[Originally published in the Freeman, November 1964, this article is included in Free Market Economics: A Basic Reader, edited by Bettina Bien Greaves.]
Back in February, 1871, a group of free enterprisers found a way to help cotton growers adjust their production to market demand. They organized the New Orleans Cotton Exchange. There, for 93 years, cotton growers, wholesalers, manufacturers, and profit-seeking speculators could buy and sell cotton at free-market prices for present and future delivery.
The prices paid and offered were published in the press. No cotton grower or user was long in doubt about the state of the cotton market, present or future. For there is no better indicator of the state of a commodity market than the prices at which that commodity is bought and sold for various dates of delivery.
The prices of the New Orleans Cotton Exchange were long a valuable guide for farmers and manufacturers alike. For farmers, they indicated how much land should be planted in cotton and how much in other crops. Through the growing season, future prices indicated how much time, care, and expense should be spent in tending crops. When future prices were high, no expense was spared to bring every possible ounce to market. When future prices were low, farmers were warned not to waste too much time and expense cultivating and picking that last possible ounce.
For manufacturers and other cotton buyers, the Cotton Exchange quotations provided a base for estimating or determining their future raw-material costs. This in turn helped them calculate the prices on which they bid for future business. On orders accepted for delivery over long periods of time, they could always make sure of their raw-material costs by immediately buying contracts for delivery of cotton on the dates they would need it.
Cotton Prices Controlled
On July 9, 1964, the New Orleans Cotton Exchange closed its doors to trading in "cotton futures," as contracts for future delivery are known. For years such sales have been fading away. With cotton prices more and more controlled by the government, neither farmers nor manufacturers need the information or insurance of a futures market.
When demand for cotton drops off, the government advances the subsidized price to farmers and stores all unsold cotton. When demand for cotton rises, cotton pours out of government subsidized warehouses and sells at the government set price. Either way, the taxpayers lose. Until present laws change or break down, cotton prices will be set by the government, cotton acreage will be guided by bureaucrats, and valuable men, materials, and tax money will continue to be wasted in nonproductive enterprise.
This situation reflects a complete lack of understanding of the rules of human behavior and the role of speculators in a free-market society. It substitutes the wisdom of a few striving to stay in political power for the wisdom of those who spend their lives studying every facet of supply and demand before pledging their names and fortunes in support of their considered judgment.
It is human nature for men to try to improve their future conditions. That is the aim of every conscious human action. Men make mistakes, but they always aim at success in providing a better future for themselves or their loved ones. Free-market transactions are merely the attempts of men to improve their own situations by social actions which also improve the situation of others. Barring force, fraud, or human error, all voluntary market transactions must improve the situations of all participants.
How Men Act
Actually, there are only three basic principles of human action. Men can act as gamblers, scientists, or speculators. Few acts fall entirely within any one classification. For every human action is confronted by elements of future uncertainty, such as those that exist in life itself.
Men act as gamblers when they know nothing in advance about the results except that some will win and others lose. There is nothing a man can know, study, learn, or experience that will help him to become a winner. When men gamble, the desired results depend upon pure chance. No skill whatsoever is involved.
Men act as scientists when they know in advance the results their actions will produce. Scientists deal only with solvable problems where conditions can be controlled and where identical actions in identical situations will always produce identical results. Automation is a modem example of scientifically directed action. In all scientific action, the repetition of prescribed procedure will always produce the same results. So, the more that scientists know about the laws of nature, the more they can undertake with prior certainty as to the actual results.
Men act as speculators when they have only partial knowledge and understanding of the results their actions are likely to produce. The more speculators know and understand, the better they can predict the future results of their actions. But they never can be certain of the actual results.
Most speculations involve people and how they will react to given situations. Since we can never know with certainty the future reactions of others, every action which involves others is a speculative action. Thus, all voluntary actions, including market actions, are speculative.
Why Men Specialize
The best way to increase the probability that speculative actions will produce the desired results is to increase our knowledge and understanding of all pertinent data, including the thoughts and ideas that motivate the actions and reactions of others. This takes time, study, experience, and economic analysis.
Men have found that the best way to gain more of the needed knowledge, experience, and understanding is for each one to select some limited area of human activity and then specialize in it. Out of this division-of-labor principle the whole market system has developed. In a market society, everyone specializes and then trades the products of his specialty for the products of other specialists, his partners in total social production.
This system permits scientists to specialize in the automatic mass production of inanimate objects of wealth with certainty as to the physical results. However, men cannot plan or plot the market value of their products with scientific certainty. All such values are relative and speculative. They depend on the ever-changing ideas of buying men as to which of the many things offered for sale will give them the most satisfaction for the sums they have to spend.
Specialization can and does help men engaged in marketing and other speculative social actions. It permits them to learn more about what they sell and also more about the needs and wants of those to whom they seek to sell. Thus they become wiser and more efficient speculators, wasting less time trying to sell the wrong things to the wrong people.
