Economic Myths #6 – Price Stability

Leave a comment

One of the so-called mandates that our economic lords and masters have arrogated for themselves is that of maintaining so-called price stability, a constant purchasing power of the monetary unit in our wallets. At first blush, price stability sounds rather appealing – not only does it “bless” us with the apparition of certainty but might we not also be “protected” by the potential of higher prices in the future, so we never have to curtail the amount that we can buy and enjoy? If so we can therefore assure ourselves that our cost of living will be sustained and manageable, relieved of the horror that the essential consumables may some day be out of our reach.

Unfortunately this ambition is not only disastrous for a complex economy but is also antithetical to the nature of human action in the first place. The whole purpose of economising action is to attempt to achieve more for less – to direct the scarce resources available to their most highly valued ends and to gain the highest possible outputs with the lowest possible inputs. In short, economic progress means that we are gradually able to attain more and more for the same amount of labour; or, to put it another way, we could attain the same quantity of goods for a lower amount of labour. Any consistent attempt to stabilise the prices in the economy would not only target the goods that we buy with our money but also the goods that we sell – and that for most of us means our labour! But if we cannot sell our labour for any more and if we cannot buy our wares for any less then it means that we will simply be locked into a repetitive cycle of working, buying, consuming and working again for the same prices for the whole of our lives with no improvement in the standard of living whatsoever. Instead of economic progress bringing goods at cheaper prices to the lowest earners, everyone will now have to attempt to be a high earner – i.e. by putting in more labour – in order to accomplish any increase in their wellbeing.

Of course, real price stability never does and never can work in this way for it is impossible for a centralised authority to monitor and regulate all the many millions of individual prices and exchanges that occur every day in the economy. Rather they target the mythical pseudo-concept of the general “price level”, usually concocted by taking a selective index of goods, an index that can be altered conveniently in order to paint the data in the fashion desired. Individual prices within the index, however, may still fluctuate relative to each other even though the absolute price average may appear constant – a fact that may not mean a great deal to the bureaucrat but is of great importance to the individuals who wish to purchase those particular goods. Furthermore, because of the belief that a dose of price inflation is good for a growing economy, “stability” usually tends to be defined as including some measure of price inflation such as the Bank of England’s 2% inflation target. We are apparently “stable” when the government is robbing your pay packet of some of its purchasing power, it seems.

Such a policy is not restricted to existing as a mere moderate tempering of an otherwise healthy and growing economy. Rather, it can have disastrous and deleterious effects upon the entire system. The outcome of a genuinely growing economy with sound capital investment should be a gradual, secular price deflation where goods and services become cheaper over time. If central banks attempt to counter this in order to achieve stability it must lower interest rates and print more money in order to devalue the monetary unit relative to goods in order to prevent prices from falling. However such an act is what induces the ill-fated business cycle; prices may appear stable but the relative prices of capital goods will begin to rise and those of consumption goods to fall as the new money gets sucked into ultimately unsustainable investment projects. This is precisely what happened in the 1920s when a high degree of productivity was countered by a voluminous expansion of credit that masked price rises, giving the illusion of price stability and suckering promoters of the scheme (such as Irving Fisher) into believing that they were living in a new era of permanent prosperity. The same was also true of the run up to the tech boom collapse at the turn of the century and the housing market collapse of 2008; these had been preceded by a period of low interest rates and apparently low price inflation – alleged hallmarks of an successful economy – that camouflaged the underlying distortions, leaving mainstream economists scratching their heads in confusion as to what went wrong.

Far from creating certainty and consistency, achieving “price stability” is one of the very worst horrors of a centralised, bureaucratically managed economy. Let us leave prices – which, after all, are supposed to result from the underlying supply and demand according to individual preferences – to the free market so that we can create a genuinely stable and lasting economic prosperity.

View the video version of this post.


“Austrian” Business Cycle Theory – An Easy Explanation

1 Comment

Against the simple and straightforward siren song of “underconsumptionist” and “underspending” theories of boom and bust, “Austrian” business cycle theory (ABCT) can seem contrastingly complex and lacking in communicability. The former types of theory, associated with “mainstream” schools of economics, in spite of their falsehood, are at least advantaged by the veneer of plausibility. A huge glut of business confidence and spending will, it seems, naturally lead to an economic boom, a boom that can only come crashing down if these aspects were to disappear. For what could be worse for economic progress if people just don’t have the nerve do anything? Add in all the usual traits of “greed” and “selfishness” with which people take pride in adorning the characters of bankers and businessmen (again, with demonstrable plausibility) and you have a pretty convincing cover story for why we routinely suffer from the business cycle. ABCT, on the other hand, with its long chains of deductive logic, can seem more impenetrable and confusing. Is there a way in which Austro-Libertarians can overcome this problem?

