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Rate Of Return as a Discount Rate Under Uncertainty

The main points of this section may be outlined in the following way: First of all, we recognize two basic facts. One is that the major candidates for use as discount rate are the rate of interest (i) and the rate of return on equity (real investment) (r). The other fact is that both rates are identical in the world of perfect foresight, but are distinctly different in a world of uncertainty. This being the case, it becomes important to ascertain whether the assumption of perfect foresight is tenable , and if not, which one of the two rates i or r, is the proper discount rate under uncertainty.

Some Basic Facts


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Many economists, in their unguarded moments, would think of the rate of interest as the standard rate of discount in project evaluation. Some, rather carelessly, use the rate of return and the rate of interest interchangeably as suitable discount rates. It is very important to recognize, however, that r and i are identical only in a world of oracles,. who know the future perfectly. For in such a world “of certainty and perfect markets, the ratio of the dividends paid by a stock (including net appreciation in the value of the stock) to the original price of the stock, the ratio of the rent of an asset (net of depreciation and other operating costs) to the original price of the asset, and the ratio of the profit of a firm to the amount invested in it all have a common value, equal to the rate of interest.” (Patinkin, p. 472).

Needless to say, once we drop the assumption of certainty, r and i become distinctly different. This is not to say that in a capitalist economy the two rates are unrelated. They are related. When r goes up significantly, it becomes attractive to borrow and purchase equities, etc. The difference between r and i is strongly influenced among other things, by the degree of uncertainty associated with r and by the attitude towards risk.4 That difference disappears completely if we can tolerate the assumption of certainty to which we now turn.

The Assumption of Certainty, Ideologically Speaking

In some parts of economics such as the theory of consumer behaviour, it is common and often realistic to conduct the analysis assuming certainty since risk is not such an essential ingredient of consumer choice.

In other parts of economics, such as the theory of the firm, it is common but often unrealistic to assume perfect foresight. One of the common and false conclusions that this assumption leads to is that excess profits disappear in the long run. They never do, just because uncertainty is always there to regenerate excess profits in one line after they disappear in another.

In still other parts of economics, such as investment and capital theory, time and risk are of the essence and the assumption of perfect foresight is false and misleading, not only unrealistic. Real capital is durable, and the net productivity of investment always lies in the unknown future. It takes more than courage to discuss investment and capital under the assumption of perfect foresight.

But beyond the question of the realism of assumptions, there is the question of outlook and ideology. We must understand why Muslim economists have good reasons to reject and some Western economists have equally good reasons to tolerate the assumption of certainty in capital theory.

On the ideological side of the question, the Glorious Quran states:

"Had / knowledge of the unseen, / should have abundance of wealth, and adversity would not touch me. ” (7:188)

“No soul knoweth what it will earn tomorrow " (31:34)

These two Quranic verses, among several others, emphasize the assumption of uncertainty about the future consequences of present actions.

Turning to the economic side, we note that under the assumption of certainty, profit, which is permissible in Islam, becomes identical with interest, which is forbidden. For there is no difference whatsoever between asking for a specific rate of interest on a loan and asking for a percentage share of the future profits of an equity where those profits, by assumption, are precisely known.

Contrast the above line of thinking with that of some Western economists, who show remarkable tolerance for the certainty assumption while readily conceding that it is false, especially in capital theory. The formal excuse is the analytical convenience of that assumption. But I suspect that its ideological convenience for the defence of the institution of interest (against Biblical than against Marxist attacks) is no less important.

For under the convenient assumption of perfect foresight: profits, rentals of capital goods, and even wages may be viewed as a form of interest income, and some of the economic functions and legitimacy attaching to these incomes may be bestowed upon interest.

Strangely enough, it seems that Marxist economists are equally tolerant of the assumption of certainty as it helps them lump together interest, profit and rentals in one category “surplus value”, which makes it easier to denounce them together.

Much confusion in thought has stemmed from the unfortunate tendency to derive results on the shaky foundation of certainty, then carry them over to the real world of investment, which is decidedly uncertain. A prime example of this is the use of interest rate as a discount factor even under conditions of uncertainty as we shall see now.

In conclusion, we note that the assumption of certainty is a misleading simplification in capital theory. It is empirically unsound and Islamically untenable.

 

Source: Fiscal Policy and Resource Allocation in Islam, Ziauddin Ahmed, Munawar Iqbal and M. Fahim Khan. Republished with permission.