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Whilst economic activity is in part an effort to maintain or replace old stocks of wealth that have depreciated, the making of an accounting profit does not necessarily signify that such wealth creating processes are occurring. For an example of this one need look no further than a casino. Here, the winner of a game of chance wins what the loser loses, less the casino's cut. As a result of this cut, the gambling process is usually profitable for the casino (which acts as an intermediary in the gambling process). Of course, for the winners themselves, the process is always profitable. However, in order to create new wealth, an economic process must do more than simply transfer existing wealth between participants.

The establishment of a national lottery can, from this point of view, be seen as a misallocation of resources. If the state genuinely wishes to raise extra revenue for charitable causes and the arts, then the existing taxation system could in fact be used to raise the required revenues at far lower cost. If the Inland Revenue already exists, why bother setting up what is effectively a whole new taxation infrastructure to duplicate it? In November 1994, soon after the opening of the UK's national lottery, Joe Rogaly wrote in the Financial Times :
The national lottery is fantasy finance. ... It is a tax on the poor derided by the rich, a machine for the creation of a spurious sense of self satisfaction for the pathetic boobies who toss their coins into the maw. There is nothing of worth in this crap game, no net gain for charities, no work of art saved or building erected that could not have been financed by less preposterous means ... Games of chance, according to the Koran, are abominations of Satan. "They ask you about drinking and gambling," says the holy book. "Say; 'There is great harm in both, although they have some benefit for men; but their harm is far greater than their benefit'." Drinkers may demur, but, as to the lottery, the Islamic view is sheer common sense.

The gambling process cannot unambiguously show that it provides new wealth for the community, yet for the intermediary it is profitable. If large numbers within a community attempt to survive on a variety of wealth transfer processes, of which theft is one further example, the implications for the maintenance of infrastructure and social cohesion are almost entirely negative. Human effort and physical resources, that could otherwise be applied to creating new wealth, are instead diverted towards activities that simply facilitate the transfer of existing wealth.

Some proponents of gambling argue that it produces pleasure to those who win and is thereby creating a form of wealth. One need only consider the fact that losing is highly unpleasurable in order to see that, even in this sense, the amount of net wealth created in the gambling process is close, if not equal, to zero.

Others argue in favour of gambling on the basis that all human activity involves a kind of gamble. The argument proposed is that to criticise gambling is to criticise any form of activity whose outcome is uncertain. If the investment of money on a roulette wheel is to be mocked, why not then the investment of money in a new business? But when crops are planted the farmer risks drought in order that we may have food to eat. I am yet to see in what way a bet on red at the roulette wheel is capable of a similar production of wealth. For an individual to say that 'planting crops is a risk and gambling at the roulette wheel is a risk, therefore I might just as well direct my effort towards roulette', is to ignore the fact that farming is necessary to the maintenance of life whilst betting on the roulette wheel is not.

The above argument is of great relevance to any debate on the economic worth of financial market speculation. Some regard such speculation simply as a form of gambling whose impact upon resource allocation is similar to that of a casino. However, there is at least one important difference. Financial market speculation can affect a variety of economic variables such as exchange rates, interest rates or commodity prices, whereas the placing of bets in a casino cannot. Through its impact upon the price mechanism, speculation can then have an effect upon resource allocation that is far wider than its own domain.

Many proponents of speculation adhere to the view that there is indeed a value-added process going on here. Three common arguments are as follows.

Firstly, because of the volume of speculative transactions in the major markets, let us use the market for foreign exchange as an example, end-users requiring foreign currency will find a liquid market in which to transact. Were no speculative operators to exist, then an end-user might come to the market looking to exchange one currency for another but find no counterparty willing to trade in a reasonable size.

Secondly, the difference between the price at which the end-user may sell or buy a foreign currency, the bid-offer spread, becomes very narrow due to the competition between speculative participants in the market. The tightness of this bid-offer spread effectively reduces transaction costs.

Thirdly, as speculators trade out profitable opportunities, the market price tends towards 'efficiency'. Whilst it is possible that benefits are derived from liquidity and low transaction costs, the chief beneficiary often seems to be the speculator himself. For this agent, the need for speedy execution of trades in large size and at short notice is paramount. Agents in the real economy place less sanctity upon such features. The quip is that a consumer buys a banana in order to eat it, not to sell it at a higher price later. More seriously, one might ask whether is it quite so vital to the functioning of the real economy that a foreign exchange deal should take less than one minute to conclude. Would a viable business project, that has taken several months to plan, be cancelled because the necessary foreign currency trade can only be completed at one week's notice?

