Saturday, May 31, 2008

The Stabilizing Role of Speculators

1. People who argue that speculation is destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when the currency (commodity) is low in price and buy when it is high.

~Milton Friedman, Essays in Positive Economics (p. 175)

In other words, speculators who continually lose money by buying high and selling low (which would increase volatility and be destabilizing) will be forced to leave the market eventually, and only rational speculators – those who will actually help to stabilize prices – will survive.


2. Speculators anticipate shortages and buy up commodities early, thereby removing them from the market. This alerts consumers to the oncoming shortage, fulfilling the important financial market role of providing information and allowing them to reduce consumption as prices rise. Later, the speculator sells, ameliorating the shortage while making a profit.

Speculators anticipate and warn others about shortages—they do not cause shortages. As a result of their trades, price swings are less severe than they otherwise would have been. We do not blame doctors, police, or firemen for profiting from the misfortune of others because it is understood that they help a bad situation. Speculators deserve the same consideration.

~Joetta Forsyth, Learning to Love Financial Market Barbarians


7 Comments:

At 5/31/2008 11:03 AM, Anonymous E. Harokopos said...

"In other words, specualtors who contintually lose money by buying high and selling low (which would increase volatility and be destabilizing) will be forced to leave the market eventually, and only rational speculators – those who will actually help to stabilize prices – will survive."

Nicely put Dr. Perry but the key parameter is "eventually".

While everyone is waiting for eventual stability, consumers get hit hard. This is a much high price to pay for letting the invisible hand work things out. Especially, because when there are no positive side effects of this kind of speculation.

When speculation is to the detriment of consumer it should be stopped by all means, even is this requires shutting down markets for a while.

Don't we all agree that the consumer is the driving force of economies after all?

Regardless, I believe speculation is parasitic in capitalism and free economies, not a necessary activity or stabilizing force.

 
At 5/31/2008 2:28 PM, Blogger Dave Narby said...

This comment has been removed by the author.

 
At 5/31/2008 2:30 PM, Blogger Dave Narby said...

Yes, that WOULD be true..

If you're only talking about LONG speculators.

SHORT speculators can drive the market down and *CAUSE* VOLATILITY.

And yes, you CAN short sell commodities!
http://retirementtrader.blogspot.com/2008/03/how-to-short-commodities-using-etf.htm

...And what a surprise! They use the stock market to do it! : p

This is exacerbated in the stock market with the continued existence of naked short selling (don't have space to explain it here, so Google it if this is new).

And yes, I know they supposedly took care of that with REG SHO, but there's still companies on that list... Some of them have been on for YEARS.

And you can still sell a naked short, simply by renting a seat on the options exchange as a market maker (I believe it's only $50k a year to do so), which doubtless large hedge funds have done in order to exploit the options market maker short loophole.

While the premise that speculators even out the market is sound, it falls apart once you become aware of the many loopholes in the system that can be exploited to "manufacture" volatility.

Until there's real teeth put into forcing brokers to deliver stocks (such as not paying them until they are delivered, and applying an interest penalty for every day they don't deliver), the 'speculators reduce volatility' argument is completely WRONG.

 
At 5/31/2008 4:39 PM, Anonymous E. Harokopos said...

"While the premise that speculators even out the market is sound, it falls apart once you become aware of the many loopholes in the system that can be exploited to "manufacture" volatility."

Very true. The article by Forsyth considers only the bright side of speculation but fails to recognize how parasitic activities can adversely affect equilibrium.

The article has an emotive aspect to it and lacks empirical support.

Commerce has been around too long before organized futures exchanges appeared in the late 1970s. The argument that futures markets and speculators contribute to efficiency lacks empirical support. On the contrary many studies show that coordinated speculation can drive underline prices and affect equilibrium for prolonged periods of time.

In conclusion, speculation should be limited to the amount required by commercial hedgers. Anythign above causes uncertainty, increases risk and can even cause bubbles, which IMO is the current situation in the Oil and grain markets to a significant extend.

It is true that "eventually" market forces will come to equilibrium but in the meantime inflation, diminishing purchasing power and unemploynment will take their toll.

 
At 6/01/2008 9:36 AM, Anonymous Anonymous said...

I don't find this argument that speculators are good to be compelling. Maybe I should read the book. The problem is that the the speculators are just as stupid as anyone else and they don't all make money. The problem is not during times of stability but during bubbles when all sorts of idiots get into the game and make a mess of things for those who would be more stable. Does condo flipping really help the housing market? Did tulip speculators provide a service to any one? I don't think so.

 
At 6/01/2008 3:07 PM, Blogger happyjuggler0 said...

Mark,

Thanks for the excellent link. While I of course realized that markets are the best method of allocating resources, it can be, and has been, difficult to explain the value of financial markets to people (as the comments preceding mine show). The author of the article gave several great illustrations that are helpful tools in illuminating the value of the role financial market particpants play.

 
At 6/01/2008 3:49 PM, Blogger Jack McHugh said...

Speculators add liquidity to markets, which is important and usually a Good Thing. But they also push prices above or below where they would have gone otherwise, which usually is not a big deal, but sometimes is.

An example of the former is the oil market now - to the extent this run-up is partially due to speculators, it will quickly reverse and unwind, and boy will they get hammered (in the aggregate).

An example of this dynamic being a bad thing is the role of speculators in an inherently illiquid market, housing. We've all seen the stories about the large proportion of residential buyers at the peak who were not buying a home to life in. This happened in part due to a classic bubble psychology (either "double digit rises forever" or "there's always a greater fool"), combined with waaaaay too much liquidity in the money market - lenders were just too eager to shovel mortgage loans out the door. The work-out is well along it seems, but the pain is pretty widespread, and appears to be taking a bite out of the larger economy, too.

 

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