Sunday, August 2, 2009

Essay: Virtual Economy - Root Cause Analysis of The Current Financial Crisis

In a statement made to a congressional committee on April 3, 2008, the Chairman of the Federal Reserve Bernanke said that "if Bear Stearns had been allowed to fail, it would have led to a "chaotic unwinding" of Bearn Stearns investments held by individuals and other financial institutions. Moreover, the adverse impact of a default would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability"[1].


In an article published by Newsweek, October 11, 2008, Daniel Gross writes [3]: "Back in 2002, Apple's stock was trading far below the level of cash on its books, ascribing a value of zero to its brands and products, compared with several billion at the height of the boom".

Both statements refer to the existence of two views of the economy: a real economy which is reflected by the level of cash on corporate books, and an inflated, exaggerated view which is reflected in the current stock values of the market. The second view of the economy will be referred to as a virtual economy in this article. Virtual economy, in this context, differs from what is being called virtual economy commerce [2], where customers trade in a virtual imaginary product with certain specifications and an imaginary value. However, this will not be the subject of this study.

The second type of virtual economy (VE) is the one that is important and is strongly related to the failure of the financial capitalist system as is being witnessed today. VE allows the economy to appear much larger than its real size. This economy is based on the assumption that the real money will not be tapped into and therefore, it is possible to deal with an assumed larger (virtual) value for the money.

A good example of this scenario is the case with Donald Trump. He ran projects worth billions of dollars, while being more than 50 million dollars in debt. He was about to file for personal bankruptcy in 1989 when he was pressed to pay some of his debts.

A parallel concept to virtual economy exists in computer systems, where the concept of virtual memory is used. Virtual memory is a special type of organisation which allows the memory in the system to appear much larger than the real size of the memory. With this type of organisation, it is possible to execute program applications which require much larger memory than the system actually has. Virtual memory organisation in computer systems remains a smart way of running applications. However, there are some cases where an application may break the limits of virtual memory and cause the system to thrash, i.e. to fail. This happens when an application insists on using more than the size of real memory instantly, at one given time.

In a similar manner, virtual economy (organisation) provides two views of the economy. One is the real value of commodities and services in a given economy which corresponds to the real economic growth and production. The second view of the economy represents the imaginary value of stock prices and the accumulation of interest (usury) in the banks. A virtual economy system, similar to a virtual memory systems, is bound to crash (thrash) at any point when the instant demand for finance at any given time exceeds the real value of the real economy. The current financial crisis in the US and the world at large is a striking example of a virtual economy crashing (or thrashing).

The phenomenon of a virtual economy, where the money in transactions appears much larger than the real money, began to surface at the level of state economies at the end of the 19th century when financial markets began to take shape in New York. This phenomenon grew to be an integral part of capitalist economies, especially in the US and in Europe due to three major reasons, namely: stock markets, interest based economy, and the removal of gold as a basis for the monetary systems. At the political front, the cold war between the capitalist and socialist camps in the 2nd half of the 20th century further strengthened the virtual economies in the west. We will examine these three factors in some detail in the next few sections.

1. Stock Markets and the Virtual Economy
Stock market activities at the start of the 20th century created a new phenomenon in the economy, where the wealth associated with stock values grew at a much higher rate than the wealth associated with the real economy. When the stock market collapsed in New York in 1929, economists attributed the crash to the great difference between the inflated values of stocks and the values of the real assets of the economy.

The Economist magazine reported on 2/11/1929 that "there is warrant for hoping that the deflation of the exaggerated balloon of American stock values will be for the good of the world." To understand this aspect it has been found that the prices of financial market increased during the preceding period from 1925 to 1929 by 120%, while economic growth for the same period did not exceed 17%. And when the market collapsed, it lost over 93% from its value, which means that the market returned to its real value which was obviously much lower than what the stock market indicated. The same scenario repeated itself in 1987 when the market collapsed again, and as observers again noted financial market had been grossly inflated compared with the real size of the economy, such that the difference between the virtual economy and the real economy was more than 200%. And by the end of the twentieth century the virtual economy was again three times the size of the real market value and this scenario came to be known as the Internet (or DOT COM) Bubble.

The result is that the nominal values of stocks do not reflect the reality of economic production. It is possible to increase the value of the shares of a given company without any real increase in production or profit achieved by that company; this was the case with Amazon, where its stock value exceeded $300 at a time when the company had not achieved any profits. Enron is another example, where the rising value of their stock was based on false information about fictitious profits.

These kind of financial activities, transactions and dealings create two faces for the economy: a real face linked to the economic growth and production which indicates the real strength of the economy. And an imaginary side, that reflects the image seen and observed by the local and global community. When the difference between the two sides is small, there does not appear to be a serious problem in the economy. When the difference, however, is vast as is the case now, in 1987 and in 1929 it is dangerous and may lead to devastating consequences for many years, as happened with the Asian Tiger economies in the late 1990's.

