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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 discussion of an ideal conventional financial system also centers on the concept of general equilibrium in neoclassical economics, which can be regarded as an attempt to provide a rigorous analytical conceptualization of Adam Smith's vision of competitive economy. The theoretical work by Kenneth Arrow, Gérard Debreu and Frank Hahn, including Arrow (1951, 1953), Arrow and Debreu (1954), Debreu (1959), and Arrow and Hahn (1971) elaborates the economy–finance nexus for risk sharing in an ideal market economy. The Arrow-Debreu-Hahn competitive equilibrium is derived from the concept of general equilibrium, which was formally rendered by Léon Walras (1874, 1877) with a mathematical modeling of competitive markets for individual commodities. Assuming that consumers and producers participate simultaneously in these commodities markets as price-takers, the price of a commodity in one market contributes to price determination in other markets. The model assumptions imply the existence of a set of prices that allows demand to equal supply for all markets. This equilibrium can be efficient under the conditions that economic agents maximize the utility derived from the purchase of commodities.

It is possible to extend the analysis of market equilibrium as proposed by John Hicks (1939) to the trading of commodities for future delivery. The optimal allocation remains conditional upon the existence of markets for future delivery for all individual commodities and on the formation of price expectations by economic agents. The existence of a pricing kernel that equalizes demand and supply in different markets for future delivery depends, however, on the conditions of homogenous expectations, where all economic agents hold the same expectations about forward prices. This calls for the strong assumption of perfect foresight, which implies in turn that economic agents are endowed with information about each others' utility and production functions. As noted by Arrow (2013), the realization that resources allocation is driven by forward-looking expectations leaves an important role for uncertainty to play in modeling competitive equilibrium. Uncertainty affects the trade-offs and relative prices that ensure that demand and supply are equal across all markets. Apart from its impact on current markets, uncertainty can also explain the limited availability of futures markets for future delivery, which are characterized by possible changes in tastes, which influence consumption and changes in technology as factor of production.

The incorporation of uncertainty into the general equilibrium model puts into perspective the importance of markets for risk sharing and risk allocation. The neoclassical or Walrasian model, advanced by the work of Arrow, Debreu, and Hahn, provides a competitive paradigm based on the interaction between profit-maximizing firms and utility-maximizing consumers. The Arrow-Debreu economy is characterized by the existence of a complete set of competitive markets. The completeness of markets implies the possibility of trading securities that span all goods under all states of nature. The price system allocates risk among economic agents based on payoffs that are contingent on different states of world. The concept of complete markets applies only to an environment of uncertainty, and should not be confused with imperfect or frictionless markets, which apply invariably under certainty or uncertainty. The completeness of markets under uncertainty implies that there is a market for insurance against risk associated with every contingency.1 The complete set of markets does not assume or presume that markets are also perfect and frictionless.

The efficient allocation of risk can be achieved theoretically through two approaches, as noted by Allen and Gale (2009). First, it is possible to ensure efficient risk allocation through a complete set of markets for contingent commodities, which are defined by the date and state of nature in which they are delivered. The complete markets allow each consumer to trade the optimal amounts of state-contingent commodities at prevailing prices subject to individual budget constraints. This approach assumes the existence of markets for an unlimited number of contingent commodities for delivery at different dates under different states of nature. The second approach to efficient allocation relies on the existence of Arrow securities, which provide payoffs of one unit of real wealth conditional on the realization of a particular state of nature, and zero in all remaining mutually exclusive states. The existence of Arrow-Debreu securities for all states of nature provides insurance against all contingencies, which implies in turn the possibility of smoothing consumption under all states of nature.

The rigorous analysis by Arrow, Hahn, and Debreu presents a conception of the decentralized competitive economy that Adam Smith envisioned based on the natural liberty to pursue individual interests. The morality and justice system is integral to Adam Smith's thinking, as it renders private actions interdependent. In his reflections on the limits of organization, Arrow (1974) himself acknowledges the importance of institutional structure to promote exchange, which is essential to the optimal allocation of risks and resources. It is argued that given the inevitable tension between the society and the individual due to competing claims, there remains a crucial role for interpersonal relations in the organization of society to (a) regulate the competition for resources and (b) achieve specialization of function. Arrow further argued that trust serves as an “important lubricant of a social system,” (1974, 23) but as with other similar values such as truthfulness and loyalty, trade of such a commodity on open markets is neither technically possible nor meaningful. More generally, Arrow (1975, 15) considers the significant role of virtues, including truth, trust, loyalty, and justice, in the operation of the economic system. Several values may be deemed indeed as the requisite or facilitator of the process of exchange. Thus, it may be further argued that these conditions also constitute the basis for complete contract. If both parties trust each other completely, it is possible to enter into a simple contract stipulating that parties “renegotiate” the terms and conditions of the contract should unforeseen contingencies arise.2 Even in the absence of a “complete contract” that stipulates all states of nature a priori, it is the institution of trust and similar virtues that has the potential of preserving the crucial property of state-contingent claims ex post basis.

