2.4.3 The Monetary System in Islam - Fall Of Capitalism and Rise of Islam | Quran Course

2.4.3 The Monetary System in Islam - Fall Of Capitalism and Rise of Islam | Quran Course

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2.4.3 The Monetary System in Islam

by Mohammad Malkawi14 min readViewed 141 times

In principle, an economic system is concerned with the process of production and consumption of goods and services, while the political economy provides it with the proper political framework. The monetary system is not necessarily a part of the economic system. Money is a tool used to measure the value of goods and services during the production and consumption processes. This measure is required during the exchange of products and benefits between the producers and consumers. Ancient groups of peoples (tribes and primitives societies) were able to produce all the goods they needed to live and survive, and hence did not require a standard measure for the values of their goods and services. Money, therefore, was not part of the system of production and consumption.

The progress and advancement of societies created the need for people to exchange goods and services within the same society as well as across societies. Initially, the trade of goods and services was conducted using barter methods through the exchange of goods for goods, goods for services, or services for services. One such example reported in the Quran is when Prophet Moses (PBUH) paid eight years of services in exchange for marrying the daughter of his employer, Prophet Shuaib (PBUH).135 The exchange of goods and services for a specific unit of exchange, called money, was introduced in the period 600-650 BC.136 Money came to be a standard measure for the benefit found in goods and services. However, money did not replace barter exchange methods but provided a new method. Therefore, money is defined as the medium by which goods and services are measured. The capitalists called the value of goods and services “price” when this value is measured by money. So the price under capitalism is another name for the exchange value of goods and services. Under Islam, the price given in money is not an intrinsic value of things; rather it is an estimate of that value.

Besides the fact that the gold standard is an Islamically lawful rule, it has several benefits, which if considered, would make the gold standard a viable global standard for the world community at large. Throughout the history of money and up until the First World War, the whole world operated the gold and silver standards. No other standards were known to the world until then. The heavy cost of the war and the imperial colonial world affairs which persisted after the war led to the collapse of the gold standard and the introduction of paper money with no gold or silver backup. Realizing the importance of the gold standard for the financial and economic stability, several European countries and the United States tried in 1933 to restore the gold standard but failed under the heavy pressure of depression. At the end of the Second World War, the United States and Europe and several other nations concurred that a gold standard is essential to the stability of the global economy and hence to world peace and subsequently signed the Bretton Woods Agreement.141

In 1971, the United States unilaterally abrogated the gold standard and forced almost every other nation to stack US dollars instead of gold reserves. Since the seventies, there have been numerous calls for a revamped international system to tackle the problem of unfettered capital flows. However, it wasn’t until late 2008 that this idea began to receive substantial support from leading politicians. On September 26, 2008, French president Nicolas Sarkozy said, “We must rethink the financial system from scratch, as at Bretton Woods.”142 On October 13, 2008, British prime minister Gordon Brown said world leaders must meet to agree to a new economic system: “We must have a new Bretton Woods, building a new international financial architecture for the years ahead.”143 Undoubtedly, the gold standard has numerous benefits for the global community. These benefits include the following:

1. The gold basis necessitates the free circulation, import and export of gold, which leads to monetary, financial, and economic stability.

2. The gold standard ensures the stability of exchange rates between the currencies of various countries (less than 5% variation per Bretton Woods). This stability in turn leads to a boom in international trade, for traders would no longer fear the expansion of foreign trade, with potential loss of money reserve values.

The gold standard prevents the explosion of virtual monetary 3. 4. wealth because central banks and governments would refrain from printing excessive amount of banknotes money. The authorities would fear that if they exceeded limits in issuing banknotes, the demand for gold would increase and they would not be able to meet this demand. Therefore, they would always tend to maintain a reasonable ratio between what they issue in terms of banknotes and gold reserves.

Under gold standard, the movements of money, goods, and labor across countries would become easier due to the fixed exchange rates between currencies of various countries. The constraints imposed by hard currency regulations would disappear, giving rise to a more stable global trade.

