In this is short illustration on the economic effects of different modes of financing unexpected public expenditures. We shall see five scenarios: 1. The economy with real money as in the time of Prophet (saw) 2. The economy with fiat money as in the current world. In this scenario we shall consider four different modes
a. Sadaqah/Wakaf
b. Lending/Borrowing
c. Quantitative Easing
d. Netting Mechanism
Let’s say there is a sudden need for the nation to go to war in order to protect the security of the people. The government needs extra funds to do that. What options does the government has?
- The economy with real money as in the time of Prophet (saw)
During the time of the Prophet (saw) the economy was all real – assets were real and the money was also real money, i.e. gold dinars and silver dirhams. There were occasions when funds were needed to go to battles, etc. the Prophet will invite the companions to contribute. The companions contributed according to their means. There are incidences where a companion gave all his wealth, half of his wealth and so on. Even the handicapped and least wealthy gave a handful of dates. So the contributions were dinar, dirhams and real assets whatever that may be. With these contributions, the Prophet (saw) and the companions were able to go for the battle.
EFFECTS | YES/NO | REMARKS |
1. Creates Inflation? | NO | Real things including real money were taken and spent into the economy. No additional money in system, so no inflation. |
2. Burdens the Poor? | NO | Wealth is contributed according to one’s own capacity. So prorated. |
3. Will it worsen wealth distribution in the economy? | NO | Since wealth if contributed according to one’s capacity. |
4. Government needs to payback? | NO | The wealth is contributed for the cause and need not be repaid. |
5. Will there be a later increase in Tax, GST or other Levies on the people? | NO | Because contributed wealth need not be paid back. |
2. The economy with fiat money as in the current world
Four scenarios are evaluated here.
a. Sadaqah/Wakaf
Since the government is requesting funds from its people for national interest, we assume Sadaqah is contributed by everyone to the government according to their own capacity. In this case the effect will just the same as in scenario 1.
EFFECTS | YES/NO | REMARKS |
1. Creates Inflation? | NO | Real things including real money were taken and spent into the economy. No additional money in system, so no inflation. |
2. Burdens the Poor? | NO | Wealth is contributed according to one’s own capacity. So prorated. |
3. Will it worsen wealth distribution in the economy? | NO | Since wealth if contributed according to one’s capacity. |
4. Government needs to payback? | NO | The wealth is contributed for the cause and need not be repaid. |
5. Will there be a later increase in Tax, GST or other Levies on the people? | NO | Because contributed wealth need not be paid back. |
b. Government Borrows from its People Domestically
In this scenario the government borrows the money needed from the wealthy in the country. The wealthy usually buy government bonds that pay interest. The effects are:
EFFECTS | YES/NO | REMARKS |
1. Creates Inflation? | YES | Initially NO, because no additional money is created when only existing money is borrowed. But when the time comes to pay back the principal plus interest, if the government is forced to increase money supply to pay the interest portion (that does not exist in money form yet) then that can create inflation. |
2. Burdens the Poor? | YES | Initially NO because the poor need not contribute any money. But later YES because the government would increase Tax, GST and Levies to payback the Loan. Inflation will also burden the poor. |
3. Will it worsen wealth distribution in the economy? | YES | The rich actually gain from this since they get their money back plus interest. It is the poor who burden the whole thing. |
4. Government needs to payback? | YES | The government must repay the Loan plus interest on it. |
5. Will there be a later increase in Tax, GST or other Levies on the people? | YES | To pay back the loan plus interest the government will have to increase Tax, GST and other Levies on all its people. |
c. Government Borrows Externally
In this scenario the government borrows the money needed from foreigners like issuing bonds or borrowing from entities like IMF, World Bank, JP Morgan etc. The effects are:
EFFECTS | YES/NO | REMARKS |
1. Creates Inflation? | YES | Initially NO, if the borrowed funds are in foreign currencies. If borrowed in local currency from World Bank then YES that will be inflationary. When borrowed in foreign currency, no additional local money is created, if borrowed in local currency then new money is created. But when the time comes to pay back principal plus interest, the government is forced to increase money supply to pay the interest portion then that can create inflation. |
2. Burdens the Poor? | YES | Initially NO because the poor need not contribute any money. But later YES because the government would increase Tax, GST and Levies to payback the Loan. Inflation will also burden the poor. |
3. Will it worsen wealth distribution in the economy? | YES | The foreigners actually gain from this since they get their money back plus interest. The rakyat in general will bear the burden of the whole thing. |
4. Government needs to payback? | YES | The government must repay the Loan plus interest on it. |
5. Will there be a later increase in Tax, GST or other Levies on the people? | YES | To pay back the loan plus interest the government will have to increase Tax, GST and other Levies on all its people. |
d. Government Prints New Money (Quantitative Easing)
In this scenario the government just prints the needed money (physically or electronically) instead of borrowing domestically or from foreign entities like IMF, World Bank, JP Morgan etc. The effects are:
EFFECTS | YES/NO | REMARKS |
1. Creates Inflation? | YES | YES because QE introduces new money into the system. However, in a recession part of liquidity gets destroyed. Hence this new money would fill-in for the liquidity-gap first before becoming inflationary. |
2. Burdens the Poor? | YES | YES because of the Inflation created. However no additional Tax, GST and Levies needed since this is not a loan that needs to be repaid. |
3. Will it worsen wealth distribution in the economy? | NO | The mechanism of using QE does not worsen wealth distribution. |
4. Government needs to payback? | NO | There is no loan to be repaid. |
5. Will there be a later increase in Tax, GST or other Levies on the people? | NO | No loan plus interest to be repaid, so the government need not increase Tax, GST and other Levies on all its people. |
e. Netting
In this scenario the government operates a mutual credit clearance system or Netting. In netting, a record of transactions among parties in the economy is kept and settled periodically, say monthly. The effects are:
EFFECTS | YES/NO | REMARKS |
1. Creates Inflation? | NO | Only transactions records are kept and periodically settled, hence no new money is created. |
2. Burdens the Poor? | NO | No Inflation created or additional Tax, GST and Levies needed. |
3. Will it worsen wealth distribution in the economy? | NO | The mechanism of Netting does not transfer wealth unreasonably between parties. |
4. Government needs to payback? | NO | There is no loan to be repaid. |
5. Will there be a later increase in Tax, GST or other Levies on the people? | NO | No loan plus interest to be repaid, so the government need not increase Tax, GST and other Levies on all its people. |
Netting has the effects like scenario 1 and hence prove the best financing alternative, but nonetheless it takes time to implement. Therefore, overall, to finance the huge economic stimulus packages for Covid-19 crisis, I would say the best is Quantitative Easing, i.e. helicopter money to immediately boost the liquidity in the economy. The government must remember that it has the legal right to create the currency of the nation, and it should duly exercise this right especially in critical times like this. QE is better than taking large amounts of loan from foreign lenders like IMF and World Bank because, even though both QE and external borrowing are likely to be inflationary, the latter will later have to be repaid back with interest. To service this loan the rakyat will have to be slapped with higher taxes, GST and so forth. If the duration of the loan is 50 years (Indonesia for example has even issued dollar-denominated 50-year bonds to raise part of the funds) then future generations will be servicing for the loans we take today, for 50 years. Should we put that burden on our grandchildren?
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