Everything you never knew you wanted to know about Islamic Central Banking

iran.

This is cool! [1] Hassan Rouhani talking about monetary policy? Could I be any more excited? No.

Despite inventing zero, arabs have no use for it, [2] at least not when it comes to central banking. Lending money at interest is haram in Islamic finance so the use of interest rates to control demand as is normal in the west doesn’t apply. So does this also means that unlike in the UK and the US there is no danger of interest rates going to zero and the economy entering the liquidity trap?

Most reporting on Iran focuses at its very high inflation but nobody is paying much attention to the tools used by the central bank. This is understandable, inflation has skyrocketed and the central bank has no independence and is controlled by the Iranian state. My rhetorical question is largely irrelevant at the moment, but if we look at the tools Iran’s central banks uses the question is likely “yes”. I think we should look a little at the tools of Islamic central banking anyway as they give us a window into a world of central banking with interest rates or a zero rate problem.

To begin, a little history. The first Islamic savings bank was established in Mit Ghamr in 1963 by Ahmad El Najjar, an economist. In the 1960s Nasser was trying to modernise egypt and so the bank kept secret its overtly Islamic nature. Riba – charging interest – is haram so the saving bank operated on a profit share basis. Today, the much larger Islamic finance industry – in 2011 $1.357 trillion of shariah-compliant assets existed globally – has a variety of alternatives to charging interest.

Islamic finance seeks to avoid unearned income, which is seen as exploitative. Instead of lending money and charging interest, which is seen as just transferring risk, risk is shared through a variety of mechanisms; as profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah), and leasing (Ijar). This can be illustrated with an example: Unlike in western finance a mortgage transaction does not involve interest payments. Instead the bank would arrange to buy the house from the seller and sell it on to the buyer at a profit with payments arranged as installments.This arrangement is called Murabahah and is the most relevant for our discussion of central banking.

Sukuk is also an important concept too. This is similar to a bond in which interest is regularly paid on a principal. However, because riba is haram in Islam it cannot be structured like this. Instead sukuk imply a transfer of ownership and can look like a form of repurchase agreement. You agree to repurchase something at a certain price over a certain period of time. This echoes previous posts of mine of what saving really is. Interest rates are just symbolic, what is really happening is people buying durable things today with an expectation they will be able to sell them on for more in the future. Interest rates are our way of expressing that, Murabahah or Sukuk are another. The latter seems clearer and more honest on the mechanism actually.

(At this point, I do want to point out to all the snooty economists, engineers, mathematicians who mock post-modernism…who’s laughing now?)

So what does all this mean for Islamic central banking? The most prominent method of controlling monetary policy is the control of the profit rates allowed by banks when they lend, the Mudharabah discussed above. Anything from an 18% to 20% on non profit-and-loss sharing arrangements, and slightly lower on profit-and-loss sharing arrangements. In a country shrinking around 5% a year finding a 20% return implies a high rate of nominal GDP growth which is split between negative growth and even higher inflation.

We can see that the implied maximum profit rates require very high growth in nominal incomes and we also see very fast growth in the monetary base. Entering into a profit-and-loss agreement will guarantee you a high nominal return in a low growth environment and monetary growth is high to accommodate these contracts. There is no reason however that the profit share cannot be set to a lower number. This would amount, via the Kalecki equation, [3] to a monetary tightening and NGDP and inflation would both have to decrease to accommodate this lower allowable rate of profit. Weirdly a shrinking of the nominal profit rate could increase it in real terms. Money is weird.

This piece from Cato, caveat lector, says that Iran stopped publishing information on its money supply in March 2011, at the time they showed continued very rapid growth in the money supply. If Rouhani has changed this that’s great. The country’s monetary policy at the moment is chaotic but once the chaos fades it will be useful to bear in mind how Islamic monetary policy works. The details in this post are broad sketches only. I took lots from these documents [12345] and I’m not sure of their quality. This is an area where I don’t even know anyone who might know an expert, so any input in the comments or on twitter is welcome. Likewise please share this as this might get picked up by someone better informed than me.

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[1] Yes. Cool. You’re here aren’t you?

[2] Yes. Persian or Iranian is more appropriate but I’ve been looking for a chance to use that line since I drafted this post months ago. UPDATE: As Lorenzo tells me, actually the Indians invented zero as a concept, the Arabs were miles behind. More here.

[3] I’m making the Kalecki equation  [1, 2, 3] do some heavy lifting here, but I think that’s right…

The ECB as Schroedinger’s cat

The European Central Bank is at all times both fulfilling its legal mandate and ignoring it. Until you look closely it is impossible to tell which it is, and once you have decided which it is it can only be because you have lost sight of its mandate as set down in law. This explains a lot: Even I can’t decide whether Mario Draghi relentlessly adheres to or has completely abandoned the whole ECB mandate.

One of the reasons that Europe is collapsing and the whole world is heading for a recession within a depression is that the ECB is charged solely with maintaining price stability not supporting economic growth. Their duty, they argue, is to without prejudice support a European wide inflation rate below, but close to 2%. However, the mandate as set out in law is so convoluted as to leave the ECB council capable of simultaneously adhering and violating both the letter and spirit of the law. No wonder Europe is a mess.

