Disastrous Interest Based Secular Financial System
Types of Modern Money
Central Bank Created Cash
Money Created Through Central Reserves
Commercial Electric Money
Interest Based Financial System The Importance of Gold Standard Five Essential Securities of Islamic Financial System
Profit and loss sharing (Mudarabah)
Joint venture (Musharakah)
Cost plus (Murabahah)
Types of Modern Money Modern financial system is based on interest on loans. The growth of banks basically depends on the return of interest with principal. More number of loans mean more money created in this current monetary system and lesser number of loans mean lesser amount of money created. To understand this, we need to understand how money is created in modern banking system. There are three customary ways money is created in the economy. Note that we said customary because of this method of money creation is not recognized in university textbooks. This shows banking industry has power to change monetary policies dynamically at whim.
Central Bank Created Cash This is the cash that we use in our daily lives consisting of notes with a digit or more on it. In US the federal reserve creates this while in UK the Bank of England. This accounts to 3% of total money supply in UK. It may be due to lack of convenience and lack of ease of use that such small amount exists in UK economy. Cash is created when needed by commercial banks or when central banks want to affect the economy. An example will be creating cash to increase loans with initial low interest and raising interest when business activities thrive. This had caused the financial crises of 2008 when banks were giving risky loans with low interest but when the rate increased with low money circulation the businesses failed to pay back and in failing to do so the banks took over the assets of people and businesses while the government, instead of backing the people bailed out the banks.
Money Created Through Central Reserves Electronic money created by central banks to use among the banks in the country. This is the reserve part of which is given to the commercial banks. This type is not used in the money supply of economy. The reserve ratio is an outdated concept. Usage of reserve ratio means central bank has ultimate control over the total amount of money in the economy. They can control the amount of money by changing either the reserve ratio or the amount of ‘base money’ – cash – at the bottom of the financial pyramid. Hence under this ﬁat money standard and liberalized ﬁnancial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements.
Commercial Electric Money This consists of 97% of the money in economy created by commercial banks. Money is created in customer deposit account through computer digit without any cash backing. When you deposit money to bank it becomes bank’s money. You do not keep it so that bank protects it for you rather you give the ownership to bank and bank creates computer digits in your account as liability to bank. Hence in the real world, banks extend loans, creating deposits in the process, and look for the reserves later. This means that the concept of reserve ratio is a myth and that money is not created through depositors’ cash being lent by banks repeatedly. In other words, the multiplier model does not work.
Interest Based Financial System As we have stated that more loans are given to create more money by charging interest rates, what this has done is made the overall economic situation more miserable, because by creating money in this way, banks have increased the amount of money in the economy by an average of 11.5% in UK a year over the last 40 years, which has pushed up the prices of houses and priced out an entire generation. The common people has been hit hard by this interest-bearing money-making banking scheme. The interest-bearing banking system is also responsible for increasing national debt. The government is at the mercy of the wealthy capitalists and rich bankers. It is the case, for example with both US and UK that they are under deficit, in other words their governments spend more than they earn from taxes and creation of money. Due to this deficit they are bound to take loans from insurance companies and pension funds instead of banks for the UK and bonds, stocks and federal reserve for the US, many of which are foreign investors from China and Gulf. Most of these investors are wealthy people who have large portion of share in stocks, funds, bonds and banks. It is basically the government taking loan from the rich.
The reason that growing national debt isn't an issue because you don't have to pay the lenders full amount outright neither they are demanding full amount. To deal with the result of this interest-bearing scheme government may take some drastic measures such as raising taxes significantly, aggressively promoting trade to foreign nations, spending cuts on welfare services for public, bailout or outright default. Many of the western imperialist nations have pursued one or more of these methods aggressively among which are wars, coup and sanctions to protect their financial interests. These aggressions may not have been done to only reduce nominal debt but also to increase the earning ability of the imperialist economy (GDP) in long term as temporarily wars will increase debt. An improved economy means more available interest-bearing debts to government which also increases the debts as well. It is like a cycle and devastating cycle it is which can lead to global warfare as debt ridden nations vie each other for control. Long terms effects of national debt can be crippling as happened with Greece and other Eurozone countries.
The Importance of Gold Standard Gold standard is workable against both inflation and deflation. It is because you cannot just mine unlimited amount of gold and that the speed of mining also plays a factor. People can own gold in exchange for paper currency and if they wish they can own the nations’ gold in exchange for their paper money forcing banks out of business. For example, during the 1920s many countries tried to protect their gold stock by raising interest rates to entice investors to keep their deposits intact rather than convert them into gold. However, this high interest rates created problem for global economy. Eventually gold standard was suspended due to this very fact that the powerful institutions and people are vulnerable and fear losing their power and monopoly. This had happened post WW1.
