Mr. Culp is an Associate Policy Analyst for the Competitive Enterprise Institute (CEI) in Washington, D. (2., and a research associate for Friedberg Commodity Management; Inc., in Toronto, Canada. Mr. Smith is the President of CEI. The authors wish to acknowledge contributions of Tom Miller in helping to prepare this article.
Financial middlemen are in disfavor everywhere. From the movie Wall Street to the pages of The Wall Street Journal, they have become the villains of our age. Our modern media and intellectual leaders recognize a range of legitimate economic activities such as farming, distribution, storage, and manufacturing, but see little value in such unfamiliar, “immoral,” and “unproductive” activities as corporate takeovers, insider trading, and junk bond financing. These activities involve too much mental acumen and too little honest sweat.
To reinforce theft biases, journalists quickly assign pejorative labels to those things they don’t understand: “insider” trading, “junk” bonds, “leveraged buy-outs,” “hostile” takeovers, “poison pill” defenses, “greenmail,” and those old favorites, “speculation” and “profiteering.” The plot outline of the media story varies, but when the story ends, the middleman always winds up wearing the black hat.
Those in the media are not alone in theft condemnation. Politicians and other social commentators find it useful to chastise such middlemen as serving no useful purpose. In fact, these entrepreneurs are typically por trayed as being mere paper-pushing, tape-watching profit maximizers who exist only to skew the distribution of wealth. But if middlemen are so non-productive, we might well ask why competitive capitalist societies have created so many types of them. Some insight into this question is gained when one realizes that today’s respected service and distribution workers were once also condemned as parasitic middlemen.
We should not be surprised that the Michael Milkens of today are caricatured and pilloried. What is not understood is often condemned, and few people understand the value of entrepreneurial activities. Mankind is reac-tionary-the new, the novel, and the unusual may be essential, but such activities rarely receive honor in their own day. Today’s insider traders and junk bond salesmen were yesterday’s draymen and warehousemen. In their day, transportation and storage were viewed as suspiciously as innovative financial vehicles are today.
The story is told well in Adam Smith’s discussion of the Corn Laws in The Wealth of Nations. Smith reviewed 18th-century public attitudes toward two new forms of wealth creation: “forestalling” and “engrossing” (terms picked for the same connotative reasons that “junk” and “hostile” are the adjectives of choice for high risk, high yield bond financing and changes in corporate control today). “Forestalling” was a new economic activity involving corn purchases during times of plenty in the hope that the corn could later be resold at a profit. “Engrossing” described a similar arbitrage activity focusing on price differentials among different locales within England. Engrossers, for example, bought low in Birmingham and sold high in London—or rather they hoped to do so. Both activities had become possible only as storage and transportation costs dropped.
The Role of the Middleman
Forestailing and engrossing were soundly criticized as sterile middlemen activities that produced no new corn but only raised prices. Such speculation, the conventional wisdom held, could only hurt the general public.
However, Smith explained clearly that such middlemen played an essential role. If speculators predicted scarcity and it failed to materialize, they lost money. They not only had to sell the corn at a loss, but also pay its storage and/or transportation costs. When the scarcity was real, however, Smith explained that “the best thing that can be done for the people is to divide the inconveniences of [that scarcity] as equally as possible through all the different months, and weeks, and days of the year” and, of course, across the nation. Smith noted that the corn merchant—the specialist in this com-modity-was the most appropriate party to carry out this “most important operation of commerce.”
Moreover, Smith noted, the risks were clearly shifted from the consumers to these specialists. When engrossers and forestallers were wrong (a situation all too likely in commodity markets) ‘and prices fell rather than rose, they bore the consequences of their follies. On the other hand, when these speculators were correct and shortages did occur, both they and the citizenry benefited. As Smith explained, “By making [the people] feel the inconveniences of a dearth somewhat earlier than they might otherwise 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.”
Smith detailed the consumer advantages of making uniform the supply of foodstuffs over time and avoiding the feast or famine problems that existed before there were middlemen. In modern terms, forestalling and engrossing were creative forms of voluntary risk-shifting, in which risks were transferred from risk-averse consumers and growers to risk-taking speculators.
Smith stated that “after the trade of the farmer, [there is] no trade contributing so much to the growing of corn as that of the corn merchant.” He continued, “The popular fear of engrossing and forestalling may be compared to the popular terrors and suspicions of witchcraft. The unfortunate wretches accused of this latter crime were not more innocent of the misfortunes imputed to them, than those who have been accused of the former.” To Smith, “the corn trade, so far at least as concerns the supply of the home-market, ought to be left perfectly free.”