They are not just charged with maintaining price stability, as interpreted, they are also empowered to…

Without prejudice to the objective of price stability, it shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union. [my emphasis throughout]

This implies that although the ECB cannot ignore inflation, it has leeway to support the policies of member states and the Union as a whole. By this criteria the ECB should have done everything in its power to keep inflation and inflation expectations running at really, really, really close to 2%. Instead they have crashed. The mandate is wider than price stability and includes supporting economic policy making rather than sabotaging it.

However, the mandate continues…

The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 119 of the Treaty on the Functioning of the European Union.

This part of the mandate implies that the ECB is empowered to not support the policies of member states if they are not compliant with “free competition, favouring an efficient allocation of resources.” That would certainly have empowered Trichet, and now Draghi, to withhold such support as is possible if they consider member states’ policy “insufficiently favourable to an efficient allocation of resources.”

At the moment it appears Draghi is refusing to cut interest rates below 1% to blackmail Greece and France into policies deemed favourable to “Article 119 of the Treaty on the Functioning of the European Union.” This seems like something that should be impermissible for a central bank but it is in fact within the Feds mandate. So refusing adequate policy until member states change policy is merely the ECB laying greater weight on supporting certain policies over others, as it is mandated.

The mandate references Article 119 which says…

1. For the purposes set out in Article 3 of the Treaty on European Union, the activities of the Member States and the Union shall include, as provided in the Treaties, the adoption of an economic policy which is based on the close coordination of Member States’ economic policies, on the internal market and on the definition of common objectives, and conducted in accordance with the principle of an open market economy with free competition.

2. Concurrently with the foregoing, and as provided in the Treaties and in accordance with the procedures set out therein, these activities shall include a single currency, the euro, and the definition and conduct of a single monetary policy and exchange-rate policy the primary objective of both of which shall be to maintain price stability and, without prejudice to this objective, to support the general economic policies in the Union, in accordance with the principle of an open market economy with free competition.

3. These activities of the Member States and the Union shall entail compliance with the following guiding principles: stable prices, sound public finances and monetary conditions and a sustainable balance of payments.

The ECB has overseen a colossal balance of payments crisis, with the Eurozone periphery persistently running deficits and the core running surpluses. In 1992, at the signing of the Maastricht treaty, they saw this problem coming and specifically empowered the institutions of Europe to deal with it, and they have failed. This imbalance, rather than government profligacy is at the core of the Eurozone crisis. Certainly under Trichet, and now under Draghi, this part of the ECB’s mandate has been completely ignored.

A mandate is fulfilled or unfulfilled, but it is impossible to tell if the ECB has, is or will fulfil its mandate in its entirety. The ECB has failed or succeeded, and is on target to achieve or betray its objectives, it has achieved its aims “impeccably” or it is insane.

To be honest, I’m too tired to work out which it is, all I know is that all this makes me very pessimistic.

Probably going to regret this one…

Here’s my controversial argument of the day.

New Labour spent a lot of money on infrastructure, education and healthcare. Lots of money, I think we can all agree on that. A lot of people think a lot of this money was wasted. Some also think Labour damaged the productive part of our economy by burdening it with too much red tape and taxation.

But UK’s unemployment is currently lower than you would expect given a nasty, steep recession. Perhaps some of New Labour’s spending is having measurable effect in reducing the non-inflationary level of unemployment, even if we couldn’t work out was while they were in office what was Labour’s return on  investment.

Despite extra burdens on employers introduced by New Labour we still have a very flexible employment market. This is especially true for the young and the newly employed. The National Minimum Wage is lower for the young and those in a job for under a year have few employment rights.

If you strip out VAT and import prices (that is, if you cheat a bit but for easily rationalisable reasons) inflation has been rather low of late. Compared to the normal employment/output dynamic unemployment has also been low.

This leads me to argue that the UK may have seen some sort of positive supply shock in the late 2000s which has improved our unemployment rate today. If true this would mean that the natural rate of unemployment has decreased and the cyclical component is higher than most people realise.

EDIT 19:05 11/05/2012: Second paragraph edited. Unemployment no longer “very” low just “lower than you would expect.”

Bad News

You know what I was saying yesterday about the Bank of England losing its nerve?

The minutes to the latest Bank of England meeting are out and the big news is that Adam Posen — a well-known dovish member of the board and frequent add advocate of more easing — does not currently support more QE.

The pound just instantly skyrocketed.

chart

Eep. Higher pound, tighter policy. Scarily the Bank didn’t even need to change interest rates to tighten policy, somebody just stopped saying something.

Inflation trends upwards

After abating in the first quarter of the year inflation has edged up to 3.5%.

Inflation was pushed up by increases in the cost of clothing and food. The uptick in inflation has been imported, but with it I worry  came a dose of timidity for the Bank of England. The Bank  has remained tolerant of inflation but has suffered because of it. I’m known for my dovishness about inflation and these numbers do little to change that.

