Speculation and on Demand for Money in an Islamic Economy

Terms like “loans with equity features” (Khan and Mirakhor), have appeared in the Islamic economics literature. It should be clear that ‘loan’ and ‘equity’ are not only of two different legal natures but also very different in economic consequences. The fact that such confusion passes unnoticed and unchallenged in the most frequently cited papers is worrying. There is an urgent need, given the growth in the literature on as well as the practice of Islamic banking both in Muslim and non-Muslim countries to re-examine these two most important economic concepts, namely money and capital, whose different legal aspects and economic consequences place them under two different contracts.

As it can be understood, the ‘many objectionable features of capitalism’ stem from the fact that the monetary sector is independent of the real sector and gives rise to the instability acknowledged by many master economists. The failure to integrate the monetary sector in the real sector has severely impaired many economies of the world. Specifically, integrating financing into the real economy must be understood as the most urgent task for Muslim economists if they are serious about seeking a sound, self-correcting, and dynamic Islamic economic system. This task, if successfully carried out, will make both money and Islamic banking endogenous. My hope for this paper is that it will help standardize both the connotation and the operation of money and capital in the literature, and thereby integrate money in capital theory. To the extent that my effort succeeds it may, in due course, carry the basic concepts in Islamic banking into the mainstream.

From the discussion so far, it is obvious that there is no need to emphasize that, given the abolition of interest and consequently of its immediate derivative, speculation, studying demand for money in an Islamic economy adds nothing to our understanding. Ignoring the mutual relationship between interest rate and speculation led the classical economists to believe that the money is for transactions and nothing else, such as speculation. Keynes later discovered its destructive role. Although the classical economists’ ignorance about speculation may be attributable to its unimportance in their day, our deliberate ignorance is due to the strict abolition of interest in Islam. I firmly believe that this prohibition is, by no means, limited to money because the effects of speculation are all the same. Money, copper, wheat, or even steel plant, can be and are all speculated upon.

It seems to be an absolute error not to condemn speculative demand for money in an Islamic framework. For those writers like Khan and Mirakhor (), who might have a problem agreeing with that, it should suffice them to ask why Keynes () asserted that there would be as many rates of interest as there are durable goods in an economy. Due to its being in the infancy of its development, such mistakes in Islamic banking can have many evil consequences. Khan, in another study with the assistance of Mirakhor, tried to develop an IS-LM curve based on Islamic interest-free banking without any justification as to its appropriateness or relevance. By re-labelling ‘real rate of interest’ as ‘real rate of return’, Khan describe the model as “a dynamic variant of the standard IS-LM model and no special factors have had to be introduced up to now”. In conclusion, he breezily avers that:

In many ways the lack of understanding and confusion that exists about Islamic economics can be attributed to the virtual absence of formal descriptions of the theory underlying the proposed system Perhaps Khan still thinks that he has successfully complemented and filled the gap of ‘the lack of understanding and confusion’ that existed in Islamic banking. He may not realize that instead of solving some problems he has, unintentionally no doubt, not only not solved any problem, he has added new problems. He further adds: “…this model does provide a reasonable portrayal of the types of Islamic banking systems that have been put into practice in certain countries” Khan. There is need here for a short digression. Labour in this system does not receive the reward it deserves. It is under-paid. Profit maximization necessitates the lowest possible wage rate for labour. Profits and wages in capitalism naturally move in opposite directions. It is not clear how equity, one of the promises of capitalism, could be preserved in such a system. Additionally, labour is not in a place it deserves if we believe that it is both the producer and the consumer of the goods and services produced in an economy. This is what we mean by independency of demand and supply in a conventional capitalist system. It is not hard to demonstrate that justice, on the part of labour, is achievable through co-operation between labour and the capitalist. On the other hand, money, in this system, accrued in the past, does not deserve any reward if regarded merely as potential capital. However, as soon as it changes its legal nature and is released/risked to become actual capital it does deserve its own proper reward. This is precisely the main topic of this paper.

