Challenges in Economic and Financial Policy Formulation

An Islamic Perspective

H. Askari, Z. Iqbal, A. Mirakhor

• Publisher: Palgrave Macmillan
• Year: 2014
• Print ISBN: 9781349482634, 9781137390455
• eBook ISBN: 9781137381996
• Topic: Theology & Religion
• Subtopic: Business General

Challenges in Economic and Financial Policy Formulation provides an introductory, yet comprehensive, treatment of macroeconomic policies and their implementation in an Islamic-designed economic system.

CHAPTER 1

Significance of Public Policy

Introduction

In any economic system, there is a role for the state and for government policy. While the specifics of this role, its mandate, and its extent would differ from one economic system to another, a legitimate government and its policies are, at a minimum, essential for the preservation of security, social harmony, the legal system, and sustained economic prosperity. In the realm of economics and finance, the role of the state is multifaceted and can be minimal to dominant, depending on the system and societal goals.

In Islam, the Creator has given humankind the rules by which they should live their lives on this plane of existence. He demands much of humans, but if humans follow His rules, they could achieve the ideal social and economic system. If humans follow His path, although there would be minimal need for government intervention in the economic system, macroeconomics would help in preserving a stable growth trajectory. Thus, there is an important role for the state in an Islamic economy, but this role may be increasingly reduced as an economy transitions to what might be called the “ideal” economy, where there is full compliance with the prescribed rules of behavior.

In this book we explore when, why, and how a government should intervene in a society and what policies it should use to improve economic and social conditions as recommended in Islam.

Economic Goals and Priorities

In every society and nation state, economic prosperity is the overriding goal. However, policies to achieve this goal are very different from one society to another. As a result of differing priorities, the target, focus, and the nature of government policies vary significantly across countries.

While the level of GDP and its growth rate are quick and useful indicators of a country’s economic success and power, they are dependent upon a country’s size, resources, and population, making cross-country comparisons almost meaningless. For comparative purposes, and with humans always making comparisons, per capita GDP or per capita income and its growth rate provide a more meaningful basis for comparisons. However, adopting the highest level of per capita income and its growth as the goal in any society is also quite meaningless. Humans do not live by national economic success alone. They cannot starve while the per capita GDP keeps on growing. They cannot eat the nation’s economic success. In short, there are many other dimensions that matter. While a people may take pride in their society enjoying the highest level of per capita GDP on earth, it matters whether an individual’s income is above, at, or below the prevailing average. To give an extreme example, it does not make for a flourishing and healthy society if it enjoys the highest per capita GDP in the world but that GDP is only because a few individuals possess an unimaginable income while the rest of society living at a subsistence level! So yes, while income distribution must also be a goal or a priority, societies view its details very differently and government policies can affect and determine the outcome.

Even a high level of per capita GDP and a more or less equitable distribution does not reflect and indicate a society’s welfare. Humans are born with dreams. Does society provide those people with the environment and freedom to realize those dreams? Are there real opportunities, with equal access to high quality education, social mobility, and good employment prospects in order for all members of society to realize their full potential? Moreover, what about the disadvantaged members of society who cannot readily avail themselves of existing opportunities? Are the interests of future generations—generations that have no vote or say today—protected when it comes to the environment, the availability of natural resources, and future economic growth rates and prospects? Government and government policies, both directly and indirectly, affect all of these outcomes. But again, the role of the state and its policies are perceived very differently from one society to another, and our focus is the role of public policy in Islam.

The Role of the State

In most states, where you are born becomes the state of your nationality. States, however, change as a result of both internal and external political and military forces. However, if you are born a Muslim, you are a member of all Muslim countries, at least that is the way it was some 1,300 years ago. In those early days, up until some century and half ago, a Muslim could travel throughout the Muslim world with no papers and expect to be treated as if he or she had been born in the land where they happened to be. How things have changed!