More domestic demand, even if it results in a little more inflation is just what we need in a depressed economy. But these inflation numbers appear to be little influenced by changes in domestic demand and much of these price increases have been imported. This means they may lead us to be poorer in two ways, one direct, one indirect. Higher import costs are like a supply shock, we really are poorer because of it. The indirect effect is that higher costs still look like the Bank of England is stimulating the economy too much and can lead to the bank doing to little or being actively counterproductive. This is the problem with a central bank targeting inflation. It can be a very, very bad idea as we saw in Europe in mid-2008.

Sometimes inflation increases because that is what getting poorer looks like, things get more expensive. A monomaniacal inflation targeting central bank, for example the ECB under the impeccable Trichet, will take this sort of inflation number as a sign that the economy is overheating, that we are not getting poorer but getting rich too quickly and will act to reduce inflation, usually by throwing lots of people into unemployment. Sometimes by throwing a whole continent into chaos (slow hand clap for Trichet).

Today’s inflation numbers mean nothing in isolation. They are provisional, subject to revision and they refer to an arbitrary length of time with little macroeconomic importance. Nevertheless  they have the power, if they become politically salient, to influence the actions of the Bank of England. These numbers already signal we’re all a little poorer, were the Bank to start to tighten policy today’s numbers could help make us all poorer all over again.

QE is Probably Going to Have to be Paid Back

I’ve already taken a pop at Richie today over QE and now I’m going to have a go at Chris, which is an all the more worrying prospect, intellectually speaking.

1. Richard Murphy is basically right to say that this means that government debt is lower than official figures show, if we consider the government and Bank of England as a single entity. What’s happening is that government borrowing is being financed not by debt sales to the private sector but by an increase in base money. This is entirely consistent with the government budget constraint (pdf). Warren Buffett was quite correct to say that you cannot have a debt crisis if the authorities can print their own money.

I think the collorary to this is that if actual government debt is lower than the official figures then the price level is about to become much higher than it is now. QE is backed by a credible commitment to unwind it to reduce the amount of base money circulating. Taking the Bank and Government as one does not lead us to the situation described above where some debt does not exist. We have a situation where some debt exists in the odd form of a credible promise that at a future date someone will be being burning money.

Evidence for this abounds. The price level is not significantly above where it should be if the Bank of England had fanatically maintain an inflation rate of 2%. According to some rough calculations, since 1997 the price level is about 20% higher than a 2% level rule would suggest. Since QE was initiated in 2009 it is somewhat above even than high trend, but that was the point of QE, there is very little evidence that investors view QE as bound to be inflationary due to it being later monetised.

That low inflation isn’t consistent with a large scale monetisation of Government debt unless there is significant slack in the economy such that nominal increases mostly show up as increased real activity. I think there is room for more monetary expansion, and a little credible commitment to recklessness may be useful at the moment, but I know Chris holds that this is unlikely.  

If markets are pricing in a monetisation of UK debt (and subsequent change in price level) they are pricing in only a very modest erosion of the Bank of England’s holdings. Chris can argue that we don’t need to consider Gilts held by the Bank of England under QE as real liabilities, but he needs to take that up with the markets, not me, it is they who are predicting much lower inflation for the UK ahead.

Laban Tall, fancy earning £20 for your favourite cause?

Laban, understandably, is rather annoyed with the Bank of England’s apparent inability to hit its 2% inflation target. Lets remind ourselves, the Retail Price Index is at 5.6% and the Consumer Price Index is at 5.2%. Laban scoffs at the idea that inflation will fall significantly in 2012 whereas I think it is incredibly likely that it will, even with the bank printing up another £75bn in freshly minted electronic cash. Only one way to settle this, I propose a bet.

I reckon inflation won’t average above 2.5% and I’ll donate £20 to anyone Laban wants if it does. If Laban will take the mirror of this bet we have ourselves a deal.

As far as why I’m so confident, this morning’s post explained why QE is a good idea when an economy is depressed and Luis‘s explains why QE isn’t really too different from your common and garden interest rate cut. I’ve already covered why temporary factors are what is to blame for elevated inflation, factors which are unlikely to be repeated:

One major source of inflation has been successive increases in VAT. In the last two years it has increased from 15% to 20%, adding at least a percentage point to inflation. A lot of inflation is also still working through import prices since sterling devalued. Lastly, crisis in Europe and continued depression in the US means the UK’s economy can expect little external support.

And finally Paul explains why inflation is unlikely to rise next year; nobody has enough money to keep it going…

Here’s the key graph, from the Office of National Statistics:

Like the US, Britain has no wage-price spiral — wages are going nowhere.

Plus we have continued contraction of the state sector which will cause people to be unemployed, to lose their services, and will have various knock on effects through the rest of the economy. Unlike Hopi I am not worried that we will soon need to battle inflation, inflation will splutter down on its own to a more comfortable rate.

So, Laban, that is why I am not worried about inflation. Would you like to take me up on my bet?