Wednesday, March 7, 2012


I recently spoke with a less than economically literate physician who began attributing gas price rises to “speculation.” I asked him how to account for the low prices in 2009, when gas was under $2/gal.? Were speculators banned back then, or simply less greedy as a group? The proffered response, when it came, was less than edifying. 
Now physicians are smart people, as a rule. Yet I know this physician is not alone in being clueless as to what speculation is and what speculators do. So I thought I’d do a quick post on speculators--what is their function--in a market economy.
Keep in mind, as Adam Smith pointed out long ago, there is a difference between the motivation an individual has for acting, and the social effect that act has. Clearly, like doctors going to hospitals, a large motivation for what speculators do, from the speculators’ perspective, is to make money. But how does speculation make money? Doctors, of course, make money by providing a value to society. Is this true of speculators as well?
The future is unknown, but let’s pretend for a moment we know it. We have a certain reserve of oil. With that supply, the price of oil is $X/barrel. We know--omnisciently, let us assume for a moment--that next week there will be a war in the Middle East that will drastically reduce the supply of oil. If we were omnibenevolent as well as omniscient, what would we want to happen? We’d want the price of oil to go up. That would both reduce the demand of oil and stimulate search to increase the supply of oil, both of which are good in the context of a lower supply suddenly thrust upon us.
And if, to modify the assumptions slightly, we all knew the supply of oil would suddenly decrease next week, the price of oil would change NOW. If we all know we have to conserve because of a supply drop next week, we don’t wait until next week to react. And this, too, is a good thing.
Now let’s assume we don’t know what’s going to happen next week. We blithely continue to buy and use oil like its supply at today’s level is going to continue. Next week, when the supply suddenly drops, we look back on our actions and think, “Damn! I wish I hadn’t been so profligate in my use of oil. If only there had been some clue I could have relied on..”
Speculators are the people providing that clue. They, no more than any of us, are effortlessly omniscient regarding the future. But they know if they estimate the future correctly, they can make a profit, so they have every incentive to work hard to use all the clues available: are politicians ruminating about war? Has Saudi Arabia just accepted a large unexpected order of tanks? Are talks breaking down? Are troops being shifted? Or even absent signs of war, is less being pulled from certain wells, suggesting they may be drying up? Is there less drilling? So many little to best interpret them? 
And different speculators interpret them differently, and act differently as a result. But the ones who do best--who most correctly predict future market conditions get the biggest profit. If they predict a drop in oil supplies next week, they buy oil now--raising the price now--when oil prices are relatively cheap, and sell it next week--lowering the price next week--when oil prices are relatively high. They smooth market prices over time. Without speculators, there are sudden and dramatic price changes in response to real changes in market conditions. With speculators, there are more smooth and less dramatic changes in prices in response to real changes in market conditions. To make a profit, the speculator has to guess correctly and has to buy low and sell high, which amounts socially to marginally raising the price when supply is plentiful and marginally lowering the price when supply is restricted. This is exactly what an omniscient, omnibenevolent person would choose to do himself.
Speculators can guess wrongly, of course. Then they would be causing a price rise that was not socially beneficial. But they would also be losing money, not making a profit. Such speculators are weeded out of the market over time. Such speculators are no more evil than you are if you buy a stock expecting its price to rise and the stock tanks instead.
Of course, prices don’t have to go up for successful speculators to make money. If a speculator correctly predicts the supply will increase next week, he will sell oil now, when it is relatively scarce, lowering the higher price, and buy it next week when it is relatively plentiful, raising a relatively lower price. As before, the speculator’s actions smooth market prices over time.
The fact that speculators can make a profit when the price of oil is dropping shows that speculators should not be blamed for rising oil prices. They don’t need rising oil prices to make a profit. Blaming a speculator for rising oil prices is like blaming Cassandra for the destruction of Troy. There is a difference between correctly predicting the future and causing the future to be as predicted.
Now, like the car industry, or the energy business, or farmers, or even physicians, speculators can try to make a profit not solely by the free market means described above, but by political cronyism. Billionaire money speculators, like George Soros, might buy Euros and sell dollars, not due to an educated guess about relative supply and demand of the different currencies, but because lobbying (paying off) US and European governments to act in ways guarantees such actions profitable. This is not morally defensible and I don’t defend it. But that’s not what most speculators do.
Without speculators, strawberries would be cheaper in season and dramatically more expensive out of season. With speculators, the price change over time is moderated. That’s a good thing. So be grateful for speculators. Not because they act altruistically. But because their pursuit of profit benefits you.
The physician who motivated me to jot this post had it completely backwards. If the price of gas is high now, the speculator would be making a profit by SELLING gas. If he hadn’t gas to sell, then the supply of gas would be even smaller. And the price would be even higher. The speculator was buying gas when the gas price was low. If I ever saw someone cursing a speculator when gas prices are low, on the grounds that without the speculator they’d have been even lower, I’d disagree with the curse, but at least I’d be grateful they had the economics down…


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