Speculation

Speculation

SPECULATION AND MARKET STABILITY

NONORTHODOX VIEWS

BIBLIOGRAPHY

Speculation is the acquisition of an asset exclusively for resale motivated solely by the anticipation of capital appreciation and gain. Most commonly, speculation occurs in anticipation of a price increase such that buying temporally precedes selling as speculators temporarily hold title to (“go long in”) an asset. The possibility exists, however, of temporally reversing the trades in anticipation of a price decline through forward contracting. Here speculators would “short” an asset by agreeing to sell that to which they do not yet have title, planning the future acquisition of the anticipated cheaper asset in advance of the contracted delivery date. Speculation is similar to arbitrage insofar as arbitrage too involves the trade of commodities exclusively for capital gain. Arbitrageurs, however, trade across markets at a point in time so that opportunities for capital gains are much less risky than they are for speculators who conduct trades over time.

Any asset—as something that is capable of producing a stream of future material benefits—has the potential to be an object of speculation. Historically, real estate, precious metals, and financial instruments (stocks, bonds, currencies, and the like) have been the most common objects. At times, speculation in such assets has advanced at an especially feverish pace as Charles P. Kindleberger (2001) demonstrates in his discussion of the many historical episodes of speculative manias and their recoil in panics and market crashes.

SPECULATION AND MARKET STABILITY

There is considerable debate centered on whether speculation will act as a stabilizing or destabilizing market force. A long-standing dispute about the desirability of flexible versus fixed exchange rates has been periodically most vigorous, turning on precisely this question. Since the 1980s, researchers have debated the presence of destabilizing speculation in the form of a speculative bubble—as a process denoting movements in asset prices that cannot be justified on any reasonable economic grounds—as an explanation for observed volatility in equity markets.

The question of whether speculation will stabilize or destabilize a market hinges critically on the manner in which speculators form their expectations of future price changes. It was thought originally that if speculators based their expectations of capital gains on anticipated future changes in the conditions affecting the demand for or supply of an asset, then the act of speculation would even out price fluctuations over time. If instead speculators extrapolated from recent price trends, their actions would serve to increase the amplitude of price fluctuations rather than dampen them down. While such a characterization remains broadly accurate, subsequent research in rational expectations modeling has shown that speculation will be destabilizing even with some forms of forward-looking expectations of price changes.

Extreme volatility in currencies, stocks, and other financial markets in the mid- to late 1920s stimulated an effective challenge to the traditional classical way of thinking about speculation. Logic had previously held that speculation of any significance must be a stabilizing force; otherwise, if speculators were indeed a destabilizing force in the market, it would mean that speculators had worse foresight than average, their losses would then be greater than average, and so their existence would be short-lived. As Milton Friedman (1953) would later argue, “speculation can be destabilizing in general only if speculators on the average sell when the currency is low in price and buy when it is high” (p. 175).

For such reasoning to be sufficient grounds on which to deduce the absence of destabilizing speculation, several conditions must hold. Price expectations must be formed independently of the opinion of others, there must be a consistency between short-term and long-term anticipated gains, and the act of speculation itself must not alter the underlying economic value of the asset. If the future is known or equivalent to such, as in the case when one can define the full range of outcomes and associated probabilities, speculation is essentially an exercise in inter-temporal arbitrage, and the foregoing conditions could reasonably hold. The opportunity to speculate would be then a constructive market force wherein producers with greater risk aversion shift price risk to less risk-averse speculators. Otherwise, when the future is uncertain (as distinct from risky), the problem is much more complicated and the dichotomy between stabilizing and destabilizing speculation unclear.

Addressing the implications of true uncertainty in the formation of long-term expectations, John Maynard Keynes (1936) discusses the manner in which interdependent opinions may confuse and complicate the expectations formation process. In his famous beauty contest metaphor, Keynes likens investment to a beauty competition in which the winner is the one who most closely predicts the outcome that will be the opinion of the majority. The challenge for contestants then “is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks is the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be” (p. 156). Keynes reserves the term speculation for this activity of forecasting psychology to underscore the important influence of social convention in the determination of outcomes and differentiates it from the “activity of forecasting prospective yield of assets over their whole life,” which Keynes terms enterprise (p. 158).

Nicholas Kaldor (1939) carefully examines the implication of speculation for market stability by distinguishing between price stability and income stability. Even if speculation can be shown to stabilize prices, depending on the reactions of producers and elasticities of supply, the action may yield a greater instability in economic activity and incomes. Kaldor further argues that where the proportion of speculative transactions in the total is large, it may well be more profitable for individual speculators to focus on forecasting the psychology of other speculators rather than on the trend of nonspeculative elements. “Even if speculation as a whole is attended by a net loss, rather than net gain, this will not prove even in the long-run, self-corrective” (p. 2). Rudiger Dornbusch (1976) captures mathematically this inconsistency between short-term and long-term anticipated gains in a model of exchange rate “overshooting” driven by speculators with myopic perfect foresight.

