Saturday, 24 November 2012

Stimulus or Austerity, is there an alternative?

Stimulus vs. Austerity.


Section 1) The Origins of the current Problem.

Section 2) Current solutions.

Section 3) Theory and practice for the Current Solutions.

Section 4) The Contest for global economic leadership.

Section 5) Market Failure & the Islamic Alternative.

Section 6) Conclusion.

Section 1: The Origins of the current Problem

The US housing market which started to collapse from around 2007, started a chain of events which included a sovereign debt crisis affecting many economies of the West.  In reality it brought out systemic flaws in the entire system.

In essence governments, corporations and individual consumers had been living beyond their means by engaging in excessive and unsustainable borrowing. This was possible due to central banks setting very low borrowing rates, an ability they have due to their legal right to increase the money supply by creating money out of ‘thin air’.  This encouraged reckless borrowing for unsustainable and damaging purposes such as speculation in the housing sector.

The results of the cheap credit include such phenomena as price bubbles where the price of certain items inflate way above the general prices of things. These are things that speculators target for making a quick gain. An extreme example was the Dutch tulip bubble of the 1630’s where the price of a single bulb of some varieties of tulip rose to 3 times the annual salary of a skilled craftsman. Modern equivalents are the bubble of the 1990s, the housing bubble that proceeded it and the food bubble of 2008 and the current Oil price bubble were prices are at least 30% driven by speculative forces.

Government had also spent too much when times were good and were not in a position to sustain  further borrowing when credit markets started to dry up as the interest rates started rising due to the shortage of credit. The credit market dried up as financial institutions didn’t trust each other and short-term inter-bank lending and borrowing which is a key factor in the lending market came to a crawl.

For households, the fact that people couldn’t further the practice of borrowing and spending, market activity started to decline due to falling levels of demand. 

For firms, as demand was affected and credit became more expensive and difficult to obtain, then potential for growth and investment became none existent. This dampened the prospects of businesses to take on credit and expand investments, assuming they even wanted to in such an uncertain climate.

The net result of these developments was that economic activity started to decline and many felt that the current path could not be expected to self correct and some type of government intervention was deemed necessary by many leading economist. Others disagreed and believe that the countries needed to tighten their finances at all costs and for government to effectively ‘get out of the way’ so that the market can self correct itself out of the situation. So there are 2 dominant and polarized views within the capitalist mainstream discourse.

Note: even within the free market and small government camp there is disagreement over the degree of government ie regulation that is good. Consensus seems to be that financial sector needs to be regulated{see Vickers report(UK), Dodd Frank(US) }

The remainder of this article will analyze these contrary positions and offer an Islamic viewpoint towards them and the underlying cause of why we are where we are.

Section 2) Current Solutions?

The current solutions to address these issues are known as by the terms stimulus and austerity. The US has adopted the stimulus route whereas the weaker Europe countries and Britain have adopted the austerity route.

A simplified explanation of these approaches follows.

Stimulus entails increasing government spending using money that is borrowed primarily from abroad in the case of the US from countries such as China, or simply created by central banks literally by entering digits into a computer.

The idea is that when markets are contracting, consumers are not spending, companies are not investing; then the government needs to make up for the missing demand. This entails creating paying for new jobs and engaging in various projects to jump start a recovery in the economy. The belief is that this recovery will self sustaining after the government withdraws its intervention. The government would then recoup its prior spending through higher taxes when things pick up when recovered firms and households can pay more in taxes.

This government spending is referred to as fiscal stimulus. Fiscal describes a government’s taxation and spending policy. The argument is that for every pound the government spends, the income the recipient will receive will be re-spent and the ultimate result will be more consequential spending in the overall economy than the initial pound spent.

This effect is known as the fiscal multiplier effect and is measured as a ratio to the initial spending. So a multiplier of 1.5 means that for every pound the government spent on projects, then it will increase overall demand in the economy to the tune of 1.5 pounds of additional income in the economy once the money has reverberated around the economy and caused a chain reaction of spending. In the US the American Recovery and Reinvestment Act of 2009 was the implementation of this strategy. In the UK, this is what Ed Milliband is referring to when he calls for Plan B.

Austerity on the other hand entails government attempt to reduce the government deficit and create an environment when businesses can help themselves out of the situation.

The argument of this camp is that govt spending programs aka fiscal stimulus programs are ineffective and don’t lead to a self sustaining recovery or kick start and just delays the recovery. Therefore advocates of austerity argue that countries balances need to be corrected and the government needs to get out of the way of the private sector so it can grow its way out of the debt and recession it is in. This correction is in the form of reducing spending, shrinking the size of the government by controversial actions such as annexing public sector jobs as we have seen in this country, and removing cumbersome regulations which slow down companies in their pursuit of investment and expansion, such as the reform of planning regulation in the UK.

