'
&
$
%
NEW PERSPECTIVES
ON
POLITICAL ECONOMY
Volume 5 Number 2
ARTICLES
2009
Edwards: The Financial Pathology of the Postwar American Welfare
State
Bagus: Monetary Reform – The Case for Button-Pushing
Hoppe: “The Yield from Money Held” Reconsidered
Šrámek: Islamic Economics: New Economic Paradigm, or Political
Agenda?
Editorial Board:
Josef Šíma President of CEVRO Institute [school of
political studies]
Dan Šťastný Department of Economics, University of
Economics, Prague
Advisory Board:
Enrico Colombatto University of Turin
Richard Ebeling Northwood University, Midland
Robert Higgs The Independent Review
Jesus Huerta de Soto University of Madrid
Jörg Guido Hülsmann Universite d’Anger
Language Editor: Shelly Gussis
ISSN: 1801-0938
ISSN 1801-0938
New Perspectives on Political Economy
Volume 5, Number 2, 2009, pp. 81 – 109
The Financial Pathology of the Postwar American Welfare
State
James Rolph Edwards
JEL Classiﬁcation: E51, E58, I38, P16
Abstract: Chronic inﬂation in the U.S. is a post World War II phenomenon. Particularly
puzzling is the period of accelerating inﬂation after 1964 and the rapid deceleration
after 1981. Arguably, inﬂation was employed to solve certain problems of ﬁnance
faced by political authorities beneﬁting from the expanding welfare state. Those solutions
depended on certain deceptions of the public, however. In particular, successful
vote maximization through redistributive politics required (1) taxing and raising
taxes surreptitiously through inﬂation to hide the costs of the subsidies, (2) covert inﬂationary
repudiation of much of the accumulating federal debt that was also being
employed to hide the costs of redistribution, and (3) the successful use of inﬂation to
reduce the disemployment eﬀects of pro-union laws and income transfers. Accomplishing
these things required accelerating inﬂation. Inﬂation stopped accomplishing
its intended functions over the 1970s, however, because the public’s expectations of
inﬂation became more accurate despite its acceleration, and certain costs of inﬂation
rose. Thus the marginal beneﬁts of inﬂationary policy to the governmental partisans
of the welfare state fell below the marginal political costs, making a lower inﬂation
rate optimal. This endogenous theory of monetary policy and inﬂation behavior may
be termed the “political neutralization hypothesis”.
Professor of Economics, Montana State University-Northern, Montana, United States, 59501,
edwardsj@msun.edu.
82 New Perspectives on Political Economy
1 Introduction
… By a continuing process of inﬂation, governments can conﬁscate, secretly
and unobserved, an important part of the wealth of their citizens. By this method
they not only conﬁscate, but they conﬁscate arbitrarily; and, while the process
impoverishes many, it actually enriches some.
John Maynard Keynes, The Economic Consequences of the Peace (1988, p. 235)
Most of us now breathing have lived with inﬂation – chronically rising prices yielding
an ongoing decline in the value of money – all of our lives. Yet chronic peacetime
inﬂation in the U.S. is an unusual historic experience, largely limited to the post World
War II period. The United States was a developed, industrial nation long before World
War II. Indeed, by 1910 it had already become the greatest industrial nation on earth
despite experiencing nearly 35 years of deﬂation following the Civil War. So there is
nothing inherent in a modern industrial society that requires ongoing diminishment
in the value of money. Clearly some crucial determinants of the price level and value
of money changed during or before World War II and have since acted to make price
level behavior depart from previous U.S. experience. Not only does the existence of
inﬂation in the post war period of the 20th century require explanation, so does its
pattern, shown in Figure 1. The rate of inﬂation, measured there by the GNP Deﬂator
index through 1990 and the GDP deﬂator after, was positive but relatively stable, even
falling slightly into the mid 1960s. Then inﬂation accelerated over the period 1964-
1981, known as the “Great Inﬂation”, after which it declined rapidly for several years,
before rising a bit in the late 1980s and then declining more slowly in the 1990s.
One prominent factor many analysts employ to explain much of the Great Inﬂation
is the OPEC oil price increase associated with the Ramadan/Yom Kippur War
of 1973. By raising the prices of everything made from crude oil, such as gasoline,
plastics, and heating fuels, and by thus also raising transport costs and reducing supplies
of nearly every good, this cost increase certainly pushed the price level up in
a relatively short period. That accounts for the ﬁrst of the two price spikes of the
Great Inﬂation. Note, however, that the inﬂation rate had been rising for over seven
years before the Yom Kippur War. Also note that such a unique supply shock, though
it shows up as an increase in the inﬂation rate, only shows up as a temporary rise in
Edwards: The Financial Pathology of the Postwar American Welfare State 83
that rate, because it actually generates only a discrete jump in the price level. It would
take a repeated sequence of such cost-pushes and supply declines to generate ongoing
price increases. In fact, a sequence of negative sectoral supply shocks occurred
which constitute part of the story, but they had nothing to do with oil. The eﬀect of
the oil price spike on inﬂation was completely gone by 1976, after which the inﬂation
rate continued rising, actually slightly below its prior trend. The Great Inﬂation is
not the story of the oil price shock, even if one adds in the second, smaller oil shock
associated with the Iranian revolution of 1979. Something much more fundamental
was occurring.
The basic nature of inﬂation has been understood for a long time. Inﬂation is a
monetary phenomenon (Friedman, 1956 and 1970, Patinkin, 1965). In the long-run
the rate of inﬂation (or deﬂation) will equal the diﬀerence between the growth rates
of the nominal money stock and real balances demanded, though in the short-run
signiﬁcant deviations occur. Since the end of the gold standard in the Great Depression,
and particularly since the 1951 Treasury accord releasing the Fed from Treasury
department control, the Federal reserve has gained discretionary control over
the monetary base, and hence (within certain short-term limits resulting from outside
inﬂuences on the money multiplier) the level and growth of the nominal money
stock (Timberlake, 1984). The basic question of why inﬂation has been chronic in the
postwar period then becomes one of what has motivated the monetary authorities to
84 New Perspectives on Political Economy
engage in chronic excess money growth. In particular we need to discover what motivated
them to accelerate money growth and inﬂation from 1965 through the late ‘70s,
and what changed to cause the subsequent rapid decline in inﬂation and its apparent
stabilization at low levels.
Of course there has been no great lack of research into the causes of persistent inﬂation.
The most inﬂuential theory currently was developed by Kydland and Prescott
(1977). They were awarded the Nobel Prize in economics in 2004 for their work. Assuming
the monetary authorities were altruistically concerned with keeping unemployment
low, which required generating more rapid inﬂation than the public expects,
and that the public preferred not being fooled, they explained chronic inﬂation
– without lower than normal unemployment – as the suboptimal outcome of a “prisoner’s
dilemma” faced by the public and the Fed. While astute and insightful, their
argument did not explain the accelerating pattern of inﬂation after 1964, nor predict
or explain the deceleration that occurred after 1981. And while simplicity is often a
virtue, their “social welfare function” approach ignored variables that might be crucial
in explaining the behavior of the Fed and the consequent postwar inﬂation pattern,
such as institutional incentives inherent in the structure of the Fed, self-interests that
Fed decision makers may have, pressures from legislators and presidents to accommodate
social policies, and changes in macroeconomic theory.
What Thomas Sargent (2003) calls the “Berkeley Story”, developed by Delong
(1997) and reﬁned by Romer and Romer (2003), is that the inﬂation acceleration of
1964-1981 and subsequent disinﬂation was due to the Fed authorities having a correct
macro model in the 1950s, forgetting or losing it in the 1960s and 1970s, with
resulting inﬂationary policy, and regaining that knowledge in the 1980s. Though it
contains important kernels of truth, there are obvious problems with this view. First,
it provides no explanation for chronic post war inﬂation at all, merely for the acceleration
after 1964. Second, its adherents have provided little, if any, explanation of
why or how knowledge at the Fed was lost and regained. Third, the story assumes
that Fed decision makers are reliably immune or insensitive to any political pressures
or personal interests. This view of powerful government appointees in control of the
nation’s money and credit seems naive at best, and Arthur Burns, at least, admitted
that it was not so.
Edwards: The Financial Pathology of the Postwar American Welfare State 85
Thomas Mayer (1998), who interviewed many members of the FOMC from the
period, developed an explanation of the Great Inﬂation similar to the Berkeley Story.
In his view various characteristics of FOMC behavior and decision making that he
terms “cognitive errors” gave policy an inﬂationary bias. Some of these he claims to
have been rooted in the nature of committee decision-making. Thus procrastination
in the making of painful (i.e. anti-inﬂationary) decisions aided the rise of inﬂation
rates. He says both Martin and Burns had no use for formal econometric models, and
operated with vague conceptions of how changes in money and credit aﬀected output
and employment. Likewise, the FOMC overemphasized the short-run eﬀects of
policy actions, had little understanding of the diﬀerence between real and nominal
interest rates, underestimated the lags in eﬀects of policy on output and employment
until well into the 1970s, and so on. Mayer’s explanation of why these institutional
and human problems had more inﬂationary eﬀect after 1964 than before appears to
be that they were aggravated by advice from economists based on Phillips curve reasoning
(Mayer, 1998, pp. 95-104). As for political factors, Mayer speciﬁcally denies
that pressures from the executive or legislative branches were crucial. In his view,
it was all a result of cognitive mistakes by well-intended oﬃcials, repeated over and
over for more than a dozen years.
In an early attempt to escape the social welfare function approach, Cukierman
(1986), working with Allan Meltzer, formally recognized that the Fed receives pressures
from the president, congress, and the ﬁnancial community that aﬀect its behavior.
In their model, Fed preferences at the margin for economic stimulation versus
inﬂation prevention shift randomly (though with some persistence) through time as
the coalitions and relative strength of pressure groups change. This allowed Cukierman
and Meltzer to explain many features of central bank behavior, including the
existence of large swings in money growth and inﬂation. Note, however, that making
the balance of Fed preferences for economic stimulation versus inﬂation prevention
a random variable involves foregoing any eﬀort to explain its value at any particular
time in terms of the speciﬁc pressures existing at that time. It leaves unexplained the
factors changing the composition of pressures on the Fed, particularly in terms of the
consequences of inﬂation itself. It is precisely the explanation of such factors in the
historic period under discussion at which the present, less formal paper, is aimed.
86 New Perspectives on Political Economy
2 Redistributive Politics and Political Neutralization
That Fed independence gave it some institutional bias towards positive money growth
can be seen by recognizing that all of its expenses, including the salaries and perquisites
of its employees, are paid for by interest earned from loans it makes to and
securities it purchases from the banking system, with base money it creates at zero
cost. Such seignorage may not imply an inﬂationary bias in monetary policy, however,
because growth in the money stock equal to the growth of real balances demanded in
a growing economy would probably supply suﬃcient revenue to the Fed to satisfy the
monetary authorities at zero inﬂation. Additional pressures must exist to account for
chronic excess money growth and inﬂation.
While the Fed is a quasi-independent agency, it is certainly a governmental entity
that receives pressures, both from presidents and from members of congress, to conduct
monetary policy in ways they desire (Kane, 1982). Grier (1991, 1996) has shown
statistically that the money growth rate over the period 1958-1984 was positively related
to the degree of (welfare) liberalism of the relevant committee and subcommittee
chairs in the Senate. The appointed monetary authorities in the Fed are more
likely to bow to those political pressures the more uniform they are, in particular if
both the president and congress want expansionary policy. They are also more likely
to yield if the policy advice they get from economists reinforces the political pressures,
as was often the case during the Great Inﬂation. Indeed, Mayer (1998) notes
that by 1970 many members of the FOMC were themselves professional economists.
The ﬁrst key argument of this paper is that the pressures for excess money growth
and inﬂation stemmed from motives and incentives of political authorities inherent in
the rise and expansion of redistributive politics in the postwar period, particularly, under
Presidents Johnson, Nixon, Ford, and Carter. Inﬂation in America is thus the
ﬁnancial pathology of the welfare state, as Arthur Burns (1979, 12-16) clearly understood.
However, inﬂation could aid the expansion of the welfare state only as long as
the public underestimated the temporal rate of price increase. The Fed extended that
period by causing the inﬂation rate to accelerate. Eventually, however, the inﬂation
expectations of the public became more accurate despite its acceleration. The second
key argument of this paper is that this neutralized not only the economic eﬀects
Edwards: The Financial Pathology of the Postwar American Welfare State 87
of inﬂation, but also most of the political beneﬁts to the architects of that policy tool.
I term this the “political neutralization hypothesis”.
One possible objection to the perspective of this paper is the similarity of the
inﬂation patterns in other major democracies of the world in the post-war period,
before, during, and since the great U.S. inﬂation, suggesting some broader, international
force at work than just surreptitious ﬁnance of the expanding U.S. welfare state.
In fact, though, there is no mystery here. The U.S. was the key currency country in
the Bretton Woods system, so the U.S. dollar was held as international reserves by all
central banks, and exchange rates were pegged by central bank intervention. When
the U.S. began its accelerating monetary expansion after 1965 to ﬁnance its expanding
War On Poverty income redistributions, and inﬂation accelerated, other nations had
to buy dollars and expand their own money supplies at similar rates to maintain their
agreed-upon exchange rate pegs. It is no exaggeration to say that our federal reserve
was driving the monetary policies of the entire democratic world, a fact about which
foreign politicians and central bankers (particularly the Germans and the French)
complained bitterly and repeatedly at the time.
Perhaps they complained too much. After all, they too continued inﬂating into
the ﬂoating rate period after 1972, when Nixon closed the Gold window at the Fed.
Arthur Burns (1979, 14-15) has explained this well, however. The same ideological attitudes
generating expanding welfare states, regulation, and other costly government
interventions here were also operating in those nations, generating the same ﬁnancial
solutions and political pressures for monetary accommodation. To this insight
it is only necessary to add, in explanation of the later correlated decline of inﬂation
rates in the U.S. and other nations, that similar processes of government inﬂationary
policy neutralization operated in virtually all democratic nations.
2.1 Inﬂationary Finance of Income Transfers
Since time immemorial, the major source of inﬂation has been the sovereign’s
attempt to acquire resources to wage war, construct monuments, or for other
purposes. Inﬂation has been irresistibly attractive to sovereigns because it is a
hidden tax that at ﬁrst appears painless or even pleasant, and above all, because
88 New Perspectives on Political Economy
it is a tax that can be imposed without speciﬁc legislation. It is truly taxation
without representation.
Milton Friedman, “Monetary Correction,” (1978, p. 27)
Pubic choice theory has fairly well delineated the nature of politics in modern democratic
states with wide franchises (Buchanan and Wagner, 1977). Politicians compete
with each other to gain and retain oﬃce by oﬀering alternative programs of expenditure
and ﬁnance aimed at satisfying diverse constituencies and interest groups in
such a way as to obtain the maximum number of votes possible. Since at least the
Roosevelt administration, and particularly since Lyndon Johnson was elected in 1964,
the expenditure side of electoral competition has increasingly involved oﬀering programs
of targeted income transfers. Those beneﬁting from such programs – including
their administrative bureaucracies – engage in organized lobbying to support their
continuance and expansion.
It is important to remember that in the U.S. most transfer payments shift income
sideways, from unorganized to organized members of the middle class, rather than
from rich to poor. Some is even redistributed upwards through business subsidies.
Virtually all tax revenue is also extracted from the middle and upper classes. Because
no gain can be made by anyone whose tax payment to provide such transfers equals
or exceeds their subsidy, the recipients have an incentive to resist the taxation in an
eﬀort to insure that they are net beneﬁciaries. Those who are not recipients, and may
even oppose such subsidies, have an even stronger incentive to oppose the taxation
required to fund such programs.
As a consequence of the combination of strong, organized, and expanding demand
for income transfers and persistent opposition to the explicit taxation required
to fund them, the incentive faced by political agents has been to oﬀer and vote for
the expenditures, but not to vote for explicit tax increases (or at least for as few as
possible). Instead, much of the revenue required to cover the expenditures came to
be acquired through deﬁcit ﬁnance, deferring the necessary taxation forward in time
past the next election. That was only a short-term solution, however, since interest
and principle on bonds must be paid. That implies future taxation, with its electoral
costs. To avoid or at least minimize such costs, the authorities began pressuring the
Edwards: The Financial Pathology of the Postwar American Welfare State 89
Fed to monetize debt and otherwise use monetary expansion and consequent inﬂation
to tax and raise tax rates surreptitiously.¹
Though the public is largely unaware of it, economists – and many federal politicians
– have long understood that inﬂation is itself a tax on the cash balances people
hold (Bailey, 1956, Johnson, 1967, Friedman, 1971). Money held loses purchasing
power as prices rise. As members of the public forego some current purchases and
add to their nominal cash balances in an eﬀort to maintain their desired real balances,
purchasing power is literally transferred from them to the government. Milton Friedman
(1978) estimated that revenue generated for the government directly through
money creation in 1973 amounted to $8 billion, equivalent to approximately 3.5 percent
of its receipts that year.
Even better from the perspective of elected federal oﬃcials, absent an indexation
provision in the progressive tax code, inﬂation causes income tax rates to rise without
a public vote, by causing nominal incomes to rise through the progressive tax brackets,
in a process commonly known as bracket creep. In addition, it generates artiﬁcial
capital gains on ﬁnancial assets on which taxes must be paid, and makes legally
allowed depreciation allowances inadequate to replace business capital assets, thus
decreasing real cash ﬂow of ﬁrms while increasing real taxes paid (Edwards, 1991, pp.
376-377). Again, this happens without a legislative vote from which those in favor can
be identiﬁed by the public.
These covert methods of taxing and raising taxes lowered the political costs of income
transfers for leftist legislators. Friedman (1978) estimated that in 1973 inﬂation
generated $13 billion in added revenue for the federal government from the corporate
income tax alone. That was over 5.6 percent of receipts that year. He was apparently
unable to obtain an estimate of personal income tax revenue added by bracket creep,
but it must certainly have been many billions of dollars, so that the sum of revenue
raised from seignorage, income tax bracket creep, taxation of phantom capital gains
and understated business depreciation must have exceeded 10 percent of federal receipts
that year.
¹ Thornton (1984) demonstrated empirically that the Federal Reserve monetized debt in this period,
and found that it apparently stopped doing so when interest rate targeting ended and monetary targeting
began in 1979. through money creation in 1973 amounted to $8 billion, equivalent to approximately
3.5 percent of its receipts that year.
90 New Perspectives on Political Economy
Given these political incentives it is no accident that, as the welfare state expanded
in the 1960s and 1970s, the federal budget went into chronic, expanding deﬁcits, rising
even as a percent of gross domestic product, and the inﬂation rate rose. For the political
authorities to gain and maintain public acceptance of the expanding welfare state
required hiding its costs. Figure 2 shows, along with the inﬂation rate, income transfer
payments as a percent of total federal expenditures (TrP%FedGovEx) from 1965
to 1990. It is easily seen that the periods of accelerating inﬂation rates and proportionately
rising transfer payments correspond closely, and that when TrP%FedGovEx
stopped rising, then began leveling oﬀ and drifting downward, so did inﬂation rates.
It should also be added, to preempt an alternate hypothesis, that Vietnam War ﬁnance
had nothing to do with the Great Inﬂation. Military spending, as a fraction
of either total federal spending or of GDP, began declining in the late 1960s and had a
strongly inverse correlation with inﬂation rates over this entire period, in stark contrast
to TrP%FedGovEx.
The two processes for hiding the costs of compulsory income redistribution – federal
deﬁcits and inﬂation – were correlated in part because of the costs associated
with the alternative mode of deﬁcit ﬁnance. The government must borrow money to
spend in excess of revenue it raises through open taxation, and it can do so by selling
its bonds to private parties. In a period of rising deﬁcits, however, the resulting increased
competition for a limited supply of savings may raise interest rates, crowd out
Edwards: The Financial Pathology of the Postwar American Welfare State 91
some private sector investment and hurt the housing and capital goods industries. To
avoid political fallout from this, the Treasury monetized a signiﬁcant fraction of its
current deﬁcits (additions to the debt) by selling the bonds to the Federal Reserve. As
the government spent the money and people deposited the checks this added to bank
reserves, increasing the monetary base and the growth rate of money and credit. Such
debt monetization, along with open market purchases by the Fed from the banking
system, tended initially to cause interest rates to fall through the “liquidity eﬀect”, or
at least to stay constant, instead of rising, as federal deﬁcits and debt expanded.²
Of course there were and are long-term counter eﬀects, which the politicians
and monetary authorities may not have initially recognized. Rising nominal income,
resulting from the monetary expansion increases credit demand and pressures the
nominal interest rate to rise again to its natural rate over time (Friedman, 1968). In
addition, changes in expected rates of inﬂation motivate credit market transactors to
² The argument here may be thought to beg the question of Ricardian Equivalence, which would prevent
interest rates from rising as the deﬁcit increased (Barro, 1974). But if future tax obligations
generated by current added debt in lieu of added current taxation are fully discounted, and seen by
present taxpayers as having the same present value, it seems obvious that the political costs to the
politicians would be the same, and they would have identical incentives to avoid those costs through
debt monetization.
92 New Perspectives on Political Economy
build compensating premiums into nominal interest rates (the Fisher Eﬀect). Here
again, expansionary monetary policy causes nominal interest rates to eventually rise.
