A Framework for Future Economics

18 Jun, 2020

There is a wealth of writings on the shortcomings of mainstream, neoclassical economics. But there is yet to emerge a coherent framework for an alternative economic paradigm. The COVID-19 crisis is an opportunity to address this matter in fresh light This short article is an attempt to outline one such a framework.

What is Different about the COVID-19 Crisis?

The COVID-19 crisis shows clearly why healthcare is an essential “good”, not only for individuals but for the economy as a whole. Such goods are usually described in textbook economics as “public goods.” A public good, in short, is mostly an indivisible good: either all (or the vast majority) of the community obtain this good or none. This is very clear in the case of the pandemic: Either all members are safe and healthy, or else they are at a great risk of infection.

Hence, health services, in principle, must be provided to all members of the community. Privatizing healthcare, therefore, is not a viable strategy. This is because the poor will likely not afford to buy the vaccines or medicines. This might be fine if health were divisible so that if the poor gets sick it will not impact the rich. But it is not. The virus does not discriminate between the rich and the poor. Healthcare must be provided to all regardless of income or wealth.

No Market without Public Goods

Can we imagine an economy without healthy agents? Of course not. Healthcare is not the only public good without which the market cannot operate. Take order, for example. Is order divisible? Is it possible that some people follow the rules (of traffic, say) while others don’t? Does the law apply to some citizens but not to others? If so, then this would certainly not be a civilized economy. Laws and rules must be applied to all concerned citizens without discrimination.

The main outcome of laws and regulations is stability. Stability, therefore, is also a public good without which no market can normally operate.

One might argue that mainstream economics admits the existence of public goods. There are chapters in almost every microeconomic textbook devoted to this topic. Public economics is an established branch of economics. This argument implies that it is possible in neoclassical theory to have a free market without public goods. But that is the heart of the problem: A free market cannot operate normally without providing the essential public goods.

The Tragedy of the Commons

Another example of essential public goods is shared or common resources, like water or oil or clean air. If each member of a community over-consumes clean water (in order, for example, to produce more crops or raise more cattle than the rest of the community), other members will follow suit because no one wants to be left behind. The result is the depletion of the resource in a short period, and all members of the community will, therefore, lose or perish (hence the “tragedy”). However, if the community agrees to consume the resource frugally and wisely, they will be able to sustain the resource for a prolonged period. In other words, sustainable development is also an essential public good.

The tragedy of the commons shows that scarcity is more likely be the result of selfish behavior rather than the finiteness of natural resources. Obviously, natural resources are finite. But the main source of scarcity might be due not to its natural limit, but to its unsustainable consumption.

Social Dilemmas

Public goods show the tension between individual self-interest and group-interest. What is useful for the individual becomes harmful to the group if adopted by all members. This is a classic example of the “fallacy of composition.” In the social context, these fallacies are called “social dilemmas.”

One way to model social dilemmas is through the well-known Prisoner’s Dilemma game. The game is as follows:

Player 2
Trust Cheat
Player 1 Trust 10,10 3,11
Cheat 11, 3 4, 4
Prisoner’s Dilemma Game

Each player has two options (or two strategies): either to cooperate or to defect. The payoff for player 1 is the first number, while the payoff of the player 2 is the second number (after the comma). Each player must decide which strategy to choose before knowing what the other will do. If both players decide to cooperate, each player will get a payoff of 10. But, if player 1 thinks that player 2 will cooperate, then player 1 has an incentive to switch (or deviate) and play “defect” and get a payoff of 11 instead of 10. This of course will not be a good outcome for player 2, as he will be getting only 3 instead of 10. If player 2 anticipates that player 1 will defect, then player 2 will be better off to switch to defect, and thus get 4 instead of 3.

The final result is that, if each player thinks the other will play selfishly, they end up with a payoff of 4 each. While if they trusted each other, and therefore decided to cooperate, each will get 10, way better than 4. This is why it is called a “dilemma”: from an individualistic point of view, each is better to defect. But if they all do so, they all will become worse off.

Trust

This shows the value and the dilemma of trust, the most essential public good. No market can operate without its members trusting each other. If the buyer does not trust the seller, he will refuse to buy, and vice versa. However, when the majority of the community behaves honestly, it pays for some members to deviate and cheat. Cheating will bring in some gains as long as the rest of the community is honest. But other members will not accept to be taken advantage of, and thus they start cheating as well. Ultimately, if all members cheat, the market simply collapses. We can present the trust dilemma as follows.

