Lately, there have been questions on what the standards for gold dinar and silver dirham are.  Since the dinar and dirham indeed formed the Shari’ah monetary standards from the time of the Prophet pbuh, our work can, therefore, only involve in the rediscovery of that classical standard.  Henceforth no parties or organizations can come up with their own standards. Since the Islamic gold dinar did not come into existence until after about 50 years of the Prophet’s pbuh demise, it is obvious from history that the solidus of the Eastern Roman Byzantine Empire was the monetary basis for the Shari’ah.  Hence the best way to determine the standard is to look at the definition given by its issuer, the Byzantine Empire.  Coins unearthed by archeologist cannot be relied upon for this purpose because such coins generally suffer from wear and possible tempering like clipping etc.  It was found that the actual historical standard for the dinar to be 4.5gm of pure gold and the dirham to be 3.15gm of pure silver.  However, since the role of dinar is simply as a measure of value that depends on the gold-content and if zakat is based upon 1-year’s provision of foodstuff, then the 4.25gm dinar of pure gold and 2.975gm dirham of pure silver, as those circulated during the Prophet’s pbuh era, is also a standard.

Introduction

Undoubtedly, the interest in gold dinar among the public, academics, business community and even governments has increased lately.  The turmoil in the US and Europe and the ongoing global economic and monetary crisis has added to this interest.  Capitalism based on interest-based fiat monetary system is indeed collapsing and the world is on the lookout for possible solutions to the crisis.  Returning back to gold as the international monetary standard has been one suggestion from some quarters.  In the case of Islamic economics, the call is to go back to the Islamic gold dinar that was the monetary standard of Shari’ah throughout Islamic history till the fall of the Ottoman Caliphate in 1924.  The gold dinar is generally agreed upon as a 4.25gm gold coin, based upon the Roman solidus that circulated during the times of the Prophet pbuh.  The gold dinar forms the monetary standard for the Shari’ah rulings on muamalat, zakat, hudud and mahr.  Nonetheless, there is difference is opinion among the proponents of the gold dinar on the purity and weight of the coin – should it be made of 22K gold or 24K fine gold? Should it be 4.25gm or more than that?.  Twenty four karat (24K) gold is fine gold, by today’s standard it is 99.99 percent pure.  The 22K accordingly contains 91.66% gold, hence known as 916 gold.  Due to the rounding, some gold dealers make it to be 917, which means that in one thousand parts, 917 parts is gold while the rest is some other metals, normally silver or copper.

The question whether the gold dinar is of fine gold or not is important because it is the Shari’ah standard and even the zakat, the fifth pillar of Islam, is based on it.  The nisab for money is 20 dinars.  One who had twenty dinar in one’s possession for one year will have to pay a 2½ %  zakat on it, i.e. half-dinar.

The objective of this paper is to determine using historical facts the standards for the dinar and dirham.

The Purity of the Islamic Gold Dinar:  22K or 24K?

This question should not be difficult to answer because the gold dinar had been a historical standard among Muslims for centuries.  It is not a modern innovation or theoretical construction.  Hence to answer the above question, one simply has to go back to history, particularly the time of the Prophet Muhammad peace be upon him.

The Prophet pbuh is reported to have said:  The system of weights and measures is the system of the people of Medina (Sahih Bukhari).

History of the Gold Dinar During the Prophet’s Era in Medina

At the time of the Prophet pbuh the Muslims did not mint the gold dinars yet.  The Prophet pbuh accepted the Roman Byzantine gold solidus, also known as the bezant, as the monetary standard for Muslims.  In this is wisdom.  It was this coin that circulated among the Arabs for decades before the Muslims minted their own coins.  The Prophet would have not accepted it if it were not Islamic in nature, i.e. it promotes the maqasid al Shari’ah.  It also has to be a standard that is just and stable; and facilitate trade and  business even among Muslims and non-Muslims.  In fact the first Islamic gold dinars were not minted until about half century after the demise of the Prophet pbuh, by the fifth Umayyad caliph Abd al-Malik ibn Marwan in the year 75H (697CE).

Since the gold coin of the Eastern Roman Byzantine Empire, the solidus, was the coin accepted by the Prophet pbuh and was circulating among the Muslims, it is this coin we need to research and understand.  Surely the Islamic gold dinars minted by the later Muslim rulers would follow this standard.  Before we go to this, let’s look at the purpose and functions of the gold dinar.

Function of the Gold Dinar

The gold dinar played the role of money in Islam.  Hence it eliminated problems generally associated with barter trades, like double coincidence of wants and the problem of divisibility.  However, as money, it also enabled people to specialize in whatever they do best and hence increased productivity, output and trade; and thereby increased the standard of living of the people.  Hence among the most important function of the gold dinar as money was as a stable measure of value.  By this, people are able to exchange goods and services in a just manner and able to save for future consumption and investments, transact in credit and repay debt in future.  Al Ghazzali and Ibn Khaldun rightly asserted that Allah SWT created gold and silver as measure of value.  Hence gold and silver are the standards by which the values of all things are measured.

Indeed, the current global monetary system that is based on fiat money has this stable measure of value missing since the collapse of the Bretton Woods in 1971.  Hence it is void of a numeraire or an anchor that links the monetary sector to the real economy.  I would assert this as the fundamental reason for the current collapsing of capitalism.

When anything is taken as a standard or measure, it has to be ‘pure’ and simple so that people can easily relate to it.  Length is measured by kilometer for example.  A kilometer is defined as the distance travelled by light in vacuum in ¹⁄_299 792.458 second.  The kilogram on the other hand is defined as the base unit of mass in the International System of Units and is defined as being equal to the mass of the International Prototype Kilogram (IPK), which is almost exactly equal to the mass of one liter of water[1].  Since international trade and business involves exchange of goods and services, what the world needs today is a stable measure of value against which the value of all things can be measured,

The Roman Aureus and Solidus

The Roman gold coin, the aureus, was among the earliest Roman gold coins, issued from the 1st century BC to the beginning of the 4th century.  The aureus of Julius Caesar was struck 40 to the Roman libra pound.  The libra pound is about 327.4gm.  Hence, the coin weighed about 8gm.  Later, the emperor Nero reduced the weight of the aureus by minting it 45 to the pound, i.e. about 7.3gm.  The aureus was then replaced by the solidus that was first introduced by Diocletian around 301 AD, struck at 60 to the Roman pound of pure gold, weighing about 5.5gm each. Due to its limited quantity its economic effects were minimal.  Hence, the solidus was reintroduced by Constantine I in 312 AD, permanently replacing the aureus as the official gold coin of the Roman Empire. The solidus of Constantine was struck at a rate of 72 to a Roman Byzantine pound of pure gold which equals 324gm, each coin weighing twenty-four Greco-Roman carats, or about 4.5 grams of gold per coin.  Analysis of the Roman aureus and solidus, regardless of the size or weight, shows the purity level to be near 24 carat gold in excess of 99%. [Cite]  Whenever the coin was taken in by the treasury, it was melted down and reissued. This maintained the evenness of the weight of the circulating solidi[2].

Hence it is obvious that the gold dinars of the Roman solidus that circulated among the Arabs during the advent of the Prophet pbuh were of fine gold, exceeding 99 percent purity.  However, since the solidi circulating outside the Roman empire including the Arab world, were not used to pay taxes to the emperor they did not get reminted, and hence the soft pure-gold coins became quickly worn[3].  The average weight of the coins in the Arab world was about 4.25gm, from the original weight of 4.5gm.  Regarding this Bernstein said the following:

Less than fifty years after the death of Prophet Muhammad (peace be upon him), the Arabs emulated the great rulers of the past with the debut of their own gold coinage – the dinar -  issued by the Caliph Abd al-Malik at Damascus in 75H.  These coins, 97 percent pure gold and minted in great quantity gradually displaced the bezant as the major international currency, circulating throughout the Arab domains and everywhere in Christian Europe as well[4].

Coins of the time of Abd al-Malik ibn Marwan, unearthed by archeologists, have the weight of the dinar at about 4.25grammes[5], matching the weight of the worn solidi that circulated in those areas.  One could attribute this slightly lower purity of the first Islamic gold dinar compared to the Roman coin to the fact this was the first attempts of Muslims to mint their own coins and hence their relative inexperience in the refining and minting technology compared to the Romans who had been doing this for centuries.  However, undoubtedly the intention was to get a coin as pure gold as possible.

However, as the Islamic empire expanded and trade flourished, it must have become apparent that the gold dinar was less in weight compared to the Roman solidus[6].  The Caliph Umar ibn Abd al-Aziz alerted that the dirhams of Abd al-Malik ibn Marwan were at 7:10.5 to the mithqal instead of the standard at 7:10.  Hence he corrected the matter and issued, in 99H/717CE[7], silver dirhams and gold dinars of weight 3.15gm[8] and 4.5gm respectively, i.e. similar weigh to the Roman solidus, i.e. 4.5gm[9]. Historical evidences show that by the time of the Fatimid Dynasty in Egypt, dinars of fine gold were already in circulation[10].

The Standard Weight of the Islamic Gold Dinar

Determining the standard weight should be easy but rather challenging.  Easy because we are dealing with something that had existed historically, and not developing a theoretical one.  One cannot totally rely on coins unearthed by archeologist in this regard because unearthed coins generally would have experienced some tear and wear depending on how long they had been in circulation and also due to some variance in the weight of individual coins themselves.  Some could have been tempered through clipping and so forth.  Hence it is best we resort to the definition of the coins as determined by the issuing authorities, like in this case the Byzantine Empire.