Perfect results depend on the perfect prediction of future conditions. Because of human fallibility, this is rarely possible. However, better predictions and thus better results are often achievable. Greater specialization tends to reduce errors and help men achieve better results.
Many men prefer the relative security of a reasonably assured steady income to the insecurity of a wholly speculative income — an income that may turn out to be very high, very low, or even a net loss. Such security-seeking people tend to become employees.
Others prefer the lure and excitement of speculation. Such people are the investors, employers, business promoters, and professional speculators.
They assume responsibility for the uncertainty of a business venture's future success or failure. Their likelihood of success depends largely on their ability to predict the future wants of buyers.
Better Foresight Pays
In a mass-production market economy, the function of prediction and speculation falls primarily on investors, business promoters, and specialists rather than on consumers. When producers seek to act as scientists only, creating wealth by relying on the known laws of the physical sciences, they must find others to undertake the predictions and speculations as to the future conditions of the market.
Such specialists must estimate, at the time production starts, what consumer demand, competitive supplies, and other market conditions are likely to be at the time of sale. Such speculators then assume the responsibility that the planned production will meet the whims and wishes of consumers. Their income will depend on how correct their early predictions of future conditions prove to be.
As the division of labor has progressed, men and firms have tried to reduce their predictive and speculative functions to limited areas in which they become specialists with a better understanding than most other men. They concentrate on making or marketing certain goods and, in doing so, pay little attention to the market conditions of other goods, including their raw materials which may come from far-away sources with which they are unfamiliar.
Of course, the future prices they can get for their finished goods are in part dependent upon the ever-changing prices of the raw materials with which they are made. So, to protect themselves against future price fluctuations in their raw materials, businessmen sometimes engage in "hedging." By "hedging," they transfer the hazards resulting from the uncertainty of future prices to professional speculators in those products.
How Hedging Works
A good example of "hedging" is the case of the cotton shirt manufacturer. He is a specialist in making and selling shirts. He knows that the selling price of cotton shirts is largely dependent upon the price of raw cotton. He has little time to study the cotton-growing conditions around the world or the other prospective demands on the raw-cotton supply. He is fully occupied with his own problems in the shirt business. However, he would like to avoid the consequences of unforeseen changes in the prices of raw cotton.
Under free-market conditions, he can hedge by contracting to sell at current prices raw cotton which he need not buy or deliver until the date he expects to sell the shirts he is making. Then, if the price for shirts has fallen, due to a drop in raw cotton prices, he would buy raw cotton at the lower price to meet his hedging contract. The profit on his raw cotton transaction would offset his loss on the shirts.
On the other hand, if the prices of both raw cotton and cotton shirts have risen, the extra profits from his shirt sales will be offset by his losses on the hedging transaction in raw cotton. By hedging he can protect himself against all possible fluctuations in raw cotton prices which might affect the prices of the shirts he sells. He rids his mind of this worry so that he can concentrate on the details of the shirt business at which he is a specialist.
The man who takes his hedge is usually a professional cotton speculator. He is a specialist who studies and interprets all the available data and conditions that are likely to affect future raw cotton prices. He trades in cotton a thousand times for every once or twice by the average cotton manufacturer. He knows how much has been planted in the many cotton-growing countries. He studies the rainfall and other weather conditions which may affect the size of the various crops. He keeps up-to-date on laws and proposed laws that may affect raw cotton prices. He follows the ups and downs in foreign exchange and transportation costs.
He also keeps an eye open for changes in demand for each type of cotton. He has informed ideas about increased demands arising from new uses for cotton, as well as any decreases due to the substitution of synthetics. He watches developments in mass purchasing power, production, and consumption in faraway lands like India. In short, he learns all he can about anything that might affect the supply of, or demand for, cotton and thus bring about a change in future raw cotton prices.
As a well-informed specialist, the speculator is much better able to predict future cotton prices than is the man who specializes in growing cotton or manufacturing cotton shirts. Competition among speculators trading on a commodity exchange forces them to share the benefits of their knowledge with their customers.
Businessmen can protect themselves from some speculative losses by taking out insurance. However, customary insurance can only be bought for risks which are largely known or predictable. Losses from fire, death, theft, or transportation accidents are thus distributed over all those insured, instead of falling entirely on the ones who suffer a specific disaster. Future price changes do not fall in this category. They are the same for everyone. Only the well-informed specialist is equipped to speculate successfully and "insure" others against losses from price changes.
In popular thinking, the speculator is a bold, bad man who makes money at the expense of others. Many people believe he gains his livelihood by luck, gambling, or inside manipulation. There are, of course, a few dishonest speculators who lie and cheat, as do some in all occupations, but the honest speculator is a serious specialist who serves mankind. He constantly strives to obtain a better understanding of future market conditions. He then places this better understanding at the service of all interested parties. Whenever his predictions are wrong, it is he who loses. When he is right, he and everyone who trades with him benefit. For if they did not expect to benefit, they would not trade with him.
