Those Infamous Speculators

Wednesday, September 29, 2010

Throughout history, people who profit during economic crises have been condemned as “speculators” and treated as scapegoats, often by the very governments whose policies caused the crises. They have been imprisoned and sometimes even put to death. Successful speculators, however, can have a beneficial impact: they usually dampen fluctuations in outputs and prices and help provide markets where companies can hedge risks that accompany their business activities.

Speculation is generally defined as bets placed on future prices of assets or commodities. A speculator in the oil market, for example, would buy some quantity of oil contracts at a given price with the expectation that he will sell these contracts in the future at a higher price that will justify interest-carrying costs and other costs of holding these contracts. If successful, he makes a profit. At the same time, however, he would perform a beneficial role in two ways. He would raise the demand for oil now, thereby raising present oil prices. When he sells his long contracts in the future he would increase the supply of future oil, hence lowering future oil prices. He thus contributes to greater stability of oil prices over time.

Speculators also provide futures, or hedging, markets for producers of commodities and assets. These producers may not want to bear the risk of what future spot prices will be, so they may contract in futures markets to sell their future outputs at market-determined prices. They sell in part to speculators who hope to profit from any difference between the prices in futures markets and actual future prices.

When prices of oil, natural gas, copper, food, and other commodities rose sharply during 2004–8 (oil reached a peak of more than $145 a barrel in 2008), politicians, the media, and many others blamed speculators in these markets. Of course, no one credited speculators with the sharp fall in these prices during the past couple of years, for it has been obvious that the worldwide recession was the main cause. It should have been equally obvious that booming world demand by China, the United States, and other countries mainly explained the price run-up before the recession. As the world economy continues to recover, commodity prices will continue to rise again, with or without speculators. Oil has already recovered from its 2009 bottom of about $45 a barrel.

Speculators provide hedging for producers of commodities and assets who may not want to bear the risk of what future spot prices will be.

Speculators who made money on the run-up in oil and other commodity prices went long; that is, they bought oil and other commodities— commonly through financial assets in futures markets—and later sold their assets at higher prices. Speculators who went short during the long period of price run-up tended to lose money; they raised the effective supply—of oil, for instance—at an earlier time in order to buy back oil at higher prices at a later time. In contrast to the actions of the successful speculators, these short sales and subsequent purchases increased rather than decreased the magnitude of price increases over time.

The economic crash provided a mirror image of this phenomenon. Speculators who shorted oil not long before it reached its 2008 peak price made money if they continued their short positions until the sharp fall in prices after the world economy crashed. These short speculators helped stabilize oil prices by lowering them before they peaked, and then helping to raise prices somewhat, by covering their short positions, after prices collapsed. By contrast, speculators who went long on oil shortly before the price peaked lost money; they exacerbated the fluctuations in prices because they had driven up oil prices when they were high and helped lower them even further when they were low.

As a rule of thumb—there are some exceptions—speculators, whether long or short, in competitive markets contribute to a more efficient functioning of the economy when they make money but help make the economy less efficient when they lose money. Yet it is precisely the speculators who make money who are attacked by political leaders, not those whose bets steer an economy in inefficient directions while losing their own money.

Apply this to the financial crisis: if, when housing prices were rising so rapidly, more speculators had been shorting the housing market (or shorted mortgage-backed securities whose value depended on what happened in the housing market), their actions would have reduced the sharp increase in housing prices and ameliorated the subsequent steep fall in these prices.

Only speculators who make money are attacked by political leaders, not those who steer an economy in inefficient directions while also losing their own money.

No amount of writing by economists will eliminate the hostility to people who make lots of money when times are bad. Still, in designing policies to reduce the severity of economic difficulties, we need to remember that speculation serves a useful social purpose—especially when the speculators are making profits.