Intermediate Islamic Finance. Mirakhor Abbas
by excessive risk-taking and excessive leverage, with little reference not only to a rigorous theory of interest rate on which the very concept of leverage depends, but with no regard also to morality. Despite the drive toward a reconciliation between economics and ethics by Sen (1987), among others, economics remains a discipline practiced in an ethical and moral vacuum, as argued by Sfeir-Younis (2001). There is indeed an emphasis on the concept of self-interest with little regard to the laws of justice to which Smith makes reference, as noted above.
Sen argues in particular about the importance of the “established rules of behavior” in Smith's analysis of human behaviour, but also notes that “there is no suggestion in Smith's writings that people in general systematically fail to be influenced by moral considerations in choosing their behaviour” (2009, 187). Thus, it may be argued that had conventional finance undertaken the development path defined by Adam Smith's framework for the economy based on institutional infrastructure and rules of behavior, and followed the same path of competitive equilibrium by the seminal work of Arrow-Debreu and Arrow-Hahn on the completeness of markets and completeness of contracts, the financial system would have been intrinsically different from its present status. It can be further argued that had conventional finance undertaken a balanced approach that integrates the competitive paradigm, which considers efficient resource allocation through risk-sharing mechanisms, and the information paradigm, which considers the distortive effects of imperfect and asymmetric information on optimal resource allocation, the financial landscape would have been different. The foundations of the financial system would have been laid on the important notions of state-contingent claims, information sharing, and risk-sharing finance. The divergence from this ideal path is, in part, due to a neglect on the part of mainstream economics of Adam Smith's conception of an economy based on a moral and justice system.
Contingent and Noncontingent Claims
The Arrow-Debreu-Hahn equilibrium models recognize the impact of uncertainty on economic equilibrium and provide a general setting for the optimal allocation of risks and resources. However, it is also important to understand the difference between contingent and noncontingent claims in the market allocation of risk. It can be argued that the presence of ex ante predetermined rates of return, or rates of interest, changes the complexion of the risk allocation mechanism. The extant literature on general equilibrium and asset pricing models tends to coalesce around theoretical settings that assume the existence of risk-free assets and give an important role for interest rates. Despite the absence of a rigorous theoretical explanation for interest rates, the focus of monetary policy, for instance, is still made on short-term nominal interest rates, which affect the term structure of interest rates and asset pricing as well. As noted by Thornton (2013), there is a greater focus on interest rates and financial markets' expectations about future policy rates as channels for monetary policy transmission, to the extent that money is becoming irrelevant to monetary policy.3 The theoretical literature is also inclusive of some studies that challenge the existence of predetermined rates of return in general equilibrium models. Tyler Cowen (1983), for instance, argued that Arrow-Debreu-Hahn models of general equilibrium (GE) cannot accommodate predetermined rates of interest. The argument is that since the prices of all commodities for present and future delivery are already explicitly included in the system of Arrow-Hahn-Debreu equations, there is no room for the imposition of a discount rate on the economy. The inclusion of interest rates is conducive to the over determination of the system of equations.
Indeed, the prices of all goods and services under all states of nature are already described by the original set of equations. An overdetermined system is characterized by more equations than unknowns, and it either has no unique solutions, when some equations represent linear combinations of others, or it is inconsistent, leading to no solution at all. It is not clear how the interest rate should enter the system of equations, but when the system is not inconsistent, the rates of interest determined within the system should nevertheless be explained with reference to the relative prices and intertemporal price ratios. However as noted by Cowen, it is difficult to conceive a theory of interest that relates the price of apples to that of oranges. It is further argued that “[o]nce we define the interest rate as the set of intertemporal price ratio percentages, GE theory loses its ability to tell us anything specific about the magnitude of interest rates. These rates may be positive, negative, or even zero. Most likely, our system of equations will simultaneously contain all three possibilities as solution” (1983, 610–11). Thus, the theoretical analysis of general equilibrium may not be able to provide a consistent internal structure and meaningful definition of interest rate, which represents neither the price of commodities nor that of capital goods.4 The essential argument by Cowen (1983) is that the GE model provides a framework for the analysis of competitive equilibrium, but leaves no room for capital theory. As argued by Askari, Iqbal and Mirakhor (2009), money markets do not exist under Islamic finance, since by definition, money markets are where “money today is traded for more money tomorrow” – the very definition of prohibited transactions or ribā.
Thus, apparently, fixed-income securities are not strictly consistent with the definition of pure contingent claims or Arrow-Debreu securities, which, as explained above, provide payoffs of one unit under a particular state of nature, and zero otherwise. A riskless asset is represented by contingent claims of equal amounts of future consumption in each state of nature. The predetermination of fixed income is made regardless of the mutual exclusivity of states of nature, with only the event of default having the potential to alter the schedule and amount of payments. As argued by Kraus and Litzenberger (1973) in the trade-off theory of capital structure, corporate bonds represent claims on the residual value of the firm in states of nature where the firm cannot earn the promised return on bonds. But they are not merely a bundle of contingent claims, since they also constitute a legal obligation to pay fixed income. Intuitively, this implies that mutually exclusive states of nature with identical payoffs are regarded as a single state with fixed payoffs determined ex ante. Apart from the state-contingent nature of default events, there is no uncertainty about the outcome of interest-based securities simply because payoffs are indifferent from the realization of any particular state of nature. The existence of different states of nature is irrelevant to the fixed-payoffs promises in debt contracts. Thus, because of the incompleteness of contract, it can be argued that fixed-income securities are not representative of investment under uncertainty.
The Information Paradigm
The theoretical analysis by Arrow and Debreu (1954) demonstrates that general equilibrium for a competitive economy can be achieved under the assumptions of complete markets and perfect information, and there is no role for monetary factors or transactions costs. Stiglitz (1994) recognized that Arrow-Debreu's analytical insight was to identify the singular set of assumptions under which Adam Smith's invisible hand proposition would be valid.5 Under this set of assumptions, the pursuit of self-interest is conducive to competitive equilibrium. But it is argued also that the relevance of this neoclassical model of general equilibrium for welfare economics would be rather limited in the absence of perfect information and in the absence of important markets for risk allocation. The assumption of perfect information implies that the set of information available is fixed and invariable to the behavior of individual economic agents, independent from the pricing system, insensitive to changes in other economic variables. It is research about the implications of imperfect information for welfare economics that gave birth to the information paradigm, which addresses the information-theoretic concerns about the distortive effects of imperfect and asymmetric information on optimal resource allocation. The efficiency of competitive economies, which is considered as the first fundamental theorem of welfare economics, is deemed, according to Stiglitz (1994), to be fundamentally flawed. This assertion is based on theoretical evidence from Greenwald and Stiglitz (1986, and 1988) that markets are not constrained Pareto efficient under imperfect or asymmetric information and an incomplete set of markets for risk allocation.
This result follows from the existence of externalities in the decisions of some economic agents that are not taken into consideration by others. For instance, the purchase of insurance reduces the incentive to avoid the occurrence of a risk event, leading to moral-hazard problems.
It is also noted that money is irrelevant in the Arrow-Debreu model of general equilibrium.
It is noted that different arguments can be made regarding the essence of interest rates, including the view by Thornton (2013), among others, that interest rate represents the price of credit, not the price of money.
As noted by Stiglitz (1994), it is also possible to identify other singular conditions for markets to be constrained Pareto efficient. The existence of risk markets, or lack thereof, would be irrelevant to Arrow-Debreu analysis if all economic agents were identical and faced with identical shocks. Such conditions would preclude the development of markets for risk allocation since the rationale for securities trading is to allocate risks between different economic agents holding different pricing expectations.