By Kinjal Doshi

There’s plenty in the market today, and not always where you’d expect

Many forecasters maintain that we are in little danger of steep market decline because of signs of speculative excess that in the past had indicated the end of the bull markets.

The term speculation has been applied to almost any financial or commodity market. Through different decades, concern over the role of speculation in markets has risen and fallen. The recent volatility in commodity markets and financial prices has once again brought questions concerning the extent to which various market players (speculators) directly impact prices through their economic behaviour. Academics in general do not focus a great deal of attention on how general public, politicians or mass media interpret financial terms. However the activities of financial and commodity markets (options and futures) affect the day-to-day lives of general public. Commodity prices bring in a great deal of attention from politicians and mass media when prices rise eventually.

When faced with public perception of commodity speculators are irresponsible, gain oriented, it is then natural for politicians to target the speculators.

The varying concept of speculation is seen in the range of presentations of the concept in the public realm. A more careful literature review of the subject indicates that investors could be in the midst of a much more risky speculative episode than one realises. Benjamin Graham has dealt with the issue of the difference between speculation and genuine investment. His well known definition of investment as “one which, upon thorough analysis, promises safety of principle and adequate return,” represent his attempt to demarcate investment.

Speculation and speculators have been present since centuries but asset speculation is one that still affects the business cycles leading to economic fluctuations. The cause of every business cycle depression is land speculation. This fact was indeed discovered by the American economist Henry George 120 years ago. Market-hampering land speculation destabilises and alters development and growth and shifts income irrationally to the landowners.

What is speculation?

Since in layman’s terms, speculation is a method of dealing with the uncertain future. Faced with uncertainties, people need to adjust their actions to accomplish their ends relative to the expected actions of others and the world. This includes every person to speculate, analyse and understand the future, to think and estimate about various probabilities and options. In the financial sense, speculation is the utilisation of one’s opinions of the future in order to draft a profit. More specifically, asset speculation consists of purchase or short sale of an asset with the aim of profiting from a favourable measure in the price due to changes in demand by others or due to supply shifts.

John Maynard Keynes compared asset speculation to a beauty contest in which the speculator does not select who he feels is pretty or for whom the public views are pretty but rather the person who fits “what average opinion expects the average opinion to be”.

Alongside, Henry George anticipated the winner’s curse phenomena and suggested a solution to prevent wasteful land speculation. Adam Smith knew about the neutrality of taxes on land. While George claimed more for a tax on land. He said taxing land has not only the virtue of not stifling production the way taxes do, but also the virtue of eliminating land speculation.

Land features

Moreover, land  is heterogeneous. Each plot has its own unique location, and is different from others and is brought and sold as individual property. The real estate investment trust (REIT) would buy and sell land. It is thus not as easy to hedge against increases in real estate prices. If a tenant fears a hike in the neighbourhood due to speculative buying, there is no market to hedge with put options or short sales. There is thus no ability to spread the risk over time. Also a distinguishing feature of land is its capitalisation of public goods and externalities. Land speculation holds tremendous importance for the economy. Markets for metals, grains and stocks have only a minor macroeconomic effect. Land is one of the basic factors of production. The construction industry has amounted to a quarter or more of total investment. A major aspect of the land market is also the dependence on borrowings, and its tie-in to the banking system and sensitivity to interest rates. For example, when property value falls and the loan value exceeds the property value, the loan can default and with multiple defaults, the bank can fail. Another characteristic of land market is the fixed supply of land sites. The total quantity of the 3D space available is fixed by jurisdiction.

As already discussed that speculation can be beneficial to the nation if speculators anticipate correctly future demand and supply. Land speculation comes with no exception. If there is a plot of bare land, the owner may speculate that rapid growth will warrant a larger building in future and that demolishing the smaller one would be more costly than the net income(from rent) gained from it. Currently overbuilding would be costly and thus the land would be left idle or put to low cost uses. This land speculation is market enhancing.

However, the advocates of greater taxation of bare land values have opposed that speculation of land is an injury to the community. It causes economic waste. It decreases productive efficiency and also increased taxes could lead to discouraging speculation on land. It is assumed that speculative holding of land is relatively unprofitable and that people will not do what does not pay.

How does one stop this cycle?

Firstly, squeeze the profits out of the land speculation by having the community or the government to collect the land rent. Secondly, stop gushing money into the banking system. Not limited to land, speculation applies to other markets such as stocks, commodities, currencies, metals, oil and even gambling. It occurs even in the most ordinary of the transactions. Every time a lady walks to a grocery store, she is speculating. If prices are falling, she might have to better off to defer her purchases. Also when a worker upgrades his skills, he is into speculating the value of the additional wages he would have earned as a result will be greater than the value to him of his currency expenditures, efforts and costs he uses in a new training. One might say that speculation is at the core of human action. The opposition to speculation, then, is at the root an opposition to human freedom.

Posted by The Indian Economist | For the Curious Mind