Archive for September, 2011

Thoughts on speculators and middlemen

Monday, September 5th, 2011

This post was inspired by Tristan Fletcher’s comments on speculation, which are a lot more to the point than mine.

The traditional argument against middlemen: in an ideal world, first seller A would trade with final buyer B, and they split the resulting benefits between themselves. However, in the real world, A trades with C, and C trades with B. Since this trade would have been possible without C, some judge the share of the benefit which C has gotten to be undeserved.

The traditional justification for middlemen: without C, the transaction would have been possible but would in fact have not happened. Walmart, playing the part of C, helps the college student in Boston trade with the sock manufacturer in Datang, China. A used-LP shop, playing the part of C, helps you to find that first-edition copy of A Hard Day’s Night without having to search through dozens of garage sales. In both these cases, C helps A and B trade more, and in doing so amplifies the benefits of trade.

In the case of financial securities, the first seller is the borrower who owns the future cash flows of (and controlling rights to) companies, and wishes to exchange it for cash now as he either wants to consume now or has better rates of return potentially available to him. The final buyer is the saver who has cash now and wishes to exchange it for cash later (at some rate of return). Here, the traditional benefit brought by middlemen would be to figure out the price at which they could shuttle stock in between the originators and the final buyers, maximizing that beneficial trade.

This is not a good description of reality, because the origination of stock doesn’t peak with some optimal price, with higher and lower prices both inducing less trading between savers and originators. This is because final buyers don’t seem to evaluate stocks in relation to their earnings — they evaluate stocks in relation to price trends. What happens in reality is that as stocks become pricier, both first seller and final buyer activity goes up.

This is what windyanabasis calls the boom-bust capital game. People form future expectations of stock returns based on both dividend yield and capital gains, and the capital gains part of this dynamic is a type of Ponzi scheme which ultimately falls apart Рwhen everyone who wanted the stock has bought, the capital gains stop and stock holders sell as they realize that the dividend yield is not enough for them to justify them holding the asset.

Speculators and middlemen serve to increase trading volume in most situations. In normal supply-demand scenarios, this increased volume of trade brings benefits.

In the case of manias and bubbles induced by price action, however, it isn’t clear what the overall effect of increased trading or acceleration of the boom-bust cycle means.