but also for their substitution with risk-sharing instruments. The Kuala Lumpur Declaration of October 2012 by participants at the Second Strategic Roundtable Discussion, including prominent scholars in Sharīa'h and Islamic economics, indeed considers risk sharing as the essence of Islamic finance. The resurgence of Islamic finance was rather the result of efforts by practitioners to develop financing instruments with the dual purpose of meeting Sharīa'h requirements and remaining familiar to market players in the conventional finance. Whereas Islamic finance emphasizes the completeness of contracts, in the sense that parties to the contract should share expected profits as well as potential losses, conventional finance is more oriented toward risk transfer and risk-shifting transactions. It can thus be argued that conventional finance provided the platform for the emergence of Islamic finance, and it is the incompleteness of markets and contracts for risk allocation that may in part explain this development.
This chapter addresses the main issues related to the epistemology of finance, drawing in part from earlier work by Mirakhor (2011), Mirakhor and Smolo (2011), and Mirakhor and Bao (2013). It includes also new perspectives about the rethinking of conventional economics, the institutional structure, the essence of risk sharing, and the role of government in the promotion of risk sharing. This chapter examines, first, the epistemology of an ideal conventional financial system based on the body of knowledge derived from the seminal work by Smith and Arrow. The inherent risks of the conventional financial system in its present architecture, and attempts to converge toward an ideal structure, are also explored. The ideal Islamic financial system is considered in the second part of the chapter. The discussion centers on the institutional structure, which emphasizes the role of contracts of exchange, trust, and markets. The argument is then made that at the foundation of this ideal system lies the risk-sharing mechanism, which allows for an optimal allocation of risk in the society depending on idiosyncratic levels of risk tolerance. Finally, the chapter considers the essential role of equity and stock markets as the ideal instrument and platform for risk sharing and long-term financing of real investment.
Epistemology of an Ideal Conventional Financial System
This section discusses in brief the epistemological roots of the conventional financial system based on the insights of Adam Smith and presents the Arrow-Debreu model of general equilibrium as an analytical conceptualization of Adam Smith's vision of competitive economy. It then considers the potential explanations for the observed divide between the ideal exchange economy and reality. Finally, it provides an account of the ongoing attempts at rethinking the future course and contents of conventional economics and finance.
Adam Smith and the System of Morality and Justice
From the epistemological perspective, the conventional economic system is usually regarded as being founded on the economic principles set forward by the work of Adam Smith. The rules of behavior derived from moral and ethical values, which constitute the foundation of the economic system, are not however described in the revered treatise The Wealth of Nations (1776), but Smith's earlier treatise on ethics The Theory of Moral Sentiments (1759). The failure to integrate economics as a moral science, a mathematical science, and a behavioral science in the formal study of economics may explain to some extent the significance of this path divergence. The general rules of morality discussed in The Theory of Moral Sentiments constitute the ethical foundations for the economic system envisaged by The Wealth of Nations. The foundations of the economic system on the general rules of justice may not lend themselves to exactness and accurate precision, but the role of morality and ethics in the process of development of social organization remains important. Smith (1759) argues that irrespective of the assumptions made regarding the foundations of moral faculties, whether in certain modification of reason, in original instinct, or in other principle of our nature, these moral faculties are certainly given for the purposes of direction of conduct in this life. It is also argued that the rules of morality are also sanctioned by religion before the arrival of the age of artificial reasoning and philosophy. These moral and ethical guiding principles provide the basis for the economic arguments in The Wealth of Nations that commerce ought to be a bond of union and friendship between nations and between individuals.
It is argued, as in Fleischacker (2004), among others, that scholars have persistently misread The Wealth of Nations. The theory of natural liberty that derives from these treatises is that one is naturally at liberty to pursue one's self interest as long as this conduct does not constitute a violation of the laws of justice. Thus, Fleischacker (2004, 252) argues that Smith “directs practically his entire economic doctrine against the maxims by which ‘nations have been taught that their interest consist[s] in beggaring their neighbours.’” This assertion is based on Smith's (1776) arguments in the two opening chapters of The Wealth of Nations. It is further noted that, in the discussion of exchange, and implicitly in the explanation of wealth as the outcome of labor division rather than competition over natural resources, “the pursuit of wealth is not a zero-sum game, not a competition in which the success of some must come at the cost of the failure of others, and we are taught throughout that the wealth of one nation, by providing a market for others nation's goods, promotes, rather than obstructs, the wealth of all others nations” (2004, 252).
The conventional wisdom from Adam Smith's notion of “an invisible hand” is that the outcome of the independent pursuance of individual interests is the maximization of the general interests of the society. At the foundation of free market economics is the argument that laissez-faire capitalism, in which private actions are guided by private interests, is conducive to the promotion of the social good. This argument is usually regarded as the basis for a moral justification for the pursuit of profit and self-interest. The economic dimension of Adam Smith's thinking, however, cannot be divorced from his jurisprudential, ethical, and moral arguments. At the conclusion of the sixth part of The Theory of Moral Sentiments, Smith (1759, 239) states that “concern for our own happiness recommends to us the virtue of prudence: concern for that of other people, the virtues of justice and beneficence; of which, the one restrains us from hurting, the other prompts us to promote that happiness.” This is indicative of the role of ethical and moral values in the generation of the economic harmony leading to the maximization of social interests. It is important to note that the Arrow-Debreu-Hahn model of general equilibrium, which embodies Smith's vision of competitive economy, did not ignore or discard the institutional structure of moral sentiments, but it was rather taken for granted. As argued also by Friedman (2005), economic growth does not just rest on moral impetus; it has also moral consequences, as rising living standards affect the moral character of a society, by fostering positive changes in terms of openness, tolerance, and democracy.
In fact, Friedman (2011, 166) contends that despite its solid empirical foundations, “economics from its inception has also been a moral science.” This concept of economics as “a moral inquiry with religious origins” is consistent with Smith's writings from the perspective of moral philosophy based on religious beliefs that the rules of morality are the commands and laws of the Deity. As argued by Evensky (1993), the essential arguments by Smith, which echo those of Isaac Newton about the principles behind natural order, are based on invisible connecting principles of the human order. This human order is the design of the Law Giver who endowed all humans with the virtues of prudence, justice, and beneficence. These connecting principles are arranged by the benevolent designer, the “Author of nature” (Smith 1759), such that private actions, arguably motivated by a concern for happiness, result in the efficient allocation of resources and increase in the wealth of the nation. The reference to a system of morality and justice in the conception of a social system driven by private interests yet promotive of social interests implies that the notion of order through design is inherent to all human enterprise. There is also recognition of limitations in the degree of self-command, and the ungovernable passions of human nature, but the principal result remains that social order can ideally be achieved through the individual commitment to a coherent system of moral and ethical values based on the virtues of prudence, justice, and benevolence.
Arrow-Debreu-Hahn Model of General Equilibrium
The