Due to interest rate ceilings the Fed had imposed on bank deposits in its regulatory
capacity, however, and by the use of accelerating money growth, causing additional
liquidity eﬀects to oﬀset the income and Fisher eﬀects, the monetary and political
authorities were able for some time to keep real interest rates artiﬁcially low, and pay
government bondholders oﬀ in depreciated dollars. Arguably, by this process the federal
authorities surreptitiously repudiated virtually all of the added federal government
debt, and thus redistributed income from federal bondholders to subsidy recipients.
As ﬁgure 3 shows, real federal debt stayed almost constant for a decade and a half
as inﬂation accelerated, even though both the annual budget deﬁcits and the nominal
national debt increased enormously. Milton Friedman’s (1978) estimate for 1973 was
that the federal government realized the equivalent of $5 billion in revenue from that
source alone. That was just less than 2.2 percent of Federal receipts that year, raising
the government’s total revenue gains from inﬂation in 1973, at a very conservative
estimate, to over 12 percent of its receipts.
2.2 Redistributive Labor Policy as an Inﬂation Motive
If the Federal Reserve then sought to create a monetary environment that
fell seriously short of accommodating the upward pressures on prices that were
being released or reinforced by governmental action … the Federal Reserve would
be frustrating the will of Congress to which it was responsible – a Congress that
was intent on providing additional services to the electorate and on assuring that
jobs and incomes were maintained particularly in the short run.
Arthur F. Burns, Chairman of the Federal Reserve Board, 1970-1979, in The
Anguish of Central Banking (1979, p. 16)
A third important motive for the policy of chronic and accelerating inﬂation – in addition
to surreptitious taxation and debt repudiation – has to do with the labor policy
favored by the proponents of the welfare state. Not all redistributive political policy
involves targeted income transfers. Many legislative programs aim at altering market
Edwards: The Financial Pathology of the Postwar American Welfare State 93
outcomes and redistributing income by other means. Because of certain widespread
public attitudes about the supposedly superior bargaining power and exploitative
character of employers, many political agents have found that large campaign contributions
and bloc votes could be obtained through legislation to raise the minimum
wage and increase the strength and bargaining power of unions. Such legislation, it
should be noted, aims at redistributing incomes directly rather than through taxation
and subsidies. It should also be noted that such legislation stems from the exact same
ideological mindset as do policies of ﬁscal redistribution.
Unfortunately for those instituting such labor legislation, it has some harmful
side eﬀects. A major one is the downward nominal wage and price rigidity that is created
by minimum wage laws and widespread union contracts. In a recession induced
by, say, a discrete decline in the nominal money stock, a suﬃcient fall in the price
level over time will raise the real money stock, thus restoring purchasing power, and
tending to oﬀset the contractionary eﬀect on business activity. However, initially,
such a price level decline will raise the aggregate real wage to unemployable levels,
reducing employer proﬁt margins and adding to the contraction (Bordo et al., 2000).
With a lag, however, unemployment will cause nominal wage rates to fall, reducing
the real wage back to employable levels and allowing the recession to end. When
such downward nominal wage adjustments are prevented by bad governmental labor
policy, however, ongoing inﬂation becomes an absolutely necessary concomitant
of such policy, because only through diﬀerences in the relative magnitudes of wage and
price inﬂation (and nominal money growth) rates can the required, stabilizing adjustments
in real wage rates and real money balances occur. This third key argument may
be termed the ﬁrst-diﬀerence hypothesis, and regarded as the central explanation for
chronic inﬂation in the post-war period.
A related though subsidiary reason redistributive labor policy led to inﬂation,
however, has to do with its initial disemployment eﬀects. While legislation and executive
branch policies raising the minimum wage and/or increasing union strength
may redistribute income from owners of ﬁrms to union employees and low wage
workers retaining their employment, as intended, it also generates cost pushes which,
partly passed on to prices, both hurt consumers and generate disemployment among
the very employee groups the legislation intends to help, thus raising the natural rate
94 New Perspectives on Political Economy
of unemployment.³ In this situation, the temptation faced by political authorities
unwilling to admit the cause of the added unemployment, and determined to avoid
its occurrence, is to pressure the monetary authorities for monetary expansion to
“validate” the cost pushes.
This was a signiﬁcant factor in the “Great Inﬂation”. Linneman and Wachter
(1986) found large increases in union wage premiums resulting in signiﬁcant declines
in union employment between 1973 and 1984. Even earlier, in 1971, Arthur
Burns made repeated public statements criticizing excessive union wage settlements
(Schmidt, 1973, pp. 97-98). Burns also admitted, in the statement quoted above, not
only both the existence of wage and welfare state ﬁnancing pressures on prices, but
that as Chairman of the Federal Reserve he had been unwilling, or at least unable, to
resist monetarily accommodating such pressures.
The pressure on the monetary authorities, such as William McChesney Martin,
and after him Arthur Burns and the other members of the FOMC, to accommodate
the political authorities as they expanded income transfers through subsidies
and labor legislation, was initially strengthened by the dominant Keynesian macroeconomics
of the day. The Keynesian emphasis on aggregate demand management
through ﬁscal and monetary policy was originally thought to show that unemployment
could be kept minimal – even eliminated entirely – by suﬃcient aggregate demand
without generating inﬂation. Speciﬁcally, the price level was assumed not to
rise until full employment was reached (Keynes, 1936). When that turned out not to
be true in the 1950s, and inﬂation, though low, became chronic, Keynesians adopted
the Phillips curve argument, that some inﬂation was beneﬁcial because the unemployment
rate was an inverse function of the inﬂation rate (Samuelson and Solow,
1960). If true, unemployment could be set as low as desired by simply generating
the required inﬂation rate. Indeed, the theory had signiﬁcant empirical support as
late as 1970. With a lag, this view heavily inﬂuenced the ﬁscal decision makers of
administrations in the 1960s, as Romer and Romer (2003, pp. 20-22) have shown.
³ Phillip Cagan (1979) estimated that unions and minimum wage laws accounted for about one-half of
a percentage point out of the natural unemployment rate, or about 16 percent of total unemployment.
In 1978, that would have amounted to approximately one million household providers.
Edwards: The Financial Pathology of the Postwar American Welfare State 95
2.3 The Welfare State and the Post War Inﬂation
In this kind of perspective, the question is whether inﬂation will indeed become
endemic and whether it will lead to basic social change… In the longer
run it depends on the willingness of society to retreat from the welfare state towards
less government taxation and expenditure and more private control over
and private responsibility for the spending of income created by private eﬀort.
Harry Johnson “Living With Inﬂation,” The Banker (August 1975, p. 864)
At this point an answer can be given to the initial question posed at the beginning
of this paper: the chronic inﬂation of the postwar period has essentially been an
outcome of the demand for and supply of income transfers through the democratic
political system. The incentives for deﬁcit ﬁnance and rapid money growth inherent
in the provision of compulsory income transfers through democratic politics are
a central element in this explanation, though public attitudinal changes should also
be stressed. Before the Great Depression, widespread public and political elite acceptance
of the classical liberal perspective on limited government, as well as of the
Protestant ethic of frugality and personal responsibility, kept both the demand for
and supply of public income transfers low.⁴ Demand for income transfers increased
from desperation during the Depression, and increased more during the 1960s, as
many people accepted the perspective, propagated by the left intelligentsia, that corporate
exploitation of workers is pervasive, and that it is a proper function of government
to insure citizens against every imaginable detrimental contingency. This
shift in opinion resulted in the election of President Lyndon Johnson in 1964, and the
subsequent rapid expansion of income transfers.
Attitudinal changes also aﬀected supply, and here is where the Berkeley story of
the Fed losing and then regaining knowledge necessary for inﬂation control has at
⁴ American leaders from James Madison in 1794 to Grover Cleveland in the 1890s made repeated statements
denying both the constitutional authority of Congress to legislatively redistribute income (or
wealth) and the morality of such acts. In Calder vs. Bull (1798) Justice Chase of the U.S. Supreme
Court pronounced such laws “against reason and justice,” and said, “the genius, the nature, and the
spirit of our state governments, amount to a prohibition of such acts of legislation, and the general
principles of law and reason forbid them.” Attitudes changed, and state legislatures began undertaking
such acts on a small scale in the late 19th century, particularly for the relief of widows. Until the
Great Depression most poor relief was, however, provided by kin or by private charities.
96 New Perspectives on Political Economy
least some relevance. The emerging dominance of redistributionist – and associated
inﬂationist – views by the elites was aided by Keynesian economics, which removed
the attitudinal constraints against both the budget deﬁcits and the monetary expansion
needed to fund income transfers (Buchanan and Wagner, 1977). In addition, with
its presumption of downwardly inﬂexible wages and prices at output rates below full
employment, such that the level of aggregate demand was all that determined the
level of output and employment, Keynesianism led politicians and Federal Reserve
oﬃcials to believe that any existing unemployment could be reduced without causing
prices to rise by simply expanding aggregate demand. And when inﬂation became
chronic despite unemployment, Phillips curve reasoning provided them with a rationale
for continuing and even increasing excess money growth and inﬂation.
In the late 1960s and 1970s, the propagation of Monetarist doctrines by Milton
Friedman and others began to threaten support for inﬂationary policies, however.
Friedman’s rejuvenation of the quantity theory of money had already made clear
the monetary nature of inﬂation. Development by Bailey (1965), Johnson (1967),
and Friedman (1971) of a clear concept of inﬂation as a tax on cash balances, literally
shifting purchasing power from the public to the government without vote of
elected representatives, threatened to remove public misconception on that score.
Perhaps most important, Friedman’s (1968) concept of the natural rate of unemployment,
developed in his famous 1967 presidential address to the AEA, created doubts
among economists and open minded political authorities about the power of monetary
policy to manipulate unemployment (Friedman, 1968). His argument, in the
same article, that inﬂation could only reduce unemployment below the natural rate
by reducing the real wage, and then only until worker expectations adjusted to the
higher inﬂation rate, began to spread recognition that inﬂationary reductions in unemployment
might be temporary, not permanent, and operated through deception of
the public.
The eﬀect of these theoretical innovations on politicians and policy was initially
limited, however. Many redistributionist politicians seem to have viewed the deceptions
required by their policies as morally justiﬁed. The notion that people must be
forced to do what is “in their own best interest” inheres in the welfare state philosophy.
It is often employed in defense of compulsory social security, just to list one
Edwards: The Financial Pathology of the Postwar American Welfare State 97
prominent example (Tobin, 1988). This notion easily justiﬁed mere deception in the
ﬁnance of such programs.⁵ The egalitarian aspects of the welfare philosophy also easily
justiﬁed the covert, inﬂationary expropriation of lenders, who were perceived as
being wealthy.
Economists of the day, at the FOMC and in academia, were certainly aware of
these eﬀects. Indeed, when the author of this paper took his ﬁrst course in Macroeconomics
at the University of Utah in 1976, the Professor, a staunch Keynesian, not
only clearly explained the distinction between real and nominal interest rates, but
explained how inﬂationary reductions of real interest rates lowered the cost of government
debt ﬁnance and redistributed income from government bondholders to
subsidy recipients. Additionally, he made clear his glee at such policy action. Disregarding
the questionable morality of this perspective, which was typical (though not
universal) among the economists at that institution, his only intellectual error was in
underestimating the intelligence of government bondholders and other private citizens
while overestimating that of politicians and Federal Reserve authorities. That
error was shared by the FOMC.
3 The Political Economy of the Disinﬂation
A political economy theory of inﬂation must provide insights not only into why a
policy of enduring inﬂation has been followed in the postwar period, and why it accelerated
after 1964, but also help explain why the inﬂation rate fell precipitously
after 1980, eventually drifting down and stabilizing at comparatively low levels. One
might attribute the rapid decline of inﬂation in the early 1980s to the anti-inﬂationary
attitudes of the Reagan administration, and certainly that was a factor. Political disenchantment
with inﬂationary policy began earlier, however, and came in the form
of a change in the incentives faced by politicians relying on a policy based on deception.
The crucial insight is that, in fundamental ways, critical elements of the public
⁵ The term “deceptions” as used here has connotations both of the public miss-estimation of simple
variables such as the inﬂation rate and what public choice economists have referred to as “ﬁscal illusions”,
i.e. voter underestimates of the costs of government due to such things as complex or hidden
tax systems (the tax on cash balances being the quintessential example), to the extent that such errors
have been deliberately induced by political authorities.
98 New Perspectives on Political Economy
stopped being deceived, and/or responded to chronic, accelerating inﬂation in ways
that diminished the political incentives for inﬂationary policy.
First, inﬂation could only be used to reduce real wages from excessive levels generated
by legal minimum-wage increases, union violence, strike threats, and pro-union
government interventions, and hence keep the unemployment rate down to politically
acceptable levels, as long as workers were subject to money illusion (or at least
underestimated the current and prospective inﬂation rates). Naive Keynesian Phillips
curve theory implicitly assumed worker money illusion. Monetarists rejected this,
and Friedman’s famous presidential paper (1968) bravely predicted that worker expectations
adjustments would, over time, make the long-run Phillips curve vertical.
Some Monetarists, however, in a doctrine known as accelerationism, argued that,
given adaptive expectations, the inﬂation expectation of the public would chronically
lag the actual rate, and the government could peg unemployment below the natural
rate if it was willing to cause inﬂation to accelerate continuously (Laidler, 1976).⁶
Whether acting on this or more naive Phillips curve reasoning, public authorities
faced in the late 1960s with the neutralization of their policy by expectations adjustment
responded by causing excess money growth and inﬂation to accelerate. By the
⁶ The accelerationists were not advocating unemployment rate pegging, however. Quite the opposite,
their point was precisely to show that the costs of doing so would be excessive.
Edwards: The Financial Pathology of the Postwar American Welfare State 99
early 1970s, however, workers were able to anticipate even accelerating inﬂation and
raise wage rates enough to compensate in advance. The inverse “Phillips Curve” relation
between inﬂation and unemployment went away, just as Milton Friedman had
predicted. Thus the 1970s were characterized by both high (and rising) inﬂation rates
and high unemployment rates, contrary to the experience of the 1950s and ‘60s and
contrary to both Keynesian and accelerationist theoretical predictions. As a political
tool for reducing the disemployment costs of redistributionist labor policies, inﬂation
had stopped working. Workers themselves sensed this, and their political allegiances
began to shift marginally against redistributionist politicians. Previously strongly
Democrat in their party aﬃliation, many blue collar workers voted for Ronald Reagan
for president in 1980.
3.1 Neutralization of the Debt Repudiation Incentive
The story with debt repudiation through inﬂation is very similar to that of unemployment
reduction. Inﬂation could only be used to reduce the real interest rate and
repudiate debt as long as public inﬂation expectations lagged actual inﬂation rates,
and transactors continued to suﬀer interest rate ceilings and conﬁscatory taxation
on ﬁnancial earnings. There is no reason to believe that sophisticated ﬁnancial market
transactors could be or were fooled much longer than workers. The operation of
the Fisher eﬀect, as such transactors built purchasing power premiums into nominal
interest rates based on their inﬂation expectations, is shown in ﬁgure 4, which
relates annual observations of GDP deﬂator inﬂation rates and prime bank lending
rates from 1965 to 1980. A simple regression line is included which shows a slope coeﬃcient
of .929 on the inﬂation rate over the period, a virtually complete adjustment
of the nominal rate to inﬂation. However, a regression over the 1965-1976 sub-period
has a much lower slope coeﬃcient on the inﬂation rate. Rising Inﬂation reduced the
real interest rate substantially in that period.
The incomplete adjustment of the nominal rate to inﬂation over much of the period
may not have been entirely due to a public underestimation of inﬂation, but also
to the Fed’s interest rate ceilings on time deposits. By the mid to late 1970s, however,
those ceilings were causing signiﬁcant distortions of the market. Banks were
100 New Perspectives on Political Economy
experiencing heavy loss of deposits as customers faced with negative real interest
rates on their deposits, made worse by federal and state taxation of their nominal interest
earnings, sought alternate liquid ﬁnancial instruments not subject to ceilings,
and non-depository ﬁnancial institutions supplied such instruments. This arbitrage,
however, tended to bid up the prices on alternate ﬁnancial assets and reduce their
rates and yields also.
Even worse from the perspective of Federal Reserve oﬃcials, when, after 1973, the
annual inﬂation rate exceeded six percent, the ﬁxed nominal interest rates paid to
member banks on their stock in the district Federal Reserve banks became negative
in real terms, and many commercial banks began to leave the system, taking their
reserve deposits with them. Astonishingly, DeLong (1997), Mayer (1998), and Romer
and Romer (2003), in their discussions of and explanations for the inﬂation pattern
of this period, all ignore these events, blotting this massive disintermediation completely
from their historical narratives. They apparently believe it had no eﬀect on
the thinking or actions of the FOMC. In fact, the eﬀect was enormous, on both the
monetary and political oﬃcials.
In a near panic as the monetary authorities realized that the marginal cost to
them of their inﬂationary policy had become much higher than they had previously
anticipated, the FOMC, under the leadership of Paul Volker, just appointed Chairman
of the Federal Reserve Board, raised its interest rate targets and started slowing money
growth in October of 1979. In addition the Fed supported, and congress passed, the
Depository Institutions Deregulation and Monetary Control Act of 1980. The Act
removed regulation Q ceilings on bank deposit interest rates and forced all banks to
hold reserve deposits with their regional Federal Reserve Bank (Timberlake, 1985).
The capacity of the political and monetary authorities to suppress real interest rates
and repudiate debt through inﬂation was gone, actually lost as early as 1977, as ﬁgure
3 shows. Gone with it was much of the political incentive for rapid and accelerating
inﬂation.
3.2 Neutralization of the Seignorage Incentive
As with unemployment rate reduction and debt repudiation, the use of inﬂation to
covertly tax and raise taxes also began reaching its limits in the mid to late 1970s. The
Edwards: The Financial Pathology of the Postwar American Welfare State 101
basic theoretical principle here, elaborated by the supply-side economists of the day,
is that while the revenue from a tax is the product of the rate and the base, the base
itself is negatively aﬀected by the rate, ceteris paribus. As any tax rate rises from a low
initial level, its eﬀects on the base will be relatively small, and revenue will rise. But
at a high level, the tax base will begin to diminish more than in proportion to the rise
in the rate, so that revenue actually begins declining. For the tax on cash balances,
the revenue is the product of the inﬂation rate and the quantity of real balances held.
The inﬂation rate expected, however, negatively aﬀects the demand for real balances,
so that the quantity demanded falls as the estimated inﬂation rate rises.
Figure 5 shows the “Laﬀer” (revenue) curve for the tax on cash balances, measuring
real balances demanded and held on the horizontal axis, and the inﬂation rate
and expected inﬂation (α and α*) on the vertical, assuming expectations are correct.
Assuming for simplicity that the inverse relationship between inﬂation and real balances
demanded is linear, there is a total revenue curve which rises as the tax (inﬂation)
rate rises over the inelastic region of the demand function, reaches its maximum
where the elasticity of demand for real balances with respect to inﬂation is unity at
one-half the distance from zero to point x on the horizontal axis, and falls again as the
102 New Perspectives on Political Economy
inﬂation rate continues rising over the elastic region of the demand function (Johnson,
1967). This is shown in the lower of the two graphs composing ﬁgure 5. The
acceptance of such supply-side arguments by the Democrats in congress some years
before their adoption by Republicans, is strong indication that something was forcing
both economists and members of congress to recognize the existence of limits
to their inﬂationary tax policy. Paul Craig Roberts (2002) has stressed the origins of
supply-side analysis precisely in the stagﬂation of the Carter era.
In years of inﬂation surprise, of course, real balances held and revenue from the
tax on cash balances will both be larger than they would be with accurate expectations
of the same inﬂation rate, and the opposite would hold when inﬂation is below
expectations. In the late 1970s the ﬁrst condition still held, as the determination of
the authorities to ﬁnance expanding income transfers, keep interest rates low, and
repudiate debt may have caused them to actually lose control of the money supply
and price level in a Wicksellian cumulative process. The CPI increased 13.3 percent in
1979 and 12.5 percent in 1980. The GDP deﬂator rose 8.5 percent and 9.2 percent in
those years. Inﬂation expectations of the public were beginning to adjust, however.
The real money stock actually fell in 1978 and 1979, despite signiﬁcant real economic
growth in those years. Monetary velocity increased, adding its own impetus to inﬂation,
as real balances demanded as a fraction of real GDP fell. The U.S. was headed
for banana republic inﬂation rates, and voter panic began to generate signiﬁcant pressure
on the authorities to do something about it. Clearly the limits of inﬂation policy,
both economic and political, were being reached.
3.3 Neutralization of Bracket Creep Incentives
Similar factors were operating to limit the capacity of the authorities to raise income
tax rates and other tax rates through inﬂation. Voters may not have known which
speciﬁc politicians to blame for bracket creep and rising property taxes on inﬂated
land values, but they were not stupid. As for businessmen, they knew very well who
to blame for capital consumption due to understated depreciation allowances in the
tax code. Over time, the rising burdens of taxation and regulation and the consequent
slowing of productivity and economic growth (Vedder, 1996) gradually created
Edwards: The Financial Pathology of the Postwar American Welfare State 103
a public backlash against taxes, which the redistributionist politicians had not anticipated.