Moreover, Smith explained that entrepreneurs seek profits not necessarily because their actions will benefit consumers; clearly, entrepreneurs have profit-maximization in mind. Yet, speculative entrepreneurship carries positive external benefits for society a priori. It is ironic that the profit-seeking activities of forestallers and engrossers yield such residual benefits, while the actions of politicians, who are generally viewed as those re sponsible for promoting the welfare of society, often do more harm than good.
The reader will notice the clear similarity between the speculators and arbitraters of today and Smith’s corn merchants. Indeed, the forestallers and engrossers were simply pioneers specializing in the fields of risk management, information provision, and information processing. As in Smith’s time, such middlemen provide society with services that are no less valuable bemuse they are intangible; speculators are willing to take risks that consumers would prefer to avoid.
The Benefits of Speculation
Speculation comes in many forms and has many benefits. Speculators, for example, constantly question the validity of conventional market wisdom by taking risks which others view as foolish. Even when conventional wisdom is correct, speculators provide a de facto cushion of insurance that improves the resiliency of society against economic risks. Speculators also serve a moral purpose by making entrepreneurial activity, and resulting economic growth and prosperity, possible.
Additionally, speculators enhance the efficiency of firms and the deployment of capital in the economy at large. If inefficient management of a corporation, for example, is detected by speculators, capital can be redistributed through the takeover process, with substantive residual benefits arising in society through better allocation of resources. Furthermore, the threat of takeovers serves as an implicit economic regulator of corporate management. Publicly held corporations typically become takeover targets when their stock becomes undervalued. This is generally the result of mismanagement or the inefficient use of capital resources. To avoid becoming takeover targets, then, firms have the incentive to operate efficiently.
Forestallers and engrossers in Smith’s day—and corporate raiders and junk bond specialists today—are merely entrepreneurs, and thus inseparable from capitalism. Unfortunately, unlike 18th-century England, we have no Adam Smith to explain their role to the American public. Our society finds it all too easy to shift the blame for declining moral standards and failing projects to today’s fore-starters and engrossers.
Rudolph Giuliani, Anton R. Valukas, and Oliver Stone play before the masses on their respective theatrical stages when they portray and prosecute the evil speculators. Adam Smith did not have to contend with television and Hollywood or crusading prosecutors; he was able to argue directly to policy makers. He did not need to simplify his message for the 30-second sound-bite. Nonetheless, Smith did make a strong case and his viewpoint eventually prevailed. The pejorative terms gradually lost their evocative power as people began tounderstand what these activities entailed.
Our challenge is to teach the American public about the value of the modern counterparts of Adam Smith’s forestallers and engrossers. This task is made even more difficult by the absence of any great Corn Law debate today. Accusations of embezzlement and corruption on the financial markets pale in comparison to the melodrama of impending starvation in 18th-century England. Despite the absence of a life-threatening crisis, though, this issue is as important today as it was in the days of Smith. Failure to consider the necessity of speculation for a growing economy will lead to the decline of entrepreneurial activity.
Attacking speculators deprives society of the vital economic and moral functions they serve. Morality cannot be restored to society by regulating and censuring the speculative class; this action would only sell our future short.
3. Many modern views of commodity futures markets depict them as insurance markets, in much the same way that forstallers and engrossers provided de facto insurance for consumers. While this is not altogether inaccurate, it is far more precise to represent these markets as intertemporal allocations of supplies. Forestallers and engrossers controlled the amount of commodities supplied in the present largely through the amount they held in inventory for future consumption. The present-day analogue is found in futures exchanges, where the price of a commodity futures contract is, in large part, a reflection of the fundamental intertemporal supply and demand forces acting on the commodity. This view of futures and forward markets has been discussed, at least briefly, by such noted economists as Piero Sraffa, John Maynard Keynes, Hol-brook Working, Paul Samuelson, and, more recently, Steve Hartke. For a detailed discussion of this issue, see Steve H. Hanke, “Backwardation Revisited,” Friedberg’s Commodity and Currency Comments, December 20,1987.
6. The theory of the public choice, contributions to which won James Buchanan the Nobel Prize in Economics in 1986. helps reveal why politicians and bureaucrats often pursue their own interests at the expense of consumer welfare.