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• Chapter 1 LARIBA Banking System

• Chapter 2 Islamic Business Ethics

• Chapter 3 Review of Islamic Economics

• Chapter 4 The Challenge

• Chapter 5 The Federal Reserve System of the United States

• Chapter 6 The Post World War II International Monetary System

• Chapter 7 The European Monetary Union

• Chapter 8 Major Features of the Islamic LARIBA Banking Policies

• Chapter 9 Relationship of the LARIBA Bank with Its Depositors

• Chapter 10 Deposits in LARIBA Banks

• Chapter 11 Investing the LARIBA Bank Deposits

• Chapter 12 The Dream: A World-wide LARIBA Banking System

The deterioration of the savings and loans industry along with the banking industry itself brought about many pressures for the bank and the savings and loans to compete.

Another parallel event was the emergence of the money market accounts, by which checking accounts could earn interest on their deposits.

With the high interest rates prevailing in the early eighties, many banks and saving and loans associations resorted to speculative lending hoping to achieve higher returns and hence pay the money market accounts, the certificate of deposits and savings accounts those high rates prevailing at that time.

When the economy turned from bad to worse and with the recessions of 1987, 1989 and 1990's many of the speculative lending practices were exposed.

Many of the troubled banks and savings and loans blamed the economy to be the real reason for their failure.

It is the author's belief which is based on real life experience, consulting for and communicating with many friends and associates in the banking industry, that the real reason for the failure was the lack of moral responsibility on the part of both the lender (lending officers) and the borrower.

The real honest businessman was deprived the opportunity of getting his/her loan approved only to find the money going to spectaculars with special connections to the loan officers or the bank management.

The result is well known and the damage done not only to the financial markets but also to whole economy will take years to fix.

It is the author's belief that if communities were to flourish again and for the economy to restructure in a fundamental and lasting way, moral community banks should be tried once again.

History shows that such banks (and building and loan societies) were the real locomotives of community developments in the U.S. out of the depression of the 1930's.

That does not mean that the regional and large money center banks have no place in the economy.

Indeed they would be the buyers of the community loan portfolios developed by the community banks.

The step wise approach towards realizing this goal is to create financial institutions which have the capacity of circulating the community savings within the community to activate its economy through financing projects and businesses, and in the process creating job opportunities for the community members and others.

The bank would be an honest-to-goodness community development bank which makes money available for non-speculative and economically productive schemes.

This is essentially the foundation upon which the concepts of LARIBA (Islamic) banks are built on.

These concepts are much needed in every part of the world.

And because the LARIBA system originated in the Islamic doctrine it becomes the responsibility of the Muslim communities in America and the West to provide a living example of such a system.

If successful, it will present America and the world with an important contribution towards the happiness and prosperity of all people, Muslims and non-Muslims.

And the result would be a closer society which harmonious in its relationships, fair and moral in its dealings, and most productive because it was done right.

This book addresses the LARIBA (Islamic) Banking system.

When we describe the Islamic Bank as a LARIBA Bank, we mean the bank which follows the LARIBA Islamic system.

Many translate RIBA as interest (The word LARIBA consists of two parts "LA" which means No and "RIBA" which means to grow, connotating the concept of money growing just because it is lent out regardless of the purpose of lending it.

The LARIBA system is a development banking system at heart).

We define LARIBA as a system which involves the creation of money (monetary system), the creation of credit (banking and financing) and the total economic system (collection of Zakah, distribution of inheritance, and most importantly savings).

The contents of the this book are based on the author's practical experience accumulated through the start up, organization and development of American Finance House-LARIBA in Pasadena, California since 1987, in addition to the author's experience in interacting, consulting and doing business with many Islamic banks world-wide.

It is our hope that this preliminary effort will be the beginning of a series of in-depth writings on each of the concepts discussed in this book.

In conclusion, we ask Almighty God to accept this effort and to forgive us any unintended errors or misconceptions of His system, the LARIBA system of banking and finance.

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It is the daily triumph of integrity, of belief in God, and belief in the future over skepticism.

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Islamic economics has matured as a discipline and "arrived." .

It has its own journal (Journal of Research in Islamic Economics), at least two research centers devoted to the subject and is now being taught in economics departments of numerous universities both in the Muslim world and in the West.

Prof. Muhammad Nejatullah Siddiqui's highly praised survey of contemporary literature on the subject lists some 700 works in English, Arabic and Urdu.

