Free Market Madness & Human Nature:

Can Islamic Finance Help?

Necati Aydin, Ph.D.Director of Neuroeconomics and Well-being Program

Florida State University, Tallahassee, FLEmail: naydin@cefa.fsu.edu or dr.necatiaydin@gmail.com

Ninth Harvard University Forum on Islamic Finance

Building Bridges Across Financial Communities

March 27-28, 2010 Harvard Law School

Cambridge, Massachusetts

Recognize and act on certain elements of human nature (three pillars of capitalism) Self (ego) Interest (nefs) Mind (rationality)

Effectively use the market mechanism based on self-interest (ego-centered human nature) Profit driven capitalists Pleasure (utility) driven consumers

Unprecedented success in production and consumption

Source: The Industrial Workers of the World (IWW)

Ignore or deny some aspects of human nature (Adam Smith’s “moral sentiments” and Weber’s “spirit of capitalism”)

Create perfect conditions for economic and financial tsunami(ignite economically suicidal behaviors due to unrestrained interests of animal soul & ego)

Fail to bring happiness (or maximize cumulative utility) despite increase in consumption (“American Paradox”, “Progress Paradox”, or “Capitalist Paradox”)

“Free Market Madness”

The root cause of all possible causes is the animal soul with a greedy and selfish nature.

• Politicians who acted upon the greed for vote

• Capitalists who acted upon the greed for profit maximization, and

• Consumers who acted upon the greed for pleasure made the crisis inevitable.

Most economists did not foresee the 2008 crisis mainly due to “the profession’s blindness to the very possibility

of catastrophic failures in a market economy…. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of

institutions that run amok; to the imperfections of markets – especially financial markets-….” (Krugman,

2009)

Perfectly rational Predictably irrational The boom in the housing market The boom in consumer spending The free market madness drivers

1. Utility maximizing populist politicians▪ De-regulation in the financial market

2. Short-term profit driven capitalists (creditors)▪ Availability of cheap an excessive credits

3. Short-term pleasure (utility) driven conspicuous consumers

▪ Unsustainable consumption

In 2007, Eugene Fama, the intellectual father of the efficient

market theory, stated that “the word “bubble” drives me nuts,” and

defended his theory even for the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It is

typically the biggest investment they are going to make, so they look around very carefully and they

compare prices. The bidding process is very detailed.”

The “dream” turned to a “nightmare” Death of trust in the financial market The cost to the federal government

$700 billion for TARP $787 billion for AERP

The cost of shoring up U.S. banks might reach $4 trillion

World-wide losses of U.S. originated loans might reach $2.7 trillion (GFSR)

The full cost to the U.S. economy might be $15 trillion (Jeffrey Sachs)

The global damage is much greater Developing countries are being affected

disproportionatelyIn its editorial, the voice of capitalism for over 165 years, expressed concern that “economic liberty is under attack

and capitalism, the system which embodies it, is at bay.”

“Free Market Madness” and Animal Spirits

"Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." (John Keynes, 1936, pp. 161-162)

“The cause of our economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship.” Alan Greenspan, 2008

“I made a mistake," Greenspan said to the House Committee on Oversight and Government Reform, "in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms" (The Washington Post, 2008)

Who am I?Who are YOU?Who are THEY?Who are WE?

“Outer universe” vs.“Inner universe”

“He that knows himself knows others.” Colton

“Knowing yourself is the beginning of all wisdom.”     Aristotle

“Knowing others is intelligence; knowing yourself is true wisdom. Mastering others is strength, mastering yourself is true power.”      Lao-Tzu

“Knowledge is to know something Knowledge is to know yourself If you do not know yourself What is the point of your knowledge?” Yunus Emre

Self-interest and free market Free Market Success Free Market Failure

Subjective well-being and free market Happiness paradox

Invisible hand(s) and free market

Key Residents of Human Palace The spiritual heart/qalb (the king) The conscience/vijdan (the judge) The mind/aql (the advisor) The animal soul/nafs (the elephant) The self/ana (the guard)

An Islamic Theory of Human Nature

Bediuzzaman Said Nursi (1878-1960)

Self EmpoweredTransformed

Humango

dMaster and owner

Shirk (partnership with

God)

Capitalism

Self WeakenedTrained

Servant to God

Servant and trustee

Shukr (giving thanks to God)

Islam

Maslow’s Needs Sources Pleasures

Physiological needs The Elephant Sensual pleasures

Safety and security need The King/The Advisor Spiritual/Intellectual pleasures

Love and belonging The King Emotional/Social/Spritual pleasures

Esteem The Guard Self-acceptance/Egoistic pleasures

Cognitive needs The Advisor Intellectual pleasures

Aesthetic needs The King/The Advisor Aesthetical/Intellectual pleasures

Self-actualization The King/The Advisor Spiritual/Intellectual pleasures

Self-transcendence The King/The Judge Spiritual/Altruistic/Conscience pleasures

Sensual pleasures

Self-acceptance pleasures

Social pleasures

Emotional pleasures

Intellectual pleasures

Aesthetical pleasures

Conscience pleasures

Altruistic pleasures

Spiritual pleasures

Egoistic pleasures

Materialism/

capitalism

serves

The elephan

tThe

guard

Sensual and egoistic

pleasures

Unsustainable

consumption

andDestructiv

e technology

Islam serves

The kingThe

judgeThe

advisor

Spiritual and intellectual

pleasure

Sustainable

consumption and

constructive

technology

Growing interest in Islamic finance (Vatican)

Moral failure and Islamic finance Assumption about human nature

▪ predict and prevent irresponsible and irrational behaviors

Moral constraints (moral/religious intervention) Market failure and Islamic finance

Market discipline No riba and gambling (qimar) Restrictions on the sale of debt, short sales Sales- and lease-based modes of financing (murabaha,

ijara, salam, istisna and sukuk)

Yes, if it sticks with its main principles:

Real asset based financial instruments Risk sharing through ownership (no pain, no gain!) Genuine transaction with full intention of giving

and taking delivery (No muta’ financing) No second hand market for debt Moral education and training Developing new instruments without

compromising Educating public about the merits of its

instruments No credit for personal consumption