The supposed improvement in price efficiency that is ascribed to speculation is even more debatable. The level of efficiency in a marketplace is commonly held to hinge upon the degree to which available information is accounted for in current prices. Such a definition seems to relegate the purpose of a marketplace to one of secondary importance only. Can a market be efficient if it does not allocate resources towards projects that maximise wealth creation? Paul Volker, in an interview with the New York Times in the Autumn of 1990, cites the destructive effects upon confidence and business planning that foreign exchange volatility can cause. In pinpointing speculation as the primary cause of such volatility, he asks what possible argument of efficiency could justify an up move of 30%, followed by a down move of 30%, in the $/Yen exchange rate over the first few months of 1987. Are we to assume that efficiency has nothing to do with stability in the market price?

In order to maximise turnover, financial intermediaries usually find that volatility of some amount is quite desirable. It is less easy to persuade a client to buy a dollar for one hundred yen if in all likelihood the dollar will still be worth one hundred yen tomorrow. Yes, it takes two to gamble, but should a financial institution actually encourage the client to place his bets? Gestetner, Gibsons Greetings, Metallgesellschaft and Orange County have all experienced the skewed incentive system that so often awaits the uninitiated. Little wealth creation here, but often a commission for the bank's salesman. The Economist magazine of October 7th. 1995 comments :
‘Red faces turned puce at Banker’s Trust, an American investment bank in a legal battle with Procter & Gamble, a consumer goods company. Leaked documents and tapes reveal that bank staff talked about a "rip-off factor" attached to complex deals involving derivative sales’.

Gordon Pepper in Money, Credit and Asset Prices (1994) addresses the speculative psychology itself :
Market participants detect that following a trend tends to be a profitable course of action. The herd instinct then prevails. Crowd psychology becomes more important than the behaviour of investors acting as rational individuals. Technical analysis (chartism), which is based on crowd psychology, becomes more important than fundamental analysis.

Many homeowners in the United Kingdom now know how powerful the herd instinct can be. This is especially the case where the instinct is given substance by means of a substantial expansion in money supply. Speculators may buy residential property because the information available to them indicates that house prices are rising. This may be efficiency in the sense of processing available information, but it is often most inefficient in the sense of resource allocation. When enacted by millions of households, the speculative game can become a self-fulfilling money-spinner that strips the price signal of any meaningful relationship to fundamentals. Very quickly, pseudo-technical arguments of the '... buy now while you can still afford it’ variety take over. In such an environment, it is rarely asked whether the devotion of substantial new resources to the construction of residential property meets a genuine need for accommodation, or simply acts as a tool for the making of speculative profit.

Pepper’s analysis may apply to the short-term only, but often the short term is quite long enough for the market 'correction' to prove highly destructive. The charity Shelter estimates that 100,000 low cost permanent homes are needed each year to meet the high levels of housing need in the UK. At the end of 1994, such accommodation would have been welcomed by many among the 127,290 households that were homeless, the 419,890 that were more than three months in arrears on their mortgages, and the several million who were living under 'negative equity'. The frantic construction boom of the 1980's did little for the affordable rental sector but has instead bequeathed to us an array of un-lettable office blocks and repossessed residential property that in some cases sit side by side with the worst of housing shortages.

Whether it occurs in the financial markets or in the real economy, the damage wrought by speculation seems far more obvious than the supposed benefits proposed by its supporters. The efficiency argument is dubious whilst the resulting resource misallocation and economic destabilisationcan at times be most obvious. Nevertheless, speculation, in spot foreign exchange for example, seems quite acceptable among some Islamic institutions. Typically I ask such participants whether they would bet their funds on a coin toss. Invariably the answer is 'No'. But what exactly is the difference between chancing money on a coin toss, and chancing it on a currency rise or fall? 'In the foreign exchange market, one uses one's mind, one examines information, one thinks' replied a senior individual in an Islamic bank. 'Poker players do that too', I said.

Islamic financial institutions should be clear on at least one principle. To profit by wealth transfer, or by wealth creation?

July 1996