As has been stated, there is much confusion surrounding money and capital. One of them has been made by Cassel, when he explicitly concludes, after some discussion, that ‘the capital produces the interest’. No one has ever cast doubts about the productivity of capital. His argument for interest mainly rests, in fact, on the productivity of capital. It is the speculation with money rather than capital that produces interest in capitalist economies. Cassel, among others, failed to distinguish how and under what circumstances money and capital work. He further states Cassel that the value of capital is the rate of interest. He appears not to have realized that capital has the value it has based upon its productivity, which is independent of the rate of interest. He seems to try to show that interest is a real phenomenon, while ignoring its origin, speculation.

There are other economists who try, by linking interest with money, to prove the ‘fertility’ of money. Still others take the vague view that money is barren (sterile). Indeed, the potency or impotency of money is not realized before it is legally combined with factors of production. But money is not naturally impotent; in fact, every penny, anytime and anywhere, has the potentiality to become potent. It is the type of economic system that keeps part of the potential capital away from factors of production (via production function) and makes it impotent. Impotent money held in a money whirlpool produces a lot of economic problems. That money whirlpool is the effect of interest (rate). Some of the money in that whirlpool may find its way into the production function and so discover its potency. But the money, as in the capitalist system, that does not so link up with factors of production, remains impotent. For centuries, humankind has greatly suffered from holding money in that impotent state. Paying interest on loans, as a legal obligation on the borrower, does not make money potent. For that matter, bankruptcy of a firm does not prove impotency of money used as capital; it has to do with market structure and conditions other than potency of money. We must look for an economic system within which there are mechanisms to make all the money available potent. Elimination of interest makes it possible both to put money next to factors of production and, through the production function, make it ‘fertile’. That part of money, which in the capitalist system, never comes out of the speculative whirlpool, is not merely impotent, it inflicts the greatest harm on the society in the form of unemployment, inflation, inequitable distribution of wealth, business cycles, and stagflation. To understand this better, the nature of speculation is needed to be explored in a rather detailed manner The term speculation is used in this paper to mean any action, which, for the benefit of very few and to the detriment of the general public, alters the normal course of events in a money economy to make it an unsound and unhealthy economy. Unhealthy events are those, which, sooner or later, bring about instability and the crises of confidence, which afflict the economy. So long as it is open to individuals to speculate on stocks, the alternative of purchasing stocks as one of their asset items cannot be rendered sufficiently attractive. Speculation harms public confidence because of the nature of speculators’ expectations about the future course of the rate of interest. Speculators normally earn income by attempting to ‘buy cheap and sell dear’. ‘Speculation’ is used here not with the meaning it has in ordinary usage, but basically the way Keynes () used it in his General Theory. To be specific, almost all transactions in stock markets involving exchange of stocks whose prices are market-based are speculation. The exception is the exchange of stocks issued by firms and sold in the market for the first time, the primary market, and subsequently when stock prices closely match the real value of the firm and not the market value of the stocks. The prices at which stocks are normally exchanged far exceed their real value due to bubbles. The real value of stocks is the real value of the assets of the stock-issuing firm. On such a distinction, ordinary stock markets, that are functioning as secondary markets are, as I understand it, money markets; the primary markets devoid of the bubbles due to speculation are capital markets. Capital markets are essential and necessary for any economic system, Islamic or otherwise.

The money market emerging from speculation in the secondary market needs justification. In the secondary markets transactions are reduced in fact to M()-C-M(), where M stands for money and C for commodity, here stock, and M()>M(). In this process, stock plays the role of collateral in exchange of money for money because the two parties do not know each other. The transaction is of a lending-borrowing nature, ‘as if’ the holder of C needs money and demands it and the buyer of C is there to lend money in exchange for stock. This process takes place over a short period of time. The lender and borrower, both speculators, enter into such transactions with the intention of reversing their positions, in many instances over the course of the same day. In this very short period of time, ‘speculation’ about the changes in the future rate of interest changes the market value of the stock, while leaving the asset value of the issuing firm totally untouched. The money rate of interest of the magnitude M()-M()]/M() emerges from such speculative actions. Keynes’ essential critique of the classical economists centres on the fact that the rate of interest causes speculation. If my argument is persuasive, we can conclude that the rate of interest is both the necessary and sufficient condition for speculation. Given that ΔK=I primary (stock) markets operate, nowadays, in effect, like highly developed money markets in that the time period between transactions on the same stock is so short that it does not allow any change in the stock of capital, or assets for that matter, to take place.

