Helping you make sense of the global economy with Islamic finance.

Join my newsletter by subscribing below. Discover a different perspective on macroeconomics and global financial markets. I'm here to help you make sense it of all through an Islamic perspective.

Check the Assumptions

What’s economics?

Simply put, it’s a social science.

A social science devoted to the study of production and consumption of goods and services and how they are traded between members of a society.

The core of economics boils down to solving one problem: how do we allocate the limited resources available to us given our unlimited wants and needs?

We’re a greedy bunch of people that can’t ever be satisfied. 

We have to figure out how best to allocate the resources we have to produce everything that we want and need.

So economists try to come up with solutions.

But economists are as useful as politicians.

The issue is that social sciences are subjective. Unlike hard sciences such as physics, there are no concrete rules and laws. Only assumptions.

And humans are very complex creatures.

There can be no certainty when dealing with human nature. The only certainty is the level of unpredictability.

How you react under a set of circumstances is always going to be different to how someone else reacts.

Economics tries to simplify this using assumptions to better explain the world we live in and how we interact with each other from a business perspective.

But why must one set of assumptions trump another?

We quickly forget that our reasonings rely on these assumptions and replace them with what we think is the truth. 

Most people don’t care about the truth if they can extract all the utility they need from assumptions. 

The more successful people become whilst relying on these assumptions the less inclined they are to seek the truth and will always rationalise these assumptions.

Until a calamity unfolds where the assumptions have to be revisited.

When I first started studying economics, I naively accepted the theory as gospel. I ravaged through macroeconomic textbooks believing that this is exactly how things work. 

Sure, I was aware that these were models. And models aren’t perfect. But I was convinced, like so many others, that this was the best way to explain the world we lived in.

The issue is that most schools and universities teach a particular branch of economics: Neoclassical economics and more precisely, Keynesian economics.

The question you must ask yourself though, is why are we taught economics based on certain assumptions? And why are we never taught to question these assumptions and these models?

What we fail to consider is why the economic assumptions we employ are so important.

The same assumptions and models shape the decisions of politicians and economists around the world.

If governments decide to implement certain policies, they better get their assumptions right. If they don’t, everyone else suffers.

On top of that, why must we use certain assumptions over others? What determines whether these assumptions are right? Why can’t we just stick to one model for economics rather than having different schools of thought?

There are three main reasons:

  1. Economists can’t agree on the foundations because the foundation of economics is an unanswerable question. There’s an element of philosophy and morality which means the very core of this social science is up for debate. Everything else will then spring up from the assumptions used here.
  2. Economies are practically impossible to experiment on. You want to test a new policy? Most likely you’ll have to implement it and see what the results will be. It can take several years to see the result. We can try looking at what past economies have gone through with similar policies but so many variables are at play that the same policy will most likely have different effects in different economies.
  3. Economics affects everything in our daily lives. Therefore there are so many opinions and many people will want to have a say.

We have to dig a little to see how we’ve come to accept today’s economic doctrine.

The Different Schools of Thought

Most will be familiar with Adam Smith from the 18th century.

Touted as the father of economics, we owe much of our understanding of modern economics thanks to his theories.

One of them being the ‘invisible hand’ of market production. 

Simply put, if the market is left alone, without government intervention, it will move towards economic growth. 

The main idea is that if everyone acts in their own self-interest, citizens will come together to produce what is needed in the pursuit of profit thus making the market efficient. 

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” - Adam Smith

Seems reasonable.

I’ve discussed previously how the teachings of the prophet Muhammad (peace be upon him) also espoused this free-market approach. He refused to control prices. He let the market decide for itself.

Another important theory that Adam Smith explained was the division of labour.

He used the example of a pin.

It’s only when the production of the pin is split into specific stations and work tasks can the number of pins produced be maximised. 

Imagine if each worker did all the tasks to produce one pin? Sourcing the metal, forging it, cutting it down etc.

It would take a lot more effort and the number of pins produced would be many times less.

Adam Smith saw the division of labour as an important method to increase productivity and thus economic growth. 

He wasn’t wrong. 

Whether this turned men into soulless machines is up for debate. We can’t deny the explosive economic growth the world experienced thanks to industrialisation from the late 18th century onwards.

We’ve all come to accept this and Adam Smith’s name is ubiquitous amongst economists and financiers.

But did you know that someone by the name of Ibn Khaldun explained this very same concept 400 years earlier?

Yeah, you probably don’t.

