Salman Ahmed Shaikh
It is encouraging and pleasing to see the authors giving consideration to the book review by writing the first rejoinder and then responding to the reply to the first rejoinder as well.
However, it is humbly submitted that the second rejoinder by the authors largely repeats the same points without answering the pin-pointed concerns raised in the reply to the rejoinder earlier.
The only cited study in the book and two rejoinders is a working paper which takes the context of the US economy. It is cited as an IMF study 5 times in the second rejoinder. Actually, it is not appropriate to cite it as an official IMF study. It is a working paper published by people who happened to work at the IMF. It is wrong to project it as an IMF study. Before even the abstract of the working paper, this sentence is written in the cited study.
“This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.”
Citing only this working paper 5 times in the second rejoinder and earlier in the book does not add meaningful academic value to the radical proposal. The working paper takes the case of the US economy which is completely different from Pakistan. US has a global reserve currency, nearly 100% financial inclusion, deeply entrenched equity markets, and a highly liquid corporate bond market that can easily substitute for bank credit.
Furthermore, there are scores of assumptions in the DSGE calibration which make the forecasts highly questionable. If it was really a very reliable estimate, the idea must not have been shelved both in the policy circles as well as the academia. There are many criticisms of DSGE models. These models were in use before and during the financial crisis of 2007-09 as well. They failed not only to predict financial fragility, but they also could not explain it afterwards.
Secondly, the author of the book “Breaking the Trap of Debt, Inflation, Interest and Poverty” argues that this working paper itself did not raise the concerns which were raised in the book review and the reply to the rejoinder. It seems the author is taking the working paper (which as per IMF is a work-in-process document) as the criteria to judge any concerns. What matters is evidence that establishes causality in a rigorous, transparent and verifiable way. Reference to the grand problems and attributing them all to the fractional reserve banking system does not prove causal connection.
When it was written in the book review that full reserve banking has not been fully implemented anywhere, the reference was made to modern day banking. In ancient times, societies worked under the barter system, without paper money and even without banks. Specifically, the author shall provide examples of any real world economy that is using full reserve banking currently or in the post-World War 2 period. There is no economy using the full reserve banking. Before World War 2, the monetary system was completely different. In the history of banking, it did not take long for Goldsmiths to work out the mechanics of fractional reserve banking.
A few quotations from economists are provided in the last one and half century in the book, but they need to be contextualised carefully. Many of the quotations cited belong to the pre-1974 era when the monetary system was significantly different. For instance, the Chicago Plan appeared during the Great depression era and was never implemented fully and formally. The quotations of Irving Fischer from 1930s is of a period when the economy was undergoing the recovery phase after the great depression. Instead of contracting money which deepened depression further, policymakers adopted quantitative easing in the 2007-09 crisis which ensured a relatively more quick recovery than leading the economy into the depression like in the 1930s.
Milton Friedman argued that by requiring full reserves, the money multiplier would be fixed at a constant value of one, turning the money supply into a direct instrument of the central bank. This was the mechanical prerequisite for his fixed-rule monetary policy (the k-percent rule). It eliminates the risk of banks hoarding reserves during recessions, which historically caused the money supply to contract and turned minor downturns into major recessions. Friedman effectively placed monetary growth on a predictable auto-pilot that removed the need for discretionary management. Milton Friedman suggested having monetary expansion which is not cyclical. Contrarily, the authors propose to link monetary expansion to GDP growth. Their proposal will result in monetary contraction in recessions and this will make recessions more severe, painful, deep and prolonged.
The authors acknowledge that they have no problems with fiat money. They are opposed to the decentralized money creation involving banks. It must be understood that the lending operations are dependent on demand for credit by firms and households. As and when the loan is repaid, the bank created money is destroyed, as acknowledged by the authors too. As mentioned earlier, the lending capacity is checked under Basel regulations of capital adequacy requirements, liquidity coverage requirements and net stable funding requirements alongside minimum paid-up-capital requirements by central banks and the prudential regulations on lending operations. The regulatory framework may have loopholes and enforcement may have lags, which need to be corrected. But, this does not automatically give a reason to abandon the whole system altogether with a radically new system implemented abruptly. As a matter of fact, the aggressive lending practices in the sub prime segment, exotic derivatives and rampant securitization are absent in Pakistan’s financial system and are hence irrelevant.
It is expected that closing fractional reserve banking will reduce the risk of bank runs as the demand deposits are held in reserves to the extent of 100% reserves. It is also expected to reduce private debt. But, as highlighted earlier, reduction in liquidity, flexibility and availability of credit lines by providing financing only through equity financing and from actual investment deposits pool-wise is not necessarily good for the economy which is already below full-employment and where private sector credit is already very low.
The authors did not mention the current savings ratio in Pakistan which will be the only source of funds available for financing or credit in their proposal. How many of the households actually invest in banks for investment purposes? Pakistan has one of the lowest savings ratios in the world. Financial inclusion (excluding the mobile wallet accounts) is also quite low. Not more than 1% of the population in Pakistan hold fixed/time deposits in banks. That figure is also when the depositors are provided pre-determined rate of return with surety of capital protection.
