Whenever there is an international currency crisis of any sort, or banking crisis, or other financial crisis, there is inevitably the familiar song of blame sung in its wake vilifying the so-called speculators and their nefarious "hot money". In the press and in political circles this argument against the black-hearted speculators has great appeal. For the press, it provides a story with a sort of literary quality, a tale of good versus evil, and one that turns into a kind of morality play. It provides a plot and helps the press flesh out a story about the wickedness of greed. For the political types, it shifts the blame, diverts attention from the mistakes of their policies and the damage wrought by their interventions.
Far from being unique to currency or financial markets, history never lacks for those who decry the evils of speculation in a variety of markets. In the late 19th century we had Henry George preaching the evils of land speculation and sermonizing about the bogeyman of idle land. In the 1930s we had Keynes and his tirades decrying speculation of all kinds, which led him to endorse its abolishment in his famous Treatise:
"The spectacle of modern investment markets has moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reasons of death and other grave cause, might be a useful remedy for our contemporary evils."
Today, the mythology continues to build and grow so that even one of the economics community's most well known trade experts was led to endorse capital controls. Further, the Wall Street Journal recently noted that Mexico has stockpiled a reserve of so many billions of dollars to avert any future crises and that in this other nations are advised to follow. The message seems to be: "Head off the evil speculators, before they get you!" The Washington Post, citing various reasons for the delay of putting together a successful European Union casually notes, as if self-evident, that "at various times, speculators mounted attacks on weaker currencies." The reader is led to declare "There they are again! These speculators, plotting, planning. We must build our defenses now, while there is still time!" The literature of such thinking is enduring as well. Charles Kindleberger's book Manias, Panics and Crashes has run through several editions and chronicles the history of financial panics and collapses of the human story. And Edward Chancellor concludes his new book Devil Take the Hindmost, with "as an anarchic force, speculation invites government restrictions, yet it is only a matter of time before it slips its chains and runs amok." Readers are left to believe that the world of finance is one big irrational out of control monster that needs to be brought under our heel and bound by the leash of the benevolent central banker who will domesticate and tame this wild animal.
Scant attention is paid, if any, on what the role of speculation may be in a market economy. Hardly a word is spent defining what is speculation. These are important questions and this essay hopes to identify a few of the positive roles speculation plays.
What is speculation?
But first, we must arrive at an acceptable definition. For that we should turn to one speculation's most ardent defenders and one its most skilled practitioners. The late Philip L. Carret (pronounced Carrey), author of the investment classic The Art of Speculation, first penned in 1930, grapples with this issue, which is more difficult than one might imagine. The term investment, of course, seems to get all the good press and avoid the negative connotation associated with the term speculation. As Carret trenchantly points out:
"A treatise on investment needs no defense. Everyone who is not a socialist or communist realizes more or less vividly the vital part which capital plays in the modern world. It is readily admitted that the investor is entitled to a fair return for the use of the wealth accumulated by his self-denial… It is only the economically illiterate who regard bond salesman, brokers and other specialists of the financial world as "parasites" or "non-producers". The case is different with speculation."
In the time immediately after the Great Crash of ‘29, the term investment often meant bonds, as opposed to stock. Investment purchases were made outright as opposed to on margin, which was considered speculative. Investments were held for the long-term; speculations were held for the quick turn. These distinctions pose numerous difficulties upon reflection. The instrument itself cannot be used as a defining feature of speculation. Certainly, there are stocks that provide better security than some bonds. The stock of a well-capitalized large publicly held corporation offers greater security than a bond floated by a thinly capitalized new venture. In this sense, the latter may be said to involve greater risk. Moreover, the use of margin should not immediately imply greater risk. In fact, if strict logic were followed the reverse may be true, for often the most thinly traded and weakest stocks must be purchased outright since no one is willing to lend money against them. In today's market, creditors are willing to lend 85% against the value of a short-term treasury instrument, for example, an instrument that is thought to entail virtually no risk of principal loss. Finally, the time one holds an investment, contra Keynes, does not provide any reasonable test for defining a speculation. Any such test is purely arbitrary. Should the holding period be one year? Six months? One week? Why? As the great dean of security analysis, Benjamin Graham, once noted, "The difference between investment and speculation is understood in a general way by nearly everyone, but when we try to formulate it precisely, we run into perplexing difficulties. In fact something can be said for the cynic's definition that an investment is a successful speculation and a speculation an unsuccessful investment."
