Metamorphosis Revisited

This past Monday, the IMF released a report on Islamic Finance. Along with the report, it also released a short video titled Four Things You Need to Know about Islamic Finance. After five days up, it has a whopping 388 views.

I tend to think of "Islamic Finance" as a kind of like a good movie with a terrible name. Other names it goes by in official circles are "Islamic Banking" or "Sharia compliant whatever", which, as far as names go, don't do it any favors in the West.

The basis of "Islamic Finance" is that usury is forbidden in the Koran. I had a few discussions about this in the comments back in 2009. Among the points I made was that the three major religions all share similar doctrines. In Islam, usury is called Riba, however there is a caveat in Islam that you may lend usuriously to your enemies, just not to other Muslims.

I also linked this History of Usury Prohibition which explains that such sentiments of contempt for usury date back to the Old Testament in Judaism, and go back equally far in Hinduism and Buddhism, many hundreds if not thousands of years before Islam even existed.

And I noted that the meaning of the term "usury" has evolved, especially in the West:

Consider this, the term "usury" changed its meaning in the last 100 years. It used to mean "interest". Now it means "excessive interest". All usury laws today have to do with an upper limit on interest rates. Age-old usury laws prohibited interest entirely.

When usury laws were repealed in 1981, they were simply making way for Volcker's 18% official interest rate, which ran credit card rates up to 40% and higher. These rates were previously called "loan sharking" and were completely illegal.

For example, look at different versions of the Bible. The NIV (New International Version) was begun in 1973 and not completed until 1983. Compare passages from the King James version and the NIV (random example):

Luke 19:23 (King James Version): "23Wherefore then gavest not thou my money into the bank, that at my coming I might have required mine own with usury?"

Luke 19:23 (New International Version): "23Why then didn't you put my money on deposit, so that when I came back, I could have collected it with interest?'"

So in 1983 they could no longer use the term "usury" in its original meaning. In 1983 usury meant "excessive interest", and that wouldn't make sense. So they had to change the word to "interest".

This is a deep subject. Think about it. We know that money is essentially credit, which is also debt, and it circulates, so shouldn't there be a time value to money? Is interest intrinsically good or bad or neither? Is it a relative thing, with many shades of gray? Or is it a simple black and white matter? I know what I think, and I'll tell you in a moment.

In December of 2009, I wrote a post titled Metamorphosis that was essentially about the concepts in Islamic Finance without mentioning Islamic Finance or the other names it goes by even once. The post did, however, contain three pictures of Dubai real estate that were financed in a Sharia compliant way. And the word "Islamic" did appear once in the post, in an article I included about Sukuk, which are the Islamic equivalent of bonds.

In "Islamic Finance", the way they get around charging interest is by calling it "rent". Say you want to buy a house under Islamic Finance rules. What would happen is you would get the money from the bank, and then you would pay it back in monthly installments of the principle plus an additional rent (instead of interest) for your use of the property. So whereas we pay principle and interest, they pay principle and rent.

It's really quite simple, but the implications run deep. Probably the biggest implication is that the lender shares with the borrower both the risks and rewards of the underlying asset. This is basically what my post was explaining. Here's a tweet from the IMF on Monday followed by a short paragraph from Metamorphosis:

IMF @IMFNews Apr 6
Given lenders share in both risks & rewards, should #IslamicFinance be made more mainstream? Read Blog http://ow.ly/LfGfd

 

A system that is built upon equity positions is much more stable as equity agreements are entered into with much more gravity. If both parties share in the risks and rewards of future performance they will take everything more seriously. Also, equity agreements are based on the flexible assumption of variable future performance! A much more realistic assumption.

Don't worry, we are not going to all be Sharia compliant in Freegold. We are not moving toward a world of Islamic Finance. That is not what this discussion is about.

If you read my Metamorphosis post, you'll notice reflections of FOA in it. In particular, you'll notice similarities with his The Wind Will Blow post.

In FOA's post, you'll read about a tractor:

The unnatural convoluted drive, of many, is to use this same "money value concept" to borrow real wealth "use"; instead of borrowing the actual wealth itself to gain said "use".

This second item comes under the heading of trying to get something for nothing and is everywhere in Western Thought!

