A Defense of the Market Speculators

By John Tamny

“In reality all economic activity outside the stationary state is speculation” – Ludwig von Mises, Socialism, p. 181-182

Amid ongoing economic and financial uncertainty, including an oil price that is inching back up, the role of speculators in the economy has and will continue to be called into question. If their detractors are to be believed, they're a destabilizing force in the economy.

Rather than produce tangible goods that we can all enjoy, it is said that in their search for profits no matter the direction of the market, speculators offer no economic benefit. Instead, they supposedly manipulate markets and prices to the detriment of those engaging in real production.

To reduce their negative impact, there have been calls to reduce the pay or bonuses of those who achieve high speculative profits. And as we saw in the fall of 2008, regulators went as far as to ban what they deemed non-economic speculative activity of the short-selling variety. If their power in the markets were reduced, so the mantra went, the economy would prosper free of the growth-retarding friction that they generate.

In truth, all economic activity is speculative, and to curb any form of speculation would be to halt economic progress. And as opposed to an economic weight, speculators perform an essential economic function by hastening the process whereby prices adjust in order to match supply and demand. If the world didn't have speculators, we'd have to invent them. Without speculators, our very existence would be characterized by a great deal of drudgery and want.

All economic activity is speculative. Throughout the 1970s and much of the 1980s, Colorado Boulevard in Old Town Pasadena (CA) was a dangerous place to be. Though the trained eye could see that the buildings that lined Pasadena's main thoroughfare were once beautiful and grand, by the 1970s the businesses within these old buildings largely consisted of dive bars, seedy stores selling X-rated goods, and pawn shops.

Fast forward to today, and a street that was once run down, dirty, and largely bereft of foot traffic is now teeming with shoppers eager to purchase the latest clothes, electronics and art from the high-end merchants who dot the formerly tired landscape. Old Town was revitalized thanks to land and business speculators who were unwilling to be intimidated by the present, and who instead saw potential that few others did. Pasadena's residents benefit from their intrepid nature on a daily basis.

Less than twenty miles from Pasadena in West Hollywood, the Sunset Strip presently shimmers with some of the world's best known restaurants, movie theaters and clothing shops. But when Wolfgang Puck opened Spago there in 1982, Sunset was then much better known for its streetwalkers, peep shows, and down-on-their luck residents hoping to score big in a movie industry that had long since left Hollywood.

Puck, much like the visionaries who transformed Pasadena, saw potential where others didn't. His initial speculation with Spago is now a world-renowned collection of restaurants. Importantly for Sunset Boulevard, Puck's success there led to myriad copycats, and it's important to note that similar speculative revitalizations have occurred throughout the US, from Manhattan's Tribeca, to the West End in Dallas, to the Gaslamp District in San Diego.

In more modern times, Canadian company Research In Motion (RIM) first introduced the BlackBerry in 1999 given the firm's speculation that consumers wanted to be able to check their e-mail anywhere and everywhere. RIM's success led to Apple's ubiquitous iPhone, along with many other phone models that allow their owners to talk, e-mail and watch television with a gadget that fits in their pocket.

As von Mises long ago noted, all economic activity outside the stationary state is speculation, and as such, all the modern conveniences we enjoy are the fruits of courageous activity on the part of others. Whether they succeed or fail, speculators drive our economic evolution all the while teaching us not just what consumers want, but also what they dislike.

Speculators provide us with knowledge that no amount of market research could ever match. Without them, nearly every venture would amount to flying blind. Speculators not only improve our lives by virtue of easing our needs, but their exploits tell us how we too can meet other unmet needs in the marketplace.

What about market speculators? In fairness to those who decry the work of speculators, much of their criticism in modern times has centered on the non-producers whose speculations are reduced to buying and selling equities, credit default swaps and commodity futures. It's been the economic actors in this space who've suffered the most ill will. Happily, their actions are every bit as essential as the entrepreneurial speculators described above.

Indeed, while hedge fund traders in the equity space may not produce anything tangible, the price signals their work provides are simply put, priceless. When the equity trader's long purchase of company shares is vindicated by a rising price of the share in question, the economy gains for investors possessing a better idea of where capital will achieve the highest return.

Conversely, if an equity trader's short sale is vindicated, markets and the economy benefit yet again for increased knowledge of what sectors and companies to avoid. Equity speculators are the market sleuths whose success and failure enlighten us as to where opportunity and danger exist.

While many investors saw the value of their investments plummet during the financial crisis in 2008, more than a few achieved staggering wealth betting against all manner of securities that up until then had performed well. That certain individuals became fabulously wealthy amid the carnage offended some, and once again, the activities of speculators were called into question.