“When six or ten persons, including a smith and a carpenter to make the tools, and others who are in charge of the oxen, the plowing of the soil, the harvesting of the ripe grain, and all the other agricultural activities, undertake to obtain their food and work toward that purpose either separately or collectively and thus obtain their labor a certain amount of food, (that amount) will be food for a number of people many times their own. The combined labor produces more than the needs and necessities of the workers.” - Ibn Khaldun

Funny then how we don’t consider Ibn Khaldun to be the father of economics.

Again, learn to question everything. Question all assumptions. Dig for yourself.

But let’s park this tangent to the side and continue with the false assumption that it all started with Adam Smith.

His views were challenged by Karl Marx, in the 19th century, arguing that the market mechanism wasn’t efficient. Instead it created great inequality between workers and entrepreneurs.

This led to developments in communism and socialism and any state that employed this economic thought process failed miserably. No further comment needed.

If anyone claims that China is successful, then please dig into their economic model which is clearly a form of government-controlled capitalism.

Then came Neoclassical economics.

This was developed in the early 20th century to provide a natural evolution to the Classical economics model from Adam Smith.

Instead of taking the classical approach whereby the most important factor in a product’s price is its cost of production, Neoclassical economists argued that the consumer’s perception of the product’s value is the driving factor in its price.

In other words, utility to consumers is the most important factor in determining the value of a product or service.

Neoclassical economists believed that the consumer’s first concern is to maximise personal satisfaction (i.e. utility). This however, assumes that people act rationally when making economic decisions. That’s not always true.

Picture yourself born in the early 18th century. Do you think you could envisage a world where there would be too much of one thing?

It would have been hard to think like that. So Classical and Neoclassical economists pushed the idea that we should produce as much output as possible and the market will deal with all the surplus.

The Austrian economists realised that there was an issue here. They introduced an important concept: the ‘marginal utility’ of a good or service. 

Imagine you want a cup of coffee.

You’re happy to pay for the first cup.

Maybe for the second cup.

But for a third and fourth cup? Probably not. You won’t even drink it if it was given to you for free.

This is where the Austrian school of thought brought a practical element to economics and taught the world how to deal with sustainable growth.

We have to look at things at the margin and not just compare product A to product B in terms of how valuable they are in the general context. You have to ask yourself, which product is more valuable to you right now given your situation?

If product A is abundantly available, you won’t want to pay large sums for it. Likewise, if product B is rare and desirable, its price will be much higher.

A good example is comparing water and diamonds.

Why is it that water is so cheap even though it’s the most valuable resource to us on earth? On the other hand diamonds, which are completely unnecessary, are super expensive.

It all comes down to abundance and the fact that water is readily available (in most places) whereas diamonds are rare.

The Austrian school of thought cared mostly about letting the consumers decide what they want. The market will converge itself to producing what is requested by the consumers in the most efficient way.

But consumers aren’t always the best judge of what is best for them. Some intervention will always be necessary.

Later on came John Maynard Keynes. Keynes became popular thanks to his theories following the Great Depression of the 1930s and WW2 and developed on the Neoclassical model. He believed that government intervention was needed as demand and supply would not automatically rebalance. 

In other words, the market needed a push to go back to a healthy equilibrium.

Fiscal policy - government spending and adjusting the rate of taxation - would play an important role to help rebalance market demand and supply in the economy. So he claimed.

The American president, Franklin D. Roosevelt became a historical figure with his ‘New Deal’ of the 1930s to help alleviate the catastrophic effects of the global depression. This large intervention became a template for Keynesian economics.

Keynesian economics stipulates the use of fiscal policy and monetary policy - changes in interest rates and increase in money supply -  as important tools to slow the economy during booms and stimulate it during recessions.

This is the accepted school of economics and one that most governments have come to base their policies on.

Austrian economists are very much against this idea given they believe this is tampering with free markets. Because of this intervention, the economy becomes inefficient. Government intervention does more harm than good.

If you’re a politician, you clearly have an interest to dampen a recession rather than ‘letting the market deal with it’. It’s why Keynesian economics is the go-to for governments.

Politician A tells the nation that the market will correct itself and it’s a matter of time before the recession is over.

Politician B tells the nation that the recession doesn’t have to be that bad and the government can spend more by borrowing more and thus help save jobs.

Who do you think will get more votes?

Nevermind what the long-term implications of this short-sightedness will lead to. It goes back to incentives. Read my previous articles (here and here) on incentives. 

When politicians have no skin in the game, they’re incentivised to present any short-term solution if it means staying in office.

So politicians are incentivised to follow Keynesian policy. Thereby also incentivised to regulate money and print as much of it as possible.

