Adam Smith is commonly regarded as the father of modern economics and an advocate of free markets. However, as Dr. Abbas Mirakhor argues there has been a subtle yet significant misunderstanding of Smith’s vision and closer inspection reveals similarities between the Smithian and Islamic conception of an economic system.
Before the inception of the Islamic finance industry, there was what could be called a “market failure” in the conventional financial system. There was a substantial unmet demand for Shari’a-compliant financial products. Islamic finance grew out of conventional finance to meet this demand. Muslim scholars writing mostly since the 1970s about Islamic finance focused on the development of an Islamic finance system; they not only emphasised the elimination of riba contracts but urged their replacement with risk-sharing contracts. The practitioners, most of whom had been operating in the conventional finance space, were however interested in developing ways and means of finance that, while Shari’a compatible, would be familiar to and accepted by market players in conventional finance. The former emphasised Profit-Loss sharing (PLS), the latter focused on traditional methods of conventional finance centred on risk transfer and risk shifting. In doing so, all financial instruments of conventional finance became subject to replicating, retrofitting and reverse engineering for Shari’a compatibility. This two-part paper argues that there are two ideal financial systems based on risk sharing, conventional and Islamic, and one actual conventional system focussed on risk transfer. Part One discusses the epistemology of the conventional financial system and finds that there has been a subtle yet significant misunderstanding of Adam Smith’s vision. A closer inspection of his views highlights palpable sim-“could be regarded, in a well-defined sense, as superior to a large class of possible alternative dispositions …” (Arrow and Hahn, 1971, pp vi-vii). These at- tempts focussed primarily on Smith’s idea of a decentralized market economy but in the process it abstracted from much of the well-spring of his thoughts represented by the societal framework emphasizing moral-ethical values envisioned in The Theory of Moral Sentiments.
The work of Arrow-Debreu (1954) is fundamentally about optimal risk sharing in a decentralized market economy. It addresses the question of how best to allocate risk in an economy. The answer is that risk should be allocated to those who can best bear it. The work abstracted from the underlying institutional structure envisioned by Adam Smith in The Theory of Moral Sentiments and The Wealth of Nations. It appears that Arrow-Debreu took for granted the existence of such institutions as property rights, contracts, trust, the rule of law
, and moral-ethical values. Two key assumptions of this work were complete contracts and complete markets. By the former,it was meant that it was possible to design contracts such that all contingencies were covered. The latter assumption meant that there was a market for every conceivable risk. Crucially, all future payoffs were contingent on specific outcomes. The Arrow-Debreu model did not include a fixed, predetermined rate of interest as pay-offs to debt contracts. Subsequent to his seminal work with Debreu, Arrow made it clear that, while not stated explicitly in his work with Debreu and with Hahn, he envisioned it “possible that the process of exchange requires or at least is greatly facilitated by the presence of several ….. virtues (not only truth, but also trust, loyalty and justice in future dealings ….. The virtue of truthfulness in fact contributes in a very significant way to the efficiency of the economic system … ethical behaviour can be regarded as socially desirable institution which facilitates the achievement of economic efficiency in a broad sense”. (Arrow, Despite Arrow’s attention to some important elements of the institutional structure that were integral to Smith’s vision of an economy, such as its value system, the economics profession developed its own vision of that economy focussing primarily on two concepts of “invisible hand” and “self-interest”.
1972, pp. 345-346). For example, if the institution of trust is strong in an economy, the universe of complete contracts can be replicated by simple contracts entered into by parties stipulating that terms and conditions of the contracts would be re- vised as contingencies arise. Arrow himself was to place emphasis on trust as the lubricant of the economy. Despite Arrow’s attention to some important elements of the institutional structure that were integral to Smith’s vision of an economy, such as its value system, the economics profession developed its own vision of that economy focussing primarily on two concepts of “invisible hand” and “self-interest”. The first was mentioned only once in The Wealth of Nations and the manner in which the second was used by economists has been regarded by many as a misunderstand- ing of what Smith actually meant by “self-interest”. Narrowing of Smith’s view has been subject to rather sharp criticism by Amartya Sen who suggests that the misrepresentation of the Smithian view has caused major deficiencies in the contemporary economy theory which has widened the gap between economics and ethics.
A careful reading of Moral Sentiments and The Wealth of Nations provides immense support for Sen’s position. Even beyond Sen’s spirited criticism of economists’ misunderstanding of Smith’s self-interest motive is the lat- ter’s insistence on the need to comply with “general rules of conduct” that align with the commands of a Deity who rewards for the observance and punishes for breach in the life hereafter.
Three observations can be made of Smith’s view. First, this is the Smith that has been ignored by the economics profession. The Smith of economics is the author of the self-interest motive that is the basis of utility and profit maximization at any cost to the society, including the impoverishment and exploitation of fellow human beings. Even his most ar- dent of supporters, Amartya Sen, has ignored the Smith of the above quotation. Second, Smith makes clear in his Theory of Moral Sentiments that compliance with the rules prescribed by the Creator and with the rules of the market was essential to his vision. Third, it is also clear that Smith considers the internalization of rules – being consciously aware of the ever-presence of the Creator and acting accordingly – as crucial to all human conduct, including economics. Smith succinctly and clearly shares some of the fundamental institutional scaffolding of Islam: belief in the One and Only Creator; belief in accountability on the Day of Judgement; belief in the necessity of compliance with the rules prescribed by the Creator; and belief that justice is achieved with full compliance of rules. To paraphrase Sen, no space need be made artificially for justice and fairness; it already exists in the rules prescribed by the Law Giver.
