One of the professional speculator’s main roles is in relieving other people from having to speculate as part of their regular economic activity, such as farming for example, where both the weather during the growing season and the prices at harvest time are unpredictable. Put differently, risk is inherent in all aspects of human life. Speculation is one way of having some people specialize in bearing these risks, for a price. For such transactions to take place, the cost of the risk being transferred from whoever initially bears that risk must be greater than what is charged by whoever agrees to take on the risk. At the same time, the cost to whoever takes on that risk must be less than the price charged.
In other words, the risk must be reduced by this transfer, in order for the transfer to make sense to both parties. The reason for the speculator’s lower cost may be more sophisticated methods of assessing risk, a larger amount of capital available to ride out short-run losses, or because the number and variety of the speculator’s risks lowers his over-all risk. No speculator can expect to avoid losses on particular speculations but, so long as the gains exceed the losses over time, speculation can be a viable business.
The other party to the transaction must also benefit from the net reduction of risk. When an American wheat farmer in Idaho or Nebraska is getting ready to plant his crop, he has no way of knowing what the price of wheat will be when the crop is harvested. That depends on innumerable other wheat farmers, not only in the United States but as far away as Russia or Argentina.
If the wheat crop fails in Russia or Argentina, the world price of wheat will shoot up, because of supply and demand, causing American wheat farmers to get very high prices for their crop. But if there are bumper crops of wheat in Russia and Argentina, there may be more wheat on the world market than anybody can use, with the excess having to go into expensive storage facilities. That will cause the world price of wheat to plummet, so that the American farmer may have little to show for all his work, and may be lucky to avoid taking a loss on the year. Meanwhile, he and his family will have to live on their savings or borrow from whatever sources will lend to them.
In order to avoid having to speculate like this, the farmer may in effect pay a professional speculator to carry the risk, while the farmer sticks to farming. The speculator signs contracts to buy or sell at prices fixed in advance for goods to be delivered at some future date. This shifts the risk of the activity from the person engaging in it—such as the wheat farmer, in this case—to someone who is, in effect, betting that he can guess the future prices better than the other person and has the financial resources to ride out the inevitable wrong bets, in order to make a net profit over all because of the bets that turn out better.
Speculation is often misunderstood as being the same as gambling, when in fact it is the opposite of gambling. What gambling involves, whether in games of chance or in actions like playing Russian roulette, is creating a risk that would otherwise not exist, in order either to profit or to exhibit one’s skill or lack of fear. What economic speculation involves is coping with an inherent risk in such a way as to minimize it and to leave it to be borne by whoever is best equipped to bear it.
When a commodity speculator offers to buy wheat that has not yet been planted, that makes it easier for a farmer to plant wheat, without having to wonder what the market price will be like later, at harvest time. A futures contract guarantees the seller a specified price in advance, regardless of what the market price may turn out to be at the time of delivery. This separates farming from economic speculation, allowing each to be done by different people, who specialize in different economic activities. The speculator uses his knowledge of the market, and of economic and statistical analysis, to try to arrive at a better guess than the farmer may be able to make, and thus is able to offer a price that the farmer will consider an attractive alternative to waiting to sell at whatever price happens to prevail in the market at harvest time.
Although speculators seldom make a profit on every transaction, they must come out ahead in the long run, in order to stay in business. Their profit depends on paying the farmer a price that is lower on average than the price which actually emerges at harvest time. The farmer also knows this, of course. In effect, the farmer is paying the speculator for carrying the risk, just as one pays an insurance company. As with other goods and services, the question may be raised as to whether the service rendered is worth the price charged. At the individual level, each farmer can decide for himself whether the deal is worth it. Each speculator must of course bid against other speculators, as each farmer must compete with other farmers, whether in making futures contracts or in selling at harvest time.
From the standpoint of the economy as a whole, competition determines what the price will be and therefore what the speculator’s profit will be. If that profit exceeds what it takes to entice investors to risk their money in this volatile field, more investments will flow into this segment of the market until competition drives profits down to a level that just compensates the expenses, efforts, and risks.
Competition is visibly frantic among speculators who shout out their offers and bids in commodity exchanges. Prices fluctuate from moment to moment and a five-minute delay in making a deal can mean the difference between profits and losses. Even a modest-sized firm engaging in commodity speculation can gain or lose hundreds of thousands of dollars in a single day, and huge corporations can gain or lose millions in a few hours.
Commodity markets are not just for big businesses or even for farmers in technologically advanced countries. A New York Times dispatch from India reported:
At least once a day in this village of 2,500 people, Ravi Sham Choudhry turns on the computer in his front room and logs in to the Web site of the Chicago Board of Trade.
