The phrase

The phrase ‘budget deficit’ emerged in early 1900s when the government of United States of America created this term to define the then faced situation of the economy. The first word ‘budget’ is described as an estimation of expected income and expenses. The second word ‘deficit’ is the amount by which a sum of money falls short of the required amount. When combined the phrase provides a much specific meaning i.e. the spending of funds in excess of income (by the government).

We may also address the distinction between actual and structural deficits. Usually the structural deficit is the level at which the deficit would be if output were at its full employment level. Likewise, cyclical deficit is the difference between the actual and structural deficits. This cyclical component reflects the impact of recession or boom on tax revenues and government outlays. Thus a convenient rule of thumb may be:

“ A percentage point rise in unemployment increases the budget deficit by about one percent”.[1]

When it is often asked that what accounts for large deficits? The answer remains the same i.e. expenditure rise over income. Further, in the chain process one must investigate what in reality accounts for large expenditures. This is just the question responsible for many fiscal policy oriented conflicts.

Adolph Wagner a 19^th century German economist formulated a “law of increasing state activity that gives rise to expenditures”, that he said applied to the ‘progressive’ states. This determinant of growth in public expenditure was latter well explained by Musgrave; where he asserted that growth of percapita income was attributable for the increases in government purchases for civilian purposes. Further Musgrave has also pointed out four other distinct factors contributing to a rise in general public expenditures. He claims that historically ‘technical change’ has a major bearing on the development of expenditure share e.g. the changes in weapons technology have greatly increased the military budget quotas around the world. Then it has been argued that population also forces the expenditure structure to be changed as in the post war period, when the so called baby boom resulted in an increased spending on education. Similarly, an aging population implies greater amounts of transfer payments. Finally, urbanization (and its related expenses) has been made the public financing, imperative for infrastructure needs.

What is more important to observe here is the conclusion in which Musgrave explains that public services are bound to become more expensive; but it does not imply that the public expenditure to GNP ratio must rise. When the relative price of public good rises, consumers will substitute private goods (this conception will carry an important role when we latter discuss the jurisdiction of state operations in Islam).

Richard Goode 1984 effectively claimed that decisions about government expenditure are firstly an outcome of a political process. The views of political leaders are influential but they are subject to various pressures and constraints. Secondly the structure of the economy, demographic, sociological and geographic factors also influence the expenditure side decisions in an ‘integrated’ manner.

Dornbusch 1994 while linking the trauma of debt and deficits goes on to show that a tightening of monetary policy in response to high and accelerating inflation raises real interest rates, which implies that more interest expenditure has to be paid on the outstanding debt.

The supply side economists have always favoured tax cuts arguing that these tax cuts would result in more total tax revenues. These economists concentrated on the incentive effects of tax slashing (according to them decrease in income tax rates would encourage people to work more, as it would increase their after tax wage).[2]

Most social scientists had their consensus upon the viewpoint that large budget deficits impair economic growth by reducing national savings and capital formation. Deficits also create a vicious cycle of more federal borrowing and higher debt service costs, which in turn make it more difficult to reduce debt.

When the government borrows from the central bank to finance its deficits, it engages in money financing (more commonly known as inflationary financing). When the government, finances its deficits by borrowing from the public it engages in debt financing. In 1980s, a new but temporary method of financing deficits and debt repayment surfaced in the form of Privatization proceeds. Formally stating, the government budget constraint can be used to depict the aforementioned ways of financing deficits. If ∆Bcb is the sale of bond to central bank by the treasury (for acquiring finances in form of debt) and ∆Bpc is the value of bonds sold to public, ‘P’ being the price level, let ∆A be the representation of government asset sales, then:

We still have to consider the traditional case of taxes and the External borrowing, financing the expenditures. Borrowing at macro level (esp. in cases of capital projects) has always remained a cost benefit question.

1) Deficits force the budget towards yet another account category ‘the debt’. This debt is a postponed tax liability and the interest paid on the debt is the cost of postponement in liability.[3]

2) Deficits also affect the economy through their short run stabilizing or destabilizing effects.

3) Likewise, deficits can also influence the economy by adversely affecting income and welfare in long run.

4) A budget deficit in full equilibrium (which is assumed to be desired) will crowd out investment in the absence of capital flows, by forcing up interest rates.

