Case B10
The Role of the Speculator
Does speculation benefit society?
... the greed of bond traders drives up interest rates, and so harms output and jobs. Stock markets
punish companies that invest in their workers instead of boosting profits. The managers of pensions
and mutual funds flood emerging markets with capital, then pull the plug on a whim. Even
governments quail before the might of speculators. When they set their exchange rate at a
vulnerable level, speculators sell the currency forcing them to devalue.1
This commonly held, yet largely unfair, view of speculators sees them as almost wholly
destructive. In fact, speculators play a crucially important and often beneficial role in economic
affairs, and it is this side of the speculator’s actions that are largely ignored and taken for
granted.
For example, take share prices. A firm’s share price reflects speculators’ estimation of the
business’s future prospects: if they believe that prospects are good, they will buy the firm’s
shares, thereby pushing up their price; if they believe that prospects are bad, they will sell the
firm’s shares, thereby pushing down their price. A falling share price will make it more difficult
and expensive for the company to raise new finance on the stock market. This in turn will result
in the firm cutting back on investment. But, if speculators were correct in their assessment of the
firm, this is desirable. Investment funds will be diverted to firms with better prospects. They
will receive more and cheaper finance.
The criticism of these arguments is that speculators frequently get things wrong. They focus
too much on the short term and on the current profitability of the business, ignoring long-run
prospects and opportunities.
But is there any basis to this criticism? The Economist thought not.
Shares derive their worth from a firm’s underlying assets. If the market in which these shares are
traded ‘undervalued’ them, anyone who bought such a share would be getting a bargain: they would
receive a windfall in the future when the firm’s long-term investment paid off. It would then be easy
for a few clever investors to exploit the market’s short-sightedness. For example, if it were true, as it
is sometimes said, that the market attaches too little value to corporate R&D, a few investors could
make a bundle by buying shares in firms with large R&D budgets. In the process, of course, these
firms’ prices would rise until they were no longer undervalued.
If this sounds abstract, consider the concrete evidence that investors care about the long term.
The shares of many bio-technology or software firms, some of which have never made a profit,
continue to fetch dizzying prices in the stock market. Indeed, a common criticism of stock market
speculators is that they push the prices of high-tech firms too high. In other words, they seem to care
too much, not too little, about the long term.
By far the greatest criticism of speculators is the volatility they create by causing prices to
move up and down – often, so it appears, at a whim. But even this might be explained away as a
virtue, as the speculator is simply responding to changing economic conditions, either at the
level of the firm or within the economy generally. Speculators are adjusting their decisions in
line with changing circumstances. In other words, they are being efficient.
Efficiency, however, does not necessarily imply that speculators’ assessment of
circumstances is correct! A particular problem arises here if the information that speculators use
to make their decisions includes the current share price movement itself: in other words, if
speculators believe that a current upward movement in share prices signifies an underlying
reason why the price should move upwards. In such cases, speculators will buy the shares,
further fuelling the upward movement in their price and encouraging other speculators to ‘jump
on the bandwagon’. What this leads to is something called ‘overshooting’. This is where the
price rises above the equilibrium that reflects underlying economic conditions. After a while,
speculators will realise that the share price has risen too high. At this point they will start selling
them and their price will fall. This may even cause the price to fall below the underlying
equilibrium, before rising back again
Question
How might it be beneficial for the economy if speculators were less efficient?
1
The Economist, 3 February 1996 (see also)