In Praise of Speculators - Island of Sanity

Island of Sanity

Policy Issues

In Praise of Speculators

You often hear people talk about how unscrupulous speculators are driving up prices and taking advantage of people. News reports about a price increase often blame it on speculators -- and I use the word "blame" deliberately here.

But in real life, speculators normally do just the opposite: They help to keep prices stable, to even out the ups and downs. They often risk huge sums of their own money to do it. And keeping prices stable is not just a pleasant convenience for the average person. It keeps people employed and stores filled.

Let me explain.

Perhaps after that lead-in I should add a disclaimer: I am not a speculator, nor am I married or otherwise related to one.

First, let's explain what a speculator is. A speculator is someone who makes contracts in which he promises to buy a specific quantity of some product at a future date, at a price agreed on now. For example, he may contract to buy a barrel of oil next March 3 for $70. If, when that date rolls around, oil is selling on the open market for $75 a barrrel, the speculator claims his oil for $70, promptly turns around and re-sells it for $75, and makes an easy $5 profit. On the other hand, if the open market price is only $65, he is still obligated to buy the oil for $70. The best he can do is sell it for $65, so he loses $5. (Of course in real life he doesn't buy just one barrel: he buys thousands or millions of barrels.)

When we say that speculators buy and sell a product, understand that they do not normally ever actually take possession of it. Most speculators do not own any warehouses or transportation facilities. They do not add anything to the product. They just move paper and cash around.

This is, I suppose, part of why speculators have a bad reputation. They're a bunch of rich people who don't do any real work, they just shuffle paper, but they can make millions of dollars. And they make the biggest bucks when prices soar. So when everybody else is suffering, when poor people are struggling just to stay aflot, those rich blankety-blanks make a killing. How callous!

Of course, the flip side is that when prices go down, when the poor people are all breathing a sigh of relief that their lives are now a little easier, the speculators lose a bundle. They rarely got much sympathy in those times.

But let's forget about how the speculators' personal fortunes go. What do they do for the economy as a whole? Think about the implications of the speculator's role.

Suppose you owned a small oil drilling company. You have an oil well that is only marginally productive. It now requires some expensive maintenance. Should you spend the money or just shut it down? If you sell on the open market, then if oil prices go down you could invest all that money in maintenance for nothing. The risk could be huge. But then a speculator comes along. He offers to buy any oil you produce at a fixed price, regardless of where the market goes. Now your sale price is fixed, and the only variable is your own costs. You can make decisions much more confidently. Without this assurance, you might not be willing to take the risk. The speculator may well be the difference between the producer selling his equipment for scrap and going home, versus continuing to produce a product for his customers and providing jobs to his employees.

Of course the speculator isn't doing this because he's a nice guy: He's in it for the money. So suppose the speculator looks at the market and estimates that when the contract date rolls around, oil will be selling for $70. He might offer a contract for $68. If his predictions are right, he makes $2. From the producer's point of view, sure, if he didn't sign up with the speculator but sold on the open market himself, he'd make an extra $2. But neither he nor the speculator know if that prediction is accurate. He gladly pays the speculator the $2 premium in return for the security of having a fixed price. It's like buying fire insurance: If your house doesn't burn down this year, you've paid all those premiums for nothing. But the insurance company is now taking the risk that your house might burn down instead of you.

But how does the speculator know what the price will be in the future? He doesn't, of course. But neither does anybody else. If nothing unusual is going on or expected, then the speculator guesses that prices in the future will be about the same as today. So he offers a price just slightly lower than today's price, with the plan that he will add a small premium for himself. If prices remain stable, he makes a few dollars, the sellers had the assurance of a fixed price, the buyers pay the same price they would have anyway, and everyone is happy.

But suppose something unexpected happens. Maybe there's a war in a country that's an important producer of this product and supplies are interrupted, or there is an unexpected increase in demand. So prices go up. But ... there is all this product being dumped on the market by speculators who are getting it at last year's price. They can then undercut the high-priced competition and still make a tidy profit. Like, suppose last year's price was $70. Speculators signed contracts to buy for $68. This year something drives prices up. If there were no speculators, if everybody was buying on the open market, the price would go up to, say, $80. But the speculators don't have to sell for $80. They'd be happy to sell for $70. They'll surely up their price some to take advantage of the overall increase, but it will be very hard to charge $80 when there are others willing to sell for $70. The price is going to end up somewhere in the middle. (Not necessarily exactly in the middle; there's no guarantee that it will end up at $75. That all depends on how much of the supply is controlled by speculators and how much by others, just what the pressures are, etc.) This is where speculators help the consumer: they hold down price increases.

On the other hand, suppose that something happens that makes prices fall. Perhaps a new manufacturing process is invented that makes it possible to produce this product more efficiently. Then the speculator's are stuck buying overpriced products. If there are many speculators with similarly overpriced products, the lower-price competition will not be quite so intense, and they will tend to keep market prices up. This is where speculators help the producer: they soften price decreases. In the short run this hurts the consumer by making him pay a higher price than he otherwise would have, but in the long run it helps the consumer too by keeping producers in the market.

So speculators make both price increases and price decreases smaller. They help keep prices stable and predictable.

This is true even if the factors that would drive up prices are anticipated. Suppose everyone can see that there are political problems and a war may break out. Speculators guess that the price will go up, and so they start bidding higher. But no one is sure that there really will be a war: they're just guessing. So they don't bid it up to the full war price. They bid it up to somewhere in the middle. If the peace-time price is $70 and the war-time price is $80, then if people believe that the chance of war is about 50/50 they may bid the price up to $75. If they think war is almost certain -- but there's still that possibility that it won't happen -- they'll bid it up higher, maybe $78. If there's just a small fear of war, they might bid it up to only $72. And so on. (In real life, of course, there's no simple formula, like 50% chance of war means a speculator's price exactly 50% of the difference between the peace price and the war price. Life is far more complicated than that. But that's the basic idea.) A similar effect happens when something would drive prices down.

So again, speculators smooth out price swings.

But what happens when there is something going on in the world that speculators think might cause prices to go up, and so they bid up the price ... and then it never happens? Like, they fear there is going to be a war, but then the countries negotiate and make a deal and the war never happens. This is another reason why speculators get a bad reputation. They have bid up the price on their contracts, which is going to put upward pressure on consumer prices, for what turns out to be a mistake. Consumers pay more ... for nothing.

That's true and it is, indeed, the down side of speculation. At the worst, irrational fears can drive up prices. But bear in mind that when speculators make a mistake like this, it costs consumers, but it costs the speculators themselves big time. If they bid the price of their contracts up to $75, and the free market price would have been $70, maybe they'll now push the overall price up to $72 or $73. Consumers will pay that extra few dollars every time they buy this product. But the speculators will be forced to take a substantial loss, because they'll be buying huge quantities for $75 and selling for $72. They'll lose millions. They certainly don't make mistakes like this on purpose.

Earlier I compared a producer making a contract with a speculator to someone buying insurance: You pay a premium to pass the risk on to someone else. In a sense, every consumer is doing the same thing. We pay a premium to the speculator -- an occasional price increase based on a miscalculation -- in return for overall greater stability in prices.

© 2006 by Jay Johansen


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