5) Budget deficits will also crowd out net exports in the presence of capital mobility by causing a real exchange rate appreciation.

6) To date, we have no specific economic theory to suggest that deficits by themselves could created inflation, but the fear persists that continuous deficits may eventually force the central bank to increase money supply, thus bringing about inflation.[4]

7) A debt that grows faster than GDP will eventually exceed the capacity of taxpayers to finance the growing interest bill. It is in this context that regrets surface when we keep on borrowing on the owe-it-to ourselves basis.

8) The dynamics of external borrowing entails a transfer of purchasing power to domestic residents when the borrowing occurs and a transfer back to foreign residents when interests payment and repayment of principal take place.

"I place economy among the first and most important virtues, and public debt as the greatest of dangers. To preserve our independence, we must not let our rulers load us with perpetual debt."
-Thomas Jefferson-

ii) Concessionary loans: a) These loans may have a lower than market rate of interest.

i) Sale of bonds: selling bonds to individuals and institutions that have the option of buying or not buying them. Government is required to bring down bond prices (with interest rated going up), which in turn attracts foreign capital and leads to an appreciation of the exchange rate.

ii) Sale of bonds to captive markets: Entities like social security institutions, pension funds, public as will as some specified private or semi government enterprises, are required by law to buy government bonds.

iii) Building up of domestic arrears: Theoretically, these arrears are equivalent to interest free loans (Tanzi 1984). Arrears may accumulate vis-à-vis domestic suppliers of goods and services, those carrying out capital projects, public employees in the form of delayed payment of wages, taxpayers in the form of delays in the payment of tax rebates or refunds.

iv) Indexed bonds: if there is high inflation and the government tries to issue indexed bonds, then these may become close substitutes of money, esp. if they are of short maturity. They may thus imply a direct monetization of deficits.

v) Borrowing from the banking channels: In practice, while working with inflationary finance, the distinction of borrowing from the central bank or the domestic commercial bank may not exist, as the net result is same. In both cases, there is an overall increase in money supply.

Pakistan during the last half century started from the scratch primarily as an agrarian economy to be transformed into a semi-industrialized state. Golden 60s, was a period of amazing economic growth, due to factors like massive foreign aid, imports substitution (for manufacturing sector), green revolution, increased rewards in the private sector etc. The era of 70s brought about great economic and political distress for the citizens in the form of; breakup of Pakistan, initiation of a mismanaged nationalization policy, oil shock, trade balance deficit (due to deterioration of terms of trade) etc. Yet, the decade was somehow sustained and the gap reduced, attributable to a mega rise in workers remittances from abroad.

Early 80s also witnessed the remittance flow that provided a breathing space to an economy about to witness fundamental changes. Trade liberalization was the new direction complimented by the adoption of flexible exchange rate regime.[6] This was the starting point in the downfall of one of the fastest growing developing nations. In mid 80s the deficit (fiscal) increased to 8% of GDP, as the rising government expenditures levied its toll. This in turn led to a soaring of external and domestic borrowing. Ultimately this borrowing was to cripple the nation’s progress in future. Despite manufacturing sector’s expansion and booming domestic market, late 80s witnessed a deepening of the balance of payment crises. On one side, the economy was being injected with increased benefits from illegal trade income (partly due to Afghanistan crises), while on the other end large debt servicing, saturating trend in investment and savings, plus the decreasing inflows, started to set in.[7] By 1990 civil war in Karachi hindered the manufacturing capacity of the largest industrial city of Pakistan in a regretting manner.

As the 90s closed their account, the world saw a failed case of democracy in the shape of Pakistan’s political and economic trauma. During the whole of 90s decade until now governments could do nothing to improve the expenditure side let alone the incomes side; that was to derive impetus with the right mix of development and productive expenditure. Today the country faces three major cost yielding burdens:

Deepening of debt problem has hollowed the economic stabilization mechanism. As far as the external debt is concerned, Pakistan has help of multilateral agencies in the form of rescheduling and rollovers, but on the contrary domestic debt has started to pose multidimensional problems. While the ratio of public debt to GDP increased to over 100% in 1998-99, the ratio of debt to revenues increase to 600%, along with the proportion of interest payments to revenues climbing well over 40%.[8]

At present, the giving judgment of Pakistan’s existent economic position becomes even difficult where we have weak executioners. Although the present government has made apparent efforts towards objectives like the implementation of transparent financial reforms, documentation of economy (through nation wide tax survey, with a view to broaden the general sales tax net), anti-smuggling trade measures, cut in establishment costs, curtailing the military expenditure etc. but the tangible rewards of the aforementioned efforts have yet to be sighted.