A more recent work by Muhammad Arram Khan contains over 1500 citations.

Islamic banks are mushrooming in almost every Muslim state, form Sudan to Iran, Pakistan, Bangladesh, Egypt and Malaysia.

Many European cities have one or more Islamic banks.

There is thus good reason to believe that Islamic economics has not only arrived, it is here to stay.

DEFINITION OF ISLAMIC ECONOMICS

But what is Islamic economics? How does it differ from the conventional capitalist and socialist economic models? What are its axioms and principles? How will Islamic economics replace the dominant economic orders in Muslim societies? One of the first points emphasized by author after author is that Islamic economics is not capitalism minus interest plus zakah or socialism minus state control plus God.

It is something unique and different and exclusive to Islam.

How unique and how different is essentially the key issue.

S. M. Hasanuz Zaman offers the following definition: "Islamic economics is the knowledge and application of injunctions and rules of the Sharia (Islamic Jurisprudence) that prevent injustice in the acquisition and disposal of material resources in order to provide satisfaction to human beings and enable them to perform their obligations to Allah (God) and society.

M. Akram Khan considered that "Islamic economics aims at the study of human falah (Salvation) achieved by organizing the resources of earth on the basis of cooperation and participation.

The role of the Sharia (Islamic Jurisprudence), the notion of adl (justice) and falah (salvation), cooperation and sharing are central to Islamic economic philosophy of the total system of Islam." Siddiqui⁽²⁾ sums up this philosophy as follows:

"The key to economic philosophy of Islam lies in man's relationship with God, His universe and His people, i.e. other human beings, and the nature and purpose of man's life on earth.

Man-God relationship is defined by Tawhid (Oneness of God).

The essence of Tawhid is a total commitment to the will of Allah (God), involving both submission and mission to pattern human life in accordance with His will.

The will of Allah (God) constitutes the source of value and becomes the end of human endeavour.

Life on earth is a test, and its purpose should be to prove successful in the test by doing Allah's (God's) will.

The entire universe with all the natural resources and powers is made amenable to exploitation by man, though it is owned by Allah (God) alone.

Life on earth being a test and all the provisions available to man being in the nature of trust, man is accountable to Allah (God) and his success in the life hereafter depends on his performance in this life on earth."

But how is this economic ibadah (worship) performed?

There are a host of Islamic concepts and values which define the extent and nature of economic activity.

There are many positive values such as iqtisad(moderation), adl(justice), ihsan (kindness par excellence), amanah (honesty), infaq (spending to meet social obligations), sabr (patience) and istislah (public interest).

Similarly, there are a number of values which are negative: zulm (tyranny), bukhl (miserliness), hirs (greed), iktinaz (hoarding of wealth) and israf (extravagance).

Economic activity within the positive parameters is halal (allowed and praiseworthy) and haram (prohibited and blameworthy) which has to be moderated, production which is regulated by the halal-haram code, and distribution which must adhere to the notion of adl (justice).

Collectively, these values and concepts, along with the main injunctions of the Qur'an, provide a framework for a unique, just and contemporary economic system.

THE CHALLENGE IS IN THE APPLICATION

Islamic concepts are almost always stated in theory.

When it comes to the question of "how it is to be done" and "what exactly needs to be done" problems emerge and differences arise.

How can Zakah (the ritual of alms giving) be made the cornerstone of public finance in an Islamic society? How can brotherhood/sisterhood be promoted; and what needs to be done to ensure equity? How can wealth be redistributed? What needs to be done to ensure that wealth does not accumulate in fewer and fewer hands.

What consumer goods constitute israf (extravagance)? What types of industry would lead to economic zulm (tyranny)? What types of technologies negate adl (justice) and promote Ihtikaar (hoarding) of wealth? How can Islamic injunctions on the use of land be introduced without the use of force? What needs to be done to break the feudal structure in Muslim society?

LARIBA ISLAMIC TERMINOLOGY, RIBA ANALYSIS

In the early sixties when Muslim economists were rediscovering the principles of Islamic economics, their output was in many respects genuinely original.

The major subject they have tried to discuss is bank interest.

They have played around bank interest, and have come sometimes very close to thinking that if they could avoid dealing with bank interest and introduce another modern means to provide the same motivation in a different way that could solve the problem.

It was a huge attempt to cast Islamic institutions and dictates, like zakah (the ritual of alms giving) and prohibition of interest, into RIBA economic mould.

