Speculators and their role in the free market

I don’t like to do this but this is so important that I am going to copy word for word multiple paragraphs from a book that has been on my mind lately. I first read Hidden Order: the Economics of Everyday Life more than ten years ago when I was at UVA and what David Friedman (son of economist Milton Friedman) wrote in Chapter 13 does a much better job at explaining the speculation in the oil market (or any other market for that matter) today than manyof the Congressmen who appeared on the news earlier today.

 

SPECULATION

It is difficult to read either newspapers or history books without occasionally coming across the villainous speculators. Speculators, it sometimes seems, are responsible for all the problems of the world – famines, currency crises, high prices.

 

How Speculation Works

            A speculator buys things when he thinks they are cheap and sells them when he thinks they are expensive. Imagine, for example, that you decide there is going to be a bad harvest this year. You buy grain now, while it is still cheap. If you are right, the harvest is bad, the price of grain goes up, and you sell at a large profit.

            There are several reasons why this way of making a profit gets so much bad press. For one thing, the speculator is profiting by other people’s bad fortune, making money from, in Kipling’s phrase, “Man’s belly pinch and need.” Of course, the sae might be said of farmers, whoare usually considered good guys. For another, the speculator’s purchase of grain tends to drive up the price, making it look as though he is responsible for the scarcity.

            But in order to make money, the speculator must sell as well as buy. If he buy when grain is plentiful, he does indeed tend to increase the price then; but if he sells when it is scarce (which is what he wants to do in order to make money), he increases the supply and decreases the price just when the additional grain is most useful.

            The speculator, acting for his own selfish motives, does almost exactly what a benevolent ruler would do. When he foresees a future famine he drives up the current price, encouraging consumers to economize on food (by slaughtering meat animals early, for example, to save their feed for human consumption), to import food from abroad, to produce other kinds of food (go fishing, dry fruit, …), and in other ways to prepare for the anticipated shortage. He then stores the wheat and distributes it (for a price) at the peak of the famine. Not only does he not cause famines, he prevents them. 

            Speculators, if successful, smooth out price movements, buying goods when they are below their long-run price and selling them when they are above it, raising the price toward equilibrium in one case and lowering it toward equilibrium in the other. They do what government “price-stabilization” schemes claim to do – reduce short-run fluctuations in prices. in the process, they frequently interfere with such price-stabilization schemes, most of which are run by producing countries and designed to “stabilize” prices as high as possible.