The gold standard would help preserve the gold preserve in each 5. country by eliminating the incentives for gold smuggling from one country to another. Gold moves between countries only as a result of trade.

International trade will not suffer due to currency exchange 6. rate fluctuations. This provides a more balanced and fair trade environment for all nations.

These are some of the benefits of the gold standard. Thus the Islamic insistence to return to the gold standard is in line with the natural financial norms and should be met with global appreciation. This was the normal standard up until the First World War, when the whole world was operating the financial system under the gold standard. At the start of the First World War, the most prevailing monetary system in the world was based on the gold standard, and money in circulation at the time was in fact gold coins and paper money readily exchangeable for their equivalent value in gold. The silver standard also operated alongside the gold standard. The implementation of this standard facilitated productive and stable global economic relations.

When the gold standard was applied throughout the whole world, it did not experience any serious problems. On the contrary, problems began to rise when the gold standard was violated and eventually removed and then replaced by nonexchangeable paper money. Worst of all, the world superpowers began to use their currency as a weapon in their warfare against other nations. The United States, emerging after the Second World War as the largest global economy, forced the US dollar to play the role previously played by gold as a basis for the monetary system.

The return to a gold standard, despite all the expected benefits, may face serious challenges from the states which demolished the gold and silver standard in the first place. The United States had built virtually large financial giants with hundreds of trillions of dollars whose value exceed multiple times the entire world reserve of gold. The existence of such huge virtual wealth poses the most serious challenge to the return of gold standard. The total gold reserve in the world above the ground is estimated at 150,000 tons. At the current price of gold, $1,150 at the time of writing this part of the book, the total dollar value of the gold is $5.4 trillion. This is less than 40% of the total US foreign debt (estimated at $14 trillion). The United States has less than 8,200 tons of gold which is worth less than $300 billion. So the US gold reserve is barely enough to cover 2% of its total debt. Thus, the United States has created a strong and high barrier in the path of a return to gold standard.

Another challenge is the potential flow of gold into the direction of states which have turned into a reservoir of goods, expertise, services, and manufacturing tools. China and India are good examples of such countries. Today, China and India provide the world with most of the consuming goods and services through a network of factories, outsourcing companies, and experts. A return to gold standard without careful consideration would lead to the accumulation of gold in the treasury of few states such as China, India, Germany, and Japan. Of course countries with large supplies of raw materials and energy resources like oil and gas can also see a flux of gold into their markets.

The fear of gold polarization (accumulation of gold in the hands of a few states) may potentially lead to the implementation of more protectionist policies by many states in order to protect their reserve of gold. Protection can take the form of high rate tariffs, high custom taxes, and export and import restrictions among other policies. In order to calm down this fear and avoid polarization, barterlike methods of goods and services exchange should be encouraged at the earlier stage of the return to the gold standard. For example, states with abundance of raw materials such as minerals, oil, and gas can exchange these products for manufactured goods and food from states which produce these goods. Also, the states which use the gold standard will be encouraged to reduce their dependence on imports by increasing their own local production and satisfying their basic needs locally. Eventually, the adoption of a gold standard while striving to preserve the national gold reserve will lead to a more balanced international trade and the trade deficits between nations will decrease. The challenges to the implementation of gold standard are more likely to occur only if few states adopt the gold standard, while many others continue to rely on monetary systems not supported by either gold or silver.

The Islamic state is not expected to face serious challenges when implementing the gold standard since the state will reside over the largest reserves of oil and gas in the world. The state can easily exchange oil and gas for manufactured products and services. The political economy of the Islamic state also calls for self-sufficiency in the production of the basic needs, particularly food, medicine, and education. Furthermore, the industrial policy of the state calls for the creation of heavy industrial base which provides the necessary machining and tools for production. These policies will help the state become rather self-sufficient and less dependent on imports which in turn helps to preserve its gold reserves. The Islamic lands host some of the largest gold mines in the world, which is expected to provide a continuous source of gold, thus making the return to gold standard much more feasible.