It is obvious that the Islamic gold dinar is based on Constantine’s Roman solidus which was struck 72 to the Roman Byzantine pound (litra) used for gold measurement.  The litra pound is recorded to be 324 gm, which gives an ounce to be 27gm[11].  Hence the weight of the solidus is 4.5 gm as recorded, equals one mithqal, equals 24 Greco-Roman carats[12].   This coin was frequently melted down and reminted to preserve the weight.  However, as mentioned earlier, the coin circulated among the Arabs with an average weight about 4.25 gm due to tear and wear.  Therefore the actual mithqal or dinar should weigh 4.5gm of pure gold.  Indeed this was corrected by Caliph Umar ibn Abd al-Aziz during his reign, by changing the weight from 4.25gm to 4.5gm.

It was reported on the authority of Jabir that the Prophet pbuh said, “The weight of the dinar is 24 qirats[13]”.  Also Ibn Khaldun asserted the following in al-Muqaddimah:

Know that there is consensus since the beginning of Islam and the age of the Companions and the Followers that the dirham of the shari’ah is that of which ten weigh seven mithqals weight of the dinar of gold… The weight of a mithqal of gold is seventy-two grains of barley, so that the dirham which is seven-tenths of it is fifty and two-fifths grains. All these measurements are firmly established by consensus.

From the above hadith and historical facts, it can be established that the Islamic dinar is of pure gold which equals one mithqal or 24 qirats or 72 grains of barley, that equals 4.5gm in modern weight.  Accordingly, a barley grain weighs 0.0625gm (4.5gm ÷ 72)[14], i.e. 62.5mg.  See Table 1 below.  Also well-known is the fact that 7 mithqals equal in weight to 10 dirhams.  Therefore, this also implies that the silver dirham is of pure silver, weighing 3.15gm (0.7 x 4.5gm) that equals 50 2/5  grains (3.15 ÷ 0.0625  or  0.7 x 72) as mentioned by Ibn Khaldun.

Inscriptions on the Islamic Gold Dinar

Generally, the Islamic gold dinar does not depict pictures of caliphs, rulers, animals or other living things in accordance with Shariah that discourages such practice.  The first Islamic gold dinar, i.e. that of Abd al-Malik ibn Marwan, had inscription based on Quranic verses.  One could notice that the earliest coins never had full Qur’anic verses on them.  Perhaps this is because the early learned scholars could have opined that it is highly possible for people to bring coins into impure places like toilets and so forth; and also possible to lose them to the ground.  Also because coins pass from hand to hand in circulation, one cannot afford to make a mistake in Qur’anic verses inscribed on the coins.  Once circulated it would be extremely difficult to call them back, in case of mistakes.

For example the dinar and dirham of Abd al-Malik ibn Marwan had the following inscriptions:  The obverse of the coin has as its central legend the Kalima Shahada, i.e. “There is no god except Allah alone, there is no partner with Him’. Around it is the mint date formula reading “In the Name of Allah. This dirham was struck in the year 79 AH”. The reverse of the coin has the central inscription based on Surah 112 of the Quran: “Allahu Ahad, Allahu-Samad, Lam Yalid wa lam Yulad wa lam Yakul-lahu Kufu-an Ahad”‘. The marginal legend is based on Surah 9, Taubah Verse 33.  It states: “Muhammad is the Messenger of Allah, he was sent with guidance and the religion of truth to make it prevail over every other religion.”  Note that these are not full Qur’anic verses.

Softness of 24K Gold Dinars and the Issue of Tear and Wear

The original gold dinar and silver dirham were made from pure gold and pure silver respectively.  In the pure form they are soft and therefore get worn in the process of circulation.  Nonetheless, gold and silver have the highest ductility and malleability among all metals[15].  The atoms of these metals are strongly bonded among them but however can move easily around them.  Therefore even though the gold and silver coins can become worn in the process of circulation, the process is not easy though and rather is slow.

To address this issue of tear and wear, the Roman empire, as mentioned earlier, would melt down and remint the coins it receives as tax in order to maintain the standard weight of 4.5 grams.

Some quarters assert that the dinar should not be of pure gold since it would easily get worn out.  They say that in about 3 years the coins may lose enough gold to be rejected as dinar.  However, the Roman solidus that was circulating, for decades, outside the Roman empire had a weight of about 4.25 grams, with some going as low as 4 grams[16] and people did accept them as dinars.  It is our contention that the Islamic government, as the Roman empire, should continuously remint the coins to preserve the weight of the coins.

Zakat on the Dinar and Dirham

It is important to note that the basis for the Prophet pbuh fixing the nisab for silver at 200 dirhams and the nisab for gold at 20 dinars was that either of these two sums represented, in his day, the market price of 5 camel-loads of grain or, in other words, of one year’s provision of essential food-stuffs for an average family.  Accordingly, the value of one dinar during the prophet’s time was equal to 10 dirhams.  Hence the basis for the nisab was not the physical count of the dinar but rather the purchasing power of the money. [Roy Jastram]

Hence it may not matter whether the dinar is 22K or 24K because the value of each will be based on their respective gold content.  Henceforth, the nisab for silver and gold must be established on the same basis as practiced by the prophet pbuh, i.e. on the proportionate value of the year’s provision of essential foodstuffs in relation thereto, as dictated by the prevailing market price.  Therefore, nisab for gold and silver must vary from year to year in conformity with the price fluctuations of essential foodgrain[17].

The Modern Implementation of the Islamic Gold Dinar

When the gold dinar gets implemented in the modern world, it would surely rely heavily on the internet.  Gold-based interest-free electronic credit is the most desirable form of  money (using cards, internet, mobile phones, computers etc).  Here, the gold dinar would predominantly play the role as measure of value that involves only the recordings of credit transactions that are periodically net-off.  Such system is not akin to fractional reserve banking because this system does not create new money and does not involve the transfer of credits for payment purposes.  Therefore, in this system the need for physical dinars will be much minimized.  The periodic settlements can be done even using gold bars and not necessarily using gold dinar coins.  Also the system permits real-time electronic audits.

Such electronic interest-free money is desirable because it fully takes advantage of the concept of money as a measure of value, as a means for keeping score.  Hence practically there will be no situations of shortage of money that can plunge an economy into recession and thereby give hoarders of money the advantage to charge interest on borrowings.  Since the system does not create new money, it will not create inflation.

Conclusion

Islam as inherited by Muslims from the Prophet pbuh is a complete religion.  As the following verse from the Holy Qur’an asserts.

This day have I perfected your religion for you, completed My favour upon you, and have chosen for you Islam as your religion

Being a religion that is complete without defects or shortcomings, it needed no human efforts to perfect it, solve or rectify any shortcomings.

As far as monetary standards in Islam are concerned, the words dinar and dirham are mentioned in the Qur’an.  These precious metals are to play the role of measure of value for just economic and business transations.  As Islam is pure, its measures of value must be pure too.  Pure makes it easier for standardization for all nations and people, without ambiguity, forex risk; simply a pure reference point, an anchor, a numeraire.

But as for all who lay up treasures of gold and silver and do not spend them for the sake of Gods  - give them the tiding of grievous suffering [in the life to come]:

With simple deductions using historical facts, we ascertained that the standard for dinar and dirham are 4.5gm of pure gold and 3.15gm of pure silver.  Hence, the correction of weight from 4.25gm to 4.5gm by Umar ibn Abd Aziz.  In the present time, we cannot mint a coin inferior to that of Abd al Malik ibn Marwan.  Hence the WIM standard of 4.25gm of 917 gold and 2.975gm of fine silver for dinar and dirham respectively are erroneous because the coins would have about 13.4% less gold and 5.6% less silver respectively than the historical standards.

The use of 22K would lower the nisab and if people were to pay zakat on it, I guess they would not be punished for lowering the hurdle, but nonetheless 24K is the standard   The value of the 22K will be based on the pure gold content of the coin, anyway.

Hence it may be trivial to argue whether the gold dinar is 22K or 24K since the gold content will determine their respective value, play the role of measure of value, and form the basis for payment of zakat based on one-years provision of food-stuff.  However since the Prophet pbuh said that the system of measure is the system of Medina, I contend that it should be perfectly alright to mint the Islamic gold dinar according to that of the time of the Prophet pbuh i.e. a 24K gold coin of 4.25 grams in weight.  Also since modern electronic payment systems are likely to be the way forward, the 24K fine gold should be the basis of a standard measure.

