America’s Growing Labor Shortage

By: Jacinta Sherris

What America’s Growing Labor Shortage is telling us about Wages, Education, and the Future of American Workers

Globalization and technological change have suppressed wage growth for many middle and low income Americans over the past few decades. Up until 2013, wage growth for Americans was stagnant at 6%- a number unchanged since 1979. While the poorest Americans have actually seen their wages decrease by 5% since 1979. Coupled with rising costs of living, high unemployment rates through the last recession, and enormous increases in the cost of education, it seemed for a while that the average American worker was in a pretty bad situation, at least until recently. Millions of jobs over the last few years have been added to the American economy, and this trend shows few signs of slowing. At 4% unemployment, it now appears that The United States is in fact facing a labor shortage, and might continue to face a disequilibrium for some time. Although businesses are having difficulties adjusting to this shift in the labor markets, middle class Americans have reason to be hopeful about the future for the first time in awhile.

According to Deutsche Bank Economist Torsten Slok, it can take up to 31 days to fill an open job in America, up from 23 days in 2006, and about 15 days in 2009. As of last summer, 85% of small businesses that were actively hiring reported few or no qualified applications for their positions. A Federal Reserve survey found labor shortages all over the United States. It appears that job growth has increased the demand for new workers, whereas an aging population, coupled with new jobs requiring higher skills than ever before, have kept the supply of workers constant. Some studies point to the labor participation rate actually decreasing. Indeed, the labor force participation rate for men age 25-54 is currently around 89%, a figure less than other OECD countries’ such as Germany, France, Canada, and Britain. The result is a disequilibrium in the labor market, in this case a labor shortage.

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Aging demographics are part of the reason why the labor supply in the United States has remained constant in response to the recent increase in demand for workers, a factor which may be offset by automation. Other reasons why able Americans are not jumping into newly created jobs but instead are choosing to remain out of the labor force, has to do with everything from wages, to the American education system. Although labor shortages can be felt throughout various industries, many are concentrated in sectors that are plagued by a lack of qualified candidates.

Many companies are concerned about losing out on business and growth opportunities, as difficulties in finding and training qualified employees can be costly. Though it seems what they fear most is having to raise wages in order to attract more applicants. Many economists seem to be indifferent towards the same labor shortage that has made business owners uneasy. Minneapolis Fed President Neel Kashkari summarized this viewpoint by stating what is obvious to economists, “if you’re not raising wages, then it just sounds like whining.” Indeed, Macroeconomics 101 explains how when demand exceeds supply in a given market, the price (in the case of labor markets this is the wage) must be increased in order to create a new equilibrium.

To some, the American shortage of labor may read as a signal to increase real wages, which many consider as long overdue. Although nominal wages have been growing in recent years at a rate of 2.6%, they still have not caught up to target growth levels of 3.5-4%. Many economists are pointing to the disparity between actual and target rates of growth as not only the reason behind the labor shortage, but also as a sign that many Americans still have not reaped the benefits of the economic recovery from the Great Recession. Although many businesses have begun to raise their wages, economists are emphasizing that more needs to be done for employers to remain competitive in a labor market with a 4% unemployment rate.

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Increasing wages will almost certainly incentivize many Americans to reenter the workforce and increase the labor participation rate. But then there is still a question of how much wage increases can accomplish in ultimately transforming the labor shortage phenomena into a golden era for the American worker. Especially considering a large part of the reason why many Americans haven’t benefited from the creation of millions of new jobs is because of a mismatch between their training and qualifications, or what is known as a skills gap.

A skills gap exists when the training or education for a job is inadequate to the job’s demands. So even though the demand for workers is rising, they are not the types of jobs that many Americans are qualified for. Professor Alan Krueger at Princeton University explained that, “The jobs in demand are more skilled than the workers we have.” The National Skills Coalition, a nonprofit organization, calculates that middle-skill jobs in computer technology, health care, construction, high skill manufacturing as well as other fields account for 54% of the total labor market, while only 44% of workers are sufficiently trained to do these occupations. The labor force participation rate for prime-age workers is 88% for college graduates, 81% for those with some college, 76% for those with a high school diploma and only 66% for those without a high school diploma.  Figures like these suggest that where there is a substantial shortage in labor, there is a high correlation of low education attainment levels within the population. It is precisely these individuals that would benefit the most from additional training programs in order to be productive workers. Many people may think that a solution to this issue is to increase college enrollment for more Americans, but it is precisely the current education system that is failing to provide students with the skills they need to be successful in a changing workplace.

