Inflation is a major problem for modern economies. Over the years, the problem shifted from one extreme to the other: from “the great inflation” in the 1960s and 1970s, to “the death of inflation” and “inflation myth” in the 1990s and 2000s, to the “deflation monster” in 2010s, and most recently, to “the biggest inflation surge in more than 30 years”. Despite the remarkable advances in monetary theory and policy, we are still unable to control inflation.
Many studies of inflation tend to miss the forest for the trees. They mostly focus on technical details and lose sight of the big picture. Here, we want to look at the big picture.
In every Friday prayer, the Khatib (orator) customarily asks the Almighty to protect the community from al-ghalaa’ (الغلاء), i.e., higher prices. Historically, lower prices were usually associated with an abundance of goods and services and therefore with prosperity, while rising prices were usually associated with the opposite.
Central bankers, on the other hand, have their own prayers. They are keen to keep the inflation rate within roughly 2-3% annually. And keeping inflation under control is certainly on the top of their concerns and, presumably, of their prayers.
Why is it today that rising prices are required for a stable economy? Money should be stable, but this requires prices to be stable not continuously depreciating. We tend to be too accustomed to such an environment that we might fail to ask this question. To answer the question, we have to look at the other side of the equation: Debt.
Follow the Debt
To understand why central banks fear declining prices or deflation, we need to understand debt deflation. This term was coined by the American prominent economist Irving Fisher in 1932-1933, at the bottom of the Great Depression. Fisher argues that disturbances in debt and price levels play more important roles in booms and depressions than all other economic factors combined. The relationship between these two factors can be summarized as follows:
When debtors are facing difficulties meeting their obligations, they will start selling their assets to pay off their due debt. Distress selling causes prices of assets to decline. The decline of prices reduces the net worth of debtors, making it difficult for them to (re)finance their positions, thus leading to another round of distressed selling, leading to yet another round of price reduction, and so on. As debtors try to sell to pay off their due debt, collectively, they inadvertently make the burden of their debt actually bigger. As Fisher explains:
In summary, when the economy is built on debt financing, a deflationary period will be dangerous, for two reasons:
Since its appearance in 1933, debt-deflation theory has, in general, proven right in numerous cases, most notably in the Global Financial Crisis.
More recently, the Chairman of the Federal Reserve System, Jerome Powell, remarks: “Below-target inflation increases the real value of debts owed by households and businesses and reduces the ability of central banks to respond to downturns.”
Targeting inflation is done mostly through injecting money into the economy, causing the value of the currency to depreciate. While this process is frequently used to reap benefits to governments, the real reason authorities tend to push up inflation, notes former Chief Economist of the IMF, Kenneth Rogoff, is to reduce the burden of debt (called “soft default”) more than to collect seigniorage.
So, deflation, which customarily was associated with abundance, becomes dangerous in today’s debt-ridden economies. Moreover, technological advances and productivity improvement in modern economies reduce prices, as is well known. But this poses threats to stability in a debt-fueled economy. There is an inherent inconsistency, therefore, between debt-dominance and prosperity.
The story does not end here. In an interest-based system, debt has the capability to grow on its own. Debt creation is structurally decoupled from wealth creation. Compounding mechanisms allow debt to grow faster than real wealth. The imbalanced growth of debt and wealth requires a balancing force, at least in the short run. An important force is inflation. While debt grows faster than real wealth, inflated prices work to reduce the gap between the two. Put differently, the real economy cannot consistently catch up with the pace of self-replicating debt, so prices must continuously rise to tighten the gap. Without a persistent increase in prices, the economy will be crushed under the heavyweight of debt.
Unfortunately, inflation will not always be able to catch up with the growing gap between debt and wealth. This is because lenders, when they decide to lend, will factor in the expected inflation into the cost of financing. For inflation to reduce the burden of debt, it must be unexpected, i.e., not factored into the cost of debt initially. But inflation cannot be systematically unexpected—this is a contradiction in terms. If it is systematic, it must be expected; if not, it will not help the economy to catch up with debt. Debt and inflation will be playing a catch 22 game. This explains why inflation is very difficult to control in an interest-based system.
If we want to control inflation, we need to control debt. But, in an interest-based system, debt is uncontrollable. Interest releases the “genie from the bottle;” to put it back, we need to impose certain measures to contain the growth of debt. This is where Islamic finance comes into play.
Islamic finance requires for-profit debt to be integral to real economic activities, like trade and production. Making money out of lending money, or riba, is strictly prohibited, not only in the Quran but in the Bible as well. The majority of faiths hold a negative position against riba.
What riba or interest does is that it breaks the synchrony between debt creation and wealth creation. Interest acts as the rate of divergence between the two processes. As is well known from geometry, a small angle appears initially negligible, but as the two edges extend farther, the divergence grows dramatically.
Islamic finance, therefore, does permit debt financing, but it draws a sharp line between “good debt” and “bad debt.” Good debt is fully integrated at birth with wealth creation; bad debt is contractually severed from value-adding activities.
Because of the restrictions on debt financing, Islamic finance encourages non-debt instruments, e.g., equity, partnership, leasing, and the like. Non-debt financing receives a boost because of its natural integration with economic activities. These financing arrangements also make the economy resistant to debt-deflation problems. In such an environment, therefore, controlling inflation is feasible.
The other most important line of defense against inflation, as well as other economic risks, is the non-profit sector. Non-profit activities are essential in Islamic finance. They include a range of activities, starting from charity (sadaqa and zakat), to awqaf orendowments, to interest-free lending, which is a form of cash-endowment.
A well-organized non-profit sector serves as a “safe haven” for the economy, providing a safety net for the weak and vulnerable. It also helps to curb inflationary pressures.
When an exogenous shock, like the current Ukrainian crisis, causes a sharp increase in prices, agents will race to cover their costs by shifting the costs onto their customers. Workers then will demand higher wages, adding to the fume. This deadly competition to beat inflation is a major driver behind self-fulfilling expectations and inflationary spiral.
Inflation cannot be tamed without taming debt first. Islamic finance provides a comprehensive framework for taming debt from the bottom up. As a system, Islamic finance is a risk-sharing system. It has the ability to resist and absorb various economic risks. This will not make the economy risk-free, but it will make these risks manageable and self-stabilizing. But whenever debt gets out of control, such risks will be self-destabilizing.
The difference between the two regimes can be elaborated by the analogy that Irving Fisher presented in his 1933 paper: