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Business Cycles: Profitable Destabilizing Speculation Literature Review

Economists have sometimes conjectured that speculators profit from buying low and selling high and thus tend to stabilize market prices. Others contend that speculators can earn profits and simultaneously destabilize markets. The possibility of profitable destabilizing speculation (PDS) affects the operation of competitive markets under uncertainty. For if speculators may profitably destabilize, then clearly real world markets can be unstable. However, if destabilizing speculators always lose money, then in a Darwinian sense they will fail to survive.

Our present knowledge of the relation between speculative profits and stability evolved from studies in international economics, price theory, finance, and modern uncertainty theory. Although PDS represents a sustainable, endogenous source for fluctuations and business cycles, macroeconomic theorists (aside from the Chicago School) have largely overlooked the debate. Yet analyzing this conjecture will provide better understandings of the microfoundations of macroeconomics under uncertainty. Indeed many post-Keynesian proponents of active fiscal and monetary policies point out the need to counteract such endogenous, destabilizing market forces.

This chapter reexamines the literature on PDS, integrating various aspects of works into the general theory of speculation. While profitable destabilizing speculation has been theoretically depicted, work in this area appears confusing and contradictory. Many of the early uncertainty theorists employed arbitrary doctrines and primitive models which inadequately portrayed a complex phenomenon like speculation. Utilizing the benefit of hindsight and modern analytic techniques, we aim to clarify and develop more formally some of the main themes of the speculation and stability literature.

The text proceeds as follows. Section 1 restates the basic proposition that profit-earning speculators stabilize markets. Since many theorists adopted different speculation and stability definitions, Section 2 attempts to describe the semantic controversy. Next, Section 3 reviews William Baumol's counterexamples, and the comments and criticisms they elicited. Section 4 continues sorting valid from invalid PDS counterexamples. Section 5 discusses some representative empirical findings, and the final section contains conclusions and a summary. The appendices derive results from Baumol's counterexamples, which provide an excellent review for differential equation modeling in economics, and a class of nonlinear excess demand counterexamples. Readers not interested in differential equations and Hilbert spaces can skip the appendices without losing any economic concepts.

1.1. Speculation and Stability: The Friedman Proposition

A number of economists have argued that profit-earning speculators stabilize markets. The argument dates back at least to the Nineteenth Century, e.g., John Stuart Mill advanced the notion in his Principles of Political Economy.1 Ross (1938) criticized Mill's notion and offered a counter argument based on stock market fluctuations.

The argument resurfaced in the mid-1950s, when economists began debating the merits of flexible exchange rates and the stability of a flexible regime as compared with exchange rates pegged to the gold standard. Milton Friedman's contention that profitable speculation tends to stabilize a market shook the conventional wisdom2 blaming speculators for exchange rate instabilities during the 1920s and Great Depression era. Supporting flexible exchange regimes and a general free market philosophy, Friedman (1953) asserted

People who argue that speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since 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....A warning is perhaps in order that this is a simplified generalization on a complex problem. A full analysis encounters difficulties in separating `speculative' from other transactions, defining precisely and satisfactorily `destabilizing speculation' and taking account of the effects of the mere existence of a system of flexible rates as contrasted with the effects of actual speculative transactions under such a system. (Friedman (1953), pp. 175, 175n)

An extensive literature then grew out of the question of whether profit-earning speculators could destabilize markets and whether proposed counterexamples had shortcomings that invalidated them.

1.2. The Semantic Controversy

Originally, theorists, such as Friedman, based their analysis on markets without speculation. The theory asserted profit-earning speculators' entry into such a market would stabilize prices. With the development of the modern uncertainty theory framework, we now know that attempting to model a `nonspeculative' market is fruitless. Chapter 3 illustrates why in an incomplete market, almost everyone is forced to speculate, because claims are not available for their optimal consumption bundle.

Modern uncertainty theory solves comparative-statics issues for speculation via the general equilibrium contingent claims model and standard economic reasoning. The standard format provides individuals with production functions, preferences, time-distributed endowments, etc., and specifies the available market range. Economists then pose comparative-statics questions: e.g., what happens if preferences change?

Unfortunately, economists have no universally accepted economic dynamics framework; therefore, no prescribed methodology exists to address issues such as stability, a dynamic concept. Consequently, what theorists might consider unacceptable modern uncertainty comparative-statics, e.g., arbitrarily specified speculative excess demand functions, have frequently shed light on important dynamic stability concepts. In Sections 3 and 4, counterexamples are illustrated that employ these arbitrary methodologies; the text will thus emphasize substance over technique. By keeping an open mind, one may glean an idea or two from these earlier works that can be transposed into a modern framework.

1.2.A. Definitions of Speculation

The first step in reviewing specific examples of PDS is to define our terminology. The classic speculator definition focuses on the capital gains motive. A speculator buys (sells) goods under uncertainty, with the intent to resell (repurchase) them after some anticipated favorable price change. We must emphasize that speculators transact in an uncertain environment. When traders profit from purchasing goods and later reselling them at an a priori known price, the traders have engaged in arbitrage not speculation. Moreover, speculators traditionally receive no gain from consuming or using these goods, lest speculation be confused with simple expected utility maximization. Kaldor (1939) characterized speculative sales or purchases as those motivated solely by perceived capital gains.