Despite the urgent need of a monetary system based on gold and silver, and the repeated calls for the return to gold standard by scores of politicians and economists, this return is not expected to occur within the current conditions and under the rules of capitalist world order. The return to the gold standard requires courage and determination by states and their leadership. That is because the return to a gold standard could be perceived by many as defiance to the current financial world order, and thus would pose a challenge to the interests of the countries which benefit the most of the current order. Indeed, it takes a great deal of valor, courage and determination to issue currency and back it by gold and silver. In fact, a decisive return to the gold standard despite all difficulties and challenges requires an ideological commitment, which makes the implementation of the gold standard a necessity rather than an option and an obligation rather than a courtesy.

Because the gold and silver based currency constitutes a law under the Islamic jurisprudence, it can be argued that under the current world conditions, the rise of the Islamic state is the only viable hope for the rise of a new monetary system based on gold and silver. We have witnessed major countries like France, Britain, India, and China calling for a monetary system based on gold, but none had the sufficient courage and the ideological commitment to carry through their call.

The ideological commitment is readily embedded within the rules of Islam. As argued earlier, the use of gold and silver as a base for the monetary system is an Islamic rule which cannot be overruled by the executives of the Islamic state. This is part of the Shari’ah laws. Moreover, the challenges of the implementation of the gold standard within the Islamic state are, by and large, less than those for any other state, due to the inherent wealth of the state. There could be some challenges during the first phase of the rise of the Islamic state. However, once the state reaches its expected steady state by unifying many of the Islamic lands and becoming more self-sufficient, the challenges will begin to disappear. On the long run, the gold standard will become a source of power and stability for the Islamic financial system, which will encourage many other states to follow the course of the Islamic state and convert to a gold standard.

In the Islamic economic framework, the price is defined as the society’s estimate of the value of goods, and the wage is defined as the society’s estimate of the value of services. Money, on the other hand, is the medium by which this estimate is expressed. It is the medium which enables people to measure various goods and services and refers them to one common base, thus facilitating the process of making a comparison between various goods and between various services by referring them to one general unit which serves as the general standard. Prices are paid for goods and wages are paid for workers on the basis of this unit, which is money.

The value of money is estimated by its purchasing power, i.e., by how many goods and services a person could buy with one unit of the money. Therefore, the medium by which the society estimates the value of goods and services must have a purchasing power in order to qualify as money, i.e., a power with which any person could acquire goods and services.

This medium must originally have its own intrinsic power, or be dependent on an intrinsic power, i.e., it should itself have a value recognized by the public, in order to be considered as money. This is exactly what grants gold and silver the power to serve as a base for money; gold and silver have intrinsic value which has been recognized by societies throughout the history of man. It has been used as a precious metal, as jewelry for men and women, as collateral items and loan guarantees, and as units of exchange. However, the process of issuing money (units with purchasing power) is not the same for all countries in the world. Some countries may adopt money which possesses intrinsic power (gold and silver) or which depends on an intrinsic power. Other countries may adopt conventional money (nonconvertible), i.e., they agree upon a medium to be considered as money and they give it a buying power by means of legislation or government decree; in this case, the money does not possess a real value on its own.

Countries which operate the gold and silver standard use metallic money, paper money, or both. Metallic money is gold or silver coins minted at a certain weight, shape, and style. For example, in the Islamic state, the dinar is a 4.25 gram gold piece struck in a circular shape with Islamic Arabic script. The dirham is a 2.98 gram silver piece struck in a circular shape with Islamic Arabic script. Fractions of the dinar and dirham (for example one-half dinar, one-fourth dinar) can also be struck and minted in certain shapes and styles. In essence, the dinar (gold) and the dirham (silver) are the two basic units from which all other money coins are derived.