States have monopoly over the levers of coercive power to force compliance. In Islam, Muslims are expected to comply because they are answerable to Allah. Yes, in Muslim societies, states do also have a coercive power, but the expectation is that the state should use its coercive powers sparingly and only when individuals are rule violators or when the use of coercion is in the interest of society. Those interests are, however, not arbitrary; they are defined clearly by the Creator.

The state is the guardian of the legal system and the rule of law. In the absence of laws, their monitoring, and enforcement, a nation-state becomes a veritable jungle—with risk that overwhelms all rational decision-making. The resulting constraints on management of economic, financial, and political risk would in turn impede social and economic progress. In the absence of a supportive legal system and the rule of law, economic actors are unlikely to entertain long-term decisions. Going beyond the legal system, the state can be seen as society’s risk manager, especially in the absence of private sector insurance against idiosyncratic risks. Beginning with the obvious—that include external threats, internal security and violence, and unforeseen natural disasters—and stretching to the not-so-obvious—that include broad economic and financial collapse, loss of all employment opportunities, and impairment of the ability to work or losses of asset values beyond the control of individuals—there is an undeniable role for the government in managing society’s risk profile. Chapters 5 and 6 will address these issues.

The state plays an important regulatory role that cannot be entrusted to private parties. Sound regulations are at the foundation of business confidence. All economic systems—from any form of market arrangement to command systems—need regulations or rules of the game (or institutions, as we will discuss in Chapters 2 and 3). In the absence of carefully constructed regulations, markets cannot transmit correct signals to consumers and producers for their decision-making. Markets can fail for a number of reasons that include price and output collusion, monopolistic power, asymmetric information, moral hazard, unfair foreign competition and trade practices, and even outright fraud. An important area for government intervention and policy is in dealing with the issue of externalities—negative fallouts, or by-products, of economic transactions. Chemical companies, as a by-product of their industrial processes, emit dangerous pollutants into the air and into the waters. In the normal course of events, they would not install expensive pollution controls. The companies would invariably prefer to maximize their profits by not paying for the external diseconomies that they cause. The government can establish rules and force companies to clean up their environmental damage and install pollution control equipment. Even in non-market systems, participants must have rules and guidelines for what they can and cannot do. However, regulations and rules are only as effective as their supervision and unbiased enforcement. Again, both supervision and enforcement are difficult to privatize and should be entrusted to a fair and just government.

The government’s regulatory role goes further. The state stands to protect society and individuals from predictable harm. Licensing of professionals is important in numerous areas—medicine (doctors and nurses), business, financial institutions, etc. A government agency, such as the Food and Drug Administration (FDA) in the United States, tests and monitors the safety of drugs before they are sold to the public. Accreditation of hospitals and schools is another role for the government. The government plays an important role in certifying the safety of the food chain and the origins and content of whatever is consumed. The government plays a key role in developing safety standards that businesses might not adopt on their own—for cars, airlines, household equipment, etc.

The state has a crucial role in ensuring expansion of economic activity and prosperity. As the world witnessed during the Great Depression and, more recently, in the Great Recession, there is no reason to believe that the economy will be operating at full employment (the natural rate or later restated as NAIRU, the non-accelerating rate of unemployment by Modigliani and Papademos in 1975). In fact, it is highly unlikely that the economy will be humming along at NAIRU for any length of time. There will be periods when aggregate demand is too low (when the aggregate supply is high) and others when it is too high (or when the aggregate supply is low), requiring government intervention to nudge the economy back to the NAIRU level of activity. Stabilization policies—monetary and fiscal (discussed in more detail in Chapter 7)—are crucial in moderating economic fluctuations and maintaining employment, something that is critical to avoid economic hardships for families, and for society in general. However, government’s role in stabilization goes beyond monetary and fiscal policies to include industrial policies, trade policy, exchange rate policy, and income policies (such as healthcare and education, that affect incomes).

