In the face of a fragile recovery and a huge deficit, my country (Britain) along with the rest of Europe seems to have decided to cope by imposing huge cuts to public services that will screw over not just the public sector but the private sector too (who will lose contracts and custom as budgets and jobs are cut and individuals tighten their belts). The coalition’s reasoning is that the “markets” are going to demand “austerity”. The same markets which caused the crisis in the first place. Now I’ve had a radical idea; instead of that, why not tackle the problem at the source?
The cause of booms and busts is speculation. Traders on the financial markets start paying more for a commodity (i.e. real estate in Florida’s 1920s land boom or house mortgages in the recent crisis) than they are really worth. What follows is a feedback spiral of increasing prices (people buy the booming commodity because they expect its price to rise, therefore it does). Then, there is a collapse and a crash in the price, which may trigger a wider depression in the economy, as in 1929, and now. The interesting thing is that the bust is due to illusion as much as the boom is – prices in the busted commodity have fallen to less than their real value. It’s as if a large herd of people were able to falsify the currency by accident.
Now my modest proposal is this; why not ban speculation? What would modern economies look like without it? And do you think it would be possible?
You’re rightly skeptical about calls for austerity— a strange and useless thing in the middle of a recession. Thanks to the zero bound, we’re in the rare position where stimulus spending is virtuous.
At the same time, remember not to reify the idea of the “real value” of any commodity. There’s no such thing; the price of something is what someone will pay for it. The idea that there’s some real or natural or underlying price for an item is common but only gets you into trouble later on.
As for banning speculation… well, I’m no economist, but my understanding is a) you can’t really isolate it from benign investment, and b) you really don’t want to. It’s one of those irregular verbs: I invest, you speculate, he throws his money away. Or to put it another way, investors are optimistic people willing to use their or other people’s money to take risks. Firms and governments benefit from their willingness to give away money, admittedly a thought hard to keep in mind when we’re suffering from crashes they engineered.
What you can do is try to isolate some of the worst excesses and regulate them. For instance, the magic of leverage usually looks pretty dubious after a crash, and regulations can be tightened. We can try to separate regular banking from investment banking, or require income checks on mortgages, or (as the recent bill passed here does) put risky instruments like derivatives in a new exchange that can be explicitly watched. At best it’s a dance: we try to prevent the last crisis but someone invents a new way of getting in trouble. (At worst there’s no reform, and a succession of crises, because the speculators are too politically powerful to oppose.)