Dear Friends, It's the Speculation

I must confess that the original title of this post was, “It's the Speculation, Stupid.” But I thought better of it. To say it that way is a little too cute. The problem is not just that we're all stupid a lot of the time. It's that we're stupid even when we're smart. And that's the flavor of speculation, actually. What may be smart, at least temporarily, for one person becomes stupid if everyone does it. So if we're all stupid, I guess it makes more sense to be friends, friends in our stupidity, but friends the same.

This is my first post where I take the issues of our immediate economic life to hand, rather than stepping back and presenting my ideas on a more general economics of compassion. No doubt I'll say some things that are, well, stupid, but it's a risk I need to take. As deeply as we need a new body of foundational economic theory, we need that theory translated into common sense in the present.

Alan Greenspan testified before a Congressional hearing the other day about the current financial meltdown. As much as I disagree with him fundamentally in so many areas of economic thought, I respect the man. He speaks well, and we can learn from him, especially from the nuanced language he uses. And I respected the fact that he admitted -- now that he's out of power of course -- that he made some mistakes. But the one word he didn't mention (at least in his prepared remarks, which are all I heard) was speculation.

People in the financial world don't like to mention that word to often, but it's the elephant in the living room, isn't it? Part of the problem is that it is often hard to distinguish between what could be called legitimate or even principled investment on the one hand, and speculation on the other. Another problem is that speculation certainly is not the exclusive province of the very rich. If you count homeowners and anyone who has stock investments, or even (indirectly) insurance of any kind, there are a lot of us in the game.

Speculation is something that falls under the general umbrella of what I call the “veil of money.” Money is an absolutely lovely invention, but it has serious flaws because people are, well, human. At the most fundamental level, money is a veil because it puts a linear demarcation of value on things that are inherently qualitative. How much is it really worth not to be hungry? Or to be cured of an illness? For that matter, how much is a clove of garlic really worth? Economists often avoid this issue by saying that something is worth what people are willing and able to pay. But there's still the fundamental problem of quantifying things that are really qualitative. Because of that, and because price really depends on perceived value, which (to put it mildly) can vary, economists have long known that price is not the same thing as actual value. Perhaps this is a gross simplification, but it certainly speaks to the problem of speculation.

In any modern economy, investment is necessary, so what is the difference between a constructive and principled investment and speculation? Simply put, if an asset is purchased merely on the expectation that it will inflate in price, and especially if it is subsequently sold to reap financial profits, it is speculation. In other words, if the whole purpose of an investment is to extract profits based on price inflation of the asset itself, we have a speculative investment. Notice that I'm not equating price and value here. Some investments, say a business that grows over time, do increase in actual value. That sort of increase in value is what stock investors and investment advisors often look for, or at least claim to look for. If the price goes up wildly due to extraneous factors such as “irrational exuberance” or just a bull market, most investors think that is just fine of course. Perhaps we could say, to be fair, that average investors, if there is such a thing, are often taking a strategy in which speculation plays a part, but not the whole part. It is hard, however, to categorize things like currency and commodity trading, and the recent hedge fund craze, as anything but speculation. And the sort of speculation that brought down the house of cards this fall was beyond even ordinary speculation. It was an orgy of extractive market behavior at its worst. It was layer upon layer of questionable debt and esoteric financial instruments (so-called derivatives and the like) being bought, repackaged, sold and resold.

Extractive investment, by the way, is a much broader concept than this sort of financial speculation. The very conduct of a business can be extractive in nature, and often is. Exploitation of natural resources, of labor, and degradation of the environment are all features of extractive business models. Setting those major issues to the side for a time, the practice of rampant speculation in financial investments is the type of extractive behavior that has brought us to the crisis we now face.

It is intuitively obvious that everyone can't make a killing in a speculative economy, but why is that so? In answering that question, we come to a truly fundamental principle, namely the economics of scope.

Most people are familiar with the notion of economics of scale, which means that certain kinds of efficiencies do or don't occur depending on how much of an activity, say manufacturing an item, you do. This is a well defined and well understood principle of economics. What has not been elucidated so clearly is the economics of scope, which I define to mean the behavior of economic action in relation to the whole system in question. Although this may seem to be leading toward rather mystical territory, there is actually a very good example of the economics of scope in classic economics, namely, the monopoly. In the case of monopoly, it does not so much depend on the size of the market in question, but whether one firm effectively controls the entire market. If that is the case, it is called a monopoly and certain very serious problems come up.

Economics of scope as a general principle has huge implications for the sorts of economic problems we face in the present day world. It is, in fact, a useful umbrella concept for the crucial issues of our times: the environment, social justice, even economic war vs. peace. What we find with economics of scope is that inevitably our activity takes place in some kind of larger context, some kind of system. As we push to the edge of system scope (i.e. as our actions come to affect the whole system) , certain non-linear effects come about. Economics of scope is itself a subset of the more general principle of co-centricity outlined in my earlier posts. The notion of pushing the boundaries of system scope is a little difficult to explain. The closest analogy I can make is in comparison to relativity theory, where it is said that as a physical object approaches the speed of light, its mass starts to increase wildly. In our everyday world, we would expect changes of speed of an object to have no effect at all on its mass. And that is more or less what we observe. But approaching the speed of light is some sort of fundamental system boundary of the physical universe. Different stuff happens on the edges of systems. And so it is with economic, ecological, and social systems, in so many ways.

Classic macroeconomics actually addresses the issue of economics of scope, though I don't know that the term has ever been used before in this way. In Keynesian macroeconomics, the central government attempts to use its powers of spending and taxation to impact trends in the overall economy of a nation. The problem in today's world of course it that we have a global economy. (I'm not implying that the lack of global government is a problem; I'm just saying that Keynesian macroeconomics can't be practiced on a global scale, though Keynes himself of course was instrumental in building some of the international economic institutions that try to operate at the global level.) All this is not to mention the fact that Keynesian macroeconomics never worked all that well anyway, even when it is not, as it has been in recent times, grossly distorted by political incompetence and hypocrisy.

But I digress. The point to made from the perspective of economics of scope is this: if an insignificant proportion of economic actors in an economy engage in speculative behavior, it is more or less insignificant. They may incur some sort of moral failings on an individual basis, but the overall economy will not be effected. But when everybody or close to everybody is involved with, or exposed to, speculative risk, it simply does not work out. When your whole banking system is sucked into wild speculative investments on “securitized” (a very ironic term) mortgages for real estate that was itself involved in a wild and unsustainable spiral of price inflation, mortgages for which “we did not correctly price the risk,” (to paraphrase Greenspan's quaintly understated admission of failure) you have a whole economy falling into a vortex of illusion. It's the pervasiveness of the speculation that collapsed the house of cards, and that's a good example of economics of scope. It is a system-scope level of failure.

I don't believe I've said anything truly original about the crisis here, but at least it's an opportunity to introduce the key concept of economics of scope. And by looking at what is truly a toxic and corrosive style of investment, we may be able to move toward a glimpse of the characteristics of a healthy investment paradigm.

For more on the roots of the current crisis, see this very informative (and not too long) article about the current crisis by Herman Daly.

(If you don't know who Herman Daly is, he's worth studying, to say the least.)

And for an article on the recent Greenspan testimony that's a lot harder on him than I was above, but with which I fundamentally agree, see this David Corn piece from Mother Jones.