From the great depression to the 2008 global financial crisis : systemic flaws in investment financing

Abstract EN

The 2008 global financial crisis (GFC) echoed the same systemic flaws in relation to investment financing that gave rise to the 1930s great depression (GD).

Although triggering factors and regulatory concerns are qualitatively different in the two crises, the diagnosis in Islamic perspective relates to two major sources: (1) an inherently destabilising force of the interest rate as it strictly separates investment and financing decisions, (2) and an ever- widening distance between capital markets and productive sectors due to unrestrained financial engineering that feeds on short term speculative returns.

The firstproblem is shown to invoke Fisher and Tobin’s Separation Theorems in the mainstream economics as they state the theoretical appeal of investment / financing separation in terms of capital market optimality.

The second problem has a long history in modern capitalist markets as it has lately resulted in transforming traditional concepts of investment, financing and liquidity.

Recent studies have provided evidence that financial derivatives in capital markets constitute 80 % of global liquidity, implying that the world economy is becoming much like a big gambling casino having producers of goods and services like sellers of nuts and crisps! The paper sets out from a brief background on the GD, shedding light on the profound structural impact of the 1933 Glass-Steagall Act asit negatively affected traditional bank intermediation and encouraged money and capital market disintermediation.

The present GFC has marked the apex of major intermittent events between the GD and the GFC that have contributed to radical shifts of profitability from productivity-based traditions to highly leveraged speculation.

In conclusion, interest-free Islamic finance can be part of the global financial solution not only through advocacy of an equity driven economic order but also through stricter control on financial engineering that feeds purely on speculative bubbles.