Monday, March 07, 2011

Why are Islamic economies underperforming?

This posting concerns a topic of great current interest. That topic is the economic and cultural backwardness of Muslim-majority countries, especially Arab ones. It is said that the value of manufactured goods that Egypt exports is no greater than that of tiny Costa Rica. Few, if any major scientific advances can be credited to Arab experts, at least those living in their own countries. In terms of these issues, conditions in Tunisia and Egypt are likely to get worse before they get better.

The disparity between Islam and the West is sometimes termed the Great Divergence. As early as the thirteenth century Muslim countries began to fall behind the West in a number of key respects. This decline is not due to the predatory incursions of imperialism and colonialism as some on the left allege, but it reflects something that happened in the Islamic civilizational sphere itself.

Accepting this point, historians are divided as to what caused the Great Divergence. Some say that the poor performance of Muslim countries is due to the very nature of Islam, which is hostile to both commerce and learning, the latter being traditionally been subordinated to religion. Others say that the problems are more local, involving particular features of Islamic practice which could be corrected without attenuating or discarding the religion itself.

Put briefly, is it a macroproblem or a cluster of microproblems? The latter position is maintained by Timur Kuran in his impressive book The Long Divergence: How Islamic Law Held Back the Middle East (Princeton University Press, 2011).

In a column in the New York Times (March 5), Nicholas Kristof summarizes Professor Kuran’s findings as follows:

“Professor Kuran persuasively argues that what held the Middle East back wasn’t Islam as such, or colonialism, but rather various secondary Islamic legal practices that are no longer relevant today.

“It’s a sophisticated argument that a column can’t do justice to, but for example, one impediment was inheritance law. Western systems most commonly passed all property intact to the eldest son, thus preserving large estates. In contrast, Islamic law stipulated a much fairer division of assets (including some to daughters), but this meant that large estates fragmented. One upshot was that private capital accumulation faltered and couldn’t support major investments to usher in an industrial revolution.

“Professor Kuran also focuses on the Islamic partnership, which tended to be the vehicle for businesses. Islamic partnerships dissolved whenever any member died, and so they tended to include only a few partners — making it difficult to compete with European industrial and financial corporations backed by hundreds of shareholders.
The emergence of banks in Europe led long-term British interest rates to drop by two-thirds leading up to the Industrial Revolution. No such drop occurred in the Arab world until the colonial period.”

Other points could be made from Kuran’s book, which I found very profitable reading. But the New York Times columnist covers the gist.

Still, to my mind, there is a curious omission from Timur Kuran’s analysis of finance and commerce in historical Islam, and that is the Hawala system. At this point, I will repeat some features of the account I gave at

Hawala (or hundi) is an informal value-transfer system based on the performance history and established trust linking a huge network of money brokers, based mainly in the Middle East, North Africa, the Horn of Africa, and South Asia.

The hawala concept has its origins in classical Islamic law (Sharia); it is mentioned as early as the eighth century in texts of Islamic jurisprudence. It is said to have later influenced the development of the principle of agency in the common law and the civil law tradition (cf. aval in French law and avallo in Italian law, both terms deriving from hawala).

Roman law had not permitted the transfer of debt, but the practice became common in medieval Europe, influenced by the trade Italian merchants conducted with the Muslim world. Again, Roman law forbade one person to act as the agent of another, for no individual could conclude a binding contract on behalf of another. By contrast, Islamic law and the later common law freely permitted agency in the field of contracts and of obligations in general.

Hawala is believed to have arisen in the financing of long-distance trade around the emerging capital trade centers in the early medieval period. In South Asia, it appears to have developed into a fully-fledged money-market instrument, which was only gradually replaced by the procedures of the formal banking system of Western origin in the first half of the twentieth century. Today, hawala plays a major role in the remittances of migrant workers to their country of origin.

In the most basic version of the hawala system, a network of hawala brokers, or hawaladars, arrange for the transfer of money. A customer approaches a hawala broker in one city, producing a sum of money to be transferred to a recipient in another, usually foreign, city. The hawala broker calls another hawala broker in the recipient's city, gives disposition instructions of the funds (usually minus a small commission), and promises to settle the debt at a later date.

A special feature of the system is that no promissory instruments are exchanged between the hawala brokers; the transaction relies entirely on the honor system. As the system does not depend on the legal enforceability of claims, it can operate even in the absence of a legal and juridical environment. Informal records are kept of individual transactions, and a running tally of the amount owed by one broker to another is maintained. Settlements of debts between hawala brokers can assume a variety of forms; it need not take the form of direct cash transactions.

In addition to commissions, hawala brokers often earn their profits through bypassing official exchange rates. Generally, the funds enter the system in the source country's currency and leave the system in the recipient country's currency. As settlements often take place without any direct foreign exchange transactions, they can be made at other than official exchange rates.

Customers find hawala attractive because it provides a fast and convenient means for transfer of funds, usually with a far lower commission than that charged by banks. Its advantages are most pronounced when the receiving country manipulates exchange rates (as has been the case for many typical receiving countries in the Middle East), or when the banking system in the receiving country is fairly primitive. Moreover, in some parts of the world it is the only option for legitimate funds transfers, and has even been used by aid organizations in areas where it is the best-functioning institution. In recent years the latter practice has caused concern because it is thought to have facilitated money transfers for terrorist groups. In principle,hawals may also be used for money laundering of drug profits, though the evidence for this is scanty.

The money transfers are informal and not effectively regulated by governments, which is a major advantage to customers with tax, currency control, immigration, or other concerns. In some countries, hawalas are actually regulated by local governments and hawaladars must be licensed to perform their money brokering services.

Let us return to the Middle Ages, in the centuries in which the Mediterranean was a Muslim lake. In those days, before the Great Divergence, the hawala system spread far and wide. That the first bankers in Italy were familiar with it is shown by the loan- word avallo, which is simply an Italian version of hawala. Yet the European bankers went far beyond their model, to introduce the wide-ranging innovations that we are all familiar with. The Islamic world kept to the more primitive institution of the hawala.

Today, of course, Western banking (sometimes disguised under the rubric of Islamic banking, which is simply Western banking with a few rhetorical changes) flourishes in Islamic countries. So does hawala. That this dual system, with one foot in the past and one in the present, is the norm is one indicator of the way in which Islamic economies are lagging.



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