Imagine that you wake up one day and find out that you are the most senior bureaucrat of a Muslim country’s central bank. Imagine that you have the political support required to implement whatever changes are needed to make the central bank’s operations sharia compliant. What would you do? If Bill Bonner was asked such a question his likely response would require just two words: “I resign!” This is an understandable response given the huge responsibility that comes with any type of public office.
Let’s assume that you have the requisite courage (or are overcome with delusions of grandeur) and think that you are able to rise up to such a gargantuan task.
A major challenge would be to implement an alternative to that aspect of central banking for which these institutions are best known: setting short term interest rates. Given that riba is forbidden it appears very bizarre when a Muslim run central bank gets involved in ‘setting interest rates’ – short term or otherwise. Generally speaking, interest rates can be considered as the price of money. (For this and the next paragraph let’s ignore Doug Noland’s brilliant analysis of money-like financial instruments.) Here are some general rules: high interest rates tend to inhibit economic activity and low interest rates tend to do the opposite. If interest rates are pushed too high this can lead to a recession and if interest rates fall too low this can lead to asset bubbles. Suppose that a Muslim central banker feels that the economy is growing at an unsustainable pace. How could he seek to reign in economic activity but without raising interest rates (which appears to be a haram course of action)? In answering this question, let us assume that we are still operating in an economy in which fiat money is widely used and accepted as a medium of exchange. Let us further assume that the central bank has at its disposal a significant amount of gold bullion. The central bank could sell some of its gold for the prevalent form of paper money and then take the received paper monies out of circulation i.e. it would not place the funds into its accounts with commercial banks. If you understand how fractional reserve banking works you will appreciate how powerful this course of action could be. Such a reduction in liquidity would raise the price of money because of a reduced quantity in circulation. In this scenario, money will tend to rise in value against other assets such as property and shares. Business lenders will become more cautious and savers will be rewarded handsomely.
If the central bank wants to encourage economic activity it could buy assets (e.g. shares on the stock market) and in doing so increase the supply of money in circulation. In this scenario, we can expect asset prices to rise alongside the willingness of commercial banks to lend which will likely spur economic growth.
Such actions could be accompanied by clear public pronouncements by the central bank in which its concerns are clearly expressed.
You may consider the above suggested alternative to setting interest rates unworkable. That may be so but it remains difficult to circumvent the logic of the following statement: If riba is haram, targeting short term interest rates must also be haram.
[For a further insight into short term interest rates consider the following text from the website of the Bank of Canada:
“The Bank carries out monetary policy by influencing short-term interest rates. It does this by raising and lowering the target for the overnight rate. The overnight rate is the interest rate at which major financial institutions borrow and lend one-day (or "overnight") funds among themselves; the Bank sets a target level for that rate. This target for the overnight rate is often referred to as the Bank's key interest rate or key policy rate. Changes in the target for the overnight rate influence other interest rates, such as those for consumer loans and mortgages.”
http://www.bankofcanada.ca/en/monetary/target.html
The target rate is not established by decree; central banks actually have to buy and sell certain financial instruments in order to get to the desired rate. Gary North has written an interesting article about this.]
Another key area to explore is the central bank’s involvement with paper money. One of the greatest mysteries of modern times is how so many people, despite the awesome amount of non-mainstream information available on the internet, feel so comfortable with fiat money. My studies of economics (albeit not ‘mainstream’ Keynesian/Friedmanite socialist economics) lead me to believe that fiat money should be considered as an unjust institutionalised form of transferring wealth from the people in general to the government and its close ‘friends’. Or, if you prefer to state matters clearly, let’s just call this theft. (See Rothbard’s “The Mystery of Banking”.) If this stance seems extreme to you have a look at the statistics for money supply growth throughout the world and also investigate the general decline of paper money’s purchasing power. [Page 5 of the following document shows the rate of increase in the money supply of major oil exporting nations: www.ustreas.gov/press/releases/reports/petrodollars.pdf (“Petrodollars and Global Imbalances”)]
Where fiat money is accepted, central banks are given an awesome, albeit unjust, tool; the ability to ‘print money’ or ‘create money out of nothing.’ If food could be created at no cost, that would be a good thing. If clothes could be created at no cost, that would be a good thing. It would amount to increased wealth; our precious time and energy could then be diverted to obtaining other desirable items. The same logic does not apply to money. Money facilitates economic activity, and subsequently economic progress, because of its scarcity. If it wasn’t scarce it would not have been adopted as money in the first place. So, if you generally accept that a central bank should not ‘print fiat money’ we can then move on to consider possible policy actions. A complete and sudden break away from paper money would probably cause chaos. A possible initial action would be for the central bank to commit to the immediate cessation of any further ‘printing’ of money. Presumably, if coupled with suitable announcements, the value of the paper money that is in circulation would rise sharply. Those who feel comfortable to keep it can continue to do so. Those who prefer to switch into other forms of money, such as gold and silver, can do so. Hopefully, there will be a peaceful transition to a system of parallel currencies in which paper money and ‘hard money’ coexist. After a period of years, as paper money suffers from inevitable wear and tear, we can hope to end up with a major transition away from fiat money issued by the central bank. It’s also possible that some people may continue to use foreign paper monies; this is not necessarily a bad thing at least in the interim. The key aim is to remove the ability of the central bank to create, at will, widely accepted fiat money.
What has been discussed thus far thus not align neatly with free market economics as lucidly promoted by the Misesians. Perhaps once the use and allure of fiat money is significantly reduced, Muslim countries may want to consider abolishing central banks and reviving the noble institution of the ‘bait-ul-mal’.
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