The common dictionary definition of speculation is that a speculation is an investment in a risky business venture with the potential for large gains (or losses). This seems an acceptable definition for everyday informal use with the connotation of risk being the key distinction between speculation compared to investment, where investment is perceived as safer. Yet risk is often in the eye of the beholder. What may seem risky to me may not seem risky at all to you. The proverbial widows and orphans have different tolerances for risk than the young twenty-five year old working person. Investing in an Internet stock seems risky to me, but it may seem less risky for those involved in the business, who understand the technology and industry better than I do. Investing $5,000 in a stock may be a significant investment for some, but a trivial gamble for others better endowed with monetary wealth. A man with tens of millions can prudently take risks that a man living pay to pay check probably should not. We are each uniquely able to determine our own capacity for such things and most of us would not easily cede this position without some trepidation. If we are going to talk about the economic role of the speculator and see speculation as it is, we would do well to distill it of its connotation of excess risk, since this risk is not objectively determinable for everyone. While there are many ways to quantitatively measure risk, ultimately the future is unknowable. Regardless of these mathematical constructs, it is a human motive that ultimately must determine and act on that information. Risk is always defined from one's specific point of view. As Carret writes, there is "an infinite number of gradations" of buyer and seller motives. "It is quite impossible to draw a sharp line and say of those on one side, "These are the investors!" and of those on the other, "Those are the speculators!""
Realizing this, Carret defines speculation thusly: "Pure speculation involves buying and selling in the same market without rendering any service in the way of distribution, storage and transportation". This is a broad definition, neutered of the emotional content and more easily discernible in real life. Therefore, Carret says that a man who buys a crate of eggs to distribute to consumers a dozen at a time at a price a few cents higher does not engage in speculation. Although, the merchant may earn a speculative profit should the price of eggs rise before he sells them. Here the merchant performs several services; he likely must store the eggs, transport and distribute them. He earns his way by adding value through these services, services that consumers are willing to pay for. However, the price of eggs fluctuates still, due to reasons not directly influenced by our small egg merchant. It is these fluctuations, Carret believed, that may be said to be speculative. In this sense, the everyday merchant cannot help but engage in speculation as a matter of course. The egg merchant must be aware of, and must deal with, the fluctuating price of eggs.
Carret used another eloquent example to illustrate his point: "When his neighbors gather at the 19th hole of the local country club and discuss the apparent prosperity of Henry Robinson, the local miller, their natural comment is that Henry is a shrewd business man. It occurs to no one to say that Henry is a successful speculator, though the flourishing state of his business may be due far more to his correctness in judging the wheat market than to his skill as a manufacturer or merchant. Though the speculation involved in the miller's operations is incidental to his main business, it is speculation none the less." To Carret, speculation involved more than stocks, bonds and currencies. It embraced all commodities and goods where a market may exist.
This is consistent with the economic definition of speculation provided by the late Austrian economist Murray Rothbard in his treatise Man, Economy & State. The value of a good has two uses from the perspective of an individual actor: a use-value and an exchange value. Whichever value is higher on that actor's value scale will be the determining factor in action (the value of all goods is ultimately derivable from its value in producing consumer goods or its value as a consumer good). If a person purchases wheat for the purpose of using it to make bread to eat, then he is a consumer of the wheat and he places a higher value on its use. If another person should purchase wheat with the expectation that he can sell it later for a higher price, then he is not a consumer and, as a result, places a higher value on the exchange-value of the wheat. In the latter sense, the person is speculating. It is this anticipatory element that defines speculation for Rothbard, and it is consistent with Carret's definition. This dichotomy between the use-value and exchange-value will be important in showing the services provided by the speculator.
Services provided by the speculator
So what are the services that speculation provides if they do not involve distribution, storage or transportation? It is not self-evident for most people. As Carret writes:
"It is by no means clear to the average man that the successful speculator contributes anything to the world's welfare by way of compensation for his financial gains…. As there seems, on superficial consideration, to be no benefit to society from speculative operations, it is commonly believed that in speculation as in gambling the gains of the successful merely offset the losses of the unsuccessful. It is small wonder that…noted speculators have never been popular figures."
The primary services that speculators provide are to assume risks, to speed market adjustments and to provide liquidity. In these ways, speculators help the market (or whatever specific sub-market one chooses to define) function more efficiently.
Let's first examine the adjustment process. Market prices adjust fundamentally to the forces of supply and demand, that is, to buyers and sellers freely interacting. The buyers and sellers purchase goods ultimately for two reasons: consumption/use or exchange. This is the use-value, exchange-value dichotomy mentioned above. The higher value on the individual's preference scale will be the determining factor for a given economic actor. If prices are low, speculators may realize that they may buy the good now and sell it later for a profit. So, to the extent that buyers and sellers anticipate prices, they will refrain from buying at a higher price and instead will buy at a lower price. As Rothbard notes, "…the more this anticipatory, or speculative, element enters into supply and demand, the more quickly will the market price tend toward equilibrium," or the most efficient market clearing price. Rothbard notes that "such unanimously correct forecasts are not likely to take place in human action" and that errors will be revealed in the ensuing shortages or surpluses. Thus, the market tends inexorably toward the establishment of the genuine market-clearing price. Speculation reduces the gap between the high prices and the low prices. Far from causing greater fluctuations, the speculator tightens the band around which prices may fluctuate and provides stability.