Table exhibits the state of fiscal deficit through out the last decade until the year 2000. The reader is advised to notice the continuously decreasing development expenditure coupled with persistently depleting revenues, throughout the period 1990-00. Once again the classification of expenditures, provided in the table will be important when we go on to analyze the Islamic treatment of this budget deficit.

Above pie chart, depicting the position of total expenditure is a crystalline scenario of a poverty-ridden economy. The striking fact is that a developing country is spending the least of its expenditure share on development (a mere 14.4% of total expenditure). Is this a forced mistake or the country has been intentionally dragged in to such a committing expenditure structure is no more the priority concern. Firstly, the interest payment is taxing the economy heavily. In no doubt at all the administrators will face and uphill task for mistake of debt accumulation, committed by their predecessors. This interest payment is an obligatory binding and cannot be struck aside, as default is no more an attractive option for Pakistan. As apart from the debt taken from multilateral agencies, we have a huge pie borrowed from different countries in the form of concessionary grants; this latter portion of debt if defaulted will bring in a loss of goodwill for Pakistan.

The second category which again poses a dilemma like situation for Pakistan is the defense spending. With the Indian defense budget rising manifolds, Pakistan has been made an inevitable race contender. Quite admirably, this expenditure has declined by 4.4% during the last decade, but still this 20.4 percent of pie taken away by military expenditure is a huge loss to a developing economy whose development is stagnant. Now the third category that, if deducted may, increase the share left for development expenditure, is marked as ‘other expenses’. These include establishment costs, free grants to entities and individuals, spending on regional social programs etc. This category needs to be targeted in order to provide a breathing space lower down the order. A recent step in this direction has been the government’s decision to shed 40000 posts from the public sector.

There is indeed an urgent need to transfer some of expenditure going into the ‘other’ expense towards the almost barren development side. In this case apart from the Social Action Program (SAP II & I) funded by the multilateral arrangement, the Public Sector Development Program (PSDP) is intended to play important role.

Above table elucidates the dire spending under PSDP. Unfortunately, the size of this programmed has to be slashed each time before budget due to the resource constraint. Although this analysis of PSDP is not directly relevant to our discussion but still a careful consideration is important as we will prove latter on that many of these projects could well have been performed by the private sector (a proposal in line with Islamic voluntary sector).

The Islamic standing as regards the budget deficits and their financing is simply very clear from operations point of view. There is a definite need to study the Islamic view from the following perspectives:

Ø Under Islamic framework at the very outset, we would like to investigate, why in the first place the deficits are realized, which implies that; is the realized increase in expenditure over revenue justified?

Ø We need to investigate the new and diverse kinds of expenditures that are imperative form modern governments.

Ø The optimal structure of public sector is also of immense importance, we would like to go on to discuss the sectors in which Islam has allowed public sector involvement, plus if there is any chance of addition in these sectors as the modern era demands.

Ø There is binding to check whether the conventional sources of financing budget deficits have any place in the Shari'ah framework or not.

Ø Why have the conventional sources of financing deficits failed to adjust in the developed and developing countries, especially the case of Latin American countries is worth exploring.

Ø What are the Islamic alternatives for financing deficits, and how they can be mechanized for innovations.

We begin our analysis by studying the very structure of expenditure in any conventional economy; as a case study, we again resort to the Pakistan’s scenario. Table I presented the last decades situation of Pakistan’s expenditures vs. revenues.

Just like it is said that the success of revenue mobilization depends upon: a) rationally constructed tax and duties structure, b) ability of tax reforms to adjust with changing economic conditions and, c) quality plus strength of tax administration. Similarly expenditure reform are a necessity for: a) ensuring macroeconomic stability, b) promoting ‘equitable’ growth, c) enhancing the efficiency of public expenditure, d) coordinating the budgetary constraints with prudent expenditure management.

By the year 1999 Pakistan was forced to increase its quota of expenditure on interest payments at the cost of development expenditure. Now what we need to check overhear is the very fact, whether such an expenditure structure is allowed under Islam or not. If not then we go back to ask ourselves why did such a structure emerge (discussed in previous section). When a society is faced with multidimensional poverty, should the government be allowed to finance its own self on the expense of 80% population living under miserable conditions? The answer even from the secular view would be a straightaway denial.

This reference towards expenditure management has exclusive importance under Islamic perspective especially when studied from the context of Israf. In his book Muqaddama, Ibn Khaldun pointed out very correctly that the primal cause of national exchequer’s downfall is the anti-productive and non-development expenditure. He justified his argument to the extent that he went on to say that if such a trend continues then nation starts desiring easy money from the state in the from of benefits, perks etc. This enigma of easy money is not at all alien for Pakistan. In the golden era of 60s, the economy was fed with concessional loans and grants. As a result of which the world highest growth rate of 13% per annum was achieved. This miraculous growth rate did not prove to be sustainable and eventually the economy was in doldrums with in the first half of 70s. This was the time when the nation had been so accustomed to easy grants, that the economic managers did not think of any other resort, than to borrow again and again, to eventually fall in to the debt trap.

Let us be very sure that Ibn Khaldun was the first one to explore (historically) the adverse effects related to the phenomenon of ‘crowding out’. He warned that governments themselves should not get involved in to tangible or intangible trading and he instead provided a proposal to make the economy efficient via allowing competition by deregulating the structure in the form very similar to Privatization (WDR).

Now after reconvening the foremast foundation that governments should make expenditures only in the jurisdiction, not contradicting with Shari’ah, we move on to evaluate the multifarious expenditures that modern governments have to commit.

It is now visible from the table that the main components of current expenditure are: a) defense, b) debt servicing, c) economic social and community services, d) general administration and current subsidies.

These components need careful consideration; we start from the subsidies. Shari’ah compliance permits the provision of subsidies:

iii) The penetration of subsides (in respective sectors) must be justifiable on equity grounds.

As the data guides us the development subsidies lagged behind the current ones, which were usually politically maneuvered by the respective governments (Rehman 1998) e.g. from 1989-96 the subsidy allowed for Pakistan Steel Mill, all proved to be a loss in the form of a white elephant. This demands cautious exploration on the part of those documenting the subsidy proposals. It is a recommendation that wrong or politically planned grants and subsidy allocated be brought to Hisba system’s monitoring and surveillance.

After incurring huge expenditure on defense and debt servicing it creates a suffocating quell for the allocators, if they are also to play their financing for the community services. To minimize the involvement of state in such community services, Islamic system may have alternatives such as:

i) Activating the voluntary sector by first harmonizing the relationship between state and individuals.

ii) Encouraging the establishment of community homes working on non-profit basis (they must mot be interpreted as the world bank proposed non-governmental organizations (NGO’s), that work for a generalized population and not targeting the regional zones in Pakistan).

iii) Providing tangible incentives to the rich class for their active involvement in helping the community. (SAHDR)

The economic and social expenditure includes the expenses incurred upon the public goods. Richard Musgrave had argued a lot in this respect where he has advocated the proposal of private production of public goods. He has gone as far as proposing even private military production. He remained of the view that current expenditure by the government on defense can also be lowered in efficiency and monetary terms if the government keeps the strategic production in its own entity and lets the ‘regular’ or mass scale defense production to go in private hands. This view is very similar to what a Mujatahid’s view may be when deciding to lower the involvement of Islamic government in sectors like military (production), health, infrastructure etc.

It must be remembered that we can never relieve the government of its responsibilities in the productive sector especially where the issue of pure public goods is concerned. However, where costs of efficiency and quality-oriented benefits are concerned then we can enjoy the Islamic provisions of private sector encouragement, where government assumes the role of a monitoring unit.

Table IV provided a breakup of present development expenditure incurred by the government. If viewed from an Islamic point then a modern government must not suffice with such a structure. Islam holds the standards and treatment of sectors like manpower, population welfare, rural development, education and training very highly but as the data instructs, these sections have been the least priority of governments. This can be explained by:

ii) Politicians holding offices stopped the development plans initiated by their predecessors.

iii) Governments kept these development expenditures on the condition of how much debt they would cater from multilateral donors. Due to which the results in these sectors have not been persistent.

Now under the Islamic framework, you will not wait for the World Bank aid for the development of such significant sectors. Instead, we will discuss later on several types of Islamic taxes that may provide impetus to economic development.

Traditionally speaking as is evident from a Hadith of Muhammad (PBUH); Islam has only allowed full government control i.e. nationalized structure in three sectors:

We can now proceed the argument in the light of Wagner’s law (on public expenditure) which states that:

“As percapita incomes in an economy grow the relative size of the public sector will also grow”.

So, can we allow an Islamic Public sector to expand and undertake activities other than the three mentioned in Hadith on grounds of modernism in governance?

For the answering of this issue cum question we would distinguish between the state and the government from the Shari’ah point of view: State can be viewed as a geo-legal entity that represents, within its territorial limits the Shari'ah authority in worldly affairs, owns assets and assumes liabilities. Against this backdrop the government’s position is that of the representative of Shari’ah (oul ul Amr) as well as the operational arm of the state.

This implies that under a transitionary phase Shari’ah oriented government responsibilities may be as follows:

v) Islamic government not to relieve itself of responsibility by selling of assets, which mark a symbol of state sovereignty.

When these transitionary goals have been achieved then we move on to a society, which is ready to embrace the Islamic principles at all levels of activity. This is the stage where Islamic governments will have to completely modify their role as that of a shepherd i.e. the one who monitors.

We over here take the example of some new sectors that will only require the Hisba system in place and will not require any active involvement of the government in office e.g. postal services, coinage, health oriented activities like the establishment of hospitals for rural areas (even where private profits are less), provision of single mode of education at horizontal levels in society, transport and railway networks, R&D etc. these sectors are usually the new services provided by modern governments that will not find their way in an Islamic system if only the government can combine the essence of incentive with Hisba. e.g. those undertaking a health rehabilitation project in far flung rural areas may be given exemptions from taxes, subject to the fact that their prices are bracketed and not fixed by any state control. Similarly, education can be provided by private sector at nominal reward given that the competition is allowed to flourish.

This is not to say that a modern Islamic government will have to make no modifications in the traditional Shari’ah charter. Like as discussed earlier, the extent of credibility and secrecy involved in strategic defense production will obviously allow the Shari’ah compliant government to undertake this sector. This defense issue previously (in Islamic history) was responsibitly of every Muslim citizen. Nationals of Islamic state were encouraged to be Sahib al Saif. However, due to the evolution of specialization defense became the subject of a state governed body called Army.

Even at this point in our analyses we can still argue that in any Islamic framework the government need not tax itself by indulging in regular or mass scale weaponry production (esp. recommended for Pakistan). Their role should be limited to very sensitive production activity. For Pakistan’s case this will be the issue concerning nuclear energy.

Now the role of government as regards the macro economic stability and functioning of a country is formidable. But what has to be borne in context of Islamic setup, is the very viewpoint that government will only be a regulator of economy rather than an economic agent itself. Such regulation will include arrangements for trade, currency stability, putting variables like unemployment and inflation at their right combination etc.

Then in Islam a very adaptive framework that includes the clause of durura has been provided to us. For the sake of which governments may enter any sector on justifiable basis. Nevertheless, this intervention due to durura must be a temporary phenomenon.

Once we have recommended government involvement in economic matters to be refrained till a limit, we can move forward to discuss, that now if a deficit occurs in the budget, what place have conventional forms of financing got under Shari’ah positioning.

Constitutionally, in an Islamic framework stress is laid upon absolute reliance on equity financing in comparison to minimal reliance on debt financing. As regard debt financing operations, only ‘good loans’ (principle of Ahsaan) can be regarded as the only lending instrument, with no profit to be gained over and above. Such example can be found vary early in Islamic history where PBUH, in times of crunch borrowed to cover the financial residuals. Following are the principles upheld by Him as regards public borrowing:

- PBUH borrowed in both cash and in kind in small as well as large amounts, from Muslims as well as non-muslins, from men as well as women.

- PBUH borrowed in anticipation of future income from which repayment could be made, but he also borrowed when no definite income was in sight.

- As a matter of principle debt incurred was never to be defaulted and was always repaid with time limit respected.

In the times of first four caliphs, there has been no instance of public borrowing, as the treasury remained in surplus. However, during the times of Umayyad and Abbasids at some instances debt was taken for temporary shortfall of funds usually in the periods of war.

Therefore, what we can observe is the very fact that public borrowing in Islam (as a source of financing deficits) was very limited to times of urgency and durura. Such essence of good loans may never find their way in a modern Islamic framework (on permanent basis), not because Islam itself has changed, but because of the presence of materialistic economics in a financially liberalized world. Therefore we would have to lay our maximum reliance on a participatory or equity based arrangement discussed latter.

Second in line, contemporary governments resort to taxes for fulfillment of deficit gap. It must be remembered that event if deficits do not arise, governments still collect taxes as a normal process of revenue generation at state level, which implies that under deficit the taxes may have to be increased; a case of tight fiscal policy. On welfare grounds, it may never be allowed under Islam, as the additional taxes would lead to an obvious burden on the society and would add to community resentment. Thus in an Islamic framework the already structured Zakah system holds immense importance. Firstly, because it levies a minimal encumber on the payee and secondly its deep penetration acts as a stabilizer in the system.

Muslin scholars have no disagreement that taxes may be levied when the state has no other resources and in quantities not exceeding the deficit of funds. Consequently in stating what may be available to a modern Islamic state, one should take time to see the traditional means of finance available:

- Kheraj is a rental fee on the land that becomes a property of the Islamic state because of its liberation by Muslim troops. It has been argued the there is no reason for not continuing this rental fee in all countries whose lands are Khairaji land, whether this land is used for agriculture, industry or urban services.

- Jazia on non-Muslim is at least equal to the Zakah on Muslims. It is a toll tax on all non-Muslim adults in the Islamic state.

- Revenue of public enterprises: According to many Muslims scholars the ownership of mineral and public natural resources such as rivers and top of ground minerals is vested with the Islamic state.

In traditional times two additional sources have been existent in the form of: Khums and Ushr.

Specifically, imposition of taxation on grounds of development and economic equilibrium has no reference in texts of Quran or Sunnah, whether implicit or explicit. Secondly texts of general cooperation and solidarity among Muslims do not serve as evidence for allowing taxes to be imposed on specific people for specific purposes unless it can be proven that there are no means of cooperation and solidarity other than such taxes.

Imam Malik (as an advocate of taxes) has been quoted as having said the following:

“If there were no funds in the treasury or the needs of the army increased above the capacity of the treasury, the state has the right to levy taxes on the rich up to the level that satisfies that need immediately and until the revenues of the treasury appear”.

Ibn Hazm is also quoted to support taxation. However, he restricts the levying of taxes to the case where Zakah proceeds are not sufficient to fulfill the needs of poor.

Kattani also discussed about the collective duties that strengthen the interest of Muslims both in religious affairs and in worldly affairs such as salaries of military personnel, students and researchers in Shari’ah studies, and teachers for young children, and concludes that such payment should be provided by the treasury and in case of shortage of its revenues, Muslims are collectively responsible for raising the necessary funds.

Thus, it becomes very clear that imposition of taxes over and above Zakah is an exception and not a rule. Taxes can be imposed by the Islamic state under certain circumstances and conditions.

Now we move on to the source of privatization proceeds for reducing deficits and the servicing of debts. It must be borne in mind that privatization proceeds would only act as a short run tranquilizer and would not be a long run sustainable supportive. However, the fact of the matter is that privatization itself must not be overseen without skepticism. At least for those Muslim countries that wish to move to an islamized system, it is very important to be careful of such foreign coined ideology.

Pakistan for example is nowadays considering privatizing the two state owned banks:

Given the present scenario government can wish to think in two directions: a) get these banks out of losses and privatize the entities to take care of your deficits. b) The second direction can be very important especially for a state in transition towards the Islamic agenda. The government must at first, free both these banks of all ills containing the essence of Riba transaction. After these banks have been put on the lines of Islamic financial path, should they be offered for the bidding. This is not only the responsibility of a to-be Islamic government but will also foster innumerable benefits in the context of the awaited “model” Islamic banking establishments.