Section 3) Theory and practice for Stimulus and Austerity

The austerity camp argue that people react negatively to stimulus spending as they realize that government spending now will need to be paid back through higher future taxes and start saving for such a situation, a phenomena called Ricardian Equivalence and proposed by George Osborne.

They also argue that when the government borrows heavily and spends, the effect of this borrowing is higher interest rates that occur as a result of the government borrowing as it reduces the supply of available credit which pushes up the cost of borrowing. Private sector investment thus shrinks as loans become more expensive and the private sector is denied the opportunities that would otherwise avail it. This phenomena is called ‘crowding out’ of the private sector who its argued suffer as a result such higher borrowing costs.

The stimulus camp (tied strongly to the Keynsian school of thought)on the other hand believe that markets rise and fall on waves of optimism and pessimism and during periods of pessimism people feel that the future is not stable and start to save and this creates a death spiral as the more people save, they less they consume and the less they consume the less demand there is and businesses start to fail as nobody is buying and layoffs and unemployment increase which positively reinforces the downward spiral even further.

They argue that only government can be relied upon to break this death spiral when all else fails and halt the decline and kick start what becomes a self sustaining recovery. This is through increased spending on projects such as building roads and creating public sector jobs. The rational is that every pound paid to a worker will be spent and the net gain is greater than the original pound creating a multiplier effect that acts as a snowball that the free market then feeds of until a self sustaining recovery results.  The justification in the government funding the initial explosion of spending is through higher future taxes when times are good and the boom is creating greater tax revenues that can pay back the debt created now.

The austerity camp in fact argue that the problems we are in are the direct result of previous government meddling in the economy in the first place and had the government stayed on the fringes were it belongs, the problem would not have existed.

The last time the economy was as bad as it is currently was the Great Depression which lasted for approximately 16 years in the US from the beginning of the 1930s to end of the second world war around 1946. It was also a global economic breakdown affecting the entire industrialized world at the time.

In very broad terms the Great Depression is similar to the current Great Recession as it is known in that there was a collapse in the New York stock market in October 1929 and according to the Keynesians (the stimulus camp) the recovery didn’t result until the government stepped in under the leadership of Franklin D Roosevelt with his massive spending programs known as the New Deal. So according to this version of history the free market failed and should not today be relied upon to self correct and only a modern stimulus ie government spending spree is required.

It is not true that government intervention including spending was the catalyst for ending the Great Depression as Roosevelt predecessor who was Herbert Hoover engaged in many interventionist policies including government spending to no avail. In fact there was evidence that many of his interventions such as minimum wage legislation exacerbated the problem and had the market been allowed to self adjust, then the recession of the 30s would have been as short lived as the less known recession of 1921 which lasted around 2 years which had far less government interference.

In a book called Depression, War and Cold War by Robert Higgs, Higgs offered a better explanation of what ended the Great Depression and it was confidence in the private sector towards the economic climate and the end of what he termed ‘regime uncertainty’ that restarted the economy in the 1940’s. This is quiet significant as advocates of stimulus programs generally point to the stimulus programs of Franklin Roosevelt as the trigger to ending the depression and the only viable solution today by direct inference.

Does this mean that the free market and a small government role is the best solution? It is the aim of the concluding section to demonstrate that the Islamic free market and not the free market under the capitalist model is robust to self heal and in fact far less prone to sink into this abyss in the first place.   

Section 4) The Contest for global economic leadership.

Today there is much debate as stated between the best approach with policy makers in the US adopting a stimulus approach whereas the European and UK are adopting the austerity and market route.

In 2010 at the G20 meeting in Seoul for example there were stark exchanges between the Germans and the Americans as to which is the best route for the future of the global economy.

Merkel along with the majority of the other countries including China and Japan were suggesting the unsustainable growth model of the US with its cheap credit and debt fueled growth from the governments perspective using stimulus funds was obsolete.

Her finance minister described American policy as ‘clueless’ and said the American growth model is stuck in a deep crisis. “The USA lived off credit for too long, inflated its financial sector massively and neglected its industrial base.”  Note here that stimulus entails living of credit hence the link between the statements and the stimulus policies of Obama.

In conclusion, Stimulus just props up government and service industry jobs which die off when the stimulus is withdrawn leaving a large tax liability with nothing to gain.  

The analogy to understand the stimulus narrative is that of the ‘Broken Window Fallacy’. According to this, if a shopkeeper has his window broken by a vandal, then he needs to hire a glazier to fix the damage and the money the glazier earns is re-spent in the economy on say clothes and the retailer who sold the clothes will re-spend the money on restaurants and a chain reaction starts as a result of the initial vandalism who is the hero in this story.

