Speculators and Markets
Suppose that you receive an advertisement in the mail
offering you a book that tells you how you can beat the
stock market and become rich. If this book is offered to you
for a mere $50, should you buy it? A little reflection
should suggest that you be very, very suspicious. If there
was a way to beat the market, the person who had the way
should keep quiet and use it. Once the method becomes
publicly known, its use will eliminate any source of profit.
A financial market is an "efficient market" if its
prices take into account all knowledge that people have
about that market. (Notice that the use of the word
"efficiency" in this context is not
the same as the use of the word in most of
microeconomics.) If there is knowledge that is not being
used, unexploited profit opportunities exist, and in
financial markets these opportunities should be quickly
taken. If one knows that a stock or bond is undervalued and
that it will rise in value, one will make a large amount of
money by buying until it does rise. Because profit
opportunities are quickly exploited once they become known,
one cannot "beat" an efficient market unless one has special
information that is unavailable to others.
If the stock market is an efficient market, movements of
stock prices from day to day will be random. Knowing the
past movements of the stock does not help one predict what
the future price will be. This idea contradicts the
technique of picking stocks used by "chartists" or
"technicians" who believe that past movements can reveal
patterns. A variety of studies that have compared randomly
picked portfolios of stocks with stocks chosen by various
technical rules supports the idea that information about
past movements of stock prices does not help predict the
future. The idea of efficient markets suggests that one
should not place a great deal of faith in any forecasts
about interest rates or stock prices, because if the person
making the forecast really does know what will happen, he
could keep quiet and get rich.
play a useful role in an efficient market where prices
adjust very quickly to new information. They are coolly
rational individuals looking at the fundamental values of
items, buying when prices are too low and helping lift these
prices, and selling when prices are too high and helping to
lower these prices. As a result, prices correctly transmit
information about values that people can then use to make
decisions. An efficient market will not be the source of
economic disturbances. It can, however, transmit
disturbances, and this alone would be enough to interest economists.
However, there are some who argue that financial markets
are not efficient and do not always adjust to economic
conditions. They argue that those trading in financial
markets are not always calmly rational in the way that those
who believe in efficient markets picture them. Rather
traders can go on speculative binges, ignoring reality. An
important reason people buy items in financial markets is in
the hope of selling them at a profit. Thus trading in these
markets involves not only an analysis of the fundamental
value of an asset, but also an analysis of how other people
will react. If people are confident that others will buy the
item for more than they paid for it, then they will buy it
even if it has little value to them.
The idea described above has been called the
"greater-fool" theory. It implies that although one
may be a fool for buying an asset that is overpriced, one
can profit if there are still greater fools who will pay
even more for it. The idea is an example of the
model of contingent behavior. In contingent behavior,
people's actions are based on the way they expect others to
act. To the extent that people act in this way and that
"greater-fool" speculating influences prices in financial
markets, financial markets can serve as a source of economic
disturbances rather than as mere transmitters.
There are cases in which markets clearly had speculative binges. One of the earliest and most famous was the Dutch tulip market of the 1630s. The tulip was introduced into Holland in the middle of the 16th
century from Constantinople. It immediately became a status
symbol among the very rich, and then as it became a bit less
rare, among the middle classes. According to Charles Mackay,
"Until the year 1634 the tulip annually increased in
reputation, until it was deemed a proof of bad taste in any
man of fortune to be without a collection of them."1
After 1630 the price of tulips reflected not only their
stylishness, but also speculation. People began to gamble on
price changes. As people began to join the speculation,
trying to get in at low prices, prices took off and the
market developed a life of its own. People bought tulips at
ridiculous prices only because they thought other people
would be willing to pay equally ridiculous prices. For
example, a single bulb was exchanged for twelve acres of
land. Another was sold for a carriage, two horses, and a substantial sum of cash.
The "bulls"those who expected rising pricesruled the
bulb market until 1636. The boom faded when enough Dutchmen
began to wonder if tulip bulbs were really worth what they
were being traded for, and decided to get out of the market
while they were ahead. As this sentiment spread, the market
peaked and began to fall. Speculative markets can crash
almost instantly because once prices begin to fall, people
realize that there is no fundamental reason for them to be
so high. The prices of tulip bulbs fell until they reached a
realistic value, which meant that a single bulb was almost worthless.
Looking back at tulipmania, we have a tendency to think,
"That is a funny episode, but of no importance. People are
smarter today." Yet in 1982 a major speculative binge came
to an end, leaving debts in the area of $90 billion. The
binge took place in Kuwait in an unregulated
over-the-counter market called the Souk al-Manakh. The
market was limited to trading in only about 35 companies,
most of which were small, and many of which did not even
publish annual reports. Activity was clearly speculative,
and as prices rose and banks began to refuse to lend money
to finance deals, people began to use postdated checks. In
effect, people promised to pay based on the belief that they
could sell their securities for more than they had paid, and
thus redeem the check. Under Kuwaiti law, a check is payable
on demand regardless of the date. The collapse came in
August of 1982 when someone demanded early payment on a
check that could not be paid. With confidence in the system
shaken, prices quickly collapsed.2 Also,
greater-fool psychology seems to widespread in the run up of
the prices of the dot-com stocks in the late 1990s.
Markets based on "greater-fool" psychology always collapse. Eventually the greatest fool is found, and once he is found, the process cannot continue. In many ways a speculative binge is like a chain letter. Everyone involved in a chain letter believes that he or she will get rich. But since all that is involved is a reshuffling of moneyin technical jargon, a chain letter is a zero-sum gameif someone does get rich, others must get poorer. Like speculative binges, chain letters die when the greatest fools have found and joined the chain.
Speculative binges can affect the production of an
economy if they cause enough financial disruption. They will
cause bankruptcies, reduce people's trust in others, and
cause unemployment for the people who became speculators.
However, few periods of inflation or recession can be linked
to speculative binges, and, as a result, most economists do
not believe that they, or the financial markets, are an
important source of macroeconomic disturbance.
Some people argue that the Great Depression was a result
of a speculative binge in the stock market in 1928 and 1929.
Most economists dismiss this theory because prices in the
stock market did not reach levels that were clearly
outlandish. Some market watchers have even argued that stock
prices were not overvalued at all in 1929 if the 1930s would
have been a normal decade.
Even if one believes that stocks were overvalued in 1929,
and that the stock market had gone on a speculative binge,
it is hard, and perhaps impossible, to explain why the
results of this particular binge were so much more severe
than the aftereffects of other, equally large binges in the
stock market. In particular, the very large drop in stock
market prices on Monday, October 19, 1987 left few traces on
production or consumption during the following year. Yet on
that one day the value of common stocks, as measured by the
Dow Jones Industrial Index, dropped by more than 22%.
Clearly a speculative crash in financial markets is not
enough, by itself, to trigger a recession.
The foreign exchange markets are an important group of financial markets.
1Extraordinary Popular Delusions and the Madness of
(L.C. Page, 1932, p. 89); original edition published in
London, 1841. It is unclear how seriously we should take
Mackay. Some recent studies suggest that, although there was
speculation in tulips and their prices did surge and drop,
the emphasis on folly is "largely the invention of
nineteenth-century Romantics, who based their knowledge on
contemporary pamphlets of dubious factual content."
(Quotation from History of Financial Disasters, Vol
1, (London: Pickering & Chatto, 2006) p xxviii.
2 For more details, see The Wall Street Journal, Dec 2, 1982.
Copyright Robert Schenk