An economy in which there are contingent markets for all commodities similarities between the Smithian conception of an economic system and that pro- pounded by Islamic economists. Part Two will focus on the Islamic system, the present state, the challenges it faces, and prospects for the future.
An Ideal Conventional Financial System
An overall socio-political-economic system gives rise to an economic system out of which grows a system of financing to facilitate production, trade and exchange. The idea of the contemporary conventional economic system is usually traced to Adam Smith’s conception of an economy as envisioned in his book, the Wealth of Nations. What has been ignored until recently, however, is the fact that, from an epistemological point of view, Smith’s vision of the economy is embedded in his vision of a moral-ethical system that gives rise to the economy envisioned in the Wealth of Nations. That moral-ethical system was well-described in Smith’s book: The Theory of Moral Sentiments which preceded his Wealth of Nations by a decade
Whereas conventional economics considered Smith’s notion of the
“invisible hand” as a coordinator of independent decisions of market participants, in both The Theory of Moral Sentiments and in the Wealth of Nations the metaphor refers to the design of the Supreme Creator, where the market agents seeking their own advantage would produce the most efficient allocation of resources and consequently the greatest possible wealth for the nation. Smith contended that the objective of the Divine Design must have been the happiness of humans. A major contribution of Smith in his Theory of Moral Sentiments is to envision a coherent moral-ethical social system consistent with the Supreme Creator’s design and how each member of society would enforce ethical positions. Recognition of human frailties led Smith to recognise the need for an organic co-evolution of individual and society in a stage-wise process of accumulation of ethical system of values from one generation to thenext While it is possible for any given society to move forward or stagnate and even regress, the benevolence of the invisible hand of the “Author of nature” guides the totality of humanity in its movement toward the ideal human society. Compli- ance with and commit to a set of values – virtues of prudence, concern for other people, justice and benevolence – would insure social order and cohesion
Smith and Arrow
It was not until the second half of the last century that attempts were made to present a particular conception of Smith’s vision of the economy. This conception saw the economy as a market system guided by the “invisible hand” toward smooth functioning, coordinating independent individual choices in a connected world. Two such attempts were the works of Arrow and Debrau (1954) and Arrow and Hahn (1971) that sought to show “that a decentralized economy motivated by self-interest” would allocate resources, such that it
…Had actual finance developed along the trajectory discernible from these works, i.e., steps taken toward completion of markets and of contracts, keeping in mind the overall institutional framework for the economy as envisioned by Adam Smith, the result might have been emergence of conventional finance different from the contemporary system.
– meaning that there are buyers and sellers who promise to buy or sell given commodities “if any only if” a specified state of the world occurs – is called an Arrow-Debreu economy. In such an economy, it is the budget constraint of the participants that determines how much of each contingent commodity at prevailing market prices they can buy. Since these commodities are contingent on future states, they are risky. There- fore, the budget constraint of individuals determines the risk-bearing ability of each market participant. Arrow himself recognised such a market is unrealistic but opined that securities on the modern market serve as partial substitute. Such securities, referred to as Arrow Securities whose payoffs could be used to purchase commodities, would reduce the number of markets required while replicating the efficiency of risk allocation of complete contingent markets. Associated with complete markets are complete contracts. These are agreements contingent on all states of nature. In the real world, not all contracts can cover all future contingencies. Therefore, they are said to be incomplete contracts and may indicate inefficiencies in exchange. However optimal contracts can be devised provided there is mutual trust between the parties to the contract.
A compelling case can be made that in so far as the financial instruments are Arrow Securities, i.e., their payoff is contingent on the “state of nature”- that is, dependent on the outcome that is not fixed, predetermined, and represents risk sharing- this ideal system would have many characteristics of an ideal Islamic system. However, not all Arrow Securities would satisfy Shari’a requirements as some may well represent contingent debt contracts to deliver a fixed predetermined amount of money if a given state of the world occurs. These may not, therefore, represent an ownership claim either. Shares of common stock of open corporations do meet these requirements. They are residual ownership claims and receive a return contingent on future outcomes. Stock markets that are well-organized, regulated and supervised are efficient from an eco- nomic point of view because they allocate risks according to the risk-bearing ability of the participants. In essence, this is the contribution of the Arrow-Debreu model of competitive equilibrium, ac- cording to which, efficient risk sharing requires that the risk of the economy are allocated to market participants in accordance with their respective degree of risk tolerance.
