February 24, 2013
By Jamal Harwood and Sarfraz Wali
There has been much discussion during the on-going financial crisis, on how to initiate a sustained recovery and the consensus shown by the mainstream commentators has been through returning to sustained economic growth.
Such is the focus in the capitalist order towards growth, that any program or strategy that is not able to demonstrate how compounding levels of growth can be achieved is not given credibility and hence many, such as the Turkish economics professor Timur Kuran, have written extensively showing how the Shariah has rules which limit the ability of economies to grow and hence are an impractical alternative to the current order.
It is the aim of this paper to demonstrate that the current capitalist economic paradigm with its fractional reserve banking model has within it a destructive growth imperative which is on an unsustainable trajectory and to present Islam’s alternative approach to the subject.
Economic output is the volume of goods and services produced over a financial year. The measure is called GDP or Gross Domestic Product. Other measures such as the Gini Coefficient have been developed to measure the distribution of wealth among the population.
A coefficient of 0 suggests a completely even distribution and 1 suggests totally uneven distribution where a small number of market participants own the majority of wealth. It is worth noting that this figure is moving towards 1 in the states which adopt the growth strategy and is something the Occupy movement has tapped into.
The disruption in continual growth in output for 2 successive quarters is defined as a recession and this is regarded as a severe harm to the economy necessitating economic management to minimize the duration of the slowdown in output. This is the essence of the business cycle which is the alternating phases of growth and contraction which have been witnessed for hundreds of years under capitalism.
What then are the stated outcomes sought from economic growth?
According to all mainstream schools of Capitalist economic thought, growth in production is the solution to the fundamental economic problem facing society due to the coupling of the unlimited wants of man in relation to the limited resources available to satisfy such wants. This definition includes both needs and wants and not just basic needs.
The thinking of the founders of the first modern economic school of thought argued that increasing production was the key to maximizing happiness for the individual.
Adam Smith, the founder of modern Capitalism, considered that if the society focused on maximizing production, this would equate with distributing wealth to the greatest number of individuals. His focus was not on targeting distribution as he felt that distribution would be a natural by-product of materialistically driven individuals all seeking their self-interest. In his book “The Wealth of Nations” Smith quotes:
“By pursuing his own interest he frequently promotes that of the society more effectually (sic) than when he intends to promote it”.
Soon it became clear that the unregulated free market approach of the Classical school of Adam Smith was good at increasing production but deficient as far as the distribution of the gains of higher rates of production.
The next development was the neoclassical school, which emerged at the end of the 19th Century, proposing new ideas relating to value. As far as the breakthrough in the view of value and exchange, its input was to bring in a more accurate way of price formulation as far as considering both demand and supply and at the micro economic level. This had some positive impact on wages being more likely to be linked to the value that the labourer’s service provided, however no distinct policy changes were associated at the macro-economic level with the emergence of the neoclassical school as far as formal re-distribution of wealth.
Since then, new thinking came in the latter part of the 20th Century through works such as the 1956 book entitled ‘The Future of Socialism’ which argued for a new way of breaking the disparity between rich and poor by not focusing on the size of the slice but the size of the pie. The argument being the same slice of a bigger pie would give more wealth to the less privileged classes.
We shall now turn to a discussion on the schools of modern capitalist economic thought relating to growth and demonstrate the single minded attitude of the mainstream approaches towards endless and exponential growth. These schools fundamentally differ over key factors that hinder growth through the mechanics of what is called the business cycle. It is of no surprise that much focus is thus placed on the business cycle by all capitalist schools of thought.
A key argument is that if a theory can help minimize the slowdown in growth that occurs during a downturn in the business cycle, its policy proscriptions should be adopted by nations seeking endless growth.
However there are some non-mainstream schools, which reject the paradigm of growth. Rejection of growth as an endless strategy was in fact advocated by the mainstream schools including Adam Smith himself and Keynes given the obviously limited capacity of the earth to sustain growth indefinitely. Renewed interest in this area was spurred by a study by a think tank called Club of Rome whose study in 1972 called ‘Limits to Growth’ argued that the ecosystem imposes limits to growth. From this have arisen branches such as those who argue for a steady state economy that plateaus after a period of exponential growth, and Welfare Economics who differentiate between good growth and bad growth, the latter being termed uneconomical growth. More extreme movements have also arisen such as the De-growth movement who argue for downscaling production. However these are considered fringe ideas and we now turn to the mainstream view which advocates continual growth.
The main schools can be broadly grouped into the following camps:
3. Neo Classical which includes Monetarists and Rational Expectations
4. New Keynesian/New Classical
The formulation of the classical school as stated was the overwhelming belief in the efficiency of free markets to self-regulate themselves. It was felt that the laws of supply and demand were sufficient to ensure the allocation of resources would always flow to the most worthy projects and temporary gluts would be short lived as unemployed workers would easily accept lower paid jobs to regain employment.