The belief that an increase in college enrollment is the solution to providing the prospective workers with skills needed for the modern workforce has resulted in what is known as degree inflation. From 1975 to 1995, all American workers’ education rose by 1.5 years, despite the fact that most jobs didn’t change much during that time period. Implying that more education for more Americans resulted in them not necessarily getting better jobs, but needing more education to do the same jobs that had been held by others with less education not too long ago. Degree inflation sets up many young people for disaster as it steers too many students who aren’t cut out for academic success onto the college track, wasting time, money & resources.

According to economics Professor Bryan Caplan of George Mason University, “The college-for-all mentality has fostered neglect of a realistic and important substitute: vocational education.” Either through the form of classroom training, apprenticeships, or other types of on-the-job training, students could be taught specific, in demand job skills at fraction of the cost and time of an university education. Research even suggests that vocational training raises pay, reduces unemployment, and increases the rate of high-school completion. With the rising costs of a college degree and the ever changing economy of the future, it is imperative that young people are given more practical and less costly avenues to career opportunities.

In order to fully close the skills gap the American labor market is experiencing, and ensure businesses will continue to grow and foster innovation, Americans who haven’t attended college need to be given opportunities for training and practical skill advancement. Business leaders are in a position to initiate cooperation with local high schools, colleges and community-based organizations to develop curricula that would produce candidates with the skills needed to fill job openings. An example to follow may be that of the Swiss education system, where compulsory education ends at the 9th grade level, after which students can choose between a vocational or academic path. About 30% of students choose the academic path which focuses on a minority of professions such as law or medicine. Nearly 70% choose the vocational track and enter different programs which prepare them for a variety of occupations. Subsequently, Switzerland’s youth unemployment rate is about a quarter that of the United States’.

The future will bring an increasing amount of technological disruptions along with unpredictable amounts of structural change. It is imperative that the United States create opportunities, both at the private or public level, for workers to be trained and retrained for the 21st century labor market. Skill training programs such as these will increase labor force participation, alleviate the astronomical problem of student debt, create sustainable economic growth for the middle class, and ultimately ensure a strong and adaptable economy. Currently young Americans’ choices after high school are either college or minimum wage employment.  Future economic prosperity is relying on America’s ability to utilize the dormant talent and skills of its citizens that have yet to be realized.

Sources

Appelbaum, B. (2017, May 21). Lack of Workers, Not Work, Weighs on the Nation’s Economy. Retrieved April 09, 2018, from https://www.nytimes.com/2017/05/21/us/politics/utah-economy-jobs.html

Bachman, D., Dr. (2017, December 18). Where’s the Labor Shortage? Retrieved April 9, 2018, from Where’s the labor shortage? (n.d.). Retrieved April 09, 2018, from https://www2.deloitte.com/insights/us/en/economy/behind-the-numbers/understanding-labor-shortage-economists-versus-business.html

Caplan, B. (2017, December 09). The World Might Be Better Off Without College for Everyone. Retrieved April 09, 2018, from https://www.theatlantic.com/magazine/archive/2018/01/whats-college-good-for/546590/

Coy, P. (2017, July 07). Five Signs Point to Skill Shortages in the United States. Retrieved April 09, 2018, from https://www.bloomberg.com/news/articles/2017-07-07/five-signs-point-to-skill-shortages-in-the-united-states

Journal, W. S. (2017, March 29). America’s Growing Labor Shortage. Retrieved April 09, 2018, from https://www.wsj.com/articles/americas-growing-labor-shortage-1490829265?mg=prod/accounts-wsj