California voters began the revolt by passing proposition 13 reducing property
tax rates in 1978. Many other states quickly followed. Politicians who opposed tax
relief were threatened with electoral defeat, and more than a few were actually defeated,
as shown in Figure 6. In 1980 Ronald Reagan was not only elected president
on an explicit program of tax reduction, but the Republicans gained a slight majority
in the U.S. Senate for the ﬁrst time since 1956.
The inﬂation policy became unproﬁtable, then, because the marginal beneﬁts of
the policy to redistributionist politicians declined as the public learned to anticipate
rising inﬂation rates, and because the marginal political costs of the policy increased,
both in accordance with the political neutralization hypothesis. The politicians could
no longer use inﬂation to reduce unemployment and interest rates, or hide the costs
of an expanding welfare state through surreptitious taxation, deﬁcit spending, and inﬂationary
debt repudiation. Thus public political support began to shift marginally
against the redistributionist and inﬂationist politicians, particularly in the U.S. Senate.
Policies of income redistribution stopped growing and even declined slightly as
a fraction of the budget, as shown in ﬁgure 2. At that point it became politically possible
to signiﬁcantly reduce the inﬂation rate, even at the cost of temporary added
unemployment.
104 New Perspectives on Political Economy
So, in Volker’s “October Revolution” of 1979, the Fed raised the interest rate, and
set monetary targets that began reducing the growth rate of the money stock. Nominal
money growth fell below the growth in money demand, generating both an excess
demand for money and, by Walras’ Law, matching net excess supplies of the other
economic goods, as people reduced their purchases in a futile eﬀort to add to their
money balances. Thus the U.S. experienced the large double dip recession of 1980-
1982. The inﬂation rate then had to fall until it was enough below the growth in the
nominal money stock that the real money stock could grow enough to satisfy real
balances demanded and end the recession. As part of this process, since the fall in
the price inﬂation rate below the rate of nominal wage inﬂation initially raised the
real wage to unemployable levels, the rate of wage inﬂation had to eventually fall,
reducing the real wage (adjusted for productivity) enough to restore more normal
employment (Vedder and Gallaway, 1997, 235).
The ﬁnal nail in the coﬃn of the inﬂation policy may have been the indexation of
federal income tax brackets by President Reagan in his Economic Recovery Tax Act
(ERTA) of 1981. Tying nominal income tax brackets, the zero bracket amount, and
the personal exemptions to the consumer price index was an act of moral principle
uncharacteristic of late 20th century politicians. That provision ended the congressional
capacity to covertly raise income tax rates without an open and public vote,
from which those in favor could be identiﬁed. This further reduced, by a large increment,
the marginal beneﬁts of inﬂation as a tool to redistributive politicians. The
bitter congressional debate over the indexation provision should dispel all doubt concerning
the deliberate, conscious use of inﬂation for surreptitious ﬁnance by such
politicians. Opponents of indexation focused their arguments precisely on the revenue
losses the government would suﬀer if indexation was included in the tax bill
(Fessler, 1981). It is beyond dispute, as their own statements show, that they knew
exactly what they had been doing, and what they were losing.
In a last gasp of Keynesian rationalization, some of its congressional opponents,
including the Republican welfare statists John Chafee and Pete Dominici in the Senate,
argued that indexation would actually make inﬂation worse. In their view, not
only would it reduce the costs of inﬂation, and hence the incentive to ﬁght it, but
indexation would put more money in the hands of the public just when expenditure
Edwards: The Financial Pathology of the Postwar American Welfare State 105
restraint was needed (Fessler, 1981). So which view was correct? Did indexation decrease
the incentives to ﬁght inﬂation, or did it decrease (in combination with the
expectations adjustments of citizens) the incentives of government and Federal Reserve
oﬃcials to generate inﬂation? Indexation passed, and the matter was settled by
the rapid disinﬂation that followed.
4 Recent Experience and Future Prospects
On the other hand, indexation may not have been the ﬁnal nail. Since the rapid disinﬂation
in the 1980s the inﬂation rate has largely stabilized at positive values in the
two or three percent range. In part, this may be because some incentives for inﬂation
on the part of political and monetary decision makers still exist. For one thing,
revenue for the federal government can still be obtained through the tax on cash balances
with little political cost. More important, even though the unionized fraction
of the labor force has declined signiﬁcantly since the 1950s, support for minimum
wage laws and pro-union policies is still strong, and consequent downward nominal
wage rigidity is still such that macroeconomically stabilizing real wage adjustments
must largely occur through diﬀerential movements of wage and price inﬂation (the
ﬁrst-diﬀerence hypothesis).
In the near future, incentives for more rapid inﬂation may increase, and factors
leading that way seem already to have begun. As the baby boomers retire in just a
few years, and the social insurance programs begin to collapse (Edwards, 2003), pressures
to “save” them through inﬂationary ﬁnance will almost certainly become irresistible.
Add to that the debt monetization being used to help fund the recent huge
Bush and Obama ﬁnancial market bailouts, the current Federal Reserve open market
purchases of worthless mortgage backed securities, and the necessity of ﬁnancing
the new health care initiatives and other added social programs forthcoming from
the Obama administration, and higher inﬂation seems inevitable. As has been said,
those who fail to learn from history are destined to repeat it.
106 New Perspectives on Political Economy
Bibliography
[1] Bailey, Martin J. 1956. “The Welfare Cost of Inﬂationary Finance.” Journal of Political
Economy, Vol. 64, April, 93-110.
[2] Barro, Robert J. 1974. “Are government Bonds Net Wealth?” Journal of Political
Economy Vol. 82, November/December, 1095-1117.
[3] Bordo, Michael D., Erceg, Christopher J., and Charles L. Evans. 2000. “Money,
Sticky Wages, and the Great Depression.” The American Economic Review, vol.
90 no. 5, December, 1447-1463.
[4] Buchannan, James M., and Wagner, Richard E. 1977. Democracy in Deﬁcit: The
Political Legacy of Lord Keynes. New York: Academic Press.
[5] Burns, Arthur F. 1979. The Anguish of Central Banking. Belgrade, Yugoslavia: The
Per Jacobsson Foundation.
[6] Cukierman, Alex. 1986. “Central Bank Behavior and Credibility: Some Recent
Theoretical Developments.” Federal Reserve Bank of St. Louis Review, Vol. 68,
May, 9-12.
[7] DeLong, J. Bradford. 1997. “America’s Only Peacetime Inﬂation: The 1970s.” In
Christina Romer and David Romer, eds., Reducing Inﬂation. NBER Studies in
Business Cycles, Vol. 30.
[8] Edwards, James Rolph. 1991. Macroeconomics: Equilibrium and Disequilibrium
Analysis. New York: Macmillan Publishing Co.
[9] ———. 1993. “Economics, Politics, and the Coming Collapse of the Elderly Welfare
State.” Journal of Libertarian Studies, Vol. 17 no. 1, Winter, 1-16.
[10] Fessler, Pamela. 1981. “1985 Indexing Change Looms As Watershed for Tax Policy.”
Congressional Quarterly, 22 August, 1531-1533.
[11] Friedman, Milton. 1956. “The Quantity Theory of Money – A Restatement.” In
Milton Friedman, ed., Studies in the Quantity Theory of Money. Chicago: University
of Chicago Press.
Edwards: The Financial Pathology of the Postwar American Welfare State 107
[12] ———. 1968. “The Role of Monetary Policy,” American Economic Review, Vol. 58,
March, 1-17.
[13] ———. 1970. “A Theoretical Framework for Monetary Analysis.” In Robert J.
Gordon, ed., Milton Friedman’s Monetary Framework: A Debate with his Critics.
Chicago: University of Chicago Press.
[14] ———. 1971. “Government Revenue from Inﬂation.” Journal of Political Economy,
Vol. 79, July/August, 846-856.
[15] ———. 1978. “Monetary Correction.” In Milton Friedman, Tax Limitation, Inﬂation
& The Role of Government. Dallas, TX: The Fisher Institute.
[16] Grier, Kevin. 1991. “Congressional Inﬂuence on US Monetary Policy.” Journal of
Money, Credit, and Banking, Vol. 28, October, 201-222.
[17] ———. 1996. “Congressional Inﬂuence on US Monetary Policy Revisited.” Journal
of Money, Credit, and Banking, Vol. 38, 571-579.
[18] Hargrove, Erwin, and Morley, Samuel. 1984. The President and the Council of
Economic Advisers. Boulder CO.: Westview.
[19] Johnson, Harry. 1967. Essays in Monetary Economics. London: Allen and Unwin.
[20] ———. 1975. “Living With Inﬂation.” Banker, Vol. 125, August, 863-864.
[21] Kane, Edward J. 1982. “External Pressures and the Operation of the Fed.” In R. E.
Lombra and W. E. Witte, eds., Political Economy of International and Domestic
Monetary Relations. Iowa State University Press, 211-232.
[22] Keynes, John Maynard. [1920] 1988. The Economic Consequences of the Peace.
Middlesex, England: Penguin reprint.
[23] Kydland, Finn E., and Prescot, Edward C. 1977. “Rules Rather than Discretion:
The Inconsistency of Optimal Plans.” Journal of Political Economy, Vol. 85, June,
473-491.
[24] Laidler, David. 1976. “Expectations and the Phillips Curve Trade Oﬀ: A Commentary.”
Scottish Journal of Political Economy, Vol. 23, February, 55-72.
108 New Perspectives on Political Economy
[25] Linneman, Peter, and Walchter, Michael L. 1986. “Rising Union Premiums and
the Declining Boundaries of Noncompeting Groups.” American Economic Review,
Vol. 76, May, 103-108.
[26] Mayer, Thomas. 1998. Monetary Policy and the Great Inﬂation in the United
States: The Federal Reserve and the Failure of Macroeconomic Policy, 1965-1979.
Northampton, MA: Edward Elgar.
[27] Patinkin, Don. 1965. Money, Interest, and Prices: An Integration of Monetary and
Value Theory. 2nd ed., New York, N.Y.: Harper and Row.
[28] Roberts, Paul Craig. 2003. “My Time With Supply Side Economics.” The Independent
Review, Vol. 7, Winter, 393-397.
[29] Romer, Christina D., and Romer, David H. 2003. “The Evolution of Economic Understanding
and Postwar Stabilization Policy.” In Rethinking Stabilization Policy.
Kansas City: Federal Reserve Bank of Kansas City.
[30] Samuelson, Paul , and Solow, Robert. 1960. “Analytical Aspects of Anti-Inﬂation
Policy.” American Economic Review, Vol. 50, May, 177-194.
[31] Sargent, Thomas J. 2003. “Commentary: The Evolution of Economic Understanding
and Postwar Stabilization Policy.” In Rethinking Stabilization Policy.
Kansas City: Federal Reserve Bank of Kansas City.
[32] Schmidt, Emerson P. 1973. Union Power and the Public Interest. USA, Caroline
House Publisher.
[33] Timberlake, Richard. 1984. “Federal Reserve Policy Since 1945: The Results of
Authority in the Absence of Rules.” In Barry N. Siegel, ed., Money in Crisis. San
Francisco: Paciﬁc Institute for Public Policy Research.
[34] ———. 1985. “Legislative Construction of the Monetary Control Act of 1980.”
American Economic Review, Vol. 75, May, 97-102.
[35] Thornton, Daniel. (1984). “Monetizing the Debt.” Federal Reserve Bank of St.
Louis Review, Vol. 66, December, 30-43.
Edwards: The Financial Pathology of the Postwar American Welfare State 109
[36] Tobin, James. (1988). “The Future of Social Security: One Economist’s Assessment.”
In Theodore R. Marmur and Jerry L. Mashaw, Social Security in Contemporary
American Politics. Princeton N.J.: Princeton University Press.
[37] Vedder, Richard K. (1996). “Federal Regulation’s Impact on the Productivity
Slowdown: A Trillion Dollar Drag.” Center for the Study of American Business
Policy Study no. 131, July.
[38] Vedder, Richard K. , and Gallaway, Lowell E. (1997). Out of Work: Unemployment
and Government in 20th Century America New York: New York University Press.
ISSN 1801-0938
New Perspectives on Political Economy
Volume 5, Number 2, 2009, pp. 111 – 128
Monetary Reform – The Case for Button-Pushing
Philipp Bagus
JEL Classiﬁcation: E50, P11, P21, P31
Abstract: In this paper I present a monetary reform plan that seeks to achieve a
sound monetary system. I suggest the following three criteria of a good reform: it
must be ethical, it must be based on sound economic theory and it must leave room
for evolutionary processes. Based on these criteria and applying them to the monetary
system, I argue for an immediate cancellation of all government intervention into the
monetary realm.
Assistant professor at Universidad Rey Juan Carlos, Madrid, philipp.bagus@urjc.es. I would like to
thank William Barnett II, Walter Block, Barbara Hinze, Guido Hülsmann and Mark Thornton for
helpful comments and the Ludwig von Mises Institute for ﬁnancial help.
112 New Perspectives on Political Economy
1 Introduction
In a previous paper (Bagus, 2008), I presented the proposals for monetary reform offered
by the Austrian economists Ludwig Mises, Murray N. Rothbard, Jesús Huerta
de Soto and Hans Sennholz. Their aim is a more stable monetary system that permits
monetary freedom. Without questioning the aim, I set out to criticize the way that
those outstanding economists proposed to get to their aim. In fact, Mises, Rothbard,
Huerta de Soto and Sennholz oﬀer plans of monetary reform that entail numerous
state interventions into the economy, inconsistencies, arbitrariness, and tactical ambiguities.
Their proposals contradict their own ethical and political principles, only
partially resulting in monetary reform. All of these problems seem to stem from the
authors’ attempt to preserve the status quo and to avoid alleged chaos, their reliance
on a problematic economic theory of deﬂation, or the attempt to gain acceptability
by avoiding a deﬂation and its supposedly disastrous eﬀects. In this paper, I will oﬀer
a monetary reform plan that does not entail the setbacks of the criticized plans.
I will proceed as follows. First, I will suggest the criteria a good reform must
fulﬁll. Second, I will develop a reform based on those criteria and that can be called
a “button-pushing” reform as it immediately abolishes all government interventions
into the monetary sphere. Third, I will name the probable consequence such a reform
will entail. Fourth, I will describe the advantage that can be derived from such a
reform, mainly that it is in concordance with the criteria a good social reform must
have. Fifth, I try to anticipate the most important objection that could be raised
against such a proposal, concluding with a summary of the main results.
2 Requirements of a reform
After having critized the plans for monetary reform by Mises, Rothbard, Huerta de
Soto and Sennholz for being too interventionists, too less laissez-faire, having too
much fear of deﬂation, I will make a proposal for monetary reform that is in line with
Huerta de Soto’s theory of the compatibility of the three approximations towards the
reality of human action.¹ The three approximations are, ﬁrst, the development of
¹ See Huerta de Soto (2004, 105-109).
Bagus: Monetary Reform – The Case for Button-Pushing 113
a formal ethical theory. Second, there is the study of economic theory and third the
study of the “conjectural history,” i.e. the interpretation of evolutionary processes and
its results. According to Huerta de Soto these three levels of study are complementary
and mutually enriching. Their careful and separated study is necessary. I would like
to apply this approach to the concept of social reform. Social reforms should be in
line with these three levels.
First, and most importantly, reforms should be ethical. This explains itself. A
reform that is unjust, cannot be regarded as a good reform as every unjust action
is something to be prevented. For example, the reform in itself should not imply
violations of property rights nor willingly sanctify property rights violations ex post.²
Second, reforms should rely on a consistent, true, and value-free economic theory.
Justifying this second criterion is also easy. Since if a reform is not based on a correct
theory, the results and the costs incurred by the reform are diﬀerent from those the
proponents of the reform thought they would be. Therefore, the proponents do not
actually know what results and costs they propose. They will aim at ends that they
would not pursue if they would possess a correct theory. For instance, a monetary reform
should not be based on a theory that claims the money supply must be adjusted
to money demand in order to allow for an increase in production.
Third, there is the study of historic evolutionary processes. Of course, this cannot
be applied one to one on a reform as a reform aims at the future and not at the past.
However, one can demand that the reform makes possible and implies itself a spontaneous
evolutionary process only determining the general abstract rules instead of
imposing from above particular results. In other words, the reform should leave room
for evolutionary processes to run their course, i. e. the reform should leave its exact
results up to an dynamic entrepreneurial process.³ This is very important to make
use of innate entrepreneurial creativity of human beings. They know best how to
solve their problems, coming up, if they are let to, with solutions that the proponents
or planners of the reform would not have thought of. For example, it should not be
determined a priori which kind of money is to be used and produced.
² Of course, we are relying here on an ethical theory that protects property rights.
³ This criterion seems to be implied in the ﬁrst requirement of being an ethical theory. However,
there might exist ethical reform alternatives that leave diﬀerent amounts of room for evolutionary
processes.
114 New Perspectives on Political Economy
If all three points are fulﬁlled, one can be sure that the reform is worth considering.
However, if the reform fails on one of the three levels one might want to look
at it in detail adjusting or discarding it. Therefore, in the following, I will develop a
proposal for monetary reform in line with the three approximations.
The proposal is as simple as it is thorough. It consists of immediately abstaining
from government intervention into the monetary realm. This is the strategy which
was implicitly endorsed by Rothbard:
Following the classical liberal Leonard Read, who advocated immediate and
total abolition of price-wage controls after World War II, we might refer to this as
the “button-pushing” criterion… The libertarian, then, should be a person who
would push a button, if it existed, for the instantaneous abolition of all invasions
of liberty… (1998, 259).
Everyone who subscribes to the idea of Rothbard to abolish government interventions
immediately cannot at the same time subscribe to monetary reform not doing
this and involving government actions. This person would always ﬁrst propose
a button-pushing reform in monetary aﬀairs and at most as a second best option or
compromise propose another reform in political negotiations.
3 Measures
So what would the “button-pushing” strategy mean for the monetary realm in the
U.S.? First, and most importantly, all restriction for private money production must
be removed in order to allow for free money competition. Then everyone is allowed
to produce money. Legal tender laws, i. e. laws that determine that settlements of
debts in the privileged currency must be accepted even though the contract was set in
another currency, must be removed. Also all laws that imply restrictions of the buying,
selling, loaning, borrowing, importing and exporting of competing monies are
to be removed. Further, it must be possible to pay taxes in any currency at the prevailing
market rates between the currencies. Moreover, the government institution
Federal Deposit Insurance Corporation (FDIC) is to be abolished, because it gives an
advantage to deposits in dollar paper money.
Bagus: Monetary Reform – The Case for Button-Pushing 115
Second, the central bank, in the case of the United States, the Federal Reserve
System is a quasi-governmental institution. It was created by the state with the 1913
Federal Reserve Act and was given the nationalized gold. Its board and chairman
is appointed by the President and approved by the Senate. It holds the monopoly
to issue federal reserve notes with the U.S. Treasury printing them. All this is to be
removed.
Third, the gold that was nationalized and is held by the central bank is to be
given back to the population. Who can prove that he was robbed or is an heir of such
a person will get his property back. The gold that is not reclaimed in this way can
be used as compensation and restitution for government interventions in the past.
Former taxpayers, conscripted and expropriated citizens, can get restitution in gold
in proportion to the harm they suﬀered.⁴ That would imply that older people would
tend to receive a higher part of the gold, because they tend to have been taxed more
in the past. Further, interest will be considered in determining their compensation.⁵
Fourth, monetary and especially bank contracts must be enforced. If banks have
committed fraud in issuing more titles to money than they have money proper or
that have obfuscated “the diﬀerence between genuine (that is, 100 percent-covered)
money titles and imperfectly redeemable IOUs,”⁶ they should be held responsible.
⁴ Of course, this group includes only people that can prove that they have been net taxpayers and net
expropriated people and have not earned the amounts taxed in virtue of some governmental privilege.
In this sense, the distribution of the nationalized gold to state victims is not arbitrary but forms part
of a restitutional process for government invasions of private property.
⁵ Guido Hülsmann arguing for a libertarian monetary reform states that the unreclaimed property of
the central bank should go to its users (1998, 115). The gold and foreign exchanges would go to the
workers in the vault. In contrast, Hoppe claims that civil servants should not get public property, because
they are not tax payers but tax receivers. (2001, 135-136). From a libertarian perspective it would
be indeed strange that in a desocialization process President Bush would receive (parts of) the White
House, limousine and Air Force One, all of which he uses. Or that Ben Bernanke receives any share
of the unreclaimed gold in Fort Knox that he is using to back the state ﬁat currency. All employers
of the central bank are to an extent part of a quasi-governmental institution and are collaborating in
the ﬁnancing of the government’s activities. The same is true to a smaller extent though, for the bank
owners and bank employers. (See Block, 2004 and 2006, for a theory of a libertarian punishment of
statists and a libertarian Nuremberg Trial.) One could make the case that lower rank collaborators
could homestead the buildings or printing press they are using. But it seems to be that these collaborators
have a smaller claim on the nationalized gold and the foreign exchanges than tax payers. For
a libertarian analysis of criminal possession, restitution and the burden of proof see Rothbard (1998,
esp. Chaps. 9-11).
⁶ Hülsmann (2003, 411). IOUs are certiﬁcates that banks issue in favor of a creditor who ususally receives
interest from the bank.
116 New Perspectives on Political Economy
4 (Probable) Consequences of the reform
With competition in the monetary production, private money producers will emerge
and start competing with each other. Commodities like gold or silver in turn historically
have a high cost of the material (of gold or silver) in comparison to their
monetary value, due to their scarcity in relation to their industrial or luxury usages.
