The Economic Function of Speculators

I have to address some silliness we have been seeing more of recently, people like Senator Byron Dorgan, saying things like we need to clean up markets to reign in speculators and only have the hedgers have access.  Dorgan isn’t the only one with an alarming lack of understanding of how markets work sitting in Congress making our policies, but the level of idiocy is stunning.

So lets imagine a market composed entirely of hedgers.  You can see the speculators with their faces pressed to the door, clamoring to get inside, but Byron Dorgan is standing there with a metal bar thrust through the handles and he will not let them in (he is assisted by Senator Shelby Chambliss and other mental giants from the congressional cabal).  The farmers and grain elevators need to sell but the only party that could take the other side is General Mills and they have decided prices are coming down and do not want to hedge right now.  Either the farmers and grain elevators will be unable to sell, or the market clearing price in a market composed only of these hedgers will swing violently downward in this case and violently upward if the roles are reversed.

Now lets imagine that a vengeful god strikes down Byron and his sycophants with a bolt of lightning (he knows an intellectually dishonest idiot when he sees one, and the rest either share his dishonesty or are simply intellectually vacuous).  The speculators flood into the trading pit and immediately start trying to strike bargains.  They all have different ideas how the market will play out.  The farmers and grain elevators find they get a much better price from the speculators than from the other hedgers and are able to effect their trade whenever they wish to.

Why we have just uncovered the economic utility of the same speculators who are sneered at and spoken of in terms that should be reserved for speaking about Robert Mugabe and his ilk by the same Senators and Congresspeople who were tryiong to bar the door.  The speculators provide liquidity, the ability for the hedgers to make their trade.  They do this because they are willing to assume the risk of price movement from the hedger.  The hedger gains certainty in the outcome of their operations and thus are free to concentrate on production rather than worrying about the risk of price movement.  The presence of a large number of speculators also smooths the price and avoids the kind of volatile movement that would occur if there were fewer participants in the market.

So the next time you hear a policymaker sneer about speculators and threaten to do away with them, write to them and point out that they actually provide a valuable economic service, unlike the policymaker.

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