Speculators, not as spectacular as governments

Civitas, 15 November 2010

With the turmoil that engulfed the global financial system in 2008, a few financial actors have, at one time or another, borne the brunt of the public’s anger. Bankers and hedge-fund managers have been widely criticised.  Speculators, however, have been the target of recent outrage.During the problems  faced by the Eurozone in the summer, the French and German governments attacked ‘speculators’, blaming them for the fact that Greece’s debt problem was spiralling out of control. ‘Speculators’ in this sense were unscrupulous investors, who made bets on the state of the Greek economy by short-selling (betting that the price of a stock or bond will fall) shares in Greek banks. Undoubtedly such speculative activity and ensuing criticism may re-emerge as a result of the current problems in Ireland and fear that it too may need to use the Eurozone bailout fund (the European Financial Stability Fund) to cover its debts.

Another group of speculators to come under fire recently were commodities traders, with the French President Nicholas Sarkozy supposedly planning to push for far greater regulation of the sector at the G20, where France now holds the rotating presidency. In the past, commodities speculators have come under fire for distorting markets and pushing up energy or food prices because of large trading positions that distort market signals, which would otherwise be set by supply and demand.

London is, along with New York, the financial centre where much of this ‘speculative’ activity takes place, and so the British Government obviously has a keen interest in ensuring that the sector is properly regulated but without driving businesses out of the country to regulatory havens; where the laws are less onerous. In reality, the power of the British Government to set its own regulatory regime will be seriously circumscribed by the influence of the EU, but this increases the need for the Government to have a strong position on the issue and to present that position forcefully at the European level. The question that the Government needs to answer is: to what extent is the current anger justified, and what is the best way to regulate the industry?

First,  it may be worth pointing out that many discussions of ‘speculators’ fail to appreciate the difference between those investors who are involved in the market because of their commercial interest and those that are simply there to ‘bet’ on prices. For the former, their ‘speculation’ is necessary for them to properly assess the risk that price movements pose to their commercial interests. For instance the buying of oil futures is necessary for firms who need to assess their future energy costs.  In contrast, the latter, who bet on price movements, may build up a significant position on one type of commodity. In doing so, such ‘speculators’ may distort the market. Regulation should try  to prevent this, but it is difficult to see how this could be easily achieved ; it is hard to separate the two activities, just as it is difficult to divide the stock market between those investors who want to invest in a firm because they believe in its long-term success and those investors who are simply betting on a stock’s price as part of a wider investment portfolio.

Although it does not lead to an easy solution, at the very least the issue needs to be addressed in these terms, and the British Government would be well advised to make such a case when proposing plans to regulate an important sector of the British economy.

The second type of speculators described above, do indeed deserve some of the blame for the damaging volatility in markets. However, government actions can be just as damaging, if not worse. Take commodities trading, it often seems to go unrecognised by those who wish to demonise speculators, but governments distort the prices of commodities whenever they create export bans or create subsidies. The volatility seen earlier this year in certain food prices was mainly the cause of some governments banning exports. ‘Hoarding’ commodities in this way causes demand to outstrip supply and prices to rise.  Furthermore, the ban could mean that farmers reduce production because they are not allowed to sell the product abroad; this further reduction in supply can lead to a further increase in prices. This occurred this year, and as a result Russia banned sales of grains in response to a drought. Subsidies are distorting too, as they can fund the production of a commodity that could be produced cheaper elsewhere and so benefit internal producers at the expense of external ones. Interestingly, France’s President, Nicholas Sarkozy, a leading ‘speculator-basher’ fails to levy similar criticism on the EU subsidies that undoubtedly harm agricultural producers in poor countries looking to access to EU’s market.

Finally, while speculators in government debt can undoubtedly add to fears about a country’s financial problems, speculators do not create the initial problems and sometimes the political response can simply benefit one group of investors over another. For instance while the German Government lambasted holders of Greek debt who bought Credit Default Swaps to hedge their position in the event of a Greek default, they also approved a Greek bail-out package that ensured that many investors did not lose money, which they would have in the event of a Greek default. This EU underwriting of Greek debt distorts the market because many investors are keen to buy debt that is de facto backed by European governments. In this sense one group of ‘speculators’  is punished,  while another, in providing finance at overblown prices with de facto EU insurance, are rewarded  with risk-free above-average profits. Similar distortions will undoubtedly occur if Ireland is bailed out.

What all this demonstrates is that speculative financial activity does need to be regulated. However, governments, keen on lambasting speculators as market distorters rarely practice the self-chastisement that is also warranted when they themselves, as far more powerful actors, distort markets.