Why has the Crescent fallen behind?

A report authored by a group of Arab scholars in 2002 has pointed out broadly, the reason why the Middle East and the Islamic world by extension had fallen behind the West in the last few centuries. The chief culprits as stated by the report were the deficits in knowledge and freedom. A salutary debate ensued. Now Timur Kuran, a Turkish-American economist has come out with an equally if not more bold book entitled “The Long Divergence: How Islamic Law Held Back The Middle East”. Let us hope that another equally salutary debate ensues once again.

For the period since the beginning of Islam up to 17th century, the Middle East was a dynamic place comparable to the Europe of today. Muslim traders flocked various parts of the region trading in items ranging from spices and silk to imported prostitutes and slaves. But somehow, the Middle East’s share of world economic activity has gown downhill since the year 1000. At that time, the Middle East Gross Domestic Product (GDP) was 10% compared to Europe’s 9%. By the year 1700 the Middle East was a paltry 2% compared to Europe’s 22%.

The standard explanations offered for this have mostly till date been unsatisfactory. It is widely believed that Islam by its very nature is hostile to commerce. But if anything, Islamic scripture is more business friendly than Christian or Hindu texts. The prophet Muhammad was a merchant and the Koran is full of praise for commerce. The second perceived reason is that Islam bans usury. But so do the Torah and the Bible. A third widely perceived belief is that Islamic countries fell behind as they were victims of Western imperialism.

Mr. Kuran’s work goes down to the very core of the problem. He reasons that the principle underlying reason for the fallback of the Islamic countries was because these countries failed to build commercial institutions – most notably Joint Stock Companies which are capable of mobilizing large quantities of productive resources over a period of time.

Europeans on the other hand inherited the Joint Stock Company from Roman Law. They built on this concept to form the modern day corporations of the 19th and 20th centuries. Islamic law on the other hand has queasy rules when it comes to managing commercial institutions. For example, according to the Islamic partnership law, a partnership can be dissolved simply by the whim of another partner. Obviously, these kind of quirks cannot work in a modern day business environment. Moreover, the widespread practice of polygamy led to the dispersion of wealth among many inheritors descending from the same paternal ancestor.

None of these things mattered when business was simple. But as business grew with more advances in technologies and the resultant technological and legal complications, these laws became a thorn in the path of developing the business. While the western concept of the joint stock company evolved along with time, the concept in Islamic law didn’t adapt itself to the changing conditions.

From the 19th century, the Middle Eastern rulers with a more outwardly looking take on things started to adopt Western style companies and institutions at home. They imported the concepts, the technologies, the people and in many cases even the style of government. The most notable example of this is the Ataturk’s introduction of a secular legal system in Turkey in the 1920s. Countries whose rulers adopted similar importation of business ideology from the West have benefitted the most (notable examples include Turkey, Egypt, Iran and the UAE).

Still, the Middle East has a lot of catching up to do. Its income per capita still remains less than 30% of Europe’s, the infrastructure in many countries is quite weak, economies are heavily dependent on export of commodities like oil instead of value adding industries and political stability is but a rarity.

Business remains complicatedly intertwined with the state as the region lacks strong commercial institutions. The Global Entrepreneurship Monitor suggests that rates of entrepreneurship are particularly low in the Middle East and north Africa. Transparency International’s corruption-perceptions index suggests that corruption is rife: in 2010, on a scale from one (the worst) to ten, Western Europe’s five most populous countries received an average score of 6.5, whereas the three most populous countries in the Middle East averaged 3.2 (Turkey scored 4.4, Egypt 3.1 and Iran 2.2)

Culture’s long shadow

The “long divergence” also helps to explain some of the Islamist rage against capitalism. Traditional societies of all kinds have been uncomfortable with corporations which, according to Edward Thurlow, an 18th-century British jurist, have “neither bodies to be punished, nor souls to be condemned”. But that unhappiness has been particularly marked in the Middle East. Corporations and other capitalist institutions were imported by progressive governments that believed the region faced a choice between Mecca and modernisation. Local businesses—particularly capital-intensive ones such as transport and manufacturing—were dominated by Jews and Christians who were allowed to opt out of Islamic law.