The dominant models guide the analysis and shape the inquiry: everything is compared and contrasted with capitalism and socialism, highlighting the fact that there is an underlying apologia at work

Once the objectives of the LARIBA Islamic economics have been stated in terms of RIBA paradigm, it is a short step to accept the major institutions of the RIBA system and try to mould them into LARIBA Islamic shapes.

The most obvious example of this is RIBA banking: the institution as it has evolved into the world since the industrial revolution has been accepted, without criticism and questions whether banks, as defined and developed over time are really needed.

While the suggested alternative for interest, which is profit-sharing, reflects the true ideals of LARIBA of Islam, it cannot fit in an institution which has grown up solely on the basis of interest and RIBA.

Professor Siddiqui, describes the function of a banking system based on "mudaraba" ^*** as follows:

"A large number of depositors enter into individual 'mudaraba' contracts with a banking company, organized on the basis of share capital, the contracts stipulating the sharing of the profits of the 'business of banking'.

The bank undertakes two kinds of business.

Firstly, it offers banking services for which the bank earns fees and commissions.

Secondly, it assumes the role of a financier-entrepreneur making judicious selection of businessmen who seek capital from it, stipulating that they share with the profits of their productive enterprise.

Liability to loss in a 'mudaraba' contract attaches to the financier only, the working party i.e. the user of the capital bears no part of the loss accruing the capital extended by the financier.

It follows that the loss incurred by an individual entrepreneur will be borne by the bank.

Losses incurred on individual advances are likely to get absorbed by some of the profits accruing to the bank from the successful entrepreneurs.

As long as the totality of profits accruing on banks' advances plus the fees and commissions earned by the bank remain a positive quantity, the depositors' capital and return on capital are safe.

But what if the total earnings of the bank is a negative quantity? This will mean a loss, to be distributed equally on share capital and 'mudaraba' deposits."

The central question is, should the ordinary act of depositing money become a risk-taking exercise.

How can one plan for the future if one is not sure what will happen to one's money at the end of the financial year? And some of the Islamic LARIBA banks as they are normally defined have no guarantee that they will get a return on their investments.

Consider what will happen to a rural agricultural bank in a year of bad harvest when it has invested all its capital in the labor of the local farmers! If the financier is risking his/her capital, he/she is likely to demand a hefty share of the profit; so the poor entrepreneur ends up working for the bank instead of him/herself.

And if the bank does not ask for a lion's share of the profit, how can it ensure that it covers for all those entrepreneurs who have lost its money? Perhaps both the bank and the entrepreneur are getting a bad deal.

Perhaps this is why many of the Islamic banks are losing their investments so rapidly.

The point of this valid and justified criticism is not that the principles of "mudaraba" do not work, but that the RIBA institution of banking is the wrong place to put an Islamic injunction into practice.

Moreover, RIBA economic institutions do not come on their own: they bring the entire system with them.

Banking, as Alvin Toffler points out so powerfully in his book "Third Wave," is the central institution of the modern money system.

Accept the RIBA banks and you accept the entire RIBA economic monetary and financial structure and theoretical framework that comes with it.

The two are integrated and cannot be decoupled.

The abolition of RIBA and the collection of Zakah are the corner-stones of the LARIBA economic system.

But the natural emphasis of a system that outlaws RIBA interest would be to play down the role of money not to raise it as the arch factor of the economy.

THE ROLE OF MONEY IN RIBA BANKING SYSTEM

Many economists and individuals are hypnotised by money, and look only at those sectors of production and consumption that are monetized and involve cash transactions.

The emphasis on the monetized economy has meant that Islamic economics has equated the monetized sectors of a country with the whole system of production, consumption and maintenance.

SUGGESTED SOLUTIONS TOWARDS

A LARIBA SYSTEM

A study by Umar Chapra on Islamic banking and monetary system, suggests a package of reforms which includes moderation in spending, elimination of hoarding, efficient use of savings, responsible government spending, increase in equity financing, reducing the powers of banks, and establishment of "sane" stock markets.

In addition, the following institutions were suggested:

1. A central bank,
2. Commercial banks,
3. Non-bank financial institutions,
4. Specialized credit institutions,
5. Deposit insurance corporations and
6. Investment audit corporation.