He has the dirt of a farmer under his fingernails and pecks slowly at the keys. But he knows what he wants: the prices for soybean commodity futures.{448}
This was not an isolated case. As of 2003, there were 3,000 organizations in India putting as many as 1.8 million Indian farmers in touch with the world’s commodity markets. The farmer just mentioned served as an agent for fellow farmers in surrounding villages. As one sign of how fast such Internet commodity information is spreading, Mr. Choudhry earned $300 the previous year from this activity that is incidental to his farming, but now earned that much in one month.{449} That is a very significant sum in a poor country like India.
Agricultural commodities are not the only ones in which commodity traders speculate. One of the most dramatic examples of what can happen with commodity speculation involved the rise and fall of silver prices in 1980. Silver was selling at $6.00 an ounce in early 1979 but skyrocketed to a high of $50.05 an ounce by early 1980. However, this price began a decline that reached $21.62 on March 26th. Then, in just one day, that price was cut by more than half to $10.80. In the process, the billionaire Hunt brothers, who were speculating heavily in silver, lost more than a billion dollars within a few weeks.{450} Speculation is one of the financially riskiest activities for the individual speculator, though it reduces risks for the economy as a whole.
Speculation may be engaged in by people who are not normally thought of as speculators. As far back as the 1870s, a food-processing company headed by Henry Heinz signed contracts to buy cucumbers from farmers at pre-arranged prices, regardless of what the market prices might be when the cucumbers were harvested. Then as now, those farmers who did not sign futures contracts with anyone were necessarily engaging in speculation about prices at harvest time, whether or not they thought of themselves as speculators. Incidentally, the deal proved to be disastrous for Heinz when there was a bumper crop of cucumbers, well beyond what he expected or could afford to buy, forcing him into bankruptcy.{451} It took him years to recover financially and start over, eventually founding the H.J. Heinz company that continues to exist today.
Because risk is the whole reason for speculation in the first place, being wrong is a common experience, though being wrong t
oo often means facing financial extinction. Predictions, even by very knowledgeable people, can be wrong by vast amounts. The distinguished British magazine The Economist predicted in March 1999 that the price of a barrel of oil was heading down, {452}when in fact it headed up—and by December oil was selling for five times the price suggested by The Economist. In the United States, predictions about inflation by the Federal Reserve System have more than once turned out to be wrong, and the Congressional Budget Office has likewise predicted that a new tax law would bring in more tax revenue, when in fact tax revenues fell instead of rising, and in other cases the CBO predicted falling revenues from a new tax law, when in fact revenues rose.
Futures contracts are made for delivery of gold, oil, soybeans, foreign currencies and many other things at some price fixed in advance for delivery on a future date. Commodity speculation is only one kind of speculation. People also speculate in real estate, corporate stocks, or other things.
The full cost of risk is not only the amount of money involved, it is also the worry that hangs over the individual while waiting to see what happens. A farmer may expect to get $1,000 a ton for his crop but also knows that it could turn out to be $500 a ton or $1,500. If a speculator offers to guarantee to buy his crop at $900 a ton, that price may look good if it spares the farmer months of sleepless nights wondering how he is going to support his family if the harvest price leaves him too little to cover his costs of growing the crop.
Not only may the speculator be better equipped financially to deal with being wrong, he may be better equipped psychologically, since the kind of people who worry a lot do not usually go into commodity speculation. A commodity speculator I knew had one year when his business was operating at a loss going into December, but things changed so much in December that he still ended up with a profit for the year—to his surprise, as much as anyone else’s. This is not an occupation for the faint of heart.
Economic speculation is another way of allocating scarce resources—in this case, knowledge. Neither the speculator nor the farmer knows what the prices will be when the crop is harvested. But the speculator happens to have more knowledge of markets and of economic and statistical analysis than the farmer, just as the farmer has more knowledge of how to grow the crop. My commodity speculator friend admitted that he had never actually seen a soybean and had no idea what they looked like, even though he had probably bought and sold millions of dollars’ worth of soybeans over the years. He simply transferred ownership of his soybeans on paper to soybean buyers at harvest time, without ever taking physical possession of them from the farmer. He was not really in the soybean business, he was in the risk management business.
INVENTORIES
Inherent risks must be dealt with by the economy not only through economic speculation but also by maintaining inventories. Put differently, inventory is a substitute for knowledge. No food would ever be thrown out after a meal, if the cook knew beforehand exactly how much each person would eat and could therefore cook just that amount. Since inventory costs money, a business enterprise must try to limit how much inventory it has on hand, while at the same time not risking running out of their product and thereby missing sales.