Kaplan, R. (2017, April 12). America Has to Close the Workforce Skills Gap. Retrieved April 09, 2018, from https://www.bloomberg.com/view/articles/2017-04-12/america-has-to-close-the-workforce-skills-gap

Mishel, L., Gould, E., & Bivens, J. (n.d.). Wage Stagnation in Nine Charts. Retrieved April 09, 2018, from https://www.epi.org/publication/charting-wage-stagnation/

Porter, E. (2017, September 19). Unemployment Is So 2009: Labor Shortage Gives Workers an Edge. Retrieved April 09, 2018, from https://www.nytimes.com/2017/09/19/business/economy/labor-shortage.html

Selingo, J. J. (2017, January 30). Wanted: Factory Workers, Degree Required. Retrieved April 09, 2018, from https://www.nytimes.com/2017/01/30/education/edlife/factory-workers-college-degree-apprenticeships.html

Shambaugh, J., Nunn, R., Liu, P., & Nantz, G. (2017, September 26). Thirteen facts about wage growth. Retrieved April 09, 2018, from https://www.brookings.edu/research/thirteen-facts-about-wage-growth/

Udland, M. (2017, July 19). It’s never been harder to fill a job in America. Retrieved April 09, 2018, from https://finance.yahoo.com/news/never-harder-fill-job-america-155558184.html

Should Art be Included in an Investment Portfolio?

By: Jacinta Sherris

With advantages such as  the low risk and disadvantages in liquidity, the art investment market is growing with a complicated fortune.

This past November, Salvator Mundi (Latin for Savior of the World), a painting of Jesus Christ, by Leonardo da Vinci, was up for bid at the renowned Christie’s auction house in New York. Despite disputes over its authenticity and undergoing restoration, the painting sold for a whopping $400 million in less than 20 minutes, making it the world record for the most expensive work of art ever sold. In 2004, a dead shark preserved in formaldehyde solution within a glass container, a piece called The Physical Impossibility of Death in the Mind of Someone Living by Damien Hirst, sold for $12 million making it the most expensive artwork sold for its time by a living artist.

The reasons some pieces of art can sell for such exorbitant prices has to do with cultural significance, limited supply (especially if the artist is deceased), artistic trends, branding, and ultimately the super wealthy driving prices upward as they compete for the most valuable in auctions. The artist’s reputation, the size and genre of the artwork, the prices of similar pieces, and the locations of the artists exhibitions  all play incremental roles in creating the sense of urgency and competition that drive bidders to pay far beyond what many would believe for a painting or sculpture. Ultimately, according to Clare McAndrew, founder of Art Economics, the reason that art can be so expensive is due to its scarcity, and how everyone is chasing the same few artistic names. Works of art do have creative, aesthetic, historical and cultural values, but it is often the vying for a few top name brand pieces that can drive up prices to astronomical amounts. The price tag of a painting or sculpture resembling the value of luxury real estate might receive eye rolls from the public, but high figures have caught the attention of economists, investors, and bankers. Nowadays, about three-quarters of art buyers are acquiring art for investment purposes. Many have begun to explore the benefits of protection that art as an asset class can offer a portfolio, but investors are still wary of the various perils associated with this type of diversification.

Artwork is categorized as a low-risk asset because it generally does not lose its principal value. This is due to artworks’ behavior as a luxury good and thereby having a high-income elasticity of demand. Artwork also shares features of many positional goods in that its value is a function of its desirability and its supply is inherently scarce (even in the short run for a living artist’s pieces). Characteristic of most luxury, positional, and even collectible goods, the value of artwork tends to appreciate over time and rarely loses principal value as its supply is inherently limited. Investors have begun to utilize these features that categorize art assets to guard their portfolios against inflation and currency devaluation. Artwork is also likely to retain value during turbulent macroeconomic conditions, though the extent of this durability is often of much debate between financial experts.

