equilibrium pricing structures across the financial sector and real economy. Also, the tax-deductibility of interest payments allows debt to change the complexion of the firm valuation. The neutrality of debt–equity financing for firm valuation rests on the restrictive assumptions of perfect and complete markets, but corporate taxes and interest tax-deductibility imply a preference of debt over equity. The Modigliani-Miller theorem about the irrelevance of debt-equity policy bears indeed some resemblance to the Ricardian equivalence theorem that financing government expenditure through tax levies or sovereign bonds does not affect household consumption and capital formation. Whereas Ricardo cautioned against the use of the irrelevance proposition to increase government borrowing to finance spending, debt preference under interest tax-deductibility undermines the Modigliani-Miller neutrality proposition and provides rather strong incentives for firms to maximize valuation through debt issuance. These developments point toward a financial system based on risk transfer.
The Morality and Justice System
The classical school of political economy based on the writings of Adam Smith and David Ricardo developed the free-market economics. Building upon the writings of other economists, including Thomas Malthus and James Mill among others, this doctrine developed into an influential school of economic thought shaping free trade, economic institutions, and public policies. Apart from the drive toward financial deregulation based on the idea that free markets have the capacity to regulate themselves, this economic orthodoxy continues to exert its influence on other areas of legislation and public policy. The formal study of economics has distanced itself from the moral–ethical system to the extent that financial crises are usually explained 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
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.