As highlighted earlier, keeping even the existing households holding onto their fixed deposits is difficult when these deposits are going to be compensated on profit and loss sharing and when the deposits are going to be invested by banks to provide equity based modes of financing. Banks will likely provide financing to even more niche clientele of large and stable businesses crowding out small scale SMEs, micro enterprises and start-ups even more. With credit lines choked, the financing activity will go to the shadow banking sector which is even more risky in terms of regulation and checking exploitation. Currently, the loan sharks charge usurious rates of interest.
To solve one problem of bank run which rarely happens, it is not rational to throw the baby with the bathtub. To solve the problem of bank runs, it is not appropriate to disrupt the whole economy. To reduce the debt of government, it is not useful to give it a clean balance sheet by writing off debt with a stroke of pen and then giving it the power to obtain 100% seigniorage revenue and issue sovereign money through a money creation committee. To make banks serve the private sector, it is not appropriate to let them only finance using the actual time-fixed deposits which are placed on profit/loss sharing principle. Freezing time/fixed deposits for 6 months and using remittances to pay foreign debt will result in disruptions including capital flight which the authors ignore as speculative and hypothetical concerns.
The authors surprisingly repeat their claim that remittances of non-resident Pakistani citizens which amount to approximately one third of foreign debt can be used for three years to repay all foreign debt. It is a recipe to suggest a logistics company to get rich instantly by tearing up the parcel and treat it as its own.
As mentioned earlier in the reply to the first rejoinder, high rates of poverty and high rates of inflation are not even the biggest problems in countries that have deeply penetrated fractional reserve systems with almost 100% financial inclusion.
The determinants of sustainable growth are completely different. They do not depend on one form of banking versus the other. The long run macroeconomics literature has a general consensus on sustainable growth determinants, i.e. capital formation and technological progress which requires savings channelled into investment and human capital development. Technological breakthroughs depend on strong property rights protection, rule of law and merit based incentive structures.
The authors take the context of Pakistan where financial inclusion is already very low. When it comes to credit, approximately less than 5% households have access to formal credit channels through banks in Pakistan. They are not trapped in debt by fractional reserve banking. They are hardly given debt. The economic problems of Pakistan are not due to deep penetration of the fractional reserve system. Rather, these problems exist because of the absence of the critical conditions of growth as highlighted in the long run macroeconomics and institutional economics literature. The authors were requested to provide causality analysis to establish that the economic problems of Pakistan are principally due to the fractional reserve banking. But, they keep on citing the single working paper which was using the US context.
The authors think that the move to go for no reserve requirements gives credence to their proposal. Actually, it shows that the move is in the opposite direction of what the authors are suggesting. Authors suggest raising the reserve requirement from 5% to 100% whereas some advanced economies are going towards 0% reserve requirement. It shows that now the regulators rely on other effective tools. Banks are not going to create an infinite amount of money under 0% reserve requirements as banks are restrained more effectively through other ways like interest on excess reserves, capital adequacy ratio, liquidity coverage ratio, net stable funding ratio, and solvency requirements.
To the concern about long term financing options, the authors point towards bonds and pension funds. There is hardly any corporate bond market in Pakistan. Much of the bonds and Sukuk are issued by government, state-run companies or by banks themselves. The pension funds market is extremely small. That can hardly cover the long term financing needs of the entire private sector including households. The amount parked in all pensions funds combined does not add up to the value of assets of any single big bank in Pakistan.
In the book, the authors mention that debt based Islamic modes of financing will continue to be used in their proposal. But, in the second rejoinder, they mention only the risk-sharing based equity financing modes. Even within fractional reserve banking, Islamic banks hardly use equity based modes of financing. Authors do not give any detail or a thought to the alternate pricing benchmark in the absence of interest rate. This paper was humbly referred for an alternate pricing benchmark earlier.
The fundamental issue in the use of Musharakah and Mudarabah is the moral hazard problem. This has been extensively discussed in the literature. The authors did not discuss or give a thought to it in their book. This paper is humbly referred which discusses the moral hazard problem in Mudarabah and how to resolve it.
There are so many shocks which affect the economy, i.e. technological shocks, supply chain disruptions, energy shocks and geopolitical crisis, for instance. Under these shocks, flexible availability of credit is required. If investors withhold the investment deposits for longer maturities, which are extremely small anyways and when the economy faces recessions due to technological shocks, supply chain disruptions, energy shocks and geopolitical crisis, monetary contraction is not a good recipe for recovery. It will deepen the recessions as mentioned earlier. Then, when the government gets involved in deciding monetary affairs through the money creation committee, it will open room for political interference and lobbying. The very few episodes of bank failures in Pakistan are by and large caused due to political interference.
The book review and the replies were meant to provide food for thought, not a defense of fractional reserve banking. There are certain functions which will remain to be performed and needs which are required to be served efficiently, smoothly and effectively without creating more problems than what are being faced now. The authors are requested to provide specific answers to the pin-pointed concerns raised in the review and in reply to the first rejoinder. The original book review, the rejoinders and replies to the rejoinders can be seen by following these links.
Categories: Articles on Islamic Economics
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