turmoil, the many heavily indebted businesses found it difficult to raise funds while debt-ridden individuals could no longer afford to borrow to finance unsustainable consumption levels.The subsequent fall in demand for consumer goods led to production cut-backs and rising unemployment. In the fourth quarter of 2008 the UK economy was officially in recession – defined as two quarters of negative economic growth. This is how the casino financial economy initiated and caused a devastating recession in the real economy.
DEBT FUELLED GROWTH
The finance sector (comprising mainly of banking, finance and insurance industries) has grown in significance in the last decade.While the manufacturing sector was in terminal decline, jobs in finance grew from 5 million to 6.6 million between 1997 and 2007 (1), accounting for 1 in 5 of all jobs in the UK. It is no coincidence that debt levels over this period also surged.
Britain’s total debt exploded during the economic boom.The total debt owed by government, businesses and individuals – commonly known as gross external debt – rose from 1.7 trillion in 1997 to £5.7 trillion in 2007, an increase of 238% (3). It was this astounding growth in debt from all sections of society that propelled continuous economic growth over the last decade.At the end of 2007, Britain’s total external debt stood at over 400% of GDP (the total value of goods and services produced by the UK) of approximately £1.5 trillion per annum. That’s equivalent to a debt of £94,000 for every man, woman and child in the UK. Indeed, this was in 2007 before the onset of the financial crisis and the bank bail-outs which have been largely funded by government borrowing. Given the estimated £1.5 trillion in new government debt to prop up banks during 2008 (4) UK debt per capita is estimated to comfortably exceed £100,000.
Household spending, which accounts for two thirds of all expenditure in the UK economy, was financed by cheap and easy credit following the deregulation of banking during the 1980s.When people ran out of income and savings to buy Banks encouraged the spending binge by offering ever greater credit to ever more riskier debtors. Banks made huge profits, with bankers earning colossal bonuses, and justified such lending arguing their new business models had diversified debtor risk by packaging riskier debt in the form of collateralised debt obligations (or CDO’s) and other such instruments. Governments encouraged these ‘gambling’ practices, no doubt allured by the prospects of greater tax revenues from the extraordinary profit-making banking sector and the not coincidental simultaneous property and asset booms, by further loosening banking regulation 5) to accommodate new banking ‘business models’
BANKING – THE FALSE ECONOMY
Bust followed boom in common with the 1970s, 1980s and 1990s as asset bubbles (over priced property and share values) burst. However unlike the recent recessions, but not for the first time, the recession was associated with a collapse in the financial sector.
So-called financial assets like CDO’s, mortgaged debt obligation, and credit default swaps could not find willing buyers and proved to be effectively worthless, resulting in huge shortfalls in bank balance sheets.The previously acclaimed highly efficient banking business model proved unworkable as credit become scarce (liquidity crisis) when banks stopped lending to one another because each was protecting its own assets and no one trusted the value of the collateral they previously lauded. Banks worth multi-billions of dollars in market capitalisation filed for bankruptcy overnight as share values fell when investors realised the false and hollow nature of banking assets.This had a negative feedback effect as banking stocks and shares were the very ‘assets’ that the financial sector relied upon to prop up company balance sheets and so market capitalisation was further undermined.Together these events precipitated a systemic collapse of the whole interdependent financial system. More banks teetered on the edge of collapse. Free market economists, capitalist thinkers and political commentators paradoxically yet vociferously argued ‘banks were too big to fail’ implying the ramifications of banking failures were too monstrous to imagine.The government obliged their friends and close allies in banking and committed trillions of tax payer money to fully bailing-out the banking sector using loans, government guarantees and the buying up of so-called toxic (worthless) banking assets despite undermining competitiveness in the sector and encouraging banks to behave even more recklessly.
The financial sector had epitomised capitalism in terms of values, culture, policies and outlook more than any other sector in the economy.The systemic and fatal collapse of finance was thus a clear and damning indictment of capitalism itself.
FINANCE AND THE REAL ECONOMY
With the finance sector barely able to stand on its own feet how was it to continue to fuel the debt ridden economy. Despite central banks individually and collectively lowering interest rates (the cost of capital or borrowing) and pumping trillions of public money into the financial market to kick start lending, banks simply hoarded the funds to cover for their worthless collateralised assets which severely depleted their balance sheets. Businesses and households that had relied on borrowing to fund their spending, found credit more difficult to access. Since credit was fuelling economic growth this directly impacted on the real economy as spending on goods and services dropped, prices fell, and with it company profitability, thereby forcing businesses to cut back production and staff.
