The capitalist economies, including Canada, are witnessing the ramifications of the COVID-19 stimulus policies. Specifically, due to the massive influx of dollars generated by the central banks we see that inflation has gotten out of control. That is, the banks had set a 2% target rate for inflation. However, the central banks flooded the system with currency. Consequently, we saw a surge in prices. For example, in Canada inflation hit 8.1% in mid-2022. To manage this inflation, the central banks have chosen to raise interest rates. For example, the Bank of Canada raised interest rates by 4.25% within one year. It now sits at 4.5%.[1]

In the US, there was a similar patten of stimulus, inflation, and interest rate hikes. Inflation “reached a 40-year high of 9.1% last June”[2]. Earlier in March, inflation was reported to have risen to “6% in the 12 months to February.”[3][4] . In response, the Fed, America’s central bank, raised the interest rate by a quarter of a percentage point from 4.75% to 5%.[5]

It is important appreciate how the capitalist system is plagued by the corruption that comes with both interest (riba) and the Fiat currency standard. The Fed is now in a difficult place to understand how to move forward. If they raise rates, they may cause other banks to fail just like Silicon Valley bank or SVB. (we will discuss in more details later in sha Allah). Alternatively, if they do not raise rates then they will continue to experience inflation.

So, the question is how did Capitalism end up here?

To answer this question, we must look at the post World War Two environment that brought into the world the Bretton woods agreement. The Bretton Woods agreement established a new international monetary system². The agreement established the US dollar as the world’s international reserve currency, and it was backed by gold at a price of $35 per ounce (link, link). All other countries had their currency pegged to the US dollar at a fixed exchange rates. Any country could exchange US dollars for gold, i.e., just as you would with a gold certificate. After the agreement was signed, America was the only country with the ability to print dollars - assuming it held the requisite amount of gold in its vaults.

By 1960, the number of dollars circulating throughout the world far exceeded the value of the gold pool in America’s Fort Knox. America was covering the cost of its war with Vietnam and its domestic spending by printing more than $35 to 1 ounce of gold ratio, specified by Bretton Woods. France realized this and in 1968 decided to cash in. It converted $150 million of its reserve dollars into gold.[6]

If France and other nations kept doing this, it would deplete America’s gold reserves.

Consequently, the then US President Nixon closed the gold window on August 15th, 1971. What that meant was that the US dollar was no longer convertible into gold. For example, France would no longer be able to cash in their U.S. dollars for actual gold. Instead, they (and anyone else) would have to buy it at the market price – like any other commodity. And this is how the world ended up with Fiat currency. That is, by closing the gold window Nixon made the US dollar backed by nothing. For example, the price of one ounce of gold is no longer $35 US. It is nearly $2,000 US dollars – illustrating how much the dollar’s value has decreased in the past 50 years.

Inflation: What is its impact on society?

America's policy to print more dollars than what was prescribed in the Bretton woods agreement resulted in inflation. According to the federal reserve, inflation was at 5.4% in 1969/1970.[7] The way to think about inflation is a ratio. That is, if the amount of goods and services is fixed, and the volume of currency increases, then the price of those goods and services will increase. For example, if there are 100 cars in the economy and then there is $1,000,000 in currency, then the price is $10,000 per car. If the central bank prints another $1,000,000, then the price will rise to $20,000 because the amount of currency in the economy has doubled, but the number of cars available for sale has remained the same.

Inflation also harms those who were saving money. Someone who has saved money will have less purchasing power. For example, if someone had saved $10,000 to buy a car, they would no longer be able to do so because the price has doubled. Conversely, they can only buy half of what they used to be able to afford. In a sense, the central bank's printing of money has stolen the wealth of the society because it devalues the savings one holds.