Reference

Bernstein, Peter L., The Power of Gold – The history of an obsession, John Wiley, 2000

Porteous, John (1969). “The Imperial Foundations”. Coins in history : a survey of coinage from the reform of Diocletian to the Latin Monetary Union.. Weidenfeld and Nicolson. pp. 14–33

Subhi

Kitab Adh-Dharaib fi as Sawad

Hunwick, John, Islamic Financial Institutions: Theoretical Structures and Aspects fo the Application in Sub-Saharan Africa, in Credit, Currencies and Culture – African Finanical Institutions in Historical Garrard Perspaectiv, Ed. Endre Stiansen and Jane I. Guyer, Elanders Gotab, Sweden, 1999. P86

Timothy, Akan, Weights and the Gold Trade, London 1980,

• Islam is complete.
• Qur’anic verse on gold and silver  – Allah must be referring to gold and gold mixed with other metals
• If dirham is fine silver, why dinar is not fine gold?
• Roy Jastram
• Rome was attacked 476AD, thereafter Eastern Byzantine empire existed.
• Byzantine emperor was Justinian who governed with his wife Theodora from 527 to 565.
• 9 May 2004 – On this day in A.D. 330, Constantine founded the city of Constantinople

[1] The IPK is made of a platinum–iridium alloy and is stored in a vault at the International Bureau of Weights and Measures in Sèvres, France.  However, the weight of this alloy has been changing over time, and hence the call for a redefinition of the kilogram.

[2] Wikipedia

[3] Porteous, John (1969). “The Imperial Foundations”. Coins in history : a survey of coinage from the reform of Diocletian to the Latin Monetary Union.. Weidenfeld and Nicolson. pp. 14–33

[4] Bernstein, The Power of Gold – The history of an obsession, p67.

[5] Subhiì, 1976: p427

[6] The Roman Byzantine Empire lasted till 1416 CE.  However, the Persian Sassanid Dynasty that was responsible for the silver dirham that circulated among the Arab, ended much earlier around 644CE.

[7] Kitab Adh-Dharaib fi as Sawad, p65 as referenced in http://islamhariini.wordpress.com

[8] Abd al-Malik’s dirham was close to 3gm, but the Roman solidus weighed 4.5gm.  Hence Umar ibn Abd Aziz’s remark of the ratio 7:10.5, i.e.

[9] Archeological gold dinars of this period weighed in the range 4.4gm to 4.6gm.  To what weight he corrected the dirham and the dinars depends on what standard dinar he was comparing the dirhams to.  We contend it must be the Roman solidus, that weighed 4.5gm.

[10] All dinars are indeed of pure gold but constrained by mining and refining technologies of the time.  By the Fatimid period Muslims seem to have perfected the technology; something the Romans had known much earlier.

[11] 27gm was the old Roman-Byzantine ounce from which the original solidus standard had been derived.  See Timothy Garrard, Akan Weights and the Gold Trade, London 1980, p215.

[12] Traditionally, 1carat (the mass of a carob seed) equaled the weight of 3 barley grains or 4 wheat grains.

[13] Qirat is carat.  In today’s jargon, 24K is also used to denominate pure gold.

[14] This weight of a barley grain is computed based on the above statement by Ibn Khaldun.  Barley grains do vary in weight, that is subject to change due to moisture content etc.  The International Systems of Units set the barley grain as equal to 0.06479891 gm

[15] Ductility is a solid material’s ability to deform under tensile stress, i.e. the material’s ability to be stretched into a wire. Malleability is a material’s ability to deform under compressive stress, i.e. the material’s ability to form a thin sheet by hammering or rolling. Both of these mechanical properties are aspects of plasticity, the extent to which a solid material can be plastically deformed without fracture [Wikipedia].

[16] That is, a loss of about 5.5% to 11.1%, but we are not sure for how long the coins circulate before losing that much.

[17] Zayas, Farishta G. de, The Law and Institution of Zakat, The Other Press, 2003, p74.

There may be many reasons for the above observations, but strange as it may sound, I have always asserted that the one most important factor that is contributing to all the above is the structure of our global monetary system based on fiat money and compound interest.   I will focus on compound interest in this article.    

Compound interest means interest over interest.  For example if one were to deposit RM1,000 at a compound interest of 10 percent per annum, one would have RM1100 at the end of the year, i.e. RM1,000 principal and RM100 as the interest.  In the following year, this balance would grow to RM1,210, i.e. 10 percent of RM1,100 is RM110, added to the beginning balance of RM1,100.  A simple formula relates this ending balance known as Future Value (FV) to the initial amount known as the Present Value (PV), i.e. FV = PV (1 + i)n  where i is the interest rate and n is the number of years.  Accordingly, the second-year balance can be obtained as FV = 1000 (1 + 0.10)2 = 1,210.  The tenth-year balance, for example, would then be FV = 1000 (1 + 0.10)10 = 2,593.74.  Note that since the formula has a power n in it, it is exponential in nature.  In fifty years, the balance is RM117,390.85 while in a hundred years it is RM13,780,612.34!  This computation is well-known to many of us, but what most of us are not aware is that it has serious implications for society, economy and the environment.    

The reason why we postulate that the compound interest is at the root of the global chaos of today is that under the present fiat monetary system, most money is created through mere accounting entries by commercial banks in the form of loans, that carry compound interest with it.  Due to this reason, both money and debt grow exponentially in almost all economies.  But the real productive economy, i.e. the economy that produces goods and services does not and cannot match the exponential growth of money and debt.  This is where the problem lies.    

As a consequence, money and debt overshoots the real economy, the difference of which shows up in the form of inflation and bubbles; stock market bubble, housing bubble etc.  See diagram.  But in the process, individuals, businesses and governments become increasingly indebted (See table below).  When the average debt level reaches a point that is unbearable for the weaker sections of the economy it then ‘bursts’, causing an avalanche of foreclosures of properties and the destruction of money in the process, which in turn brings about recession, unemployment and so forth.  If individuals, businesses and governments all become indebted then one wonders who the creditors within the system are.  Of course the creditors are indeed the banks to whom the system has given the legal right to create money out of thin air and lend it out to others at compound interest.  Hence during times of crisis if one were to take a helicopter-view of the economy below, one would see things seem so normal down there but what really happens is that huge transfer of wealth taking place, from those who are distressed by the debt-situation to a small section of the economy, i.e. the banks. 

The world after being under this pure fiat money system for the past few decades has been brought to the precarious position we are currently observing.  There is now a global debt crisis, a situation significantly brought about by compound interest, but compounded further by the fact loans themselves are created out of thin air.  This is the reason why a great productive nation like Japan, a nation of very hardworking and intelligent people, has fallen into a receding economy since almost two decades ago.  In the real economy, one would expect such people to be able to produce abundantly and lend to others any extra they might save.  And yet, in a compound interest-based system, Japan has become the country with the largest total debt as a percentage of GDP, i.e. more than 450%, with the government debt alone accounting for almost 200% of GDP.  Government debt is indeed debt of the people.  This can, therefore, ultimately wipe-off the national savings of the people, thereby transferring the saved wealth of the people to the government.    

The US is also somewhat in a similar situation albeit it is not a nation with high savings rate like Japan.  Compound interest has brought its economy practically to a halt, as shown by employment data.  In capitalism, the compound interest-based monetary system strengthens a small section of the economy at the expense of the system itself.  Hence compound interest is a seed of the capitalism’s own destruction.  While strengthening a small group of people, it causes outright calamity on the rest of the people – economic deprivation, inflation, social disparity, high crime levels, erosion of moral values, collapse of the institution of family, erosion of feelings of love and compassion for others etc.   Hence one is not surprised by the Occupy Wall Street movement, with its reverberations worldwide.  In a recent interview by Bloomberg, George Soros mentioned that the turmoil in the US and Europe reminded him of the Soviet collapse.  On how to fix the European debt problem, his amusing answer was “There is a lot of confusion and I am also confused.”    

The compound interest monetary system has also brought the whole world to an interesting historical juncture.  Almost every nation would be facing political upheavals and challenges due to this precarious position the world is currently in.  At this juncture, we are reminded that the ongoing Arab unrest in the Middle East was triggered by one individual’s self immolation as a reaction to serious economic deprivation.  The debt crisis is threatening even the very existence of the European Monetary Union, particularly with the latest crisis faced by Greece.  Italy, Spain and others might follow soon.  It’s crucial to note that Italy’s debt is larger than that of Greece, Spain and Portugal combined.    

As mentioned earlier, the compound interest system in a fiat monetary system causes individuals, businesses and governments to become continuously and increasingly burdened with debt.  Government debt, being the debt of the people, would have to be paid through collection of tax and other revenues from the people.  This is the reason why in the case of Greece, for example, draconian austerity measures were required on its citizens.  All these would but add extra burden on the people.    Accordingly one could see why the anger against banking system worldwide – it is highly lucrative and relatively risk-free.  In good times banks collect interest while in bad times, i.e. default-period times, they collect real assets placed as collaterals.    

The political implications of the compound interest system are already obvious in many countries.  In Malaysia I think it will be apparent by next year.  In such times radical forces would make headways.  Even the political challenges faced during the last election by PAP, the ruling party in Singapore, I would attribute it to the economic distress felt by many of its citizens, particularly the younger generation.    

In Malaysia too, I believe that in the coming general election Barisan National would face among the strongest challenges it has faced, particularly caused by this socio-economic distress factor caused by the global monetary order.  People would attempt to seek solace by going to the opposition, thinking that the opposition might be able to help them out of their predicament.  But, nonetheless, even the opposition would not be able to help them on this unless it can effectively address the debt-burden faced by the people.  Since compound interest is time-based, the challenge would only grow stronger as time elapses.    

Therefore the solution to all these lies in giving the entire economic system a debt relieve – i.e. writing-off the interest portion of loans and demanding repayment of the principal amount alone.  Indeed this is also what the whole world actually needs today – both the developing and developed nations.  But unfortunately I do not see any political will towards this end anywhere in the world.  The Barisan National government can hence become the hero and darling of the people if it can do this.  It can lead and show the world the right path to recovery.    