While government can adopt policies to support economic activity and nudge the economy towards its NAIRU level, it could play an important role in enhancing growth. Sustained economic growth needs supportive policies and institutions to encourage businesses to invest for the long term, for individuals to get more education to enhance their human capital, and for individuals to forego current consumption and invest for the future. The state is also uniquely positioned to provide the needed infrastructure to support economic growth and development. While the private sector could undertake some infrastructural projects, the investment lumpiness, the long-term payoff, and the myriad spillover benefits of infrastructure investment requires direct government intervention, at least in the form of public-private partnerships. It is not only today’s prosperity that matters. A couple of percentage points of additional economic growth for 20–30 years can put a country on a different level of economic wellbeing. Just look at how Argentina has fallen and South Korea has risen!

A series of important, yet controversial, roles of the government deal with allocation of resources—its distribution and re-distribution—or whatever commonly falls under the umbrella of taxation and entitlement programs or might also be referred to as “what, how and for whom.” First, and maybe least obviously, is the fact that the government has a significant impact on the allocation of resources because of taxation (reducing a company’s, an institution’s, or an individual’s available resources to affect investment, production, and consumption) and expenditures (increasing the availability of resources for the recipient of these expenditures and affecting the allocation of factors of production to the sectors that produce the goods and services demanded by the government). Second, in most societies, the government in its role as a risk manager of society provides a minimal level of income; in some countries, this is only for a limited period of time, to those that cannot find employment through no fault of their own—unemployment insurance. This program, welfare programs, and some forms of taxation (income and sales taxes) are referred to as “automatic stabilizers,” as they tend to cushion the decline in economic activity (demand) and limit the limit its boom. They act automatically in that the government does not take any explicit action for their impact to be felt; and their impact limits economic fluctuations. Third, and as always with very differing application from country to country, societies provide a number of services for the economically unable and disadvantaged who cannot provide for themselves because their ability to access resources has been constrained. While private institutions, NGOs, and individuals do a magnificent job in a number of countries to support the disadvantaged and the economically unable, it is invariably insufficient, and the state must still be the protector of last resort. Fourth, no matter how well the economic system is organized, highly skewed income and wealth distribution has increasingly become a hot-button political and social issue in many countries. On the one hand, governments should be wary of stifling incentives. On the other hand, they should not enable income and wealth concentration to translate into immense political power to impede economic and social mobility and divide societies into a few “haves,” and a preponderance of “have-nots.” While some have argued that skewed wealth and income distribution supports more rapid growth, evidence does not appear to support this proposition. As one would expect, income incentives are important up to a point, but beyond that point, they could be a detriment to the participation of the majority in the economic life of a state and not afford any added incentives to others who have amassed fortunes and or have vast incomes. Thus, in most countries, a significant proportion of the population is supportive of the state’s adoption of policies to tax income and wealth only beyond a certain threshold level.

No matter the political and/or religious views, there are important roles for the government in the economic and social life of any country. Divisions and disagreements arise over the extent and the specifics of the role and level of intervention. Although our focus is on the role, content, and formulation of economic policies in the context of an Islamic economy, we will continue to make references to policy formulation in the conventional economic system.

Economic Systems and the State

The organizational structure of states could be classified into three main categories. First, there is the monopolistic state—where one or few persons do everything in their own interests. Everything is structured and organized to this end. Those in control of the state create illusions to make the citizenry think that policies have been formulated and implemented to benefit society as a whole, but this is only a mirage. Illusions can be fiscal (taxes collected to be used for the benefit of all, but not so in fact). Just look around—Assad’s Syria, Bin Ali’s Tunisia, and Peronist Argentina, in all of the oil/gas rich Middle East (not from taxes, but from the oil and gas birthright of all generations), and in most of the other developing countries around the world. Second, we have the individualistic state structure—an aggregation of individual interests. All actions and policies are targeted at individuals. There is no collective interest as such. Individuals are not concerned with collective interests. Here, there is no connection between the individual and society (e.g., when using a public amenity, an individual does not consider the interests of others—leaving public toilets dirty after use). In such a system, the concept of the “free rider” comes into play; with some individuals consuming more than their fair share of a public amenity or not paying the price for the benefit they enjoy. Third, there is paternalistic structure—whereby the interest of society at large is the guide and compass. Divergence between individual and public interests do arise, but only public interest matters. The state does what it can to bring about a convergence between individual public interests. In this structure, future generations and environmental factors take on great importance—the state comes to their rescue and incorporates their interest into its objective functions and policy goals. While in the individualistic structure, individual interests are summed up to arrive at the public interest, in the paternalistic structure, it is the opposite, with society’s interests overriding individual interests. We should not confuse the paternalistic with the dictatorial structure, as the freedom of individual choice exists only in the former system.