The capitalist countries are aware of the magnitude of the problem, and its seriousness, and keep developing plans and alternatives to prevent or delay an inevitable devastating collapse, to mitigate the effects of the collapse, or to exit quickly in case a collapse happens. A good example of such plans is the recent bail out of the Bear Stern Bank, which almost collapsed after the drastic decline of its stock prices. (The most recent bailout of more than a trillion dollars in US and Europe occurred few months after this article was written).

The direct cause of a stock market collapse is the attempt made by some investors to transfer what they own from fictitious money to real money. As an example, let's assume that the real money is 10% of the total virtual money. This means the amount that can be turned into real money, is no more than 10% of total capital, and the rest is equal to none. So when the owners of the shares notice that a major investor started selling his possessions (to convert them to real money), they panic and start selling their possessions hoping to cash in some real money before the collapse. Then a collapse takes place and brings everything to the foundation (real money).

Let's work through the example more thoroughly. Assume that there are 1000 shares in a company. Also, assume that each share is worth $100. So the total stock value of the company is $100,000. For the sake of argument, assume that the real value of the company is $10,000. In other words, the real value of the company is 10% of the virtual value. Now assume that a major investor sells 50 stocks at $100 and cashes $5000. If the rest of the share holders start selling their shares hoping to get real money from the company, they will be able to get no more than $5000 at best, which translates into $5 per share. Now if one more person was able to sell 50 shares at say $50 and cashes $2500, then the rest of the crowd will have to share the remaining $2500 at $2.5 a share. Eventually when all $10,000 are gone, the share will go to zero. This is how the stock values of Enron and Martha Stewart companies collapsed.

The danger of the virtual economy is that it creates a state of delusion in the economy, which can deceive senior economists and politicians, and drives them to undertake projects larger than their real wealth. There could be a temporary positive effect from this delusion, especially when competing with others for large projects. America has benefited greatly while in a conflict with the Soviet Union during the cold war era, where the Soviet Union used real money to finance its projects, and America used the virtual economy for its own projects. But when a state is exposed to a financial or political crisis larger than the size of its real economy, the illusion may push the state into a losing gamble. The current wars in Iraq, Afghanistan, Somalia and the devastating effects of hurricanes in the US must have contributed to the recent financial crisis in the west. Some countries may sometimes intentionally create real crisis for other countries that depend on the virtual economy, in an attempt to push them to the limits of their real economies. Note also that a sudden collapse of the virtual economy brings the economy to levels much lower than the real value of the economy.

2- The Usury and the Virtual economy
The objective of the financial policy in the capitalist economy, as stated by the bylaws of the Federal Reserve Bank in the USA, is to maintain the highest return on production and labour and to sustain price stability. This objective will be achieved through a mechanism that controls the value of usury (interest rate). During a recession in the economy, the state reduces the value of usury in order to encourage borrowing and increase the demands on goods and services. Conversely, the value of usury would be increased to curb inflation. The point here is to recognize the importance of usury for the capitalist economy as the most important tool to control the ups and downs of the economy. This explains the wide spread of financial institutions that offer loans to individuals, companies, institutions and even governments themselves.

Within this usury based economy, the money flows in two directions. In one direction, the money flows from the investors towards the bank in a form of deposit payments. The other direction is from the banks to the investors in a form of loan payments. Except for cases where the inflation rate is higher than the interest rate during the repayment period, the amount of money going towards the bank is steadily more than the amount of money going towards the investors. If the real money is the money which the investors deal with to increase production and to maintain price stability as required by the fiscal policy, this money will certainly be less than the money that accumulates in the banks. This is the main reason for the difference between the real money and the virtual money. And there are two cases that lead to this phenomenon.

The first case is when the bank performs the lending process. Let's assume that the bank provided a loan of 100 million dollars with 5% usury for 1 year. Let's assume also that the inflation during this period was 2%, the real interest rate becomes 3%. Now presume as well that the borrowed money (100 million) was spent on profitable projects and the total profit was 2%. Now the total value to be paid back to the bank = 103 million dollars, while the real money which is the sum of the initial money and the profit is equal to $102 million. This means that (1) $million accumulates in the bank account which does not correspond to actual value in reality. This surplus is the usury which is described in the Qur'an (That, which ye lay out by usury for increase through the property of (other) people, will have no increase with Allah). Note that the biggest borrowers in the world are governments which borrow money to pay for their operations and not for profit production. Consequently, the accumulated pure usury will be much higher than the ratio of (1%) in the above example. That is why usury money can reach during a specific period of time hundreds of billions of dollars and up to twice the amount of real money. It is worthwhile to know that the real economic growth rate in the US was no more than 3.5% during the last (30) years, while the actual interest rate was more than (8%). This means that virtual money over (30) years was (135%) of the actual value of money. So if the actual value of the US economy was 5 trillion dollars, the value of usury excess of the true value will be $6.75 trillion dollars. This makes the virtual money value (11.75) trillion dollars.