The Pareto optimality conditions achieved under an Arrow-Hahn-Debreu economy with complete markets, under which every individual feels better according to one's own values, have two fundamental implications. First, the possibility arises for the resolution of uncertainty. It can be shown that uncertainty does not affect the equilibrium pricing of risky assets under certain conditions consistent with Arrow-Debreu economy. Following Ross (1987), these conditions are also consistent with the no-arbitrage arguments that underlie the Modigliani-Miller theorems about the irrelevance of the debt–equity ratio and dividend policy for the firm valuation. Second, given the absence of equilibrium under incomplete markets, it is also possible to improve Pareto optimality through the inception of markets for the trading of new financial securities. The development of markets for derivatives securities, which represent state-contingent claims, can thus be regarded as an attempt to gradually approach and converge toward the completeness of markets.

The theoretical advances in the analysis of general equilibrium by Arrow, Debreu, and Hahn provided the central argument that optimal risk allocation can be achieved through risk sharing. The subsequent development of finance theory provided useful insights into various areas of finance, including investment and financing decisions, portfolio risk diversification, equilibrium asset pricing, and derivatives pricing. But finance theory developed in the footsteps of the general equilibrium analysis relies also, to a large extent, on the assumption of the existence of a risk-free asset, which is arguably not included in the Arrow-Debreu model. The cornerstones of conventional finance are represented by modern portfolio theory by Markowitz (1952 and 1959), the Modigliani-Miller irrelevance theorems about the firm's capital structure, by Modigliani and Miller (1958a and 1958b), the capital asset pricing model by Sharpe (1964), Lintner (1965), and Mossin (1966), efficient markets hypothesis by Fama (1970), option pricing theory by Black and Scholes (1973), and arbitrage pricing theory by Ross (1976), among other theoretical propositions.

The Divide between an Ideal Image and the Reality

The optimal mechanism for risk allocation suggested by the Arrow-Hahn-Debreu model of general equilibrium is based on the concept of risk sharing, where predetermined interest rates are not explicitly included in the analysis. The existence of a risk-free asset in the competing theories of asset pricing results in an artificial floor for the 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 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. Also, Stiglitz (1994) argues that competitive market equilibrium with imperfect information is not necessarily described by market conditions where demand equals supply. The assumption that the pricing system ensuring market-clearing conditions is linear may not be tenable in light of price discounts relative to purchased quantities. The incomplete set of markets can also be explained by prohibitive information costs and transactions costs, which render difficult the inception of markets for risk allocation under all contingencies and all future delivery dates. Furthermore, Stiglitz (2011) notes that the recent literature on general equilibrium indicates that even under rational expectations, markets are not necessarily (constrained) Pareto efficient. This degree of market efficiency is never achieved under imperfect and asymmetric information and incomplete markets for risk allocation. It is the failure of modern macroeconomic models to account for market inefficiencies that limits their relevance for prediction, policy, or explanation purposes.

Rethinking Conventional Economics and Finance

Thus, the scope and limits of Arrow-Debreu equilibrium analysis are subject to continuous scrutiny. But this general equilibrium model provides a theoretical framework for optimal risk sharing. In an ideal conventional financial system, financial markets and financial intermediaries provide opportunities for intertemporal consumption smoothing by households and capital expenditure smoothing by firms. Savings represent a trade-off between current and future consumption, and real investments represent present expenditures with expectations of future economic output. It is natural that attitudes toward risk, including income risk and consumption risk, differ across market participants. The Arrow-Debreu framework allows for the distribution of risk in the economy among economic agents according to their respective degrees of risk tolerance, as noted by Hellwig (1998). In addition, the significant advances in general equilibrium models and finance theory have, nevertheless, provided a rigorous analytical framework for the examination of an ideal financial system for optimal allocation of risks in the society. They provide also clear evidence about the existence of a trade-off between risk and return and about the concept of no-arbitrage asset pricing, which underlie the capital asset pricing model and the arbitrage pricing theory.

However, the recurrence of financial crises has exposed the inherent instability of the conventional financial system. Reinhart and Rogoff (2009) provide evidence from the history of debt crises about the universality of serial defaults. The procyclicality of the financial system reflects the propensity of the banking system to expand credit during economic booms and restrict it in response to economic downturns. This procyclicality is, as noted by Rochet (2008), intrinsic to the financial system, but it is associated with financial fragility, which as defined by Allen and Gale (2009) reflects the potential for small shocks to generate significant effects on the financial system. As argued by Stiglitz (2011), there is a general recognition of the failure of standard macroeconomic models to predict the U.S. financial crisis or to understand the extent of its implications. It is further argued that the pursuit of self-interest “did not lead, as if by an invisible hand, to the well-being of all.” Indeed, Mirakhor and Krichene (2009) argue that the Arrow-Debreu conceptualization of an exchange economy based on risk sharing was transformed in steps into an economy based on risk transfer and eventually on risk shifting to taxpayers through government bailouts. As argued by Reinhart (2012), elevated levels of government indebtedness are conducive to a resurgence of financial repression, as reflected by tightly regulated financial environment. Since financial repression involves a distortion of resources allocation, as noted by Cottarelli (2012), this process is not consistent with the ideal conventional financial system and the Arrow-Debreu competitive economy with optimal allocation through risk sharing.

