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.”

Yes, speculators should respond more to interest rate hikes …

… in a negative real interest rate environment.

There’s an issue that Paul Krugman raises in “Strange Arguments for Higher Rates” that merits a response.  Krugman asks rhetorically:

Are we to believe that an interest rate change that matters not at all to firms making real investments somehow has huge effects on speculators?

To which I can only respond:  Yes!  The speculators are often financial intermediaries and other financial players who exist on spreads.  The whole point of raising interest rates is to restrict the access of the financial system to free financing  and thereby reduce the quantity of punts taken on risk assets.  Furthermore, because a 1% increase is likely to affect the spread much more dramatically than the real economy’s debt payments, of course, speculators respond more dramatically than non-financial firms.

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

Were gambling laws designed as financial regulation?

Economics of Contempt claims “anti-gambling laws are anachronistic holdovers from a more paternalistic era”.   I have argued that gambling laws were designed in part as a form of financial regulation.  He’s the lawyer.  But I’ve started to wonder how well lawyers are trained in the history of law.

On the costs and benefits of speculation

Darrell Duffie writes “In defense of financial speculation” in the WSJ (via Alea):

George Soros, Washington Democratic Sen. Maria Cantwell and others are proposing to curb speculative trading and even outlaw it in credit default swap (CDS) markets. Their proposals appear to be based on a misconception of speculation and could harm financial markets.

It is interesting that he opens his defense by eliding from a discussion of speculative trades to a discussion of speculators:

Speculators earn a profit by absorbing risk that others don’t want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.

The problem with this elision is that when “speculators” are taking on economic risk that investors do not want, their trades don’t meet the definition of a speculative trade and thus are rarely covered by laws proposed to restrict speculative trades.  For example, when a law requires purchasers of CDS protection to own the underlying bonds, nothing prevents bond investors from hedging with or selling their positions to “speculators”.

A speculative trade take place when (i) the transaction (like a standard derivative contract) is zero-sum — whatever one party gains the other necessarily loses and (ii) neither party to the transaction has an existing economic exposure that would be hedged by the transaction.   In other words, a speculative trade occurs when both parties to the trade are speculators.  Typically regulations to control speculation focus on speculative trades and are careful to exclude hedging transactions.

The only defense of these transactions is:

Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment’s value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country’s default.

The argument rests on an assumption that more accurate prices mean that information is more “useful” and that this has some social value.  It’s possible that this is true, but it certainly hasn’t been demonstrated.  What were the costs of inaccurate pricing in the bond market before CDS contracts allowed speculators to express themselves?  We know that bond markets functioned well enough to develop dramatically from the 18th through the 20th centuries.  But somehow the incremental information created by CDS contracts is supposed to have some great added value.  How do we measure this?  To whom does the added value accrue?  Does the public actually benefit or do the speculators themselves capture all the gain?  These questions need to be answered before one can conclude that any increase in the accuracy of prices created by speculation outweighs the costs of such speculation.

Duffie fails to take into account the largest cost created by speculation.  He focuses only on market manipulation, but the real cost of speculation is the cost to the judicial system of enforcing speculative trades.  Remember that these are trades between two speculators — these trades do not interact directly with the real economy or contribute to economy’s productive capacity.  On the other hand under current law these trades are enforceable contracts.  Judges on the public payroll must spend weeks if not years adjudicating issues related to these contracts.

A successful defense of financial speculation will require a careful demonstration that the social benefits that derive from the incremental pricing accuracy due to speculative trades outweighs the social costs of expending public resources on the enforcement of speculative contracts.

This is not a Minsky Moment

This is not a Minsky moment.  A Minsky moment would have taken place if the housing market had collapsed in early 2005 after the Fed had started raising rates.

This is much, much worse than Minsky moment.  On top of the natural tendency toward speculation we have a new class of speculative derivatives that had been illegal for more than a century before Congress chose to legalize them.  This is not a natural Minsky bubble, this a souped-up bubble in hyperdrive.  On top of this souped up bubble, we have a financial sector that has been encouraged to increase its “efficiency” by maintaining minimal equity capital and relying on the government for a bailout whenever things go a little bit wrong.  These are not Minsky’s natural speculators, these are speculators who fully expect to be permitted to charge their losses to a government credit card.

What we are going through is much more frightening than a Minsky moment.  I think we’re going through a Minsky moment cubed.

A final thought on wheat prices

I got into an extended discussion of the use of data in the social sciences over at Felix Salmon’s blog.  The underlying issue was the recent Senate report attributing price dislocations in the wheat market to long only index investors (aka excessive speculation).

dWj chimed in with a good summary:

The existence of the delivery oligopoly [in the wheat market] is necessary and nearly sufficient. That should be considered the primary cause of the failure here, even if it needed a trigger before the spreads got particularly wide in the last couple years. Making the futures cash-settled requires a way to determine the authoritative final settlement price; if it’s not too messy (in terms of performance risk) to dramatically expand the number of permitted deliverers, that would seem to me to be the sensible solution.

I think, however, that there are two important issues brought up by the Wheat Report:  first, what caused the huge divergence between cash and futures prices at expiration in 2008 and, second, is it possible for speculators to affect the spot price of a commodity.   dWj’s comment addresses the first issue — which may well require the existence of a delivery oligopoly.  On the other hand, I don’t see any reason that a delivery oligopoly is necessary for speculators to affect spot prices.

(I’m posting this comment here, because from an aesthetic point of view I think dWj’s comment is a fine conclusion to that thread.)