The transition involves the declaration of interest as illegal, substantial increases in equity/loan ratio of Muslim countries and communities, reform of the tax system, mobilization of idle funds, and the gradual conversion of interest RIBA-oriented financial institutions into profit-sharing ones.

Chapra⁽⁷⁾ clearly believes that an important step towards a just society can be produced simply by modifying the monetary system.

Additional emphasis should be directed to the relationship between production and consumption, the role or mode of production in shaping a society, the psychological impact of the divorce-- in time, space and social distance --between a producer and a consumer and the illusionary nature of paper money." What is the role of theory of profit in Islam?" "What function does macro consumption perform in Islamic economics?"

Many Muslim economists have based their analysis on a number of metaphysical assumptions: first, that money is to be studied like a physical commodity; second, what needs to be done is to analyze how the money system of today actually works; third, that monetary problems can be solved by modifying the dominant institutions of RIBA; fourth, that the tools of modern economics, whose cultural impact needs to be appreciated by Muslim economists, can solve the problem of Islamic LARIBA economics; fifth, that the economic environment is never depleted; and sixth that the goals of the Islamic LARIBA economic system can be achieved without changing the energy base of Muslim countries.

Many Muslim economists need to focus on working on research directed toward producing policies that are different from the capitalist and socialist alternatives.

If this is not done, Muslim countries will end up with the same crisis that confronts industrialized societies.

THE AXIOMATIC ANALYSIS

If Islamic LARIBA economics, just like Islamic science, has any meaning it is purely in the context of Islamic society and Muslim civilization.

In this context, Islamic LARIBA economics has to rely not just on Islamic principles and injunctions, but must develop its own tools of thought and analysis and its unique institutions and apply such on Muslim communities.

Islamic LARIBA economic institutions have to be rediscovered, evolved and invented on the basis of the needs of Muslim societies and the principles of Islam, not taken or adopted from what already exists in the market-place.

This means that Islamic LARIBA economics must construct a living dynamic Islamic economic system, concept by concept, institution by institution applying Islamic junctions such as the prohibition of RIBA and introduction of zakah in a truly authentic manner.

More recently, however, Syed Nawab Haider Naqvi in his "Ethics and Economics: An Islamic Synthesis" argues that any set of axioms to be meaningful must satisfy four criteria: they must be adequate and legitimate representations of Islam's ethical views; they must form the smallest possible set; the elements of the set must be internally consistent; and the axioms must have predictive powers.

Four axioms: unity, equilibrium, free will and responsibility were recommended.

Unity, or Tawhid, refers not only to the unity of God, but also the unity of human life and the healing of the "current schism between ethics and economics." Social justice is only one component of equilibrium which is derived from adl (justice).

Free will refers to human freedom in the realm on worldly affairs; but free will can also lead to the denial of unity and upset nature's equilibrium unless man is made responsible for his/her actions.

All four concepts are interlinked and interrelated, and cannot be isolated from each other.

Naqvi uses his four axioms to develop the basic policy objectives of the Islamic LARIBA economic system.

He isolates social justice, universal education, economic growth and employment generation as the key policy objectives of Islamic LARIBA economics.

Language and concepts have a profound impact on our thinking.

Tawhid (unity), adl (justice), istislah (public interest) and khilafah (leadership as a vicegerent of God on earth), are all examples of the rich reservoir of concepts to be found in the Qur'an and Sunnah (the traditions and teachings of Prophet Muhammad (S)). It is believed that they are not there to be ignored.

How does one, for example, on the basis of linear logic, reconcile the idea that zakah, which involves subtracting from one's income, can actually lead to increase of wealth? Growth by subtraction is an idea that RIBA economics has no understanding of.

The linear logic of RIBA economics is reflected in the present structure of the world.

Economically and technologically, the globe is structured as though developing countries, including all Muslim countries, were colonies of the industrialized states.

Colonialism is alive and well, and many industrialized countries are reaping its benefits.

It is believed that Islamic LARIBA economics is not going to break this structure if it freely borrows from this paradigm.

On the contrary, it may become part of the structure.

Thus, all those Muslim economists who argue that we should not hesitate to borrow the "good " and "neutral" bits of the RIBA economic theory may be asking to be absorbed into the dominant paradigm.

The fact is that RIBA economics, is one vast, interlinked, value-laden, self-perpetuating system that is taking linear logic to its ultimate conclusion.

If Islamic LARIBA economics is to move toward the ideals, then it must develop not just its own body of theories and models, but also its own tools and modes of logic, thought and actual physical operation.