Japanese automakers are famous for carrying so little inventory that parts for their automobiles arrive at the factory several times a day, to be put on the cars as they move down the assembly line. This reduces the costs of carrying a large inventory of parts and thereby reduces the cost of producing a car. However, an earthquake in Japan in 2007 put one of its piston-ring suppliers out of commission. As the Wall Street Journal reported:
For want of a piston ring costing $1.50, nearly 70% of Japan’s auto production has been temporarily paralyzed this week.{453}
Having either too large or too small an inventory means losing money. Clearly, those businesses which come closest to the optimal size of inventory will have their profit prospects enhanced. More important, the total resources of the economy will be allocated more efficiently, not only because each enterprise has an incentive to be efficient, but also because those firms which turn out to be right more often are more likely to survive and continue making such decisions, while those who repeatedly carry far too large an inventory, or far too small, are likely to disappear from the market through bankruptcy.
Too large an inventory means excess costs of doing business, compared to the costs of their competitors, who are therefore in a position to sell at lower prices and take away customers. Too small an inventory means running out of what the customers want, not only missing out on immediate sales but also risking having those customers look elsewhere for more dependable suppliers in the future. As noted in Chapter 6, in an economy where deliveries of goods and parts were always uncertain, such as that of the Soviet Union, huge inventories were the norm.
Some of the same economic principles involving risk apply to activities far removed from the marketplace. A soldier going into battle does not take just the number of bullets he will fire or just the amount of first aid supplies he will need if wounded in a particular way, because neither he nor anyone else has the kind of foresight required to do that. The soldier carries an inventory of both ammunition and medical supplies to cover various contingencies. At the same time, he cannot go into battle loaded down with huge amounts of everything that he might possibly need in every conceivable circumstance. That would slow him down and reduce his maneuverability, making him an easier target for the enemy. In other words, beyond some point, attempts to increase his safety can make his situation more dangerous.
Inventory is related to knowledge and risk in another way. In normal times, each business tends to keep a certain ratio of inventory to its sales. However, when times are more uncertain, such as during a recession or depression, sales may be made from existing inventories without producing replacements. During the third quarter of 2003, for example, as the United States was recovering from a recession, its sales, exports, and profits were all rising, but BusinessWeek magazine reported that manufacturers, wholesalers, and retailers were “selling goods off their shelves” and “the ratio of inventories to sales hit a record low.”{454}
The net result was that far fewer jobs were created than in similar periods of increased business activity in the past, leading to the phrase “a jobless recovery” to describe what was happening, as businesses were not confident that this recovery would last. In short, for sellers the selling of inventory was a way of coping with economic risks. Only after inventories had hit bottom did the hiring of more people to produce more goods increase on such a large scale as to make the phrase “a jobless recovery” no longer applicable.
PRESENT VALUE
Although many goods and services are bought for immediate use, many other benefits come in a stream over time, whether as a season’s ticket to baseball games or an annuity that will make monthly pension payments to you after you retire. That whole stream of benefits may be purchased at a given moment for what economists call its “present value”—that is, the price of a season’s ticket or the price paid for an annuity. However, more is involved than simply determining the price to be paid, important as that is. The implications of present value affect economic decisions and their consequences, even in areas that are not normally thought of as economic, such as determining the amount of natural resources available for future generations.
Prices and Present Values
Whether a home, business, or farm is maintained, repaired or improved today determines how long it will last and how well it will operate in the future. However, the owner who has paid for repairs and maintenance does not have to wait to see the future effects on the property’s value. These future benefits are immediately reflected in the property’s present value. The “present value” of an asset is in fact nothing more than its anticipated future benefits, added up and discounted for the fact that they are delayed. Your home, business, or farm may be functioning no better than your neighbor’s today, but if the prospective toll of wear and
tear on your property over time is reduced by installing heavier pipes, stronger woods, or other more durable building materials, then your property’s market value will immediately be worth more than that of your neighbor, even if there is no visible difference in the way they are functioning today.
Conversely, if the city announces that it is going to begin building a sewage treatment plant next year, on a piece of land next to your home, the value of your home will decline immediately, before the adjoining land has been touched. The present value of an asset reflects its future benefits or detriments, so that anything which is expected to enhance or reduce those benefits or detriments will immediately affect the price at which the asset can be sold today.
Present value links the future to the present in many ways. It makes sense for a ninety-year-old man to begin planting fruit trees that will take 20 years before they reach their maturity because his land will immediately be worth more as a result of those trees. He can sell the land a month later and go live in the Bahamas if he wishes, because he will be receiving additional value from the fruit that is expected to grow on those trees, years after he is no longer alive. Part of the value of his wealth today consists of the value of food that has not yet been grown—and which will be eaten by children who have not yet been born.
One of the big differences between economics and politics is that politicians are not forced to pay attention to future consequences that lie beyond the next election. An elected official whose policies keep the public happy up through election day stands a good chance of being voted another term in office, even if those policies will have ruinous consequences in later years. There is no “present value” to make political decision-makers today take future consequences into account, when those consequences will come after election day.
Basic Economics Page 33