Wednesday, June 25, 2008

Money-Making Speculators Must Stablize Markets; Only Money-Losing Speculators Can Destabilize

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)

My crude chart above (sorry!) illustrates Friedman's point. The blue line above represents commodity (or currency) price movements over time in a market WITHOUT speculators (due to a government ban for example), and the red line represents that same market WITH the fictional destabilizing speculators (as portrayed by the media and politicians) now being allowed to trade. For speculators to destabilize that market, they would have to make prices more volatile over time, and that is what the red line illustrates - there are greater price swings, and greater price volatility (both up AND down) WITH speculators compared to price movements over time WITHOUT speculators.

But saying that speculators destabilize the market above is also the same thing as saying that destabilizing speculators must BUY when the market prices are at a HIGH point (driving them up even higher) and must SELL when the market prices are at a LOW point (driving them even lower). And as we all know, buying HIGH and selling LOW is a sure way to lose money, and speculators can then only be destabilizing if they are LOSING money, as Friedman points out, and therefore the chart above can NOT represent reality.

Conversely, if and when speculators are making money, they have to be buying low and selling high, which would be the same thing as saying that they are stabilizing markets and reducing price variability. And the more "excessive speculation" and "unfair profiteering" they are accused of, the GREATER the role speculators play in stabilizing prices and markets.

Update: The chart above shows what a theoretical market would look like ONLY if fictional speculators destabilize prices and markets by losing money, but keep coming back to lose more and more money over time. The chart does NOT represent reality, but represents the fictional, destabilizing speculators portrayed in the media and by politicians, and those traders would have to be losing money in the process of destabilizing oil markets.

Bottom Line: If speculators are making money, they MUST be stabilizing markets. If speculators are losing money, they MUST be destabilizing markets (fictional chart above). But speculators can NOT make money and destabilize markets at the same time.

22 Comments:

At 6/25/2008 9:57 AM, Blogger David Damore said...

There must be something I am missing. The red line, a market with speculators, appears to have a greater change in price and scale. The blue line representing a market without speculators appears to change to a lesser degree [stability in the consumers eyes].

Consumers [and producers] like things [Prices] to be somewhat predictable. They make choices based on how things will work out for them. If prices change faster and go up [or down] further than a market without speculators it would appear that the red line represents price instability.

What am I missing?

Are the lines [colors] reversed?

Or is stability defined by the continual availability of a commodity based on signals sent to producers [the signal is to bring more or less to the market in the future]?

Any clarification you can provide will be greatly appreciated.

Thanks,
David

 
At 6/25/2008 10:16 AM, Blogger Mark J. Perry said...

I have now clarified on the post that the chart does NOT represent reality, but represents the fiction portrayed by the media that speculators: a) make money, and b) destabilize the market at the same time. If speculators are making money, they MUST be stabilizing markets. If speculators are losing money, they MUST be destabilizing markets. But they can NOT make money and destabilize markets at the same time. That is the point of the post.

 
At 6/25/2008 10:28 AM, Blogger David Damore said...

Mark,
Thanks for the clarification. Makes sense now.
Best,
David

 
At 6/25/2008 10:52 AM, Anonymous Anonymous said...

Speculators have, on balance, an extremely important stabilizing role for markets. It is evident to anyone who understands the pits of the Chicago Board of Trade that they provide liquidity (take the other side of the trade) to end users of commodities (hedgers). Government would do well not to interfere.

It is also clear that speculators in isolated cases can overwhelm a market. Look at the Hunt’s attempt to corner the silver market or the NASDAQ more recently. In the late 90’s everyone had an understanding of the potential value of computing and the internet. Investors projected this value on a universe of stocks of internet stocks that was in its infancy. This disconnect between the universe of internet shocks and capital allocated to this market created the subsequent bubble. So while on average speculators have a stabilizing effect – they don’t always.

 
At 6/25/2008 10:56 AM, Anonymous Anonymous said...

One idea would be to add a third line to the graph showing less variation than the baseline and labeled as "Reality: Stabilizing Speculators" and also label the dotted line as "Fictional: Money-Losing Speculators". Something like this might help to clarify the point?

 
At 6/25/2008 11:18 AM, Blogger Sophist said...

Fairly simplistic argument that makes a host of assumptions that are not necessarily true.

(1) You have defined stability the way that suits your end objective. However, a line straight up can have very low volatility as measured, for example, by a 14-day ATR, a popular volatility measure used by technical traders. Under that environment, speculators BUY new highs constantly with the objective of creating a bubble effect (PUMP) to unload (DUMP) at some point in the future. Yet, volatility remains low.

(2) You have completely neglected possible external benefits which can be substantial as compared to profits made in a particular market. Destabilizing speculators, according to your simplistic model, maybe losing money in exchange for external benefits in some other market, like shorting stocks and making money that way or buying other commodities in amounts much larger than their bets in the particular market they are destabilizing to cause the side effects.

(3) Even if you simplistic model can be argued to correspond to reality, what is important is the period and amplitude of your peaks and valleys. If the underline market dynamics are such that they do affect other important markets by spilling over to them, the destabilization effect can take place there and then fedback.

I'm afraid you havenot made a case for speculators. Actually, you have raised more questions with your example as for what roles speculators can play in passively or even actively destabilizing markets.

 
At 6/25/2008 11:27 AM, Anonymous Fred said...

"So while on average speculators have a stabilizing effect – they don’t always."

So while investors have bought stocks that go up - they don't always.

 
At 6/25/2008 11:30 AM, Anonymous Fred said...

The lesson I got from the Brian Hunter / Ameranth natural gas disaster is that if you are a small part of the market then there is a market. If you are a large part of a market then you are the market.

 
At 6/25/2008 12:26 PM, Anonymous Machiavelli999 said...

I think it is useful to look at commodities that are widely traded (like oil, copper, gold) and compare it to commodities that are lightly traded (like tin and orange juice). I'll leave looking up the information to you guys, but you'll see that the volatility is much higher with the thinly traded commodities.

 
At 6/25/2008 12:43 PM, Blogger bobble said...

professor perry. thanks for all the analysis. this is a good discussion.

while i agree with what you say, it seems like you are talking about the 'smart money' speculators. they are the ones that are in the markets day in and day out, evening out the price movement by keeping the markets liquid, and making money in the process.

but at the end of a large price movement often times there is an influx of 'dumb money' speculators.

i wonder if this is where we are now. 'dumb money' evenually goes broke, but for a while, they pile in towards the end of a price move and cause prices to spike. think of the oil/gold price spike back in 1979-1980.

in the past, dumb money used to be individuals. now, the new 'dumb money' is hedge funds. with stocks, housing, commercial real estate, collateralized debt, etc all tanking, commodities are the only game left. perhaps they are all jumping in at the same time causing the market price to spike up.

 
At 6/25/2008 1:18 PM, Blogger OBloodyHell said...

> In the late 90’s everyone had an understanding of the potential value of computing and the internet. Investors projected this value on a universe of stocks of internet stocks that was in its infancy. This disconnect between the universe of internet shocks and capital allocated to this market created the subsequent bubble. So while on average speculators have a stabilizing effect – they don’t always.

The overall issue with this is that IP essentially represents a currently ill-understood commodity on the market. How to value it is difficult, esp. in the face of piracy (both commercial and individual). It is a particularly counterintuitive product, and a large percentage of the "old rules" about commodities DO NOT apply (or apply in a sufficiently different ratio that it represents a defacto phase change in the behavior -- like Ice vs. Steam -- same stuff, but different properties). Real, manufactured goods are not the same, by any means, as IP. For one thing, virtually all the costs of IP creation are front-loaded. That first "widget" (film, book, software) is the one that costs all the real money. After that, each "additional unit" is comparatively free -- pennies on the thousands (assuming digital distribution).

Intellectual property vs. Real property -- manufactured goods and food -- are no more the same commodity, propertywise, than ice and steam are. There is literally a phase change between them, and hence the entire system of allocation, tracking, and distribution require a new and thorough analysis. You can no more rely on Real Property rules to effectively distribute and apportion IP than you would think to use steam pipelines to distribute ice.

The effects of such a change on the economic structure -- financial, monetary, etc., cannot be underestimated.

An IP and Services Economy is a radically different animal from the precursor Ag and Industrial Economies. For one thing, casual analysis calls to the fore that a heirarchical model works for the two earlier setups, but an IP&SE is, by nature, a network (yes, despite the tendency to "forcefit" popular ideas into systems, in this case, the idea of a network is "popular" is because it is so inherent in the whole IP&S paradigm).

We have no experience with an economy which acts upon a network rather than a heirarchy. We have no experience how wealth flows in such a system, nor what interferes with it. There are other things which can be applied (a whole host of rules from Information Theory), but accuracy of understanding currently isn't much to be found. I haven't seen much from economists which even ack that IP-related things might be substantially different.

Everyone spoke of the "New" economy in the 90s. Despite the "failure" of this, as an idea, it was accurate -- what we saw was society's First Draft. Subsequent drafts will follow, until we get it down pat. Misery may certainly ensue if we get it substantially wrong, like the Depression and later with Keynesianism.

The relevance to the quote above is that speculators in this case had no idea what they were doing (pretty much, they still don't -- all internet and IP stock prices are based entirely on SWAG).

