The material from Book IV, Chapter 5 of Wealth of Nations is quite interesting, and applicable to today’s debate over speculation. In this regard it is useful to distinguish between financial speculation and what is sometimes referred to as “speculative storage.” Financial speculation is what often gets people’s jockeys in a bunch, but unless these financial speculators are somehow affecting quantities produced or consumed–by distorting prices in ways that induce distortions in storage, for instance–this activity will not affect the prices that consumers pay or producers receive. Financial speculators deal in price risk, and affect the price of that risk first and foremost. (These statements are a little overbroad: I refine the analysis a bit below.)
What Smith discusses in IV.5 is speculative storage. People holding inventories of commodities in anticipation of future market conditions.
Such storage decisions are inherently speculative, in the sense that they are based on expectations about future market conditions. That’s what storage is all about-and what my book on structural models of commodity prices is all about. Based on noisy signals, market participants try to determine whether the commodity is going to be more scarce in the future than it is at the present. If so, it is optimal to add to inventories because the commodity is going to be more valuable in the future. If not, it is optimal to draw down on inventories.
Since these decisions are necessarily based on conjectures about future fundamental conditions, there is a natural role for speculation: taking risky positions in the expectation of earning a profit, based on current information.
If a speculator is correct, he can make large profits. A speculator who anticipates that the next crop will be small will add to inventory, and if he is right, can sell that inventory at a high price when the crop is harvested and the shortage revealed. And note that his actions are beneficial: yes, he sells at a high price, but the price would have been higher still had he not added to the speculative inventory in anticipation of the future shortage. Further note that his actions do raise prices at the time he adds to inventory: if he doesn’t those bushels would be sold and consumed, and the price today (prior to the harvest) would be lower than they are when he holds them off the market (in Smith’s terms, “forestalls” or “engrosses’.)
Of course the speculators are not always right. They are working on limited information, and things can change over time-think of how decisions made in June of 2008 looked in October of that year. But this means that speculators have an incentive to collect information to allow them to make better decisions. Moreover, purely financial speculators that collect information and trade on it (such as by trading calendar spreads) can contribute to price discovery that leads to better inventory decisions. And as I’ve shown in some of my academic work (some currently in progress) financial speculators can reduce the cost of inventory by absorbing price risk from inventory holders, leading to an efficient unbundling of the functions of making inventory decisions and holding inventory on the one hand, and bearing the price risk of inventory on the other. (Smith makes a similar point, related to the allocation of capital rather than risk, at IV.5.55-56.)
Smith recognizes the benefits of this intertemporal trade, undertaken by speculators:
Secondly, it supposes that there is a certain price at which corn is likely to be forestalled, that is, bought up in order to be sold again soon after in the same market, so as to hurt the people. But if a merchant ever buys up corn, either going to a particular market or in a particular market, in order to sell it again soon after in the same market, it must be because he judges that the market cannot be so liberally supplied through the whole season as upon that particular occasion, and that the price, therefore, must soon rise. If he judges wrong in this, and if the price does not rise, he not only loses the whole profit of the stock which he employs in this manner, but a part of the stock itself, by the expence and loss which necessarily attend*79 the storing and keeping of corn. He hurts himself, therefore, much more essentially than he can hurt even the particular people whom he may hinder from supplying themselves upon that particular market day, because they may afterwards supply themselves just as cheap upon any other market day. If he judges right, instead of hurting the great body of the people, he renders them a most important service. By making them feel the inconveniencies of a dearth somewhat earlier than they otherwise might do, he prevents their feeling them afterwards so severely as they certainly would do, if the cheapness of price encouraged them to consume faster than suited the real scarcity of the season. When the scarcity is real, the best thing that can be done for the people is to divide the inconveniencies of it as equally as possible through all the different months, and weeks, and days of the year. The interest of the corn merchant makes him study to do this as exactly as he can: and as no other person can have either the same interest, or the same knowledge, or the same abilities to do it so exactly as he, this most important operation of commerce ought to be trusted entirely to him; or, in other words, the corn trade, so far at least as concerns the supply of the home market, ought to be left perfectly free.
Let me emphasize this part:
When the scarcity is real, the best thing that can be done for the people is to divide the inconveniencies of it as equally as possible through all the different months, and weeks, and days of the year. The interest of the corn merchant makes him study to do this as exactly as he can: and as no other person can have either the same interest, or the same knowledge, or the same abilities to do it so exactly as he, this most important operation of commerce ought to be trusted entirely to him; or, in other words, the corn trade, so far at least as concerns the supply of the home market, ought to be left perfectly free.