If we lend an item of real wealth, say a tractor or chair, its future value is unimportant to the lender as long as the real item is returned. It is the "use" that is lent, not the money concept in the form of a trading value. In this process we recognize that, because the value of things change, the debt to be repaid is the item of wealth, regardless of its higher or lower value. Only its "use" changed hands during the lending and repayment of debt. All is well.

And in mine, you'll read about a crane:

Now some items that we find in our planetary inventory are productive equipment items. These are things that if used properly can increase the amount of wealth in the world. A giant crane, for example, can be used to build new structures that can then be valued and traded relative to everything else in the world.

With nearly 7 billion people in the world today, the various tasks of production have been divided to the extreme. For example, you will be hard pressed to find a man operating a crane, who also owns that crane, and also owns the project he is working on as well as the land underneath it. If such a man exists, then it is surely a very small project in his own backyard.

So cranes are generally loaned, leased or financed to those who want to build, by those who want to own (productive capital). And the return to the owner of the crane is a function of the value of the use of the crane. Not the appreciation in the tradable value of the crane itself. Can you see the difference? If someone owns a full equity position in a piece of productive capital, he does so in order to earn a return, a yield based on the value of the USE of that capital. He does not count on the value of the crane increasing in the future so that he can sell it for a profit. There is a big difference! Think about this.

The point of both FOA's post and mine was not what's wrong with banks, fiat money, lending or interest. It was about understanding concepts and principles so that you can see what is inevitably unfolding. The way conventional banks lend for interest is neither good nor bad, it simply is. Same with Islamic banking. Islamic Finance is not the cure for what ails Western finance, but understanding the difference between the two may help you see how the $IMFS will resolve.

The point of both posts was that the resolution of the $IMFS, the cutting of the Gordian Knot, will be dollar hyperinflation and "gold prices beyond imagination," not deflation. Here's a bit from the conclusion of Metamorphosis:

Deflation?

If today's deflationists are correct then the numéraire will remain strong or even grow stronger while the world runs from equity ownership of the physical world into the warm embrace of casual debt creation stabilized by its own Ponzi-like exponential growth pattern.

Think it through. We don't just muddle through from here. We either shift toward equity or debt. We are currently not in stasis.

[…]

What about Gold?

Gold is a little different. Yes, it is the ultimate equity position with assured future global liquidity. Yes it is the ultimate wealth reserve as a known timeless claim on anything you may need in the physical world of your future.

[…]

I will leave you to do your own math on where the real value of physical gold will come to rest on the other side of morphosis. I have already presented my calculation in other posts.

And here's a bit from the conclusion of The Wind Will Blow:

The tables are turned; deflationary policy will not defend the dollar. Only inflationary policy will. Make no mistake, we are not calling for price inflation to end the dollar's reserve reign! We are calling for "inflationary policy" to dethrone it while said hyperinflation follows.

[…]

The very changes needed in our money universe, today, would kill dollar demand by devaluing all dollar assets in super higher gold prices. The debts and the dollars would remain; only 90% of their current illusion of value would vanish. Hyperinflation in prices of all wealth objects will be the workout result of this process. As such, opposing dollar political motive will force the US to give the markets what is needed; both gold and gold prices beyond imagination.

Above, I asked if interest is intrinsically good, bad or neither. I think it is neither good nor bad, it just is. I think there is definitely a time value to money, but to use that time value on a system-wide basis as a form of risk-free savings or as a wealth reserve is what leads to problems. Think about the difference between conventional and Islamic banking in terms of buying a house. In conventional banking, the buyer alone is exposed to the risk and reward of changes in the value of the home during the life of the loan, so presumably the lender is not.

As we now know, this works well as long as home values are rising, but if they decline, homeowners can be quickly wiped out and go bankrupt or default on the loan. So there is risk exposure to the value of the underlying asset. And in Islamic banking, the lender shares that property value risk proportionally with the buyer throughout the life of the loan, so there is risk there too.

There is always risk involved in lending, yet with fiat currencies we have the ability to eliminate the nominal risk by printing more money (e.g., FDIC deposit insurance, QE, etc…). All this does is transfer the risk to the value of the currency itself, which is exactly where we find ourselves today.

The IMF has two stated reasons for studying Islamic Finance. The two reasons in one word each are stability and inclusion. Inclusion means bringing the Islamic financial world into the warm embrace of the international monetary and financial system, and stability means finding new ways (perhaps by studying the principles of Islamic finance) to avoid another global financial crisis. In addition to banning interest, Sharia law also bans speculation, gambling and short-sales.

