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Islamic Banking Principles Vs. Federal Reserve Policy

Currently in the US, the Federal Reserve is attempting to formulate a palpable

progression in the economy by changing its current strategy on monetary policy. For months

now, most global markets have been waiting anxiously for the adoption of minimally higher

interest rates. There are cynics and proponents for each side, and both have due cause. Most

cases are caused by choosing a side on the Fed’s dual mandate of price stability and full

employment. This debate isn’t new by any means. William Greider, author of Secrets of the

Temple, picks apart John Maynard Keynes’ philosophy on the issue. “Economies operating

efficiently at full employment would, in time, produce such an abundant supply of capital that

the price for it would fall to very low levels-that is, very low interest rates.” (Greider, 174) We

see this trend right now. But which came first, the low interest rates dictated by the Fed, or full

employment? Also, what happens if there are no interest rates, would economies without interest

rates automatically be at full employment? This is the case in Islamic regions as the Quran

forbids the collecting or issuing of interest or ribā. In comparison, usury often has the

connotation of interest in excessive amounts, but in strictly Islamic terms, usury indicates any

amount of interest, no matter how small. The concentration of this paper will navigate through

the growth of the US and Saudi Arabia over the past 30 years. It should be seen if a Keynesian

perspective on interest rates that is present in productive Islamic countries is able to keep pace

with the United States and their Federal Reserve’s implemented monetary policy. Also to be

included is a synopsis of Islamic banking and a notation of the major differences, on top of

interest rates, that stand out between them.

In the US, there are times when critics are in a deadlock when it comes to choosing a dual

mandate side. Raising interest rates should slowly pick up the inflation rate from its near

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stagnant rate, which isn’t beneficial and negatively impacts real wage growth. Supposedly

keeping interest rates the same will not cause markets to go haywire, but in the past few months

it has been seen that major volatility occurs without implementation of new monetary policy.

Interest itself creates a lucrative market for most parties involved.

At this point in time, if interest rates were raised, savers would see a greater potential of

their capital without the risk of investment. With inflation being so low, any increase in interest

rates would be a real gain that isn’t eroded immediately by inflation. Citizens who are employed

would greatly enjoy this benefit as they can finally have a small grasp on the idea that their

money isn’t going to disappear as it did in the recent financial crisis. Cleveland Fed president,

Loretta J. Mester notes this by recently stating that price stability “allows households and

businesses to focus on productive activities rather than on ways to protect the purchasing power

of their money and to make long-term plans and commitments without having to deal with

uncertainty about the value of their money.” (Mester) If price stability and higher interest rates

coincide, people would have the option to save rather than take the risk in investments. What

about in places like Saudi Arabia? What investment vehicles do households and businesses there

have to increase their wealth outside of interest based accrual?

First let’s look at the objectives of Islamic banking. A research paper by Ashfaq Ahmad

et al. published in the African Journal of Business Management gives the principles of Islamic

banking. “The basic aim of Islamic banking is to perform interest-free activities based on

principles of Sharia’h and carry out only Halaal (permissible) transactions.” ( Ahmad et al.)

From this we can see that Islamic banks are modeled around the guidelines set by a higher

power, unlike the rest of the world who get their guidelines from men. Also there is a differing

view when it comes to making money. The Institute of Islamic Banking and Insurance puts

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investments in two different categories, debt financing, the western way, and PLS, the Islamic

way. So in the western based system, capital seekers come to a bank asking for a loan. The loan

is paid out with interest, with the interest being used to cover the spread and compensate the

savers that have money in the bank. If the investment goes sour, the capital seeker is left solely

on his or her own to repay the money and the interest agreed to. This is a risk that may deter

entrepreneurs from getting an idea off the ground. With the PLS system, profit-loss sharing,

investors in Islamic countries put their money into a bank. Once a person or business comes

along, negotiations are drawn up and proportions of profits and losses are drawn up before the

transaction. If it is a successful investment, the profits are used to pay the investors who placed

their money in the bank, not interest. Essentially, the capital seeker in this situation has no

liability to pay back the bank for a failed venture, however it is deemed okay. “As long as the

owner of money is willing to become a shareholder in the enterprise and expose his money to the

risk of loss, he is entitled to receive a just proportion of the profits and not merely a merely

nominal share based on the prevailing interest rate.” (IIBI) In Islamic banking, investors are

compensated well do to their risk more than just interest. Here is a stark differentiation between

the two systems.