The collapsing global compound interest monetary system is currently taking the world into a runaway global hyperinflation mode.  The low returns from equity and bond markets coupled with cheap money from the Quantitative Easings are fuelling a commodity bubble.  Any bailouts in the European Union would add to this.  Hence the prices of commodities, particularly grains like wheat and rice, are expected to skyrocket and potentially devastate millions of people.  Malaysia would not be spared. In the case of rice, the problem is further exacerbated by the flooding in Thailand that has wiped out millions of acres of rice fields.  Accordingly, the Malaysian government must take proactive actions now to control the prices of basic food items from seriously affecting the people.  Otherwise things can get very bad particularly by next year.  The authorities must also take measures to prevent food items from being smuggled out of the country, so as to contain prices and keep inflation to its minimum.    

There are a lot of talks of transforming Malaysia into becoming a high-income nation by 2020.  This on the outset looks something commendable, but nonetheless we must be wary of such simple macroeconomic statistics.  Pushing national average income into the high income bracket may not mean much if there is wide disparity in income and wealth distribution.  Averages alone do not tell the true picture.  Accordingly some additional measures of income dispersion among individuals and even among the races may be necessary if we are to develop the nation as a whole into a high-income nation that enjoys not only prosperity but also peace among its people.  Economic deprivation among groups of people or races can lead to tensions, crime and chaos.    

Going back to the global scenario, what worries me most is that, judging from history, in situations as we are in now, mankind tend to resort to devastating wars to ‘solve’ such problems.  The last ‘stronghold’ in this global political game, as I see it, is Iran.  An attack on it seems imminent.  I hope I’m wrong on this because the effects of a World War III, with many countries having nuclear capabilities, are unthinkable.    

In conclusion, I have no doubt that the precarious global socio-economic-politico-environmental situation we are currently in is rooted in fiat money compound-interest monetary system.  It is hence not surprising that Albert Einstein had apparently once remarked that the most powerful force in the universe is compound interest.  We are at a juncture of human history where mankind has to boldly and urgently confront this manmade ‘virtual force’ if it must save itself from its own utter destruction.    

Prof Dr Ahamed Kameel Mydin Meera
Head, Department of Finance
Kulliyyah of Economics and Management Sciences
International Islamic University Malaysia    

]]> http://www.ahamedkameel.com/archives/435/feed 0 http://www.ahamedkameel.com/archives/426 http://www.ahamedkameel.com/archives/426#comments Tue, 06 Dec 2011 05:54:42 +0000 akameel http://www.ahamedkameel.com/?p=426 On the 28th February, 2011 the Chief Minister of Perak, Dato’ Seri Dr. Zambry Abdul Kadir, launched the state of Perak’s own gold dinars and silver dirhams.  The state of Kelantan had earlier launched its gold dinars and silver dirhams on the 20th of September 2006 in Kota Bahru where I was invited to address an excited crowd.  Kelantan issued a newer design for its coins in August 2010.  The issuance of gold dinars by the states attracted comments from many quarters, with the Deputy Minister of Finance, Datuk Dr. Awang Adek Hussin highlighting the fact that the gold dinar is not a legal tender in Malaysia.  Also, many people queried the difference between the coins issued by Perak vis-a-vis the coins issued by Kelantan.

To start with, the gold dinar and the silver dirhams are generally understood as the Islamic monetary units, i.e. Shari’ah money.  These being the dominant money and measures of value during the entire history of Muslim empires that stretched from Morocco in the west to India in the east, covering a time-span from the 7th century to the first quarter of the 20th century when the Ottoman caliphate was defeated.  Nonetheless, in reality the gold dinar and silver dirham were not of Islamic origin, rather owe their origin to the Roman gold coin called denarius and the Persian silver coin called drachma.  The prophet of Islam, Muhammad peace be upon him, accepted the two coins as the monetary standard for Islamic trade, business and financial transactions.  They also form the monetary basis for Shar’iah laws of business transactions muamalat, capital punishments hudud, marriage dowry mahr and the compulsory religious alms zakat.  Hence the gold dinar and silver dirhams lost their monetary role officially with the collapse of the Ottoman caliphate in 1924.  Nevertheless, gold continued to play a role in the international monetary system until the Bretton Woods was ended in 1971.  In the Bretton Woods system, only the dollar was redeemable for gold, i.e. 1/35 oz of gold for each dollar.  The rest of the world currencies were not required to be gold-backed as the dollar was, but only needed to keep their exchange rates with the dollar stable.

With the current global monetary and economic crisis continuing, people have begun to look towards precious metals like gold and silver as safe havens for their savings.  Firstly the price of precious metals are expected to rise further, making gold and silver as excellent investment choice while at the same time these metals can also protect savings from the hyperinflation that is being predicted in the current global economic scenario.  Inflation, of course, eats into the purchasing power of savings and future returns.  The current rush for gold in the country is evident from the frequent advertisements and articles on gold that appear in the news media.  Now let me highlight the difference between the dinar of Perak and the dinar of Kelantan.

The gold dinar weights 4.25 grams but historically there have been differences in the purity of the coins depending on where, when and who issued the coins.  The first Islamic gold dinars were issued by the fifth Umayyad caliph Abd al-Malek ibn Marwan in the year 75 Hijra which coincides with the Gregorian year 697 CE.  We call it ‘Islamic’ simply because the caliph replaced the Roman pagan inscriptions on the coin with those based on Qur’anic verses.  The fact that the first Islamic gold dinars were issued only after about half a century from the prophet’s demise indicates that what matters most is not the inscriptions on the coin but rather the gold content of the coins; and Abd al-Malek’s coins were 97 percent of purity, constrained by the mining and refining technology of the time.  Historically Muslims had always striven to improve the quality of the coins.  Some coins from the Fatimid Dynasty period in the 11th century Egypt, were of pure gold.  Abd al-Malek minted the coins in large quantities, imposed strict quality control and severe punishment for any kind of tempering of the coins.  These caused the coins to circulate wider and even replaced the Roman bezant as the dominant coin in Christian Europe.  This is clear evidence that when there is freedom of monetary choice, good money would drive out bad money.

Such being the legacy of the gold dinar, the Perak and Kelantan gold dinars are also of 4.25 grams but with the purities of 99.9 and 91.7 respectively.  This means the Perak gold dinars are made from pure gold, also known as 24 Karat gold, whereas the Kelantan gold dinars are made from an alloy of 91.7 percent gold, 8.3 percent of it being other metals, normally copper or silver.  This is also known as 22 Karat gold (note that 22 divided by 24 gives 91.7%).  So indeed the Kelantan gold dinar is inferior to even the first ever gold dinar, that was 97 percent pure.

Kelantan initially launched the gold dinars and silver dirhams claiming them to be alternative money to the national currency, ringgit.  It also claimed that about a thousand businesses were ready to accept them as money.  This, of course, attracted the attention of the authorities, particularly the Ministry of Finance and the Bank Negara.  As mentioned earlier, the Deputy Finance Minister, Datuk Dr. Awang Adek Hussin responded by saying that the gold dinar is not a legal tender.  The Deputy Finance Minister challenged the state government of Kelantan to prove that the gold dinar monetary system can work and succeed.

Indeed, given the present laws of the country, the gold dinar as money is unlikely to succeed. The legal tender law would prevent it from circulating as money.  With the legal tender law in place, i.e. when monetary freedom is curtailed, bad money would drive out good money from circulation, contrary to when there is no such law as was the case when Islamic gold dinars became the dominant coins even in Europe. Therefore, in this case the ringgit which is a fiat paper currency would drive out the gold dinars from circulation.  In economics, this is known as Gresham’s Law. This law seems to explain the apparent silence of Bank Negara regarding the gold dinar because they know with legal tender law, gold will not circulate as money.  Kelantan’s actions would be mere futile unless the people intentionally defy the law.  Hence, the success of the gold dinar not only lies in the general acceptance of it as money but also simultaneously lies with the freedom of people to reject inferior money, like fiat currencies.  Without this freedom bad money would drive out good money from circulation.

Realizing the above fact, the state government of Perak did not issue its gold dinars and silver dirhams as alternative money but rather as excellent items for investing in precious metals or for hedging against inflation. The state, therefore, does not intend to break any Federal law.  On the contrary, it is engaging with the authorities to form a coalition of the willing regarding the gold dinar.  With the global financial-economic-political crisis continuing unabated, hyperinflation is predicted to set in and the price of precious metals like gold and silver are expected to continue to rise to high levels.  The graph below shows the gold price for the period 2000 to present.

Notice the exponential growth of the gold price.  The table below provides the annual return for gold investment based on average annual gold price in dollars per ounce.

Notice that the average annual return for the nine-year period is 18.24 percent while the holding period return for 2001 to 2010 is a whopping 351.79 percent.  The increasing vulnerability of the dollar, the quantitative easings of the US, the political chaos in the Middle East, the earthquake-tsunami followed by the ongoing nuclear crisis in Japan, global climatic changes etc. are all putting severe stress on the global monetary and economic condition.  Hence my prediction is that gold will continue to make strides at least till the end of 2012.