Mr Kuran’s arguments have broad implications for the debate about how to foster economic development. He demonstrates that the West’s long ascendancy was rooted in its ability to develop institutions that combined labour and capital in imaginative new ways. The Protestant work ethic and the scientific revolution no doubt mattered. But they may have mattered less than previously thought. People who want to ensure that economic development puts down deep roots in emerging societies would be well advised to create the institutional environment in which Thurlow’s soulless institutions can flourish.

Mitul Choksi

31-January-2011

2:37 PM Indian Standard Time

Rise of the 'redback'

IN 1965 Valéry Giscard d’Estaing, then France’s finance minister, complained that America, as the issuer of the world’s reserve currency, enjoyed “an exorbitant privilege”. China’s president, Hu Jintao, does not have quite the same way with words. But on the eve of his visit to America this week he told two of the country’s newspapers that the international currency system was a “product of the past”. Something can be a product of the past without being a thing of the past. But his implication was clear: the dollar’s role reflects America’s historical clout, not its present stature.

Mr Hu is right that America’s currency punches above its economy’s diminished weight in the world. America’s share of global output (20%), trade (only 11%) and even financial assets (about 30%) is shrinking, as emerging economies flourish. But many of those economies, such as South Korea, still sell their exports for dollars; many, including China, still peg their currencies to the greenback, however loosely; and about 60% of the world’s foreign-exchange reserves remain in dollars.

This allows America to borrow cheaply from the rest of the world. Its government has been able to overspend, secure in the knowledge that its IOUs will be bought by foreign central banks, which are not too fussy about price. America would show more self-discipline, many Chinese believe, if the dollar had a little bit more competition.

Could the yuan become a rival? China’s economy will probably surpass America’s in outright size within 20 years. It is already a bigger exporter. It is prodding firms to settle trade and even acquire foreign companies in its own currency. That is adding to a pool of “redbacks” outside its borders. These offshore yuan are, in turn, being tapped by borrowers, issuing “dim sum” bonds in Hong Kong (see article).

But as the dollar’s history shows, economic clout is not enough without financial sophistication (see article). If foreigners are to store their wealth in yuan, they will need financial instruments that are safe, stable and easily sold. Dim sum makes for a tasty appetiser. But the main feast of China’s financial assets is onshore and off-limits, thanks to its strict capital controls. The government remains deeply reluctant to let foreigners hold, buy and sell these assets, except under tight limits. Indeed, it is barely ready to give its own people financial freedom: interest on bank deposits is capped; shares are largely owned by state entities; and bonds are chiefly held by the banks—which are, in turn, mostly owned by the state.

Over time China will relax its financial grip. But even if it could usurp the dollar’s role as the world’s currency, it will not replicate the American set-up. The United States takes advantage of the dollar’s position to borrow cheaply from the rest of the world, selling its assets in return for goods. China is a mirror image of this. It runs a trade surplus, selling goods in return for financial claims on foreigners. Its firms, households and government save more than they can invest at home.

A different kind of perk

Rather than seeking to borrow in its own currency, China may harbour the opposite ambition: to lend in its own currency. The exorbitant privilege it may covet is a lower foreign-exchange risk on its savings. On top of the trillions China has lent to America’s treasury, it also holds stakes in Australian mines, African farms and Swedish car companies. But because none of these assets is in yuan, China suffers a capital loss whenever its currency strengthens. It would no doubt like to share some of this risk with the rest of the world. The model is not America, but Germany, an international creditor which holds 70% of its foreign assets in euros.

There is a catch, though. No one will want to borrow in a currency that is only ever going to strengthen, increasing the value of their debts. So if China wants to “yuanify” some of its claims on the rest of the world, it will need a currency that can go down as well as up. To make people believe the yuan can fall tomorrow, China will have to loosen its currency’s peg and let it rise faster today. China is different from America: it is a rising economic power and a thrifty one. But one rule still holds: China will have to open its financial system to the world if the yuan is to be the dominant currency.

Mitul Choksi

24-January-2011

8:31 PM Indian Standard Time