It must assume a civilizational role and work towards laying the foundations and building the structures of a muslim civilization of the future.

It has to break the shell of an atomized discipline and become a multi-disciplinary mode of inquiry, taking into consideration the social organizations, the political ideals, the environmental imperatives, and scientific and technological needs of Muslim underdeveloped societies.

Economics has to draw not just form Muslim history, and contemporary muslim societies, but also from a clear vision about the future.

Islamic economics has to develop a future consciousness for the Muslims and the society at large.

The following are global trends that spell danger for Muslim countries and the world and should be taken in consideration:

1. The world is shrinking and becoming more and more economically interlinked and interdependent.

The only winners are the RIBA banking systems.

How to co-exist with and/or delink from the world's economic and monetary systems must, therefore, become a major theme of Islamic economics.

 

2. Electronic banking and funds transfer systems are giving money an unparalleled and dangerous importance.

Because of the speed of electronic systems, the same amount of money now supports five times as many transactions as before.

Thus the speeding up of money handling also increases its velocity of circulation.

At a point not too distant in the future, when the speed of transaction reaches "real time," money will acquire a strange new status.

The velocity of the information about money flows would lose all relationship with thermodynamic realities of the actual system (subject to natural cycles of crops, weather, friction, inertia, and human frailties), and the amount of money and capital available at any point in the banking system would tend towards infinity.

As information about the money system become delinked from actual events, all manner of new ventures and schemes might be initiated by false promissory notes signaling capital availability with nothing more than an electronic impulse over a computer terminal.

Moreover, computerization of stock markets throughout the world has blurred the distinction between investment and speculation.

The entire system is moving towards becoming a huge worldwide gambling casino with no pretension to serving social needs.

Muslim economists must be aware of the changing role of money and its implications for Muslim societies.

They must work to diversify the basis of Islamic LARIBA economic thought towards non-monetarist and non-fiscal areas.

 

3. Information itself is becoming a key commodity.

Economic power in the future will be determined by the ability to generate and having access to information.

It will play the same role as energy is playing now.

Thus, Islamic LARIBA economic theory must be developed to cope with non-material commodities like information.

 

4. The use of energy and other natural resources (especially water) of a society is intrinsically tied with economics.

The globe's energy and natural resources are depleting at a rapid rate.

Both inflation and employment are tied to the rate of depletion of energy and natural resources.

As it becomes more costly to extract energy and other natural resources, they become more and more scarce, so the cost of transforming them into usable commodities increases.

Throughout the world, the price of basic goods and services is tied to the costs associated with the exchange and transformation of energy.

Unemployment is the other side of the equation: the faster conventional sources of energy run out, more and more people become unemployed and underemployed.

Thus transformation to a renewable energy base is essential for the future survival of the world.

 

5. At present, Muslim countries are essentially consumer states relying exclusively on imported goods.

This situation is likely to get worse and the associated ill-effects of the ever-increasing social, psychological and intellectual distance between producers and consumers will multiply at greater speeds.

A major task of Islamic economics is to change the patterns of consumption in Muslim societies as well as to direct production towards directions which are more suitable to the needs of Muslim consumer.

The formidable task is to transform these ethics into a dynamic economic system that has its individual identity with its own institutions and methodological tools.

This system will provide a viable, kinder and gentler alternative to the dominant systems of RIBA economies.

 

6. Muslim economists, social scientists and leaders living outside the Muslim countries in many of the developed countries of world must carve a role for themselves to implement the theory of Islamic LARIBA financing in their communities in the world and try to branch out into the Muslim countries world-wide in order to facilitate the bringing about of the dream of a world-wide community based LARIBA financing system.

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These are:

1.The establishment of a "LARIBA" bank within a master plan of a perfect Muslim society which is governed by a government and operating by a full fledged and complete Islamic LARIBA financial system, and

2.The establishment of a "LARIBA" bank which follows the Islamic LARIBA laws and which is independent of the other parts of the society at large, in a society which does not operate according to the Islamic laws.

This approach assumes that the transformation to a full Islamic society governed by Islamic laws and ethics will take time.

The first approach will result in applying the prohibition of RIBA in the banking system in its totality.

Yet, in the second approach, the prohibition of RIBA will be applied only to the particular LARIBA bank.

We all live in this second option.

