The main reason the knife is overpowered is because even after a guard has spotted you, it is fairly simple to quickly walk up to him and kill him with a knife stab. In the first and second game, a guard spotting you would be much harder to handle since you didn't have that option (and you could only instant knockout from the back). You ended up having to really learn the level design, enemy movement, and your gadgets to get through each encounter without being spotted.
But you make a good point about playing without killing anyone. You can still play the later games with almost all stealth and no killing, and Chaos Theory had several missions and areas where killing and being spotted was not allowed. Even so I prefer the design of the first two games, where stealth was mandatory even if the mission didn't end if you got out of stealth. Getting out of stealth meant you would get severely punished, and I loved that.