Savers in western systems have their will to save or invest dictated by the Federal

Reserve. If interest rates are high, less people are spending and they assume their money will go

further in the future if he or she saves now. But with interest rates being high businesses are less

likely to go in search for loans to improve or expand their business. Within a reasonable amount

of time, unemployment will pick up because business are looking to cut to save money, and

interest rates will have to be lowered to make the job market more accommodative. With the

PLS model, there is no saving; only investing. Every time money is put in to the Islamic banking

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system, it has a risk of loss, but the risk of profit payouts, tend to outweigh the consequences of

the loss. Western savers are saving for their own benefit and expose themselves to virtually no

risk, while Islamic savers are ultimately investors and share their wealth with people looking to

make entrepreneurial strides.

These principles also apply to personal loans for houses, cars, and tangibles that may

need financing. The lenders in these situations play a similar rule but tend to be more lenient. In

A Guide to Contemporary Islamic Banking and Finance, an example is given if a lender loans

$10 over 10 years. The question is raised about the time value of that money lost. This loan

contract is considered charity as the charitable contribution includes the time value of money.

The following quote best explains this Islamic banking idealogy:

“If that time value is higher due to inflation, then the lender has given a larger charity.

Notice that if the debtor cannot pay the creditor must give him extensions until he is able.

In fact the debtor may never be able to pay back, in which case the entire lent sum is

considered charity.” (El-Gamal 32-33)

This is a stark contrast compared to western banking. If payments are late, they are most

definitely not forgiven. The debtor is pursued relentlessly until payment is made or the goods

are forfeited. Of many things western banks have been called, charitable is not a term often

thrown around. Western banks appear to be chasing the God Almighty interest rates.

Effectively, “If money was not God, it appeared to be the next best thing.” (Greider 234)

Historically US banks have been at fault for making speculative loans with major

repercussions such as the lending upward of a billion dollars to the Hunt brothers of Texas to

corner the silver market in the early 1980s. The bubble was caused by the blindness of banks

thinking the price of silver would keep ever increasing and push the banks’ investments sky high.

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When the Hunt brothers started their binge effort, silver was around $10 an ounce. In six

months, they had watched as the price climbed up to $52 mainly influenced by high inflation and

their global purchases. William Greider points out those banks were eager to give them money

at first as they were already wealthy Texas oil tycoons with millions already. In all they held

129 million ounces of silver, most of it on margin. (Greider 144) Ultimately the price crashed

hard, plummeting the whole way back down to $10. Engelhard, still a major supplier of silver

today, is to whom the Hunt brothers and vested banks were indebted. When the time came for

Engelhard to collect, they did not act charitably and write off hundreds of millions of dollars, and

who would blame them? In this instance the Federal Reserve wielded its power and intervened

to save some of the major banks that would have gone under without such intervention.

Islamic financing would have never allowed such a financial injustice. While speculative

options are available for investment like stocks, trying to corner the silver market would have

been considered gambling. On top of this, “if a business’s primary activity is deemed

unproductive (e.g. a casino, or a beer brewery), then Muslims will not be permitted to own shares

in that company since owning such shares constitutes an implicit participation in the business’s

activity.” (El-Gamal 35) So nowhere in the Islamic realm would such speculative investments

be made and they would not have had deal with the near collapse of their major banks. Western

banks have also drawn the attention of other religious affiliates. After the 2009 financial crash,

the Vatican voiced their opinion in their official newspaper Osservatore Romano that “ethical

principles on which Islamic finance is based may bring banks closer to their clients and to the

true spirit which should mark every financial service.” (qtd in Totaro) Inherently, capitalism

really isn’t based on a close relationship between banks and clients. Free markets aren’t about

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building relationships. It’s about providing the best product at the most efficient price which in

turn is driven by many economic principles and theories, not relationships.