The premium that the monetary value has on the material value is for gold and silver
much smaller than for existing paper money. Therefore, it is more risky to accept
paper money in daily exchanges, because its market value can drop considerably if
people start abandoning it.
Thus, people would start using other monies than the ﬁat paper currency in their
transactions. It will probably not be an instantaneous process and it is not so that entrepreneurs
will stop quoting prices. Rather they will quote their prices in something
else other than the ﬁat paper currency or in several media of exchange. Entrepreneurs
will look at other entrepreneurs and chose the commodity or money they regard as
most appropriate. At the same time, the most perspicacious (farsighted) entrepreneurs
will pick up the business of money production, picking commodities of a high
saleability. Other people will notice that some people are buying those commodities
in order to resell them. As these commodities are easy to sell, people will imitate the
innovators. As more people use those commodities, their saleability rises and it becomes
ever more attractive to use them. In a self-enforcing process new monies arise.⁷
One cannot know how fast and smooth this process will be. However, there is also
no reason why it could not be fast and smooth.⁸ Probably in the beginning, when the
new money producers are just starting their production, people might start using foreign
exchange. Yet, there already exists producers of gold and silver currencies⁹ that
might expand their business immediately when the restrictions on monetary competition
are removed.¹⁰ Furthermore, in the long run the foreign paper money is likely
⁷ See Menger (1892, online: http://www.mises.org/web/2692) for the origin of money.
⁸ R. A. Redford (1945) describes how in a prisoners of war camp in World War II cigarettes immiediately
evolved as the general accepted medium of exchange.
⁹ For example: http://www.e-gold.com/ or http://www.goldmoney.com/ .
¹⁰ Note also that due to the denationalization of the central bank gold, most people will possess at least
a small gold stock, which gives gold the headstart to emerge as one of the future monies. (According
Bagus: Monetary Reform – The Case for Button-Pushing 117
to be driven out of the market by commodity money because, as pointed out before,
commodity monies are less risky. It is important to notice that during the process of
the evolution of new monies there is inﬂation (i.e. increase in the money supply) and
deﬂation (i.e. decrease in the money supply) going on at the same time. This always
happens when people start changing from one medium of exchange to another. The
old money is abandoned, its supply shrinks and its material is used in other lines of
production. At the same time new money emerges with an increasing supply. The
German hyperinﬂation in 1923 serves as an example of this process.¹¹ While the hyperinﬂated
paper money was abandoned and demonetized, i.e. not accepted as a
medium of exchange anymore, new currencies backed by foreign exchange or gold
emerged spontaneously.
As the monopoly to print federal reserve notes is removed, we face two possible
alternatives. The ﬁrst alternative is that people accept notes in daily exchange that are
printed after the end of the monopoly. If this is the case, entrepreneurs would start
printing fed notes freely, resulting in a hyperinﬂation and quick abandoning of the
paper money.¹² The other possibility is that people only accept the old pre-reform
notes. This seems to be more probable than the ﬁrst alternative, especially when
courts decide about contracts entered into before the reform. Why would a creditor
that made a contract in the old fed notes accept the notes that a debtor just printed to
repay the debt? The contract was set in terms of the old monopolized federal reserve
notes. Why would someone accept a note that can be printed at no cost by everyone?
Courts would probably decide in favor of creditors. If no new fed notes are accepted,
the amount of fed notes would be ﬁxed.¹³ In this case, it is not hard to predict that
to wikipedia there are currently 147.000.000 ounces of gold in Fort Knox. That means on average half
an ounce for every citizen of the U.S.)
¹¹ See Stucken (1953, 31-60, esp. 49).
¹² See for this scenario Hoppe (1994, 59). Walter Block (1991, 93-104) makes the case for a private counterfeiter
under a ﬁat money regime. For good critiques of his view see Robert Murphy (2006) and
Matteusz Machaj (2007). However, the whole scenario becomes diﬀerent with the button-pushing
reform. There the government monopoly is abolished, and people would be free to accept or no, old
or new bank notes (printed after the monoply was abolished). Producers of new notes, pretending
them to be old ones, would be considered counterfeiters.
¹³ Probably the new owners (tax payers or homesteaders) of the old federal reserve printing press will
try to print new notes and try to make people accept them. Yet, without the prestige of the state, the
legal tender laws, etc. probably no one would accept these notes either. The antique federal reserve
printing press becomes like every other printing press.
118 New Perspectives on Political Economy
a price deﬂation would occur. It is probable that with the abolition of the Federal
Reserve System and the FDIC bank runs would occur immediately. The conﬁdence
on which the system depends will be shaken. Some people might even call for runs
on certain banks, an action that will be legal. Also, banks that committed fraud in obfuscating
the distinction between money titles and IOUs or that issued more money
titles than they have money, will be sued.¹⁴ This also increases the possibility of a
decrease in conﬁdence and increases the likelihood of bank runs. As one bank run or
bank failure undermines the conﬁdence in other banks, all fractional reserve banks
are likely to collapse in a domino eﬀect. Even if there are no immediate bank runs,
the system is very likely to eventually collapse. When the next recession, or political
crisis looms, conﬁdence will fall and a credit contraction will likewise occur. If people
for some other reason want to have more cash, likewise a severe credit contraction
ensues. This credit contraction in turn can lead to business bankruptcies, bad loans
for banks and even less conﬁdence in the fractional reserve banks, eventually leading
to purging bank runs. The whole fractional reserve banking system will go bankrupt
as they loose their cash and are sued for fraud. Their assets will be turned over to
their creditors and depositors.¹⁵
¹⁴ The exact legal status of fractional reserve banking is a historical contingency and must be decided
case by case. It is not necessarily fraud, since people might voluntarily agree to an IOU with a redemption
promise. See Hülsmann (2003, 402). Huerta de Soto (2006, 156) names seven possible
legal classiﬁcations of a bank-deposit contract with a fractional reserve, one of them implying fraud.
Beside the question of fraud there are two additional considerations. First, banks obtain a “de facto
monopoly” (Hülsmann 2003, 415). One might consider the creation of new money through this privilege
as a kind of “stealing.” Second, there is the question of collaboration. In a libertarian Nuremberg
trial banks would probably be sued for exploiting their monopoly and for ﬁnancing the criminal activities
of the state. It would of course be an extremely diﬃcult exercise to ﬁnd the main responsibles.
¹⁵ Mateusz Machaj argues that, maybe, not all assets should be turned over to the depositors or creditors.
The outstanding loans to private companies could simply be canceled or renegotiated, because
capitalist entrepreneurs were in a bad position in a system that privileged banks. They had to borrow
money from them in order to survive in the competition. Banks made contracts that are very beneﬁcial
to them and that were signed thanks to their privilege. When a price deﬂation occurs, they would
have diﬃculties to repay their debts. Depositors do not only gain through the increase in purchasing
power, but also by taking over the production facilities that were created by stolen money. Hence,
debt should be renegotiated decentrally or cancelled. While this is an interesting argument, I do not
agree with it. It is ethically just that the assets of bankrupt banks are turned over to their creditors and
defrauded depositors. Also, debts must be repaid. If they cannot be repaid, there will be a change in
the ownership from the former owners to the creditors. This poses no economic or ethical problems.
No one was forced to cooperate with a privileged banking system.
Bagus: Monetary Reform – The Case for Button-Pushing 119
5 Advantages of the reform
Let us ﬁrst turn to the ethical, economic and evolutionary advantages of the proposed
reform. First, the reform is ethical. It is in accordance with the libertarian
non-aggression axiom.¹⁶ It itself abstains from violations of property rights; it tries
to compensate for past property right violations as much as possible and it enforces
property rights.¹⁷ It is a libertarian “button-pushing” reform.
Second, the reform does not want to avoid deﬂation, because there is a sound
theory of deﬂation underlying it. It merely lets the free market run its course as a
natural reaction to the government interventions into the monetary realms and does
not aim at preventing monetary or price deﬂation. It recognizes that deﬂation purges
eﬃciently and quickly malinvestments that were committed in a inﬂationary boom
period. It is built upon a theory of entrepreneurship that shows that the reform is dynamically
eﬃcient in the economic sense that it does not inhibit the entrepreneurial
function.¹⁸
Third, it does not inhibit the entrepreneurial function and the reform leaves room
for evolutionary developments. And this is an important addition to the ethical requirement.
Only considering ethics, one might argue that it would be a restoration
of property rights to introduce a gold standard, 100 per cent or not. However, the
money that would evolve out of voluntary decisions of market participants might be
very diﬀerent from gold and silver, now. Therefore, it is important that a gold or silver
standard is not imposed from above. Also in diﬀerent regions people might prefer
diﬀerent monies. In a dynamic, decentralized, competitive process the best money
will be chosen by market participants. It is even likely that there might be several
monies used in everyday life. For example, silver might be used for small purchases
¹⁶ For a natural rights approach to libertarian ethics see Rothbard (1998). Note also that the proposed
reform in contrast to other reforms is argumentatively justiﬁable. One cannot even coherently argue
for other monetary reforms that imply a violation of property rights. This is so, because every argumentation
in favor of reforms that imply violations of property rights or amnesty for past violations
of property, imply a contradiction. The attempt to engage with someone and convince him in an
argumentation (of a reform) implies the abstention of violence and requires the acknowledgment of
property rights. Hence, one cannot consistently argue in favor for a reform that violated property
rights.
¹⁷ See Hoppe (2006, 305-338).
¹⁸ For the concept of dynamic eﬃciency see Huerta de Soto (2003, 231-254).
120 New Perspectives on Political Economy
and gold for larger ones. There is also room for innovations in monetary substitutes
like credit cards, etc.
In addition to the evolutionary, economical and ethical advantages there exist
some minor additional advantages of the proposed reform. First, there are some
practical advantages. The reform itself is fast and uncomplicated. The managing
or planning costs of the reform are very limited. Second, there is a unique opportunity
to reduce the welfare state. The government bonds held by the central bank
and bankrupt fractional reserve banks can be defaulted which reduces the national
debt burden. Also the ﬁnancing of the welfare state by inﬂation will become impossible.
Another interesting feature of the reform is that the denationalized gold will
primarily go the older and retired persons. That allows for reduced tensions that the
abolition of a public pension system could cause.
Fourth, there will be public pressure to make the economy more ﬂexible and reduce
state interventions. For example, during the reform there will be a price deﬂation
which could result in pressure from the involuntarily unemployed to break union
power and abolish minimum wage laws.
Fifth, one has to put emphasis on the results of the reform. There will be a totally
free monetary system, with competing moneys whose success results from the
choices of economic agents. The inﬂationary redistribution that entails a ﬁat paper
money system backed by a central bank immediately ends when the reform is put into
practice. Also recurring business cycles induced by the credit expansion of fractional
banks are put to an end. The implied misallocation of resources and impoverishment
of the population ends with it. A stable, sound monetary system can develop as fast
as is possible with freely interacting individuals.
Sixth, it is very diﬃcult to reverse this reform. It does not leave in place state
institutions or laws in the monetary sphere, and it does allow for a dynamic system.
Moreover, people will not have the impression that the government provided them
with their newly emerged system, because they experience that government is not
necessary to provide for a monetary system or reform. Actually, there is not a single
case of monetary reform managed by the government that changed the trend toward a
ﬁat paper money system controlled by a central bank. For instance, the German mon-
Bagus: Monetary Reform – The Case for Button-Pushing 121
etary reforms in 1924 and 1948 were conducted by the government (Stucken, 1953).
Instead of permitting the already emerging alternative media of exchange to compete,
the government stayed involved in the monetary system. Even though Germany got
back to the gold standard in 1924, this was only for a short intermediate time. By introducing
a foreign exchange control the German government efectively introduced
a ﬁat paper money standard in 1931 again. The monetary break-down after World
War II could have been used for a thorough monetary reform. However, the monetary
reform from 1948 just changed the name of the currency and the institutional
framework. Even though the Bank Deutscher Länder engaged in restrictive monetary
policy in the beginning (Erhardt, 1968, 34), the new D-Mark was also just another ﬁat
paper money currency.
Furthermore, the collapse of the old monetary system is also an educational advantage
in showing that the former monetary system was inherently unstable and
bankrupt. Rothbard´s hope that the failure of the governmental monetary system
provides insurance against its reemergence might become true with a thorough reform.
As Rothbard stated in one of his earlier more radical works on the subject:
And if, as we contend, banks are inherently bankrupt and “runs” simply reveal
that bankruptcy, it is beneﬁcial for the economy for the banking system to be
reformed, once and for all, by a thorough purge of the fractional-reserve banking
system. Such a purge would bring home forcefully to the public the dangers
of fractional-reserve banking, and, more than any academic theorizing, insure
against such banking evils in the future (2000, 21).
6 Objections to the “button-pushing” plan
Let us deal with some of the objections that come to mind regarding the aforementioned
plan. The ﬁrst objections one would raise is the political impossibility of such a
plan. This objection must of course be taken seriously.¹⁹ The political elite, banks and
¹⁹ Historically, there actually have been reforms entailing monetary and subsequently price deﬂation.
That shows that the proposed reform is not in principle impossible. These reforms happened after
wars, though, periods of great unrest. It happened in Great Britain after the Napoleonic Wars and
WWI and in the German monetary reforms after the hyperinﬂation in the 1920s and after WWII
in 1948. Also in the Netherland in 1946 deﬂation was employed in monetary reform. This induces
122 New Perspectives on Political Economy
other individuals proﬁting from the current system will oppose the reform. Maybe
also frightened voters unable to grasp the economic importance of and their beneﬁts
from the reform would object to the plan with politicians picking up their concerns.²⁰
However, it is in principle not impossible to convince the majority of voters or the
population that they would beneﬁt from a plan that is just and consistent.
More importantly, the political practicability is irrelevant when searching for an
optimal reform plan. Often plans that are politically less practical present the best
solutions. In turn, what is most politically popular is normally the worst solution.
Adding as a fourth criteria the popularity of a reform would mean adding a criterion
that does not necessarily and very probably contradicts the other three (ethical, economical,
evolutionary) criteria. Also it must be understood that by oﬀering a monetary
reform, I am not opposing any other monetary reform. In fact, every reform that
moves in the direction away from state intervention in the monetary system is a step
in the right direction. And this step should be endorsed under the condition that it
is made clear, that the step is only a step and not an ideal monetary reform.
One could further argue that another criterion for a good reform should be that it
is stable. One might fear that after the reform there would occur social unrest that is
likely to reverse the reform. People would say: “That did not work.” While this might
be considered a complementary argument, the most important criteria is that it is
ethical, economically sound and leaves room for the entrepreneurial process. They
are primarily important. Furthermore, the proposed reform is necessarily just and
based on sound economic reasoning. In contrast, there is not necessarily social unrest.
It is possible that there will be no strong social unrest for two reasons. First,
in order to introduce the reform one would have to convince people of it in the ﬁrst
Hamilton (1952, 330) to say about the role of monetary deﬂation in monetary reform: ”Deﬂation
through writing down bank deposits and destroying currency, in eﬀect, crying down money, has been
the commonest type of monetary reform in recent years [Footnote about monetary reform in Germany
and the Netherland omitted] and is likely to continue in medieval fashion, alternately with inﬂation
of paper currency and bank deposits in a distinctly modern and sometimes violent fashion.”
²⁰ See on this problem William Hutt (1971). He points out that the competition of economists in gaining
political inﬂuence and swimming with the political tide leads them to make compromises in theories.
As a consequence the argumental basis and the prestige of economists as experts weakens. Paradoxically
their inﬂuence might decline. He argues (1971, 22), that the economist should propose both the
ideal and expedient policies and make explicit what he is dealing with. In this paper, I am proposing
an ideal reform leaving it to others to come up with expedient reforms.
Bagus: Monetary Reform – The Case for Button-Pushing 123
place. Therefore, they would know its consequences. Second, there are many winners
from the reform who would embrace it. The losers are mainly the government,
the banks and the welfare-warfare complex. Why should there not be social unrest
when the losers of the actual system become aware that they are under an unjust
system and exploited? Why should there not be social unrest if an unjust reform is
carried out? In the change from the D-Mark to the Euro, Germans had to calculate
in a diﬀerent medium of exchange over night. With the button-pushing reform the
transition would be smoother and people would gradually learn to perform economic
calculations in terms of other media of exchange.
Moreover, historically button-pushing reforms have become stable and successful
after initially being confronted with short lived reistance. Ludwig Erhard pushed at
the button on price controls after WWII, in 1948 eliminating over night all price controlls
in Western Germany and initiating the economic recovery of Germany. Erhard
introduced the market economy in a day even though there was opposition by contemporaries
arguing that one should make a gradual refrom. The majority of people
thought that the reform could not be successful as it seemed to be too radical. Even
though there was a strong opposition and a general strike, Erhardt held on to the
reform (1964, 18-48).²¹ A similar button-pushing reform happened in the 1990 in former
communist Eastern European countries when price controls were abolished.²²
As Daniel Gros and Alfred Steinherr (2004, 107) in their analysis of the transition of
former communist countries point out “…the revovery was stronger in countries that
had liberalized most thoroughly…” The authors also point to the dangers of slow reforms
(2004, 127):
Our ﬁrst result is that experience has shown that slow reforms meant, in
many cases, just that: slow reforms and no willingness to progress faster after
the ground work had been done. The tortoises did not overtake the hares.
Another set of questions is can a major “turmoil” be prevented at all, and can the existing
system ever be stable. Economic theory tells us that a fractional reserve banking
²¹ See Erhardt (1964, pp.18-38) for the details of the reform.
²² There is a parallel of the former socialist countries in Eastern Europe and our case of monetary reform,
because we are faced in the Western World with socialism in the monetary sphere. (See for the
socialism in the monetary sphere Huerta de Soto, 2006, pp. 647-675)
124 New Perspectives on Political Economy
system headed by a central bank leads to recurrent boom and bust cycles. That is
not a stable system either. This system can easily end in hyperinﬂation and Rothbard
predicts its crash: “…we have to realize that the banking system is headed for a
mighty crash in any case” (Rothbard 1995, 11). That means that the current system
causes social unrest as well, which will likely get much worse as credit expansion and
economic cycles increase.
Another objection might be that the monetary system collapses. That is true.
Yet, the system collapses because it is unsound and people voluntarily change towards
other monies. The collapse of the German monetary system in 1923 occured,
because people began to abandon the old inﬂated currency. Instead of letting people
discover new monies that seemed to be appropriate, a process that was already
under way²³, German authorities introduced another state money. Would one argue
that if a fraudulent ﬁrm collapses and a sound one takes its place that this would
be somehow bad and a new fraudulent ﬁrm should be installed? Of course, many
individuals that were hurt by or beneﬁtted from the fraudulent ﬁrm will experience
(substantial) changes in their life. However, there is no necessary “disruption” of economic
activity. As the fraudulent gas trader Enron went bankrupt, stakeholders were
hurt. However, houses did not go cold due to a shut down of gas. Gas was still being
produced, traded and distribuited as was in the interest of agents involved in the
bankruptcy. The same will happen when the monetary ﬁat paper system collapses.
Stakeholders in the state´s monetary system will be hurt, but their goods and services
that are demanded by economic agents will still be supplied, money included.
Furthermore, to speak of “disruption” would already involve an ethical statement.
There will be a redirection of economic activity. Namely, the structure of production
that was distortet by continous inﬂation will be readapted. Further, more activity will
be spent to come up with monetary innovations or barter ideas that make life simpler.
One might also argue that button-pushing reforms do not work as institutions
need time to develop. However, how long will this time be? Would the development
of institutions not be the fastest if there is a button-pushing reform. Moreover, this
argument contrasts with the ethical criterion and leads to questionable conclusions.
Against an immediate abolition of slavery one might argue that slaves do not possess
²³ See Stucken (1953, 49).
Bagus: Monetary Reform – The Case for Button-Pushing 125
institutions to live successfully in liberty; therefore, slavery could only step by step
be abolished in order to give the slave opportunities to develop institutions. Probably
the slaves would not accept such a reasoning, as they wanted to develop their
capacities to live free as fast as possible. The same can be said about the monetary
system. Free monetary institutions can be developed faster, if monetary interventions
are abolished immediately.
Another objection might be that there is a huge redistribution of wealth. Of
course, every reform has its winners and losers, as has every change in the economy
and continuation of government intervention for that matter. It is arbitrary to
say that a certain amount of redistribution is too big. It is also hard to see, that if
individuals who anticipate the abolition of government interventions and position
themselves to proﬁt from it, would earn unfair gains during the reform. The important
question is if the changes that occur and turn people into winners and losers
are based on decisions of voluntary interacting individuals or not. Of course, there
will be a huge readjustment of the structure of production due to the redistribution
of wealth. There will also be many bankruptcies. But by which standard can one
say that there would be too much of a readjustment or too many bankruptcies? By
which standard could one say that they are bad? One objective standard to judge
this is property rights. And property rights are restored by this reform. Always when
government interventions are abolished there are disruptions in the economy, small
ones if agricultural subsidies are abolished, greater ones if slavery is abolished.
