Covid-19 and the Need for a New Economic System

Rami Abdelkafi

29 Apr, 2020

An unprecedented economic situation…

Most economists refer to the 2008 global financial crisis to assess the economic impact of the Covid-19 pandemic. They suggest that in terms of magnitude the impact of Covid-19 would be like or even bigger than that of the financial crisis. However, in terms of nature, there is a consensus that the two crises are different. While the financial crisis of 2008 was related to demand, the present one has impacted both supply and demand at the same time. Estimations from the Economic Intelligence Unit (EIU 2020) show a devastating impact of the Covid-19 crisis on economic growth in most powerful economies (Table 1):

While no country is likely to escape the impact of the crisis, the magnitude of the impact will be different from one country to another. In Europe, for example, manufacture-based economies like Germany will be less affected than tourism- and services-based economies like Spain and Italy, which already suffer from a high public debt during the last years. However, at the global level the synchronization of these demand and supply effects and the negative impact on the production value-chain will worsen the situation in all countries.  

With the hope that the international community would be able to contain the spread of the virus globally and its potential new waves are avoided, the negative impact on supply will be managed and signs of recovery will start in the second half of 2020. However, it is expected that the impact on demand will be long-lasting due to the sequelae of the crisis on investment and on household behaviors (EIU 2020). This will translate into an increase in the borrowing costs and a tightening of financial conditions as banks will have negative expectations about the ability of consumers and firms to repay their loans (Gita Gopinath, 2020). 

…and usual solutions

In such an unprecedented situation, the immediate reaction to the crisis is an increase in health spending to support and strengthen the health systems all over the world to cope with the effect of the Covid-19 pandemic. This should be followed by, first, additional measures that would consolidate demand and ensure an adequate supply of credit and, second, by adequate liquidity that would offset financial stability risks (Kristalina Georgieva, 2020).

In times of crisis, injecting liquidity has always been a spontaneous reaction of the central banks and international organizations to economic disruptions (FT Editorial Board, 2020). The current crisis is not an exception. With the increasing impact of the crisis on the American economy, the Federal Reserve’s (FED) actions included a huge lending package of USD 2.3 trillion to support households, employers, financial markets, and state and local governments(Jeffrey Cheng et al, 2020).  At the international level, the FED has made the dollar available to other central banks. The FED has extended its swap lines to nine additional central banks increasing the number of countries using these facilities to 14 including two emerging economies (Canada, England, Japan, the European Central Bank, Switzerland, Australia, Brazil, South Korea, Mexico, Singapore, Sweden, Denmark, Norway, and New Zealand). Moreover, a temporary repurchase agreement facility for foreign and international monetary authorities (FIMA Repo Facility) was established to allow repurchase operations with central banks and other international monetary authorities holding accounts at the Federal Reserve Bank of New York.

In Europe, the first Coronavirus Response Investment Initiative package consisted of three main elements: about €8 billion of immediate liquidity to accelerate up to €37 billion of European public investment, flexibility in applying EU spending rules and extend the scope of the EU Solidarity Fund. This has been complemented by the Coronavirus Response Investment Initiative Plus (CRII+), introducing more flexibility to the use of the dedicated funds.

In developing countries, the Covid-19 pandemic is compounded by the already severe economic and financial issues. According to estimates of the EIU 2020, the Middle East and North Africa Region will have a negative growth of -2.2 of the real GDP and inflation rate reaching 8%.

With their limited resources, developing countries have no option but to appeal for international aid, especially from international financial institutions. In this context, the IMF has dedicated $50 billion through its rapid-disbursing emergency financing facilities for low-income and emerging market countries that could potentially seek support. Of this, $10 billion is available at zero interest for the poorest members through the Rapid Credit Facility financing facilities for low-income and emerging market countries. Another $10 billion out of the same amount is available at zero interest for the poorest members through the Rapid Credit Facility and the lending capacity of the Fund for this crisis is USD 1 trillion (Kristalina Georgieva, 2020). Along the same lines, the Islamic Development Bank (IsDB) has approved USD 2.3 billion for the IsDB Group Strategic Preparedness and Response Programme for Covid-19 pandemic, while the African Development Bank (AfDB) has created a $10 billion facility to support governments and the private sector.

