Panic Grips Financial Markets as Bubble Bursts

Panic and turmoil gripped the world’s financial markets in August as the US housing market bubble burst. The crisis threatens a worldwide economic depression, bringing to a halt more than a decade of increasing prosperity and employment for Western economies. The last decade has seen billions pour into real estate in both the US and Europe, which has resulted in the US housing sector reaching a staggering $10 trillion in value. Whilst in the UK the housing sector, is worth over £1 trillion. Global investment banks, hedge funds, pension houses and even high street banks have poured money into the housing sector in the hope of hansom returns.

The crisis gripping the world was caused due to defaults on US home loans that have caused a credit crunch which is reverberating around the world as billions of dollars are being written off as liabilities. Stock markets on both sides of the Atlantic have continued to swing wildly from hour to hour. This money which found its way into the US housing sector was in origin only for speculative purposes. In the hope that the price of housing would rise further higher in the hope large profits can be made. Investment banks developed innovative products to further their profits by creating the Sub Prime mortgage industry, Put simply, it is loans to people who have patchy credit histories or cannot prove their incomes. It involves lending money to people usually on low incomes and who are unable to receive mainstream mortgages. The whole sub prime industry is built upon giving loans to people who are unable in most cases to actually pay them back. On top of this most international banks borrowed the money they poured into the housing sectors in Europe and America.

What was witnessed on the world’s financial markets in August was something some pessimistic observers have previously mentioned but their voices were drowned out due to the Euphoria of incredible gains made as housing prices continued to rise further and further.

In March 2007 half of the 25 sub prime companies in the US collapsed including the largest, New Century Financial. US public debt stands at $8.5 trillion; this is six times the amount of dollars in circulation (M1 Money Supply), which is $1.3 trillion.

International institutes who poured their money into the US are now realizing they will not actually receive their money that they loaned out to investors as individual sub prime mortgages holders have now defaulted on mass on such loans and this then means all those who took positions in the housing sector will not actually be in a position to pay the institutes they borrowed money from. It was for this reason central banks across the world intervened in the global economy in an unprecedented manner providing large amounts of cash to ensure such banks and institutes do not go bankrupt. The European Central Bank, America’s Federal Reserve and the Japanese and Australian central banks injected over $300 billion into the banking system within 48 hours in a bid to avert a financial crisis. They stepped in when banks, such as Sentinel, a large American investment house, stopped investors from withdrawing their money, spooked by sudden and unexpected losses from bad loans in the American mortgage market, other institutions have followed suit and suspended normal lending. Intervention by the worlds central banks in order to avert crisis has cost them over $800 billion after seven days.

The question that needs to be asked is why is such a ‘boom and bust’ phenomena a common occurrence in the West?

The answer lies in the way Capitalist economies are organised and run and that is that such economies function on the basis of the perceived confidence people have in the economy. The current problems highlight this very clearly as Investors and consumers alike are continually bombarded with information on what to buy and the next big boom, which all want to be part of and benefit from.

Like the UK, the US has been experiencing economic growth that has been fuelled by the expansion of personal debt, which in turn is being fuelled by the high price of real estate. As the cost of housing rises, house owners have increasingly been taking out personal debt, offering equity in their homes as collateral. This process of effectively re-mortgaging homes in order to fund an extravagant lifestyle has been a nation wide phenomenon for the US and Europe. As long as house prices continue to rise, consumers will be able to take out more debt against the value of their homes. This practice has been evolving since the 1990’s, and we now have a situation where house prices are so high that they have outstripped salaries by several times. This means that the situation has reached a dangerous level where this debt is now struggling to be serviced and houses are increasingly too expensive to be bought by people. US household debt is $8.5 trillion and 20% of households have more debt then assets.

This situation is not sustainable. House prices have been rising not because of demand but mainly due to speculation. Speculators are seeking to make profits by buying houses, holding on to them and selling them on for a higher price. This process of speculation is fuelled entirely by the confidence speculators have that house prices will continue to rise. On top of this they are funding this speculation by borrowing money.

As it is confidence which forms the basis of the current economic boom being experienced by Western economies, it is no wonder that they are subject to uncertainty. This confidence could be shattered if enough people feel that economic indicators in major economies in the world are not looking good. This is what has occurred on the 9th and 10th of August with panic selling on the worlds financial markets. What we are witnessing is that borrower’s weather individuals or large banks are no longer able to finance their debts. If enough people perceive this to be so, the housing market will begin to be flooded with people trying to quickly cash in on their homes before prices start to crash. As more homes come on to the market, a downward spiral is created as the extra supply of housing on the market forces prices down, causing yet more people to panic and try to sell their houses which continues the cycle. This would have a knock on effect on the rest of the economy, which so heavily relies on this perceived confidence in the real estate market, which would then impact the world who rely on the US economy for most of their exports. This is exactly what we are witnessing right now.

The economic speculation on housing markets across the world is driving economic spending and thus growth. This speculation is inherently instable by its nature and will affect other parts of the economy which are reliant on the housing sector such as luxury goods, construction, DIY industry and many utilities. This speculation has created a chronic debt situation and shows no signs of slowing down. This problem is fundamentally a result of the way the global economy has been run which gives economic growth priority before everything else, even the well being of people and it is here the damage of such speculation will be felt the harshest.

As speculators pull their money out of the housing sector this will result in the value of house prices collapsing and all those who have mortgages will end up repaying well above the value of the property. This will impact other sectors within the economy as property was the main driving engine for economic growth hence it will impact consumer spending which will result in closures of companies, which will lead to unemployment and a downward spiral.