It ignores the fact that the shopkeeper may have been saving to buy a suit and now this purchase will not happen so in effect the spending has been redirected and there is no new spending that has resulted in this chain of events. The government spending is likened to the act of the vandal as if the government like the vandal has kick started spending that would not otherwise have happened. In reality it is special interest groups that benefit from this redistribution as the beneficiaries of these stimulus projects.

It is difficult to answer conclusively as to which camp is right as each camp relies on often complex assumptions beyond the reach of other than experts and hence many counters can be made on both sides. For example the stimulus camp would argue that the vandalism of the window will force the shopkeeper to spend at a time when he would otherwise save and not engage in market activity.  They also argue that the government spending doesn’t raise interest rates under certain circumstances (known as the liquidity trap) so the crowding out phenomena doesn’t occur.  Finally they suggest that the situation would have been much worse had they not engaged in stimulus spending and although job growth may be small or negative, it would have been more negative without stimulus. So its not easy to prove either way hence the reason this debate survives to this day. However in the medium to long term, the evidence demonstrates that there is no positive correlation between govt stimulus and increase in GDP so clearly the increase in GDP is only as long as the government is engaged.  Needless to say the stimulus camp argue that the reason there is no correlation is due to the stimulus not being big enough!

Therefore a new and fresh angle is needed which can sidestep such endless and ongoing technical debate resting on complex assumptions. This alternative angle which will conclude this presentation.

Section 5) Market Failure & the Islamic Alternative

The question to ask is why is there a hole from which to climb out of through either stimulus plans or austerity programs in the first place? Surely if the market was efficient then we would always be relatively immune from these dire circumstances and not in need of these drastic remedies.

So how would an efficient market work?

In any market, there is a balance between supply and demand. If the supply increases then the price declines. Conversely if the supply decreases the price increases. The same applies to increasing and decreasing demand as far as its effect on price. If the market is left alone, then the price will be free to move up or down to ensure all products are priced at the level at which everything is sold i.e. the market clears at this price.

Take an example for the price for labour services were many people are unemployed. If the workers accept lower wages, then more workers would be employed and this would help the economy stay strong.

It is my assertion that only the Islamic model works in this efficient way and is the real preventative solution to the problem highlighted. The question arises of why markets fail in the current man made approach to economic management?

Market Failure under Capitalist version of the Free Market

A set of key Capitalist market failures in the context of our discussion are the following types :

·    Labour market failure

When there is a recession, firms usually fire workers rather than drop salaries to the level they can afford. This increase in unemployment results in less demand which causes further layoffs as products are not being sold. In an efficient labour market, salaries and wages would need to fall until all workers could be employed and the market would clear i.e. surplus labour would be allowed back into the labour market.

·    Interest rate meddling

The pricing of money is reflected in the rate of interest. If the market sets the rate, then the interest rate represents a signal for the amount of savings in the economy i.e. when savings are high then the need and hence demand for borrowing money is low and hence the interest rate will be low. If however the central bank bypass this key market signal and set the base rate of interest low through policy intervention, then this vital signal is masked and businesses take the wrong decisions and this leads to a massive waste of resources as unsuitable projects are started for which there is no long term demand as the low interest rate was not an indication of a high level of savings but instead was artificially created rate by the central bank which once rises causes the chaos we know as the business cycle which disproportionately hurts the working and middle classes.

  • Credit failure.

Currently, the Central banks have created money through programs such as Quantitative Easing, which means creating new money that can be loaned out to desperate firms especially small to medium sized ones to new job creation. However the banks are not lending and are instead looking for ultra safe investments such as buying government bonds which pay interest and are sought due to their being considered risk free. This is starving the private economy of credit and thus cant invest and rejuvenate the market.

  • Moral hazard.

Alan Greenspan, the former Federal Reserve Chairman said that the big banks on Wall Street operated with knowledge that their losses would be covered by the taxpayer. This is the so called moral hazard situation. The effect of this moral hazard is that governments go further and further into debt by bailing out these banks and this impose higher and higher taxes which hurt the spending power of citizens. When individuals are over burdened taxation, it becomes difficult to spend and this hampers recovery.

  • Confidence and expectations
The nature of the secular mindset is clearly disconnected from creedal concepts and as a result suffers from waves of optimism and pessimism and herd behavior.  John Maynard Keynes called this tendency of humans the ‘animal spirits’. When the herd moves towards pessimism this creates downturn in confidence and this manifests in recession which is a failure of the market.

Allah SWT has decreed a system which is immune from these failures. Consider each area highlighted above:
  • Labour market failure
A primary reason why employers do not drop wages is that workers are always in fear of inflation and a decline in their buying power. Under our currency model, monetary inflation is not a significant reality as we operate according to the gold standard. This is because we have a fully backed bi-metallic currency (Gold and Silver Standard) which stops us from printing money causing inflation.

  • Money market failure
In Islam we have the concept of Equity based financing which negates the need for interest rates and interest based loans. In Islam pooling of capital were fund holders form partnerships with people with creative ideas and this replaces the interest based loans market and consequently much needed finance reaches projects. 