“Austrian” economics is unique in that all its laws are deduced from a handful of self-evident truths, the most important being the action axiom, often peppered with a few additional assumptions or empirical truths (such as the desire for leisure time). The entire corpus of economic law – right from the isolated individual choosing between simple ends all the way up to complex structures of production, trade and finance – therefore forms a unified and logically consistent whole. This is not true, however, of “mainstream” schools of thought which tend, nowadays, to be splintered and scattered into separate, specialised areas of study that are based upon their own, individual foundations. The fissure between so-called “microeconomics” and “macroeconomics” is a prime case in point; while “Austrians” will read much that is agreeable in “microeconomics” (although it still contains many faults and general misunderstandings resulting from the lack of coherence and soundness that is furnished by deduction from the action axiom), “macroeconomics”, on the other hand, seems to be a completely different ball game, considering only “the economy as a whole” without reference to its individual components1. It is this fact that “Austrians” can use to give them the upper hand when explaining the business cycle. For in ABCT, the explanations of “macro” phenomena are little more than an extension of what is found in “micro” price theory.

The market price for a good is the price at which the quantity demanded equals the quantity supplied. Prices therefore serve to ration goods as a response to their scarcity, the goods available being traded from the hands of the most eager sellers to the most eager buyers. Those buyers who are not willing to pay the market price will go away empty handed and those sellers who are unwilling to sell at the market price will not be able to get rid of their goods. What happens, then, if this relationship is disturbed by a forced fixing of prices by the government? First, if the price is raised above the market price to create a price floor, the new price will attract more sellers into the market for that good because the price that they will receive for a sale is now the price at which they are willing to sell. However, at this heightened price there are fewer people wishing to buy the good. Some, who were not previously prepared to pay the lower, market price, are certainly not going to pay the higher price now. And those who would have paid the market price before may now decide that the new price is too high so they also do not buy. What results, therefore, is an increase in sellers and a decrease in buyers which can lead to only one thing – a surplus of unsold goods. The sellers may be very eager to sell at the new price but they will have a hard time finding anyone to sell to. Secondly, the opposite case, where the price is lowered below the market price (a price ceiling) creates, as one would expect, the opposite effect. This new price will attract more buyers into the market for that good because the price that they will pay for a purchase is now the lower price at which they are willing to buy. However, at this lowered price there are fewer people wishing to sell the good. Again, some, who were not, before, prepared to sell at the market price, are certainly not going to sell at the lower price now and those who would have sold at the market price may now decide that the new price is too low so they also do not sell2. What results, therefore, is a decrease in sellers and an increase in buyers which, clearly, leads only to a shortage of goods. Buyers will swarm into the marketplace eager to purchase the articles at the new, attractive price but, to their dismay, the shelves will be empty, cleared out by all of the more hasty buyers who got there before them3.

It is this latter scenario – that of artificially lowered prices – that is relevant for ABCT. For the business cycle is, according to “Austrians”, little more than price fixing on the widest scale, the fixing and the manipulation of what is possibly the most important price in the economy – the interest rate on the loan market. Rather than being the price at which a single good is traded, the interest rate is the price at which saved funds are borrowed and lent (i.e. demanded and supplied) in the economy.

When the stock of money is fixed, if one person wants to borrow (demand) money then another must have saved it in order to lend (supply) it. The resulting rate of interest is the point at which the quantity of money saved/lent equals the quantity of money borrowed. Any borrowers who want to borrow at a cheaper rate and any sellers who want to lend at a higher rate will find themselves priced out of the market for loanable funds, the sub-marginal buyers unable to borrow any money and the sub-marginal lenders unable to lend any. This situation produces a stable amount of saving, lending, borrowing and investment because the interest rate – the price of saved funds – is in harmony with the preferences of consumers, in particular, their preferences for allocating their funds towards either capital or consumer goods. The portion of his funds that the saver retains for consumption will be spent on consumer goods (i.e., present consumption) whereas the portion that he allocates towards saving and lending for investment will be spent on capital goods that will not provide any immediate consumption but will provide a greater amount of it in the future. At the market rate of interest goods and resources in the economy will be allocated in harmony with these desires. If, for example, a borrower wishes to borrow money to build a factory (a capital good) and his calculations reveal that the prevailing rate of interest is low enough for him to make a return on this enterprise, it means that savers are willing to lend a sufficient quantity of funds in order to make it viable. If, however, the prevailing interest is too high it means that savers are not willing to lend enough funds to build the factory – the money that could be spent on building the factory they would prefer to spend on their own, immediate consumption4.