The biggest falls in economic activity have been in consumer goods: cars and ‘white goods’ such as washing machines and fridges.These are primarily financed by credit and in recent years loan agreements have been designed to be more manageable and more readily available to entice an ever greater number of households to continue to buy what they don’t need so that companies can maintain high and more profitable production growth schedules. Though this model of capitalist economic growth is clearly unsustainable, it has devastating consequences, as it causes a downward negative economic spiral.When production falls unemployment rises which in turn causes lower spending on goods and services, lower production and more unemployment.The economic decline quickly becomes more widespread and more prevailing, generating its own negative momentum. At the start of 2009 unemployment in the UK officially rose to 2 million and is forecast to rise to 3 million before the end of the year.The UK economy is presently forecast to contract by 3% in 2009 and remain in decline in 2010. These are probably optimistic forecasts given that official forecasts have been downgraded several times already since the start of the crisis.
HUMAN CONSEQUENCES OF THE RECESSIONARY CRISIS
Capitalists view recessions in cold and calculated terms quantifying only the loss (destruction) of wealth and property – the number of jobs lost and business closures. However, recessions have huge social as well as economic consequences. Presently, unemployment is rising throughout the UK, across all sectors and industries.A loss of livelihood has huge ramifications for individuals, families, communities and society at large. Some communities will be blighted for decades as in previous recessions – for example coal mining communities remain largely ruined from the recession in the 1980s .Tens of thousands of families unable to pay their debts have already lost their homes and possessions. Some have even committed suicide unable to bear the consequences of their debts and a loss of livelihood. Job insecurity exists even among those who are still employed who fear that they may be next to be made redundant. During recessions government tax receipts drop while expenditure rises due to benefit payments to the unemployed and poor. Central and local government claw back funding from elsewhere by cutting back expenditure on schools and hospitals, assistance for the elderly and help for the weak and vulnerable – for example cut backs in local meals-on-wheels for the elderly and less funding for local libraries. Economically strained times lead to increasing demands on public services like police and hospitals from accelerating crime and rising stress levels and a general physical and mental deterioration in health. Family relationships tend to strain during recessionary times with potentially painful and lasting impacts on children. Thus recessions spread insecurity and instability contributing to a plethora of social ills.
ISLAM’S ECONOMIC APPROACH
In Islam the success of the economy is not judged by the size of GDP. High GDP in the UK, equating to income per head of £24,000 per annum, among the highest in the world, conceals the heavily debt ridden economy. Importantly, GDP or income per head says little about the distribution of wealth.This is exemplified by the fact that according to government data nearly 3 million children in the UK live in relative poverty (6) in spite of high GDP levels and growth rates.
In contrast to Capitalism, the success of the economic model in Islam is judged by its ability to secure the satisfaction of the basic needs of every citizen.
Bukhari narrated from Ibn Umar:The Prophet (sallallahu alaihi wasallam) said: “The Imam is in charge (ra’i) and he is responsible for his citizens.”
The Prophet (saw) also said: “Do you have, son of Adam, of your property except that which you ate and consumed, that which you wore and exhausted, and that which you donated and kept (for yourself)?”
Islam’s focus is on the real economy which is the wealth creating aspect of any economy. Finance in Islam is not an end in itself as there is no interest (Riba). “That is because they say: “Trading is only like Riba,” whereas Allah has permitted trading and forbidden Riba” [Surah al-Baqarah]
While finance plays an important role in business and economics in Islam it is exclusively (6) in the context of partnerships where the financial contributing partner(s) are involved with the ‘body’ (those running the day to day business) partners aiming to generate a profit from their business activities or sharing the loss if the business fails.
In contrast to capitalism, finance in Islam is intrinsically tied to the real economy and does not become an industry in itself.This eliminates the potential for generating self-destructive financial instruments that have been so pivotal in the collapse of the capitalist financial sector.
The prohibition of interest works in tandem with the ruling that the monetary unit in Islam is effectively the gold and silver standard and this prohibits credit creation.Thus the monetary base of the economy in Islam changes only with growth in the real economy through the creation of wealth or increase in productivity.This minimises inflationary pressures; provides economic stability and ensures sustainable growth without the destructive boom and bust cycle.
Capitalism’s flaws and systemic failures have been clearly exposed by the current crisis.The capitalist economic model, therefore, does not deserve to be emulated by the Muslim world. By contrast, the Islamic ideology and rulings provide real practical solutions to the economic problems of the day.The Islamic economic system with its focus on the real (not financial) economy has withstood the test of time, and with the money supply tied to gold and silver provides a model of sustainable and responsible growth, with distribution of the nations wealth at its core.
1. Workforce jobs by industry : United Kingdom: Thousands: Seasonally adjusted http://www.statistics.gov.uk/STATBASE/tsdataset.asp?vlnk=495&More=N&All=Y
2. GVA at Basic Prices, Seasonally adjusted http://www.statistics.gov.uk/statbase/TSDdownload2.asp
3. Pink Book http://www.statistics.gov.uk/StatBase/TSDSelection1.asp
4. Business.scotsman.com http://business.scotsman.com/lloydstsb/Banks–add–1.5000273.jp
5. Basel II Banking Accords
7. Muslims are allowed to borrow and lend money without interest only