Faced with the emergency, the international community is undertaking several measures with unclear net impacts on the economy. Coping with the potential negative impact of these measures is postponed to the post-Covid-19 pandemic period. There is no question that the post-Covid-19 period will be different from the pre-crisis one. For many, the pandemic has brought to the fore the inefficiencies of the neoliberal capitalist system and a new system is under formation. In this context, there is a need to not repeat the mistakes made during and after the 2008 financial crisis.

First, the capitalist economic model has shown its limits in all countries with no exception even within developed countries. This model, which gives more weight to business, has weakened the governments and made them unprepared for a crisis like the one we are witnessing (see, for example, James K. Galbraith, 2020). In the United States, as well as in other developed countries, the health system has proved its incapacity to deal with such a situation. The poor insurance system has worsened the situation of the most vulnerable populations. 

Second, the dominance of financial sphere over the real economy has always been a source of issues in the current economic system. After the financial crisis, the huge amount of liquidity that been injected has been directed toward the financial system instead of good investment opportunities (See, for example, Mariana Mazzucato, 2020a and Mariana Mazzucato 2020b).

The need for a new economic system

As mentioned above, calls for rethinking the dominant economic system has increased with the proliferation of the economic and social impacts of Covid-19 (see also Barbara Stiegler, 2020). From the Islamic economics perspectives, at least three main features could have provided some solutions to the actual pandemic. 

First, some economists have emphasized the role of safety nets embedded in the Islamic economic system as an efficient tool to cope with the impacts of the crisis. These safety nets include zakah, awqaf, sadaqa, etc. (See for example, Abdullah Mohamed and Layachi Feddad, 2020). As a component of the non-profit sector, these safety nets represent an essential component of the Islamic economic system. More than that, this non-profit sector represents even an essential factor of stability and sustainability of the economy. More details about this can be found in Sami Al-Suwailem (2013). The author emphasized that the balance between the profit and non-profit sectors is what distinguishes the Islamic economic system from capitalist economy that has overpowered the profit sector and the market economy, and from the socialist system that gave more weight to the general interest at the expense of the private initiative. With the development of new technologies, the role of this non-profit sector would be more efficient and more significant (see for example, Mohamed Obaidullah, 2020).

Second, as mentioned above, the evidence shows that the new financial resources intended to cope with the negative impact of the global financial crisis of 2008 have been mostly invested in the financial sector without achieving the expected outcome. Another obvious evidence of this finding was the outcome of the tax plan based on trickle-down strategy adopted by the United States to reduce corporate taxes (Rana Foroohar, 2017). According to Fillion (2017), 80% of this tax plan would have benefited the richer 1% of the American population. Furthermore, the rich are more inclined to invest these benefits in the financial market rather than in the real economy, which would increase inequalities significantly. In the context of an Islamic economic system, the risk of this deviation of financial resources injected in the economy toward non-productive sectors can be avoided. Indeed, according to the Islamic economics principles, any financial transaction must be backed by a transaction in the real economy.

Third, despite its recent development and its huge potential, the role of Islamic banking in development is yet to be confirmed. Until now, Islamic banking operations have been dominated by low risk operations like Murabahah and Ijarah (IFSB Islamic Financial Services Industry Stability Report, 2019). A more active role in economic development would require that Islamic banks should be more involved in financing more operations with real economic development impact. There is a consensus among economists that the new global economy after the pandemic would be different from the one that we had before. One of the potential changes in the new global economy is the establishment of new value chains that may reduce the dependency of several countries on China in their production processes. At least in the medium term, this would represent an opportunity for developing countries to constitute an alternative and to occupy a more important place in these value chains. However, this would require huge investments. Therein lies the role that Islamic finance can play to finance these investments capitalizing on the wide range of Islamic finance instruments.

Furthermore, based on the risk-sharing principle, the use of Islamic financial instruments would result in a more stable financial system, which is more resilient to economic shocks. In any financial transaction, the different parties involved in this transaction are rewarded according to their participation in bearing the associated risk. An economic system based on this principle of risk sharing will mitigate the negative impact of recessions on investors, while, at the same time, it allows for a more equitable distribution of returns during the high-growth episodes (Global Report on Islamic Finance 2016).

Acknowledgement

The author is grateful to colleagues at the Islamic Research and Training Institute for helpful and fruitful discussions. The opinions presented in this brief do not necessarily reflect the views of the Islamic Development Bank.