Good speculation vs bad speculation

Betsey Jensen, a family farm owner and instructor in farm management, has an opinion piece in the NYT today defending speculation:

My biggest worry is what the legislation will do to speculators in the market. These are the traders who buy and sell wheat or corn without taking physical control of the crops. Farmers love speculators when they are buyers, helping push prices higher, and we despise them when they are sellers, driving prices down. Regardless of their position in the market, I am well aware that the system would not function without them — there wouldn’t be enough liquidity, or money, in the market.

According to the trading commission, about one-third of the long positions in hard red spring wheat futures, which is what I trade on the Minneapolis Grain Exchange, are owned by speculators. If speculators were driven out of the market, it would be as if I’d lost a third of my customers.

Will speculators continue to provide market liquidity if the legislation ends up increasing margin requirements — the amount of cash an investor must deposit before buying futures — or restricting how much or how often they can trade? Changes like these could do a lot of damage to agricultural markets.

Contrast this traditional Chicago (referring as much to the pits as to the University) view of speculation with the current corporate view of the state of modern financial speculation.  The FT reports that a survey of “European companies that depend on raw materials markets” finds:

But the companies surveyed ranked financial hedging as the least effective way of managing volatile raw materials costs, believing instead that inventory management and flexible pricing systems were more valuable tools.

In other words even as small American farmers are defending speculation in financial markets in the New York Times, many of the biggest corporations trading commodities are giving up on the pricing provided by those markets.

I’m repeating myself, but here goes:

Speculation is good when the speculator trades with someone in the real economy and therefore bears real economic risk.  Speculation is bad when the market is dominated by speculators trading with each other and, as they become a tiny fraction of the contracts traded, contracts bearing real economic risk stop determining prices.  Futures markets are successful only if the amount and nature of speculation is careful monitored to ensure that “enterprise [does not become] the bubble on a whirlpool of speculation” and “the capital development of the country [does not become] a by-product of the activities of a casino.”

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3 thoughts on “Good speculation vs bad speculation”

  1. All fair comments, Carolyn (I noticed that article too and was kind of impressed with Betsy Jensen).

    In terms of what best to do about it, it seems to me excess speculation is primarily born of monetary disorder. It’s more of an effect than a cause, although as it grows and mutates it too contributes to that disorder. Fix the latter (if only!) and the former would probably soon fade away.

  2. I agree that monetary disorder feeds excessive speculation, but I’m not sure that it’s the primary cause. I think that market structure that discourages excessive speculation is very important too. I’m as concerned about the huge changes that have taken place in market infrastructure over the past few decades as I am about monetary policy.

  3. I (finally) got around to reading “Do derivatives make the financial system more efficient?”, thinking it might help me to better understand your perspective in this post.

    Nice piece, and I think you’re right. Even though derivatives taken in isolation are zero-sum, they have a very real (and sometimes disastrous) impact on the real economy by fostering the delusion that certain essentially unmanageable risks can in fact be managed and thereby enabling those risks to multiply.

    I think you’re right too that we’d be best to accept that some of these risks (like 30 year fixed mortgages) are simply too dangerous, at least for the banking system. If they’re to exist at all, perhaps it should be as an asset for pension funds and other institutions with similar time horizons. Or, as you say, adopt some of the approaches used overseas.

    So, bottom line, no argument that speculation in recent decades has taken on some alarming characteristics quite apart from its unhealthy proliferation due to the monetary excesses of our screwed up financial system.

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