Freeman

ARTICLE

The Benefits of Speculation

DECEMBER 01, 1981 by WALTER BLOCK

Dr. Block is Senior Economist, The Fraser Institute, 626 Bute Street, Vancouver, B.C., Canada V6E 3M1.

Whenever housing prices rise we hear a chorus of complaints blaming the speculator. Speculators have always been vilified for high and rising prices.

This view is incorrect. In fact, the opposite is true: speculation holds the rise of prices to less than would have prevailed without it. To see this clearly, let us consider the un-controversial example of “widgets.” Then, having established the basic principles for the classic case, we can apply them to the special and more sensitive issue of land and housing prices.

Suppose that in the absence of speculation, the future supply of widgets is as in the Biblical story: seven fat years followed by seven lean. Given similar demand in the two periods, the years of ample supply would result in low prices and the era of short supply in high prices.

Enter the speculator. What will he do? He will try to buy when prices are low and sell when they are high. His initial purchases will, to be sure, raise prices above the low levels that would otherwise obtain in the first period, as his additional speculative demand is now added to the demand to buy widgets for consumption purposes. But his subsequent sales will reduce prices from the high levels that would prevail, apart from his efforts, in the second time interval. This is because speculative sales, when added to other sales, must depress prices further than all other sales would have done by themselves.

The speculator will be seen by people to be selling at high prices in years 8 to 14. People will thus blame him for these escalated prices, even though prices would have been still higher in his absence.

But the speculator does far more than merely iron out prices over time. By dampening price oscillations, he accomplishes something of crucial importance: the stockpiling of wid-gets during the years of plenty, when they are least needed, and the dissipation of the widget inventory during times of shortage, when they are most useful.

Furthermore, the speculator’s actions in the market signal to all other businessmen that an era of short supply is expected in the future. His present purchases raise widget prices, and hence the profitability of producing them now. This encourages others to do so before the lean years strike. The speculator is the Distant Early Warning System of the economy.

But, as in the days of yore when the bearers of ill tidings were put to death for their pains, modern day messengers—the speculators—are blamed for the bad news they bring. There is talk of prohibiting their activities outright, or of taxing their gains at 100 per cent confiscatory rates. Such moves, however, deprive society of the beneficial effects of speculation.

There is only one possible fly in the ointment. If the speculator guesses incorrectly and see years of plenty ahead when belt tightening is really in store for the economy, chaos can result. Instead of stabilizing prices and supplies of widgets, the speculator will destabilize them; instead of hoarding during the fat years and reducing inventories during famines—and leading others to do so as well—he will encourage needless saving under adversity and wasteful profligacy in good times.

The Market Guards Against Unlimited Profit or Loss

The market, however, has a fail-safe mechanism to prevent just this sort of disaster. The speculator who guesses wrong will buy high and sell low—and incur losses, not profits. If he continues to err, he will go bankrupt, and usually very quickly. Professional speculators who have survived this rigorous market test of profit and loss can be relied upon to forecast the future with far greater accuracy than any other conceivable group, including bureaucrats, politicians, marketing boards or swamis.

Now let us consider the effect of speculation on land and housing prices.

As in the case of widgets, the speculator is observed to be selling at high prices, to be holding land off the market until yet higher prices are reached. But if we carefully trace out the effects of such activities, we can see that the only time the speculator could have raised prices is when he buys—and that he bought when prices were low, before the increase in demand. We can likewise see that the only result of speculative sales is to decrease prices. No matter how expensive the level at which the sales take place, prices would have been higher still in the absence of this additional land and housing supply.

The speculator can function as a distant early warning line in this market as well. His initial housing purchases can encourage the construction of additional housing: at higher home prices, more profits can be earned in building, lumber, cement, wiring and so on. By definition, additional land cannot be created (barring reclamation from the sea, as in the case of Holland) but space can be converted to housing from other uses, such as farming and industry.

Now let us consider several objections to the view that the speculator makes a positive contribution to the public good.

1. But the speculator’s initial purchases start the upward price cycle even in the “fat years.” Of course the speculator’s initial purchases start the upward price movement during the “fat” years, when prices are low (and decreases prices when he sells during the “lean” years, during the time that prices are high). This is precisely the main effect of speculation: to dampen down the price oscillations, or cycles, that would otherwise prevail in its absence. Decreasing price variation must inevitably imply raising low prices, while decreasing high ones. To blame the speculator for this is like blaming apple pie for tasting so good. That’s the whole point of the enterprise.

2. If the speculator hadn’t scooped up the housing at that early point in the cycle and held on to it, exactly the same amount of housing would already have been available when the lean years arrived. This objection ignores the point, made above, that the speculator serves as a sort of Distant Early Warning System. By making his initial purchases during the “fat” years, when prices are low, the professional speculator may well encourage imitators. These people may want to “ride along” with the speculator, and earn profits by adding to the housing stock.