What happens, then, if the rate of interest is set below the prevailing market rate? Exactly the same as what happens when prices are forcibly lowered for any single good. At this rate borrowers who before found the rate of interest too high for their ventures suddenly find that they can afford to borrow. The quantity of funds demanded, therefore, will rise at this new, low price. Savers, however, will be less willing to lend at this price. Certainly if they weren’t prepared to lend at the previous rate of interest they will not be induced to do so by an even lower rate and some savers who were prepared to lend at the market rate will not be prepared to do so at the new, artificially fixed rate. The increase in borrowers and decrease in sellers, therefore, causes a shortage of saved funds, or at least it should do so. Why, then, does this shortage not materialise immediately at the point that the interest rate is fixed? Why aren’t the banks empty of cash and why can they keep on lending and lending and lending? Why can this situation perpetuate for years and end in a calamitous crash that causes almost unrelenting havoc?

This is where a degree of complexity enters the explanation. What is really being borrowed and lent is not money but, rather, the real goods and resources that they can buy. We said above that if someone wishes to borrow money another person has to have saved it. But what this really means is that the saver has to have worked to produce real goods and resources in order to earn that money. He then lends that money to the borrower and the borrower uses that money to buy those goods that the lender produced and diverts them towards his enterprise. If, of course, saving, lending and borrowing took place with real goods, or if the supply of money was fixed, then obviously a forced lowering of the rate at which these goods could be borrowed would result in their shortage very quickly. But the fact that the saving and lending takes place through the mechanism of an easily expanded paper money supply creates a clever smokescreen. For our entire financial system rests not on the principal of every pound borrowed requiring a pound to be saved, but rather that pounds can be “created” out of thin air by the central bank and lent out even though someone has not saved. By printing fresh money (or its digital equivalent) the volume of borrowing can expand without a corresponding expansion of the volume of saving. This easy ability to produce more money to meet the higher demand for borrowing means that the artificially low interest rate never causes a shortage of money as we would normally expect when the price of any other good is fixed below its market price. A second problem, though, is that the real goods that this new money can buy have not increased in line with the increase of the supply of money, but, rather, have remained constant and there is, therefore, still only the same quantity of goods that have to be allocated towards either consumption or investment. Surely the artificially low interest rate will mean that there will be a shortage of real goods to devote towards investment?

Unfortunately, at the beginning, this is not so. For the newly printed money transfers purchasing power over goods out of the hands of those holding existing money and into the hands of those who have the new money. The result of this is that the borrowers of the new money – those who want to devote the goods purchased to capital investment – now have an advantage over those who wish to devote them to consumption. Let’s say, for example, that I earn £1000 in a given month. This means that I have worked for and created real goods in the economy on which I can spend this £1000. Let’s say that I allocate £750 towards consumption and £250 towards saving and investment. Therefore, what I want to achieve is to consume 75% of the goods on which I can spend the money and save and invest 25%. This £250, the 25% of the goods I wish to devote to saving and lending constitutes supply in the loan market that will help to set the market rate of interest. We can illustrate this allocation accordingly:

Consumption  £750   75%


Saving          £250   25%


TOTAL           £1000  100%

If, however, a commercial bank depresses the interest rate and simply prints an extra £500 to meet the new demand at this lower rate, what has happened now? There has been no change, remember, in the quantity of goods – the new money must be still be spent on these goods. The purchasing power of the existing money that I wished to spend on consumption therefore reduces and that of the new money that is to be spent on lending and investment correspondingly increases. All that happens therefore is that the proportion of goods that can be devoted to lending and, hence, to investment has now been forcibly increased from £250 to £750 – and increase from 25% to 50% of the new total stock of money, thus:

Consumption  £750   50%


Saving          £250   17%

New Money    £500   33%


TOTAL           £1500  100%

Newly printed money that enters the loan market therefore forces the economy onto a different consumption/investment ratio from that which is desired by consumers. The poor consumer will find that the newly created money has caused the prices of goods to rise; he is forced, therefore, to curtail his consumption in real terms. The goods that he can no longer afford to buy and consume will be purchased by the new borrowers who will devote them towards their capital enterprises. It is for this reason that none of the expected effects of price fixing occur and the economy proceeds along what appears to be a sustainable boom in capital investment. The problem, though, is that capital projects usually take several years to complete and rely on a continuous supply of goods throughout this time. But consumers don’t want to save voluntarily the amount necessary to complete these projects. The interest rate must therefore be constantly kept low and the new money reeling off the printers to meet it if the projects are to continue. It is only down the line when price inflation inevitably begins to accelerate and the central bank forces an increase in the interest rate and a corresponding reduction in growth of the money supply that the problems are revealed. For now the consumption/investment ratio once again begins to reflect the preferences of consumers – they want, if we remember, more consumption and less saving which means that lending and investment has to reduce. Hence half-finished capital projects have to be left incomplete. They have been starved of the resources necessary as they can no longer afford to purchase them at the new rate of interest. This precipitates a collapse in the prices  of capital assets, a collapse that causes widespread bankruptcy and liquidation of firms and enterprises that, hitherto, had seemed sustainable and profitable. Ludwig von Mises describes the perfect analogy:

The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal5.

Mises’ last sentence is important. As the prices of capital goods were accelerating upwards during the boom and then suddenly come crashing down, there is a temptation to analyse this as “overinvestment”. While this is true and that “too much” has been devoted to long term investment projects it should be clear from our analysis that the real problem is malinvestment – a diversion of resources from desired consumer goods to capital goods.

Observant readers might say that it is actually the return to the market rate of interest and not the fixed rate that has caused the sudden shortage of capital goods. This would not be a correct interpretation. Artificially lower prices always give the illusion of plenty, of abundance and availability for everyone. It is just that with the fixed price of a particular good the illusion becomes obvious more quickly. But with fixing the rate of interest, because it takes effect through the mechanism of money, the illusion of plenty is obscured and, for a time, looks very sound. For this new money has the very real ability to divert resources away from consumption towards capital investment. Nothing more has been created but it looks like there has. Couple that with price inflation with higher nominal wages and people, at least, think that they are better off than they were before the “miracle” of artificially low interest rates. Real abundance and plenty, however, would not merely divert resources from consumption. Rather, resources for capital investment would exist independently of and in addition to those desired for consumption, as dictated by the desires of consumers.


What we have seen, therefore, is that ABCT sits coherently with the examination of individual price action and is little more than an extension of it. The business cycle is simply a case of price fixing writ large, causing widespread waste, chaos and misery when its effects are finally revealed. There are no separate bases or foundations of this “macro” sphere of economic theory. There are, however, certain special features that make this form of price fixing especially insidious and long-lasting – that of the easy ability to print fresh money to meet the new, low rate of interest, permitting purchasing power to be transferred to new borrowers and, hence, the real diversion of resources. As soon as this situation ceases the smokescreens vanish to reveal the waste and futility of these diversions.

Whenever, therefore, one has difficulty in either understanding or explaining ABCT, think back to what you know about simple price fixing. In fixing the rate of interest, the most important price in the economy, “Austrian” economics, with its strict deductive logic from the action axiom, will tell you that the results will be the same.

View the video version of this post.

1Murray N Rothbard, Man, Economy, and State with Power and Market, p. 269 (n. 19).

2This isn’t just stinginess on the part of sellers; rather, the cause of their unwillingness to sell will be, in the long run, that they simply cannot – the lower price will usually not be sufficient for them to recoup the costs of production so they have to abandon the particular line altogether.

3These results were seen during the high inflation of the 1970s in the US when price controls led to long queues at gasoline station because the demanded quantity of gasoline could not be supplied at the artificially low price.