The state of Perak also stressed other uses for its dinars and dirhams, i.e the coins make good choice as gifts for many occasions; like mahar or marriage dowry, wedding anniversaries, new births, birthdays and so on.  They also make good corporate gifts – golden handshakes, medals, awards for recognizing achievements etc.

As for the design, the Kelantan gold dinar features the crest of the state of Kelantan on the obverse side of the coin with a modern calligraphy of the Muslim ‘shahadah’ and a full Qur’anic verse, i.e. verse Al-Mu’minun, 23:52,  on the reverse side.  The Perak gold dinar also depicts the ‘shahadah’ but not complete and full Qur’anic verses.  I am of the opinion that the original Islamic gold dinars never depicted full Qur’anic verses because of the possibilities that people might take them into impure places like the toilet or lose them to the ground.  Another grave danger of depicting full Qur’anic verses is, if the already minted and distributed coins were found to have errors in the verses.  This would be most unfortunate for the minting government because it would be extremely difficult to recall back such coins.  People would even tend to keep them because coins with errors tend to fetch higher prices in the market!

The Perak gold dinar design, on the other hand, depicts historical heritage and modernity.  On the obverse of the coin is the crest of the state of Perak, which depicts modernity, while the reverse of the coin replicates the design of the first original gold dinar, signifying historical heritage.  Accordingly, the Menteri Besar of Perak, Dato’ Seri Dr. Zambry Abdul Kadir was proud when he acclaimed, “It [the Perak gold dinar] is one of its kind and probably the first in the world, because it revives back the first Islamic gold dinar ever minted, that is the coin issued by the caliph Abd al-Malik ibn Marwan in the year 75 Hijrah, that coincides with the year 697C.E.   I am proud to revive the original Islamic gold dinar after 1,357 lunar years.”  The Perak gold dinars are minted by an experienced Perak-based local company whereas the Kelantan gold dinars are minted in Dubai.

The Perak gold dinar venture would also contribute towards some wakaf initiative as its social responsibility.  Wakf is a religious public endowment, usually given in the form of lasting assets like land, building etc., for the purposes of religious activities, education, healthcare etc.

The gold dinar project is expected to boost the economy of Perak in the long-run by promoting employment, creating new business ventures including investment in gold mining, designing, minting, assaying, hallmarking, gold dinar agency etc.  Spill-over effects are expected to provide additional business to existing business units.

To conclude, given the current global political and economic situation, it is my ardent hope that the government would give permission for or by its own put in place parallel gold-based monetary systems as soon as possible.  Such real-money systems are very much needed now considering the fact that the global economic system is currently showing serious vulnerability and threatens the world with serious recession, unemployment, inflation and possibly wars, the social implications of which are unimaginable.  The greatest advantage at present times of the gold dinar initiative is that it can protect the savings of the people from being eroded by inflation or even from possible monetary meltdowns while promising good returns.  The gold dinars and silver dirhams issued by both the states are, therefore, timely.

Prof. Dr. Ahamed Kameel Mydin Meera
Head, Department of Finance
Faculty of Economics and Management Sciences
International Islamic University Malaysia

I cannot agree less with the professor that at current times we need to give some thought to economics of peace.  With peace, we can enjoy economic activities – both production and consumption. It is common for people to estimate costs of wars and conflicts but seldom do we measure the economic benefits of peace.

Peace is the priceless characteristic of any society.  If we think deeply, we cannot but come to the conclusion that peace is the ultimate of life.  It is a combination of positive feelings of happiness, calmness, contentedness, love, compassion and harmony with nature, with the absence of negative ones like pain, conflict, hostility and imbalance with nature.  We may attain this peace when the inner self and the outer environment are in balance and harmony.  One who experiences peace would depict a healthy physical and mental state, which needs nourishment from inside and outside, i.e. spiritual and material needs.

The word Salam or the phrase Salam 1Malaysia are greetings that depict peace onto others.  Indeed the word Islam too has its roots in a word that means peace.  “Assalamu’alaikum” which means ‘peace unto you’ is also said to be the greetings of the people of the Paradise.

Ironically with all the rapid economic and technological progress around us, there is less peace and tranquility around the world.  There seem to be more inner and outer imbalance that is causing more pain, hostility, lack of welfare, environmental destruction and so forth.

The Institute for Economics and Peace (IEP), based in Sydney, releases an annual Global Peace Index (GPI), which is apparently the world’s leading measure of global peacefulness.  The index gauges the peace levels in 153 countries by taking into account 23 indicators that include levels of domestic and international conflict, perceived criminality in society, level of violent crime, violent demonstrations, threat of terrorist attacks and militarization.

The cost of absence of peace can be huge.  For example, to prevent just housebreaking we install burglar alarms, keep dogs, pay for security guards, keep lights on when we go for vacations etc.  All these involve cost.  Victims of burglary and violent crimes not only incur economic costs but also psychological costs.  There is also huge public cost incurred for the prevention of crime and maintenance of peace.  This includes costs of maintaining police force, both development and operational costs, costs of judiciary to try criminals in the courts and also costs of prisons that includes operational costs and maintaining the convicted inmates.  Hence criminals incur cost to the society whether they successfully carry out their crime or caught and convicted.

The table below provides the Global Peace Index ranking for selected countries.  Iceland ranked number 1 as the most peaceful country among the 153 countries ranked.  Somalia ranked last.  Interestingly Malaysia ranked 19, i.e. ranking top among the Southeast Asian countries, beating even Singapore that ranked 24.  It is indeed true that Malaysia is a highly tolerant and peaceful country.  This is what among others, attracted immigrants into this country, being blessed with economic prosperity and peace.  For some reason Brunei has not been ranked.  If it were, I believe it would have occupied a respectable rank too.

Selected List of 2011 Global Peace Index

According to the GPI Report, countries of the Arab Spring (not shown in the table) saw drastic drop in their rankings.  Libya (143) for example saw the most significant drop, i.e. falling 83 places while Bahrain (123) and Egypt (73) dropped 51 and 24 places respectively.

What we can learn from the Arab Spring is that “forced peace” cannot last.  Peace must come from within self.  For this to happen, I believe that the basic necessities of life must be guaranteed for the people– food, clothing, shelter, health, education, transportation and religious freedom.  If people enjoy the minimum of these I believe they will not revolt.

The GPI Report contends that for the period 2006-2010, a complete cessation of violence would have resulted in a whopping economic gain of US$37.58 trillion, i.e.  US$12.62 trillion of economic activity redirected from industries that generate or contain violence to other productive industries, and another US$24.96 trillion from additional economic activity generated.  To quote the report:

If the world had been 25% more peaceful over the past year the global economy would have reaped an additional economic benefit of just over US$2 trillion. This amount would pay for the 2% of global GDP per annum investment estimated by the Stern Review to avoid the worst effects of climate change, cover the cost of achieving the Millennium Development Goals, eliminate the public debt of Greece, Portugal and Ireland, and address the one-off rebuilding costs of the most expensive natural disaster in history – the 2011 Japanese earthquake and tsunami.

The Institute for Economics and Peace also reports a general fall in peace globally.  Hence there seems to be a lack of or fall in peace in almost every nation of the world.  There may be many reasons for this observation, but I contend that significantly the cause is rooted in the present-day global monetary system, characterized by fiat money and compound interest.  These characteristics are continuously transferring wealth from the middle and low income groups to the high income group, causing a huge wealth and income gap among the people.  These capitalistic features have now brought the world towards the danger of prolonged economic recession and social unrest.  It is these characteristics that are causing even the advanced nations of the world – like Japan, Europe and the US – to dwindle economically. The younger generation is particularly discontented and is rising up against the ruling powers.

Malaysia too has been observing widening disparity in income and wealth distribution among its people, both inter and intra racial.  I would not blame this on the strength of any one race or the weakness of another, but again significantly blame it on the prevailing monetary system.  As a consequence of colonial monetary policies where money is mostly created by the commercial banks out of thin air, together with the limited liability law, have transferred tremendous wealth away from the people, causing large wealth-ownership gap among the races.  Accordingly, the system has now caused many Malays, the pioneer people of the country, to become economically distressed and hence the apparent dissatisfaction of many Malays towards the ruling government.  Others are exploiting the situation for the political opportunity that comes with it.

In my opinion, this also why BERSIH 2.0 organized by the opposition parties seem to have garnered some support.  The support is not so much for its ideological stand but rather an expression of economic distress caused by the present-day monetary system.  Household debt including credit card debt is rising exponentially.  With continued global recession and threat of hyperinflation, this distress can only worsen.  Of course people must be given avenues to voice their opinions and dissatisfaction, but using street rallies for this purpose does not bring good to the people.  Not only it costs a lot of money to mobilize the police force etc. to contain such rallies, the country would lose a lot from reduced economic activity.  Normally such rallies would also end up in violence, destruction of public property and filthy streets.

To attain general peace, therefore, I contend that the government strives to make every individual to be at peace with his or her self by guaranteeing the basic necessities as mentioned earlier.  This would, of course, necessitates a gradual revamp of the monetary system and redistribution of national wealth to reduce inter and intra racial economic gap.  As a national policy, we may pursue social cohesion rather than social integration where each race respects the language, culture and religion of others, i.e. pursue unity in diversity.  In this way we may enjoy ‘peace in colour’ instead of a homogenous dull.

