Modern Fiscal Setup Versus Zakat-Based Islamic System

The credit crisis which started in 2007 has brought into light many defects in the current economic system. One of them, which I will discuss in this post, is the intricate relationship between economic condition and fiscal spending power (of Government).

The major source of revenue for government’s fiscal spending comes from taxes on:
1) Revenue generated (by individuals and corporations).
2) Taxes on real-estate property and other fixed-assets.

In an economic downturn, the decline in economic activity leads to a decrease in:
(1) Individual incomes as well as a decrease in corporate revenue.
(2) Devaluation of fixed assets.

All this factors lead to decrease in government’s tax revenue.

However, this is the very time when people lose jobs and start to depend on government’s public welfare schemes. Government’s expenditure shoots up and is in dire need of money. The tax-revenue (as we discussed above) falls sharply and government goes into huge deficit. In short, the current fiscal structure is designed in such a way that an economic downturn becomes a double whammy for the country and sharply raises the fiscal deficit and decreases the standard of living.

Let us compare this with the Islamic system. In an Islamic system, apart from the regular taxes, a major source of revenue for the Government’s public welfare fund (baithul-maal) comes from Zakat. Zakat is an Islamic principle of contributing a percentage of a person’s wealth (not income) towards public welfare. It is mandatory upon eligible Muslims to give out this charity and in an Islamic system this becomes a law.

Apart from the generous charitable aspect of Zakat, there is another beautiful aspect that I want to bring out. And that is, the fact that this charity is independent of the economic cycle. In fact, in some cases the charity goes up during bad economic times. The reason is that Zakat is based on an individual’s total liquid assets and not the yearly income. Liquid asset is anything which is available or can be readily converted to cash. One of the features of economic downturn is that people flock to cash and pull out money from the economic system. This increases the liquid asset of an individual which should lead to an increase in the amount of money that gets collected as Zakat.

In other words, while the modern fiscal policies lead to a dearth in fiscal revenue during an economic downturn, the Zakat-based Islamic system generates consistent (if not excess) charity for the welfare of poor and needy in the most needed time. This in turn protects the economic system from catastrophic collapse.

Indeed, this type of policy (Zakat) is something which modern nations of the world have to learn from Islam.

Functioning of Fractional Reserve System

Ever wondered how our fractional reserve system works. How $100 printed by Federal Reserve (Fed) can generate a $1000 worth of economic activity (assume a 10% reserve requirement). Fractional reserve requirement is the percentage of money that a commercial bank has to keep with Central Bank as reserve (Currently it is 10% in United States). In this post, I will try to briefly explain how this "borrow from Peter to pay Paul" type system works.

Lets say the Feds decide to float $100,000 in the market. They do this by writing a blank check against themselves and buying Treasuries in open market worth $100,000. This buying releases $100,000 in the banking system.

Lets say Bank-B1 decides to sell $100,000 worth of Treasury bill to Feds.

* The result would be B1 will have $100,000 to loan.

* B1 lends $90,000 to Paul who wants to buy land from John. ($90,000 because $10,000 has to be kept in reserves due to reserve requirement).

* John deposits the amount $90,000 that he received in bank-B2.

* B2 lends $81,000 (keeping $9,000 in reserves) to Peter who uses it to buy a fleet of cars from Mary

* Mary deposits $81,000 in bank-B3. B3 in turn lends $72,900 (Keeping $8,100 in reserves) to Jim who wants to upgrade his kitchen by contracting the work to Home Depot.

* Home Depot then deposits $72,900 in bank-B4 and the chain continues.

The total worth of economic activity generated (in dollar terms) can be computed by summing up all the activities described above. All these activities can be expressed as a geometric sequence whose sum can be computed by using standard geometric progression formula:

100,000*(1 + 0.9 + (0.9)^2 + (0.9)^3 + .....infinite series) = 100,000/(1-0.9) = 1000,000

The overnight lending between the banks and Central Bank keeps the capital fully tied up (in terms of loan) and keeps the economy flowing. Any stagnation in lending between the banks will cut that geometric series (described above) short and hampers the capitalist economy.

Misconceptions about Islamic-Organizations

Islamic-organization is one word which not only alarms Non-Muslims but also repels many Muslims. In this post, I will try to bring some of the fears that Muslims have about Islamic-Organization and try to evaluate their genuineness.

1) Many Muslims feel there is no need for organization. There favorite punch line is “We as Umma’h are an organization”.
2) Some other Muslims feel: Organizations create a division and hence Fitna’h.
3) Others feel Organizations are necessary but are “scared” that they will come under government’s radar.

Let us examine these conceptions.

Claim (1) looks more like an excuse of not willing do any positive work and a way of discouraging people who are trying to contribute towards the welfare of Muslim community. One should ask him/herself what he/she has accomplished out of his individual effort. Has he/she run any successful project for the community? Even if an individual has run a project in his local community, does he/she have any macro-vision of how they could make a difference on a larger scale? In many cases, that I have seen, such people don’t even feel that a change is needed in the world. Most of them are indifferent to events happening around and at max they have casual opinions.

