Dr Anas Zarka, a pioneering Islamic economist, reacted to a recent report published in The Economist, entitled ‘Why the World is Addicted to Debt’ (The Economist, May 17, 2015) by asserting that the marginal utility of more debt to an addictive debtor increases, the more indebted he becomes. Dr Usamah Othman, of King Fahd University of Petroleum and Minerals, was however quick to rebut by arguing that the utility theory was not an adequate premise to explain the behaviour of an addictive person, as the addiction violates the fundamental assumption of rationality.
Actually, the whole notion of addiction to debt is subject to psychological, behavioural and linguistic scrutiny. In fact, it may very well be the case that The Economist chose a completely wrong word for individuals’ and corporates’ preference for debt. A vast majority of economic players (individuals, businesses and governments) borrow because they find it more beneficial to do so as compared with other alternatives like the sale of equity. As a number of studies have suggested that owners of successful businesses tend to prefer debt over equity to preserve their residual claims on the future profit streams. In most cases, an owner of a business, who is not sure about the outcome of the business in terms of its success or failure, will be open to partnerships or raising capital in the form of equity. This is an example of the well-known adverse selection problem. Moral hazard problems associated with share contracts (of which equity is an example) are also well documented. Read more → (228)