Countries which operate the gold and silver standard, like the Islamic state, can also issue paper money in lieu of the gold and silver. The dinar can be issued in the form of a paper printed in a certain style. Each paper dinar will be matched at the state’s treasury by 4.25 grams of gold. Each paper dirham will also be matched by 2.98 grams of silver. Besides paper money, the state can issue metallic coins made of copper or other cheap metals; by the same token these coins will be matched by an equivalent gold or silver. With the advancement of technology, the state may issue electronic currency, where the currency will be provided in digital form. But in all cases, the money in circulation, whether paper, digital, or coins, will not exceed the gold and silver reserves owned and possessed by the state. This type of paper or digital money is called intrinsic money. The state may prefer this method to issue currency for cost saving and security reasons.

The second method relies on partial coverage of gold and silver for the paper money in circulation. The paper money in this case is only partially covered by gold or silver. The issuing house, be it a bank or a government treasury, would however maintain a lesser amount of gold and silver than the claimed value of the paper money, or its nominal value. For instance, a bank or the state’s treasury would issue paper money worth 500 million dinars and maintain in its treasury only 200 million dinars worth of gold and silver. In this case, 40% of the money in circulation is covered by gold. This type of paper money is known as fiduciary paper money. A country which issues money under these conditions would still be considered as operating the gold standard. The idea behind this method is that not all money in circulation needs to be converted to gold or silver at once, so the state estimates a probabilistic ratio for potential conversion and, based on that, issues more money than it actually can convert into gold. The state expects that in the worst-case scenario, only a portion (say 40%) of the money in circulation will have to be converted to gold. The state should be able to meet that demand without too much difficulty. If a situation arises such that more than 40% of the money needs to be converted to gold, and the state cannot meet that demand, the currency then faces the consequences of devaluation. This is one of the risks of using fiduciary money.

The countries which operate a nonexchangeable paper money standard issue bills which are not convertible to gold or silver or any precious metal. The institution which issues these bills is not required by law to exchange these banknotes for gold at a specific price. Gold in such countries is treated just like any other commodity; the price of gold fluctuates from time to time according to supply and demand. Since 1971, when the United States severed the link between gold and the US dollar, the price of gold had risen from $35 per ounce to more than $1,200 per ounce, that is, almost thirty-five times. It is interesting to note that during the two hundred years prior to 1971 (1771-1971), the gold price ranged between $20 and $35 per ounce.

The banknotes, issued in paper-based money are not backed by a metallic reserve, and thus cannot be exchanged to metallic money at a preset rate. They only hold a legal value and do not possess an intrinsic power, nor do they depend on an intrinsic power. They merely represent a unit that has been agreed upon as a means of buying goods and services, and it is the law that gives it the power to become a means of circulation, with which a person may acquire goods and services. Its power is derived from the power of the state which issues the currency. If the government issues a decree canceling one of the circulated money bills, then that bill would lose its buying power immediately. People holding a quantity of the canceled bill would lose that money unless the government allows the exchange of the canceled bill by another legalized one.

In essence, any country could agree upon a particular unit which expresses the society’s estimate of the values of goods and services. A decree issued by the government enables the unit to become a purchasing power for goods and services. Therefore, any country could issue a currency that has a fixed and a distinguished quality, which expresses the society’s estimation of the value of goods and services, i.e., money with which any person could acquire goods and services in the issuing country, according to the value given to that money. It is the issuing country which forces other countries to recognize its currency so that these countries could acquire the goods and services produced by the issuing country.

In principle, a country does not need to depend on the International Monetary Fund, the World Bank, a federal reserve bank, or any other institution for issuing currency and giving the currency a specific buying power. The strength of the unit and its ability to obtain goods and services would be sufficient to turn it into a currency either by itself, such as gold and silver, or by its dependence on gold and silver, e.g., intrinsic paper money which represents its nominal value in gold and silver, or through having a certain amount of gold and silver held in reserve, as is the case with fiduciary paper money. The same can also happen for the nonexchangeable paper money with a certain economic and political power which enforces its acceptability and allows people to use it for acquiring goods and services.