The main difference between Neoclassical and Keynesian economics is that Neoclassical economists believe that supply is the most important determinant to affect the macro economy.

In other words, the focus should be on supply-side policies: focusing on education, increasing the labour force, technological advancements etc.

On the other hand, Keynesian believe that it comes down to aggregate demand and therefore intervention helps fuel consumers to buy and businesses to invest.

All Theory but No Soul

Given its popularity in the mainstream, we will focus on the issues of Neoclassical and Keynesian economics.

Let’s go back to the initial assumption of Neoclassical economics: humans aim to maximise utility (i.e. personal satisfaction).

The issue with this is that seeking utility is limitless. 

Whilst we may have a lower margin of utility over time for a specific good or service (as the Austrian economists have rightly pointed out), we will constantly desire newer and better goods or services.

“Pleasure and pain are undoubtedly the ultimate objects of the Calculus of Economics. To satisfy our wants to the utmost with the least effort ... in other words, to maximize pleasure, is the problem of Economics.” - William Stanley Jevons

This clearly doesn’t align with Islamic values.

Even if you’re not a Muslim, ask yourself if this is sustainable.

Humans left to their own accord will pursue their desires relentlessly and seek to maximise pleasure.

It has to be reigned in. If not, we become animals devouring the world’s resources in an attempt to fill our insatiable appetites.

Islamic economics thinks beyond individualism. It’s not just about maximising utility.

Sure, seek wealth. Seek growth. But know that there are limits.

The very first thing is to understand that Allah owns everything. Our souls, bodies and our wealth. This is in contrast to the world’s dominant way of thinking that we own ourselves and therefore own all that we produce.

By understanding that nothing truly belongs to us, we detach ourselves from material.

We are less likely to want to hold on to our wealth and be greedy towards the needy.

The obligation for each Muslim to give charity (zakat) gives the needy a right over a portion of our wealth. This very principle solidifies the distinction between Islam and economic individualism.

On top of that, Islam promotes a free-market economy with little government intervention.

Certain rules have to be implemented such as what is permissible and certain industries, like defense, have to be heavily regulated. But overall Islamic economics falls more in line with Austrian economics.

What’s interesting to note is that Keynesian economics can only really be effective when money is controlled by the government.

Let’s say that the economy runs on a gold standard. There is no fractional reserve banking and all the money we use is backed by gold.

How can the government increase spending?

One way is to increase taxes on the wealthy but that’s not entirely effective. Increase in taxation will most likely result in lower consumption and investment which will affect aggregate demand and reduce output.

The whole point of increasing government spending is to increase economic output.

Clearly the government can’t spend more than the gold it receives from collecting taxes.

On the other hand, if there’s no hard money, the government can simply print more of it.

Governments can borrow money which will be printed by the central bank and use the proceeds to spend on whatever it wishes. Whatever wins votes.

You cannot have Keynesian economics without the financial ponzi of a banking system that we have come to rely on. It just won’t work.

Governments are in too deep. They’re addicted to borrowing to win votes. They continue to kick the can down the road.

Why would they want to teach an alternative school of thought in school? Imagine what would happen if the next generation of economists were to refute all these assumptions.

It’s funny to think of it but I only came across Austrian economics when I started diving deep into Bitcoin. Even after having studied economics at university. Saifedean Ammous, author of the Bitcoin Standard, is a big proponent of the Austrian school of thought so I have him to thank for that.

Not once did we ever discuss this in any of my economics classes.

So it’s about time we throw away those assumptions and go back to the drawing board.

Ask the Right Questions

So far I’ve given an overview of the different branches of economics.

I hope I’ve managed to get you thinking. To ask the right questions. To question why a certain branch of economics is considered ‘standard’.

But I haven’t really dived into the issues of Keynesian economics.

It can’t be completely wrong if it’s been implemented for decades. Right?

I’ve only discussed the incentives as to why Keynesian is put at the forefront of economics.

In the next article, I’ll dive deeper into why Keynesian economics is flawed. I’ll expand on how the government’s preference for controlling money and issuing debt goes hand in hand with Keynesian economics.

It’s easy for me to argue that Keynesian economics is alive and well thanks only to the monetary ponzi we are living through.

But does that make it an inherently bad model?

Watch out for next week’s article for more on this.

Secret muslim banker profile picture
About Me

I manage a $100m private investment fund and I explore Islamic finance and economics through a personal lens. I help simplify financial markets from a Muslim perspective.

Subscribe below for more insights.

Learn More