Attainment of any goal requires a group of individual who share a common vision. It is not enough for a group of individuals to share a common vision but also to put effort in an organized way and hence the need to have an organization. The favorite punch “we as Umm’ah are an organization” is an incorrect statement because neither all people in Umma’h share a common view nor will they put efforts in attainment of his goal.

Claim (2) is again an excuse of laziness because any work that is initiated will be disliked by few in the community. If a person starts to satisfy everyone in the community, he will end up doing nothing. Indeed, some low caliber individual of an organization may create differences in the community, but that does not justify stopping work for the welfare and revival of Islamic work. It is a way of stereotyping based on acts of few (bitter) individuals who are way far from the spirit of Islam.

Claim (3) is due to Nifaq in the heart (May Allah save us all from this!). One should read surah al-Tauba (Chapter-9) to see how Allah has addressed the Munafiqs who held back from helping Prophet Muhammad (PBUH) and Islam. Indeed the claim of a person is incomplete (rather false) if he doesn’t consider Allah and his Prophet dearer than anything in this world. Islamic-Organizations in US and many parts of the world are well-registered and work in a COMPLETE lawful way. If someone is scared even after this then it is nothing but a psychological phobia.

Inflation: A Necessary Evil?

In this classic period of deflation (Dec 2008), one must be wondering why I am writing about Inflation. But the fact is, as soon as the economy bottoms out, inflation will strike back again. Once again the purchasing power of dollar will go down and people will again recall those good old days when gas use to be $1.50.

One wonders as to how actually the money is getting devalued. Money is supposed to be a store of value, an asset which a human preserves by refraining him/herself from immediate consumption. Yet it defies the very definition and loses its value gradually.

The major reason, as any economist in the world would suggest, is increase in the money supply. The simple logic they refer to is supply/demand equation. The number of dollars (or any other currency) has increased at a rapid rate compared to other assets whose value is being analyzed. The number of dollars has particularly gone up when we consider the money in the sense of M3 (Physical currency + Checking Account + Time deposits + Money Market funds). (For more discussion on Money-Supply click here)

But this explanation to me is oversimplification of a complex issue. The fact of the matter is no wealth is created unless we have inflation. Wealth is defined as: "anything that has utility and is capable of being appropriated or exchanged". Increase in wealth includes:
1) Any new thing that is useful for humanity
2) Increase in production of existing things to satisfy the need of growing population.

Hence, growth of wealth is necessary for the survival of growing population as well as to make human life more comfortable.

Let us analyze the role of Central Banks in this increase of wealth. For a moment lets assume that Central Banks stops minting (or printing) more money and assume Human being will continue on their mission to increase wealth and population. In such case, the money (dollars) will become scarce compared to the total human wealth. Purchasing power of money (dollar) will increase over time and big investors and common public alike would like to store their wealth in dollars. Ideal scenario isn’t it? No! Because this would lead to lack of investment leading to an actual decrease in wealth and hampering of production cycle, unemployment will rise and standard of living for many people will fall apart.

This is where the Central Bank comes into picture. They dilute the demand of money (dollars) by printing more money leading to a re-establishment of balance between the wealth and number of dollars. This dilution of dollar demand will lead investment bankers and common public to think about preserving their purchasing power by investing their surplus capital into the production system.

Thus, dilution of dollar demand is key to creation of new wealth. One might wonder if the job of Central Banks is to establish equilibrium between number of floating dollars and the wealth then why is the value of individual items (like gasoline) is rising? Why is gasoline more expensive now than in 1972 (if Central Bank is doing what it is supposed to do)?

The answer to this is:

The number of goods that were available in 1972 was far fewer than what we have now. Think about all the I-phones/G-Phones/Hi-Tech computers/Fax-machines/Advanced weapons etc., we did not have them in 1972. The equilibrium is being established between aggregate wealth and the number of dollars (not between individual item and the number of dollars). The reason for this inflation in individual commodity (like Gasoline) is that the rate of growth of it has been lower as compared to the rate of growth of dollars. The reason being as state above is the creation of new goods. Had it been that we had same number of items and the same technology that we had in 1972, then the central bank would have increased their money supply in such a way that the cost of each item would have been almost the same.

However, one needs to remember that Economics is an inexact field. The Central Bank doesn't have an exact measure of what the wealth of each year is (especially when you include the service sector in wealth computation). So the effect of their dollar-printing activity will have uneven effect on different commodities/goods.

So, it is unjust for people to blame Central Bank for inflation because the creation of new wealth, sustenance of growing population, and desire for increased human convenience requires central bank to do what they are doing (i.e. printing more dollars and diluting the dollar demand). However, this does not mean that Central Banks (Federal reserves) are perfect organizations; it has got many drawbacks which will be discussed in a separate post.

Some people (especially from Austrian school of economics) argue that markets take care of themselves. They will themselves establish the equilibrium between the number of dollars and the wealth. But the fact of the matter is it will be very chaotic if the markets were left to bring this equilibrium. Great depression of 1928 and the frequent booms/busts before it (in late 19th century and early 20th century) clearly shows that market do figure out this equilibrium but in a very painful way.

Of course there is one (impractical) way of stopping inflation and that is:

1) Human beings should stop improving their standard of life.
2) Human beings should stop increasing their population.


Any comments/criticism is welcomed.