The service of a speculator is to smooth out some of the gaps between supply and demand and some of the extreme ups and downs in prices. He tries to buy when and where a commodity is plentiful and the price is low and to sell when and where the commodity is in short supply and the price is high. When he does this wisely and successfully, he tends to raise extremely low prices and reduce extremely high prices.
Frequently, the speculator is the first to foresee a future scarcity. When he does, he buys while prices are still low. His buying bids up prices, and consumption is thus more quickly adjusted to future conditions than if no one had foreseen the approaching scarcity. A larger quantity is then stored for future use and serves to reduce the hardships when the shortage becomes evident to all.
Since a price rise tends to encourage increased production, the sooner prices rise, the sooner new and additional production will be started and become available. So a successful speculator reduces both the time and the intensity of shortages as well as the hardships which always accompany shortages.
Likewise, speculators are often the first to foresee an increase in future supplies. When they do, they hasten to sell contracts for future delivery. This in turn drives down future prices earlier than would otherwise be the case. This tends to discourage new production that could only be sold at a loss. It also gives manufacturers a better idea of what future prices will actually be. So, here again the speculator tends to smooth out production and consumption to the benefit of all concerned.
A good example of how speculators serve society was provided in the coffee market a few years ago. A small newspaper item reported a sudden unexpected frost blight in Brazil. Speculators immediately realized that such a frost must have killed large numbers of coffee bushes. This meant much smaller future supplies for the United States. So the speculators promptly bought all the coffee they could below the price they thought would prevail when consumers became fully aware of the approaching shortage. This tended to raise coffee prices immediately.
The effect of this was to reduce consumption and stretch some of the existing supply into the shortage period. It likewise alerted coffee growers in other areas to be more careful in their picking and handling of coffee so that there was less waste. Higher prices encouraged them to get to market every last bean, which at lower prices would not have been worth the trouble. Higher prices also speeded up the planting of new bushes. Since it takes five years for a new coffee bush to bear berries, the sooner new planting was undertaken the shorter the period of shortage.
The speculators who first acted on this development served every coffee consumer. If these speculators had not driven up prices immediately, consumers would have continued drinking coffee at cheap prices for a time. Then, suddenly, they would have faced a still-greater shortage and still-higher prices than those that actually prevailed.
By buying when coffee supplies were still relatively plentiful and selling later when the shortage was known to all, speculators helped to level out the available supply and reduce the extreme height to which prices would otherwise have risen. Speculators make money only when they serve society by better distributing a limited supply over a period of time in such a manner that it gives greater satisfaction to consumers. They thus permit other businessmen and consumers to proceed with greater safety and less speculation in their own actions.
If a speculator buys a product thinking its price will rise and it later falls, he loses money for the simple reason that he has acted against the general welfare. He has sent out false indicators to producers and consumers alike. That happened just recently in the case of a large sugar importer. The firm bought large quantities of sugar when it was selling at 11¢ a pound. Its purchases were not hedged. In six months or so the price of sugar fell below 5¢ a pound and the importer was forced to file a petition under the National Bankruptcy Act.
Hedging with a professional speculator would have prevented that loss. Of course, if the speculator had made no better estimate about future sugar prices than the importer did, it might have been the speculator who filed under the bankruptcy law. But as a rule, speculators are the specialists who are best informed on what future prices are likely to be.
Fruits of Intervention
When governments set prices, quotas, acreage limits, or other hampering restrictions on the honorable activities of men, they countermand the checks and balances that the free market places on supply and demand. The result is always surpluses and shortages: the former, where producers' rewards are set too high; the latter, where they are set too low. Where there are surpluses of some things, there will always be shortages of others. For the men and materials subsidized to produce surpluses have been lured from producing those things which free-market conditions would indicate that consumers prefer.
Political interference with free-market processes can only burden the taxpayer and weaken the human impulses of free men which tend to bring demand and supply into balance at the point which provides the greatest consumer satisfaction. With the passage of time, each such intervention can only make matters worse. Then, if people still believe the remedy for every economic ill is more intervention, political interventions will increase further until the police state is reached.
In any such trend toward a police state, the speculators are among the first to be eliminated. They are the specialists who study worldwide markets in order to reduce the uncertainties that face all farmers and businessmen. Without the services of speculators, bottlenecks of production — a symptom of socialism — soon develop.
Men and materials are then wasted in the production of surpluses. As a result there are ever-increasing shortages in the things people want most but can't have because the means to produce them have been misdirected by government decree. The recent end to trading in cotton futures on the New Orleans Cotton Exchange is an omen that should make thoughtful men reflect on the road we are now traveling.