Chicago’s defense of speculation assumes synthetic assets don’t exist

Gary Becker has kindly explained “The Value of Profitable Speculation

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.

Notice that Prof. Becker assumes that when speculation takes place in competitive markets, each act of speculation either results in profits or losses for the speculator.  Of course, many speculative contracts have a speculator on both sides of the transaction.  (In fact we have heard the argument that when trading derivatives “one counterparty must be long … and one counterparty must be short” pretty frequently these days.)

When there is a speculator on each side of a transaction, then one party necessarily loses and other necessarily gains.  According to Prof. Becker’s analysis this transaction both increases economic efficiency and decreases it.  Hmm.

The resolution of this conundrum is, of course, that Prof. Becker is assuming that “speculators” are interacting with the real economy, not with each other.  In the Anglo-American legal tradition, however, when a so-called “speculator” is interacting with the real economy — and thus taking on real economic risk — the transaction is not a “wager” and therefore there is no speculation going on.

In short, it is precisely when speculators are not speculating that they can contribute positively to economic efficiency by making money.  (Note: I recognize — just like SCOTUS in the 1880s early 1900s — that regulated futures markets merit a notable exception to this principle.)

I beg to differ with Prof. Becker when he discusses housing as well:

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.

There was no lack of short speculators in the housing market.  The problem was that the vast majority of their trades were offset by long speculators like AIG, the monoline insurance companies, German banks in search of yield, etc.  In my view, the problem was not a deficit of short speculators, but a failure of the short speculators to interact with the real economy and affect the underlying prices.

Note: 5-4-10 Title revised


3 thoughts on “Chicago’s defense of speculation assumes synthetic assets don’t exist”

  1. Er, there WAS a lack of short speculators in the market. Until the CDS on subprime market matured it was next to impossible to short the market or any of the bonds. Once it matured the bubble started to burst and the shorts got it in the neck like all bearers of bad news.

    Finally all assets are sooner or later related to the “real economy”.

    1. Huh. The ABX index was established in January 2006. Since that date, it was easy, not “next to impossible” to short subprime. Prior to January 2006 many CDS contracts were written on subprime (c.f. AIG, MBIA, Ambac), so sophisticated investors could definitely short if they wanted to — the problem was a lack of demand for the product. For example Michael Burry, a small time hedge fund manager, shorted subprime in May 2005 — within months of first inquiring about the product. (Probably it was growing demand from people like Burry that led to the creation of the ABX in the first place.)

      The problem with your “sooner or later” approach to the economy, is that in the years over which swaps are mispriced (just look at the ridiculous assessment of credit risk in 2006) huge, even devastating, losses build up in the financial system.

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