In fact, regardless of whether a government is in a Muslim land, or non-Muslim land, most every one, with a very few exceptions, does not apply Islamic laws in their entirety.

That is why one needs to find a format that is legally acceptable from the point of view of Islamic law in our efforts to establish an Islamic LARIBA bank in a world which is not governed, in most cases, by Islamic laws.

The following three conditions are thought to be necessary and required to achieve our goal:

1.The LARIBA bank should not violate the rules and laws of Islamic LARIBA banking and financing and the spirit of Islamic economic principles.

2.The LARIBA bank should operate and compete in all aspects of the banking business with the other RIBA banking institutions in the community.

The LARIBA bank should be designed to have the flexibility, operating creativity and the financial products "manufacturing" ability to attract customers (Muslims and non-Muslims) and to keep them.

It should aspire to make a clear and distinguished difference in the lives of the citizens of the community at large.

3.The LARIBA bank should be operated as a profitable business entity.

In particular, the LARIBA bank should offer superior services and returns as compared to the RIBA banks.

In addition, the LARIBA bank should play an important role which is felt by the community at all levels, especially at the grass roots level.

The LARIBA bank in its active effort to serve the community will become the force behind capital accumulation from the community and in using that capital to finance projects and services which will make a difference in the economic well-being of the community.

This is done through job creation for members of the community and others outside the community.

4.The LARIBA bank should be more sensitive to risk management than the RIBA banks.

So, in its efforts of capital accumulation, the LARIBA bank, in its slow and gradual effort to get established, should target a smaller percentage of the assets and savings of the community to be used in LARIBA financing.

It should also be made clear to the participating investors, that because of the start-up nature of the LARIBA bank venture, there is a risk of loosing all or part of their assets.

But on the other hand, it should be made clear both operationally and to the investors that the bank will apply careful due diligence and portfolio diversification methods and will keep enough reserves for potential losses in order to minimize the possibility of loosing money while paying acceptable returns on the investment.

5.The LARIBA bank should start by a core group of shareholders who believe in the dream of having a bank and/ or a finance company which operates according to the LARIBA system.

They should satisfy the following requirements:

5.1 They should be hand picked to form a homogeneous group with the same vision, dreams, social and personal backgrounds as well as the same investment and business temperament.

5.2.They should be financially well-to-do (but not necessarily very rich).

This will make them able to meet any run on the LARIBA bank in case a rumor or an unexpected event occurs.

This way the LARIBA bank will always be able to meet any requests for withdrawal of investors' deposits

5.3.They should come with a highly diversified actual "hands-on" experience in the business fields to be targeted for financing by the LARIBA bank.

This way, the bank will be able to evaluate the projects by owners/experts who are looked upon as managing their own funds and who are in actual operational sense the "managing partners" (not employees) of the LARIBA bank.

5.4.They should be willing to accept no pay or low pay for their services to reduce the overhead expenses of the LARIBA bank.

Especially, when the LARIBA bank is in its infancy and the assets under management are still small.

6. The LARIBA bank should structure its capital such that the core group of share holders' capital and/or investments represent at least 50% of the total assets under management.

This way the LARIBA bank can meet any unexpected run on its deposits.

(As mentioned above under 5.2)

7. Deposited (investors') assets in the LARIBA bank are looked upon as liabilities of the shareholders.

This way every shareholder/member of the board of directors and bank management will make sure to carefully evaluate every project to be financed by the LARIBA bank to minimize their perceived personal liability.

8. Investments made by the LARIBA bank should be shorter term in the beginning (3-5 years) to assure enough cash flow to meet any demands for withdrawals by investors.

Chapter 5 reviews the historic development of the system, and the concept of creation of credit in the banking system.

In an effort to shed some light on the effect of monetary policy on inflation and the use of monetary policy to enhance major political goals, a case study on the post World War II international monetary system is reviewed in chapter 6. Chapter 7 review Europe's efforts to unite as a case study for all these nations with homogeneous and converging social and human values and with integrated market and economic potentials on their way to realize the same dream of unity as that of Europe.

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Any discussion of financial and monetary system, especially regarding the LARIBA system as compared to the RIBA system, should be based on a clear understanding of how the U.S. Dollar monetary policies are handled.

It is a known fact that most world currencies are either directly pegged to the U.S. dollar or are dependent on the U.S. dollar.

This chapter is a must for everyone who has the dream of building a LARIBA banking system.