Further, there was a large expansion of the money supply during the Clinton Admin, which is usually attributed to a cause of "cheap credit", which leads to more risky speculation (the same can also be applied to the Real Estate bubble currently in the process of popping, caused by easy credit in the early 'Oughts). Hence, just when there was a whole raft of brand new, ground-floor investment opportunities, there was also lots of risk capital to throw at it. So people started grabbing it and throwing it, hoping to be the next Bill Gates or Larry Ellison.

This also ties to the issues that all the models have (I believe) with the fact that the economy has NOT tanked despite some measures which suggest it should. The "new economy" has, in fact, generated a truly huge mass of new wealth in the form of IP with an uncertain value (what are all those old movies, music, books and such really, really worth?). Hence, the large expansion of the money supply by Clinton, while not very well tuned or aimed, is supported by the massively enhanced valuation of digitized IP (you no longer have to make an expensive container to sell it, you can just send someone a copy).

Note: the societal value of something (i.e., the measure of its contribution to total societal wealth) is only partly related to one's ability to collect the reward for "ownership"/creation of it. Society benefits from every extant copy of Photoshop, pirated or legitimate, regardless of whether Adobe gets to see a reward from that copy. Just because someone pirates a movie does not mean that society has not gained wealth from the IP, only the assigned "rewardee" -- the copyright holder. This reward does have an effect on the creation of subsequent IP, but has limited effect on the societal wealth resulting from existing IP.

The existence of piracy, and its associated problems, is an artifact of a poorly designed reward distribution system in the face of the internet and digital media distribution channels.
These reward systems absolutely require a massive overhaul (they utterly cannot work as currently defined, by any amount of "tweaking"), but that is another topic.

P.S., I strongly recommend everyone reading this read the excellent article John Perry Barlow wrote in the mid 90s --

The Economy of Ideas -- A framework for patents and copyrights in the Digital Age. (Everything you know about intellectual property is wrong.)

Barlow knows of what he speaks because, among other things, he got rich by putting his money where his mouth is, as have other creators who followed suit.

 
At 6/25/2008 1:25 PM, Blogger OBloodyHell said...

> Yet, volatility remains low.

Pump and dump would obviously affect volatility quite a bit. You confuse volatility with chaos. Volatility is any increase in the variance area from smoothest best-fit curve. What you are thinking of is how "spikey" (i.e., smooth) the actual curve is, which is not tied to that. I can spike a curve up and down and still have the market be far less volatile.

Neither is particularly desirable, but people outside of the spec and production markets -- consumers, to say -- are much more sensitive to true volatility rather than momentary predictability.

.

 
At 6/25/2008 1:31 PM, Blogger OBloodyHell said...

> consumers, to say -- are much more sensitive to true volatility rather than momentary predictability.

By this I mean that the market itself for most product tends to smooth out radical short spikes. You aren't likely to see a $1 a gallon price jump at the pump just because the spec price on a barrel goes up 50% for a whole day , then drops down to the original level (due to, say, a suddenly perceived crisis which just as quickly disappears as false). Market inertia alone will dampen such a spike to almost nothing, unless you got caught speculating during the spike.

 
At 6/25/2008 1:53 PM, Blogger Sophist said...

"Pump and dump would obviously affect volatility quite a bit."

Not until the dumping takes place, in most cases.

What I said is that it's wrong to associate volatility with stability. If you agree, just say so.

Regardless, both volatility and stability are kind of subjective terms. Volatility often relates to dispersion of returns for a given security or market index. Stability is a vague term otehr than when used in relation to deterministic dynamical systems.

On the contrary, price is an indisputable fact.

 
At 6/25/2008 4:28 PM, Anonymous Norman said...

What a joke, the government wants to regulate oil trading to curb minipulation whereas regulation is the Mother of all minipulations.

 
At 6/25/2008 5:09 PM, Anonymous Anonymous said...

It is like the analogy of the dead horse. When one sees a dead horse that covered with maggots and flies, one could conclude that the flies & maggots were the cause of death rather than being merely pests attracted to the carcas?

Are speculators the cause or just a symptom of price volatily in commodity markets? Two excellent posts present a very good case as to why the case for destabilizing speculators is less than airtight. Simple answers to complex questions seldom, if ever, account for all of the data.

 
At 6/25/2008 5:38 PM, Anonymous Anonymous said...

Sophist,

If complex market systems can be boiled down to the most simplistic explanations, doesn't it suggest that the study of economics is an opportunity cost to be ranked just slightly ahead of playing tiddley-winks for the Sorbonne?

Our presence and the diversity of opinion on this topic suggests otherwise.

