Eco-Economy: Trivialising Speculation
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By Chris Harris
The question of whether we’re in for a rerun of the Great Crash of 1929 is very topical at the moment. Bearish websites like http://www.prudentbear.com, http://www.financialsense.com and http://www.itulip.com, and books like Edward Chancellor’s recent Devil Take the Hindmost: A History of Financial Speculation (NY: Farrar, Straus & Giroux 1999), hold that the world is in a “credit bubble” possibly more severe than that of the Roaring Twenties.
The concept of a “credit bubble” comes from the classical theory of destabilising speculation, as elaborated by all the great economic theorists from Adam Smith to Hyman Minsky. Banks and other financial institutions are able to lend money up to a certain multiple of their assets. As they lend out more money, assets like real estate and stocks and shares begin to inflate in value. So the banks are able to lend out more money still.
This self-reinforcing cycle continues until there is so much money and credit washing around that inflation spreads to ordinary goods and services (“headline inflation”). At this point, the value of financial assets becomes endangered, because the dollars in which they are denominated start to lose purchasing power faster than the assets are appreciating. At this point credit creation slows down and crash may occur.
The credit-crash cycle occurs with monotonous regularity, in minor and more serious episodes, like storms. Every sixty years or so there is a “Perfect Storm,” wreaking havoc that takes years to repair.
The credit-crash cycle is the “unacceptable face of capitalism.” Financial speculation drains resources away from productive enterprise, and the periodic crashes throw millions out of work.
There are roughly two approaches that economists have taken to the question of speculation. One approach is to analyse its dynamics and see whether there is any way of damping them down, for example by bank regulation or curbs on the international movement of capital.
The other approach is to trivialise the issue by focusing on the motives of individuals and omitting mention of the credit bubble dynamic. This second approach is exemplified by Milton Friedman, in a 1960 paper termed “In Defense of Destabilizing Speculation.”
First, Friedman argues that:
“The empirical generalization about the prevalence of destabilizing speculation, which is what gives the theoretical proposition its interest, seems to be one of those propositions that has gained currency the way a rumor does— each man believes it because the next man does, and despite the absence of any substantial body of well documented evidence for it.”
According to Friedman, speculation of the sort that increases price swings cannot long persist, because in some sense it must involve individuals buying assets when they are expensive and selling when they are cheap. It’s well known that there is a class of speculators which buys assets like oil when they are cheap and sells them when they are expensive. Such an “insurance” strategy makes money for speculators while at the same time damping market price fluctuations for everyone else. Ergo, speculation that increases price fluctuations must lose money. Presumably speculators aren’t in business to lose money. Friedman therefore proves by logic that destabilising speculation must be indeed something of an urban legend.
To the extent that destabilising speculation does exist it must reflect boredom with the “insurance” strategy and a consequent willingness to pay for the right to gamble. Since gambling may be viewed as a service, it follows that no moral significance can be attached to any losses incurred in the process of speculative gambling.
“The ready acceptance of the proposition that destablizing speculation is economically harmful reflects, I believe, a natural bias of the academic student against gambling and in favor of insurance…. Is speculation the rendering of a productive service that commands a reward? Or is it a means of gaining utility on which people spend part of their income? If it turns out to be the second rather than the first, is this any reason for regarding it as involving economic loss? Does not the tendency to do so simply reflect the preconceptions of the academic?”
Nowehere does Friedman’s paper mention the word “credit.”
Nor does Friedman address the diversion of investment away from science and technology into real estate and car numberplates.
Instead he focuses on proving that losses suffered by individuals selling high and buying low are really a payment for the right to gamble.
Nowhere does Friedman question whether bank managers and other fiduciary agents do, in fact, have the right to indulge a private gambling fetish with their institution’s funds.
Lastly, anyone who questions this logic is labelled an “academic,” an interesting case of the pot calling the kettle black.
Thus encapsulated in a nutshell is the core rhetorical strategy of what might be termed “bankers’ economics.” Namely, the trivialisation of speculation and associated issues by misrepresenting opponents’ arguments and the treatment of social questions in individual terms.
Friedman is of course a recipient of the Nobel Memorial Award in Economic Science. One hopes that it isn’t for this stuff— and fears that it may be.
- Chris Harris
The Fugu Option
The Japanese have a saying with regard to the puffer fish, known in its prepared form as 'fugu': "He who eats fugu is a fool, he who does not eat fugu is also a fool."
The saying comes from the fact that when prepared properly, the puffer fish is particularly delicious. But occasionally the chef slips up, in which case the diners suffer serious poisoning.
Central bankers now seem to face a series of fugu options in dealing with current financial instabilities.
First, consider the Euro-fugu option. If the Euro continues to decline, the resulting instability of currencies may trigger a crash. If however it recovers, then the US dollar will decline relatively, and this may cause trend-following "hot money" to flee the USA, also triggering a crash.
Second, consider what must be done if a crash does occur. Under increasingly open discussion is the possibility of direct intervention to prop up stock markets. This will save the markets in the short run, but at the expense of an increase in "moral hazard."
Perhaps more fundamentally, a stockmarket rescue operation will politicise the economy in a way that has simply never happened in the past. It is central to capitalist ideology that stockholders bear the possibility of being wiped out. They accept entrepreneurial risk in return for the right to keep the profits. Now, if the market is insured by the state, then this means that the state bears the entrepreneurial risk, and should therefore become the recipient of profit.
While government bailouts are by no means uncommon, they have always been limited to particular companies, or to the banking sector (e.g. S&L), which, it is generally accepted, has a fiduciary role warranting a degree state intervention (unless you're a real hardliner). The state has never stepped in to rescue stockholders in general.
It goes without saying that a general intervention to prop up the stockmarket will have unparalleled visibility, as well. The whole world will indeed be watching.
Hence, the politicisation of the economy. Nor is this a long-run, theoretical issue. In the short run, the demonstration-strike-blockade mob will ask: "Why is the government buying out these financial parasites at the top the market, when our small businesses are being driven to the wall by high interest rates and fuel prices, and our jobs being retrenched?" The more socially concerned may ask, "Why is Third World debt not also being cancelled?", or "Why is the government not spending all this money on health-education-public transport?" They will conclude (probably rightly) that their demonstrations are not yet big enough, their strikes not sufficiently solid, their blockades of essential industries not yet sufficiently disruptive.
Alternatively the markets could be allowed to crash, in which case there would also be a revolutionary climate engendered.
To sum up, the markets may crash whatever happens. And whether the stockmarket is then rescued or not, the legitimacy of such concepts as "shareholder value" and "management's right to manage" will be shattered. Ascendent in their stead will be concepts of economic "stakeholding" as advocated by such figures as John Kay http://www.johnkay.com, if not the outright "industrial democracy" of the 1970s.