In an effort to stabilize the U.S. monetary element of the economy and to systemize the process of money and credit creation, the U.S. developed one of the most sophisticated central bank systems in the world.

The system is considered to be one of the most important pillars upon which the U.S. as whole is built.

The following is a summary of how the system was developed, where it derives its power from and how it operates.

The small quantity of paper currency that circulated in the United States' early years consisted of the notes issued by the First (1791) and Second (1816) Banks of the United States--two precursors of the Federal Reserve.

After the Second Bank of the United States closed in 1836, the dominant form of currency became private bank notes issued by state-chartered commercial banks (normally redeemable on demand for gold or silver).

The U.S. did not have a uniform national currency, and the system of state-bank issues of notes was confusing and inefficient.

By the 1860s, as many as 8,000 different issues of state bank notes were circulating in the United Sates.

Banks rarely accepted at face value notes issued by banks unknown to them.

During the Civil War national bank notes were issued, and until 1913 these formed the bulk of the nation's paper currency.

National bank notes were currency the government gave to nationally chartered commercial banks for them to issue as their own.

National bank notes grew out of the government's need to raise money to finance the Union army.

Faced with a depleted treasury and reluctant to raise taxes on northern industry, President Lincoln reluctantly agreed to a plan formulated by his Secretary of Treasury, Salmon Chase.

Under Chase's plan, the federal government would offer a new type of banking license--a federal, or national, charter.

A bank with a national charter would have the power to issue a new form of currency; national bank notes.

However, for each note issued, the bank would have to hold a somewhat larger dollar value of government securities as collateral (a "backing" requirement).

The banks could purchase the government securities directly from the Treasury for gold and silver; a universally accepted money at that time.

In effect, the government would receive money assets (gold and silver) in return for its liabilities (government securities).

Chase's plan was embodied in the National Banking Act of 1863.

To enhance the prospect that national bank notes would be successful and to eliminate the competition from notes issued by state banks, Chase also developed a tax that Congress gradually increased until the state bank practice of issuing currency ended.

Because national bank notes had to be fully collateralized government securities, the nation's supply of paper currency effectively depended on the government's debt.

The supply of currency expanded and contracted in direct response to changes in the value of government securities in the nation's bond markets and not in response to the needs of the economy.

When the government began repaying its Civil War debt, redeeming and retiring securities issued in earlier years, the supply of collateral available in the banking system for note issuance shrank.

Currency was inelastic (incapable of adjusting to the public's changing needs and demands), and this led to the money panics (episodes of irrational public hoarding and runs on banks) that periodically plagued the economy of U.S.A.

THE PYRAMID OF BANK RESERVES

The National Banking Act of 1863 specified three tiers of reserve requirements for national banks.

Small "country" banks could keep some of their reserves in cash but were required to deposit most of their reserves with the larger "Reserve City" banks (those in the nation's major cities).

Reserve City banks had to deposit most of their own reserves in still larger "Central Reserve City" banks (those in the nation's money centers of New York, Chicago, and St. Louis).

The central reserve city banks had to keep all their reserves in vault cash.

The banking system's reserves were thus effectively dispersed throughout the country and could not be quickly transferred to banks in regions that might be under liquidity pressure.

Because the central reserve city banks were the ultimate depositories of the banking systems' reserves, they were particularly susceptible to the accumulation of pressures that often led to bank panics.

A bank panic would generally begin in the Midwest, when small banks found they did not have enough currency on hand to pay out to farmers.

These banks would call on their reserve city correspondents for their reserves.

The reserve city correspondents, in turn, would call on the central reserve city banks for their reserves.

Thus, a few central reserve city banks were often hit by the cumulative shock to liquidity that the needs of thousands of country banks generated.

A fundamental problem was lack of a lender of last resort for the banking system; a source of guaranteed liquidity that all banks could tap when they needed money.

This act violates the Federal Reserve rules and the bank will be subject to severel federal stipulations, controls and penalties.

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The International Monetary Fund (IMF) was established by the Bretton Woods Agreement.

The Agreement foresaw the need for occasional adjustments in exchange rates among the various currencies of the Western allies.

At the time, this was thought to be a seldom used and highly exceptional emergency operation that most nations, and especially the industrialized nations, would not have to resort to.

To deal with the expected post World War II growth in international economic and trade activities, and to facilitate it, a set of rules was laid down at an international monetary conference in July 1944.