Dr Ahamed Kameel Mydin Meera
Head, Department of Finance
Kulliyyah of Economics and Management Sciences
International Islamic University Malaysia

Karat grade is used to express the purity of gold. It basically refers to the proportion of gold in an alloy. Pure gold (100 per cent) is 24 karat. The proportions in other karat are as in the table below.

Example: 22K means that 22 out of 24 portions are gold. This equals 91.66 per cent of gold, hence it is also known as 916 gold. Similarly 18K contains 75 per cent gold.

• As an element, gold cannot be further broken down by chemical means. Hence it is indestructible and permanent.
• Gold is also such an inactive metal that it is not affected by air and water, i.e. does not oxidize (tarnish, rust or corrode). Gold artefacts unearthed in the Egyptian pyramids still look new and bright.
• Gold is highly malleable (i.e. the ability to be pound into thin sheets) such that a single ounce of gold can be hammered into a 100 squarefoot sheet.
• Gold can be hammered so thin that sunlight can shine through it. A pile an inch high can contain more than 200,000 sheets!
• Gold reflects infrared rays while allowing sunlight to pass through, hence its use in astronaut helmets and window glass.
• Gold is most ductile (ability to draw out into wire) that a single ounce of it can be drawn out into a 50-mile long wire!
• Gold is so rare that only about 90,000 tons of it have been taken from the earth in recorded history
• South Africa is the largest gold producing country in the world. Other leading producers include Russia, Canada, and the United States.
• Gold is so heavy that one cubic foot of it weighs half a ton.
• All the gold in the world could be compressed into an 18-yard cube.
• Gold has been used by man for more than 6000 years.
• In 1933, President Franklin D. Roosevelt banned the private ownership of gold, which was then lifted on December 31, 1974.
• Gold is said to be a cure for rheumatoid arthritis. It is chemically liquefied and injected into the muscles of arthritic patients. It is said that the treatment is successful in seven out of ten cases.

Reference: www.goldgold.com/goldfacts.htm

The ringgit depreciated from an exchange rate of about RM2.47 to the dollar before the crisis to a rate of RM4.80 at some point in time during the crisis.

While one may argue that it is ethically not right for speculators to attack a currency, it is the current global monetary system that allowed them to do so. When an exchange rate moves due to speculative attacks or otherwise, it breaks the equilibrium among currencies. This makes it possible for further profiteering called arbitrage profits. Arbitrage is like finding money on the ground. An example of currency speculation and arbitrage is given below.

Currency Speculation and Arbitrage: An Example

Consider the ringgit when it was attacked in August 1997. The shorting of the currency by speculators pushed the ringgit downward. Let us assume an initial exchange rate between three currencies, say, the ringgit, dollar and Singapore dollar as below:

The ringgit exchange rate is RM2.40 and RM1.50 to one dollar and Singapore dollar respectively. The Singapore dollar rate is S$1.60 to the dollar.

Such exchange rates are in equilibrium since no one can make profit by just trading between the three currencies. If one were to start with a dollar, exchange it into Singapore dollar, then change the Singapore dollar into ringgit and then back into US dollar, one would end up with a dollar again[2].

Now assume that the shorting of the ringgit by the speculators pushes the exchange rate to RM3.80 per US dollar as shown below:

By attacking the currency as such, the traders make two types of profits:

(i) speculative and

(ii) arbitrage profits.

Speculative Profit: Speculative profit comes from the speculating that a currency would appreciate or depreciate (either due to economic factors or the speculative attacks themselves or even both). If the speculation is correct, then the traders would make profits, however, if their speculation turns out to be wrong, they would then make losses. In our example, profit is made as follows. First, the trader sells short RM2.4 million ringgit at the initial exchange rate of 2.40 per dollar. This equals US$1 million and would be credited to his account. Assume now that the attack caused the ringgit to depreciate to RM3.80 per dollar. Now at this new exchange rate the RM2.4 million is worth only US$0.63 million[3].

Therefore, the trader closes his position by buying back the RM2.4 million at this new rate and makes a handsome profit of US$0.37 million (i.e. US$370,000!). Even though the trader makes a hefty speculative profit of about US$370,000, the profit does not end there. There is another profit to be made — the arbitrage profit.

Arbitrage Profit: Arbitrage profit is made from the mispricing or disequilibrium among the exchange rates. In our example, this disequilibrium happened when the ringgit exchange rate moved. Arbitrage profits are realized at a point in time unlike speculative profits that require a span of time. In the above example the arbitrage profit is made as below:

Step 1: Borrow US$1 million[4] and exchange it into RM3.8 million (at the new prevailing exchange rate of RM3.80 per US dollar).

Step 2: Exchange the RM3.8 million into S$2.533 million (at the exchange rate of RM1.50 per Singapore dollar)

Step 3: Exchange the S$2.533 million into US$1.5833 million (at the exchange rate of S$1.60 per US dollar)

Step 4: Return back the loan of US$1 million, and keep the remaining  US$583,333 as arbitrage profit[5].

Hence the total speculative and arbitrage profits equal 370,000 + 583,333 = US$953,333. Note that for a transaction of US$1 million each in the speculative and arbitrage activities, the profit is almost a whopping US$1 million too! Currency traders, however, do not just trade in millions but rather in billions! Hence imagine the amount of profits they would be making!!

As arbitrageurs make profit through their actions, the exchange rates between currencies would move until the arbitrage opportunity is eliminated. In our example since a profit is made by first exchanging US$ into ringgit, there would be a tendency for the ringgit to appreciate over the US dollar (or to “fight back” the attack). Similarly, the action of exchanging ringgit into Singapore dollar would make the Singapore dollar appreciate over the ringgit. The last transaction of changing the Singapore dollar back into the US dollar would cause the US dollar to appreciate over the Singapore dollar. Therefore, even though the speculators attacked only the ringgit, the Singapore dollar would appreciate over the ringgit and the US dollar would appreciate over the Singapore dollar until the arbitrage opportunity is eliminated. A final exchange rate as below would have eliminated such an arbitrage opportunity and would now form the new equilibrium exchange rate between the three currencies:

An arbitrage profit, as shown above, can be made with any three currencies and need not be using only the ringgit, the US dollar and the Singapore dollar. Therefore, movements of all cross-currency rates could be expected. Nonetheless, only three currencies are needed for making an arbitrage profit. It takes only three currencies to break equilibrium and make arbitrage possible. For this reason such an arbitrage is also called a triangular arbitrage[6].

Speculative and arbitrage profits using national currencies are made possible by the mere existence of numerous fiat currencies that are volatile in nature. The global fiat monetary system provides a fertile ground for speculation, manipulation and arbitrage in the foreign exchange market[7].

[1] But erroneously termed the ‘Asian Miracle’.

[2] In this example we have ignored transaction costs. In practice, the buying and the  selling rates for currencies would differ; the difference being the profit to the bank or money changer. Ignoring transaction costs, however, does not affect the illustration of this example.

[3] In practice the speculators and arbitrageurs would not wait till the exchange rate moves this much in order to profit. Profits are realized when the exchange rate moves enough to cover transaction costs.

[4] Since arbitrage is done at a point in time, one may borrow this US$1 million probably for just a few minutes within which the entire transaction could be completed, particularly if transactions are done on-line using computers.

[5] Note that, in the example, the arbitrage transactions must be done clockwise starting from any of the currencies. This example starts from US$. If we had started using RM1million, the profit would have been RM583,333 instead. Transactions done anticlockwise would result in losses. Therefore, upfront one needs to determine the direction for making arbitrage profits — clockwise or anti-clockwise.

[6] If profit is made using four or more currencies, then all transactions except three are either redundant or they reduce the profit made. Mathematically, if all the cross exchange rates were placed in a matrix, equilibrium would imply the determinant of the matrix to equal zero. If the determinant does not equal zero, then it implies arbitrage opportunity exists somewhere between the currencies.

[7] Back in the 1970s, the daily global volume of foreign exchange transactions was around $10-$20 billion. By 2000, the average transaction was around $2 trillion! See Bernard Lietaer, The Future of Money, Century, 2001, p.312.

Where M is the money supply; V is the velocity or the number of times per year the average dollar is spent on goods and services; P is the aggregate or average price level; and Y is the real output of goods and services produced in the economy[1].

The money supply M consists of currency in circulation plus demand deposits in banks. In monetary aggregates this is usually referred to as M1. We take this definition for money here since payments for most transactions are done with either of these two. The velocity is the number of times the average dollar is spent on goods and services within a year. Assume that Mr A used a RM50 note to buy a book, and then the bookseller used the note to buy a pair of shoes. The same RM50 note changed hands twice, being used to pay for two items in the economy within the year. Therefore, its velocity is two. The P is the aggregate price level, which is like the average price of all things in the economy. It is not measured by the consumer price index (CPI), which tracks the price of only a basket of selected goods. The Y is the real output of goods and services produced in the year — the actual quantity of tables, cars, etc.

The above equation therefore simply equates the flow of money to the opposite flow of goods and services. M times V is the total amount of money in the economy while P times Y, i.e. price times quantity is the total dollar value of the output of goods and services in the economy.