This scenario is eerily similar to the great depression which lead to complete economic breakdown. The problem began in the US after WW1 when the US began a period of isolation. The US concentrated on individualism, which was termed the American dream promoting the acquiring of goods as the means to happiness. Demand was manufactured by new marketing methods and the US witnessed an unprecedented level of economic growth, were many individuals become millionaire’s overnight due to the huge increase in national production. However by 1927 the US public was purchasing goods with more and more borrowed money even the rise in the Stock Exchange during the 1920’s was by borrowed money. This new wealth was not distributed in an evenly manner and cracks begun to appear in 1927. The problem lied in the fact that the huge increase in wealth was in the hands of a few with the vast majority not actually receiving the fruits of national wealth and were using more and more borrowed money to keep pace with the boom. The US under the leadership of Herbert Hoover in order to stimulate the Economy after WW1 manufactured demand by making the acquiring of consumer goods the ultimate level of pleasure the result of this was a huge increase in the purchase of consumer and luxury goods. This ensured companies increased production gradually and the US population would find employment. However, Most of this lavish lifestyle was being funded by debt and over a course of 7 years more and more Americans used debt to fund their lifestyles. In 1927 most Americans began to feel the squeeze and began to use their salaries to pay for the debt they had accumulated. The result of this was eventually shop shelves remained stocked with consumer items as a large chunk of the populations disposable income was being used to service their accumulated debt. This had a knock on affect to other sections of the economy as suppliers to department stores no longer received orders, manufacturers stopped receiving orders from suppliers and then manufactures were forced to lay staff off. The first manifestation of Capitalism un-sustainability was the October 27th 1929 Stock Market crash on this single day $10billion was wiped of the stock Market. The capitalist system’s unsustainable bubble had burst.

As each segment of the capitalist economy relies on the proceeding segment the system is built upon creating artificial needs to keep the consumers purchasing more and more goods to keep the main segment (catalyst) going. This is why the developed world witnesses regular recessions when enough people have spent beyond their means there would inevitably be a reduction in aggregate spending by consumers as a large chunk of disposable income is now used to service debt, this cycle of spending – increase in production – more jobs – purchasing more goods is never sustainable and has to end somewhere.

Capitalisms un-sustainability has been proven time and time again and what is really needed is an alternative system of organizing the economy and an alternative set of investment opportunities.

In a khilafah state stock markets, derivatives and other forms of paper investment is not existent as all investment is in physical goods, such as the starting of a business, the building of a plant or the purchase of gold. This means the speculation seen in the West will be non-existent in the khilafah hence the boom and bust cycle would not exists which will bring the much needed stability missing in the Western world.

Islam’s economic system deals with debt and organised the economy in a way completely different to what is witnessed in the world today. The main reason for the masses being in debt is due to the manner in which wealth is distributed. Capitalism promotes a whole host of rules and incentives to restricting the distribution of wealth. The best example of this is the role of interest. Interest like debt has become a commodity hence profitability is the number one concern for banks and similar institutes. The basic problem everyone faces is in regards to their wealth is - is the risk of the rate of return on an investment offset by the rate of interest. If this is the case then the incentive would be to save the money rather then to use (invest) it. Although interest is money sitting in an account which banks use for their investment, this money is still not circulating in the economy as banks invest a large chunk of their money in paper i.e. bonds, shares, IOU’s etc. This means that money is held for a promised rate of return rather then going on actual production of goods, or the building of a plant etc. The next problem is if you do spend you are further hampered by a tax on spending, such as general sales tax and Value Added Tax.
In Islam such incentives to not spend are non existent, interest is forbidden and hoarding is taxed. Having no interest means there is no incentive to leave money in a bank account as it will not accumulate interest, but instead be taxed if it’s held for a year. By not having taxation on income one is free to spend a larger proportion of disposable income in physical goods, assets and items, which in turn will create jobs and fulfill any demand in the economy. Paper such as shares, bonds and debt as a form of commodity are non existent in Islam, the only types of investment are in real goods which ensures the economy continually generates wealth.

So under Islam there will never be recessions as we will never have a scenario were too little money (due to most of it being taken out of circulation) chasing few goods as the Islamic economic system is geared towards deregulating all restrictions on wealth circulation

Whilst the economic system in the developed world concentrates on production economic policy in Islam concentrates on distribution of wealth. The more wealth changes hands the more economic activity proceeds. If wealth is removed from circulation exchange becomes scarce. This is best understood by viewing every person and all companies’ income originating from another person or company. Taxes levied by the state are regarded as income for the state and an expense to individuals. The monies spent on projects by government and salaries paid would be income for the individuals and an expense to the state. Then money spent by employees on goods is an expense to them and income to companies. Hoarding money and leaving it in an account to accumulate interest would in fact take it out of circulation. This would lead to a fall in spending, which would reduce production and result in the complete halting of the economy.

With so much circulation of wealth it is possible the economy could overheat. Overheating is the term given to the reality where too much money is chasing too few goods leading to inflation. This only occurs due to the government printing more money to aid wealth circulation. Islam completely avoids such a reality as its currency is backed by gold. This means the government is not free to print money at will. This situation ensures the supply of money never outstrips production. The key reason to why prices can rise in such a manner is because goods are left completely to the market forces to decide what should be produced and at what level. In Islam key items such as utilities which are indispensable for the economy are public property and not owned by the private sector.