Like the Fed has its dual mandate, the Islamic Monetary Regime has a fourfold plan that

includes an interest free economy, low to moderate inflation, stable exchange rates, and

increased savings. Having already discussed the interest free topic, the issue with inflation is the

next topic. Typically with the Federal Reserve’s policy, they like to confine inflation to between

the 10 year Treasury note interest rate and the 3 month Treasury note interest rate. They do this

by dictating interest rates and reserve requirements to either increase or decrease the supply of

money dependent on the circumstance. So how would an Islamic state regulate inflation without

the interest rates to dictate? Firstly, research did by Salman Shaikh notes the four factors that

impact inflation “are interest rates, depreciation of money, indirect taxes and price distortions

due to imperfect markets.” (Shaikh) Therefore in an Islamic economy they only have to worry

about 3 factors. Money creation is how these banks limit inflation. Rather than using interest

rates on loans, “money supply expansion will be dependent upon productive loans disbursed.”

(Shaikh) However, what if in an extended time period, loans that were given turn sour, or what

if they are all massively successful? Would Islamic banks give loans to people that they expect

to fail to make up for the excess money that successful loans produce to keep inflation tame? It

seems very unlikely for that to be the situation. Cycles occur and there are good years and bad

years. But without effective monetary policy, these swings of inflation and deflation can become

habitual.

For my research I looked at the GDP of Saudi Arabia and compared it to the US’s over

the time from 1970 to 2013. Rather than convert currencies and find a baseline dollar value, I

chose to look at the percentage change in GDP from the previous year. Tracking it over this

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period yielded evidence that Saudi Arabia suffers much greater volatility compared to the US.

The graphs below comprised of data from the St. Louis Federal Reserve paints this well. The

graph on the left indicates a spike of 211 percent increase in Saudi Arabia’s GDP from1973 to

1974, thus skewing the other figures relative to it. The graph on the right gives a more

meaningful representation of the data. The GDP of the US is indicated by the red line which

appears to have very little variation. Saudi Arabia is no stranger to having negative GDP growth

throughout this time period, while the US only experienced it once for less than a year.

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It only lasted through the fourth quarter of 2008

and the first two quarters of 2009. I would like

to believe the use of the Federal Funds rate

aided in this. Shown directly left is a graph that

matches the same time frame as the GDP graph

shown above it. What it displays is the change

in the Federal Funds Rate set by the Fed.

Depending on the situation, increases or decreases in the rate can be seen in the area around the

grey bars. The grey bars in the charts also indicate recessions in the US which often corresponds

with down turns in Saudi Arabia’s GDP. With similar monetary policy less the use of interest

rates, speculation would lead to the notion that interest rates are formidable when intervention is

needed in the economy. Throughout the times shown, the US was the economic global

powerhouse and many economies depended on our imports and exports and overall economic

health. It’s shown that the US is almost constant in percentage change compared to Saudi

Arabia’s volatility.

On top of being an interest free economies, most counties on the oil rich Arabian

Peninsula, do not impose individual income taxes of any sort or charge sales tax. Hellen Ziegler

and Associates is a Canadian company that recruits health care professionals to work in Saudi

Arabia, Qatar and the UAE. They offer insight on the tax scales that their employees would be

subject to. Anyone making less than $99,400 is not subject to Saudi taxes. Business’ however

that are linked to the production of hydrocarbons are taxed 85% while other sectors are between

20-30%. (Ziegler) To this effect someone making $40,000 less the cost of living has more

disposable income than someone in the US. If inflation were to spike in the US at any given

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time, a person or family with comparable income would feel a much greater strain than someone

in Saudi Arabia would. Not having interest rates seemed like a big issue when it came to

maintaining a stable economy, but if forgoing an average personal income tax of 25% is at stake,

I don’t think the citizens are too distraught. If anything they are being honored for their

commitment to not participate in riba based transactions in a sense. Currently in the US interest

rates and inflation are quite low, and in principle our money is going further but the tax rate is

still present. Currently to me, Saudi Arabia sounds more appealing than the recovering economy

of the US and our slow rising wages. Granted there are a lot of non-economic factors that would

lead to the deterrent of job seekers to go to the area, but still no income tax.