The last objection that is considered here is the aﬃrmation that the proposed reform
could only be undertaken on a world wide scale, because otherwise there would
be huge foreign exchange ﬂuctuations disrupting international trade. However, this
is not necessarily the case. While the old currency might lose in value quickly, the
new monies will not necessarily ﬂuctuate more against foreign exchanges than the
old one. They will probably increase in value, showing the competitive advantage of
the new monies regarding paper money. Actually, there is a ﬁrst mover advantage
for those countries who apply the reform ﬁrst (Hülsmann 1998, 113). This is so, because
the ﬁrst movers will get the new monies at lower prices, before their purchasing
power increases as other countries apply a similar reform. Those countries are similar
to the entrepreneurs who are more farsighted than others in choosing a medium of
exchange.
126 New Perspectives on Political Economy
7 Conclusion
Most plans for monetary reform have been interventionist and unethical and they
impose results. This is partly so, because of a problematic underlying economic theory
regarding deﬂation. Sometimes the reform plans are in apparent contradiction to
other writings of the very same author. An ethical, dynamical reform based on value
free economic analysis consists in the immediate abstention of state intervention into
monetary aﬀairs (“button-pushing”). This plan would very likely imply the deﬂation
of the old money and the purge of the banking system, i.e. those consequences that
other reforms tried to avoid. Even though this plan is far away from getting only near
to a political approval it is important to show its advantages. It can serve as a standard
for comparison.
Bibliography
[1] Bagus, Philipp. 2008. “Monetary Reform and Deﬂation – A Critique of Mises,
Rothbard, Huerta de Soto and Sennholz.” New Perspectives on Political Economy,
4 (2) 2008: 131-157.
[2] Block, Walter. 1991. Defending the Undefendable. San Francisco, California: Fox
& Wilkes.
[3] Block, Walter. 2004. “Radical Libertarianism: Applying Libertarian Principles to
Dealing with the Unjust Government, Part I.” Reason Papers 27, Fall: 113-130.
[4] Block, Walter. 2006. “Radical Libertarianism: Applying Libertarian Principles to
Dealing with the Unjust Government, Part II.” Reason Papers 28, Spring: 85-109.
[5] Erhardt, Ludwig. 1964. Wohlstand für alle. 8th ed. Düsseldorf: Econ Verlag.
[6] Gros, Daniel and Alfred Steinherr. 2004. Economic Transition in Central and
Eastern Europs. Planting the Seeds. Cambridge: Cambridge University Press.
[7] Hamilton, Earl J. 1952. ”Prices as a Factor in Business Growth: Prices and
Progress.” The Journal of Economic History, 12 (4): 325-349.
Bagus: Monetary Reform – The Case for Button-Pushing 127
[8] Hoppe, Hans-Hermann. 1994. “How is Fiat Money Possible? –or, The Devolution
of Money and Credit.” The Review of Austrian Economics 7 (2): 49-74.
[9] Hoppe, Hans-Hermann. 2001. Democracy The God That Failed – The Economics
and Politics of Monarchy, Democracy, and Natural Order. New Brunswick, New
Jersey: Transaction Publishers.
[10] Hoppe, Hans-Hermann. 2006. The Economics and Ethics of Private Property –
Studies in Political Economy and Philosophy. 2nd ed. Auburn, Ala.: Ludwig von
Mises Institute.
[11] Hülsmann, Jörg G. 1998. “Liberale Währungsreform – ein Entwurf.” Eigentümlich
frei 4: 110-115.
[12] Hülsmann, Jörg G. 2003. “Has Fractional-Reserve Banking Really Passed the
Market Test?” The Independent Review 8 (3): 399-422.
[13] Huerta de Soto, Jesus. 2003. “The Theory of Dynamic Eﬃciency.” in Backhaus,
Juergen, Hejmann, Wim, Nentjes, Andries, van Ophem, Johan (ed.) Economic
Policy In An Orderly Framework: Liber Amicorum For Gerrit Meijer. Münster: Litt
Verlag.
[14] Huerta de Soto, Jesus. 2004. “Historia Conjetural, Ciencia Economica, y Etica
Social.” In Huerta de Soto. Estudios. 2nd ed. Madrid: Union Editorial: 105-120.
[15] Hutt, William H. 1971. Political Impossible...? An Essay on the supposed electorial
obstacles impeding the translation of economic analysis into policy or why
politicians do not take eocnomic advice. Westerham: The Institute of Economic
Aﬀairs.
[16] Menger, Carl. 1892. On the Origin of Money. Economic Journal (2): 239-55. available:
online: http://www.mises.org/web/2692.
[17] Machaj, Mateusz. 2007. “Against Counterfeiting”. The American Journal of Economics
and Sociology, 66 (5): 977-984.
128 New Perspectives on Political Economy
[18] Murphy, Robert P. 2005. A Note on Walter Block’s Defending the Undefendable:
The Case of the ”Heroic” Counterfeiter, The Amercian Journal of Economics and
Sociology 65 (2): 463-466.
[19] Radford, R. A. 1945. “The Economic Organisation of a P. O. W. Camp”, Economica
12 (48): 189-201.
[20] Rothbard, Murray N. 1991. The Case for a 100 Percent Gold Dollar. Auburn, Ala.:
Ludwig von Mises Institute.
[21] Rothbard, Murray N. 1992. “Aurophobia: or, Free Banking on What Standard?”,
The Review of Austrian Economics 6 (1): 97-106.
[22] Rothbard, Murray N. 1994. The Case Against the Fed. Auburn, Ala.: Ludwig von
Mises Institute.
[23] Rothbard, Murray N. 1995. Taking Money Back. Available at:
http://www.mises.org/rothbard/moneyback.asp
[24] Rothbard, Murray N. 1998. The Ethics of Liberty. 2nd ed. N.Y.: New York University
Press.
[25] Rothbard, Murray N. [1963] 2000. America’s Great Depression. 5th ed. Auburn,
Ala.: Ludwig von Mises Institute.
[26] Stucken, Rudolf. 1953. Deutsche Geld- und Kreditpolitik. 2nd ed. Tübingen: J.C.B.
Mohr (Paul Siebeck).
ISSN 1801-0938
New Perspectives on Political Economy
Volume 5, Number 2, 2009, pp. 129 – 136
“The Yield from Money Held” Reconsidered
Hans-Hermann Hoppe
Below we publish the Franz Cuhel Memorial Lecture of 2009 by Hans-Hermann Hoppe
– a critique of the notion that money held as cash balances is barren and leads to economic
predicaments. He shows that while there is a wide family of proponents of such
view, few economists recognize the beneﬁts of holding money ﬂowing from the removal
of uncertainty. He demonstrates that far from being unproductive, increasing the cash
balances can be viewed as an investment into greater certainty (lower uncertainty) taking
place at the cost of lower consumption of goods (present and future) perceived as
certain. Hans Hoppe concludes his lecture by linking this theme with the current economic
crisis and attempts at alleviating its consequence.
This paper has been delivered as Franz Cuhel Memorial Lecture during the Prague Conference on
Political Economy, April 24, 2009.
hans@hanshoppe.com
130 New Perspectives on Political Economy
Franz Cuhel occupies an honorary place in the history of economic thought and
of the “Viennese” or “Austrian” school of economics in particular. In his book Zur
Lehre von den Beduerfnissen (1907), Cuhel presented for the ﬁrst time a strictly ordinal
interpretation of marginal utility and thus contributed to a systematic advance of pure
economic theory. Since this lecture is named in Cuhel’s honor, I felt it appropriate that
I, too, should discuss here a purely theoretical problem of economics. My subject is
not the general theory of value, however, but, more speciﬁcally, the theory of money.
I have chosen the title of my lecture after a famous article by William H. Hutt,
“The Yield from Money Held.”¹ Like Hutt, I want to attack the following notion: that
money held in cash balances and deposit accounts is somehow “unproductive,” “barren,”
or “sterile,” oﬀering a “yield of nil”; that only consumer goods and producer (investment)
goods are productive of human welfare; that the only productive use of
money lies in its “circulation,” i.e., in its spending on consumer or producer goods;
and that the holding, i.e., the not-spending, of money diminishes future consumption
and production.
This view is extremely popular within the economics profession and outside. Hutt
oﬀers many examples of its proponents. I will oﬀer only two here. The ﬁrst is John
Maynard Keynes. One famous quote from his General Theory will suﬃce for my purpose:
“An act of individual saving,” by which Keynes means cash holding or “hoarding”
instead of consumption- or investment-spending, “means – so to speak – a decision
not to have dinner to-day. But it does not necessitate a decision to have dinner or buy
a pair of boots a week hence or a year hence or to consume any speciﬁed thing at any
speciﬁed date. Thus it depresses the business of preparing to-day’s dinner without
stimulating the business of making ready for some future act of consumption. It is
not a substitution of future consumption-demand for present consumption-demand
– it is a net diminution of such demand.”²
Here it is: The holding of money, i.e., the not-spending of it on either consumer
or investment goods, is unproductive, indeed detrimental. According to Keynes, the
government or its central bank must create and then spend the money that “savers,”
¹ William H. Hutt, “The Yield from Money Held,” in: Freedom and Free Enterprise: Essays in Honor of
Ludwig von Mises, ed. M. Sennholz, Chicago: Van Nostrand,1956, pp. 196-216.
² John Maynard Keynes, The General Theory of Employment, Interest, and Money, New York: Harcourt,
Brace, and World, 1964, p. 210.
Hoppe: “The Yield from Money Held” Reconsidered 131
i.e., the holders of cash balances, are unproductively holding back, so as to stimulate
both consumption and investment. (Needless to say, this is precisely what governments
and central banks are presently doing to supposedly rectify the current economic
crisis.)
The second example is from closer at home, i.e., from the proponents of “free
banking” such as Lawrence White, George Selgin, and Roger Garrison. According to
them, an (unanticipated) increase in the demand for money “pushes the economy below
its potential,” (Garrison) and requires a compensating money-spending injection
from the banking system.
Here it is again: An “excess demand for money” (Selgin & White) has no positive
yield or is even detrimental; hence, help is needed. For the free bankers help is not
supposed to come from the government and its central bank, but from a system of
freely competing fractional reserve banks. However, the idea involved is the same:
the holding of (some, “excess”) money is unproductive and requires a remedy.³
I do not want to engage in a textual critique of Keynes or the “free bankers” here.
I only mentioned them to further elucidate the idea that I want to attack, and to
indicate how widespread – and consequential – its acceptance is within the economics
profession, both inside and outside Keynesian circles. Unlike Hutt, who proceeds
“critically” in his article, i.e., through a textual examination of various authors, and
arrives at his own contrary view of the (positive) yield from money held in a rather
indirect and circumstantial way, I want to proceed “apodictically”: by way of a positive
demonstration of money’s unique productivity.⁴
The ﬁrst natural response to the thesis that money held in or added to cash balances
is unproductive is to counter: Why, then, if money held in or added to cash
balances is unproductive of human welfare, do people hold them or add to them?
³ Roger Garrison, “Central Banking, Free Banking, and Financial Crises,” Review of Austrian Economics
9, no.2, 1996, p. 117; George Selgin & Lawrence White, “In Defense of Fiduciary Media,” Review of
Austrian Economics 9, no. 2, 1996, p. 100/01.
⁴ For a detailed critique of Keynes see Hans-Hermann Hoppe, “Theory of Employment, Money, Interest,
and the Capitalist Process: The Misesian Case Against Keynes”; for a detailed critique of the free
banking doctrine see idem, “How is Fiat Money Possible?” Review of Austrian Economics 7, no. 2, 1994
and idem, “Against Fiduciary Media,” Quarterly Journal of Austrian Economics 1, no.1, 1998.
These articles are collected in Hans-Hermann Hoppe, The Economics and Ethics of Private Property,
2nd
Edition, Auburn, Al.: Ludwig von Mises Institute, 2006.
132 New Perspectives on Political Economy
If cash holdings are indeed “good for nothing,” no one would hold or add to them
- and yet almost everyone does so all the time! And since all money is always held
or hoarded by someone – when it “circulates,” it only leaves one holding hand to be
passed into another – money must be continuously “good for something” all the while
it is being held (which is always).
To understand what this “good for something” of money is, it is best to ask: When
and under what conditions would there be no demand for cash holdings? Interestingly,
wide agreement exists within the economics profession on the answer. It has
been most lucidly stated by Ludwig von Mises. No money and no demand for cash
balances would exist in “general equilibrium,” or as Mises calls it, within the imaginary
construction of an “evenly rotating economy.” In this construction, all uncertainty is
by assumption removed from human action. Everyone knows precisely the terms,
times, and locations of every future action, and accordingly all exchanges can be prearranged
and take the form of direct exchanges. Writes Mises: “In a system without
change in which there is no uncertainty whatsoever about the future, nobody needs
to hold cash. Every individual knows precisely what amount of money he will need
at any future date. He is therefore in a position to lend all the funds he receives in
such a way that the loans fall due on the date he will need them.”⁵
Based on this fundamental insight, we can state as a ﬁrst provisional conclusion
concerning the positive theory of money that money and cash balances would disappear
with the disappearance of uncertainty (never) and, mutatis mutandis, that the
investment in money balances must be conceived of as an investment in certainty or
an investment in the reduction of subjectively felt uneasiness about uncertainty.
In reality, outside the imaginary construction of an evenly rotating economy, uncertainty
exists. The terms, times and locations of all future actions and exchanges
can not be predicted perfectly (with certitude). Action is by nature speculative and
subject to error. Presently unpredictable surprises can occur. Whenever double coincidences
of wants between pairs of prospective buyers and sellers are absent, for
instance, i.e., when one does not want what the other has to sell or vice versa, any direct
trade (exchange) becomes impossible. Faced with this challenge of unpredictable
contingencies, man can come to value goods on account of their degree of marketabil⁵
Ludwig von Mises, Human Action, Chicago: Regnery, 1966, p. 249.
Hoppe: “The Yield from Money Held” Reconsidered 133
ity (rather than their use-value for him as consumer or producer goods) and consider
trading also whenever a good to be acquired is more marketable than that to be surrendered,
such that its possession would facilitate the future acquisition of other directly
or indirectly serviceable goods and services. That is, a demand for media of
exchange can arise, i.e., a demand for goods valued on account of their marketability
or re-salability. And since a more easily and widely resalable good is preferable to a
less easily and widely resalable good as a medium of exchange, “there would be,” as
Mises writes, “an inevitable tendency for the less marketable of a series of goods used
as media of exchange to be one by one rejected until at last only a single commodity
remained, which was universally employed as a medium of exchange; in a word,
money.”⁶
While this brief reconstruction of the origin of money is familiar, insuﬃcient attention
has been drawn to the fact that as the most easily and widely salable good
money is at the same time the most universally present – instantly serviceable – good
(which is why the interest rate, i.e., the discount rate of future goods against present
goods, is expressed in terms of money) and, as such, the good uniquely suited to alleviate
presently felt uneasiness about uncertainty. Because money can be employed
for the instant satisfaction of the widest range of possible needs, it provides its owner
with the best humanly possible protection against uncertainty. In holding money, its
owner gains in the satisfaction of being able to meet instantly, as they unpredictably
arise, the widest range of future contingencies. The investment in cash balances is
an investment contra the (subjectively felt) aversion to uncertainty. A larger cash
balance brings more relief from uncertainty-aversion.
The term uncertainty-aversion is meant here in its technical sense, as opposed to
risk-aversion. The categorical distinction between uncertainty on the one hand and
risk on the other has been introduced into economics by Frank H. Knight and further
elaborated on by Ludwig von Mises with his distinction between case probability and
class probability.⁷
⁶ Ludwig von Mises, Theory of Money and Credit, Irvington, N. Y.: Foundation for Economic Education,
1971, pp.32-33.
⁷ Frank H. Knight, Risk, Uncertainty and Proﬁt, Chicago: University of Chicago Press, 1971; Ludwig von
Mises, Human Action, chap. VI.
134 New Perspectives on Political Economy
Risks (instances of class probability) are contingencies against which it is possible
to take out insurance, because objective long-run probability distributions concerning
all possible outcomes are known and predictable. We know nothing about an
individual outcome, but we know everything about the whole class of events, and we
are insofar certain about the future. Insofar as man faces a risky future, then, he does
not need to hold cash. To satisfy his desire to be protected against risk, he can buy
or produce insurance. The sum of money that he spends on insurance is an indication
of the height of his aversion to risk. Insurance premiums are money spent, not
held, and are as such invested in the physical production structure of producer and
consumer goods. The payment of insurance reﬂects a man’s subjectively felt certainty
concerning (predictable) future contingencies (risks).
In distinct contrast, insofar as man faces un-certainty he is, quite literally, not
certain concerning future contingencies, i.e., as to what he might want or need and
when. In order to be protected against unpredictable contingencies at unpredictable
moments, he cannot invest in producer goods (as in the case of risk-insurance); for
such investments would reﬂect his certainty concerning particular future needs. Only
present, instantly serviceable goods can protect against unpredictable contingencies
(uncertainty). Nor does a man want to invest in consumer goods for uncertainty protection.
For an investment in consumer goods, too, is an expression of certainty concerning
speciﬁc momentary or immediately impending wants. Only money, on account
of its instant and unspeciﬁc wide-ranging salability, can protect him against uncertainty.
Thus, just as insurance premiums are the price paid for protection against
risk-aversion, so cash holdings are the price paid for protection against uncertainty-
aversion.
To the extent that a man feels certain regarding his future needs, he will invest
in consumer or producer goods. To invest in money balances is to invest neither in
consumer goods nor producer goods. Unlike consumer and producer goods, which
are used up in consumption or production, money is neither used up through its use
as a medium of exchange nor transformed into another commodity. To invest in cash
balances means I am un-certain about my present and future needs and believe that
See also Hans-Hermann Hoppe, “The Limits of Numerical Probability,” Quarterly Journal of Austrian
Economics, 10. no. 1, 2007, and idem, “On Certainty and Uncertainty,” Review of Austrian Economics,
10, no.1, 1997.
Hoppe: “The Yield from Money Held” Reconsidered 135
a balance of the most easily and widely saleable good on hand will best prepare me
to meet my as of yet unknown needs at as of yet unknown times.
If a person then adds to his cash balance, he does so, because he is confronted with
a situation of (subjectively perceived) increased uncertainty regarding his future. The
addition to his cash balance represents an investment in presently felt certainty visà-vis
a future perceived as less certain. In order to add to his cash balance, a person
must restrict his purchases or increase his sales of non-money goods (producer or
consumer goods). In either case, the outcome is an immediate fall in certain nonmoney
goods’ prices. As the result of restricting his purchases of x, y, or z, the money
price of x, y, or z will be lowered (as compared to what it would have been otherwise),
and likewise, by increasing his sales of a, b, or c, their prices will fall. The actor thus
accomplishes exactly and immediately what he wants. He commands a larger (nominal
and real) cash balance and is better prepared for an increasingly uncertain future.
The marginal utility of the added cash is higher than (ranks above) the marginal utility
of the non-money goods sold or un-bought. He is better oﬀ with more cash on
hand and less non-money goods, otherwise he would not have reallocated his assets
in this way. There is more investment in the removal of perceived uncertainty, and
there is less investment in needs, present or future, considered as certain.
The situation does not change if there is a general increase in the demand for
money, i.e., if all or most people try to increase their cash holdings, in response to
heightened uncertainty. With the total quantity of money given, the average size of
cash holdings cannot increase, of course. Nor is the total quantity of producer and
consumer goods that make up the physical production structure aﬀected by a general
increase in the demand for money. It remains unchanged. In general striving
to increase the size of their cash holdings, however, the money prices of non-money
goods will be bid down, and the purchasing power per unit money will correspondingly
rise. Thus, the (increased) demand for and the (given) supply of money are
equilibrated again, but at a higher purchasing power per unit money and lower prices
of non-money goods. That is, even if nominal cash balances cannot rise as a result of
a general increase in the demand for money, the real value of cash balances can; and
it is this increase in the value of real cash balances that brings about precisely and
immediately the eﬀect desired of being better prepared for a future deemed as less
certain.
136 New Perspectives on Political Economy
No one cares about the nominal number of money units in his possession. Rather,
people want to keep cash with a deﬁnite amount of purchasing power on hand. If the
purchasing power per unit money increases as the result of an increased demand
for cash holdings, each unit of money confronted with an array of generally lower
non-money goods prices can do a better job in aﬀording its owner protection against
uncertainty.
This shall suﬃce as my attempt of providing a positive demonstration of the
unique productivity of cash holdings as “yielders of certainty” in an uncertain world.
Only a brief additional comment concerning the present, unprecedentedly severe
economic crisis and the consequences that our theoretical considerations imply for
its solution seems to be in order.
I shall say nothing here about the cause of the present crisis, except that I consider
it another spectacular vindication of the so-called Austrian – or “Mises-Hayek”
– business cycle theory. In any case, the crisis has led to heightened uncertainty.
People want more certainty vis-à-vis a future considered far less certain than before.
Accordingly, their demand for cash increases. With the quantity of money given, the
higher demand for money can be satisﬁed only by bidding down non-money goods’
prices. Consequently, as the over-all “level” of prices falls, the purchasing power per
unit money correspondingly rises. Each unit of money is productive now of more certainty,
and the desired level of uncertainty-protection is restored. The crisis is ended.
The solution to the crisis suggested instead by most economists and pundits and
oﬃcially adopted by governments everywhere is entirely diﬀerent. It is motivated
by the here criticized, fundamentally ﬂawed doctrine that money held in or added
to cash balances is money unproductively withheld from production and consumption.