Exactly. (See also IV.5.42.)
Smith also understood that attempts to control this type of speculation, in particular by limiting price increases during times of dearth, were extremely counterproductive:
When the government, in order to remedy the inconveniences of a dearth, orders all the dealers to sell their corn at what it supposes a reasonable price, it either hinders them from bringing it to market, which may sometimes produce a famine even in the beginning of the season; or if they bring it thither, it enables the people, and thereby encourages them to consume it so fast as must necessarily produce a famine before the end of the season. The unlimited, unrestrained freedom of the corn trade, as it is the only effectual preventative of the miseries of a famine, so it is the best palliative of the inconveniences of a dearth; for the inconveniences of a real scarcity cannot be remedied, they can only be palliated. No trade deserves more the full protection of the law, and no trade requires it so much, because no trade is so much exposed to popular odium.
But Smith also understood the political economy of the situation:
In years of scarcity the inferior ranks of people impute their distress to the avarice of the corn merchant, who becomes the object of their hatred and indignation. Instead of making profit upon such occasions, therefore, he is often in danger of being utterly ruined, and of having his magazines plundered and destroyed by their violence. It is in years of scarcity, however, when prices are high, that the corn merchant expects to make his principal profit. He is generally in contract with some farmers to furnish him for a certain number of years with a certain quantity of corn at a certain price. This contract price is settled according to what is supposed to be the moderate and reasonable, that is, the ordinary or average price, which before the late years of scarcity was commonly about eight-and-twenty shillings for the quarter of wheat, and for that of other grain in proportion. In years of scarcity, therefore, the corn merchant buys a great part of his corn for the ordinary price, and sells it for a much higher. That this extraordinary profit, however, is no more than sufficient to put his trade upon a fair level with other trades, and to compensate the many losses which he sustains upon other occasions, both from the perishable nature of the commodity itself, and from the frequent and unforeseen fluctuations of its price, seems evident enough, from this single circumstance, that great fortunes are as seldom made in this as in any other trade. The popular odium, however, which attends it in years of scarcity, the only years in which it can be very profitable, renders people of character and fortune averse to enter into it. It is abandoned to an inferior set of dealers; and millers, bakers, mealmen, and meal factors, together with a number of wretched hucksters, are almost the only middle people that, in the home market, come between the grower and the consumer.
The ancient policy of Europe, instead of discountenancing this popular odium against a trade so beneficial to the public, seems, on the contrary, to have authorized and encouraged it.
And as we see over and over again, it is not just the ancient policy of Europe, but the modern policy of the US-or at least it would be if many politicians were to get their way.
This discussion is useful in making a valuable distinction. It is wrong to say that speculators don’t affect prices: competitive, efficient speculation does affect prices by ensuring that information about future and current fundamental conditions is reflected in inventory decisions, and hence consumption and production decisions: this necessarily affects prices. But as Smith notes, these price effects lead to a more efficient utilization of the commodity over time, in a way that actually alleviates the most acute shortages-shortages that would be even worse if speculative storage were constrained in some way.
That’s different from saying that speculation distorts prices: affecting prices and distorting them are two very different things.
Moreover, these price effects can be different from those of purely financial speculation, e.g., spread trading by hedge funds, although this trading can (as noted above) affect in a beneficial way inventory decisions through both an information channel and a risk allocation channel.
Finally, since speculative storage requires financing of inventory, it is often efficient for banks or other financial institutions to engage in it as they are often incur the lowest cost of financing: witness the large speculative storage of oil by big banks (e.g., Morgan Stanley) at the depths of the financial crisis. Financial/capital markets and financial institutions are all about the movement of resources over time: storage is just the movement of resources over time too, so there can be a natural complementarity between finance and storage. This last issue is evidently a source of policy controversy involving the Federal Reserve and large banks that it regulates. More on this soon. It is fascinating on many levels.
One other policy issue. Smith’s concern about the perverse effects of price ceilings during periods of shortage is the most defensible rationale of government storage programs, like the SPR. If the government cannot precommit to let prices clear the market during periods of shortage, there will be an insufficient incentive for private, speculative storage, especially since as Smith notes it is selling into these spikes that is most remunerative to inventory holders. Government storage programs can be a second best response to its inability to precommit not to screw things up. This raises questions about how the government storage program should operate: again, I hope to post on that soon. Hint: SPR doesn’t appear to be operated in the efficient way.