Some further advantages that come with purchasing art for investment purchases include certain tax benefits, and although artwork does not generate a discounted cash flow similar to a bond’s coupon or a stock’s dividend, some artwork can be lent out in return for a rental fee. There are also numerous financial institutions and even art funds that allow artwork to be put up as leverage for loans which could be used by an institution or an individual to refinance, raise liquidity, or fund new investments. Art markets are also known to be less volatile than other asset markets, primarily due to illiquidity constituting a primary characteristic of this asset class. Many investors and art industry experts also assert that the art market is negatively correlated with other financial assets, making it an ideal candidate for diversification. However, the extent of this is often debated and has not always proven to be true.

Like any asset class, artwork is not without its shortcomings that investors need to be aware of. Art is incredibly illiquid which makes speculative, short-term investments enormously risky and unattractive. One of the major issues with artwork is the opaqueness surrounding pricing and prevalent lack of transparency in the art market. Most investment decisions are based off an asset’s worth in relation to its price, but neither can be pinned down in an elusive art market as many transactions happen behind closed doors, and the parties involved are usually incredibly secretive about pricing. Art galleries and art dealers rarely reveal prices to the public, making past auction prices the best place to start in determining the value or potential future value of a piece. A couple of indexes attempt to report on values of the art market including Art Market Research and Mei Moses, though they are unable to capture the entirety of the market.

Issues such as these make it imperative for those looking to purchase art as an investment to consult with an appraiser. Because art assets tend to turn over relatively slowly and trade thinly, they must be assessed and analyzed with human expertise and subjectivity in order to gauge possible returns on investments. Hiring such experts can be costly, however, and increases the transaction costs of investing in this asset class. Nowadays, art investment funds are making it easier for prospective investors to diversify their assets into the art industry while simultaneously reducing the cost of acquiring the information needed to make such decisions.

Art investment funds operate much like private equity firms. They combine art industry expertise coupled with opportunities for returns on investment. Well-managed, knowledgeable art funds generally generate returns between 6-8%, while returns from 10-15% are considered extremely lucky and require increased risk. The Fine Art Fund is one such example that boosts an average return of 9% on investments before 1% to 3% in management fees and 20% of profits made (only after a 6% return) are taken into account. Still, such firms have limited opportunities for investments that often depend on the duration of their funds as well as how much money is being offered for deposit.

Art funds are offering investors the promise of the benefits of low-risk returns that come with investing in art, and have succeeded in lowering transaction costs for prospective investors. However, they are not without their shortcomings and do not entirely wipe out the issues facing art investors, primarily the lack of transparency central to the art market. After the recession of 2008, many investors were eager to diversify into less volatile markets. Whether art markets will remain a viable option for investors depends on how willing the industry is to accommodate to the needs of investors in terms of regulation and transparency.

Sources

 

The Truth Behind the Gender Wage Gap

By: Jacinta Sherris

Are Women really making 78 cents for every dollar a man earns? And if so, why?

This past year has brought to light the role women play in contributing to society, with the economy at the forefront of discussion. The issue of gender economic inequality has captivated American politics. “Equal pay for equal work” has been chanted with much anger and outrage towards the notion of the gender wage gap. But is it really true that women are being paid 78 cents for every dollar their male colleagues make? In order to properly address the issue we need to investigate the inner workings of the gender wage gap.

Much of the news surrounding the gender-wage gap revolves around the statistic that women make 78 cents for every dollar a man earns. People are left to conclude that women are paid less than men in the same jobs and that this is ultimately due to discrimination. Although there are definitely cases where a woman may be earning less than her male counterpart in the same field, the truth of the matter is that there is more to this statistic than meets the eye. The statistic represents the median annual earnings of all women and all men working full-time in the United States. It does not take into account education levels, hours worked, job positions, and therefore overlooks incredibly important determining factors specific to women. In fact, data from 25 countries collected by Korn Ferry, a consultancy,  firm, show us that women earn 98% as much as men who do the same job for the same employer.

The truth is that women and men are often segregated between occupations, industries, and ranks. Many times women occupy lower paying professions and positions.  Teacher, nurse, secretary and health aide are the top four professions occupied by women, at around 80%. That percentage decreases substantially when looking at managerial or higher ranking positions. The shortage of women in higher paying occupations and senior positions are definitely not the result of a lack of motivation, talent, or competence, but ultimately due to the cost of motherhood and familial divisions of labor. Indeed, women tend to occupy more lower-paying, less skill intensive jobs, despite many being overqualified because of the difficulty they face in balancing familial and career responsibilities.