It became clear very early on that in reality many market imperfections would act as impediments to this idealistic model and some type of interventionist approach by the state would be required to ease the market mechanism along to achieve this level of efficiency. Such intervention takes the form of monetary and or fiscal policy as the primary means of perpetuating the boom phase and minimizing the bust phase of the business cycle.
The period from the work of Adam Smith in 1776 with the publication of his famous book “The Wealth of Nations” to the onset of the Great Depression following the 1929 stock Market crash in the US was the golden era of the neoclassical school which deemed there to be a minimal role for the state. It became clear after a short while that the market was unable to recover by itself and needed active governmental efforts to kick start a recovery.
Prices were declining and unemployment was rising and the market was unable to self-correct from this situation. The saviour was the British economist John Maynard Keynes who entered the debate with his influential book “The General Theory of Employment, Interest & Money” published in 1936.
The central concept from the work of Keynes was that markets when in a downward spiral would not recover and the government needed to act as a catalyst to reinvigorate demand for goods and services through increased spending when the private sector was saving. This would however increase government deficits, nevertheless the argument was put that when times are good, taxes could be used to pay for such emergency spending for when times are bad.
This approach, adopted by the 1933 Roosevelt administration, was so instrumental in ending the Great depression that Keynes ideas ruled supreme until the 1970’s when new phenomena called stagflation baffled economists on both sides of the Atlantic. This reality threw into question the policy proscription devised by the Keynesian revolution and the new saviour was the Chicago School economist named Milton Friedman whose ideas formed the Monetarist school which remained popular from the late 70’s until the high inflation induced after the end of Bretton Woods was reigned in.
Stagflation saw the simultaneous upward climb of unemployment and inflation. Prior to this, as depicted by the Philips curve, there was always perceived to be an inverse relationship between the two where governments could bring down unemployment at the cost of some inflation and vice versa. As far as unemployment and the supply of money, if there is inadequate money in circulation to sustain trade requirements, then traders will be unable to trade at current prices as they lack the means to conduct their transactions. This would cause unemployment as traders would be unable to trade and be forced to start laying off staff due to the lack of sales for their production.
Therefore Friedman argued that the supply of money should be kept at an optimal level to avoid either extreme. Furthermore, he advocated that there was a `natural rate of unemployment’ which the government shouldn’t take action to reduce and instead the government should try to control the money supply so that it was in line with the level of economic activity. This theory was implemented through aggressively raising interest rates to soak up the excess money supply which brought the hyperinflation of the 1970’s to an end.
Other schools such as the Rational Expectations School lead by Robert Lucas came to prominence since the mid 1980’s that added that people could no longer be tricked by the government policy tools and that they would anticipate the actions that the state’s economists would try to do and by so doing would be able to negate the intended aim of such governmental policies. For example when the government would increase the money supply economic agents would tend to bargain for higher wages ahead of time and firms would increase prices, so the effect of lowering unemployment which would otherwise have occurred, is not realised.
This insight was not new in that Friedman also used expectations to explain stagflation by arguing that economic agents anticipate the actions of the government when the government increase the money supply and the effect of lowering unemployment does not occur as economic agents would tend to bargain for higher wages ahead of time and similarly firms would increase their prices ahead of time and this would fuel inflation above the level intended by government policy and hence would render the attempt to reduce unemployment ineffective.
Regarding the development in ideas related to rational expectations, both Keynesians and neoclassical schools reinvented themselves with new and post prefixes.
Other schools such as the Austrian School are variations of these themes and more recent contributions have come from what is known as behavioural economics which try to incorporate the physiological disposition of individual behaviour to explain the un-coordinated and often irrational behaviour of economic agents which prevents markets behaving in an optimal self-adjusting manner.
The final question to ponder is the issue of what the Policy differences are between the major schools. The preceding discussion is quite abstract as far as how theorists such as Keynes and Hayek, who is popularly characterised as the extreme end of the spectrum of mainstream thought, see the economic fundamentals necessary to prolong boom and minimise the bust phase of the business cycle. As far as policy, this difference manifests in the form of monetary and fiscal policy and which instrument is favoured to help return an economy that was in growth, towards growth in a downturn.
Other ways of framing this difference are also well known such as big government vs. small government or whether to regulate or ‘get out of the way of business’ a game cry of the right popularised by the ‘tea party movement ‘ in the US. Ultimately these labels all point back to the fundamentally different views presented by the schools mentioned above.
This paper earned the Award for Best Paper at Sharia Economics Conference 2013 , authored by Jamal Harwood and Sarfraz Wali. You can find Sarfraz Wali’s blog at http://www.breakthrougheconomics.blogspot.co.uk
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