Understanding the Current Economic and Financial Crisis

Islam Online. Aug 5, 2009

Easy credit and risky derivatives are the apparent factors that triggered this once-in-a-generation global financial crisis.

However, the fact is that responsible and reputable institutions, that are otherwise risk-averse, engaged in extremely risky trades without adequate protective measures, which points to something more fundamental being amiss.

Despite mounting evidence to the contrary, major financial institutions and regulators mistakenly clinged to the dogma that human beings are "rational" and make financial decisions purely motivated by economic incentives.

This assumption has been challenged for quite a while, but has grown louder since the start of the crisis. Influential voices in the field of economics, including Nobel laureates, are seeking fundamental changes in public policy.

The quest to better understand human nature is as old as human civilization. Religious texts and non-religious philosophies have pondered over this matter quite extensively.

Islam is no exception; it can be posited that Islam does provide a more holistic look into human reality by exploring not just observable facts about human nature, but also the eternal mysteries of soul and heart.

The Crisis

The current global financial and economic crisis, while not unprecedented, is certainly the most severe since the Great Depression of the 1930s.

On October 23, 2008 testifying before the House Committee on Government Oversight and Reform, former chairman of the US Federal Reserve, Alan Greenspan called this crisis a "once-in-a-century credit tsunami," that resulted from the collapse of the US housing sector.

The impact of this crisis on the developed world is quite well documented. The US unemployment rate is expected to reach 10 percent and the projected GDP growth for 2009 is at an anemic 0.1 to 0.2 percent (Most economists agree that the ideal growth for US GDP is between 2-3 percent per a year).

Somewhat lost in the maelstrom is the impact of this crisis on the 1.4 billion people who live in extreme poverty, mostly in the developing world.

A global economic crisis is turning poverty into a catastrophe. The administrator of the UN Development Program, Kemal Dervis, warned that the, "current global economic conditions threaten the gains that have been made to reduce poverty, and advance development for large numbers of people."

The number of people who are chronically hungry could increase by 130 million in 2009, reaching three-quarter of a billion people now.

A crisis evokes a quest for not just solutions, but a renewed interest in examining the very fundamentals of the current system.

Economics Noble Laureate Joseph Stiglitz recently said that the current financial crisis requires a global response based on the principles of social justice and solidarity.

Rejecting "trickle-down" theories that dominated finance and economics since the 1980s (championed by Ronald Regan in the United States and Margaret Thatcher in United Kingdom), Stiglitz questioned the fundamentals of the current system, saying: "what is good for Wall Street is not necessarily good for all."

The Dogma

We have arrived, in part, to a dogmatic belief in free markets – primarily the notion that the "invisible hand" of the market is adequate to keep markets properly functioning.

The regulators of the economy (the Fed and the Treasury in the United States) placed an inordinate emphasis on laissez-faire (hands-off or let do) ideology, thus favoring systems that prefer "efficiency" without regarding the equally important societal concern of "fairness".

Moreover, regulators and many economists were unwilling to budge from the assumption that investors are "rational", (technically the marginal investor is assumed to be rational) disregarding an emerging body of literature in finance and economics that posited investor behavior to be driven by psychological or cognitive factors, such as fear and greed.

If people were purely rational then we would not see massive expenditures on lottery or gambling, where the cost of a lottery ticket always exceeds the expected pay-off from winning the lottery. For example, if the winning jackpot was $1,000,000 and 1,000,000 tickets were sold, then the probability of winning the jackpot is 1 in 1,000,000.

The expected payoff from this gamble is computed by multiplying the winning jackpot with the probability of a win; this equals $1.

If the cost of this lottery ticket exceeds $1 then the ticket is overpriced. Even without knowing any expectation theory, it is easy to understand that if this were not the case, Las Vegas will go out of business! In gambling, the house always wins and for every winner there are a million losers.

Thus, the Qur’anic injunction (5:93-94) against gambling is not just a matter of religious spirit, but also a matter of common sense[1].

