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Pittsburgh Tribune-Review: “Don’t punish speculators”

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In my July 24th, 2008, column for the Pittsburgh Tribune-Review, I defended speculators by doing my best to reveal the economic benefits they bestow on humanity [2]. You can read my column beneath the fold.

Don’t punish speculators

A modern-day witch hunt is under way. The fervor for finding witches and burning them blazes hot throughout the land, but nowhere as blisteringly as on Capitol Hill. Representatives and senators are self-righteously lighting bonfires while being cheered on by many pundits, business people and citizens.

The witches, it is widely believed, are maliciously causing innocent people to suffer unjust deprivations. Rounding them up, exposing them for the cruel tormentors that they are, and putting an end to their dark arts is thought to be a must if the American way of life is to be secured.

Who are these sorcerers wreaking havoc on Americans? Why, speculators, of course. They are the shady but surely well-healed operators on Wall Street who, greedily caring only about their own wealth, buy oil betting that its price will rise. And when it does rise, these money magicians will … what exactly?

“Sell it” is the obvious answer. But selling oil drives its price down. The resulting lower prices for oil will hurt those speculators who weren’t among the first to sell.

If, on the other hand, speculators never sell the oil they bought, then they never cash in on their investments: They hold physical oil (or paper claims on oil) but never get the profits that their speculative buying was meant to produce.

Seems wise in these heated times to step back, take a deep breath and examine the economics of speculation coolly.

Begin by noting that all investment is, to one degree or another, speculative. Buying shares of stock in USX, buying indexed mutual funds, stuffing dollars into your mattress — these, like all investments, are not guaranteed to pay off in the future. Any investment necessarily involves making some guess — some speculation — about the unknown future.

Indeed, even refraining from making any investment involves speculation: By spending that $5,000 on an Alaskan cruise rather than on shares of stock or on some other asset, you speculate that the likely risk-adjusted rate of return available to you is too low to make it worth your while to forgo consumption.

So it’s misleading to talk about “speculators” as if they are fundamentally distinct from other investors — as if there is an easily observed mark, characteristic or practice that sets “speculators” off from “non-speculators.”

The best we can do to meaningfully define “speculators” is to classify them as investors who take unusually high risks. (Of course, that’s how they got their name — their investments are more “speculative” than are the investments of persons who, say, buy mutual funds or Treasury bills.)

Even here, though, it’s essential to recognize that “unusually high risk” is a subjective concept. Risks are arrayed on a continuum; there’s no distinct point distinguishing high-risk from mid- or low-risk investments. Moreover, what might be called “speculatively risky” for Mr. Jones is perhaps a prudent investment for Ms. Smith.

Note, though, that if speculators are investors who take unusually high risks, then it’s clearly mistaken to suppose that they have some sorcery at their disposal to guarantee profits from their investments. Sometimes they will make impressively large gains, but these will be offset over time by impressively large losses.

This fact — the unusual riskiness of investments properly called “speculative” — points to one important reason why government regulation isn’t needed to ensure that speculation isn’t “excessive.” Speculation is inherently self-regulatory.

A speculator who speculates excessively is a speculator who subjects himself to inordinate risks of losses relative to his prospects for gain. Should he persist in his “excessive speculation,” he will likely soon enough be bankrupt. That’s a powerful deterrent.

“Fine,” you might reply. “But what harm can such regulation do? Shouldn’t government add its own oversight to that of the market to better ensure that speculation isn’t excessive?”

No. The reason is that no government official can possibly know when speculation is excessive and when it’s not. So even the best-intentioned regulator will often act to suppress speculation when it really isn’t excessive. And suppressing speculation would unambiguously harm the market.

Fundamentally — and lost in the current hysteria to punish speculators — is the fact that speculators make markets operate more efficiently, more smoothly and more predictably.

In my next column I will explain the beneficial role that speculation plays in smoothing out market prices over time and, hence, in making production plans more reliable, resource use more efficient and consumer welfare higher.