Therefore, the equation of exchange is actually an identity — something that is true by logic. The equation suggests, for example, that if we increase the quantity of money without a corresponding increase in goods and services, only price levels will go up, i.e. inflationary (assuming velocity is constant). An example would be during the Japanese occupation of Malaya, when the Japanese introduced an abundance of paper money sometimes called by the locals ‘banana leaf money[2]’. This sudden increase in money supply only brought about inflation. This suggests that a nation cannot be made wealthy by simply printing money and putting it into the hands of its people. The velocity of money supply is generally constant in the short run[3].

It may change, for example, if there is a change in the mode of payments as when credit cards are introduced into the system for the first time. After a change, it would remain fairly constant until some other shocks come about. As suggested by the equation of exchange, if for any reason the velocity increases abruptly, the effect would be inflationary too. An example would be during the fall of the Soviet Union, people lost confidence in the Russian rouble and thus tried to get rid of it by spending it away. This increased the velocity significantly and hence brought about hyperinflation. If we take velocity as constant, this transforms the equation of exchange into the quantity theory of money that states that the nominal income (P x Y) is solely determined by thequantity of money, i.e.

Therefore, a direct relationship between money supply and nominal GDP would be observed if velocity is constant.

[1] MV is the monetarist counterpart of C + I + G + X in the Keynesian framework, that we normally see in Macroeconomics textbooks. MV is the total amount spent on final goods and services in one year, thus is equal to nominal GDP. Nominal GDP, in turn, equals PY which is the price level times physical output of goods and services.

[2] The money had a picture of a banana tree featured on it.

[3] This is a monetarist view. The Keynesians may argue that the V is not stable. If V is infact stable, then a direct, predictable relationship must exist between the money supply and nominal GDP. In fact, this is the case for Malaysia. The correlation coefficient between Money Supply, M1 and nominal GDP is almost unity, suggesting a stable and predictable relationship.

The word ‘fractional reserve’ refers to the fraction from total deposits that banks must keep as reserve. This reserve ratio is determined and used by the central bank as one tool of monetary policy for controlling the money supply in the economy. The Bank Negara Malaysia, for example, imposes this reserve requirement on commercial banks as the Statutory Reserve Requirement (SRR). This reserve requirement determines the amount of money that commercial banks can create (The total = deposit ÷ SRR). The smaller the reserve requirement is, the more the money that can be created. For example, if the SRR is 4 percent, a RM1 million cash deposit can support a total deposit of RM25 million. The additional RM24 million can be introduced into the economy by the banking system in the form of loans. Opposed to currencies and coins in circulation, the money created by commercial banks takes the form of numerical or accounting money, circulated as cheques, credit card payments, electronic transfers, and the like. In other words, it is money created by means of mere accounting entries. The benefit of new money creation, known as seigniorage (the value given to money over and above its cost of production), accrues to the bank that lends it out at interest.

The fractional reserve banking and its accruing seigniorage have implications for asset ownership through their distributional effects, including the creation of poverty. Since fiat money is easy to create, most economies create too much of it relative to their ability to produce goods and services. This results in the growth in money supply that exceeds the growth of the real GDP, thereby causing inflation to reel (The table below, extracted from the writer’s book entitled The Theft of Nations, provides the statistics for some selected countries. The reader can easily guess which countries are likely to experience hyperinflation and hence socio-economic problems).

The socio-economic implications of this inflation arise from the fact that the newly created money does not accrue in the hands of every individual ‘evenly’. If the money or income of the people were to grow as the inflation rate does, then their real income would be intact and inflation would not be a problem. But true to the contrary, the new money created in the form of loans would instead go to corporations and individuals who are already relatively ‘well-off’ as only they are capable of depicting better credit-worthiness. A host of socio-economic problems would naturally result as a significant portion of the population does not experience income growth that would match the growth in money supply and the henceforth inflation rate.

This group would find its real income being gradually eroded by the annual growth in money supply, and hence the possibility of running into poverty. This increase in money supply can be aptly described as ‘inflation tax’, a tax on every individual in the economy that accrues to the one who creates and owns the money.

To illustrate the point, when a commercial bank extends a loan of RM300,000 for the purchase of an existing house, all individuals in the economy are actually financing the transfer of ownership of the house to the bank by means of inflation. This is because when the bank creates the additional RM300,000 through fractional reserve banking, there would now be more money in the economy relative to the real things and inflation would naturally come about. Initially, the bank neither had the RM300,000 nor the house. However, a mere accounting entry immediately places the ownership of the house with the bank. The implication of this is that the transfer of ownership is actually paid for by the entire economy through inflation. As a result, the seigniorage of the principal amount and interest accrues to the bank, all by means of mere numerical accounting only. The way money can be created with such ease would also mean the possibility of the excessiveness of its creation, and thus the ballooning of inflation. This inevitably forces governments to enforce price controls on basic necessities, particularly food items. The excessive money supply also creeps into other sectors and causes asset price bubbles, particularly in the stock and property markets. Furthermore, any productive activity whose profitability cannot match the interest rate would naturally ‘die-off’. The agricultural sector, being a much government-controlled sector, is particularly vulnerable to such a system, such that in many cases it warrants governments to subsidize the sector. Economically advanced countries, for that matter, still substantially subsidize their agriculture despite their highly modernized techniques in agricultural produce.

The property sector, being a sector that significantly absorbs money supply, would depict on average better growth and profitability. Price of homes and other properties on average are likely to grow faster than the general average inflation rate. This of course would pose housing problems for those pushed into the lower rung of the economy by the growing money supply in terms of real income. Home affordability would therefore gradually decrease, prompting calls for smaller homes, more flats, lowcost housing, longer mortgage durations, and other such price-cutting measures. Mortgage durations of 10 to 15 years were common during the 1970’s but banks today are even willing to extend them to as long as 35 years. There are even suggestions for two-generation mortgages.

Poverty can be caused by real economy, that is to say, by the lack of supply of real things. It can also be caused by the monetary system. In a modern capitalist economy, the creation of abundance of money that accrues very unevenly in the hands of individuals can aggravate poverty. Milton Friedman, a well-known monetary economist, says that inflation is predominantly a monetary phenomenon. If this is the case, the worsening of the global poverty problem can be significantly pointed at the institutions that are responsible for the creation of fiat money.

To tackle this problem, one of the imminent steps to be taken is the revamp of the local and global monetary systems that will tailor to a gradual move away from the fiat monetary system towards a system that is based on real money, such as gold.

Poverty eradication must, therefore, be approached not only from the real economy perspective, but also from the monetary perspective. The World Bank’s motto, namely ‘Working for a World Free of Poverty,’ has largely remained a utopian chase and rhetoric precisely because it is operating on the principles of fiat money and a global monetary system that lacks the mechanism for equitable distribution of wealth, that are ironically two of the defining causes of poverty.

The cash account (reserve) is debited while Mr X’s deposit account is credited with RM1,000. The cash reserve now is 100 per cent of the deposit. However, since the bank is required to keep only 10 per cent as reserves, the bank creates additional deposits until the reserve is 10 per cent of total deposits. How can additional deposits be created? By means of giving loans! The balance sheet position after money creation (assuming maximum money creation)[2]3 would be as follows:

Notice that for the original RM1,000 deposit, an additional RM9,000 deposit is created by means of loans[3].After money creation, the original RM1,000 deposit is now equivalent to 10 per cent of the current total deposits of RM10,000, i.e. the required reserve ratio. This increase in money through multiple deposit creation is a one-time increase in the ‘money base’. The formula for multiple deposit creation may be written as follows:

Interest Rates and the Growth in Money Supply

In addition to the above, the interest rates given and charged by banks also increase money supply in the long run[4].5 In the conventional economic thinking, interest rate is said to be the price of money capital, following the normal demand-supply theory. However, we should notice that interest rates themselves, ceteris paribus, would increase the money supply. This fact is very important. Therefore, we expound on this matter further.

Continuing with the earlier example, let us assume that interest rates are as follows — 5 per cent for the deposit rate and 10 per cent for the lending rate. We shall also assume that borrowed money does not earn interest. Now, in the next period the RM1,000 deposit money would earn RM50 interest and thus becomes RM1,050. The depositor would now be able to buy things in the economy for RM1,050. On the other hand, the loan balances would become RM9,900 (RM9,000 + 0.10 x RM9,000). The extra RM900 is simply the interest income to the bank. After paying depositors the interest of RM50, the bank makes a spread of RM850, which is 85 per cent of the original deposit. It is with this spread, the bank would pay the salaries of its employees, utility bills, etc., the remainder of which would comprise the bank’s retained earnings. The current balance sheet position is as shown below:

Notice that the current reserve of 1,000 is now inadequate for a total deposit of RM10,050. This suggests that, in the long run, the central bank would be forced to continually increase fiat money and/or the banks would continuously extend loans so that the reserve requirement can be met and thereby sustain the system[5]. The implication of this is that the existence of interest rates would themselves, ceteris paribus, force a continuous increase in both state money (fiat money) and bank money (loans).

Hence with the simple existence of interest rates alone, under normal circumstances, money supply in an economy will grow by default. However, it is possible for this money supply to shrink back if a depositor withdraws cash from the banking system (and keeps it from re-entering the financial system), or when a loan is repaid, or when a borrower defaults on loan repayment (which at serious levels may cause banking crises, as was the case with non-performing loans or NPLs during the 1997 Malaysian financial crisis).

In summary, a fiat money interest based financial system continuously creates money in the economic system, and by the reverse process, the money so created can also be destroyed in the event deposits are withdrawn, loans repaid or borrowers default on loan repayments.