Moreover, there is another reason for dismissing the claim that “exactly the same amount of housing would be available.” The speculator, it must be remembered, is by assumption one of the few people who foresees the lean years ahead. Surely we may expect more housing to be saved (through better upkeep, maintenance, more investments in repairs, upgrading) by people such as the speculators, who expect housing to sell at a premium in the near future, than by people who do not.

3. When the speculator finally sells, during the “lean” years, he will sell at homeowner prices instead of speculator prices—it being given that speculators can usually hold out for their desired price longer than homeowners who need to sell quickly. If any proposition is more likely, it is the very opposite. For the speculator is more likely to be a person with his eye strictly out for the “main chance.” Who has ever heard of a speculator sitting on a piece of land and refusing to sell for any price, because the house on top of it “was in the family for years” and has “sentimental value”? In land sales homeowners can usually hold out for longer time periods than speculators, who are ever on the search for yet another profit opportunity, and unwilling to keep their funds tied up in any one venture for a long time.

4. The speculator keeps land idle. This is wasteful, and deprives the economy of a much needed impetus. We can answer this objection in several ways. On a somewhat superficial level, it (usually) exposes the inconsistency of the person who makes it. For most people who oppose speculation also favor conservation. But idle land is by definition land being conserved. If a person favors conservation, and thinks that speculation keeps land “idle,” he cannot logically oppose speculation.

On a more fundamental level is the fact that land speculation serves several useful social functions.

The Functions of Speculation

First of all, speculation in an unhampered market tends to put land into the hands of the most capable property developers. Many people do not realize that property development requires a great amount of ability. They feel, somehow, that it is only a matter of renting (or selling) to the highest bidder.

Even were that the case, land development would still be a task calling for a great degree of skill. How else can we account for the economic importance of auctioneers and brokers of all kinds, whose “only” job is to ensure that sales are indeed made to the highest bidder (and that all bids are as high as possible in the first place)? How else to account for the graft, corruption and otherwise poor records attained by city governments which have taken upon themselves the responsibilities of “contracting out” municipal services to private firms (in this case, trying to ascertain the low bidder)?

But real property development calls for far more than the ability to rent or sell to the highest bidder. Right at the offset is the choice between renting and selling. If renting is decided upon, there are an indefinitely large number of alternatives, including duration of the lease, security, financial terms, services provided, and so on. A wrong decision in any of these dimensions can lead to lower profits through an inefficient use of property.

Land is valuable not only for what value it can create in the present but for what may be accomplished with it in the future. Prescience is denied mankind, at least this side of heaven. Therefore, the best future use of idle land is never known for sure. (Does anyone believe that present settlement and building patterns would have been as they now are had we somehow been able to know what the economic conditions of 1981 were to be like 10, 30, or 50 years ago?)

This is the reason speculators ofttimes keep their land “idle”: they do not as yet perceive the future course of events as clearly as they think they someday might. They forgo the present rents they might otherwise have obtained, in the opinion that the gains to be made by being flexible (keeping land idle and unencumbered) are likely to be higher than those alternatives. The speculator, in other words, fears that a better use for this land might make itself known later, right after he commits it to a poorer use; and that the cost of clearing up this mistake (demol ishing a building, buying out a tenant’s lease) might be greater than the additional rents he could have collected from the better use. In weighing these alternatives, the speculator attempts to determine the most valuable use the members of society place on his land.

An Optimal Building Rate

Do the opponents of speculation really wish no land to be “idle,” for these precautionary purposes? If so, they cannot be motivated by a desire to satisfy consumer sovereignty. For there is an optimal building rate over time—that is, an optimal rate at which land is withdrawn from “precautionary balances”—deviations from which can reduce welfare. This rate is determined by consumer (and landowner) preferences, by interest and time-preference rates, by the prices of substitute and complimentary factors of production, and so on. Perhaps in some conceivable circumstances this optimum rate might call for the immediate discontinuation of all “idle” land, as desired by the opponents of speculation. But even under these circumstances, speculators would themselves be led “as if by an invisible hand” to sharply reduce “idle” balances of land. Thus, there would be no need to oppose the operation of the unhampered marketplace even in these circumstances.

Let us close with the observation that speculation is very much more widespread than its opponents seem to realize. Not limited to land, speculation certainly applies to other organized markets such as stocks, commodities, currencies, metals and so on. But this is just the tip of the iceberg.

Speculation occurs even in the most ordinary of transactions. Every time the housewife goes grocery shopping she is speculating. If prices are falling, she might have been better off to defer her purchases; if they are rising, she might have done well to buy twice as much. Every time the worker upgrades his skills, he is speculating that the value ofthe additional wages he may earn as a result will be greater than the value to him of dollar expenditures, efforts and psychic costs he expended in obtaining the new training. Every time a child buys a toy he is speculating that he won’t see another toy he likes still more—after the money is gone.

We may even say that speculation is at the very core of human action. The opposition to speculation, then, is at root an opposition to human freedom.

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December 1981

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