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When Speculation Fails

Cover of  by Daniel O'Sullivan


Tim Worstall?s defence of oil speculators is an immaculate exposition of neoclassical thinking. It is also deeply questionable. He says:
This is the point about speculators. If they're correct, if there really is a shortage looming (of anything) then they bring that price signifying shortage forward: thus making shortage less likely. So they make their money from providing us with the signals which mitigate the very problem they've identified. If they are wrong then they lose their money.
All of which leads to the conclusion that, far from decrying speculators in search of profit, we should be applauding them.
There?s a problem here. In financial markets, you don?t make money by being right. You do so by being right at the right time. Let?s take Tim?s example, of a man who believes in peak oil. He would indeed have made money in 2007-08 as prices doubled. But he?d have lost money before then - prices fell by a third in late 2006 - and in late 2008 as prices collapsed. These gyrations don?t reflect any changing facts about geology, but rather traders? beliefs.
Any decent speculator, then, must focus upon what he expects others to believe. He must play Keynes? beauty contest game, and anticipate what average opinion expects average opinion to be.
And the problem is that average opinion needn?t have any knowledge about future shortages at all. It might be merely trying to anticipate the next move in average opinion, or just be swept along by an information cascade or herding. Prices, then, can be moved by ?noise traders? - those who have no knowledge of (or even interest in) the ?fundamentals.? For an analysis of how this has happened in oil markets, I commend Petromania, by my friend Danny O?Sullivan.
There?s worse. In the presence of noise traders, traders who do have hard knowledge might stay out of the market, figuring ?these prices are stupid, but they might get even stupider?. The result is that prices can move far from their fundamental level. And - contrary to Tim?s thesis - it?ll be possible for stupid investors to make money and smart ones not to. For example, in the late 90s Tony Dye at Phillips & Drew thought shares were over-priced*. Eventually, he was proved right - but only after he lost his job. Rational investors can do little to exploit excess volatility.
So, sorry Tim, but speculators can be destabilizing.
But here?s my problem. At one extreme, we have Guardianistas and arrogant idiots who think they know better than others, who seem to see speculative bubbles everywhere. At the other extreme, we have some free marketeers who deny the possibility of them. As for me, I?m in the middle. I can see that excess volatility and the potential for bubbles exists, but it?s a long way from this to spotting them at the time, and an even longer way to being able to profit from them.
If I were Tim, I?d defend speculators not on the grounds that the profitable speculator is a public benefactor, but rather on the basis that even bubbles don?t necessarily do harm. Who cares if $100 oil was a bubble if it inspired companies to do more exploration than they otherwise would? Why care about the bubble in tech stocks given that it provided us with investment in broadband?
Maybe it just doesn?t much matter if markets get things wrong.

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