When families members need care, such as a child or an elderly parent, it is often the woman that takes up the responsibility. Mothers with newborn children are often the ones to assume additional caretaking duties since they are already at home recovering post birth. Such seemingly simple or temporal decisions can have enormous consequences in the long run. Consequences include lower overall economic productivity from unused talent and potential, increased chances of poverty for women who divorce, and ultimately the gender wage gap.

A study from Harvard University suggests that the pay gap between mothers and non-mothers could in fact be larger than the overall pay gap between men and women. In the United States, women do not have a legal entitlement to paid maternity leave. Many women are often forced to altogether quit their jobs after having a baby. Because child care can often be very expensive or unavailable in terms of the quality and hours a mother is looking for, many women often have to sacrifice their careers or fall into lower-paying, under qualifying jobs that offer the flexibility in hours they need. Indeed, jobs where the gender wage gap is most severe are correlated with rigid hours that offer little leeway for people needing to accommodate familial responsibilities. Motherhood coupled with a lack of flexibility in the workplace, is where women tend to fall behind on the careers ladder as they struggle to balance professional success with familial responsibilities. It is often the case that the opportunity for the first critical career promotion coincides with the opportunity to start a family.

International surveys with data from both the EU and the United States, show us that out of all the women with children at home, 44-75% had scaled back after becoming mothers by working fewer hours or switching to a less demanding job with less travel or over time. Such career options almost always coincide with less pay. On the contrary only 13-37% of fathers said they had also scaled back after having children, of whom more that half had a partner that also scaled back. What is known to be the motherhood penalty- or the cost a woman endures to her career by becoming a mother- can be seen reflected in terms of monetary and social welfare. A recent American study put the motherhood penalty in causing a 4% decrease in a mother’s wages for each child, and as high as 10% for the highest earning, most skilled women. Women who are out of the workforce for a longer duration must commonly accept less demanding and rewarding positions in an attempt to restart their careers. Indeed the long term consequences of women missing out on professional development can be severe. Resulting in not only lower wages for women, but increased discrimination against mothers, waste of human talent, skill, creativity, and ultimately a decrease in productivity due to lack of diversification in many fields.

The issue of the gender pay gap is not so much the result of outright discrimination but rather the result of an institutional failure according to Harvard economists. An institutional problem that places value and incentives that do not align with the realities women face, therefore putting women on the back burner and ultimately causing a loss in economic productivity and well-being for society. Although programs for alleviating the gender wage gap have been criticized as costly or unfair “special treatment”, there are ways we can shift societal incentives to not only reduce the gender wage gap in an uncostly manner, but also improve economic productivity and familial happiness. One way to do this is to restructure current paid maternity and paternity absences. Research shows that an increase in paternity leave can have enormous benefits for children, mothers, families, and the rest of society. Fathers become engaged with their children, contributing to the children’s well-being and prospects of thriving later on. Women whose careers have not been derailed by motherhood also end up paying higher taxes as they continue to advance in their careers. More and more fathers want to have a larger part in their children’s lives, and giving them a legal right to request paid absences will have enormous benefits for everyone.

Women ultimately are faced with the difficulty of reconciling familial and career goals. The current gender wage gap is a byproduct of this conundrum, and not necessarily a result from direct workplace discrimination. Yet, the problem and more so the solution is complex nonetheless. What we do know is that women tend to be more successful in different areas of their lives when they have access to flexibility. This can mean flexibility in the hours they work, day care options, or simply the diversification of familial responsibilities that comes with increasing men’s engagement at home. Women face different realities than men, and the current incentives of the modern day workplace and economy neither recognize nor appreciate this fact. John Stuart Mill, the late British political philosopher and economist, recognized that women and men are indeed different, and it is the work environment and the incentives at force that contribute to the achievements of women in society.