The word ‘capital’ as used in textbooks implies a long-term commitment on the part of the lender and a long-term need for the funds on the part of the borrower. The money market is a market for short-term (less than one year) loans (Luckett, :  and ). The naive distinction, in which the capital market is distinguished from the money market according to time period of the loan, is one of the many sources of confusion. It is very hard to pinpoint when and how such misunderstandings have originated. In the money market, the time period is too short to allow any addition to be made in capital or, for that matter, assets of a firm. Although speculation literally reduces to an exchange of money for money, it must not be confused with trade for reasons that are beyond the scope of this paper.

What should worry us most about speculation is the instability it introduces into the economic system. The notion ‘that speculation – if mistaken – tends ultimately to be self-correcting in any commodity market’ is not well-founded: “Keynes recognized that the self-correcting mechanism is either absent or very slow and painful in the case of the interest rate”. One can then argue that if inconsistency exists in the classical model between saving and investment functions, the former being primarily a function of income and the latter a function of the rate of interest, the rate of interest would fall toward zero, except to the extent that the speculative demand for money cushions it's fall. This combined with a relation, attributed to Wicksell (), to which we will soon return, means in many instances that there exists a saving gap, i.e. S>I, in turn meaning that the real cause of unemployment is the speculative demand for money. This is the kind of instability speculation brings about and it should worry us. The manipulated ‘price’ emerging from speculative activities, quite often, far exceeds the real value of stocks, does not contribute any extra value whatever to the assets or capital of the issuing firm. The difference in value is nothing but bubbles, which have frequently burst in the past and no doubt will again.

How important is the foregoing discussion for an Islamic framework? Given that speculators are aware of the bubbles in the market price of stocks, special attention must be given to avoiding any activity that involves encouraging interest (rate) to develop. A digression is necessary here to clarify what I understand the prohibition of riba to be prohibiting. I am convinced that the prohibition of interest does not apply exclusively to interest on money but to all kinds of interest in relation to any durable commodity since ‘for every durable commodity we have a rate of interest in terms of itself’. Also, it is not only professional speculators who do transactions on the stock market. Ordinary people also do so. We need to provide them with full information about what they are really buying. They have a right to be informed about what they, in fact, take ownership of when buying stocks at their market prices. To protect the general public, bubbles must not be allowed to develop. Prices of stocks supplied in the primary markets must be kept as close as possible to their real values. To ensure that buyers are not cheated, we need to make the necessary information available through whatever channels are effective. Ample evidences can be found that a sound Islamic Bazaar can be effective in this regard. Bazaars are still active in many Islamic countries where buyers have access to information regarding the prices and qualities of different products. The functioning of these Bazaars has attracted the attention of some location theorists on efficiency grounds and they have made some recommendations.

A sound, closely supervised stock market would prevent a money market developing from the conventional stock market. As a result, a capital market, as defined above, would take its place. Islamic economics, by abolishing interest, clears the fog in one stroke. Deprived of the option of interest, finance can only look for profit that originates in the real sector of the economy. The integration of the real and financial sectors leaves no room to grow for the money market and its chief pastime, speculation.