In light of the properties of the conventional financial architecture, there is an ongoing debate about rethinking the foundations of macroeconomics and financial economics, and reconsidering the implications of behavioral economics and behavioral finance for policymaking, regulatory, and academic purposes. In this regard, Stiglitz argues that “New Macroeconomics will need to incorporate an analysis of risk, information, and institutions set in a context of inequality, globalization, and structural transformation, with greater sensitivity to assumptions (including mathematical assumptions) that effectively assume what was to be proved (for example, with respect of risk diversification, effects of redistributions). Agency problems and macroeconomic externalities will be central” (2011, 636–637). The misalignment of incentives, moral hazards, information asymmetry problems, and regulator's capture stemming from risk transfer activities indeed contribute to the complexity of an interconnected financial system and to the complexity of prudential regulation. It is for these reasons that Bean (2009) also argues for the need to reconsider the role of financial intermediation in the development of macroeconomic models, in consideration of the peculiar properties of the balance sheets of financial intermediaries.

The renewed argument is thus made also for abolishing fractional reserve banking with the aim of dissociating the credit and monetary functions of commercial banks. As argued earlier by Fisher (1936), the merits of the Chicago Plan for monetary reform, created by some Chicago economists during the Great Depression based on the requirement for hundred percent reserves against demand deposits, include the attenuation of business cycle fluctuations, elimination of bank runs, and reduction of the levels of public and private debt. The revisit of the Chicago Plan by Benes and Kumhof (2012) using a dynamic stochastic general equilibrium model provide analytical evidence that the implications of the monetary reform program are strongly validated. It was also found that altering the banks' attitudes toward credit risk resulted in additional benefits, including significant steady-output gains due to the reduction or elimination of distortions such as interest-rate risk spreads, and costs of monitoring credit risks. There is also a potential for steady-state inflation as the focus of banks is directed towards the financing of investment projects as the government's ability to control broad monetary aggregates is increased. These analytical results are also consistent with the proposal for limited-purpose banking advanced by Kotlikoff (2010), which argues for confining banks to their core and legitimate function of channeling savings toward real investment. It is further argued that financial intermediation through limited purpose banking is less prone to breakdowns and that trust in the financial system would be restored.

In the aftermath of the U.S. financial crisis, there has also been a renewed focus on the role of morality and the relation between finance and good society, which is examined by Robert Shiller (2012), among others.6 Shiller notes that not everyone is “good” in the good society, but the issue is whether it is possible to redefine the role of institutions to contribute toward a system “that encourages all the complex basic patterns of actual human behavior into an effective and congenial whole.” (2013a, 402) This process involves the democratizing and humanizing of finance. As argued by Shiller (2011), democratizing finance entails the development of technology and human arrangements such as financial education and financial advice to facilitate greater participation into the financial system. The humanizing of finance involves the organization of financial institutions under effective incentives to take into account the reality of human nature and human psychology. It is about the development of institutions that are cognizant of behavioral patterns and attitudes toward risk that are conducive to the formation of asset bubbles and financial crises.

There is indeed a growing awareness about an insufficient representation, if not neglect, of human psychology and economic history in economics teaching. Whereas the role of mathematical models in understanding the complexity of economic systems, properties of general equilibrium, and effects of financial crises is widely recognized, the relevance of abstract theory to the discipline is not. There are indeed concerns that economics has developed as a mathematical science in pursuit of minute exactness, with insufficient relevance to economic experience and public policy. As noted by Boulding, the failure is apparent, for instance, in the economists' attempts to “develop mechanical models of the business cycle, somewhat along the lines of celestial mechanics” (1970, 8). For similar reasons, the relation between moral philosophy and economics is also revisited. For instance, Zingales argues for an active role for finance academics in elevating moral standards, stating:

[o]ur standard defense is that we are scientists, not moral philosophers. Just like physicists do not teach how atoms should behave, but how they do behave, so should we. Yet, physicists do not teach to atoms and atoms do not have free will. If they did, physicists would be concerned about how the atoms being instructed could change their behavior and affect the universe. Shouldn't we be concerned about the effect of our “scientific” teaching? (2015, 32)

Thus, there is a serious debate about the systemic failures of the actual financial architecture. The intellectual discourse about the inherent instability and inconsistencies of the financial system underlines an increased awareness about the limits of regulation, and about the need to reform the basic fabric of the financial system in ways that are cognizant of human nature. The convergence toward an ideal conventional financial system rests on moral philosophy and competitive economy. The efficient risk allocation in a competitive exchange economy is achieved through risk-sharing mechanisms that do not depend solely on the completeness of markets, completeness of contracts, and perfect information, but also on a system of morality and justice. The epistemological roots of an ideal Islamic financial system can be also understood in light of Islamic thought, the full spectrum of Islamic financial instruments, and contributions of Muslim merchants to the early development of modern corporate entities and Muslim scholars to the disciplines of Islamic finance and economics. It is shown that an ideal Islamic financial system is also based on a risk-sharing mechanism that promotes the optimal allocation of risks and resources, and on the internalization of the code of conduct based on moral and ethical values.