From Ideal to Actual: conventional finance
The spring that motivates the action of market agents in Smith’s story has been carried forward, but much of the rest of his insights have been forgotten. Smith’s vision of the institutional infrastructure (rules of behaviour) that is articulated in the Theory of Moral sentiments has not been correctly identified and executed, and, as such, abstracting from them would be unlikely to change the outcome of the mathematical analysis of Arrow-Debreu and/or Arrow- Hahn. Furthermore, had actual finance developed along the trajectory discernible from these works, i.e., steps taken toward completion of markets and of contracts, keeping in mind the overall institutional framework for the economy as envisioned by Adam Smith, the result might have been the emergence of conventional finance different from the contemporary system. That system would instead be dominated by contingent, equity, risk-sharing financial instruments.
Perhaps the most influential factor in derailing that trajectory is the existence and the staying power of a fixed, predetermined rate of interest for which there has never been a rigorous theoretical explanation. All, so-called, theories of interest from the classical economists to contemporary finance theories explain interest rate as the price that brings de- mand for and supply of finance into equilibrium. This clearly implies that interest rates emerge only after demand and supply forces have interacted in the market and not ex-ante prices. In fact, in some theoretical models, there is no room for a fixed, ex-ante predetermined rate of interest
Even though no satisfactory theory of a positive, ex-ante fixed rate of interest exists, all financial theory development post-Arrow-Debreu-Hahn assumed its existence in the form of a risk-free asset, usually Treasury Bills, as a benchmark against which the rates return of all other assets, importantly equity returns, were measured. These include theories such as the Capital Asset Pricing Model (CAPM), Modern Portfolio Theory (MPT); and the Black-Scholes option pricing formula for valuing options contracts and assessing risk. For all practical purposes, the assumption of a risk-free rate introduced an artificial floor into the pricing structure of the real sector of the economy, and into all financial decisions.
It can be argued that it is the existence of this exogenously imposed rate on the economy that transformed Arrow-De- breu vision of a risk-sharing economy and finance. The resulting system be- came one focused on transferring or shifting risk rather than sharing it. Such a system needed strong regulation to limit the extent of both. However, further developments in finance theory pro- vided an
analytic rationale for ideologically aggressive deregulation. One was the Modigliani-Miller Theorem of neutrality of capital structure of firms. In essence, this theorem asserted that the value of a firm is independent of its capital structure. This implied that since firms want to maximize their value and since Modiglian-Miller showed that the value of the firm is indifferent towhether the firm debt finances or equity finances its capital structure, firms would prefer to incur higher debt levels for the firm rather than issue additional equity. Hence, the risk of additional debt would be shifted to other stakeholders.
Another was the development of the Efficient Market Hypothesis (EMH) that claimed that in an economy which is similar to that of Arrow-Debreu, prices prevailing in the market contained all relevant information such that there would be no opportunity for arbitrage. The implication was that if market efficiency is desirable, then markets should be allowed to move toward completion, through innovation and financial engineering, in order to create a financial instrument to allow insurance against all risks. For this to happen, it had to be demonstrated that it is possible to develop such a wide array of instruments and that regulation had to become passive or even regressive to allow an incentive structure to induce innovation. The latter was initiated in almost all industrial countries in the 80s and continued with an accelerated pace until the 2007- 2008 crisis. The former had already been demonstrated by the theory of spanning developed in the late 1960s and early 1970s showing that one basic financial instrument can be spanned potentially into an infinite number of instruments. These developments coupled with the high magnitude of leverage available from the money-credit creation process characteristic of a fractional reserve banking system represented an explosive mix that reduced the vision of Adam Smith to the rubble of post-crisis 2007-2008. The Arrow-Debreu vision of an economy in which risk was shared was first transformed into an economy in which the focus became risk transfer but which quickly transformed into one in which risks were shifted, ultimately, to taxpayers.
Conclusion
The economy-finance nexus de- fined by Arrow-Debreu-Hahn general equilibrium models were risk-sharing conceptualizations in which securities represented contingent financial claims on the real sector. Equity share claims represent first best instruments of risk sharing and satisfy the characteristics required of Arrow Securities. It would appear that had the financial markets in industrial countries developed their financial sector along the lines suggested by the Arrow-Debreu-Hahn model, they could have had much more efficient risk sharing and, perhaps, avoided the crises that have plagued conventional financial system. A number of post-mortem analyses of the recent crisis have developed constructive insights that may help steer the conventional system away from high credit, high leverage, and high debt which are the ultimate causes of all fi- financial crises. Almost all of the many recommendations for reform of the conventional system – from the Stiglitz Report (2010), at one end, and The Squam Lake Report (2010), at the other end of the spectrum of thought among finan- social-economic scholars and practitioners – include some form of control, direct or indirect, on credit, debt, and leverage within the financial system, including higher capital adequacy requirement. Some have gone beyond these recommendations and have suggested reform of the fractional reserve banking system and deposit insurance. It is likely that if such reforms are implemented reliance on debt-creating flows within the conventional system will decline in favour of greater equity. Basel III has already taken steps – albeit not as significant as some scholars demanded – to enhance capital adequacy requirements, impose limits on leverage and curtail proprietary trading of the banks. Whether these changes are sufficient to induce the conventional system to move away from its overwhelming dominance by interest-based debt contracts, risk transfer and risk shifting or it will take more severe bouts with crises before it does so remains to be seen.