Interest rates and its role in controlling inflation

Nixon had failed to rein in inflation. The year-over-year inflation rate bottomed out at 5 percent in December 1976 before moving higher once again.[8] By July 1979, inflation hit 9%. July 1979 was also significant because Paul Volcker became and the president of the US federal reserve. He became famous for instituting what came to be known as the Volcker Shock. He raised the interest rate from 10.47% in July 1979 to 17.61% by April 1980. He raised it a second time hitting about 19% between May and July in 1981.

This caused to two recessions. Unemployment in 1978 was 6% and went up to 7.8% by December 1980. The impact of the second rate hike can be seen by the unemployment rate of nearly 11% recorded at the end of 1982.

Why did this happen?

When the interest rate goes up, it becomes more costly to borrow money. For both people and businesses, borrowing becomes pricier, which means they'll likely borrow less, spend less, and invest less. This slowdown in borrowing and spending means that companies will not invest as much in new projects, and people will delay big purchases like homes or cars and cut back on spending in other areas. On the flip side, saving money becomes more attractive to Capitalists because they can earn more interest. So, businesses and people will put more money into bonds and other so-called investments to earn higher interest rates. The result is that the economy contracts. Companies stop hiring and start laying off people. This is why the Volcker shock caused the high rates of unemployment. It is also one of the key reasons why we see Facebook, Google, and others in the tech sector laying off people.

Getting back to SVB: Why did the rate hikes cause the bank to fail?

The recent rate hike was a surprise to the Banking sector. Recall that on March 22nd 2023, the Fed raised interest rate 25 basis points or a quarter of a percentage point from 4.75% to 5%.[9] Banks expected that the Fed would not raise rates given the recent collapse of Silicon Valley bank (SVB). Part of what led to the collapse of SVB was that the bank owned over $80bn of mortgage-backed securities with 97% of them being 10+ year duration at a weighted average yield of 1.56% interest (link), which they bought during the era of low-interest. The value of these interest-bearing securities held by the bank had collapsed in value because interest rates rose.

Why?

When interest rates rise, the value of existing interest-bearing securities and bonds decreases because they pay a lower interest rate compared to the newly issued bonds. This makes them less attractive to Capitalists, who will demand a discount on the existing bonds to compensate them for the lower interest rate offered.

For example, let's say a Capitalist bought a bond for $1,000 that pays 3% interest per year ($30). Now, imagine that interest rates increase to 4%. New bonds being issued would pay $40 per year for the same $1,000 investment. Capitalists would prefer to buy the new bond with the higher interest rate.

To make the 3% bond more attractive to potential buyers, the holder of the bond would have to lower its price so that the $30 interest payment becomes more competitive. For example, if they lowered the bond's price to $750, the $30 interest payment would now represent a 4% return ($30/$750), making it more appealing despite the lower interest rate. In this example, a 1% rise in the interest rate resulted in a corresponding decrease of the bond’s value by 25% or $250.

And this is a key reason why SVB could not cover the run on the bank that they experienced on March 10th, where companies and others pulled $42 billion worth of deposits from the bank. According to Bloomberg, SVB had lost $15 billion on the value of the bonds they held.[10] In other words, if they sold these bonds, they could not make the depositors whole. And so the Federal Deposit Insurance Corporation (FDIC) had to takeover and the government had to step into bailout the depositors. The key point, however, is the bank’s collapse is directly tied to the Fed’s decision to raise interest rates.

The Islamic Perspective: How does the Khilafah stop such problems?

There are three things to consider when looking at this situation from the Islamic perspective.

· first is to link the problem to the issue of freedom of ownership and show how Islam offers superior economic solutions because they are from Allah (swt),

· second is to discuss the gold silver standard that is prescribed by Allah (swt), and

· third is to convey the idea that Islam prescribes a zero-interest rate economy the consequences of which is that debt is a charity not a business.

It is critical to link the current problems in the economy to the issue of freedom of ownership. When man legislates for himself, it will result in misery and turmoil. As discussed, the goal of interest rates hikes is to increase unemployment. This is not a small point. It speaks to how for the economy to “work”, the people must suffer. It is but one illustration of the callous disregard that capitalism has for human beings.