Real investment expenditures have their own attractiveness. As mentioned earlier, statistics show that the rate of profit for the G countries, combined and for each individually, has been much higher than the long term rate of interest, without exception, for twenty-nine years consecutively Ciocca and Nardozzi. The internal rate of return (IRR), the essential criterion for selecting capital investment, would undoubtedly have been even higher than the long-term rate of interest. Neoclassical theory holds that the relationship between the rate of profit on productive capital and the real rate of interest on money is based on investment. Investment is increased by high rates of expected return on speculative demand for money. The resulting pressure on available resources because real interest rates to rise, with the cost of these high rates being passed on to the consumers of the community. By ‘profits’ is meant the gross trading profits of privately owned industrial and commercial companies. That is, in capitalism, profits are measured gross of interest payments, taxation, and depreciation provisions, but net of non-trading income such as interest on financial assets owned by the companies. In an Islamic setting all interest charges vanish. We retain the capitalist assumption that the chief objective of the typical firm is to expand its productive capacity, which requires investment in fixed assets, and that the amount of profits that the firm sets out to earn is determined by the amount of investment that it plans to undertake. Unlike the position held by neoclassical theory, that the firm is willing and able to finance by borrowing any investment project, there would be no borrowing on interest in our model. While we rule out some Neoclassical assumptions we hold on to others, among them certainty, but not with the same meaning. It is well understood that investment expenditure projects inherently and inevitably carry risk: reality is too complex to guarantee certainty, so one anticipates ‘natural risk’. However, we need not incorporate the uncertainty and instability, the artificial risk, that result from speculation in stock markets. Rather, we need to reduce any such artificial risk, whose distribution is unknown (uncertainty is the better term), to the minimum level. Then, it is the rate of profit (which has its own distribution) whose mathematical expectation plays the central role in investment decision-making.

In order to have full employment, money must go directly to the production process. In that way, almost all the ills of capitalism can be removed. This is the type of radical surgery capitalism needs. To put it bluntly, interest really is the root of all economic evils. The most capitalism is able to do is to deploy monetary and/or fiscal policies either to boost aggregate demand or aggregate supply. It has proven unable to boost both simultaneously. Capitalism needs to go through a thorough surgical operation in order to enable a system that will enable it to boost aggregate demand and aggregate supply simultaneously. Weitzman’s suggestion for defeating stagflation — to follow the Japanese type of labour remuneration alien to capitalism, is not a remedy but only a palliative. My own investigation of the problem suggests that no one suggestion will succeed unless the cancer cells, i.e. interest and speculation, are removed from capitalism. In the surgical operation, we would be able not only to make the economy a healthy one with built-in self-regulating and self-adjusting elements but also a system that guarantees sustained growth. This will partly save economics from its dismal state. Recall what Adam Smith in his The Wealth of Nations states that: “When the stocks of many rich merchants are turned into the same trade their mutual competition naturally tends to lower its profits; and when there is a like increase of stock in all the different trades carried on in the same society, the same competition must produce the same effect in them all”.

Again, it was Smith who first took the essential step of disentangling the long-lasting confusion between money and capital. The sum of money supplied to benefit from interest in the money market may, or may not at all, go into the ‘venture’ of investment. In fact, the investor seeks to maximize his/her profits or (to be more precise) internal rate of return, which is totally separate from the rate of interest, according to the way interest is customarily treated in relation to the internal rate of return on any investment project. It is for the proponents of interest to explain why interest exists in the absence of inflation and risk, in the first place. An investor works within the legal framework of the ‘firm’, which enables production. That is essentially and totally different and separate from ‘buying and selling money’ as if money were a private good with the important difference that the former has all the social benefits attached to it but the latter produces harm to the society. In defending earlier economists, Cassel, like others, confused the concepts of profits and interest by observing that: “It would be misleading to suppose that the earlier economists did not understand the difference between business profits in general and that part of them, which is properly interest on capital…”

Profits are not subdivided into interest and profits of enterprise as Cassel mistakenly asserts, who further observes, Smith tells us expressly that, in his time, double interest was considered a fair rate of profit. Let us make it clear. Take a simple example where an entrepreneur uses only two factors of production: capital and labour. He borrows the sum of money, at the going rate of interest necessary to undertake a business venture and pays the labour it's going wage rate. Assume, additionally, that interest charges, as well as wage bill, are paid after the product is sold out and from the total revenue (TR). Obviously, the entrepreneur’s reward is not TR, but TR– r.K– W.L, that is the correct definition of profits (π). Self-evidently profits are exclusive of both interest charges and wage bill. What an entrepreneur earns and puts into his/her pocket, in a tax-free system, is his/her own reward to which no one else can have any claim whatever. It is hard to understand why this should present any sort of difficulty to anyone. One is reminded of the observation made by Hazlitt that “economics is haunted by more fallacies than any other study known to man”

Either the proposition really is hard to understand, or there is a pretence that it is. If the former, it would not be hard to make it understandable, but if the latter, one is bound to think that there is something wrong with capitalism that people are trying to keep hidden. This was probably the reason Alan Greenspan, the former Chairman of the Federal Reserve Board, stated, in April , that “it has become increasingly difficult for policy-makers who wish to practice, as they put it, a more ‘caring’ capitalism, to realize the full potential of their economies”. Joan Robinson  said it more forcefully and bluntly: “The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn to avoid being deceived by economists”.