Maybe their tax rate leads to their 5% unemployment rate. Trading Economics has their

current unemployment rate at 5.7% and tracking the figure back until 2001, peaked at 6.3% in

the end of 2006. Looking back to the early graph depicting GDP growth, even in the time when

their GDP shrank nearly 20% in 2009, unemployment was relatively unscathed compared to the

US’s. Nearly the opposite of what one would expect to happen. The US’s GDP shrank for 3

quarters and an overall decrease of just 2% led to a drastic increase in unemployment, nearly

eclipsing the 10% mark over the same time. This could be tied to the Saudi Arabian economy

being a one trick pony with their cash cow of oil. The services and industries provided in the US

were marginalized during the most recent financial crisis, but not so for Saudi Arabia. There

were no massive layoffs in the oil industry because they pretty much supply a near necessity to

the world. Quandl, an international database, notes that 24.7% of the Saudi population is

involved the industry sector. I would have assumed to find unemployment concerns in the 70%

that work in the service industries, but there seemed to be none at the time of the crisis or even

now. (Quandl)

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Granted a 2% decrease of GDP in the US is substantially large. The 2% that the US

dropped equated to half a trillion dollars, which is equal to Saudi Arabia’s GDP of 500 billion

US dollars for that time. This does make the large increase in unemployment a little easier to

realize because 2% is a large figure to the US. Often statistics like such are over looked for that

reason, but when your country has the largest GDP, small variances can have large impacts like

those realized in the recession. But what the Fed is good at as of late is regulating inflation. No

matter the increase or decrease of GDP, inflation has remained steady. That much cannot be said

for Saudi Arabia. Saudi Arabia’s inflation rates fluctuate and reach much greater magnitudes

than that seen in the US. The following graphs depict the historical percent changes in GDP and

inflation rates through the past forty odd years and show the differences seen between the US

and Saudi Arabia.

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The differences are substantial. The graph on the left depicts US statistics and the right is Saudi

Arabia. For the US the bounds are shown to have a high inflation of about 15 percent around

1980 and high GDP growth around the same time of 13 percent. Lows for both stats reached

negative growth in the 2009 financial crisis almost hitting -2.5 percent. For Saudi Arabia the

statistics can’t even be represented well on the same axis due to the high fluctuations. But what

it does show is that the high changes in GDP are followed by increases in inflation. For example

as shown, the 220 percent increase in GDP was followed by a roughly 35 percent increase in

inflation soon after. Also shown for Saudi Arabia is the nearly 20 percent decrease in GDP in

2009 while at the same time as mentioned before the US only suffered a 2 percent. With similar

monetary policy principles such as reserve requirements, one of the differences is the ability to

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use interest rates to conduct economic growth or destruction for the greater good and price

stability.

For my regression analysis, I looked at the inflation growth or decreases as well as the

GDP growth or decrease for each nation and pitted them against each other. Removing interest

rates from the equation, GDP growth directly impacts the increase of money for each nation

leading to inflation. What I expect to see is that the GDP increases in the US have minimal

significance or impact on inflation since The Fed has tools to readily combat these issues. For

Saudi Arabia I expect to see a major link between the two especially since the graphs shows

correlation already. Since inflation is often associated as an effect of GDP shifts, I made

inflation my dependent variable for both analyses. First I did the US comparison and got the

following output.

Model 1: OLS, using observations 1969-2013 (T = 45)Dependent variable: INF_US

Coefficient Std. Error t-ratio p-valueconst 4.9244 0.722708 6.8138 <0.00001 ***GDP_US -0.204691 0.20818 -0.9832 0.33099

Mean dependent var 4.354325 S.D. dependent var 2.893168Sum squared resid 360.2001 S.E. of regression 2.894261R-squared 0.021988 Adjusted R-squared -0.000756F(1, 43) 0.966756 P-value(F) 0.330991Log-likelihood -110.6522 Akaike criterion 225.3043Schwarz criterion 228.9177 Hannan-Quinn 226.6514rho 0.816788 Durbin-Watson 0.380241

This regression shows that in the US, GDP is not statistically significant in predicting inflation in

the US. We are currently seeing this in our economy because GDP has increased ever since the

recession but our inflation has been near stagnant. Looking at the R-squared statistic, it shows

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that GDP could account for only a two percent shift in inflation. Also with an high P-value, the

GDP coefficient is rendered void.