Fortunately incentives can be changed, and they do tend to change as political and social climates shift. There may be some who believe it would be easier, or even beneficial, to simply continue the separation of work between the sexes and not bother to change incentives. But if we simply remember that economic growth ultimately results from capitalizing on the talents, skills, and potentials of all citizens, that women with goals and opportunities tend to be happier and turn into happier and more powerful mothers for their children, and that future generations reap the biggest benefits from increased engagement from both their fathers and mothers, we will recognize the need to change incentives in both society and the workplace. This will mean creating incentives for workplaces to accommodate families and ultimately improving upon the balance between work and family for both men and women.

 

Sources

The Market Rallies (For the Few)

By: Jacinta Sherris

Enormous stock market returns are not telling us everything we need to know about the American economy

It is no secret that the recovery from the 2008 financial crisis has been a long and grueling one. But with interest rates set to rise in 2018, national unemployment at its lowest point in 16 years, and financial markets performing exceptionally well, it appears that the recovery process is finally over and the economy is growing once again. Indeed, 2017 so far has been an outstanding year for financial markets. News that the stock market is currently reaching all time highs has been celebrated, tweeted, and even proudly proclaimed by some of America’s politicians. While there is much to celebrate, it is important not to become too carried away.

Economic growth is a complicated phenomena that is measured in a variety of different ways. Stocks are essentially partial ownership of a firm and when stock performance increases, it is an indicator of increased faith in the profitability of firms. However, while stocks are important an economic signal, they are only a small part of the entire picture of economic health.

Gross Domestic Product (GDP), though not perfect, is meant to provide a more realistic indication of economic growth. Unlike stocks, which report earnings of public companies, GDP is comprised of more inclusive data of all markets in an economy, including investment, government spending, consumption, and the foreign balance of trade. GDP (especially real GDP which adjusts for inflation rates) is used as a broad measurement of economic activity and an estimate of the standard of living.

There are many ways in which GDP and stock market returns do affect one another, and it is intuitive to assume that strong economic growth and high stock market returns are correlated. However, data from the long run shows us that the relationship between real GDP growth and stock returns are weak, or even in some cases non existent. In fact, in most countries around the world, including the United States, stock returns on average have greatly outweighed real GDP growth since the 1970’s.

This lack of correlation between real GDP and stock market returns can be explained by the fact that although they are related in some ways, they fundamentally represent different things. Long-term economic growth and especially real wage growth are in many ways independent of fluctuating financial markets. This is why it is important, especially for politicians who should be concerned with long-term growth, to not become overly excited by the all time highs Wall Street has been reporting. Real GDP, sustainable employment opportunities, and real wage growth against inflation are what is important to most Americans.

In fact, many Americans may not even be feeling the benefits from the current bull market. According to Gallup, in 2016 only about 52% of Americans currently have money invested in the market (either through stocks, mutual funds, or retirement plans like a 401(k)), with the wealthiest 10% owning 81% of all stocks. This means that almost half of Americans are missing out on the enormous heights stock returns are reaching almost daily. Though it is true that some wealth may trickle down to those who are sitting out on the gains to be made, it is also suggests that there is still a lot that needs to be done in order to raise the standard of living for millions living in the United States. Simply rejoicing over financial market returns is not enough.

Financial markets may also not be displaying the entire economic reality because of the extensive rounds of quantitative easing (QE) that took place in response to the financial crisis of 2008. After the crisis, the Federal Reserve essentially created money to buy the enormous debts banks held on their balance sheets in order to preserve the supply of credit to the rest of the economy. A healthy supply of credit is vital in order to keep the economy going (think about what would happen if no one could get a loan to start a business or buy a house), but there are repercussions of QE. One such example is the prevalence of low interest rates coupled with over valued assets. According to The Economist, the enormous returns in financial markets today is likely the result of rounds of QE from 10 years ago.

