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Why Do We Regulate Speculation?

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Why Do We Regulate Speculation? and times they are needed, as when a vendor prising, since the casual first presumption of WHY DO WE in a flood-prone area maintains an excess an economist would be that a transactions REGULATE inventory of emergency supplies such as tax is a creator of negative liquidity—prima batteries and matches. facie a bad thing. This point is much like SPECULATION? Speculative trading also helps security Kenneth Boulding’s comment that a tariff is By David Hirshleifer prices impound new information. This is like a negative railroad. vital for guiding financing and investment However, as mentioned earlier, specu- Why, in many countries, is there regulation activity, but not salient. A swashbuckling lation creates externalities. Does it really designed to constrain speculation, such as story about making a killing on the stock of follow that government needs to step in to restrictions on short-selling and derivatives, a new social media firm attracts attention. correct them? Or might it be that market and taxation of securities transactions? But the fact that such activities promote institutions can respond to internalize the There are potentially valid theoretical argu- innovation and help direct capital to strong externalities, reducing speculation when it ments against speculation based on the idea businesses over weak ones does not. is excessive? In reality, securities exchanges that it imposes costs (“externalities”) on So the notion that speculators are para- make choices that determine the liquid- others. The problem can be exacerbated if sites is enticing. From there, it is tempting ity of stocks, such as deciding whether to speculators are irrationally overaggressive. to blame them for correlates of their activi- designate a market maker with an obliga- But in practice, securities regulation is ties, such as market booms and crashes. In tion to maintain liquidity.1 In recent years, driven by more than economic theory. Vot- reality, price volatility is generally beneficial. international exchanges have had greater ne- ers and the media are often hostile toward Prices must move to reallocate resources in gotiation with individual listed firms about speculation and speculators, owing to naïve response to fundamental economic shocks. means of creating liquidity for their stocks. popular notions about how markets work. Most observers, however, dislike price Firms have a variety of means of making Where do these notions come from? I also volatility on the basis of a string of mental their shares illiquid, such as not going will argue that people (including experts) associations: Volatility implies risk, and risk public, or by going private. They thereby tend to overvalue the net benefits of market is bad, so volatility is bad. create their own “transactions taxes.” Simply regulation. But if so, why? I outline some by refraining from stock splits, Warren Buffett’s answers based on arguments developed “…firms, financial intermediaries, Berkshire Hathaway has maintained a high more fully (Hirshleifer, 2008). and exchanges regulate liquidity, stock price that reduces liquidity and limits Adam Smith viewed the fear of specula- and at least to some extent inter- trading. Firms that choose to offer less tors as a kind of folk superstition, similar to nalize the effects of speculation.” information disclosure reduce liquidity by the fear of witches. During the Middle Ages, creating information problems for investors. speculative trading of various sorts in Associative reasoning goes further to Mutual funds use front- and back-end loads commodities was a crime under English blame speculators for volatility. Since specu- to limit inflows and outflows; closed-end funds common and statute law. But why fear and lation is most active, and sometimes highly take flow decisions out of investor hands. loathe speculators, rather than musicians, or Center for the Study of Financial Regulation of the Study for Center profitable, during volatile market periods, it So even a fairly perfunctory examination radishes? For one thing, when a crop fails, it is found guilty by association. turns up a plethora of means by which is more satisfying to blame the merchants who Some of the biases and misperceptions firms, financial intermediaries and ex- are charging high prices than to blame nature. mentioned, such as suspicion of volatility, are changes regulate liquidity, and at least Furthermore, people perceive that tempting even to experts. But the more to some extent internalize the effects of speculation does not create value—“mere general problem is that sophisticated, speculation. These mechanisms certainly gambling.” In any exchange transaction, the influential observers, including academics do not eliminate all externalities. But to interests of the traders are partly in conflict. and regulators, tend to be overconfident of evaluate the desirability of transactions taxes This can be naively construed as a zero-sum their understanding of how markets work. on a practical level, one must weigh costs game, especially for speculation. It is easy As a result, they underestimate the creativity and benefits. To measure the net benefits of to see the benefit when a restaurant owner of markets in addressing possible externality securities transactions taxes requires assess- serves a customer pancakes. It is hard to see problems. ing the extent to which markets, when left just whom speculators are serving, and what This is illustrated by the case of security alone, internalize some of the externalities. service they are providing. transaction taxes (STTs). STTs designed to Proponents of securities transactions taxes The benefits of speculation are indi- limit speculation (rather than just raise rev- have not, to my knowledge, provided such rect. Inventors can increase their rewards by enues) are prevalent globally, and have been an assessment. speculating on the effects of their creations, proposed repeatedly in the U.S. Supporters It is odd that most of us abhor the idea which increases their incentives to innovate. include such luminaries as Keynes, Tobin, of suppressing deviant speech by taxing the Speculators can shift resources to the places Stiglitz and Summers. This is at first sur- press or shutting universities, yet don’t mind 1 SPRING 2012 | ISSUE NO. 8 government suppression of the opinions of speculators. I’d argue that more harm is done by people who express pernicious opinions than people who make pernicious stock trades. The greater willingness to tol- erate intellectual than financial speculation seems to be a result of mere prejudice. David Hirshleifer is a Professor of Finance and Merage Chair in Business Growth at the University of California, Irvine. References 1 A possible rationale for obliging market makers to maintain liquidity for a stock is to internalize externalities between market makers and other traders. Market makers may sometimes prefer not to trade, as op- posed to losing money to investors with su- perior information. But such losses are mere redistributions of wealth, not social costs (Bessembinder, Hao, and Lemmon 2007). Bessembinder, H., Hao, J., and Lemmon, M., 2011, “Why Designate Market Makers? Affirmative Obligations and Market Quality,” University of Utah. Hirshleifer, David. “Psychological Bias as a Driver of Financial Regulation,” European Financial Management, November 2008, 14(5) pp. 856-874 Center for the Study of Financial Regulation of the Study for Center 2.
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