? Speculation | Is it good for the economy?

Speculation and speculators market role. Is speculation a useful function on the market? Or is the opposite true – its harmful and bad for the economy?

▪ Economics and speculation problem

Speculation is often perceived as something wrong or immoral. Such problems are beyond the limits of economics. It is not a task of economics to morally evaluate a particular behavior. The role of economics is to examine economic consequences of a given action. Every human action is a speculation in broad meaning of this word, because every action is directed towards the future, which is uncertain. People take action to satisfy their needs, but they can make a mistake in their assessment, and take a subjective loss. Today however we will take a look at speculation in a more strict sense of the word.

▪ What is speculation?

Let’s start with the definition. In finance, speculation is:

“The act of buying something hoping that its value will increase and then selling at this higher price in order to make a profit”¹

If you watched our previous video, about the role of an entrepreneur, you can see some similarities. We’ve said, that an entrepreneur notices the difference between prices of factors of production, and the anticipated price of final product, and try to use it to make a profit. The actions of an entrepreneur is also a speculation in a broader sense, but the difference is, he does something. He transforms factors of production into a new product, thus creating a new value.

Phillip Carret, who was a speculator himself, defined speculation in this way:

“Pure speculation involves buying and selling in the same market without rendering any service in the way of distribution, storage and transportation”²

The man who bought 60 eggs, and sells them a dozen per customer at a higher price, is not a speculator in this meaning, because he must store the eggs and distribute them. His profits is the payment for his services, which customers want to pay for. At the same time, part of his profits may be speculative, if the egg market price were to go up.

We can thus notice, that entrepreneur, even though he speculates in his business out of necessity, produces goods or services, whereas a speculator on financial, commodity or currency market, does not. At least at the first glance. He only buys stocks, commodity or currency, he holds them, and then sells them if the price goes up.

Is this an action that has no other function? Is it harmful? Or maybe the opposite is true – it’s both necessary and useful?

▪ Speculation market role

1️⃣ Contrary to the first impressions, speculation is useful on the market

The first role of speculation is to accommodate the market to constantly changing conditions. Let’s assume, that speculators anticipate, that there will be a big problem with the availability of crude oil soon, and its price will go up. They will start to buy oil at a present, lower price, only to sell it at a higher price later. As a result, the price of oil goes up, because they are buying it. The price surge is an impulse for the rest of market participants. It tells consumers to reduce consumption of oil, and it tells the producers to increase production.

The economist Malte Tobias Kähler writes, that:

“Each speculator possesses a piece of disperse, subjective, and oftentimes tacit knowledge and reveals this information through his buying actions, which ultimately determine prices. In doing so, multitudes of market participants reveal data that otherwise could not be gathered”, and then he adds, that “[…] the market’s efficiency derives precisely from its ability to gather and make available dispersed knowledge. Speculators are one of the driving forces behind this process”.

So, when the anticipated problems with crude oil availability will come, the market will be better prepared for it. The prices will change less steeply, than they would without the speculators. Without them there would be sudden, unexpected shortages. We can notice however, where the resentment for speculators is coming from. It may seem in this situation, that they are the ones, who raise the prices. But we must remember that its not their actions which are responsible for the price increase, at least if their anticipations are correct. Speculators are not responsible for the oil supply problems, they just anticipate it, and act accordingly. The prices would go up anyway, only later, and more violently, and the availability problems would be more severe.

Kähler puts it like this:

“The capital market’s concern and the action of speculators can be compared to a medical thermometer that helps to evaluate the patient’s state of health. Would any patient really blame the thermometer for his fever?”

Because of speculators’ actions prices are less volatile, and reach a market equilibrium quicker, than they would otherwise.

Well, everything is great, as long as speculators are right. But what if they are wrong? It can and does happen, that speculators don’t correctly anticipate future conditions. What happens then? They lose money. The market clears itself of ineffective speculators, by taking their capital away, and rewarding the effective ones, who got it right. It’s very hard to be infallible with the anticipation of future events, so its natural to make mistakes sometimes. The speculator don’t always get everything right. He will be fine as long as he is right more often than he is wrong. There are many speculators, so absolute infallibility of every single speculator is not required for the market to work as described previously. Even if the majority of speculators would make the same mistake, and the price will reach different level than the market equilibrium, it would be only temporary. There would be a shortage or a surplus, which will soon be adjusted by subsequent actions of buyers and sellers. So the negative effects wouldn’t last long.

2️⃣ The second role of speculation is to take over the risks

Lets assume, that a company needs copper in their production process. The present copper price is beneficial, so the company wants to avoid the risk of copper price changes. There is a chance that the copper price will fall, which would benefit the company even more. But the price may also rise, and the company doesn’t want to speculate. It wants to focus on the production. Using the right financial instruments the company can protect itself against price changes, and ensure, that it will buy the copper at present price for some period of time. But someone has to take the risk of price changes. The copper producers don’t want to take this risk either. The one, that can take the risk is a speculator, who thinks, that the copper price will increase in this period. The transaction is mutually beneficial. The speculator hopes he will make a profit, because of the price difference. The company does not like the risk, and wants a constant price. It’s worth noting, that the speculator does not create the risk, he simply takes over the risk that existed anyways. Without the speculator, the company would have to take this risk.

3️⃣ The third role of the speculators is to provide liquidity

As we know, for any transaction to take place, the mutual will from both the seller and the buyer is needed. The uyer must want to buy, and the seller must want to sell. When there are no problems with finding a buyer or a seller, we say that we have a liquid market. Illiquid or thin market is when there is a problem with selling or buying, because the other side of transaction is reluctant to either buy or sell. As speculators are not buying to use, but only to hold and sell later, it’s easier to find a buyer or seller on the market, where there are speculators. Thus, this kind of market is more liquid than it would be otherwise.

▪ Summary

To sum up, speculators, even though they are perceived as harmful idlers, in fact provide some services, whether they know it or not. They contribute to better and faster resource allocation in the economy, they decrease business risks for companies, they provide liquidity and they help decrease price volatility. Speculation in itself is not a cause of the business cycle, as long as there are no additional factors, that distort resource allocation. You can learn more about these additional factors in our video about business cycles.⁴ We will leave the moral judgment of speculation to you – dear viewer.

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