It is in this buying and selling that speculators help to better allocate resources to their highest uses. As Carret articulated it, speculators do so by "opening reservoirs of capital to the growing enterprise, shutting of the supply of capital from enterprises which have not profitably used that which they already possess." In this respect, the speculator is an "advance agent" directing capital to its highest uses.
The speculators also absorb risk. For example, the speculator may sell cotton futures. The buyer of these futures may be a mill who wishes to lock-in a price now for cotton, thereby protecting itself against the risk that prices rise. The speculator here assumes some of that risk.
Or, perhaps, as James Grant wrote, "…the speculator is a buyer – for instance, a Tunica cotton farmer. The farmer is occupationally bullish, but he is also realistic, and he sees that the price of cotton for October delivery is well above his cost of production. It is now the Fourth of July, and long weeks of uncertainty stand between him and his harvest. By selling forward an unharvested portion of his crop, he is able to lock in a profitable price. This he does with the self-interested help of the speculator."
It is shown in these examples that the buyer and seller are not typically antagonistic. The mill and cotton farmer are able to lock-in prices now and reduce the risk of uncertain future prices. The speculator stands to profit if the speculator's estimation of the future market is right.
Grant makes an interesting distinction between the gambler and speculator. The speculator, Grant maintains, bears risks that come into existence prior to the speculator's decision to bear it. "Thus, the risk of falling cotton prices antedated the decision of the cotton speculator to enter the futures market. In a world without speculators, every farmer would have to hedge his or her own crops, every banker his or her own securities, and every insurer his or her own promises to underwrite the next disaster. In gambling, no risk of loss existed before a casino patron sits down to try his luck. The risk borne by the gambler, like that by the skier, is created specifically by the participant for the occasion."
Finally, the presence of speculators provides liquidity for a market. Liquidity is the degree to which an asset or good can be converted into cash. Stocks and bonds and many other financial assets are very liquid assets precisely because there are many speculators willing to buy and sell these securities. Without a stable of ready buyers and sellers, it would be difficult to convert investments into cash quickly at prices that reflect market values.
A note on bubbles and crashes
Speculators, as defined, represent no threat to an economy. On the contrary, the speculator provides useful services that improve the efficiency of the market. But what of the spectacular bubbles and crashes of years gone by? Aren't they caused by excessive speculation?
These historic events, such as the crash of '87, or the S&L crisis, or the great crash of '29, should each be treated as unique occurrences. Each had its own seeds, so to speak. Speculation itself does not cause crises, however. Instead, speculation reveals quickly the underlying weaknesses in a market and affirm the buying public's approval or disapproval. The currency collapses of many Asian nations in 1998 revealed concrete weaknesses in the economic and political environment and were not caused by speculation. The Austrian school of economics has famously argued that credit expansion and intervention bring on the boom-bust cycle, and that the boom-bust cycle is not endogenous to the market system. Further, government can often create an environment that encourages risk taking. The existence of Federal Deposit Insurance and government bailouts of failing firms changes the behavior of market participants. The FDIC weakens depositor discipline on financial institutions, for example, and keeps poor performers in business when they should have closed their doors.
The point is that speculation itself, the mere buying and selling for profit, is not an evil. It is a necessary component of a fluid efficient market. Moreover, human beings are not omniscient and opinion can change quickly, especially in financial markets. Great collapses can be brought on by errors in judgment that are revealed only after they have occurred. No one can predict what the future state of a market will look like.
It has been said that markets make opinions, and sometimes they are not always right, but who better to make these opinions speculators or bureaucrats?
Further, as this article has hopefully shown, speculation is more prevalent than most people are willing to admit. As Carret wrote, "Even in the highest grade securities there is a certain inescapable speculative risk. It is not decreased by burying one's head in the sand like an ostrich and saying "I never speculate!""
The Failure of the New Economics (Irvington-on-Hudson, New York, 1994)
Jagdish Bhagwati "Yes to Free Trade, Maybe to Capital Controls," The Wall Street Journal, November 16, 1998
Jonathan Friedland, "Mexico Prepares for Election with Financing", The Wall Street Journal, June 16, 1999
Paul Blumstein, "Currencies In Crisis", The Washington Post, February 7, 1999
Philip L. Carret,The Art of Speculation (John Wiley & Sons, 1997)
Benjamin Graham, Security Analysis (McGraw-Hill Companies, 1934)
Murray Rothbard, Man Economy & State (Ludwig von Mises Institute, 1993)
James Grant, The Trouble with Prosperity (Time Books, 1996)