The additions to their cash holdings that people want to bring about are thus
interpreted, wrongly, as a diminution of human welfare. Accordingly, huge eﬀorts
are now undertaken to increase the amount of spending. But this stands at crosspurpose
to the general public’s needs and desires: In order to be better protected
against heightened perceived uncertainty, prices must fall and the purchasing power
of money must rise. Yet with an inﬂux of additional, newly created money, prices will
be higher and the purchasing power per unit money will be lower than otherwise.
Thus, as the result of the current monetary policy the restoration of the desired level
of uncertainty-protection will be delayed and the crisis prolonged.
ISSN 1801-0938
New Perspectives on Political Economy
Volume 5, Number 2, 2009, pp. 137 – 167
Islamic Economics: New Economic Paradigm, or Political
Agenda?
Ondřej Šrámek
JEL Classiﬁcation: B59, G18, G21, N25, Z12
Abstract: The concept of Islamic economics emerged during the decolonization process
in Muslim countries. Its creators sought a new economic paradigm reshaped
along Islamic principles in an attempt to clearly distance the newly independent
countries from their colonial legacy. The whole concept was strongly politically motivated
since its very creation and this legacy has never been overcome. This paper
outlines the ideological foundations of Islamic economics and its underlying theoretical
principles focusing on Islamic banking, undoubtedly the most developed segment
of Islamic economics. The empirical analysis of Islamic banking across Muslim countries
in the last decade, however, reveals a major general discrepancy between the
claims and the reality as well as some interesting regional diﬀerences. It turns out
Islamic banking does not stand up to its own claims and even more so in those countries
where Islamization of economy was imposed by the government. The reasons
behind such discrepancy are identiﬁed, and inﬂuence of political agenda on Islamic
ﬁnance is suggested as the driver behind the whole concept.
Dept. of Political Science, University of Economics, Prague, srameko@vse.cz.
138 New Perspectives on Political Economy
1 Introduction
The concept of Islamic economics, i.e. economics reshaped along the principles of
Islam, emerged during the decolonization process after World War II and has been
gradually attracting more attention ever since. Its ﬂagship, Islamic banking, is a very
fast growing segment: while in 1970 Islamic banks in Muslim countries (countries
with majority a Muslim population) occupied a mere 2% of the banking market; thirty
years later it was already 15% (Aggarwal & Yousef 2000: 93). The total assets of Islamic
banks today according to diﬀerent sources may be anywhere between USD 200 and
500 billion,¹ roughly an equivalent of GDP of a medium-sized country like Norway
or Poland. Moreover, Islamic banking is no longer conﬁned to Muslim countries, as
even the biggest Western banks now oﬀer products compliant with the Islamic law,
Sharia.
This boom led some authors to claim that Islamic economics constitutes a whole
new economic paradigm. This is obviously suggested mainly by Islamic scholars.
Choudhury (1997) for instance even claims there is Islamic Political Economy with
distinct epistemology. Some Western scholars also share this view, such as Presley &
Sessions (1994), Humayon and Presley (2000) or Nienhaus (2000), who writes:
despite the fact that progress is slow and not always continuous, Islamic economics
is clearly beginning to establish itself as a science, which will not allow
itself to degenerate into an ideology or social revolution or a veneer for conservative
dogmatism. (Nienhaus 2000: 98)
Other scholars have not been as enthusiastic. Kuran (esp. 1995, 1996) criticised the
economic foundations of Islamic economics, while Aggarwal & Yousef (2000) gathered
some empirical evidence to show that Islamic banking falls behind expectations.
Proponents of Islamic banking acknowledged some of the critiques, but countered
that these are infant diseases that will gradually diminish.
¹ Sources vary, according to Business Week (“Islamic Banks: A Novelty No Longer”, August
5, 2005) it was USD 262 bn in 2005, according to Time (“Banking On Faith”,
December 8, 2002) almost 300 bn already back in 2002. Memri economic blog
(http://memrieconomicblog.org/bin/content.cgi?news=861, January 24, 2008) even quotes the
ﬁgure of 450 bn reportedly stated at the Algerian economic forum in 2008.
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 139
While the news and the Internet burst with marketing information on how Islamic
banking thrives, the academic debate based on empirical research has gone
somewhat silent in the last ten years. In this paper, I want to evaluate what progress
there has been and whether we are ﬁnally entering the new era of two distinct competing
economic systems (Islamic and Western) or whether Islamic economics is just
an inﬂated bubble. In the ﬁrst section I brieﬂy outline the ideological foundations
of Islamic economics and its underlying theoretical principles with a focus on Islamic
banking, the single most developed segment in Islamic economics. In the second
section, the empirical analysis of Islamic banking across Muslim countries in the
last decade reveals a major discrepancy between the claims and the reality as well as
some interesting regional diﬀerences. Vis-à-vis the evidence, Islamic banking does
not stand up to its own claims and even more so in those countries where Islamization
of economy was imposed by the government. In the third section I attempt to explain
the reasons behind such discrepancy. Finally, the inﬂuence of a political agenda on
Islamic banking is suggested as the driver behind the whole concept.
2 Theoretical framework of Islamic economics
2.1 Ideological background
Islamic economics emerged as a part of the Islamic resurgence—an eﬀort to cut oﬀ
from the political, social, economic and cultural heritage imposed on Muslim countries
by Western colonial powers. A leading Pakistani Islamic leader, Sayyid Abu’l-A’la
Mawdudi, for instance, openly stated that Islamic economics was a political tool to
re-establish Islamic authority over economy (Kuran 1995: 156).
Early Islamic economists, such as Pakistani politician Mawdudi or Iraqi Shi’ite
scholar Baqir al-Sadr found inspiration in socialist critique of capitalism.² According
to them unfettered market and private ownership lead to injustice and must be contained
by Islamic regulation (Watt 1988: 57, Weberová Babulíková 2001, Aziz 2003).
² Pro-capitalist interpretations of Islamic economics are fairly rare. One of the examples could be former
Malaysian Prime Minister Mohammad Mahathir, who for instance claimed that Islam is not an
egalitarian doctrine and that social stratiﬁcation is given by God, who also provides tools for its reduction
(2002). Mahathirm however, does not enjoy the reputation of an Islamic scholar.
140 New Perspectives on Political Economy
As failure of socialism was gradually becoming more evident, Islamic economists
moved to the “third way” argument, according to which Islam oﬀers the moderate
compromise between the two utopian extremes: capitalism and socialism (see for
instance Ishaque 1983, Siddiqi 2002, Taheri 2003, Jafry n. d.)
2.2 Theoretical principles
The central principle of Islamic economics is prohibition of usury (riba). Usury is
commonly understood as excessive proﬁt on lending out money, and its prohibition
is not unique to Islam. In ancient times it used to be a common practice with the
inability to pay one’s own debt resulting in slavery. That, however, gradually became
socially unacceptable and regulations on interest rates were introduced in most
societies.³ Another reason probably was the eﬀort to prevent exploitation by lifesustaining
goods (animals and crops) upon which the Muslim barter-trading community
was heavily dependent (Mohammed 1988:119).
In most societies harsh restrictions were later gradually lifted, but some degree
of regulation remains common to date in most countries (for instance rate-caps on
consumer credit is quite common). On the contrary, the proponents of Islamic banking
insist that any non-zero rate of interest—even the lowest one—constitutes usury.
Interest thus must be not only regulated, but banned entirely.
Apart from prohibition of usury, there are several other Quranic principles that
underlie Islam. One of them is the obligation of Muslims to pay religious alms to
the poor (zakat). While liberal Muslims understand zakat as their personal religious
duty, many Islamic conservatives and fundamentalists maintain that zakat should
be institutionalized, its collection centralized and enforced and its revenues redistributed
by the government (Qutb 1996, Taheri 2003). Another principle aﬀecting
economy is prohibition of gambling and speculation (gharar) which under certain
interpretations results in a ban on ﬁnancial derivatives and futures, but it also renders
conventional insurance unlawful as an attempt to protect oneself from the will
of the God. Islamic alternative to insurance (takaful) is based on mutual cooperative
risk-sharing.
³ For an overview of historical development of usury and its regulation (in Czech) see Weberová Babulíková
(2001)
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 141
2.3 Instruments of Islamic banking
Prohibition of interest obviously creates a need for interest-free banking methods.
The two main types of transactions used in Islamic banking are proﬁt and loss sharing
(henceforth PLS) and mark-up methods.
The two pure methods to conduct business in compliance with Sharia are based
on proﬁt and loss sharing partnership and are called mudaraba and musharaka.⁴ Under
a mudaraba agreement the owner of capital provides it to the entrepreneur, who
conducts the business. The proﬁt is then divided between both in a proportion agreed
on beforehand. In case of business failure the lender loses his investment and the entrepreneur
his time and eﬀort. Mudaraba is thus an equivalent to limited partnership.
Musharaka is a partnership in which all partners contribute capital and all share the
proﬁt or loss together accordingly (general partnership).
Where partnership is not applicable, “mark-up” methods are allowed. The major
two instruments are murabaha (deferred payment) and ijara (leasing). Under
murabaha the bank buys the property for its client, increases (marks up) the price
and then sells it to the client at the higher price, which is then paid by the client
later, usually in instalments.⁵ Murabaha is thus basically equivalent to mortgage or
loan. Under ijara, the bank owns the asset and rents it to the client for a rental fee.
The rental fee should be ﬁxed at the beginning for the whole duration of the contract
and entitles the client to the usufruct of the asset—it may or may not result in transfer
of ownership.
As globalization proceeds and complexity of ﬁnancial instruments increases, new
methods are introduced, among which the “Islamic bond” (sukuk) became prominent.
The same dispute about Sharia compliance applies, though. The Economist⁶
points out that the prominent Islamic scholar M. T. Usmani⁷ said in November that
⁴ Other transliterations of mudaraba and musharaka include modaraba, mudharabah, mozarebe, and
musharika, musyarakah, musharakat respectively. For simplicity I will use only mudaraba and
musharaka, unless quoting others.
⁵ Usage of terms varies slightly. For instance Malaysian banks use a separate term Bai’ Bithaman Ajil
for a mark-up transaction with one-time deferred payment, while the term murabaha is reserved for
deferred payment in instalments. The underlying principle is the same, though, and we may safely
lump them together for the purpose of this paper.
⁶ The Economist, “Under the microscope”, 10 March, 2008
⁷ Muhammad Taqi Usmani is the deputy chairman of Islamic Fiqh Council of the Organization of Islamic
Conference (OIC)
142 New Perspectives on Political Economy
“some 85% of sukuk issues in the Gulf Co-operation Council (GCC) member states
failed to comply with sharia principles.”
2.4 Mark-up controversy
Muslim scholars themselves are aware that avoiding the prohibition of interest by
relying heavily on mark-up instruments (such as murabaha or ijara) is a questionable
practice for two principal reasons. First, it is prone to be interpreted as interest in
disguise, and second, it runs against the declared superiority of economy based on
proﬁt and loss sharing. For instance A. A. Kazmi says that “if the Sharia accepts markup
as valid, it is left with no basis to reject interest (...) Sharia jurists cannot reject
interest if they accept ‘mark-up’” (in Ayub 2004). Prominent Islamic economist from
Pakistan Muhammad Ayub⁸ adds that murabaha is permissible only in a very limited
extent: “It goes without saying that the mark-up technique, or for that matter any
Islamic modes, should not be used as a back door for allowing interest” (Ayub 2004).
Other thinkers acknowledge that genuine Islamic banking should be based on
genuine PLS operations, such as mudaraba or musharaka, as illustratively summarized
by M. T. Usmani (1998):
It should never be overlooked that, originally, murabahah is not a mode of
ﬁnancing. It is only a device to escape from ‘interest’ and not an ideal instrument
for carrying out the real economic objectives of Islam. Therefore, this instrument
should be used as a transitory step taken in the process of the Islamization of the
economy, and its use should be restricted only to those cases where mudarabah
or musharakah are not practicable.
In other words, Islamic economists agree that most of Islamic banking should be conducted
on the basis of partnerships. Mark-up methods are permissible under certain
circumstances where partnership is not applicable, but they should be more or less
exceptional, not form the backbone of the system. For many decades the reality was
the opposite, though. For instance Ariﬀ (1988) reviewing some empirical evidence
⁸ Muhammad Ayub is senior joint director in the Islamic banking department of the State Bank of
Pakistan.
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 143
pointed out: “The most commonly used mode of ﬁnancing seems to be the ‘markup’
device which is termed murabaha”. Aggarwal & Yousef (2000:102-103) presented
detailed data for several Islamic banks as well as some aggregate ﬁndings from the
1980s and early 1990s and demonstrated that the share of PLS ﬁnancing consistently
fell below 10 percent. They also reported that although the fully Islamised Iranian
banking system relied on PLS to a greater degree, mark-up principle still outweighed
it. This disparity of declarations and reality was countered by Islamic economists as
a temporary infancy problem of Islamic banking and it was expected that the share
of PLS products in banks’ portfolios will rise in time.
One trick to disguise mark-up is so-called diminishing musahraka. Under it, the
client and the bank buy a property together as equal partners and the client then pays
rental fee, thereby gradually increasing his or her share in the partnership up to 100%,
after which the agreement terminates. The deﬁning feature of such a transaction
is thus not the initial partnership, but the instalment payments based on mark-up.
For instance Dubai Islamic Bank (2008) calculates the rental fee based on interbank
interest rate EIBOR, meaning that interest is directly built-in!
2.5 Claimed superiority of interest-free economy
Many proponents of Islamic economics have steadily been trying to justify prohibition
of interest on rational as well as moral grounds.⁹
Most claims of interest-free economy superiority are vague, ill-conceived ideologically
biased declarations, whose bias is readily apparent. Some hypotheses merit
closer examination, though. For instance Khan and Mirakhor (1990: 356-7) suggest
that due to non-existence of interest, Islamic economy might be better suited to tackle
shocks by absorbing them immediately into the nominal value of shares. This hypothesis,
however, lacks any empirical evidence so far. Further hypotheses hold that
interest causes unemployment and business cycles. However, Ariﬀ notes that none
of them “has really succeeded in establishing a causal link” (1988). It is also often
claimed that Islamic system will enable easier ﬁnancing for small enterprises.
⁹ For a more detailed critical analysis of arguments underlying prohibition of riba and equation between
riba and interest see the Farooq (2005). Claims made by the International Association of Islamic Banks
are criticized by Aggarwal & Yousef (2000)
144 New Perspectives on Political Economy
Siddiqi (2002) claims that Islamic ﬁnance is not only eﬃcient but also more moral:
(…) superiority [of Islamic ﬁnance] over conventional ﬁnance (…) lies in its
promise to ensure that good returns to investments shall be accompanied by
promotion of the good of the society as a whole. A combination of eﬃciency with
morally better end results requires that institutional changes be accompanied by
moral regeneration.
For Siddiqi interest is morally unjust because the lender enjoys an unfair advantage
of a ﬁxed return, while the whole risk is assumed by the entrepreneur. Secondly,
interest allows for “money to be exchanged for more money, making the moneyed
richer,” thereby aggravating social injustice. Thirdly, prohibition of interest will result
in greater emphasis on proﬁtability, productivity of capital and hence overall
eﬃciency.
The moral argument is bound to eventually end in a clash of value judgments.
While I do appreciate such debates, I shall not enter it at this point because my goal
is diﬀerent. Suﬃce to say that there are some challenging questions that Islamic
economists have not yet answered suﬃciently. On a philosophical level, for instance,
Kuran (1995: 157) raises serious doubts about morality of banning interest based on
depriving risk-averse individuals of a safe way to invest money. El-Gamall (2000: 10)
also thinks that “any ﬁnancing conducted through valid trading by mutual consent
is permissible [in Islam].” On a practical level, we have a recent example of Grameen
Bank in Bangladesh, where interest brings demonstrable beneﬁts especially to the
poor.¹⁰
On the other hand, the claim about higher economic eﬃciency is a clear statement
that can be subjected to an empirical test. I shall thus look at the real conduct
of Islamic banks to assess this claim in the next section. If the argument about better
eﬃciency of interest-free banking holds, I shall no doubt ﬁnd plenty of Islamic banks
oﬀering genuine PLS-based interest-free products and services.
¹⁰ Although operating in a Muslim country, Grameen is not an Islamic bank. It provides micro-loans
based on interest. Grameen is very successful in supplying capital to the poorest people and especially
women. In 2006 Grameen and its founder, M. Yunus were awarded Nobel Prize for peace for their
eﬀort.
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 145
3 Islamic banking: reality check
3.1 Hypotheses
From what proponents of Islamic banking claim and what previous scholars wrote on
the topic, I am able to make following three hypotheses:
The larger part of total assets of Islamic banks are instruments of Islamic banking
(both mark-up and PLS). This is the ﬁrst condition if we want to speak meaningfully
about Islamic banking.
The larger part of Islamic ﬁnancing is based on PLS (mudaraba or musharaka).
This is a logical expectation, since proponents of Islamic banking agree PLS instruments
are what really distinguished Islamic banking from the conventional one.
In countries with government-imposed Islamic banking (Iran, Pakistan) we will
see higher use of Islamic banking than in other Muslim countries (Middle East or
Southeast Asia).
3.2 Quantitative evidence
Let us examine the ﬁrst and second hypotheses in the light of empirical evidence.¹¹
The table below shows the proportion of Islamic ﬁnancing on total assets and PLS
¹¹ Note on methodology: In order to avoid possible “Western bias,” I gathered all data exclusively from
annual reports of the Islamic banks published on their own. A second measure to avoid bias was to
focus on those banks that are considered champions of Islamic banking—for this purpose I used IFN
Awards, in which Islamic banks choose the best from among themselves every year (IFN Awards 2006,
2007, 2008, available at http://islamicﬁnancenews.com/awards.asp). Such a sample will not only be
practically free of Western bias, but in fact it will probably be slightly biased in favour of Islamic
banks. In total, I examined 37 Islamic banks in 15 countries. This search yielded close to a hundred
annual reports from the past ten years. For the overall quantitative analysis I selected only 18 banks,
for which at least three observations were available in the last ﬁve years. For each year and bank I
extracted three key ﬁgures: total assets (in balance sheet), amount of PLS instruments (mudaraba,
musharaka) and amounts of mark-up instruments (mostly murabaha and ijara but to smaller extent
also istisna, salam and other methods)—these breakdowns are usually available in the Notes to the
Financial Reports sections. From these the two key unitless ratios were calculated: the proportion
of Islamic ﬁnancing on total assets and the proportion of PLS instruments on total assets. Where
data from two consecutive reports diﬀered, the later report (restated) was given priority. Two Iranian
banks do not break down their assets suﬃciently, so we only know their PLS on total assets share, but
not their Islamic ﬁnancing on total assets.
146 New Perspectives on Political Economy
ﬁnancing on total assets of 18 Islamic banks in the years 2003-2007. The chart shows
the average ratio for each year.
Islamic ﬁnancing / total assets PLS / total assets
bank 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007
Abu Dhabi Islamic Bank (UE) 59,2% 63,5% 64,2% 59,6% 58,5% 0,6% 2,7% 2,5% 4,7% 3,7%
Dubai Islamic Bank (UE) 53,7% 57,1% 65,8% 54,7% 58,4% 9,8% 9,9% 18,7% 9,1% 11,1%
Sharjah Islamic Bank (UE) 86,5% 84,1% 88,9% 82,6% 78,3% 1,5% 3,0% 8,1% 9,0% 5,7%
Al-Tawfeek (SA) 15,9% 11,3% 10,8% 19,0% 1,5% 1,5% 0,9% 0,3%
Gulf Finance House (BH) 56,4% 62,9% 63,9% 52,4% 36,0% 0,0% 1,2% 3,2% 4,1% 3,7%
Al Baraka Group (BH) 51,5% 51,5% 54,2% 59,5% 66,1% 3,1% 4,5% 3,8% 3,1% 7,0%
Qatar Islamic Bank (QA) 72,3% 56,6% 61,4% 2,3% 2,0% 5,9%
Islamic International Arab Bank (JO) 17,3% 30,5% 44,9% 42,5% 51,4% 1,1% 2,9% 9,9% 9,2% 8,8%
Meezan Bank (PK) 66,6% 62,6% 64,4% 57,5% 51,5% 0,9% 0,5% 0,3% 0,3% 0,1%
Al Baraka Islamic Bank (PK) 58,6% 49,3% 51,4% 57,0% 0,5% 0,1% 3,0% 4,3%
Standard Chartered Modaraba (PK) 95,5% 97,1% 97,3% 96,7% 98,9% 9,8% 13,8% 7,5% 8,3% 0,5%
Refah Bank (IR) 0,4% 0,3% 0,7% 0,7% 0,6%
Sepah Bank (IR) 1,3% 2,2% 2,1%
Parsian Bank (IR) 63,3% 67,6% 64,0% 7,4% 11,3% 15,2%
Bank Mandiri (ID) 62,0% 75,8% 69,2% 74,9% 77,6% 9,7% 15,3% 20,2% 27,1% 32,5%
Bank Muamalat (ID) 70,4% 79,1% 80,8% 77,6% 79,7% 25,0% 37,6% 35,7% 37,9% 36,9%
Bank Muamalat (MY) 31,1% 35,8% 40,4% 39,9% 42,5% 0,0% 0,1% 0,1% 0,1% 0,1%
Bank Islam (MY) 52,4% 61,6% 63,4% 70,0% 51,7% 5,8% 4,8% 0,5% 0,5% 0,4%
Mean 55,3% 59,7% 62,3% 59,9% 62,1% 4,9% 6,3% 7,1% 7,6% 8,1%
In the ﬁrst hypothesis I expected that the proportion of Islamic ﬁnancing on total
assets should be higher than 50%. This hypothesis is conﬁrmed, as in every year the
mean was consistently above 50%. On average through all ﬁve years it was in fact
60.0%.