Now we arrive at certainly the most debated source of financing deficits: the “inflationary financing”. this source has not only been a bone of contention amongst the conventional economists but also attracted a lot of concerns from Islamic economists. This source takes the form of governments directly borrowing from the Central Bank on short and medium term basis (usually not for the long run).

Surprisingly this source is the most referred one by most treasury operators due to the easy accessibility involved in dealing with the country’s own central bank. There is no doubt that deficit financing is the only source that allows the government with more breathing space and acts as a quick relief during the crunch days. However, this source has not gone with out drawbacks. Central banks usually come to the rescue of governments via printing additional money. It has been long recognized that printed money if brought in excess can create inflation.

Maqraizi even before the quantity theorists realized this problem and besides the quantity of Money he also held two other ‘structural’ factors responsible for the price increments; a) Increased rents of agricultural lands,

Milton Friedman remained very precise in defining that inflation is a ‘general’ rise in prices due to money increase. He always asserted the monetary agencies to be very careful while manipulating with money.

Abu Yousaf found out that it is injustice to get a less value back in a fulus loan or deferred payment given previously (or during a split transaction between fulus on one and intrinsic valued money on the other hand).

Rising trends in inflation besides leading to price deformation also guide us to some other mishaps:

In Latin America in the 1960's, economists proposed inflationary financing for high development. They were of the view that this could lead to forced savings, i.e. governments will borrow from the central bank, and spend on designated projects, now when prices increase than the real value of money will decrease in the hands of public, thus forced savings can be brought about. Thus they expected the real output to increase and the occuring inflation to be self liquidating. But unfortunately this could not happen. After about one year everyone discovered that, their money is buying less. Now the expectation of further inflation triggered the demand for higher wages. This lead to a decrease in real profits and after about three years when output started to catch up, the prices started to increase more sharply!!

Now the question arises; even with so much accessibility and ease involved in obtaining deficit financing from the Central Bank, can we allow this on Islamic grounds?

In times of PBUH and caliphs, there never arose such a problem originating from inflationary financing of government losses. Even if such problem had taken place the increased intrinsic valued gold and silver might not gave mattered. Fulus latter on came to be recognized as a semi token money. In Makraizi’s time when hyperinflation was, experienced people did recognize that excess of token and semi token money is a source of many evils (the case of maghshosha money was also apprehended).

Now as regards the Shari’ah point of view there is nothing wrong in the very action of printing new money (letting alone the aftereffects). However given the nature of government in an Islamic milieu this action has to be exercised subject to the following constraints:

- In all cases, where public expenditure is justified on account of the government’s discharge of state obligations but no tax revenue or alternative mean of financing are available, the government can do the needful by issuing fresh currency. Fulfillment of the Shari’ah guaranteed minimum needs of the poor fall in this category. Defense procurement and debt servicing may be two other cases, because these involve shared interest of the entire society.

- If the above action comes into conflict with other state responsibilities, such as stability in the value of money, a balance would also have to be maintained between printing money and keeping inflation within acceptable limits.

For policy, recommendations as regards the alternatives, now available for filling up the deficits under Islamic framework, need to be discussed in greater detail. It is of special importance to us, as the dead line of the Supreme Court Riba verdict is fast approaching its end.

Ø Public Debt: By public debt we mean voluntary and obligatory internal borrowing, and borrowing from abroad. All loans must be interest free. Voluntary domestic loans are motivated by Islamic inspiration, which generates a sense of responsibility amongst the nationals. Obligatory loans may be obtained directly from the public or indirectly in the form of loans obtained from the central bank to the extent that they do not destabilize prices. Forced borrowing from the public in times of emergency may act as a viable alternative for conventional (perpetual) taxation. Borrowing from the central bank is a form of forced borrowing, but it reflects badly on the general price level. Therefore, its use should be restricted to the extent of urgent need. Interest free loans from other Muslim countries may be a possibility in future, but presently we cannot count on its reliable availability.

Ø Equity Financing: Financing many development projects through the sale of their shares to the public is an important means of recruiting participation, involvement and resources of public for the development scheme. Equity sharing on the basis of Qirad may be practiced domestically and internationally, provided that the foreign shareholding does not adversely affect the economic and political independence of the state.