Throughout history, three types of money existed in the world: metallic money made of gold and silver, intrinsic paper money (covered by gold and silver), and nonexchangeable banknotes. Since the end of the Second World War and until 1971, countries in the world used to operate two main types of money, the metallic and the paper money with full or partial gold cover. Since 1971, the whole world began operating exclusively the nonexchangeable paper money standard, with enforced acceptability, when the US President Nixon aborted the Bretton Woods declaration, thus severing the link between the dollar and gold.

Currency exchange is the process of converting one currency for another. This would be either exchanging one currency for another of the same type, such as the exchange of gold for gold, and silver for silver, or the exchange of one currency type for another one of a different type, such as the exchange of gold for silver or vice versa.

The exchange of currencies which belong to the same type is allowed in Islam under two conditions. First, the exchange has to be for the exact same amount, and second, the exchange has to take place at the same time. The Prophet (PBUH) is reported to have said, “The exchange of gold for gold must be done with equal weight and exact amount; otherwise the difference is Riba (usury).”144 The same rule applies to the exchange of silver coins for silver coins. For example, assume that some person has a one-hundred-gram piece of gold and wants to exchange it for five smaller pieces of gold. This transaction is permitted only if the five smaller pieces of gold have a total weight of one hundred grams. Also, the exchange has to take place at the same time, i.e., the person with the one-hundred-gram piece should hand in his piece at the same time when he receives the five smaller pieces. In other words, it is not allowed to give the large piece and receive the five pieces in installments at different times. Islam considers this transaction illegal and treats it as a form of Riba. This rule is extended to all types of currencies. So, if someone wants to buy dollars with dollars or euros with euros, then the amount of exchange must be the same and the money should be received in full at the time of executing the transaction.

When the exchange occurs between two distinct types of currencies, e.g., gold for silver, or dollar for euro, then the weight or quantity can vary because these are two different types of currencies with different values; but the exchange of money must be completed at the same time when the transaction is executed. If the receipt of any of the exchanged currencies is deferred to a different time, then that would be considered Riba according to Islamic law. The Prophet (PBUH) is reported to have said, “Sell gold for silver the way you wish, hand in hand”145 meaning that the rates can vary but the sale should be instantaneous. This rule extends for all types of currencies; for example, the exchange of dollars for yen, or dinars or euros can take place per the rate of each currency, given that the transaction of sale is completed at the time of exchange.

Islam requires that the exchange of the currencies be completed at one time; as such, it prevented any loss due to potential fluctuation of the rates of one currency in relation to the other. When the transaction is completed at the time of exchange, the negotiated prices for both currencies are guaranteed for both the seller and the buyer. However, if one of the currencies is not received at the time of transaction, then its rate may change in the future which means that one of the traders will lose while the other one will gain more or less than what was negotiated at the time of executing the transaction. This is especially true when the currencies are measured by weight rather than numbers; metallic money may lose weight over time due to circulation or due to change of altitudes of the sale locations. The restrictions imposed by the Islamic law on the currency exchange transactions intend to protect both the seller and buyer of currencies and to avoid any conflicts which could arise from the sale of currencies. Furthermore, it leads to more stable currency exchange rates which forces the economists to focus on productive economy for achieving financial growth rather than on currency exchange rate fluctuations.

Currency exchange inside the same country is not expected to cause any economic problem, since the rates of exchange are clearly set and fixed by the same government. The exchange occurs between currencies issued under the same standard, which is normal and conflict free. What could be a potential problem is the exchange between different currencies in two or more countries. That is because countries operate different standards; some countries may operate the gold standard, while others may operate the nonexchangeable paper money standard. When both countries operate the gold standard, the exchange rate between these countries or the ratio of exchange between their currencies would remain almost stable. If the currencies in both countries are based on metallic gold or silver coins, then the exchange of currencies is rather simple. It will be conducted on the basis of the weight of currencies in both countries. The ratio between the weights will determine the exchange rate. The exchange rate could only fluctuate within minimal margins which depend on the transfer charges of gold between countries. Since these charges are minimal, the exchange rate between countries operating the gold standard is virtually stable.