Some theorists maintain Kaldor's definition excludes `speculation' involved in dynamic consumption or production plans. For example, does a manufacturer `speculate' by postponing a required input's purchase to realize an expected capital gain? We can clarify our speculation definition by introducing a legal per se distinction. To meet the three criteria for speculation per se, a person must (1) purchase (sell) a good, (2) face price/profit uncertainty, and (3) transact primarily with a capital gains motive. The manufacturer above did not sell the desired input with the intent of later repurchasing it; therefore, he did not speculate per se. Put another way, he could not be charged with speculation per se, since one of the three essential elements (purchase) is missing. He did `speculate' in the sense of attempting to minimize his input costs over time, but this type of behavior lies outside the definition.

The same distinction holds for consumers who `speculate' by shopping at a particular grocery store or who consider the potential resale value in their house and automobile purchases. We can distinguish between investors who consider a capital good's salvage value and those primarily concerned with reselling the capital good at a profit. The latter group primarily purchases (sells) to realize a capital gain, while the former group is not speculating per se. The more a house purchaser weighs the capital gain potential of his investment, as opposed to wanting to capture the benefits from living in a house, the more he acts like a speculator per se.

Consider now an individual who has no intention ex ante to speculate, but finds he can realize an ex post capital gain. The third essential element of our definition - the capital gains motive - does not influence the individual. An ex post transactions focus potentially would include nonspeculative capital gains as well, e.g., a Pigou effect.

Particularly in the stock market, differentiating between ex ante and ex post speculation would sometimes fail to include investors who speculated but did not realize their ex post capital gains or losses. Most importantly, a speculation definition based on ex post activity would deemphasize the crucial expectations and motives that economists mean when they discuss speculative behavior.

Rather than proceeding with a common speculation definition, from which theorists might distinguish other market transactions, the profitable destabilizing speculation literature at once began to quarrel over the ongoing problem of defining `nonspeculators.' As we will now proceed to demonstrate, the old `nonspeculator' semantic controversy appears avoidable by defining speculation per se.

Friedman [(1957) at p.269] suggested that `perhaps a nonspeculator can only safely be defined (if this is done in terms of his demand curve) as one whose purchases are directly influenced by current prices but not by past prices or price trends.' Telser defended Friedman's notion and added that nonspeculators derive profits from other sources.

What distinguishes speculators from other traders in the market is that their profits depend only on the price or price change of the commodity they trade. Nonspeculators' profits are determined not only by the price of the commodity traded on the organized exchange but also by the prices of other related commodities. If the nonspeculators are hedgers, they can make their profits almost independent of the price level itself. (Telser (1959), p.295)

Telser illustrated his nonspeculator definition with a textile manufacturer purchasing raw cotton and for whom cotton fabric and textile prices also determine his profit level. To illustrate his `profit from other sources' criterion, Telser chose an importer who profits from decreases in exchange rates and shipping costs, in addition to the imported commodity's price. Although the textile manufacturer and importer meet Telser's criterion, they would be `foolish to ignore price trends in their supply and demand decisions.' (Baumol (1959), p.302)

Upon reexamination, we note that if Telser's importer purchases primarily with the intent to resell at a gain, no matter where he may derive additional profits, then he has engaged in speculation per se. Telser's `speculator' definition - an investor who solely profits from exchange rate capital gains - is a convention frequently used in the international economics literature. However, in this chapter we will broadly apply the Friedman Proposition across markets and will not add the sole profit motive limitation to the elements of our per se definition.

Baumol defined nonspeculators as the speculators' trading partners.

The practical question which has lain behind the discussion is whether the entry into a market of skillful professional speculators, people who have no desire to hedge their holdings, can be stabilizing. Now it is clear the remaining participants in the market, the nonspeculators, the people who would like to hedge, must in their own interests consider price trends. For price changes must also affect the values of nonspeculators' holdings and obligations unless in fact they have succeeded in setting up perfect hedges, which in most markets is out of the question. (Baumol (1959), p.302)

Baumol's comment raises an interesting, though not widely understood, fact about hedging. In futures market jargon, imperfectly hedged contracts sometimes force hedgers to speculate per se on the basis, the spread between the cash and futures prices. If the hedgers leave their hedge positions in place and do not unwind them, then they will not speculate per se.

Cite as Michael A. S. Guth, "Profitable Destabilizing Speculation," Chapter 1 in Michael A. S. Guth, SPECULATIVE BEHAVIOR AND THE OPERATION OF COMPETITIVE MARKETS UNDER UNCERTAINTY, Avebury Ashgate Publishing, Aldorshot, England (1994), ISBN 1856289850.

Profitable Destabilizing Speculation*

Dr. Michael A. S. Guth, Ph.D., J.D. is a Professor of Financial Economics and Law for several universities with on-line degree programs and an attorney at law in Tennessee. He wrote his doctoral dissertation on topics in speculation theory, and this article on profitable destabilizing speculation is the first chapter in his published book, and one of his favorites.

In addition, Dr. Guth is a financial quant and former investment banker, having worked for Credit Suisse First Boston and Deutsche Bank in London and Frankfurt. He specializes in developing investment strategies and hedging techniques using derivatives. For five years, he consulted to the electric power and gas industry in the USA, even managing the Middle Office (financial risk control) function for two trading floors.

Dr. Guth has taught over 30 courses on-line at the undergraduate and graduate level on topics ranging from Managerial Economics to Strategic Management to Business Law. He can be reached through web page http://riskmgmt.biz/economist.htm