But what if a development project represents pure public good, out of which neither the government nor the participants can expect profits?

For this purpose, government can innovate the derivatives of the two fundamental instruments depending on the type of expenditure:

- Salam Certificates (bai salam can be adopted to generate non-tax revenue for the government)

We have yet to discuss the case where the need is to finance the deficit only and not any specific project. For this issue we first need to consider the present public finance instruments being brought into usage conventionally (in Pakistan):

What is quite visible from the table above is the apparent fact that all these instruments are in essence doing the same job of mobilizing the savings, but with different denominated holdings. We propose over here that the same task of mobilization can be better performed through the Islamic instruments with an added advantage of quick adjustably in accordance with the business cycles. Such Islamic instrument fundamentally can take two broad forms, but again governments can derivate instruments out of these principle arrangements:

Islamic financial practitioners have advised diverse kinds of instruments capable of covering governed expenditures, but the need for the treasury operators is to mould these Islamic instruments in order to firstly match the varying (country to country) requirements and secondly not to violate the Shari’ah jurisdiction (as happened in Pakistan during 1985). An example of financial product innovation can be the debt equity swaps that now a day Pakistan’s Finance Ministry is chalking out.

Mohammed Akacem also at the fourth International conference on Islamic Economics held at Loughborough University discussed using secondary market for external debt, to convert Riba contracts into equity investments. He went on to discuss the proposal of debt equity swaps, which involve a bank actually swapping part of its debt into equity. His examples of debt conversion techniques, like the following one must not go with out consideration:

“Suppose a major airline were to be interested in buying some muslin country’s tourist resort or a part of national airline for example. It could of course use its own capital or borrow to finance the transaction as done conventionally. But alternatively the airline could purchase the muslim country’s debt at a discount in the secondary market and convert that debt into equity (provided and agreement is entered at government level)”.

If the real growth of an economy is ignored and if inflation is fully anticipated and equal to the rate of monetary expansion (assumingly as money supply increases for deficit financing inflation comes about in the form of a tax; whose rate is equal to the rate of increase in Money Supply) then the desired real balances are equal to the actual real balances.

Similarly, the demand equation for real balances (L) can be described as follows:

[M/Y]^d = ae^-b^∏ where [M/Y]^d is the ratio of money demanded to income, ‘a’ is the ratio of Money to income when the expected inflation rate is zero, ‘∏’ is the inflationary expectation, ‘e’ is the natural log base and ‘b’ is a measure of sensitivity of demand for real balances to the anticipated inflation rate.

Now if we continue to assume that actual price changes are equal to inflationary expectations, then the amount of inflationary finance R^∏can be written as follows:

Thus the size of maximum deficit that a country can have will be limited by the sources of financing.

[1] Stanley Fisher

[2] One must also consider the microecomomic theory which shows that substitution effect of the increse in after tax wage carses the worker to more work, while the income effect reduces work.

[3] K. Alec Crystall

[4] Put more simply, large and persistent deficits push up interest rates, thus reducing investment.

[5] Tanzi

[6] See “External shocks and Domestic adjustments”- Naqvi and Sarmad.

[7] “Trends in Pak. Macroeconomic variables”- Vaqar (www.ecovista.8m.com)

[8] Hasan 1999.

[9] If these are allowed for the individuals as well, then they would be specially feasible for the public sector employees.

Item	1997-98	1999-00
Defence	136.2	143.4
Interest Burden	202.3	244.5
Socio/Eco.Services	84.8	100.8
Current Subsidies	8.8	24.0
General Administration	61.4	65.9
Others	27.7	18.9

Public debt Instruments	Rate of return	Maturity period
Federal investment bonds	13% for three years	3,5 and 10 years
Prize Bonds	-	Min. two month holding for prize eligibility.
Defense Savings Certificate	16% for 10 years	10 years
Special Savings Certificates	15% for first two years, 17% for third year	3 years
Khas Deposit Certificates	12% for first two years 14% for third year	3 years
Savings Accounts	11% per annum	-
Mahana Amdani Account	Monthly return	5 years
R.I. Certificates	14.65% per annum	5 years