Moreover, we must go out of our way to show how this is about freedom of ownership. The capitalist system and the economic solutions it brings to humanity are based on the idea that human beings can derive whatever economic contract they want. Allah (swt), in contrast, forbids us from dealing in interest (riba):

“Those who consume interest1 cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, "Trade is [just] like interest." But Allāh has permitted trade and has forbidden interest.” [TMQ 2:275]

Like COVID or cancer, interest grows at exponential rate. According to the New York Times: "Nigeria...borrowed $5 billion, has paid back $16 billion and still owes $32 billion on the same debt". So a $5 billion debt results in ~$50 billion of wealth being transferred from a "former" colony to "former" colonizer(s).

The same is true for the Fiat standard; it is a product of the idea that humans can lay down any system they want. Though it seems beneficial to the American empire to use paper and digital accounting entries to buy the treasures of the world, it will ultimately result in ruin. Islamically, the Khilafah must use the gold-silver standard. In Islam, there are fixed rules that connect the use of these two metals as the mediums of exchange. Specifically:

Zakat, where the minimum threshold (i.e. nisab) was determined in gold and silver.
Nisab for determining theft was set in terms of gold and silver, RasulAllah (saw) said: "The hand is cut for the theft of one-quarter dinar and upward." [Bukhari]
Blood money for murder: "The blood money for one soul would be 100 camels...and for those who deal in gold it would be 1000 dinars.” [An-Nasai].
The prohibition on the delay when exchanging currencies referred to gold and silver, as the mediums of exchange: "Gold for silver would be Riba, unless it was hand to hand (without delay)." [Bukhari].

Furthermore, RasulAllah (saw) determined the weight of gold and silver with a specific weight, which was the weight of the people of Makkah. In a hadith reported by Abu Dawud and An-Nasai, Messenger of Allah (SAW) said: "The weight should be that of the people of Makkah."

The result of using gold and silver as the medium of exchange is that prices will be stable, as it will be impossible for the State to print gold and silver. Thus, inflation will not be an issue in the Khilafah, in sha Allah.

In conclusion, it is inevitable for the Capitalist system to fail – just like Qarun did. At one point he was so wealthy that it took a band of strong men just to carry the keys to his wealth. During this time, Allah (swt) revealed that:

“Those who desired the life of this world wished, “If only we could have something like what Qarun has been given. He is truly a man of great fortune!” [TMQ 28:79]

Then when Allah (swt) caused Qarun to be swallowed by the earth, Allah (swt) revealed:

“And those who had craved his position the previous day began to say, “Ah! It is certainly Allah Who gives abundant or limited provisions to whoever He wills of His servants. Had it not been for the grace of Allah, He could have surely caused the earth to swallow us up! Oh, indeed! The disbelievers will never succeed.” [TMQ 28:82]

Consequently, we should be confident in explaining the Islamic economic system and exposing the flaws of the Capitalist system.

[1] https://globalnews.ca/news/9535701/bank-of-canada-interest-rate-mar-2023/

[2] https://ca.finance.yahoo.com/news/march-fed-interest-rate-decision-103222154.html

[3] https://www.forbes.com/advisor/investing/fomc-meeting-federal-reserve/

[4] That was down from the 6.4% annual gain in January and well off peak inflation of 9.1% in June 20”

[5] https://www.forbes.com/advisor/investing/fomc-meeting-federal-reserve/

[6] https://dailyhistory.org/Why_Did_the_Bretton_Woods_Economic_System_End

[7] https://www.federalreservehistory.org/essays/gold-convertibility-ends

[8] By January 1979, inflation was threatening to rise further, as prices jumped 7.7 percent from the year before

[9] https://www.forbes.com/advisor/investing/fomc-meeting-federal-reserve/

[10] https://www.bloomberg.com/opinion/articles/2023-03-13/svb-couldn-t-ignore-its-losses-but-the-fed-can