As a secondary point, any type of price fixing is not permitted and the example of fixing the price of money through artificially setting interest rates can be refuted from another perspective.

The Prophet's said as part of one hadith “Allah is the One Who fixes prices”. (Reported by Ahmad, Abu Daoud, al-Tirmidhi, Ibn Majah, al-Dari and Abu Y'ala.)

  • Hoarding of money
There is a clear evidence to prohibit the hoarding of money due to its effect on making trading difficult in the short term. This coupled with taxes (ie zakat) on unused funds acts as 2 key disincentives which ensures funds are constantly being reinvested back into the economic cycle.

 “And let those who hoard gold and silver and do not spend them in the way of
Allah know that a severe and painful punishment is awaiting them.”
[At-Tauba: 34]

  •    No need for large firms which cuts out the need for  stock markets which has resulted in overgrowth of financial  sector or virtual economy over real economy.
Critics of our system argue that the means to foster large companies do not in the Islamic model as it lacks stock markets and other financial systems. 1991 Nobel Laureate Ronald Coase who wrote an article back in the 1930s called ‘The Theory of the Firm’ and argued that firms grow needs are in line with their need for information. Today information is attainable without such large sized companies and furthermore our concept about intellectual property ensures knowledge and hence intellectual capital flows much more freely in the economy.

Furthermore public property, an areas which in the West relies on huge pooling of capital via stock markets is taken care of via fees levied by the state who manages such industries on behalf of the public for public benefit and not the monopolistic desires of a few private firms, so this is not a shortfall in our system.

  • Too big to fail and reckless business practices causing moral hazard and massive taxpayer liability which turns spenders into savers.
Liability in Islam is not limited to the assets of the partnership but extend to the personal assets of the partners according to the capital share of the partner. It is an interesting observation that off shore banks are not prone to take the type of risky ventures that other banks take as they are not privy to government bailouts and have far greater stability records than the banks on wall street that push the society towards austerity once they have been rescued.

Abdurrazzaq narrated in Al-Jami’ from ‘Ali (ra) that the Prophet said: “The loss (Al-Wadhi’a) is upon the capital and the profit is according to what they stipulated.”

  • The concept of Rizk 
The Islamic society understands that provision (Rizk) is predetermined and this gives much more stability to the edgy inclinations which induce the herding and irrational behavior of economic agents we see in the Western markets. This concept is a key stabilizer to many market failures that lead to the type of recession and rigidity in western markets.

Furthermore stimulus programs are not needed as the commands of Allah not only oblige the Muslim from such irrational fear of loss that prevents spending in times of such pessimism, but also direct evidences that encourage and oblige the open hand with respect to spending on the permissible things. Allah SWT says in Surah Al-Isra verse 29

“And let not your hand be chained to your neck, nor open it with complete opening lest you sit down rebuked, derided.”

Furthermore, the beloved Prophet Muhammed SAW said

“Allah loves to see the sign of His favour on His servant”, narrated by At-Tirmidhi.

The Prophet said also: “If Allah gave you property, let Him see the sign of His bounties and dignity on you”, narrated by Al-Hakim from the father of Abu Al-Ahwas. So if someone has property and was miserly when spending on himself, he would be sinful in the sight of Allah. Such rules help prevent slowdown in economic transactions that are key to market efficiency.

  • Known government stance with clear rules of intervention and enforcement of property rights.
Higgs, as stated earlier, argued emphatically and convincingly that the reason the GD lasted for as long as it did, by most accounts from 1929 to 1946 is that there was so much uncertainty in the private sector towards what the government would do as far as interventions and this stifled confidence. In Islam the rules for intervention are clearly defined and ad hoc government intervention, such as setting minimum wages, high degrees of borrowing and imposing import tariffs and other price meddling would not be a reality.


In summary the point being made is that Stimulus is a sure way to increase debts further and help special interest groups with projects and not a means to lift a sinking economy.

The alternative, i.e. the free market approach were the budget is brought back into balance (i.e. austerity when spending has taken the government debt to unsustainable levels) doesn’t work very well as there are too many market failures in the Capitalist model for markets to work efficiently. So I am not advocating what the austerity camp argues by refuting what the stimulus camp argue. Islam offers a unique position. 

The alternative economic paradigm now needs to be brought into the mainstream debate as the entire world is tolerating the system that stands on the basis that there is no coherent alternative narrative that is being articulated. The debate needs to be taken to audiences according to the level of understanding to bring across this different branch and root approach. The lack of a viable alternative vision has caused everyone both Muslims and non-Muslims alike to have suffered for far too long and this must end. We must not allow the military industrial complex and the international banking establishment from usurping our natural rights any more. The time to make a stand is now.

August 2012


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