The Cost (that is Price) of Speculation – Going Beyond The Minsky ‘Ponzi’ Model

How do you make speculation endogenous to economic theory?

Further how do you make the full suite of potential profit making activities, speculation, hedging, arbitrage and investment endogenous?

By endogenous I mean a variable that is determined alongside other variables rather than outside the economic model.

The reasoning in this post comes was prompted in part from speculation by Steve Keen on to what extent the speculative drive is a necessary component of capitalism even though it is destabilising, partly from some dissatisfaction with the Minsky ‘Ponzi’ model of asset speculation, which has been too easily dismissed by neoclassicals as somehow individuals not behaving ‘rationally’. The model here is a generalisation of our earlier model of default risk in banking and insurance across all sectors.

In this model income not consumed – in the Keynesian vocabulary ‘saved’ – is split into a Tobinesque portfolio of investment, arbitrage, hedging or speculation. What about money held in bank balances? This is treated as speculation in that it is holding an asset, in this case money or near money, with some speculation about the retention of the purchasing power of money during the period with which it is held liquid. So then a portfolio is held with assets of varying degrees of liquidity, risk and expected return.

Imagine in an initial model perfect price information. Here arbitrage cannot exist so it simplifies to three variables.

Imagine a further wholly unrealistic simplification (which we will reject) that all expectations about future prices are correct. Here no profits can be made from speculation as all investment decisions will be made at correctly anticipated prices. Here there will be no risk premium on venture capital or corporate debt – and equity prices will instantly price in the results of successful investment. In such a world there would be alpha but no beta, or in more classical terms average profits but no excess profits. This shows the intimate relationship between speculation and investment. Once a financial asset is created by investment (whether debt or equity) that asset can be traded and speculated against. The initial investment provided financing the subsequent speculation does not, however if the price expectations of speculators raise prices of the financial asset it provide additional scope for financing of the investment term, either through raising new equity, extending loans (as the risks on the original loans are lowered) or through increased collateral (owners equity) allowing greater debt financing or investment through retained earnings.

An investment decision is a prediction of returns over period. Speculation involves estimations of whether there will excess profits or losses using knowable risks. Hedging is adopting the opposite position. So investment is a three way vector where any point on a future yield curve is the sum of the speculation vector (return x probability of return) and the hedge vector (loss X (1- probability of return)). Speculation and hedging being a zero sum game, they help prices of assets adjust to real prices but do not directly add to wealth, their effect is indirect.

Prior to Neidhoffer’s ‘The Speculator as Hero’ the tendency was to see speculation as entirely negative:

Let’s consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.

Neidhoffer shows is the amorality, rather than the immorality, of capitalism in this regard, much like the much misunderstood Machiavelli shows us the logic of political power. Speculation is an inevitable component of the price adjustment process when production or prices are not to expectations. This of course is not to say it is moral or the best means of allocating scarce resources (as for example when people might die before a new crop is grown or imports arrive).

Let us extend the unrealistic assumptions slightly by assuming that market agents do not know future prices but are able to successfully predict future risks, that is the probabilities of certain prices. This commits the ergodic fallacy, but lets test this expanded model for a moment. Here there is a role for speculation and hedging, indeed the prices of options, the prices of both can be calculated exactly. Here there is beta, but is simply impossible to know whether you will gain it, but you can adjust a portfolio to remove all downside risk by hedging, so you can guarantee alpha. Speculation and hedging are again a zero sum game.

How are prices different in this model from those in a world with no speculation and hedging? Speculation has a cost, it has a price, the cost is the cost of the hedge. This adds to the cost base of the firm and the price of goods (or the price of money if the commodity demanded is a loan). It shifts the supply curve upwards reducing the consumer surplus and increasing the producer surplus. This is not a disequilibriating facto, rather it defines a new pareto optimum position as the seller will not sell and the buyer will not buy without hedging risks. It defines the proper equilibrium position. As an additional risk it has an additional cost requiring additional financing, either through saving or newly issued debt.

In a final step towards realism lets introduce Keyne’s radical uncertainty, uncertainty rather than risk, what is unknown and unquantifiable about the future. Of course none ergodicity means that the future can never be like the past, all we have is evidence from past events about what the future is likely to be like. So lets assume we have a property, or any other type of asset bubble, but no one knows if it will pop this year or next or next decade, the evidence of history simply suggesting that prices of the asset will rise in the short term and collapse in the long term. If a bubble seems likely to pop it is rational therefore to increase estimation of risk and not to cease all altogether speculative investments but to adjust your portfolio and increase your hedging.  If you cease speculative investment altogether, unless your are preciant in your forecasting, you could lose altogether what alpha exists in the short run. With increasing risk, even if not wholly quantifiable there must be increased hedging and increased cost of hedging. In a market where asset prices continue to rise it is irrational to wait and undertake crusoe like savings – you lose out on a rising market, so demand for borrowing increases to finance the hedge costs. But that demand will push interest prices (the cost or money) up as banks or other lenders, now at the top of the market at maximum leverage of deposits must attract additional equity or loan funding (either forced by the market assessment of default risk or statutory deposit requirements if they exist). With interest rates rising the bubble may pop as the over leveraged default and credit dries up.

Note the key fact about this story. Note there is no irrational behaviour, it does not rely on Ponzi or speculative borrowers to use Minsky’s terms behaving irrationality, indeed all participants wisely hedge risks as much as they can given an uncertain future, and the more they wisely hedge the nearer the systemic crisis approaches. We are in the world of 2007 where despite massive hedging and covering of collateral financial collapse was not averted – indeed in the model presented here it is bright closer.

In this model there is no intermediation between the risk averse and the risk bearing, as with banking intermediation is not a function but an exposte rationalisation of net portfolio decisions. Some by the size and nature of their portfolios can afford to be greater risk takers than others but in this model all will rationally hedge these risks. In this model finance is from endogenous money and interest rates driven by demand and supply of liquid financing.

Seen from the perspective of the individual speculative or Ponzi financier their behaviour may bring thir own state of bankruptcy closer but not necessarily the state of breakdown closer, indeed in normal times bankruptcy is a good thing. Rather in the model presented here it is normal and well hedged financing which brings the breakdown closer regardless of the irrational behaviour of individuals, indeed the more ‘rational’ they are the quicker the breakdown comes. The instability fo capitalism comes not from foolishness it is endogenous.