Seeing A Forest of Overspeculation

There’s been a number of recent columns seeking to define the financial upheaval that we’ve been through.  New York Times columnist David Brooks wrote an excellent piece, “Greed and Stupidity,” that identifies the competing theories as either A) narratives that argue that greedy bankers became so powerful they manipulated politicians into writing rules in their favor and ultimately collapsed the system out of their own greed, or B) narratives that essentially point to the unwitting ignorance of Wall Street professionals who mistook the precision of their financial models for accuracy.  In yet another approach, Fed Chairman Bernanke weighed in during a speech at Morehouse College by blaming the global credit glut.

Each of those explanations would take policymakers down different paths in seeking to avert future upheavals.  But what if all of those explanations are incomplete? 

I think it’s worth considering another argument, that our economy has suffered from a surplus of “overspeculation.”  This is a concept that’s usually associated with the Great Depression (out of curiousity, I created a Google histogram of the usage and dates associated with “overspeculation” — note the spike in 1929). 

overspeculation-on-google

Generally, “overspeculation” represents an economic condition where an inordinate amount of investment capital is diverted to non-traditional vehicles.  This presupposes that one accepts that one kind of investing is “different in kind” and not merely “different in degree” than another.  This is best illustrated by examples:

1.  Owning a share of stock is to own part of a company whose employees are trying to make better lives for themselves and their families by producing something of value.  So, what does being short that stock represent?

2. Most companies use debt to leverage their business.  The managers of those businesses determine what level of debt is appropriate for a given industry and economic climate.  What does it mean to take baskets of stocks, each with its own level of leverage, and then lever that basket up 6 or 7 fold in a hedge fund?

These are but a few examples that suggest that so many of the non-traditional ways of putting investment capital to work are not just alternative ways of initiating traditional positions, but something cut from a different cloth altogether.   I would argue that these sort of things are fine and even beneficial on the margin, but damaging if disproportionately large.   To be concerned about the volume of assets diverted into such vehicles is not to be “anti-free market,” but rather to recognize that free markets require rules to function effectively and to preserve their integrity.    

We already place lots of restrictions on trading for these and other reasons (e.g., no insider trading, prohibitions against front-running or touting, to name but a few).  Perhaps we should consider restrictions in light of an overspeculation problem.  I’ve argued for the restoration of effective position limits on commodity futures and for the regulation of commodity swap contracts.  George Soros recently suggested that only bona fide hedgers (those long the bonds in question) be permitted to use credit default swaps.   There seems to be widespread interest in lowering the leverage of banks, and some talk of placing limitations on leverage with hedge funds.

Overspeculation seems to be a theme that runs through many of our financial problems, from the leverage of subprime securities to the explosion of the credit default swap market.  The good news is that regulations that would act upon such concerns call for a light hand.  Such restriction would not impact the heart of the free markets, but rather would set barriers of conduct at the periphery.   Free markets need rules, but we need to understand the nature of the violation before we attempt to impose regulatory fixes.

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3 Responses to “Seeing A Forest of Overspeculation”

  1. anon Says:

    speaking of overspeculation…FERC just released a report regarding 2008 nat gas prices. Their conclusion was:

    “while physical market fundamentals, particularly storage levels, can explain why natural gas prices rose during the first six months of 2008, none of the market fundamentals were extreme enough to explain why spot Henry Hub prices reached $13.31/MMBtu by July 3.

    …the rise in natural gas prices coincided with a global increase in many commodity prices. This increase in commodity prices occurred as large pools of capital flowed into various financial instruments that essentially turn commodities like natural gas into investment vehicles. Ultimately, we believe that financial fundamentals along with the modest tightening in the supply and demand balance for gas during the first part of 2008 explains natural gas prices during the year.”

    Here’s the full report: http://www.ferc.gov/market-oversight/st-mkt-ovr/som-rpt-2008.pdf

    I seriously hope we don’t “waste a crisis” and let commodity trading off the hook. Like most every bit of financial innovation that got taken to the n-th degree, it’s a cancer consumers and the world economy.

  2. FERC Calls Out the Speculators « (in)efficient frontiers Says:

    […] (in)efficient frontiers Inefficient Frontiers: insight on our less-than-efficient markets and the risks of life on the investment frontier « Seeing A Forest of Overspeculation […]

  3. Derivatives are the weapon of choice… « (in)efficient frontiers Says:

    […] overwhelming speculative volume in the Credit Default Swap marketplace is a good example of “overspeculation,” an excessive diversion of investment capital away from traditional vehicles and into […]

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