Between the lines: Don't blame speculators, they have a real job to do

Published on Tuesday 8 July 2008 22:15

YOU can always tell a serious economic crisis is in the works because there is a rush by the politicians to blame anonymous "speculators" for everything that is going wrong.

I'm old enough to remember when Harold Wilson denounced the "Gnomes of Zurich" (un-named Swiss bankers) for destabilising the pound. Lately, the speculators have been accused of sending the price of oil to unsustainable heights, starving the world's poor by trading in wheat, and ruining perfectly sound British banks by shorting their shares.

Stage 2 of any economic crisis arrives when the politicians (or public agencies) move from merely criticising unnamed speculators to using them as scapegoats to justify intervening in turbulent market operations. Thus, on 20 June, the FSA, which had blotted its copybook over Northern Rock, suddenly imposed new disclosure requirements regarding short selling. These rules require the disclosure of significant short selling in companies when a rights issue is under way and were clearly aimed at helping HBOS and Bradford & Bingley.

Short selling is the selling of stock that a trader does not own in the expectation that it will fall, thus making that fund money when it buys it back at a lower price.

The FSA justified its action by implying that short selling causes severe volatility in the shares of companies making rights issues. The authority argued that non-disclosure of significant short positions gives the market a false and misleading impression of supply and demand in the securities concerned. A "significant" short position is defined as 0.25 per cent of the issued shares.

Now I'm all in favour of greater financial disclosure – most countries require aggregate short positions in individual stocks to be disclosed. And no-one can see the FSA rule change as particularly onerous compared to the decision of Malaysia's finance ministry in 1995 to introduce caning as a punishment for abusive short selling.

However, rule changes made on the hoof are seldom successful and it is apparent that the FSA decision has confused matters rather than clarifying them. Of 41 disclosures made so far, as many as 20 contain incorrect calculations, were unnecessary, or else were filed late. Worse, forcing companies to reveal short positions but not their long ones is quite misleading. The short positions could be underwriters covering the long position they have already agreed with the rights issuer – not "nasty" hedge funds talking down the issue itself.

Cue a quick economics lesson. Short selling and other forms of market speculation are not a problem in themselves. On the contrary, speculation (properly defined) is what makes markets work efficiently.

The market-clearing price of a good, commodity or stock – the price which just balances supply and demand – reflects its scarcity value to society. But how do we establish the true market-clearing price in volatile and uncertain trading conditions? We can't just take the seller's word for what a good is worth in the long run.

Enter the rational speculator. Profit-maximising speculators always tend to stabilise prices, not destabilise them. This may sound counter-intuitive, but think about it. If speculators buy low and try to sell above the long-run market-clearing price they will go bust for want of buyers. As a result, in scrambling to dump the goods the market does not want, the speculators only push prices back to the long-run, stable norm.

Conversely, if speculators try and force prices below the long-run clearing norm by shorting, they will find themselves creating a huge demand for cheap shares or commodities that don't exist. This excess demand only pushes the price rapidly to the long-run norm, leaving many speculators out of pocket.

More often than not, short-selling actually aids price discovery by preventing shares from becoming overvalued. Indeed, the most successful shorters are not cheats rigging the market but those who are good at scrutinising company performance and smelling out management weakness or failure. Not that I would dare suggest that any of our distinguished banking houses were trying to overvalue their stocks at the time of a global financial crisis.

Speculators also provide a market – particularly in financial instruments or commodities – with essential liquidity. This liquidity gives the market breadth, depth and resilience which, in turn, lowers the cost of hedging. And without hedging – the ability to offset risk – the world's investment markets would contract and we'd all be a lot poorer. Many (if not most) short sales are actually attempts to hedge other market positions

This rational form of speculating is what makes markets work. It is very different from insider trading or deliberately spreading misleading or false information to distort share prices. The latter is illegal and should be punished, not just because it is theft but because it stops markets working properly through informed risk-taking. My point is that blaming legitimate speculators and introducing rules to limit normal short-selling is counterproductive and will only make markets less efficient.

But there is a second danger in this current bout of speculator bashing. It is a subterfuge used by governments to pretend that the problems in the global economy are somehow the fault of market manipulators rather than (as is the case) the result of genuine imbalances in supply and demand.

A case in point is oil. The dizzying rise in oil prices is routinely blamed on speculators. But petroleum prices have been going up remorselessly for four long years. This is not some speculative bubble, but correlates with the latest boom in the Asia economies – increasing demand – and a plateau in oil production and refining capacity. In fact, speculative trades in oil on the New York exchange have decreased in volume somewhat in the past 12 months precisely because even the traders are frightened by events and are reluctant to second-guess where things are going.

If we want to do something about high energy and food prices, then we need to invest in increased production and moderate demand. If bank share values are to rise then bank executives need to prove they are taking the correct decisions. Pointing the finger at so-called speculators is a red herring.