The second case that leads to an increase in the virtual money is when investors deposit their money in the banks for investment in usury. If investors deposit in the bank (100) million with (5%) interest after taking into account inflation, and for a period of (10) years. The value of the money invested becomes (150) million. For the bank not to lose money, it in turn invests the (100) million. Let's say the bank gains (7%) by investing its money ($ 170 million); if (5%) of that investment was part of productive investment by the bank and the rest was pure usury, we will have (20) million usurious money which has no real value in reality. The reality is that most banks do not invest their money in production processes, but rather by investing in other banks and by recycling the loans to other borrowers. This makes the virtual money increase repeatedly and multiple times.

Either way, the resultant quantity of the money accumulated in the banks is much more than the quantity of the initial real money that represents the (real) production. However, what encourages and motivates the continuation of the increase in virtual money is the absence of the urgent need to withdraw large amount of funds from many banks at once. When one of these banks gets exposed to pressure from investors and depositors to withdraw amounts of money (Run On The Bank) that exceed the amount of the real money, the bank soon collapses for the lack of ability to meet customer needs, as happened with the Bank of Boston in the early eighties of the last century. If the Government does not intervene to save the bank and back it up by its funds, a collapse of the bank becomes imminent. When the problem becomes severe and has the potential of affecting several financial institutions, the big countries such as the US begin to print and pump money that could match the amount of the virtual money. This leads to massive inflation, decline in prices and weak production and may lead to a huge financial disaster. Sometimes a disaster may occur by withdrawing large amounts of investors' money at the same time from the banks (similar to the real estate and credit crisis in the US - this occurred few months after writing this article).

3- Breaking away from the Gold Standard
The virtual economy would have not become a genuine trend, if the main currency (i.e. Dollar) remained linked to the gold standard as per the Bretton Woods Agreement in 1944. The agreement established a clear base of exchange into gold within a fluctuation rate of not more than (1%); it also set the bases on how to convert currencies into gold. The existence of such a law can not permit any State economy to appear much larger than its real size. That would cost its stockpile of gold to deplete. There will not be sufficient gold to match the fictitious numbers of the virtual economy. But when the US turned against the Bretton Woods Agreement (in the early 1970's) and broke the link between the dollar and the gold standard, it freed its economy from the rein of the market prices without any restrictions. The US was not satisfied with breaking the linkage between the dollar and the gold, but it also broke the link between the value of its currency and the economy. It made it possible for money to grow more rapidly and at much higher rates than the growth of the economy. It was this separation between money and gold on one hand, and between money and economic growth on the other that enabled the existence of the virtual economy and its tendency to grow at an alarming rate. (Recently the Prime Minister of Britain Gordon Brown called for the reconstruction of the Bretton Woods agreement - Report on Business.com Oct. 14-2008)

4- Conclusions
Is the presence of a virtual economy a matter of strength or weakness for the State? There is no doubt that the presence of a virtual economy leads to the emergence of the state as a powerful state with an ability to manoeuvre, threaten and impact other countries. A virtual economy and strength may allow one country to destroy the economies of other countries especially if those countries rely on a real economy or have less ability than the attacking state. America is still using the virtual economy to influence Europe, Japan, China and others. However, the virtual economy is like an Achilles' heel for these States. While it appears as a point of strength, it also could be a potential point of destruction for the state. When a state is exposed to real crisis, whether caused by disasters or wars, the crisis would drain up what is equivalent of the real economy of that State which in turn may lead to the bankruptcy of the State economy.

Today, the major capitalist countries in Europe and the US have built their enormous economies on the basis of the virtual economy. Most importantly, these countries cannot go back to rebuilding a more realistic economy. The financial politics are based on usury and exorbitant wealth, and the steady increase of the money has become the only goal of their economic and financial policies. And from here we cannot imagine rebuilding the economy in the capitalist countries to become closer to reality, and therefore they will remain vulnerable to destruction and collapse.

And Allah سبحانه وتعالى says:

الَّذِينَ يَأْكُلُونَ الرِّبَا لاَ يَقُومُونَ إِلاَّ كَمَا يَقُومُ الَّذِي يَتَخَبَّطُهُ الشَّيْطَانُ مِنَ الْمَسِّ ذَلِكَ بِأَنَّهُمْ قَالُواْ إِنَّمَا الْبَيْعُ مِثْلُ الرِّبَا وَأَحَلَّ اللّهُ الْبَيْعَ وَحَرَّمَ الرِّبَا فَمَن جَاءهُ مَوْعِظَةٌ مِّن رَّبِّهِ فَانتَهَىَ فَلَهُ مَا سَلَفَ وَأَمْرُهُ إِلَى اللّهِ وَمَنْ عَادَ فَأُوْلَـئِكَ أَصْحَابُ النَّارِ هُمْ فِيهَا خَالِدُونَ
"Those who devour usury will not stand except as stands one whom the Evil One by his touch hath driven to madness. That is because they say: "Trade is like usury," but Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (the offence) are Companions of the Fire; they will abide therein (forever)." [Quran Chapter 2; verse 275]



References

1. Bernanke Defends Bear Stearns Rescue, http://newsok.com/bernanke-defends-bear-stearns-rescue/article/3224837
2. http://virtual-economy
3. Daniel Gross, NEWSWEEK; Oct 11, 2008

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