Player 2
Trust Cheat
Player 1 Trust 10,10 3,11
Cheat 11, 3 4, 4
The Trust Dilemma

Islamic Finance

How about the principles of Islamic finance? Do they fit within the above framework?

Let us start with one of the most essential principles of Islamic finance: Prohibition of riba or usury. The Quran (2:275) clearly states that trade is legitimate while riba is prohibited. How do these two kinds of activities compare to each other?

Trade involves converting money to goods then converting goods back to money. Riba, on the other hand, is only one step: money now for more money later. It short-circuits the trade cycle. It is therefore tempting to switch from trade to lending at interest. But what would happen if all members of the community switch to lending? The economy will obviously collapse. No economy can thrive without trade. Riba can bring in some gains to lenders (or usurers) as long as the majority of the community are doing trade. However, the community cannot thrive by collecting interest from lending each other. Riba, therefore, is subject to the fallacy of composition: it pays to some to live off the interest paid by others, but it is impossible for all members to do so. In other words, trade is the cooperative outcome, while riba is the defective one.

Group 2
Trade Lend
Group 1 Trade 10,10 3,11
Lend 11, 3 4, 4
The Dilemma of Riba

Is trade subject to the fallacy of composition? If all members of the community participate in the market, each selling what he needs less and buying what he needs more, the market will flourish. What if too many members sell the same good? Then the good’s price will go down so that it will be profitable for these sellers to switch to other goods. 

But in the case of riba, if too much lending takes place, then the quality of loans will deteriorate (as happened in the subprime crisis). Unfortunately, the higher credit risk will not be sufficient to deter from lending, because lenders can offer bad-credit borrowers to refinance and, therefore, continue to collect interest. Riba allows debt to self-multiply without an in-built correction mechanism until the crash becomes inevitable.

Risk Sharing

Another important principle of Islamic finance is risk-sharing. There are many forms of risk-sharing, but the most common is equity financing. The general impression is that equity is expensive and that is why companies prefer debt financing. But why equity is expensive?

Equity is expensive because it is risky, and it is risky because of the large amount of debt it supports. Larger debt financing, in other words, makes equity riskier and thus more expensive. But if the size of debt was smaller relative to equity, equity will be less risky, and thus the cost of a dollar of equity will be lower. Put differently, equity is expensive in a high-leverage environment because then only little equity is absorbing the huge risks of a large debt. But, when debt is reduced and equity is increased, the cost of a dollar of equity falls. The more equity the enterprise has, the less risky each share becomes, and thus the lower the cost of equity financing becomes. Equity, therefore, is expensive in a high-leverage environment but is inexpensive in a low-leverage one.

A low leverage environment will be obviously more resilient and stable than one with high leverage. Stability, as pointed out earlier, is a public good. Is there an incentive to deviate from a low-leverage environment? With debt financing, return on equity (ROE) will be higher. As more companies switch to high-leverage strategy, there is an incentive to take on additional leverage, and there will be a race towards financial fragility. This result will obviously be harmful to all players.

Group 2
Low-leverage High-leverage
Group 1 Low-leverage 10,10 3,11
High-leverage 11, 3 4, 4
The Dilemma of Leverage

Conclusion: Redefining the Economic Problem

Social dilemmas arise in almost all social interactions, including market interactions. No market can operate without first resolving the essential dilemmas facing market members. This should be the “economic problem” that economics focuses on solving. Studying the operations of a free market is valuable, but more valuable is the study of how to create or design a market in the first place. To design a successful market, we have first to know how to resolve the relevant social dilemmas.

The main crises of the 21st century (and in fact most crises in history) are predominantly social dilemmas: The Global Financial Crisis, the Climate Change Crisis, and the COVID-19 Crisis. If economics is to be relevant to real-world challenges, we should reformulate it as the science that aims at resolving social dilemmas. Principles of Islamic finance will fit naturally within this framework.

Note

This is a summary of a keynote address delivered online at the 12th International Conference of Islamic Economics and Finance, organized jointly by Istanbul Sabahattin Zaim University, Turkey, Islamic Research and Training Institute (IRTI), and International Association for Islamic Economics.

References

Further discussions and additional references can be found in the following two articles:

A-Suwailem, S. (2009) “Tenets of the Islamic Economic System,” Encyclopedia of Islamic Economics, edited by Abdelhamid Brahimi and Khurshid Ahmed, Volume II, UK.

Al-Suwailem, S. (2014) “Complexity and Endogenous Instability,” Research in International Business and Finance, vol. 30.


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