Back in 2012 when I first met Aristotle in person, he brought with him the latest edition of the Central Banking Journal, which I found him quietly reading on my sofa one morning with a cup of coffee. That sparked a conversation about what he had told me by email a year or two earlier, about the "many international policy stirrings" he'd been following in the journal which he felt pointed to preparations "for assertively rolling forth the freegold paradigm."

What surprised me the most was that, aside from mentions of gold in the journal, one thing he paid particular attention to was the repeated and frequent mentions of Sharia compliance and Islamic banking rules in the Central Banking Journal. Western central bankers have apparently been studying and discussing this stuff for nearly a decade now, and for good reason. According to the IMF paper, "Islamic financial assets have grown at double-digit rates over the past decade, from about $200 billion in 2003 to an estimated $1.8 trillion at end of 2013. (A large part of Islamic finance—around 80 percent—is composed of Islamic banking assets; the remainder is composed of Sukuk (15 percent, asset-backed or asset-based instruments), Islamic funds (4 percent), and Takaful (Islamic insurance)."

More from the IMF research paper:

WHAT IS ISLAMIC FINANCE?

Islamic finance refers to the provision of financial services in accordance with Islamic jurisprudence (Shari’ah). Shari’ah bans interest (Riba), products with excessive uncertainty (Gharar), gambling (Maysir), short sales, as well as financing of prohibited activities that it considers harmful to society. It also requires parties to honor principles of fair treatment and the sanctity of contracts. Transactions must be underpinned by real economic activities, and there must also be a sharing of risks in economic transactions.

Islamic finance products are contract-based and may be classified into three broad categories:

* Debt-like financing structured as sales, which could be sales with mark up and deferred payments (Murabahah) or purchases with deferred delivery of the products (Salam for basic products and Istisna’ for manufactured products), and lease (Ijārah) with different options to buy. Pure lending is allowed only when benevolent (Qard, which is often used for current deposits);

* Profit-and-loss-sharing (PLS)-like financing with two modalities: (i) profit-sharing and loss-bearing (Mudarabah) whereby the financier (investor, bank) provides capital and the beneficiary provides labor and skills (profits are shared, but losses would be borne by the financier who does not have the right to interfere in the management of the financed operation, unless negligence, misconduct, or breach of contract can be proven); and (ii) pure profit-and loss- sharing (Musharakah) where the two parties have equity-like financing of the project and would share profits and losses; and

* Services, such as safe-keeping contracts (Wadi’ah) as for current deposits, or agency contracts (Wakalah), which are also increasingly used for money market transactions.

The principles are rather sound, as you can see, although their Arabic names are a bit off-putting. And as I have stated, I don't really consider these principles to be particularly Islamic, but Islamic finance does provide an existing structure of sorts that can be studied.

It is my personal feeling that these principles reflect changes that will emerge naturally as the $IMFS collapses and Freegold rises like a phoenix from the ashes. That was kind of the whole point of my post, why I called it Metamorphosis, and why I included the illustration of a caterpillar turning into a butterfly.

That's also why I hesitate to even use the term Islamic finance. But don't you find it interesting at least that Western central bankers have been studying these principles for years now, perhaps as Ari views it in preparation for dealing with a new reality?

Here are the documents and tweets released on Monday by the IMF for your perusal:

 

IMF #IslamicFinance research just released. Read about main findings: http://t.co/9IHa8ubPpk
— IMF (@IMFNews) April 6, 2015

 

#IslamicFinance needs consistent application of Islamic financial standards to enable its safe and sound growth http://t.co/UmmnapvBZH
— IMF (@IMFNews) April 6, 2015

 

Given lenders share in both risks & rewards, should #IslamicFinance be made more mainstream? Read Blog http://t.co/gns67btZQF
— IMF (@IMFNews) April 6, 2015

 

#IslamicFinance can improve access to finance, support inclusive growth. Read how. http://t.co/gmhKT9HhEb
— IMF (@IMFNews) April 6, 2015

 

Why #IslamicFinance matters? IMF research suggests it holds the promise of fostering financial inclusion & stability http://t.co/yVISu8h86i
— IMF (@IMFNews) April 7, 2015

Sincerely,
FOFOA