Another common confusion is to use the term ‘capitalist’ for the moneylender who does not have anything to do with providing capital because she/he has no part in the establishment of the firm, by which alone money is transformed into capital. An entrepreneur by taking the risk of investment becomes eligible to earn profits; there is no reason for the moneylender to ask any portion of that profit unless she/he is also sharing the risk in the same way as the entrepreneur is. The existence of profit does not, on any objective ground, justify payment of interest. That has not stopped some economists, like Samuelson, from concocting a normative argument, namely fairness. This kind of reasoning hardly belongs in a discipline that claims to be positivist; and its understanding of what constitutes fairness could only fit the capitalist school of thought.

Would-be moneylenders who have money but are averse to risk and so cannot be motivated to lend except by interest could, when interest-free banking is properly introduced and established, be hedged against any risk. There are no objective reasons for clinging on to the institution of interest; rather, as we have argued, interest and speculation are at the root of the ‘objectionable features of capitalism’ Keynes was so concerned by, and the root of many problems and fallacies — in economic practice and the literature discussing that practice. In another futile attempt Cassel, like many, if not all, Western economists, tried somehow to make some connection, however artificial, between the rate of interest and productivity of capital, the origin of which goes back to the Bohm-Bawerk era. At one point Cassel sums up the results of the discussion between Ricardo and Malthus, in the following three points:

(i) Interest is determined by the principles of supply and demand;

(ii) The supply [of capital] is regulated by the tendency of accumulation to diminish when the rate of interest diminishes, and

(iii) The demand [for capital] is regulated by the tendency of the natural productivity of land to diminish when the population increases.

The last two, according to Cassel would have been good starting points for further investigations into the forces operating on the supply and demand of capital. We need to construct the theory of the firm in a different context incorporating the missing elements. Mukherji in an excellent effort tried to utilize Wood’s  framework to develop a theory of the firm in such a system. Wood’s pioneering book has been rightly praised as “…filling] a major gap in economics by providing a new theory of what determines the profit margin of the individual company and the share of the profits in national income. It is inconsistent with existing theories of profits, but it is consistent with most empirical studies of company behaviour”. Harcourt’s outstanding attempt to utilize accountants’ way of dealing with the finance problems of companies ought not to be omitted from the list of those rare economists who have tried to reconcile some principles of economics with those of accounting. Harcourt’s work undoubtedly adds further insights to Wood’s on the behaviour of firms. Economists can surely learn a great deal by theorizing their models with accounting type analyses. Many losses have been suffered as a result of ignoring and/or under-valuing the efforts of Wood and Harcourt. It was Irving Fisher who took the first step toward co-ordinating the work of economists and accountants in a book much admired by Pareto. Schumpeter, recognizing it as the first economic theory of accounting, said it should become the basis of modern income analysis.

Nevertheless, the fact remains that no rational justification for the necessity of interest has been offered. Robinson accepting the belief widely held among Western economists that capital is ‘a sum of money’, asked whether K, quantity of capital, was supposed to be a sum of money or a list of machines. An eminent authority, aware of the ‘defective methodology’ in economics, and the first and probably the best economist ever to name the ‘defective’ areas in economics, Robinson unfortunately failed either to correct the defectives or to incorporate the corrections in a coherent analytical method. Instead, she ended up by following in line with the very mainstream of thought she had raised objections about. Quoting the familiar saying, “A man of words but not of deeds is like a garden full of weeds”, she commented: “This is sadly true of the theory of capital”

Source: Prof. Iraj Toutounchian, A Legal Perspective Towards Islamic Finance. Republished with permission.