In the second hypothesis, I expected that PLS instruments will take more than
half of the Islamic ﬁnancing. Since the average share of Islamic ﬁnancing on total
assets was 60% and since I expect PLS to be more than half of that, I can reformulate
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 147
our second hypothesis: PLS will be on average at least 30% of total assets. It is readily
apparent that the real PLS share is consistently and signiﬁcantly lower than 30%. In
all ﬁve years the ratio was in fact under 10%, although with a mildly increasing trend.
The overall average through the ﬁve years was 6.84%. The second hypothesis clearly
does not hold.
0,0%
10,0%
20,0%
30,0%
40,0%
50,0%
60,0%
70,0%
80,0%
90,0%
100,0%
2003 2004 2005 2006 2007
Islamic financing / total
assets
EXPECTED AT LEAST
PLS / total assets
It is also interesting to look at average ratio of PLS on total assets of each bank over
the ﬁve years, which is captured in the chart below. It is readily apparent that only
a single bank (Indonesian Bank Muamalat) exceeded the expected threshold. Only
two banks reached more than half of it, only ﬁve banks reached at least one quarter.
Conversely, the absolute majority of the banks did not even reach one quarter of the
expected PLS share.
The empirical evidence thus clearly shows that in Islamic banking continues the
massive use of controversial mark-up instruments at the expense of allegedly superior
PLS instruments. In other words, Islamic banking fails on its own terms.
148 New Perspectives on Political Economy
0,1%
0,4%
0,6%
1,0%
1,9%
2,0%
2,4%
2,4%
2,8%
3,4%
4,3%
5,5%
6,4%
8,0%
11,3%
11,7%
21,0%
34,6%
EXPECTED
1/2 EXPECTED
1/4 EXPECTED
0,0%
5,0%
10,0%
15,0%
20,0%
25,0%
30,0%
35,0%
40,0%
3.3 Regional speciﬁcs
In order to answer the third hypothesis about the regional speciﬁcs, the overall data
presented above must be complemented by other qualitative observations. I found
it useful to divide Islamic banks into three groups: Middle East, Southeast Asia, and
Iran and Pakistan.
3.3.1 Middle East
Most of the eight Middle Eastern Islamic banks in the table above (banks in United
Arab Emirates, Saudi Arabia, Bahrain, Qatar and Jordan) kept the share of Islamic
ﬁnancing consistently over one half of total assets. It is noteworthy that Sharjah Islamic
Bank that has one of the highest ratios was originally a conventional bank and
claims to be the ﬁrst bank in the world to convert successfully to Islamic banking.
At a ﬁrst glance in the annual reports it would seem that many Middle Eastern
banks are genuinely convinced about superiority of Islamic banking and PLS instruments.
Annual reports regularly start with a prayer to Allah and the banks take great
care to introduce their Shari’a Supervisory Board members. The Head of Al-Tawfeek,
an Islamic investment company operating in Saudi Arabia for instance writes in their
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 149
2004 Annual Report: “Al-Tawfeek Company continue (…) its marvellous march and
signiﬁcant role in applying concepts of Islamic banking.” (Al-Tawfeek 2004). Similarly,
Faisal Islamic Bank in Egypt praises the beneﬁts of mudaraba in its product
portfolio:
Mudaraba is an operation of great beneﬁt to economic activity since there are
a lot of people who have the eﬃciency and the ability to operate funds but do
not have the money to do so, therefore, the Mudaraba contracts open the door of
opportunity to many talented enterpreneurs and increases the volume of trade.
(Faisal Islamic Bank 2008)
However, the reality is quite diﬀerent. All eight Middle-Eastern banks rely heavily on
mark-up instruments. The proportion of PLS instruments remained under 10% and
it often dropped even under a scant 1%. The only exception was Dubai Islamic Bank,
the “world’s ﬁrst fully-ﬂedged Islamic bank,” whose PLS on total assets share reached
almost 19% in 2005 (still below what we expected). However, an unspeciﬁed part
of PLS ﬁnancing consisted of so-called diminishing musharaka, which, as discussed
above, is in fact a mark-up product.
Al-Tawfeek’s “marvellous march” is worth noting, too. Al-Tawfeek’s assets in mudaraba
in 2003 suddenly soared up more than 20 fold. Upon closer examination,
however, it turned out it had been caused by an investment into an aﬃliated company
with guarantees issued on repaying proﬁt. That obviously violates the key risksharing
principle of mudaraba. When this investment was deducted to keep the time
series consistent, it turned out that the share of PLS instruments in fact never exceeded
2% of total assets. Faisal’s real fondness in mudaraba could not be established,
as Faisal consistently reports all Islamic methods in a lump sum and does not break
them down into PLS and mark-up (Faisal IB 2003-2006).
Some might expect that due to conservative Islamic government, Saudi Arabia
would be among the top-performers. However, Cunningham (2007) has shown that a
minority of banks in SA are Shari’a compliant and that the share of PLS in those that
are Islamic is minuscule. Also The Economist noticed that Saudi Arabia is a largely
interest-based economy.¹²
¹² The Economist, “How to be Islamic in Business”, 7 June, 2007
150 New Perspectives on Political Economy
There are three more groups of Middle-Eastern Islamic banks that could not be
included in the quantitative analysis.
The ﬁrst group are banks that call themselves Islamic, but oﬀer only mark-up
instruments (diﬀerent combinations of murabaha, ijara, istisna and salam) while PLS
products are completely missing from the oﬀered services. This is the case of ABC
Islamic Bank (2008) and UBS Bank (2008) in Bahrain, Kuwait Finance House (2000-
2006) or Emirates Islamic Bank (2005-2006).
The second group are banks that do oﬀer PLS products, sometimes even at a very
high proportion of their total assets. However, upon closer examination it is revealed
that their products are altered by additional conditions that violate the very principles
of PLS instruments. For example Al-Amin Bank (2003) in Bahrain reported mudaraba
at almost two thirds of the bank’s total ﬁnancing. However, the bulk of mudaraba ﬁnancing
went to aﬃliated companies that issued guarantees on repaying the principal
plus proﬁt, again violating the fundamental principle of risk sharing. Shamil Bank
(2008) in Bahrain, on the other hand, oﬀers mudaraba with “proﬁt rates” speciﬁed as
ﬁxed percentage (i.e. interest).
Third group are banks that either have been established recently and hence do not
have data yet (e.g, Syrian Cham Bank established in 2006 or Emirates Global Islamic
Bank established in 2007), banks that provide only old annual reports and not the
recent ones (e.g. Islamic bank of Yemen for Finance and Investment has last report
from 2003),¹³ banks that for whatever reason do not publish Annual Reports online at
all (Al Baraka Banks in Lebanon or Sudan), or banks that do publish reports, but do
not break down the ﬁgures meaningfully for our purpose (Jordan Islamic Bank 2006,
Faisal Islamic Bank in Egypt 2003-2006).
While banks in the third group have no bearing for my ﬁndings, the cases in the
ﬁrst two groups further reinforce my point that Islamic banks do not use PLS according
to their own claims.
¹³ Nevertheless, the share of PLS on total assets of Islamic Bank of Yemen were 5.6% and 3.7% in 2002
and 2003, respectively, which is consistent with our general ﬁnding about the very low level of PLS
usage.
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 151
3.3.2 Southeast Asia
In many studies on various aspects of Islam, the Middle East seems to be somewhat
more in focus at the expense of Southeast Asia (at least in Europe), despite
the fact that the world’s most populous Muslim country is Indonesia. Indonesia and
Malaysia are often discounted as not being part of the “core” Islamic world. Southeast
Asian Islamic banks are often criticized for overly liberal interpretations of Sharia
(e.g. El-Gamall 2000: 5, Obaidullah 2005:105). An expectation might thus arise
from this stereotype, that the share of PLS instruments will be trailing behind the
already low percentages that we have seen in the Middle East. Certainly, our two
Malaysian Islamic banks seem to support such hypothesis, as they are among the
lowest-performing in terms of PLS usage in the whole sample.
Bank Islam Malaysia, speciﬁcally, is one of the older Islamic banks (established
in 1983). BIM was until recently speciﬁc in that it oﬀered interest-free Sharia-based
‘benevolent loans’ (qard) at about 2-4% of total assets, unmatched by other Islamic
Banks. As of 2005, though, qard is no longer reported. Apart from standard markup
instruments, BIM oﬀers a special repurchase transaction called Bai Al-Inah. In it,
the client sells an asset to the bank and the bank immediately sells the asset back
to the client at a higher price to be paid later. Obviously, this is nothing else than a
regular money loan on a ﬁxed interest, disguised by selling an asset back and forth.
The other Malaysian bank CIMB Islamic (2007) started oﬀering a product based on
the same principle in 2007. This instrument is widely criticized by Islamic scholars
as Sharia non-compliant and BIM does not even advertise it on its website (though it
does report it in Annual Reports).
If Malaysian banks play into the aforementioned stereotype of laxity in application
of Sharia, the two Indonesian banks are truly astonishing. Both of them are clearly
the top-performers in the whole sample. Bank Muamalat is the only bank in the
whole sample that matches our criterion of PLS share on total assets. Our ﬁndings
are furthermore corroborated by a lengthy study on Islamic banking in Indonesia by
the Central Bank (Bank Indonesia 2005). The study shows that the share of Islamic
ﬁnancing in Indonesia grew from roughly a quarter in 2000 to three quarters of assets
in 2005 and the share of PLS instruments rose from 10% to 25% in the same period.
152 New Perspectives on Political Economy
The outstanding results of Indonesian Islamic banks are somewhat moderated
by the fact that despite being the biggest Muslim country, Indonesia has only three
Islamic banks altogether. It appears as though the Islamic banks focus on a speciﬁc
market segment (pious Muslims), which in turn forces them to uphold high standards
of Sharia compliance to preserve that distinction.
3.3.3 Iran and Pakistan
Iran and Pakistan are both special cases, because they share the experience of government-led
“Islamisation” of the economy. However, they diﬀer in the pace with which
the change has taken place (Khan and Mirakhor 1990). Economic “Islamisation” in
Iran was a part of the political agenda of the Islamic Revolution and had a more devastating
eﬀect. Pakistan, on the contrary, proceeded gradually in phases and the process
is still underway (State Bank of Pakistan 2008).
Let us brieﬂy examine Pakistan ﬁrst. As Islamic banks are backed by favourable
government regulation, we would certainly expect high ratios of PLS-based instruments.
Such expectation is wrong, though, as only one bank (SC Modaraba)¹⁴ reached
10% at least once in its history while the other two banks (Meezan and Al Baraka) trail
behind with a scant one percent. Meezan furthermore increases its PLS proportion by
diminishing musharaka, which is not a real PLS, but disguised mark-up instrument.
The situation in Iran seems similar. Despite the enforced “total Islamisation” of
Iranian economy, Iranian banks (unlike their Middle Eastern counterparts) do not
dedicate many pages to glorifying Islamic ﬁnancing and explaining its superiority in
their annual reports. In fact they barely make any reference to Islam at all. Instead,
they typically focus on very secular economic or technocratic issues.
CIA World Factbook is perhaps unsurprisingly critical about the Iranian economy,
but what certainly is surprising is that one of the Iranian banks cites CIA’s criticism on
its own website: “Iran’s economy is marked by a bloated, ineﬃcient state sector, over
reliance on the oil sector, and statist policies that create major distortions throughout.
Most economic activity is controlled by the state” (Saderat 2008).
¹⁴ Standard Chartered Modaraba, despite its name, in fact does not oﬀer mudaraba at all The title means
that SCM and another company from a big transnational family Standard Chartered are grouped
together on a partnership (mudaraba) basis (SC Modaraba 2008).
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 153
Analysis of PLS and mark-up instruments ratio of Iranian banks was diﬃcult, as
they do not even break down their assets according to these criteria. I used the balance
sheet item “Investments and Partnerships” that most closely resembles PLS instead.
Similar to Pakistan, two out of three banks (Refah, Sepah) barely reach one
or two percent share. The third bank, Parsian (2006) reports much higher (but still
low) 15 percent of PLS on total assets. Surprisingly though, in its annual report Parsian
also openly operates with interest, both received and paid. And a closer look
at the description of credit facilities oﬀered in the form of partnerships reveals that
Parsian charges interest and requires the applicant to pay for any extra costs and contingency
expenses of the project (Parsian, 2008). Such agreement resembles a regular
interest-based business loan rather than genuine partnership ﬁnancing.
Another bank, which openly reports income from interest is Bank Refah (2004)
and also London-based Persia International Bank (2007), which is a joint venture of
two major Iranian banks Mellat and Tejarat.
In sum, Iranian banks in general do not seem to be very enthusiastic and genuine
about the ban on interest like the Middle-Eastern banks . Quite the contrary,
they seem to minimize the compliance-costs by just labelling interest as “proﬁt rate”
or “rate of return,” loan as a partnership and formally adjusting accounting practices
rather than transforming the substance of their products toward real PLS. Iranian
banks seem to be playing parts in a gigantic theatre orchestrated by the Iranian Central
Bank, which caps the annual “rates of return” of the commercial banks, but itself
is excluded from the ban on interest when ﬁnancing government debt (Ariﬀ, 1988).
3.4 Summary of ﬁndings
Although in terms of PLS ﬁnancing there are outliers in both positive and negative
terms, we can say with certainty that Islamic banks still do rely heavily on mark-up
instruments. The proportion of PLS-based instruments in most cases remains deep
under hypothesised 30% of total assets and I have failed to discover a single bank that
used more PLS than mark-up ﬁnancing.¹⁵ Moreover, in many cases where PLS share
exceeded 10 percent it was so due to misleading usage of terms, such as diminishing
¹⁵ Even the top-performing Bank Muamalat at its peak reached 41% of PLS (mudaraba and musharaka)
on total assets, but the mark-up instruments (ijara) on total assets ratio was 42%.
154 New Perspectives on Political Economy
musharaka. Another common trick is to label as mudaraba such a ﬁnancial operation
in which guarantees are issued, violating the very deﬁnition principle of risk sharing.
My ﬁndings thus perhaps somewhat surprisingly challenge those of Aggarwal &
Yousef (2000) who found that Iran outperforms other Islamic countries in terms of
PLS ﬁnancing. According to my own research it appears that forced top-down Islamisation
of the bank sector in Iran was in reality counterproductive: Iranian banks lag
behind, and the top-performers are surprisingly Islamic banks in Indonesia, which
are often considered too liberal in interpreting Islam. I shall revisit this paradox in
the conclusion.
4 Why Islamic banking fails?
At the outset I noticed that Islamic economists claim that Islamic banking based
on proﬁt and loss sharing is both more eﬃcient and more moral. I explained that
the moral argument lies outside of the scope of this paper and I focused on the efﬁciency
argument. Empirical inquiry provided suﬃcient grounds to reject this hypothesis—were
PLS more eﬃcient, Islamic banks would use it much more, but they
do not. Having identiﬁed this failure, I would like to look at why that is the case
and whether the ﬂaws are of temporary or of structural character. Not too surprisingly,
the failure of Islamic banking can be explained with common sense and basic
concepts of economic theory.
A. Gafoor (2001), a defender of Islamic banking, maintains:
Broadly speaking, a passive investor has three options: one, deposit in a bank
and receive interest; two, buy securities or bonds and receive interest; three, buy
shares in a company and receive a dividend. In an Islamic economy, the ﬁrst two
options would be regarded as riba (interest) income and therefore prohibited
while the last option and the active investment are permissible. On the entrepreneur
side, he may ﬁnance his project using his own capital, by selling shares
in his enterprise, or by borrowing on interest. In an Islamic setting the ﬁrst two
methods are permissible while the last is not.
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 155
Presumably not intentionally, Gafoor accurately summarizes the crucial problem of
Islamic banking and ﬁnance: it reduces individual freedom of choice by forbidding
all interest-based methods without providing any functional alternative to them, effectively
leaving the individual with only two options: invest on a PLS basis, or not
invest at all.
4.1 Ineﬃciency for individuals
Khan and Mirakhor (1990: 357) suggest that eradication of interest will not necessarily
reduce savings. On the contrary, if proﬁt rates will be high enough, savings might
actually increase. This argument, however, is ﬂawed. While some market actors may
be willing to allocate their capital into a riskier PLS investment, risk-averse individuals
are deprived of the possibility of a safe ﬁxed return (interest). Being stripped of
incentives, they have no reason to deposit their savings at a bank. In other words, riskaverse
actors are as a matter of fact forced to accumulate their wealth in cash. There
is thus no reason to think that after abolishing interest, risky PLS instruments would
experience a boom. Those who were willing in expectation of higher reward to invest
in riskier PLS instruments have already done so. Those who deposited their savings
on interest-based saving accounts were presumably risk-averse and only a fraction of
them would move their funds to PLS investment. Most would choose not to invest
at all. The Islamic system in fact results in precisely the opposite to what it seeks to
achieve—capital circulation rather than accumulation.
A study by Presley and Sessions (1994: 587) suggests that “[mudaraba] under certain
conditions, will act to raise the level of capital investment in the project.” This
can of course be true. Similarly Usmani (1998) says that particular problems, such as
dishonest clients “should not be taken as a justiﬁcation, or as an excuse, for rejecting
the whole system of musharakah.” That reality is a misunderstanding. Criticism of
Islamic banking does not imply criticism of PLS methods as such. PLS instruments,
such as mudaraba may be perfectly suitable under certain conditions (esp. high level
of conﬁdence). The real problem lies in eradicating other than PLS instruments thus
leaving individuals with no choice under such conditions, where PLS is not applica-
ble.
156 New Perspectives on Political Economy
4.2 Ineﬃciency for banks
Similar problems arise for the bank as a lender. The bank, deprived of the possibility
of lending out money on a ﬁxed interest rate, incurs substantial additional costs
on in-depth risk assessment that would not be necessary on an interest-based loan.
While for specialized investment banks or private equity funds PLS investment (jointventure)
may indeed be the most eﬃcient form of investment, in most other cases,
prohibition of interest-based loan creates ineﬃciency. Moreover, these additional
costs will be relatively higher for small investments, thus harming particularly small
businesses. That contradicts another goal of Islamic banking: better accessibility of
capital to small businesses.¹⁶
Finally, as Kuran (1995) and others have pointed out, banks operating under a
proﬁt and loss sharing mode face higher risk of moral hazard (deceit, information
withholding and proﬁt diversion) on the part of the entrepreneurs trying to reduce
the bank’s share on proﬁt. In most countries Islamic banks compete with conventional
banks. Hence, entrepreneurs will tend to choose a conventional bank when
they expect high proﬁt (instead of sharing it they will pay lower ﬁxed interest), while
to Islamic banks will go those with low expected proﬁt (the bank will bear the loss,
or a bank’s proportion of the proﬁt will be lower than would be the interest).
Some proponents of Islamic banking are aware of some of the problems following
the ban on interest and suggest some counterarguments. Usmani (1998), for instance,
claims that the increased risk of PLS investing can be alleviated by better risk
assessment and diversiﬁcation. The problems with dishonesty may be countered by
a “well-designed system of auditing” and uncompromising punishments. That is, of
course, true, but Usmani misses the point—these measures are exactly the additional
costs that render Islamic banking less eﬃcient.¹⁷
¹⁶ Weberová-Babulíková (2001) points out that in order to asses the risk, banks will require accurate
information from the investment-seeking businessman. Since common small entrepreneurs in the
Muslim world are often illiterate and incapable of comprehensive book-keeping, they will less likely
ﬁnd funding for their projects.
¹⁷ Usmani’s argument is like arguing that the risk of driving a less safe car instead of a safer one can be
mitigated by fastening the seatbelts. Seatbelts will indeed increase safety, but that applies to both
cars, so it will still make more sense to choose the safer car. Islamic banking here is clearly disadvantaged.
Another parallel with cars comes to mind here. As Sam Peltzman (2007) showed on Auto
Safety Regulation, a newly imposed regulation tends to be partially or even completely oﬀset by its
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 157
4.3 Internal inconsistency
Third critical point I would like to raise about Islamic banking and economics as well
is its internal inconsistency. Islamic economics rests on vague grounds. For example
proﬁt of a businessman is acceptable, as long as it is “not excessive.” Workers are
to be paid “fair” wages, and social stratiﬁcation is acceptable to a “reasonable” degree.
Vague deﬁnitions may in fact be advantageous, since they allow for ﬂexible
adjustment according to the circumstances—after all Western law also operates with
similar terms. The problem is that Islamic conservative religious authorities tend to
monopolize the interpretation of these principles, preventing the needed ﬂexibility.
Proponents of Islamic economics often refer to the idealized early Islamic community
(umma).¹⁸ Along with the Qur’an, actions of the prophet Muhammad (recorded
in a collection of stories called Hadith), also serve as guidelines for Muslims. Liberal
Muslim scholars encourage Muslims to re-interpret the meaning of the stories and apply
them to contemporary issues with their own individual reasoning (called ijtihad).