What too many missed is that the billions made by mortgage bear John Paulson were merely the "seen" in the investment equation. The unseen in this case concerned how much capital was not destroyed in worthless mortgage securities thanks to Paulson's outsized gains revealing major problems in the market for loans.

Absent the willingness of speculators to create a liquid market for orange, meat and jet fuel futures, we could still drink orange juice, eat steaks and fly commercially, but all three would either be very expensive, or worse, scarce. That there are markets for commodities means that the producers themselves can lock in prices without which commodity production would amount to a form of gambling.

Of course in a free market for commodities not distorted by currency gyrations (more on that later), rising prices tell producers what consumers want more of, and falling prices tell producers what consumers aren't interested in. Considering consumer products, price signals thankfully have Blockbuster Video in bankruptcy, while the price of Netflix shares continue to rise given the latter's skill at delivering movie content to us in the way we desire.

Luckily for all of us, the history of the former Soviet Union tells us in uncomfortable fashion just how difficult it would be to live in a world free of speculators. Lacking the price signals that some of us take for granted, Soviet era factories produced lots of goods that drove up the faulty indicator that is GDP, but these were products that few Soviet citizens desired.

Much as we would have to invent speculators in the U.S. if they did not already exist, the black market in the Soviet Union was one run by speculators, and it was in the underground markets that individuals suffering under communism's cruel thumb could buy some of what they wanted. Courageous speculators in the Soviet era made a harsh life at least somewhat bearable.

Oil. In January of 2000, the price of a barrel of oil sat at $25.50, but on July 14, 2008, oil reached an all-time high of $145/barrel. To many, this was a sure sign that speculative forces were at work, eager to make oil and its subsidiary products wildly expensive.

More realistically, something far more basic was at work. Oil, as is well known, is priced in dollars, and since the dollar had collapsed against gold during the time in question, it was all too natural that oil would become dear in nominal terms.

Indeed, while the dollar price of oil rose 509% from January of 2000 to July of 2008, its increase in British pound and euro terms, though substantial, was quite a bit less. In pounds oil rose 382%, while in euros it rose 276%. It should also be noted that in gold terms, both the pound and euro had declined a great deal also, which explains an oil spike felt in currencies of all shapes and sizes.

Looking at oil since President Nixon severed the dollar's link to gold in 1971, it can't be stressed enough that market speculation concerning its price has really been speculation about the dollar and its direction. Sure enough, if we measure the oil price in gold terms, an entirely different, non-speculative story emerges.

As the late Warren Brookes wrote in his classic 1982 book, The Economy In Mind, "From 1970 to 1981 the price of gold rose 1,219% - the price of oil 1,219%. That's no coincidence." Brooks went on to point out that in 1970 an ounce of gold at $35/ounce bought 15 barrels of oil at $2.30/bbl. In May of 1981 an ounce of gold ($480) still bought fifteen barrels of oil at $32/bbl.

In May of this year, an ounce of gold trading at $1176 still bought 15 barrels of oil at $79. And while oil has at times departed from the 15/1 oil/gold ratio, history shows that it traditionally reverts. Far from a commodity controlled by speculators, the greatest driver of the oil price is the dollar as evidenced by its tight relationship with oil.

In that sense, for those truly bothered by oil's gyrations, the answer is really quite simple, and it involves a return to a stable dollar relative to gold. To understand why, one need only Google "oil price history" to see that during the Bretton Woods era, the price of oil was flat and cheap.

It was only when the dollar's link to gold was severed that oil became volatile. In short, the dollar's undefined nature is what has driven speculators into the oil market, not the reverse.

Conclusion. In his Tract On Monetary Reform, John Maynard Keynes observed that monetary debasement among other things "discredits enterprise." All enterprise is speculative, and with the dollar having fallen substantially since 2001, the activities of the enterprising in our midst have increasingly been called into question.

This is unfortunate because the speculators that are at the root of all economic activity are either advancing heretofore unseen concepts, providing prices that signal where limited capital should go, or merely trading on the chaos wrought by money detached from anything real. As opposed to bringing economic harm, it is the speculators who, if they're not easing our unmet needs, are giving the producers the prices necessary for rational production.

A world without speculators is hard to imagine, and as the Soviet experience reminds us, an impossibility. To bash speculators might be profitable as political theater, but the joke is on their detractors. To decry the act of speculation is to cast a negative eye on reality, along with economic progress itself.

John Tamny is editor of RealClearMarkets and Forbes Opinions, a senior economic adviser to H.C. Wainwright Economics, and a senior economic adviser to Toreador Research and Trading (www.trtadvisors.com). He can be reached at jtamny@realclearmarkets.com.

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