Until up to WW1 the western nations enjoyed and promoted gold standard due to the loot they have been doing from their colonies for centuries. Spain's plunder of treasures from the New World (invasion of Americas) raised Europe's supply of gold by five times in the 16th century. Subsequent gold rushes (loot and plunder) in the Americas, Australia and South Africa took place in the 19th century. However, WW1 changed all that as the western nations were gripped in a savage war almost bankrupting them of their gold reserves and devastating global economy as political alliances changed, international indebtedness increased, and government finances deteriorated. Only USA came victorious out of this due to its isolationist policy. While Europe fought in WW1 America developed economically.
USA sold enough gold during 1930s for dollars due to increased dollar to gold price. It had caused enormous amount of dollar circulation. Due to this development and through the Bretton Wood System all national currencies were valued in relation to the U.S. dollar, which became the dominant reserve currency. At the end of WWII, the U.S. had 75% of the world's monetary gold and the dollar was the only currency still backed directly by gold. However, as the world rebuilt itself after WWII, the U.S. saw its gold reserves steadily drop as money flowed to war-torn nations, the Vietnam war and its own high demand for imports. With a surplus turning to a deficit in 1959 and growing fears that foreign nations would start redeeming their dollar-denominated assets for gold US finally ditched the gold standard when in August of 1971, Britain requested to be paid in gold, forcing Nixon's hand and officially closing the gold window. By 1976, it was official; the dollar would no longer be defined by gold, thus marking the end of any semblance of a gold standard.
So, we see that gold standard was used and retained by imperialist nations or through rivalry among them if it suited their monopoly and control and if they had surplus gold. The discussion sheds critical information on why Russia and China are trying to amass gold reserve and that is to be free from the dollar hegemony. Gaddafi was also murdered due to his struggle to create a gold standard for Africa and South Africa has the biggest gold mine reserve. Even though the western imperialist nations have the most gold reserve we saw how warmonger they are and how easily they can go in deficit of gold. Also, the gold standard prevents unlimited money creation as is done by today’s banks. Gold standard thus prevents exploitative behavior from bankers and impedes the current interest rate system of banks. Gold standard makes nations independent in its financial activities. Simply put, sanctions have no effect on gold standard.
Five Essential Securities of Islamic Financial System First, historical, jurisprudential and textual evidence of Islam show gold and silver as the de facto standard of finance. Modern monetary system is based on deception when a bank creates money out of nothing the bank is effectively lying to the client about actual loan of money. As we have stated that this digit number in your bank account is not backed by cash and definitely not gold. Second, it is based on intensive interest-bearing activities which contradicts Islam’s interest on loan. An Islamic financial system will tackle inflation, prevent increasing burden of debt, prevent whimsical unlimited wars and effectively result in a balanced wealth class where the gap between rich and poor is not increasing and neither wealth is only circulating among the rich. There are some mechanisms of wealth creation in Islam and Islamic banking can play vital role. Islamic taxation system further minimizes the wealth gap between the class. Wealth creation in Islam can be summed up as follows:
Profit and loss sharing (Mudarabah) A contract between two parties; one provides the capital and the other provides the labor to form a partnership to share the profits by certain agreed proportions. This is the father of modern principal-agent stock system.
Joint venture (Musharakah) A financial contract between two or many parties to establish a commercial enterprise based on capital and labor. The profit and loss are shared at an agreed proportion according to the amount of contribution.
Cost plus (Murabahah) Refers to a sale of a good or property with an agreed profit against a deferred or a lump sum payment. There are two contracts in Murabahah: the first contract is between the client and the bank, whereas the second contract is between the bank and supplier. The client (purchaser) orders a certain commodity through the bank, the bank then buys the commodity from the supplier and sells it to the client with specified profit whereby the client can make a lump sum or a deferred payment to the bank. This is how Islamic mortgage works.
Leasing (Ijarah) In which two parties are involved therein: the lessee and leaser. The leaser (bank) is the real owner of the asset or property and it is rented out to the lessee until full payment is received. The lessee has the option to keep the asset at contract maturity or give it back to the bank. If all payments are received, the lessee can keep the asset but at a higher price than the usual asset price. This is also another Islamic mortgage framework.
Salam Is another contract where full payment for a good is paid in advance but the delivery of the good is made at an agreed future date. This is suitable at the industrial level.
Modern tools such as statistical techniques can enhance Islamic financial activities with further development. In interest-bearing finance unlike Islamic finance there are two aspects of money: time value and risk. The time value of money is the concept that money available at the present time is worth more than the identical sum in the future. However risk is a factor also in Islamic finance.
Conclusion In current financial system money is created out of nothing which is interlinked with interest scheme. Interest based financial system is burdensome on individual, society and nations. It is responsible for wealth gap, inflation, piling national debt and global wars. Islamic financial system offers a simple solution. It offers wealth creation through collective effort and not like the one where one becomes powerful at the expense of other.