Credit Cards and Growth in Money Supply

The credit card system also increases the money supply. This is because every credit card transaction is a credit transaction. The implication of this is easy to see using a T-account. Assuming Mr A purchases something from Mr B for RM1,000 using his credit card. The Bank that issued the credit card will record the transaction as follows: Mr A’s account is debited as a loan to reflect a credit transaction while Mr B’s account is credited. This simple accounting entry is, however, interpreted as follows: The Bank had paid Mr B on behalf of Mr A.

Therefore, Mr A owes the Bank RM1,000!

Now since Mr B’s account is considered as a deposit, the Bank could also create money as discussed earlier through the fractional reserve requirement system. The bank can create multiple deposits by means of loans from this accounting “deposit”. If the reserve ratio is 10 per cent, then additional RM9,000 deposits can be created through loans.

Apart from this, the bank also has an additional way to create money. Let us assume that Mr A fails to pay the Bank when he receives his statement. Then the Bank will impose two charges on Mr A: (i) interest on the $1,000 for not settling it! and (ii) a late payment fee! Note that Mr A has to pay these charges even though the bank did not pay anything to Mr B in the first place. It’s all in accounting!

While it is possible to reduce (or control) money supply in the short run, for example, by increasing the reserve requirement ratio or through open market operations (i.e. the selling of government bonds or by increasing bank discount rates), we postulate that the net long-run effect will still be an increase in money supply. This is simply due to the existence of interest rates in the economy (note that government bonds too pay interest even though the money obtained through the sale of such bonds may be simply kept in the vaults).

Therefore, in an interest-based fiat monetary system, money supply simply grows in the long run, even though in the short run it may be altered through monetary policies.

[1] Other variables include the capital adequacy ratio, which we ignore here for simplicity.

[2] Although real world multipliers may never create the maximum amount, in principle the fractional reserve system allows ‘money to be created’.

[3] Notice how banks create money out of thin air. Money is created when banks extend loans. Hence money in most part is only accounting entries in the books or computer records in the form of binary bit memory space.

[4] See Tarek El-Diwany, The Problem With Interest, TA-HA Publishers, United Kingdom, 1997.

[5] In most countries the domestic debt levels have continuously grown.

At the same time, the sliding US dollar is causing jitters because that has global repercussions.

However, the symptoms of financial distress are not new. The last few decades have seen a number of currency crises, even though this one is different. The US dollar, being the leading international currency, comprises a significant portion of reserves of central banks worldwide. After the collapse of Bretton Woods in 1971, the US dollar, like other world currencies, became a fiat currency. Since then, the world has operated under a “pure” fiat money system.

The volatility and instability in the global monetary system today can be attributed largely to the structure of the global fiat monetary system. The kind and frequency of financial distress faced by firms and governments could be blamed more on the national and international macro monetary structure rather than on their doings. Needless to say, the cause of this distress is the fiat monetary system.

A fiat currency is money that has no intrinsic value of its own. It is not redeemable for gold, or anything of value for that matter. It takes predominantly two forms — currency notes and coins (state-issued money) and accounting money such as cheques and electronic money (created by commercial banks through loans).

The normal definitions of monetary aggregates, including those by Bank Negara Malaysia, define the former as M0, and the total of all monetary aggregates as M3. It is interesting to note that in this monetary system, most money takes the second form. Malaysian data for 2004, for example, show that only 4.6% of money stock was notes and coins (debt-free money) while the remainder was credit money, or accounting money. Generally, over time, the proportion of credit money in the economy will grow while that of debt-free money will fall (see chart). A similar trend is seen in most countries, including the UK where current credit money comprises about 98% of money stock. The process that enables commercial banks to create credit money is the fractional reserve banking system.

So, what’s the problem with this? And what has this got to do with MG Rover or the financial distress of other long-established corporations, or the dollar crisis itself?

The thing is, as money is continuously introduced in the form of debt, the total indebtedness of a nation would keep rising, in the form of individual, company or government debt. There are two important things to note. Firstly, there is a fundamental mismatch in the risk profiles of credit money and the business world in general. When money is created out of nothing and given out as loans to business organisations, banks generally demand the repayment of it on a periodic basis. The repayment schedule is contractual and, therefore, represents a “riskless” cash flow from the financial perspective.

Nonetheless, business ventures are not riskless in nature. Therefore, as the proportion of credit money in a nation increases, this mismatch and its implications become increasingly obvious. In other words, the rising proportion of credit money has implications for the capital structure of firms. It is a well-known fact that firms can only bear debt up to a certain level, depending on the level of their business risks.

Secondly, an important feature of credit money is that the total debt is non-repayable in aggregate. In other words, while some borrowers may be able to repay their loans, there are others who may “default”. Loans are not repayable in aggregate because the money needed to settle the aggregate interest in the economy does not exist in the system. In other words, the total interest in the economy must and can only be paid in the form of real goods and services. This real payment of interest takes place when banks confiscate collateral or other assets, or spend the loan repayments made by borrowers. The government could pump in more non-debt state money to avoid such defaults, but statistics in most nations reveal a falling proportion of this form of money.

It is contended that this mismatch in the risk profiles and the “sure-default” characteristics of the interest-based fiat monetary system are manifested in the numerous corporate and government loan defaults that we witness globally now. For example, the number of AAA-rated companies in the US was 58 in 1979 (a few years after Bretton Woods), 27 in 1990 and only eight in 2002

Why do we see such statistics in the aggregate economy when nowadays, we have financial managers who are assisted by sophisticated computers with access to real-time database and other professional financial advisers? How could the huge “low-risk” energy firm Enron fail? Why is MG Rover in financial distress? While normally, we would look for firm-specific reasons, debt is undoubtedly the main culprit. Reasons like irregularities in accounting and the like are simply the manifestation of the problem entwined with agency problems.

The root of the problem is what’s technically called the seigniorage of fiat money. Seigniorage is the value given to fiat money over and above its intrinsic value. For example, when the bank creates RM1 million in the form of electronic money, the seigniorage is RM1 million, since the cost of creating an electronic record is negligible. On the other hand, if a RM1 coin has 20 sen of metal content in it, then the seigniorage is 80 sen. Seigniorage is the benefit obtained by the first user of the fiat money, that is, the bankers in the case of credit money, and the government in the case of currency notes and coins.

Indeed, it is seigniorage that makes counterfeiting illegal, since the counterfeiter unfairly benefits from the first use of the counterfeit money. Currently, the seigniorage of credit money has made all nations highly indebted, including the US which, surprisingly, is the largest debtor in the world. If all nations, including the US are indebted, and for every debtor there must be a creditor, who then are the creditors?

In the global scenario, seigniorage of the international fiat currencies is, in large part, behind the current instability of the global monetary order. The Nobel Laureate Robert Mundell regards the Federal Reserve as the greatest engine of inflation ever created, pumping out billions of dollars, which other nations collect as reserves (Robert Mundell, The International Monetary System in the 21st Century: Could Gold Make a Comeback, page 5, http://www. robertmundell.net/gold). Of course, the seigniorage of these billions of dollars is a benefit to the Federal Reserve, which has enabled the US to fund its huge trade deficits for years.

Indeed, such value creation out of nothing cannot go on indefinitely. As too much money is created, the economic subjects, at some point, would begin to question the credibility of the whole thing. This is what the US is facing currently. According to Richard Duncan, the former consultant to the World Bank and the International Monetary Fund (IMF), a dollar crisis is now inevitable. If the experts’ predictions are correct, the situation is indeed scary. The World Bank recently issued a warning that the falling dollar would bring about serious repercussions to Third World countries, contradicting earlier IMF calls to these countries to “beef up” their dollar reserves. It is unfair that poor nations are made to bear the burden of the falling dollar.

Some economists think that in such an event, the dollar is likely to be replaced by the euro, yen or/and renminbi as international currencies. But it would be catastrophic if a dollar crisis occurs as people globally would lose confidence in the entire fiat monetary system. What guarantee is there, for example, that the euro will not show similar dynamics?

Nations must therefore strategically put in place alternative money systems so that the effect would not be so disastrous. Former Prime Minister Tun Mahathir Mohamad has ceaselessly called for the use of other currencies, including gold, as reserves, and for international trade settlements. Even domestic payment systems based on real money should be encouraged.

Developing nations can take a cue from Curitiba, Brazil, which its mayor transformed from a downtrodden slum into a city. Amazingly, it became as beautiful as cities like Hong Kong or Singapore within one generation, all using a real money system. Imagine a First-World city in a Third-World country. The thing that makes the difference is the monetary system. Thus, the type of monetary system employed defines relationships in the economy and the kind of social structure that emanates from it.

Any long-term reform to the global monetary structure must address the problem of the seigniorage of fiat money. If a number is written in the “books” and out of nothing made to have value and purchasing power, it will surely translate into problems and crises later. Money must have its own intrinsic value (like gold) or linked to assets that have such value.

Corporate financial managers should therefore know the fiat money system in depth, including the seigniorage of fiat currency, the fractional reserve banking, the ownership effects of these and the implications for corporate finance. The macro financial system has a lot to do with the financial performance of individuals, firms, governments, economic cycles and the like. The seigniorage of fiat money is ignored in macroeconomic analysis. Syariah scholars too need to study and analyse its implications for Islamic banking and finance.