American consumers and demand are by far the biggest factors driving economic growth. Another consequence of QE is the result of creating or sustaining a false level of demand in the economy. Think about walking into a store and seeing something so ridiculously cheap, so heavily marked down from its original price that you buy it even if you do not really need it or even want it. That’s essentially what has been going on in the economy as a result of QE. And with interest rates are set to rise this year, it is imperative that demand levels do not fall. Keeping domestic demand strong and therefore the purchasing power of the American consumer strong is a determining factor of the health of the American economy. This is done by ensuring real economic growth, wage growth, and productivity growth.

Despite a slow but sure recovery from the Great Recession, productivity growth has been sluggish within the Western world in recent years. This may be due to the low interest rates allowing companies that would otherwise go under to survive, new innovations being less significant than older innovations, and a preference among businesses to use extra labor when wages are low.  Either way, low productivity growth is detrimental to the economy in the long-run. In order to ensure real economic growth, rising wages, and a higher standard of living for a majority of Americans, policy makers must be keen on creating sustainable opportunities, incentives to spur innovation, and adjust our economic model to be competitive on a global scale. Not so much concern themselves with the fluctuations in financial markets.

We cannot afford to sit back and relax even though stock market returns might indicate otherwise. The economic outlook still has not improved for millions of Americans and there are still challenges we face to ensure equal opportunities and an increasing standard of living for all. With rising interest rates just around the corner, it is important to ensure the American economy is healthy enough to not only remain resilient in the face of a stock market correction, but to continue to grow at healthy rates in order to ensure a better life for its citizens.

Works Cited:

Islamic Finance

By: Jacinta Sherris

What is it and what can it tell us about our own financial system?

Islamic finance refers to financial activities and institutions that conform to Islamic, or Sharia law. Islam is one of the world’s most politically oriented religions and thus there is much religious law that governs a variety of different aspects of daily life, such as business and even finance. For most people, the workings of Islamic finance remain a mystery. Studying this fascinating sector of finance can introduce us to different cultural interpretations of money and even demonstrate how profitable conscious capitalism can be realized.

The Islamic banking industry came into existence in the mid-1970’s as a result of specific political and economic conditions, but primarily by the quadrupling in the price of oil The driving force behind the growth of Islamic finance is attributed to this supply of funds rather than the demand for Sharia compliant financing by business in the region. With enormous global reliance on oil, the Muslim world witnessed rapid economic growth. As newly wealthy Islamic conservatives began searching for investment opportunities outside of the Western financial system, they created their own financial markets in compliance with Sharia law.

Since its inception, the Islamic banking industry has had many ups and downs. Nonetheless, its growth is still considerable. As of 2015, Sharia compliant financial assets, mostly held in the form of bank deposits, bonds, investment funds, and insurance, were worth approximately US$2 trillion worldwide. Countries that dominate Islamic banking include Iran, Saudi Arabia, Malaysia, Kuwait, and the United Arab Emirates. The United Kingdom, Singapore, and Hong Kong are among some of the global financial hubs that have expressed interest in this growing niche of a financial market.

Still, most individuals do not know exactly how Islamic banking differs from conventional banking. Aside from prohibiting any transactions with entities involved with things that are banned in Islam, (including pork, alcohol, and pornography), one of the main tenets of Islamic finance is its ban on charging interest. Such a practice is incredibly remarkable for banks since in conventional finance, interest is at the core of financial markets and economies.

Interest is banned in today’s Islamic banks because of the idea that charging interest on a loan is an act of sin. The banning of interest did not originate with Islam and was in fact practiced by early Jewish and Christian societies. What is striking about considering interest sinful is that it stems from an alternative view of the nature of money. Many religions do not view money as a commodity that can be bought and sold like food or furniture. It is the idea that money has no intrinsic value and is merely a means to achieve an objective and not the objective itself. Such an idea has enormous implications on the ethics of financial markets.

Thus in modern Islamic finance, monetary transactions must be tied to some concrete economic activity and be able to contribute to the real economy in order to be deemed moral and permitted. As you can imagine, such a practice stands in enormous contrast to conventional financial markets. Swapping (essentially exchanging one cash flow for another) and trading in high complex financial assets whose values are derived from other assets to which the trader has no legal title, are common examples of transactions where value has been created despite no real economic activity. Islamic finance is often considered by its proponents to be more in alignment with conscious capitalism because of its insistence of profit being tied to production.