On the contrary, conservative Muslims insist that what is contained in Qur’an and
Hadith is to be obeyed literally in the light of traditional interpretation. Since modernity
constantly brings new challenges, their rigid interpretation is bound to produce
numerous mutually inconsistent interpretations and in some cases even contradicting
authoritative religious rulings (fatwas).
An example of such controversy is the debate on private property in Iran captured
by Behdad (1995: 203). One interpretation maintains that there exists no scarcity of
resources, as God provided inﬁnite amounts of those and their scarcity in the real
world is caused by “coercive social relations”, private property being the major one
of them. An opposing interpretation holds that the state of inﬁnite resources in the
unintended side-eﬀects. The impact is therefore uncertain and even a very “well-designed system of
auditing” is unlikely to lead to the desired outcome.
¹⁸ Labib (1986:80) calls this era Pax Islamica: “Islamic trade reached from Gibraltar to the Sea of China.
The voyages of Christians, in contrast, were limited to modest coastal journeys...” However, Labib also
shows that even in the idealized medieval Islamic community, interest was quite common: “Interest
and usury were legally prohibited; however they were customary. Usury and excessive proﬁt played
an important role in Islamic capitalism. (...) Even Caliphs, Sultans, and Emirs received loans carrying
too high an interest rate.”
158 New Perspectives on Political Economy
Qur’an refers to the era after the return of the Hidden Imam.¹⁹ In the current real
world, resources are limited and private ownership is thus legitimate. Another example
are two contradictory rulings on indexation as a tool to counter inﬂation: one
fatwa forbids it, whereas another one requires it (Kuran 1995:165, see also El-Gammal
2000:33).
Discord remains at the very heart of Islamic banking. While most Islamic thinkers
seem to agree that interest equals usury (riba), Rector of Al-Azhar Dr. Tantawi issued
a fatwa in 2002, which says interest is permissible on account of mutual consent and
beneﬁt of eradicating uncertainty and moral hazard. In other words not all interest
is necessarily usury—only the evil abusive part of it used on others in need is banned
(El Gamal 2003: 9-12). Although, as has been shown, informally practiced in reality,
this view still oﬃcially remains a controversial taboo and Tantawi’s fatwa was hastily
rebutted by Islamic Fiqh Institute in Qatar in 2003 (El Gamal 2003: 13).
5 Conclusion
At the outset of this paper I have outlined the concept of Islamic banking based on
proﬁt and loss sharing and its claimed superiority. I have then conducted an empirical
study and established that in reality Islamic banking does not deliver what
it promises, being overwhelmingly dependent on interest-like mark-up instruments.
I have suggested that the reason for this underperformance is that contrary to the
claims of the Islamic economists, abolition of interest creates ineﬃciencies. Banks
realize that and in practice either use various techniques to disguise interest or claim
that prohibition of usury does not cover reasonable mutually agreed interest rates.
In the formal public debate, though, interest remains taboo: “To be recognized as
an Islamic economist, it is not suﬃcient to be a learned Muslim who contributes to
economic debates. One must be opposed in principle to all interest” (Kuran 1995:157).
Why is that the case? Farooq (2005) suggests that it is because “Islam in general
has become a victim of an overly legalistic approach, where form has overtaken
the spirit and substance” and I concur. Islamic banking and Islamic economics is in¹⁹
Eschatological concept of Shi’a Islam: the Hidden Twelfth Imam will return and lead the humanity
to the last apocalyptic battle and salvation.
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 159
tended to present a consistent economic paradigm based on Islamic values. But since
Islam is a living and internally diverse doctrine, there is no uniform set of values upon
which to build. As I have shown, there is not even a clear consensus whether any interest
should be prohibited or not. Islamic banking based on prohibition of interest
is merely one of possible interpretations of Islam. Individuals and particularly banks
do not necessarily see interest as ineﬃcient or immoral, but they are led to believe
it is un-Islamic thus propelling a “guilt-ridden Islamic subeconomy” (Kuran 1995).
In reality banks oﬀer products more or less obviously based on interest and clients
use them, but formally interest is not involved by careful wording of the contracts.
This, in turn, it is criticized by Islamic economists as circumventing the key principles
of Islamic banking. Islamic economists fail to see or do not want to see that the
very principles of the system are ill and therefore their circumvention is inevitable.
Forcible imposition of Islamic banking on all Muslims is a purely political act, not
very diﬀerent from imposing a socialist utopia by force and regardless of the number
of victims.
The “qui bono?” question remains to be answered: Who has the motive to perpetuate
such an ineﬃcient and economically ﬂawed system? On one side of the equation
are the banks and especially their Shari’a boards. These lucrative posts are often taken
by prominent Islamic economists, who at the same time fuel the whole discourse on
Islamic economics, and their “dual role” was already criticised by, for instance, El
Gamal (2003: 2). The banks veil their questionable practices and resist attempts for
independent external auditing (Al Nasser 2008), because that would reveal that the
real level of Shari’a compliance is much lower than publicly presented.
But why do the customers participate? There are two reasons. First, because
they have to—there is no alternative. The most obvious example is Iran with its topdown
imposition of Islamic banking. Second, because they want to—they simply
believe Islamic banking is the right way. That is probably the case of many Southeast
Asian or Middle-Eastern Muslims. Their belief that God banned interest is a perfectly
suﬃcient reason to participate on Islamic banking. Although the Islamic banks are
less eﬃcient and disadvantaged to their conventional competitors, it is a sacriﬁce
the believers are prepared to make, because it is compensated by greater (intangible)
beneﬁts.
160 New Perspectives on Political Economy
My research has indicated that the real level of compliance with Shari’a is highest
in the most liberal Muslim country (Indonesia). The reason probably is that
the clients that seek Islamic banking do so in good faith, therefore requiring genuine
Shari’a-compliant products. The Middle East seems to be in the middle, with
heavy reliance on mark-up and disguised interest, but with publicly displayed aﬀection
about the moral superiority of Islamic banking. This public image may be simply
a marketing tool to capture a speciﬁc market segment of pious Muslims, who however
do not take the pain to inspect the real level of compliance with Shari’a in depth.
The lowest adherence to the principles of Islamic banking seems somewhat paradoxically
be in the countries where Islamic banking is enforced by the government as a
part of its political agenda (Iran). By forcing all banks to become Islamic, the Islamic
speciﬁcity and genuine motivations were lost.
The diﬀerences among these three groups indicate that the more an agenda is imposed
and enforced from the top, the more it becomes a caricature of what it ought
to be and the less people feel attracted by it. The most conservative Muslim governments
that imposed Islamic banking by force have, paradoxically, most contributed
to its failure.
Bibliography
[1] Aggarwal, R. K. and T. Yousef (2000): Islamic Banks and Investment Financing.
In Journal of Money, Credit and Banking, Vol. 32, No. 1 (Feb, 2000), pp 93-120
[2] Ariﬀ, M. (1988): Islamic Banking. In Asian-Paciﬁc Economic Literature, Vol. 2,
No. 2 (September 1988), pp. 46-62.
[3] Ayub, Muhammad (2004): Interest, Mark up and Time Value of Money. Available
at http://www.sbp.org.pk/departments/ibd/InterestMarkUp.pdf
[4] Aziz, T. M. (2003): An Islamic Perspective of Political Economy: The Views
of (late) Muhammad Baqir al-Sadr. In Al Tawhid Islamic Journal, vol. X, No. 1,
Qum, The Islamic Republic of Iran. Published at http://www.al-islam.org/al-
tawhid/politicaleconomy/title.htm
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 161
[5] Behdad, S. (1995): Islamization of Economics in Iranian Universities. In International
Journal of Middle East Studies, Vol. 20, No. 2. (May, 1995), pp. 193-217
[6] Choudhury, M. A. (1997) Money in Islam: A Study in Islamic Political Economy.
London, New York: Routledge
[7] Cunningham, A. (2007): How Big Is “Islamic Banking”? – A Snapshot From
Saudi Arabia. In Middle East Economic Survey, Vol. L, No. 41, 8 October 2007
[8] El-Gamall, M. A. (2000): A Basic Guide to Contemporary Islamic Banking and
Finance. Available at http://www.ruf.rice.edu/ elgamal/ﬁles/primer.pdf
[9] El-Gamal, M. A. (2003): ”Interest” and the Paradox of Contemporary Islamic
Law and Finance. In Fordham International Law Journal, vol 27; part 1, pages
108-149. Available at http://www.ruf.rice.edu/ elgamal/ﬁles/interest.pdf
[10] Farooq, Mohammad Omar (2005): The Riba-Interest Equation and Islam:
Reexamination of the Traditional Arguments. Unpublished paper,
http://globalwebpost.com/farooqm/writings/islamic/ribainterest.html
[11] Gafoor, A. L. M. A. (2001): Mudaraba-based Investment and Finance. Available
at http://www.islamicbanking.nl/article2.html
[12] Humayon, A. D. and J. R. Presley (2000) Lack of Proﬁt Loss Sharing
in Islamic Banking: Management and Control Imbalances. In Economic
Research Paper No. 00/24, Loughborough University. Available at
http://islamicﬁnancepro.ﬁles.wordpress.com/2007/08/lack-of-proﬁt-loss-
sharing-in-islamic-banking.pdf
[13] Ishaque, K. M. (1983): The Islamic Approach to Economic Development in Esposito,
J. L. (ed.): Voices of Resurgent Islam. New York, Oxford: Oxford University
Press
[14] Jafry, J. (n. d.). Interview with a scholar: Prof. Nejatullah Siddiqi. Available at
http://www.soundvision.com/Info/money/nejatullahinterview.asp
162 New Perspectives on Political Economy
[15] Khan, Mohsin S. and Abbas Mirakhor (1990): Islamic Banking: Experiences
in the Islamic Republic of Iran and in Pakistan. In Economic Development and
Cultural Change, Vol. 38, Issue 2 (Jan 1990), p. 353-376
[16] Kuran, T. (1996): The Discontents of Islamic Economic Morality. In The American
Economic Review, Vol. 86, No. 2 (May, 1996), pp. 438-442
[17] ——— (1995): Islamic Economics and the Islamic Subeconomy. In The Journal
of Economic Perspectives, Vol. 9, No. 4 (Autumn, 1995), pp. 155-173
[18] ——— (1989): On the Notion of Economic Justice in Contemporary Islamic
Thought. In International Journal of Middle East Studies, Vol. 21, No. 2 (May,
1989), pp. 171-191
[19] ——— (1986): The Economic System in Contemporary Islamic Thought: Interpretation
and Assessment. In International Journal of Middle East Studies, Vol.
18, No. 2 (May, 1986), pp. 135-164
[20] Labib, S. Y. (1969): Capitalism in Medieval Islam. In The Journal of Economic
History, Vol. 29, No. 1 (March 1969), pp. 79-96
[21] Mahathir, M. (2002): Terrorism and Islam: maintaining our faith. Address to
the OIC, Kuala Lumpur, May 7, 2002. In Vital Speeches of the Day, Vol. 68, Issue
16 (June 1, 2002), pp 484-8
[22] Mohammed, N. (1988): Principles of Islamic Contract Law. In Journal of Law
and Religion, Vol. 6, No. 1 (1988), pp. 115-130
[23] Al Nasser, L. (2008): Islamic Banking and External Auditing. Available at
http://www.asharqalawsat.com/english/news.asp?section=6&id=11799
[24] Nienhaus, V. (2000) Islamic economics: Dogma or Science? In Hafez, K. (ed.)
The Islamic World and the West: An Introduction to Political Cultures and International
Relations. Trans. Mary Ann Kenny. Leiden, Boston, Koln: Brill
[25] Obaidullah, Mohammed (2005): Islamic Financial Services. Jeddah,
Saudi Arabia: King Abdulaziz University. Available at
http://islamiccenter.kau.edu.sa/english/Publications/Obaidullah/ifs/ifs.html
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 163
[26] Peltzman, S. (2007): Regulation and the Wealth of Nations: The Connection
between Government Regulation and Economic Progress. In New Perspectives
on Political Economy, Vol. 3, No 2, 2007, pp 185-204
[27] Presley, J. R. and J. G. Sessions (1994): Islamic Economics: The Emergence of
New Paradigm. In The Economic Journal, Vol. 104, No. 424 (May, 1994), pp. 584-
596
[28] Qutb, S. 1996. Social Justice in Islam. In Shepard, W. E. (tr.) Sayyid Qutb and
Islamic Activism: A Translation and Critical Analysis of Social Justice in Islam.
Leiden, New York, Koln: Brill.
[29] Siddiqi, M. N. (2002): Comparative advantages of Islamic banking and ﬁnance.
Presented at Harvard University Forum on Islamic Finance, 6 April 2002. Available
at http://siddiqi.com/mns/Advantages.html
[30] Taheri, M. R. (2003): The basic principles of Islamic Economy and their eﬀects
on accounting standards-setting. Available at http://www.accountancy.com.pk/
articles.asp?id=100
[31] Usmani, M. T. (1998): An Introduction to Islamic Finance. Available at url-
http://www.muftitaqiusmani.com/BooksPublication.aspx
[32] Weberová Babulíková, G. (2001): Islámská ekonomie a bankovnictví. Praha: Dar
Ibn Rush (in Czech)
[33] Wilson, R. (1982): Economic Change and Re-Interpretation of Islamic Social
Values. In Bulletin of British Society for Middle Eastern Studies, Vol. 9, No. 2
(1982), p. 107-113
Islamic banks sources
[1] ABC Islamic Bank, Bahrain (2008). Product description: http://www.
arabbanking.com/world/index.asp?hParentCatID=186#a188 (acc. Feb 2008)
164 New Perspectives on Political Economy
[2] Abu Dhabi Islamic Bank, United Arab Emirates (1999-2006). Annual Reports:
http://www.adib.ae/web/guest/about-adib/adib-financial-info (acc. Feb 2008)
[3] Al-Amin Bank, Bahrain (2003). Annual Report: http://www.alaminbank.com/
media/pdf/rating-2-2.pdf (acc. Dec 2006)
[4] Al Baraka, Bahrain (2006). Annual Report: http://www.barakaonline.com/
financial/annual.htm (acc. Feb 2008)
[5] Al Baraka, Lebanon (2008): Website, http://www.al-baraka.com (acc. Feb 2008)
[6] Al Baraka Islamic Bank, Pakistan (2005, 2006). Annual Reports: http://albaraka.
com.pk/downloads/annualreportpakistan2005/annualreport2005.pdf
http://albaraka.com.pk/downloads/annualreport2006.pdf (acc. Feb 2008)
[7] Al Baraka Bank, Sudan (2008): Website, http://www.albarakasudan.com/
english/profile.htm (acc. Feb 2008)
[8] Al Tawfeek, Saudi Arabia (1999-2006). Annual Reports: http://www.altawfeek.
com/Annual%20Reports/annrepmain.htm (acc. Feb 2008)
[9] CIMB Islamic, Malaysia (2007). Press release 14 Sep 2007:
http://www.cimbislamic.com/index.php?ch=islamaboutnews&pg=
islamaboutnewsoview&ac=1226&tpt=2 (acc. Feb 2008)
[10] Cham Bank, Syria (2008): Website, http://www.chambank.com/ (acc. Feb 2008)
[11] Dubai Islamic Bank, United Arab Emirates (2002-2006). Annual Reports: http:
//www.dib.ae/en/aboutdibfinancialreports.htm (acc. Feb 2008)
[12] ——— (2008) Product description: http://www.dib.ae/en/
realestatemusharika.htm (acc. Feb 2008)
[13] Emirates Global Islamic Bank Limited (2008): Website, http://www.egibl.com/
(acc. Feb 2008)
[14] Emirates Islamic Bank (2005-2006). Annual Reports: http://www.
emiratesislamicbank.ae/eib/aboutus/financials/annualreport.htm (acc. Feb
2008)
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 165
[15] Faisal Islamic Bank, Egypt (2003-2006). Annual Reports: http://www.
faisalbank.com.eg/FIB/faisalen/T3aml22.jsp, .../T3aml22b.jsp, .../T3aml22c.jsp,
.../T3aml22a.jsp,
[16] ——— (2008). Product description http://www.faisalbank.com.eg/FIB/
faisalen/NezamMasrfy31.jsp (acc. Feb 2008)
[17] Gulf Finance House, Bahrain (2004, 2006). Annual Reports: http://v2.gfhouse.
com/v2/pages/irelations.htm (acc. Fen 2008)
[18] Bank Indonesia (2005). Report on the Development of Islamic Banking: http:
//www.bi.go.id/NR/rdonlyres/3E60517D-7ABF-48F6-9B00-BAEA70875B1C/
3974/LPPSeng2005.zip (acc. Feb 2008)
[19] Islamic Bank of Yemen for Finance and Investment (2003). Annual Report: http:
//www.islbank.com/report.htm (acc. Feb 2008)
[20] Islamic International Arab Bank, Jordan (2006). Annual Report: http://demo.
batelco.jo/iiabank-en/Portals/0/FARE22006.pdf (acc. Feb 2008)
[21] Bank Islam Malaysia (1998-2006). Annual Reports: http://www.bankislam.com.
my/AnnualReports.aspx (acc. Feb 2008)
[22] Jordan Islamic bank (2006). Annual Report: http://www.jordanislamicbank.
com/annualreport.html
[23] Kuwait Finance House (2000-2006). Annual Reports: http://www.kfh.com/
english/AboutUs/Annual-Report/index.asp (acc. Feb 2008)
[24] Bank Mandiri, Indonesia (2000-2006). Annual Reports: http://www.
bankmandiri.co.id/english/corporate01/financial.asp, http://www.
syariahmandiri.co.id/laporankeuangan/laporantahunan.php (acc. Feb 2008)
[25] Meezan Bank, Pakistan (2003-2006). Annual Reports: http://www.
meezanbank.com/financialHighlights.aspx (acc. Feb 2008)
[26] Bank Muamalat, Indonesia (2002-2006). Annual Reports: http://www.
muamalatbank.com/profil/lapkeueng.asp (acc. Feb 2008)
166 New Perspectives on Political Economy
[27] ——— (2008). Product description: http://www.muamalatbank.com/produk/
biamudeng.asp (acc. Feb 2008)
[28] Bank Muamalat, Malaysia (2004-2006). Annual Reports: http:
//www.muamalat.com.my/index.php?ch=5&pg=22&ac=355&bb=181,
http://www.muamalat.com.my/index.php?ch=5&pg=22&ac=279&bb=122,
http://www.muamalat.com.my/index.php?ch=5&pg=22&ac=350&bb=192 (acc.
Feb 2008)
[29] Parsian Bank, Iran (2005, 2006). Annual Reports: http://www.parsian-bank.
com/english/annualReport.pdf, http://www.parsian-bank.com/english/
annualReport06.pdf, Product description: http://www.parsian-bank.com/
english/facility.php (acc. Feb 2008)
[30] Persia Bank, Iran (2007). Annual report: http://www.persiabank.co.uk/
Pibreport2007.pdf (acc. Feb 2008)
[31] Qatar Islamic Bank (2006). Annual Report: http://english.qib.com.qa/mritems/
streams/2007/11/5/1145113.75%20MB).pdf (acc. Feb 2008)
[32] Refah Bank, Iran (2000-2006). Annual Reports: http://www.bankrefah.ir/
en/statements/default.asp, http://www.bankrefah.ir/en/annuals/default.asp,
http://www.bankrefah.ir/pdfs/en/annuals/report4-5.pdf (acc. Feb 2008)
[33] Saderat Bank, Iran (2001). Annual Report: http://www.saderbank.com/eframe.
aspx?j=eabout&i=p0g2NHVB60zsOVIHRVEBbg== (acc. Dec 2006)
[34] ——— (2008). Our Country: http://www.saderbank.com/eframe.aspx?j=
country&i=DoiOg65j1ECp60PdmO76fQ== (acc. Feb 2008)
[35] Sepah Bank, Iran (2005, 2006). Annual Reports: http://www.banksepah.ir/EN/
FinReport/AnnualReports.aspx (acc. Feb 2008)
[36] Shamil Bank, Bahrain (2008). Product description: http://www.shamilbank.
net/modaraba.htm, http://www.shamilbank.net/pdf/alehsanew.pdf (acc. Feb
2008)
Šrámek: Islamic Economics: New Economic Paradigm, or Political Agenda? 167
[37] Sharjah Islamic Bank, United Arab Emirates (2004-2006). Annual Reports: http:
//www.sib.ae/eng/sibfinancialsannualreports.asp (acc. Feb 2008)
[38] Standard Chartered Modaraba, Pakistan (2003-2006). Annual Reports: http://
www.scmodaraba.com/html/financialstatments.htm (acc. Feb 2008)
[39] ——— (2008). About us: http://www.scmodaraba.com/html/aboutus.htm
(acc. Feb 2008)
[40] State Bank of Pakistan (2008). Islamic banking department: FAQs. http://www.
sbp.org.pk/ibd/faqs.asp (acc. Feb 2008)
[41] Tejarat Bank, Iran (2005). Annual Report: http://tejaratbank.ir/PDFFiles/EN.
pdf (acc. Dec 2006)
[42] UBS Bank, Bahrain (2008). Product description: http://www.ubs.com/1/e/
wealthmgmtww/islamicfinance/definition.html (acc. Feb 2008)
Note: All Internet sources listed in this section have been veriﬁed as of 1 November
2009.