May 2, 2010
The Value of Profitable Speculation
The Value of Profitable Speculation-Becker
Throughout history people who make good profits during economic crises have been condemned as "speculators", and used as scapegoats, often by the very governments whose policies caused a crisis. These speculators have been imprisoned, and sometimes even put to death Successful speculators, however, usually dampen fluctuations in outputs and prices, and help provide markets where companies can hedge risks that accompany their business activities.
Posner's definition of speculation as bets placed on future prices of assets or commodities is good enough for my purpose. 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 sufficiently higher prices than he paid to justify interest carrying costs, and other costs of holding these contracts. If successful he makes a profit. At the same time, however, he would serve two socially useful functions. He would raise the demand for oil now, and thereby raise present oil prices. When he sells his long contracts in the future he would raise the supply of future oil, and hence lower future oil prices. In this way, he would contribute to greater stability of oil prices over time.
Speculators also provide futures, or hedging, markets for oil and other 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 the period 2004-08-oil reached a peak of over $145 a barrel in 2008- politicians, the media, and many others blamed speculators in these markets for the severe price increases. 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 of this steep fall in commodity prices. It should have been equally obvious that booming world demand by China, the US, and other countries mainly explained the run up in commodity prices during the boom years prior to the world recession. As the world economy continues its recovery from the crisis, commodity prices will continue to rise again, with or without speculators. Oil has already recovered from its bottom of about $45 a barrel in 2009 to reach over $80 a barrel in recent months.
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 they sold their assets in the future at higher prices. They profited by buying at lower prices and selling at higher future higher prices, but their purchases and sales helped to even out commodity prices over time. That is, successful speculators tended to help commodity markets by leveling somewhat the movement of commodity prices over time. Speculators who went short say in the oil market during the long period of run up in its price tended to lose money because they raised the effective supply of oil at an earlier time in order to buy oil back at higher prices at a later time. Their short sales and subsequent purchases increased rather than decreased the magnitude of price increases over time.
To be sure, speculators who shorted oil not long before it reached its peak price in 2008 made money if they continued their short positions until the sharp fall in oil prices after the world economy crashed. Yet these short speculators also helped stabilize oil prices by lowering them before they peaked through their shorting activities, and then helping to raise oil prices somewhat after prices collapsed by covering their short positions. Similarly, speculators who went long on oil shortly before the peak in oil prices lost money because they bought at higher prices than they were able to sell at after the crash. These speculators exacerbated the fluctuations in prices since they helped bid up oil prices further when they were high, and helped lower them further when these prices were low.
As a good rule of thumb-there are some exceptions to this rule- speculators in competitive speculation markets, whether long or short, contribute to a more efficient functioning of the economy when they make money, and they 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 and others, not those who make bets that steer an economy in inefficient directions and also lose money for themselves.
Applied 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 reduced the subsequent steep fall in these prices. Therefore, it was the absence of sufficient short speculators when commodity and asset prices were rising sharply that helped widen the run up and eventual collapse in these prices.
No amount of writing by economists will eliminate the hostility to individuals who make lots of money when times are bad. Still, in designing policies to reduce the future severity of financial and other economic difficulties, it is important to continue to emphasize that speculation serves a useful social purpose, especially when the speculators are making profits.
Did Speculation Make the Economic Crisis Deeper or Shallower? Posner
Speculators have never been popular, and they have never been as unpopular as they are in the United States today. Increasingly they are blamed for the economic crisis. Probably they should be rewarded for making the crisis less grave than it would otherwise have been.
There is a wide range of speculative activities, but my focus will be on financial speculation, which I'll define as a bet on the future price of some commodity or asset, which could be a house or a bond—to pick the two speculative assets centrally involved in the crisis. (Mortgage-backed securities and collateralized debt obligations, the specific financial instruments at the center of the crisis, are essentially bonds or bond clusters—debt obligations or packages of debt obligations that pay a contractually fixed interest rate or rates.) In the 2000s, until the crash, there was a great deal of speculation in housing prices, including by people who bought a house with a mortgage that they could afford only if the value of the house increased. They would buy the house with no down payment and very low (sometimes zero) interest rates usually for two years, after which the interest rate would be "reset" at a higher level—a level they could not afford unless their house appreciated significantly in value, in which event they would have equity in the house and could use it to refinance the house with a normal mortgage at a normal interest rate. So they wouldn't have to pay the reset rate.
At the other end of the market from the speculating home buyer was the speculating investor. Buying MBSs (mortgage-backed securities) and CDOs (collateralized debt obligations, often an assemblage of the riskier slices of mortgage-backed securities) entailed speculating on future housing prices, because the direction of those prices—up or down—would affect the default rate on the mortgages in which the buyers of the securities were investing indirectly. If the default rate rose because housing prices cratered, the securities might not pay the agreed-on interest rate, and so their value would fall.
Some very smart, very unconventional people, though they were only a tiny minority of the financial community, began thinking, some as early as 2005, that housing prices might well crash, that the housing boom was a bubble—house prices were rising because house prices were rising, convincing people that they would keep on rising. The "contrarians"—the subject of Michael Lewis's new book, The Big Short—wanted to put their money where their mouth was. But while it is easy to bet on a rise in the future price of some asset, simply by buying the asset, it is not so easy to bet on a fall in that price. If it is a stock (or other security, including a bond), you can borrow it and agree to sell the stock to someone at some specified date in the future at a specified price. If as you expect the price falls, you can buy the stock that you've agreed to sell at a price lower than the sale price, deliver the stock you borrowed to the buyer and be paid the agreed-on price, pocket the difference, and deliver the cheap stock you just bought to the person you borrowed the stock from for the speculation, thus completing the transaction. The process I have just described is selling short.
Selling short is risky, because the price of the stock may rise over the price specified in the short sale when you expected it to fall (which means you'll have to buy at a price higher than the price specified in the sale contract the stock that you need in order to return stock equivalent to what you borrowed), and costly, because you have to pay interest to the person you borrowed the stock from.
As an alternative to short selling, you can buy a credit default swap, which is a form of insurance on debt—not necessarily your own debt. If there is a bond that you expect to go into default (it might be a bond backed by a collection of mortgages), you can buy insurance against the resulting loss in the bond's value. So if there is a default, the issuer of the credit default swap pays you, and so you gain just as the short seller gains when the price of the stock or bond that he's shorted falls.
Like other speculators, short sellers and buyers of credit default swaps that insure strangers' debt are unpopular because they are trading on and therefore hoping for a future calamity. When the price of an asset falls as a result of speculative activity, the speculators are blamed. That's like blaming a thermometer for a fall in temperature. Provided the speculators do not spread false rumors about the assets they're hoping to see fall in price, or engage in other fraud, their activity is socially beneficial. It adds to the information in the market and by doing so tends to bring about a more rapid and complete alignment between prices and underlying values.
It's hard to sell houses short, but one can speculate that housing prices will fall by selling mortgage-based bonds short, since as I said a housing crash will increase the mortgage default rate and thus reduce the value of bonds that are based on mortgages. Had there been rampant short selling of such bonds in the early 2000s, the price of those bonds would have fallen because a high level of short selling would have been a signal of widespread doubt that housing prices would continue to rise. When bond prices fall, yield rises, because the interest rate of a bond is a fixed percentage of the bond's face value. (So if the value of a bond that pays 2 percent interest falls in half, the interest rate to buyers of the bond rises to 4 percent.) With interest rates on mortgage bonds higher and housing prices therefore lower (because mortgage interest is a major cost of buying a house), we might have been spared the housing bubble whose bursting triggered the economic crisis that the nation and the world are still struggling to climb out of.