Alongside the debate about the effects of speculation on the stability of currency markets is a parallel debate about the effects of speculation on the stability of equity markets. In a mathematical approach similar to that of Dornbusch, Robert P. Flood and Peter M. Garber (1980) examine a model of the speculative bubble in which forward-looking “rational” expectations may or may not motivate destabilizing speculation. The source of instability is a fundamental indeterminacy in the formal mathematical model, which is resolved in the literature by variously reducing the liquidity of the traded asset, introducing slow to adjust expectations, or imposing what is in effect a transversality condition that precludes by assumption anything but stability and convergence to a steady state. The steady state outcome is “efficient” in the sense that market prices fully and accurately reflect all relevant information about the future net income earning prospects of the assets discounted to the present. Viewed differently, the various “solutions” serve, in one way or another, to alter either the elasticity of expectations or the elasticity of speculative stocks, which together, as Kaldor had earlier argued, determine “the degree of price-stabilizing influence of speculation” (p. 9).

NONORTHODOX VIEWS

Where the orthodoxy focus on debating the stability implications of speculation in a probabilistic framework, heterodox economists concentrate on the implications for economic stability of speculation under conditions of true uncertainty. For Hyman Minsky (1982), financial fragility occurs in a world in which speculation in fixed assets is debt-financed and investors have both severely constrained foresight and limited memories of past distress. In his financial instability hypothesis, the evolving margins of safety between the streams of asset income in relation to the contemporaneous changes in debt service costs (rather than discounted present values) both characterize and explain the path of business fluctuations.

In a similar framework, Brenda Spotton Visano (2006) explores how the norm of speculation—as a collective dynamic—emerges when a revolutionary innovation shatters common understandings of the economic environment. The rate at which speculation in liquid financial assets related to the innovation becomes fashionable and spreads—thus sending asset prices spiraling upward—parallels the nonlinear, path-dependent diffusion course of the precipitating innovation itself. Because here the speculative activity materially affects an innovation’s potential, the material outcome is dependent on the collective assessment of that potential. In this case, what constitutes “excess” speculation is wholly unclear; in such environments, no criteria exist on which to base independent estimates of an asset’s fundamental value.

It follows that those who believe that speculation causes greater market volatility and misallocations of investment will advocate for some form of market intervention. Minsky recommends the presence of a lender of last resort in critical credit markets. Paul Davidson (1998) argues for a buffer stock mechanism in the control of a market maker. It is James Tobin’s proposal (1978) to levy a tax on foreign currency transactions, however, that has attracted the greatest attention. As a means of raising the cost of speculative transactions, levying a “Tobin tax” would “throw some sand in the wheels of our excessively efficient international money markets” (p. 154)—a proposal that is similar in practice and in purpose to the longstanding policy of levying stamp duty on the buying and selling of British property and shares.

By contrast, those who believe that speculation is predominantly a stabilizing market influence continue to advocate for less market intervention. The theoretical and policy debates persist with no clear agreement in sight.

SEE ALSO Bubbles; Efficient Market Hypothesis; Finance; Financial Instability Hypothesis; Keynes, John Maynard; Manias; Panics; Stability in Economics; Tobin, James

BIBLIOGRAPHY

Davidson, Paul. 1998. Volatile Financial Markets and the Speculator. Economic Issues 3 (2): 1–18.

Dornbusch, Rudiger. 1976. Expectations and Exchange Rate Dynamics. Journal of Political Economy 84(6): 1161–1176.

Flood, Robert P., and Peter M. Garber. 1980. Market Fundamentals versus Price-Level Bubbles: The First Tests. Journal of Political Economy 88 (4): 745–770.

Friedman, Milton. 1953. The Case for Flexible Exchange Rates. In Essays in Positive Economics, 157–203. Chicago: University of Chicago Press.

Kaldor, Nicholas. 1939. Speculation and Economic Stability. Review of Economic Studies 7 (1): 1–27.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. Reprinted in vol. VII of The Collected Writings of John Maynard Keynes, eds. Donald Moggridge and Elizabeth Johnson. London: Macmillan, 1974.

Kindleberger, Charles P. 2001. Manias, Panics, and Crashes: A History of Financial Crises. 4th ed. New York: Wiley.

Minsky, Hyman. 1982. The Financial Instability Hypothesis: Capitalistic Processes and the Behavior of the Economy. In Financial Crises: Theory, History, and Policy, eds. Charles P. Kindleberger and Jean-Pierre Laffargue, 13–39. Cambridge, U.K.: Cambridge University Press.

Spotton Visano, Brenda. 2006. Financial Crises: Socio-economic Causes and Institutional Context. London: Routledge.

Tobin, James. 1978. A Proposal for International Monetary Reform. Eastern Economic Journal 4 (3–4): 153–159.

Brenda Spotton Visano