Model 2: OLS, using observations 1969-2013 (T = 45)Dependent variable: INF_SA

Coefficient Std. Error t-ratio p-valueconst 2.34488 1.15266 2.0343 0.04812 **GDP_SA 0.107119 0.030878 3.4691 0.00120 ***

Mean dependent var 3.991510 S.D. dependent var 7.880447Sum squared resid 2134.943 S.E. of regression 7.046264R-squared 0.218675 Adjusted R-squared 0.200504F(1, 43) 12.03469 P-value(F) 0.001200Log-likelihood -150.6917 Akaike criterion 305.3834Schwarz criterion 308.9968 Hannan-Quinn 306.7305rho 0.488065 Durbin-Watson 1.023790

This model substantiates my original hypothesis that GDP in Saudi Arabia precedes inflation

significantly. Looking at the P-value of GDP_SA, it is shown to have strong statistical

significance by having 3 stars and unlike the US figure it is positive which portrays a positive

linear relationship between the two. There are other factors that can contribute to inflation, but

using the R-squared value in this model, GDP can be responsible for a near 22 percent change in

inflation.

The major difference I would attribute to these occurrences is the ability to dictate

business cycles with interest rates, which for these models appear to work in the benefit of the

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United States and its central bank. Interest rates have had controversy tied to them occasionally

because they aren’t dictated by market forces but by the Fed. If the Fed wasn’t in the position to

dictate interest rates, would the US have a need for them? Other than interest rates driving large

profits for the financial sector, could we possibly find an appreciation for loans based on their

profitability in the long run rather than just on interest rates.

Works Cited

Ahmad, Ashfaq, Kashif-ur-Rehman, and Asad Afzal Humayoun. "Islamic Banking and

Prohibition of Riba/interest." African Journal of Business Managment 5.5 (2010): 1763-

767. 4 Mar. 2011. Web. 30 Sept. 2015. 

El-Gamal, Mahmoud Amin. "A Basic Guide to Contemporary Islamic Banking and Finance."

(2000): n. pag. Web. 19 Nov. 2015. <https://www.lariba.com/site/pdf/islamic-banking-

guide.pdf>.

Farooq, Mohammad Omar. "Exploitation, Profit and the Riba/interest Reductionism." I J Islam

Mid East Fin and Mgt International Journal of Islamic and Middle Eastern Finance and

Management 5.4 (2012): 292-320. Proquest. Web. 10 Oct. 2015.

Greider, William. Secrets of the Temple: How the Federal Reserve Runs the Country. New York:

Simon and Schuster, 1987. Print.

IIBI. "Institute of Islamic Banking and Insurance - Islamic Banking Principle." Institute of

Islamic Banking and Insurance - Islamic Banking Principle. Institute of Islamic Banking

and Insurance, n.d. Web. 19 Nov. 2015.

<http://www.islamic-banking.com/islamic_banking_principle.aspx>.

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Mester, Loretta J. "Long-Run Economic Growth." Clevelandfed. Federal Reserve Bank of

Cleveland, 15 Oct. 2015. Web. 19 Nov. 2015. <https://www.clevelandfed.org/newsroom-

and-events/speeches/sp-20151015-long-run-economic-growth.aspx>.

Quandl. "Saudi Arabia - Unemployment Data - Data from Quandl." Saudi Arabia -

Unemployment Data - Data from Quandl. Quandl, n.d. Web. 19 Nov. 2015.

<https://www.quandl.com/collections/saudi-arabia/saudi-arabia-unemployment>.

"Saudi Arabia Unemployment Rate | 1999-2015 |." Saudi Arabia Unemployment Rate | 1999-

2015 |. Trading Economics, n.d. Web. 19 Nov. 2015.

<http://www.tradingeconomics.com/saudi-arabia/unemployment-rate>.

Shaikh, Salman Ahmed. "Role and Functions of Central Bank in Islamic Finance." Role and

Functions of Central Bank in Islamic Finance. Academia, n.d. Web. 19 Nov. 2015.

<https://www.academia.edu/565309/Role_and_Functions_of_Central_Bank_in_Islamic_

Finance>.

Totaro, Lorenzo. "Vatican Says Islamic Finance May Help Western Banks in Crisis."

Bloomberg.com. Bloomberg, 4 Mar. 2009. Web. 19 Nov. 2015.

<http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aOsOLE8uiNOg>.

Ziegler. "Frequently Asked Questions - Saudi Arabia." Frequently Asked Questions - Saudi

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<http://www.hziegler.com/articles/saudi-arabia-faq.html>.