AN ISLAMIC ECONOMIC PERSPECTIVE
IV. EMPIRICAL EVIDENCE
IV.4. Results and Analysis 1. Stationary Test
Where, ∆ is the change of variable from previous period, λ is an adjustment level from short- term to long-term equilibrium.
To determine the inter-relation among variables under study, innovation accounting of Impulse Response Function (IRF) and Forecast Error Variance Decomposition (FEVD) will be utilized. IRF can be used to determine the response of one endogen variable from the shock of other variables in the model. FEVD can be used to determine the relative contribution of one variable to explain variability of its endogenous variables. All data in this study is transformed into natural logarithmic form (ln), except interest rate, PLS returns, and expected inflation, to obtain valid and consistent results. Software to be used in the data processing is Microsoft Excel 2007 and Eviews 4.1.
IV.4. Results and Analysis
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Lessons Learned from Repeated Financial Crises: an Islamic Economic Perspective
satisfied the criteria of integration process. Cointegration test based on trace statistics will be applied to determine the number of equation systems that can explain long-term relationship.
Table III.5 and III.6 in the appendix show the results of cointegration test for original model and alternative Islamic model, respectively. Trace test of original model indicates 1 (one) cointegrating equations at the 5% critical value, while trace test of alternative Islamic model also indicates 1 (one) cointegrating equations at the 5% critical value.
IV.4.4. Stability Test
The VAR system at its optimal lag should be stable. Unstable VAR system will make the results of Impulse Response Function (IRF) and Forecast Error Variance Decomposition (FEVD) are not valid. The stability test based on modulus or unit-circle will be applied to determine if the VAR system at its optimal lag is stable within its unit-circle or with modulus less than one.
Table appendix III.7 and table appendix III.8 in the appendix show the results of stability test for original VAR system (optimal lag = 2) and alternative Islamic VAR system (optimal lag = 2), respectively. Original VAR system is stable up to lag 10 with modulus 0.184767 √ 0.984235, while alternative Islamic system is stable up to lag 11 with modulus 0.070512 √ 0.997073.
IV.4.5. Results
a. Impulse Response Function a. Impulse Response Function a. Impulse Response Function a. Impulse Response Function a. Impulse Response Function
Table III.3 shows the summary of IRF results for CPI inflation shocks by various conventional determinants of inflation.
Table III.3
Impulse Response Function Summary
lnFM Fiat Money
InIR Interest Rate
LnEXC Exchange Rate
SHOCK ORIGINAL ISLAMIC SHOCK
Positive Positive Positive Positive
Positive and permanent at 0.004
0.004 0.004 0.004
0.004, stabilize in 16th period
Positive Positive Positive Positive
Positive and permanent at 0.013
0.013 0.013 0.013
0.013, stabilize in 22th period
Positive Positive Positive Positive
Positive and permanent at 0.006
0.006 0.006 0.006
0.006, stabilize in 17th period
Positive and permanent at 0.001, stabilize in 10th period
Negative and permanent at 0.002, stabilize in 16th period
Positive and permanent at 0.0008, stabilize in 8th period
lnJM Just Money
PLS PLS Returns
lnGOLD Single Global Currency
Figure III.1 shows that the responses of financial crisis (CPI inflation) to the shock of root causes of the crisis are varies, where interest rate lnIR and multiple currency system or exchange rate lnEXC give the biggest positive impact, followed by lnFM to the crisis in Indonesia. Whereas, figure III.2 shows that the responses of financial crisis (CPI inflation) to the shock of alternative Islamic substitutes are mostly very small.
Figure III.7
Response of Financial Crisis (CPI Inflation) to Fiat Money and Just Money
Response of LNINF to Cholesky One S.D. LNFM Innovation
-.004 .000 .004 .008 .012
10 20 30 40 50 60
Response of LNINF to Cholesky One S.D. LNJM Innovation
-.004 .000 .004 .008 .012
10 20 30 40 50 60
Figure III.7 compares the impact of fiat money lnFM and just money lnJM to financial crisis (CPI inflation). It shows that lnFM gives greater and permanent positive impact to the crisis, while lnJM only gives smaller and permanent positive impact to the crisis. Moreover, estimation results show that lnFM gives statistically significant impact in the long-term, while lnJM gives statistically no significant impact to the crisis.
Figure III.8
Response of Financial Crisis (CPI Inflation) to Interest Rate and PLS Returns
Response of LNINF to Cholesky One S.D. IR Innovation
-.004 .000 .004 .008 .012
10 20 30 40 50 60
Response of LNINF to Cholesky One S.D. PLS Innovation
-.004 .000 .004 .008 .012
10 20 30 40 50 60
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Lessons Learned from Repeated Financial Crises: an Islamic Economic Perspective
Figure III.8 compares the impact of interest rate IR and PLS returns RS to financial crisis (CPI inflation). It clearly shows that INT gives much greater and permanent impact to the crisis than that of PLS. Moreover, estimation results show that IR is statistically significant in the short-term and long-term, while RS are statistically not significant in short-term but significant (negative) in long-term.