 
At 6/25/2008 8:32 PM, Anonymous Anonymous said...

sophist-

I ask that you offer an alternative model and explanation rather than poke holes. Understanding is advanced by alternative explanations not applying logical constructs designed to deal with universal concepts. The model offered here lives in the realm between 0 and 1 not 0 or 1.

 
At 6/26/2008 2:36 AM, Blogger Sophist said...

Anon,

Here is a specific model of how you can get a speculative bubble in crude oil prices (or anywhere else):

Some speculators play buyers and some others sellers. Buyers concede to higher sell offers from those speculators who constantly sell short crude oil contracts. When buyers do not concede to higher sell offers any longer, they cover their shorts causing a rally up. All they need to do is repeat this pattern a few times to cause a bubble run.

For this model of manipulation to work you need concerted speculation, which I think it is highly possible is happening for at least the past year or so.

So for those that asked, this is a very specific model which shows how speculators can drive prices sky high.

Note that this may not always be successful and in the past speculators have lost money doing it. This time around, they have succeeded because it seems that many other factors are in their side plus the external benefits are many, like shorting stocks and the dollar.

Not all speculators are bad, but this kind of speculation is very bad to your pocket.

The Sophist, me, proposes the following compromise:

All oil and oil product futures players should be allowed to keep open positions without delivering or taking delivery for a maximum a 5 days. Open positions after 5 days should be required to deliver or take delivery. This solution does not deprive futures markets from needed intraday and short-term volatility but forces speculators to cover their positions, increases their transaction costs and makes their presence evident.

Other proposals are welcome. I agree we should not kill good speculation and thus kill liquidity.

Let us turn this blog into an effort to propose solutions to important problems, rather than arguing about silly things.

The final solution will probably be a combination of different ideas and inputs from other posters, but I am glad to get this thing going.

Remember, talk is cheap, we need effective solutions.

 
At 6/26/2008 12:56 PM, Blogger OBloodyHell said...

> "Pump and dump would obviously affect volatility quite a bit."
> Not until the dumping takes place, in most cases.

Don't be ridiculous. The area between the curves either changes up or down. If it decreases, then it's going to lower volatility. If it increases, it would increase volatility.

So it rises when you pump, but doesn't LOWER until you dump.

Do you not grasp basic calculus? "The area under a curve" -- In this specific case, the area BETWEEN two curves ??

This is something you learn in a high-school calculus course.

> What I said is that it's wrong to associate volatility with stability. If you agree, just say so.

No you didn't. You tried to substitute a measure of stability FOR volatility, when they aren't the same thing.

Dr. Perry is attempting to show how proper speculation has a smoothing effect, which lowers the area between the longer-term best-fit price curve and the actual price curve (not shown on graph, but implied) -- and *reduces* the difference lower than between the "no speculation" curve and the (i.e., smooth) best-fit curve (Doc, might not be a bad mod of it, I'll ack)

The value of low volatility is that it allows longer-term planning and better risk management. You know which resources are needed at most to reach your goals.

Stability, while also good, is nowhere near as important. It only affects the short-term. "Do I full up on gas at the pump today or wait until next week?" vs. "What are my fuel bills going to be for the time I own this car? Is it cost-effective to consider buying a more fuel-efficient vehicle?"

Ineffective, money losing speculation has no such effect, and increases instability AND volatility.

> On the contrary, price is an indisputable fact.

LOL, really? Tell me why the price of oil isn't a relatively smooth line, then, based on a simple division of known reserves vs. current demand?

Price is just as subjective as anything else. "The value of a thing is what that thing will bring".

Since "what something will bring" depends on a lot of objective and subjective factors, "price==fact" is a null-value statement. Pricing is kind of opposite to quantum mechanics. You can determine the xact price at an exact space and time, but it's not reliably valid for entirely identical objects if you vary either the space or the time -- even a little.

 
At 6/26/2008 2:49 PM, Blogger Sophist said...

"...Dr. Perry is attempting to show how proper speculation has a smoothing effect..."

Blah, blah blah...

Is proper speculation like a proper drug dealer versus an improper drug dealer?

How in the world can anyone in the right mind make up such notions?

You, and others who do not understand how financial markets work confuse adding liquidity with speculating.

Speculators also remove liquidity from markets making them more volatile. When they remove liquidity that does not mean they must lose money necessarily.

" Pricing is kind of opposite to quantum mechanics. You can determine the xact price at an exact space and time, but it's not reliably valid for entirely identical objects if you vary either the space or the time -- even a little."

Sorry, I'm not a psychiatrist...

Don't you feel any shame at all posting such nonsense in public forums?

 
At 7/26/2008 4:56 AM, Anonymous Carlos said...

Good Job! :)

 

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