Similarly, the exchange rate between paper money backed by gold or silver remains rather stable, since the paper money is very much similar to the metallic money. The only difference is that the paper money circulates in lieu of metallic money and acts as a representative of gold or silver. Therefore, the intrinsic paper money would be dealt with in exactly the same way as far as the exchange rate is concerned. In fact the rule of intrinsic paper would in all aspects be the same as metallic money.

If a country operated fiduciary paper money, i.e., banknotes, the gold in this case would only be covering some of the fiduciary money’s value and not all of its value, even though the country would be operating the gold standard. Therefore, the value of the fiduciary paper money would differ according to the amount of gold covering it, and this would determine the exchange rate between them. This exchange rate is also a rather stable one and easy to monitor, because it depends on the percentage rate of gold backing the paper money.

When countries operate the nonexchangeable paper money standard, the exchange rate between the currencies of these countries may pose a serious challenge. Fixing the exchange rate of paper currency in relation to gold is rather impossible, because the paper money has no intrinsic real value to be fixed against a certain weight of gold or silver. The value of paper money is measured by its buying power in the country which issues the paper money notes. As an example, assume that country A uses paper money of type A and country B uses paper money of type B. Assume that ten units of currency A are needed to buy one loaf of bread in country A, and one unit of currency B is required to buy one loaf of bread of the same quality in country B. Then the exchange rate between the two currencies would be 1 B unit = 10 A units. If the prices of goods and services in country A increase, while they remain stable in country B, then the exchange rate between the currencies will change in favor of currency B; for example 1 B unit becomes equal to 20 A units if the prices double in country A. In other words, the exchange rate between currencies fluctuates based on the fluctuation of goods and services prices in the countries issuing the currencies. This, of course, is subject to the governments and central banks not interfering to protect the exchange rate of their currencies despite the diminishing buying power.

Government interference in the affairs of the currency exchange rates has become a well-known phenomenon, especially during wartime and financial crisis. The absence of the gold standard leaves the price of a currency and its exchange rate subject to political and economic conditions. The imbalance between world currencies and the abilities of governments to raise or reduce the ratio of their currencies against the currencies of other nations have become a source of concern for many nations in the world. In the most recent financial crisis, China, for example, had serious concerns about its large reserve of US dollars. The reduction of the value of the exchange rate of the US dollar by say 10% would cause China to lose $140 billion of its $1.4 trillion reserve.

The main concern in regard to currency exchange rate is associated with paper money. The Islamic state, which operates the gold and silver standard, will be in a position to avoid much of that trouble and concern. The Islamic state is compelled to abide by the gold and silver standard because it is a Shari’ah rule upon which many other Shari’ah rules depend (Zakah, punitive rules, hoarding, and others). When dealing with other states which operate gold and silver currencies, the Islamic state will proceed according to the rules of exchange in a rather smooth manner. Also, Islam allows the purchase of a paper-based currency under the assumption that this currency is of type different from gold and silver. The state applies the rules of exchange between currencies of different types. In evaluating the exchange rate between the Islamic dinar or dirham and the foreign currency, the Islamic state needs to estimate the power of the foreign currency to buy gold and silver or to buy the goods and commodities deemed necessary by the state. At any rate, the Islamic state policy is to avoid as much as possible exchanging its gold—and silver-based currency for a nonmetallic currency.

In the current foreign trade and commerce practices, countries accumulate the currencies of foreign countries in order to be able to buy the products produced by those countries. The truth of the matter is that when a state has a gold based currency, it will have no problem buying the products of any country using its own currency, thus avoiding the need to exchange its gold-based money for a pure paper money.

The policies for self-sufficiency and increased productivity should help the Islamic state avoid the conflicts of monetary exchange between the Islamic gold dinar and the non-Islamic paper money. In essence, the implementation of the Shari’ah laws regarding the gold and silver monetary base and regarding the currency exchange provides a solid protection to the Islamic state’s currency and to the political economy at large.