Figure III.9
Response of Financial Crisis (CPI Inflation) to Multiple Currencies and Single Global Currency
Response of LNINF to Cholesky One S.D. LNEXC Innovation
-.004 .000 .004 .008 .012
10 20 30 40 50 60
Response of LNINF to Cholesky One S.D. LNGOLD Innovation
-.004 .000 .004 .008 .012
10 20 30 40 50 60
Figure III.9 compares the impact of multiple currency system lnEXC and single global currency system lnGOLD to financial crisis (CPI inflation). It clearly shows that lnEXC gives much greater and permanent impact to the crisis than that of lnGOLD. Moreover, estimation results show that lnEXC is statistically significant to influence the crisis in the long-term, while lnGOLD is also statistically significant to influence the crisis.
b. Forecast Error Variance Decomposition b. Forecast Error Variance Decomposition b. Forecast Error Variance Decomposition b. Forecast Error Variance Decomposition b. Forecast Error Variance Decomposition
Figure III.10 compares the results of Forecast Error Variance Decomposition (FEVD) of original and alternative Islamic models. Figure 4.6 (left) shows FEVD of original model, where fiat money (lnFM 2.8%), interest√rate (INT 45.2%), and exchange rate (lnEXC 18.6%) give 66.6% share to the behavior of financial crisis (CPI inflation).
Figure III.10
FEVD of Conventional and Islamic Models of Determinants of Inflation
Meanwhile, figure III.10 (right) shows FEVD of alternative Islamic model, where just money supply (lnJM 0.7%), PLS returns (RS 2.5%), and single global currency (lnGOLD 0.2%) give only 3.4% share to the behavior of financial crisis (CPI inflation).
IV.4.6. Analysis
The phenomena of financial crisis first appeared in the debasement of metallic currency, i.e., when gold or silver coins as currency was diluted with other metals by the government to increase the total number of coins issued without a requirement to increase the amount of gold used to make them. This is essentially the transgression of Allah»s law and the natural balance. At that time that was the only option to create money without any counter-value, while the transgression of Allah»s law will result in natural imbalance, catastrophe or crisis. In contemporary conventional economics this is called seigniorage income from printing fiat money that causes excess money supply. Ibnu Arabi stated that every economic transaction without any «iwad or counter-value will amounted to riba. Moreover, gold and silver as currency were originally public goods which now can be owned privately, so that piling and hoarding gold/
silver become legal, which were previously prohibited.
Nevertheless, in today»s sophisticated economic and finance, financial crisis is not solely due to riba from money creation or the printing of fiat money. Other sources of financial crisis are many forms of riba and many forms of maysir. Many forms of riba include money creation from paper fiat money, fractional reserve banking system, interest system, credit card, derivatives, etc. Many forms of maysir include stocks/assets trading to make capital gain, forwards, future and options contracts, derivatives products (such as Credit Default Swaps), etc.
IR LNEXC LNFM LNINF
100%
90%
80%
70%
60%
50%
40%
30%
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57
PLS LNGOLD LNJM LNINF
100%
90%
80%
70%
60%
50%
40%
30%
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57
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Lessons Learned from Repeated Financial Crises: an Islamic Economic Perspective
Financial crisis triggered from inflation is recognized by Austrian school as ideological and political diseases, where the government deliberately runs inflation economics. Therefore, to get rid of inflation triggered financial crisis is just a matter of political will and commitment.
Austrian school offers two choices, inflation or gold standard (i.e., replace fiat money with gold standard and replace fractional reserve banking with free banking).
Most root causes of financial crises have been recognized by conventional as well as Islamic perspectives, although there are some differences among different conventional school of thought. However, Islamic perspective has gone further into the detail and some more (such as, interest, credit card, derivatives, corruption, and poor administration).
Massive efforts have been made to get rid of financial crises with more failures than success due to the failure to distinguish natural and artificial (human error, criminal activities) root causes of financial crises. We should understand natural causes, but natural causes should not be used as an excuse/smoke screen to allow artificial causes (criminal activities) to continue.
Artificial causes of financial crises can be eradicated.
In the end, economic and financial systems are ideological and political choices of economic regimes taken by the government. With the political will and commitment by the government, financial crises can be gradually and systematically eradicated and controlled.
From the empirical exercise, riba rooted causes of financial crises (lnFM fiat money 2.8%, IR interest rate 45.2%, and lnEXC exchange rate 18.6%) give 66.6% share to financial crises in Indonesia, while if we replace these three systems according to Islamic perspective (lnJM just money supply 0.7%, RS PLS return 2.5%, and lnGOLD single global currency 0.2%) will give only 3.4% share to financial crises in Indonesia, or a massive reduction of 63.2%.
Interest rate IR is the most dominant source of financial crises (45.2%) and exchange rate lnEXC is the second most dominant source of financial crises (18.6%). The replacement of interest rate IR with PLS returns RS alone will reduce 42.7% share of financial crisis in Indonesia.
The further replacement of multiple currency system lnEXC with single global currency lnGOLD will reduce further 18.4% share of financial crises in Indonesia.
V. CONCLUSIONS AND RECOMMENDATIONS