So the question remains as to how Islamic financial institutions can generate profit without charging interest. In order to do so, the Islamic financial system functions on partnerships between the depositors and borrowers based on sharing profits as well as losses (mudaraba).

One such example is that of an Islamic bond, known as sukuk. A traditional bond is essentially a claim on debt to be repaid at a set time in the future, along with interest. An Islamic bond is not a claim on debt but instead represents partial ownership of whatever enterprise the money was spent on and a partial claim on the profit generated by that asset (Lumpur, 2014). An Islamic mortgage, also, would not consist of a customer borrowing money to buy a house. Instead, the bank would buy the house and the mortgagor would pay monthly installments to the bank along with rent until the mortgage is paid in full. Wealth savings generally work in a similar fashion. Usually depositors will pay a premium to hold their funds with a bank and then the bank will pay them in the form of profit shares instead of interest.

It is important to acknowledge that the Islamic financial industry has had many difficulties maintaining growth and staying competitive in global markets since its inception. It has had to remodel itself numerous times and there is constantly much debate among Islamic scholars whether certain transactions are becoming too resembling of charging interest.

Another difficulty for Islamic banks is the problem of moral hazard. In economics, moral hazard is the risk that comes when one partner in a transaction has an incentive to undertake additional risks that negatively impact the other partner. Parties seeking funds from Islamic financial institutions are more inclined to use their debts in more risky ways because they are not subjected to predetermined interest payments in the same way conventional banks charge customers. The amount the borrowers owe the financial institutions is dependent upon the profits and losses of their enterprises, and subsequently if their enterprises are not successful, it is the bank that suffers the greater loss. Islamic banks are thus under an enormous disadvantage as medium or long-term loans are especially risky for them. Indeed, much of the financing in Islamic financial markets has been focused on the short-term.

Another issue for Islamic banks is that they incur high monitoring costs. They need to be actively involved with the enterprises they work with in order to ensure the proper allocation of risk and to make sure the enterprise is not manipulating its profits and losses at the expense of the bank. Fundamentally, Islamic banks face much more limitations than conventional banks in terms of raising revenue and reducing risk.

Despite its shortcomings, Islamic finance is becoming more prevalent globally. Many argue that this growth is driven by the availability of Islamic capital and the distrust towards Western institutions in the Muslim world, though this is growth nonetheless. Its financial system is also an interesting one to consider especially when trying to understand some of the challenges the modern American financial system faces.

Interest rates on student loans are one of the biggest obstacles younger generations are facing in paying off their university debts and subsequently being able to invest in their futures. Perhaps we should consider how viable it would be for students to share percentages of their future incomes with their creditors instead of paying enormous interest rates on their loans. In light of the 2008 crisis, could we conceive of financial markets being less risky if people were more aware of the underlying assets behind their securities? The growing Islamic financial system is one to watch in order to understand the realities of incorporating ethical practices into mainstream finance, without compromising economic growth and innovation.

Works Cited

Alawode. A. A. (2015, March 31). Islamic Finance. The World Bank. Retrieved from http://www.worldbank.org/en/topic/financialsector/brief/islamic-finance

Henry, C. M. (2004). The Politics of Islamic Finance. Edinburgh: Edinburgh University Press.

Irfan, H. (2015, May 15). The Nature of Money: Islamic Banking and Conscious Capitalism. The Foreign Affairs. Retrieved from https://www.foreignaffairs.com/articles/2015-05-15/nature-money

Lumpur, K. (2014, September 13). Big Interest, No Interest. The Economist. Retrieved from https://www.economist.com/news/finance-and-economics/21617014-market-islamic-financial-products-growing-fast-big-interest-no-interest

Warde, I. (2010). Islamic Finance in the Global Economy. Edinburgh: Edinburgh University Press.

Investopedia Staff. Interest. Retrieved from http://www.investopedia.com/terms/i/interest.asp

Investopedia Staff. Moral Hazard. Retrieved from  http://www.investopedia.com/terms/m/moralhazard.asp