A More Realistic Look at Economic Decision Making

Since Kahneman and Tversky's ground-breaking work 30 years ago, a new area of research called Behavioral Finance or Behavioral Economics explains why people often fail to rationally respond to economic choices[2]. The example on gambling is illustrative of such failures[3].

Value or price of an asset (financial or otherwise) is not always efficient — not reflecting the asset's true, fair value.

Thus, irrational human beings contribute toward irrational markets. The British economist John Maynard Keynes in his 1936 classic "The General Theory of Employment, Interest and Money" wrote that contrary to being rational, human beings are far more likely to make decisions under the impulse of what he described as the "animal spirits".

In our time, economists Robert Shiller and George Akerlof in their book, "Animal Spirits ”, identify five "animal forces" that drive economic choices:

Confidence: Rather than making investment decisions based on objective facts, such as cash flows, investors are more likely to use "gut feelings" to make asset pricing decisions. Confidence is also contagion, like any virus. This leads to severe boom and bust cycles.

Fairness: People in general want to be fair and they want others to live with fairness. Thus, the ideas of fairness influencing wage-setting and the labor market explain "sticky" wages and persistent involuntary unemployment.

Corruption: Each major financial crisis of the past century has been preceded by anti-social behavior. The 1991 recession was preceded by the savings and loan crisis. The lead-up to the 2001 recession, with an outbreak of corporate corruption cases like Enron and WorldCom.

The current recession was preceded by sub-prime mortgages issued to people who logically could never have the means to repay them, and their securitization in packages that even the rating agencies that gave them AAA ratings could not understand.

Even watch-dog agencies, like the US Federal Reserve, had no understanding of types of risk that AIG was exposed to and how that risk could take down the US economy[4].

Money illusion: Refers to the tendency to think of asset value in nominal rather than real terms. People often take the numerical or face value of an asset as its true value, ignoring the impact that inflation had in reducing the purchasing power or real value of the asset.

Since accounting is based on nominal value and not real value "money illusion" clouds economic decision making.

Stories: Human lives are built around story telling. Without a narrative, life will be just one event after another, seemingly unrelated and random.

Stories give life purpose allowing the development of confidence in nations or institutions. Sometimes the "stories" are urban legends.

Take for example the myth that property prices or housing prices will always rise, because there is only so much land available.

This is not true. Yet, people believed this urban legend which led to the housing bubble in the United States. Stories can propagate myths, which in turn leads to bubbles. Eventually the bubble has to burst causing untold misery.
This "behavioral" deconstruction of human reality is not new to Islam's foundational texts. It is common knowledge that human beings have both an angelic and devilish side to them.

God says in the Holy Qur'an [We have indeed created man in the best shape, then we reduced him (to be) the lowest of the low, except those who believe and do righteous deeds: for they shall have a reward unfailing.] (95:46).

The presence of "animal spirits" in human beings is well illustrated in the many stories of human failings in the Quran.

However, the same human being is also capable of extraordinary compassion and understanding. Prophet Muhammad, peace be upon him, said, "God created Adam in His form".

This suggests that human beings have unlimited capacity for development and the pursuit of perfection. With proper nurturing, appropriate environment, and enforceable reward-punishment structure, human beings can gain reasonable control over their "animal spirits".

Thus, it is important to understand human nature in order to better explain why economic systems undergo severe boom and bust cycles, and what can be done to create a more stable and sustainable economic and financial system.


Footnote:

[1] [O you who believe, truly intoxicants and gambling and divination by arrows are an abomination of Satan; avoid them in order that you may be successful. Assuredly Satan desires to sow enmity and hatred among you by means of intoxicants and gambling, and to hinder you from the remembrance of Allah and from prayer. Will you not then desist?] (Al-Ma'idah: 93-94)

[2] Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk", Econometrica, V. 47 No. 2, 263-292.

[3] Over half the US population has at one time or another bought a lottery ticket. The average expenditure on lottery exceeds that of spending on books or movie tickets.

[4] "Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe," By Gillian Tett. Little Brown.