An Islamic system structured on the basis of the Qur’an and the Tradition of the Prophet (sawa) doesn’t fit neatly into anyone of these three categories. The paternalistic system is the closet to the Islamic structure. In Islam, the paternal figure is the Creator—Allah. In an Islamic system, individuals are first and foremost concerned with the collective interest. The individual lives to serve the interests of all, because therein lies her/his own interests. Essentially, in an Islamic society, public interest is broader than that in the paternalistic structure. Islam, as we will see throughout this book, is a rules-based system to guide humanity in their every action. Muslims are, by definition, those who have submitted their own will freely to that of their Creator, meaning that they are rule compliant. Incentive structures are needed to encourage rule compliance. Regulation is not an absolute necessity in an Islamic economy, but supervision is always needed in every economic structure, including one that is based on Islamic teachings.

Each of the systems—the three just discussed and the Islamic—can use the market system; but the market may be used very differently in each.

The market is a place for exchange. It is an institution. The market mechanism operates to bring supply and demand into balance efficiently. In a pure market system, markets make all the decisions. That is why all markets—labor, resource, goods and services (that include the exchange of property rights), money (short-term instruments), and capital (long-term instruments)—play an overriding role in a pure market system.

The principal strength of the market system is its assumed efficiency—putting in the minimum resources for the maximum output. However, production or technical efficiency does not necessarily mean economic efficiency. For example, the result may be the maximum output, but what if there is no demand for the good that is produced in such abundance? Economic efficiency is the value of output in relation to the value of input. Is market mechanism efficient? Yes and no. For example, alcohol is produced efficiently through the market but it may cause deaths. Furthermore, markets can increase or reduce inequalities. Markets take things as they are given, and if unfettered markets decide upon everything, the result could be obscene income and wealth inequalities. To state the obvious, markets have no conscience! Adam Smith, the great philosopher and economist, appreciated this seemingly forgotten fact by noting that supervision by the state was invariably needed because of human greed that could lead to adverse results. More importantly, while the world has touted the phrase “invisible hand” that is mentioned only once in his most famous book, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), it has chosen to neglect the message of his other book, The Theory of Moral Sentiments (1759): ethics and morality matter in the proper functioning of markets and, in particular, the love of self should translate into sympathy (empathy) for others as new participants enter the market system. To some, the market is an ideology and to others (as in Islam), the market provides an efficient signaling device and resource allocative system.

Adam Smith’s essential idea was that continuous material improvement could be assured of as a result of individual decisions motivated by self-love and moderated by the moral value of “sympathy” for others, among other virtues. Sympathy is the quality that each individual would take to the ma...

Table of contents

• Cover
• Title
• Chapter 1  Significance of Public Policy
• Chapter 2  Institutional Perspective of Islamic Economics
• Chapter 3  Economic and Social Justice: The Policy Objective in Islam
• Chapter 4  Risk-Sharing Finance and the Role of Public Policy
• Chapter 5  Lessons from Financial Crisis: A Policy Failure?
• Chapter 6  Financial and Capital Market Policies
• Chapter 7  Fiscal and Monetary Policy in Islam
• Chapter 8  Developing Social Capital
• Chapter 9  Financial Inclusion: Implications for Public Policy
• Chapter 10  Environmental and Natural Resource Policies
• Chapter 11  Benchmarking Islamic Finance–Enabling Policies
• Chapter 12  Policy Challenges: Building Institutions
• Notes
• Bibliography
• Index