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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.

Speculators 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 prices—ruled 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 money—in technical jargon, a chain letter is a zero-sum game—if 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.

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1Extraordinary Popular Delusions and the Madness of Crowds (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