Throughout history people who make good profits during economic crises have been condemned as “speculators”, and used as scapegoats, often by the very governments whose policies caused a crisis. These speculators have been imprisoned, and sometimes even put to death Successful speculators, however, usually dampen fluctuations in outputs and prices, and help provide markets where companies can hedge risks that accompany their business activities.
Posner’s definition of speculation as bets placed on future prices of assets or commodities is good enough for my purpose. A speculator in the oil market, for example, would buy some quantity of oil contracts at a given price with the expectation that he will sell these contracts in the future at a sufficiently higher prices than he paid to justify interest carrying costs, and other costs of holding these contracts. If successful he makes a profit. At the same time, however, he would serve two socially useful functions. He would raise the demand for oil now, and thereby raise present oil prices. When he sells his long contracts in the future he would raise the supply of future oil, and hence lower future oil prices. In this way, he would contribute to greater stability of oil prices over time.
Speculators also provide futures, or hedging, markets for oil and other producers of commodities and assets. These producers may not want to bear the risk of what future spot prices will be, so they may contract in futures markets to sell their future outputs at market-determined prices. They sell in part to speculators who hope to profit from any difference between the prices in futures markets and actual future prices.
When prices of oil, natural gas, copper, food, and other commodities rose sharply during the period 2004-08-oil reached a peak of over $145 a barrel in 2008- politicians, the media, and many others blamed speculators in these markets for the severe price increases. Of course, no one credited speculators with the sharp fall in these prices during the past couple of years, for it has been obvious that the worldwide recession was the main cause of this steep fall in commodity prices. It should have been equally obvious that booming world demand by China, the US, and other countries mainly explained the run up in commodity prices during the boom years prior to the world recession. As the world economy continues its recovery from the crisis, commodity prices will continue to rise again, with or without speculators. Oil has already recovered from its bottom of about $45 a barrel in 2009 to reach over $80 a barrel in recent months.
Speculators who made money on the run up in oil and other commodity prices went long; that is, they bought oil and other commodities- commonly through financial assets in futures markets- and they sold their assets in the future at higher prices. They profited by buying at lower prices and selling at higher future higher prices, but their purchases and sales helped to even out commodity prices over time. That is, successful speculators tended to help commodity markets by leveling somewhat the movement of commodity prices over time. Speculators who went short say in the oil market during the long period of run up in its price tended to lose money because they raised the effective supply of oil at an earlier time in order to buy oil back at higher prices at a later time. Their short sales and subsequent purchases increased rather than decreased the magnitude of price increases over time.
To be sure, speculators who shorted oil not long before it reached its peak price in 2008 made money if they continued their short positions until the sharp fall in oil prices after the world economy crashed. Yet these short speculators also helped stabilize oil prices by lowering them before they peaked through their shorting activities, and then helping to raise oil prices somewhat after prices collapsed by covering their short positions. Similarly, speculators who went long on oil shortly before the peak in oil prices lost money because they bought at higher prices than they were able to sell at after the crash. These speculators exacerbated the fluctuations in prices since they helped bid up oil prices further when they were high, and helped lower them further when these prices were low.
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. Yet it is precisely the speculators who make money who are attacked by political leaders and others, not those who make bets that steer an economy in inefficient directions and also lose money for themselves.
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. Therefore, it was the absence of sufficient short speculators when commodity and asset prices were rising sharply that helped widen the run up and eventual collapse in these prices.
No amount of writing by economists will eliminate the hostility to individuals who make lots of money when times are bad. Still, in designing policies to reduce the future severity of financial and other economic difficulties, it is important to continue to emphasize that speculation serves a useful social purpose, especially when the speculators are making profits.