This is the well known Bretton Woods Agreement, which led to the creation of the International Monetary Fund, or IMF.

Among the stated objectives of the IMF are the following:

1. Expansion and balanced growth of international trade.

2. Promotion of exchange rate stability among international currencies, and

3. Shortening the duration and lessening the degree of disequilibrium in the international balances of payments of member countries.

So far, the only one objective that was met was the growth of international trade.

The Balance of Payment Concept

The U.S. experiences a balance-of-payment deficit when more U.S. dollars leave the country than enter it.

Dollars leave the country when Americans buy goods and services abroad (import) or when they invest abroad.

Conversely, dollars enter the country when foreigners buy U.S. made goods and services, or when foreigners invest here in the U.S.

These are not the only causes of international dollar flows, but they are the major ones.

Others are such as international remittances, military and non-military grants, international aid, etc.

The Bretton Woods Agreement worked reasonably well in the first few years of its existence, perhaps because the IMF, being in its infancy, moved with caution.

By 1950, the first signs of trouble started to appear.

From then on, the United States persisted in accumulating balance-of-payment deficits, with only rare and insignificant exceptions.

The question is, how did the U.S. get away with this persistent deficit accumulation for so long when no other nation could? The simple answer: By convincing the creditor nations to hold the U.S. dollar itself as a means of settling its deficit.

As the U.S. dollar continued to accumulate in foreign central banks, it was always thought that a simple reversal of policies could, in due time, reverse the trend.

In the meantime, as long as the U.S. government adhered to its policy of keeping its dollar pegged to gold and convertible into gold, a run on the U.S. gold stock was not likely.

If a run on gold were to be made, the U.S. would lose.

But so would most Western nations, since they would be left holding U.S. monetary units for which there was no gold backing.

As it became increasingly clear with time, the Bretton Woods Agreement discriminated in practice in favor of the U.S.

The U.S. assumed the role of the monopolistic money-supplier to the world.

The purchase mechanism provided the U.S. with foreign-made goods and/or services.

The loan mechanism (compounded by the Euro-and Asia-dollar markets) allowed the U.S. corporations to make capital investments abroad; i.e. to buy up foreign companies and productive facilities or to create such facilities on foreign soil.

In return for this accumulation of wealth, the U.S. has done no more than run the money printing presses a little faster.

The only way America could make U.S. dollars available to the outside world was by incurring balance-of-payments deficit.

The greater the deficit, the greater the international liquidity.

The world got hooked on the spend, spend and spend policies to meet their ever increasing consumptive behavior and localized war adventures.

These activities were financed indirectly through America by using the U.S. dollar as the reserve currency of the world through the IMF.

The fact that the pre-1971 international monetary system favored the United States was not the only area of friction among the leading nations of the West.

Money, at least the so called M1-concept, is defined as: all checking account deposits and currency in the hands of the U.S. non-bank public.

This part of the total money aggregate created by the Fed is watched closely by them to make sure that the economy is under control.

But since the U.S. dollars held outside the U.S. either privately or by foreign central banks, do not fall in the M1-category, the Fed did not concern itself with the supply of dollars held abroad.

As an example, suppose the U.S.

M1 money supply is $500 billion and that some $50 billion (only 10%) wind up abroad.

That would leave $450 billion at home here in the U.S.; not enough to sustain the growth of the economy (Gross National Product-GNP) at the previous level of $500 billion, since the reduction in money supply to the public de-stimulates and reduces the nation's public demand (to buy goods and services).

So, America has what looks like a demand-induced recession on its hands.

To keep the economy going in the U.S., the Federal Reserve in this case, will count and recount the M1-(domestic) money supply, find it short $50 billion and promptly fill the gap (that was during the 60's and 70's; now the Fed watches the M2-supply which includes large CD's and the M3-supply which include Eurodollar term deposits and large deposits and money market accounts).

This supposedly would solve the problem and bring back demand.

The GNP would rise, unemployment is reduced and the problem is solved.

The question is: is it really solved? The real question is: if America is short $50 billion, where did the money go? And what is its impact at the new locations overseas?

The answer:

It went abroad and caused inflationary pressures there.

In summary, by not filling the money gap created by transfer of dollars abroad, a recession is generated in the U.S. and on the other hand, by filling the gap, a U.S. recession is averted but inflation is created abroad.

What would be the choice for the fed? The lesser of the two evils: inflate abroad.