Speculators Stabilize Prices

One of the most pervasive and persistent economic fallacies -- even among many people who claim to advocate free markets -- is that the speculator disrupts markets by making prices more volatile. In fact, the opposite is true.

In Walter Block's witty and iconoclastic book Defending the Undefendable, in which he puts the free market's most extreme and controversial cases to the test, he makes the following bold claim that I can almost guarantee you never heard in school: "The popular hatred for the speculator is as great a perversion of justice as can be imagined." The surprising reason is that the speculator, despite his selfish attempt to turn a profit by buying low and selling high, actually promotes the public good. Adam Smith described this counterintuitive truth in his 1776 classic The Wealth of Nations:

Every individual endeavors to employ his capital so that its produce may be of the greatest value. He generally neither intends to promote the public interest, nor knows how much he is promoting it. And he intends only his own security, his own gain. He is led in this as if by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.

The successful speculator is an example of a person who acts in his own selfish interest, yet (usually without knowing or caring) promotes the public good. The frequent objection is that speculators cause prices to rise or become volatile, but the overall effect of speculators is rather to stabilize prices. Walter Block explains using the example of food:

In times of plenty, when food prices are unusually low, the speculator buys. He takes some of the food off the market, thus causing prices to rise. In the lean years which follow, this stored food goes on the market, thus causing prices to fall. Of course, food will be costly during a famine, and the speculator will sell it for more than his original purchase price. But food will not be as costly as it would have been without his activity! (It should be remembered that the speculator does not cause food shortages which are usually the result of crop failures and other natural or man-made disasters.)

Block goes on to emphasize that the effect of the successful speculator on food prices is not to make them more volatile, but rather to level them off. The effect on him is to earn profits: the market's way of compensating him for his valuable service. Effectively, what the speculator does is to relieve other people of certain financial risks and volatility in exchange for a "fee." Block concludes:

Yet instead of honoring the speculator, demagogues and their followers revile him. But prohibiting food speculation has the same effect on society as preventing squirrels from storing up nuts for winter -- it leads to starvation.

He has a point. And the food example can be applied to just about any other commodity or asset. "But what about unsuccessful speculators," you ask? Block points out that the occasional unsuccessful speculator tends to lose his capital due to his lack of predictive skill. Eventually he is forced into another line of work for which he is better suited -- the market weeds him out. "Ah," you say, "but what about the unsuccessful speculators that appear in droves during financial bubbles, masses of lemmings who blindly follow each other into the financial stratosphere until the bubble bursts, at which point most of them lose everything? Surely you aren't trying to tell me that they are promoting the public good!"

Not necessarily. However, given that speculators earn profits by buying low and selling high, we should ask ourselves whether, in financial bubbles, an obscenely large number of otherwise skilled and intelligent speculators start "recklessly" investing capital not because they are collectively insane, but because there is something in the economy that is in fact artificially undervalued (kept below its market price). I asked myself that question, and here is the answer I found: Such an artificially undervalued "something" does exist during financial bubbles. It is bank credit itself -- driven to bargain-basement interest rates and incredibly lax lending standards as a direct result of government intervention.

Many people forget that bank credit, like any other commodity or asset, has a "price": the interest rate. An artificially low interest rate enforced by the Federal Reserve System means "cheap" bank credit, and as we have just seen, speculators are eager to buy things that seem unusually cheap in the hopes of selling them later when their price better reflects reality. So of course speculators (and businesses in their speculative roles) will take out more bank loans than usual during Fed-fueled credit expansions. If the expansion is sustained over a number of years, even the most street-smart speculators who recognize the beginnings of the bubble may have no choice but to play along in order to avoid being forced out of business by their competition. Even the legendary billionaire investor Warren Buffett recently admitted to doing "some dumb things in investments" last year.

Since the Fed so severely distorts our money system, which results in false market signals automatically feeding everyone with the same misleading, overoptimistic information, it should not be a mystery why speculators far and wide appear to become infected by insatiable greed and even collective mania during financial bubbles. In the absence of government intervention, the self-regulating processes of the free market do not sustain such madness and disorder. Only government is capable of such massive failure.

Give the successful speculator a break for once. Better yet, give him a pat on the back. He deserves it.