4An interesting question is whether the interest rate may strictly be considered a “price”. In the exchange of goods, the price of a good is the quantity of another good that is fetched in exchange. For example, if one apple sells for two oranges, then the “orange” price of an apple is two oranges (and the “apple” price of an orange is 0.5 apples). In the complex economy, of course, every good is exchanged for money so we always reckon prices in terms of the quantity of money received in exchange. However, whatever the other good that is received, it makes no sense to compare the two physically heterogeneous goods in terms of magnitude. For how does one calculate the “difference” between two apples and one orange, or between £2.00 and a bag of oranges? In the exchange of a present good for a future good, which is what happens in the loan market, this is not the case, however. If a borrower agrees with a lender to borrow £100 today and to pay back £110 in one year’s time, strictly the price of one unit of present money is 1.1 units of future money (or the price of 1 unit of future money is approximately 91p of present money). But because the two goods are physically homogenous we can compare the two magnitudes – 1.0 and 1.1 – in order to derive a rate or ratio between them of 10%. We would therefore state that the interest rate per annum in this scenario is 10%. This rate is therefore not strictly a price but an expression of two prices – the price of present money in terms of future money and the price of future money in terms of present money. However, it should be clear that a manipulation of the rate of interest would have the effect of fixing the actual prices of present and future money. If, for example, the interest rate is forcibly lowered to 5% then the price of one unit of present money is now 1.05 units of future money rather than 1.1 units of future money. The resulting effects of price fixing will therefore be felt in this scenario. Hence, it makes sense to speak of the rate of interest as a price just like any other and, indeed, this is how it is treated by acting humans in the loan market.

5Ludwig von Mises, Human Action, p. 557.

Money, Inflation and Business Cycles – The Pricing, Profit and Loss System Explained


Against all of the fallacious forms of “under-consumption” theories of boom and bust Say’s law stands as a charming and simple rebuttal. Wrongly and ignorantly described as “supply creates its own demand”, a better and accurate formulation is “goods are paid for with other goods”. In short, while recognising that money is emphatically not neutral and is itself a good, goods are supplied by an individual (demand) in return for money, the latter of which is then used to buy other goods (supply).

This essay will use Say’s Law to illustrate that what is meant by “under-consumption” is, in fact, not a dissatisfaction with consumption (or rather purchasing) per se, but rather that the precise structure of production is not in harmony with the valuations of consumers; the distortion of this structure at the height of the boom proceeding to a bust is only the most extreme of this type of instance.

Say’s Law

While emphasising again that money is not neutral and its status as a good in its own right does have an effect on the structure of production, money does not in and of itself constitute demand. Rather, your demand is the goods that you have to offer for sale in the first place as it is these real goods that sustain the supplier in producing what you buy from him in turn. How productive you are determines the effectiveness of your demand as revealed in the precise exchange ratio – if the goods with which you demand are highly valued they will be able to buy more; if they are valued lower they will buy less. In reality this exchange ratio takes place not directly but through the money mechanism. For example:

1 apple          sells for         20p

20p              buys             1 orange

The mere possession of money in this scenario does not constitute demand. For in order to gain money to demand oranges a person must first have supplied apples and the amount of money he receives will be determined by his productivity in producing apples – the more productive he is the more money he gets which in turn allows him to demand more oranges. His demand is linked firmly to his original ability to produce and supply apples. It is not therefore that 20p, the money, is the demand for either one apple or one orange. It is, rather, that one apple will demand a supply of one orange1. In other words, the price of a single apple is one orange and the price of a single orange is one apple.

It follows, then, that if changes in the relative valuation occur between goods then this will be reflected in the exchange ratio between these goods. If, for example, oranges decline in value relative to money yet apples maintain their value relative to money a future exchange rate might be as follows:

1 apples        sells for         20p

20p              buys             2 oranges

In other words, whereas before one apple could buy only one orange, the value of oranges has declined so that now one apple can buy two oranges. Any change in valuation of a commodity therefore necessarily takes effect as a change in the exchange ratio between goods.

Supply, Demand and Prices

In the first place we must be somewhat suspicious of any theory that tells us that there is any under-consumption, i.e. that there is a general glut of everything. For it is suggesting that we suddenly find ourselves in the position of having too much stuff. But this is nonsensical even without any analysis for it implies that humans have suddenly stopped desiring; but human wants are insatiable and we are always striving for more. So engrained in our own experience is this fact that it seems pointless to try and prove it – an abundance of goods, all else being equal, is a cause for celebration rather than for alarm.

If we dig deeper what is really meant when there is a “general glut” is that the costs of producing goods cannot be recouped by their selling revenue, in other words that all goods are experiencing losses. But this is nonsensical because the very existence of a cost means that there is an alternative use for the capital goods that produced the final good – if a loss is experienced then it means that some other good was more highly valued than the good that was in fact produced. It is therefore impossible for there to be a general glut of all goods as the very reason for the glut – the existence of costs – presupposes that there is a demand for some other good. But if capital was misdirected and should have been used to produce another good then it follows that there is not a glut of this latter good at all but a relative shortage.

Let us take a hypothetical economy where all the only goods are fruit. Let’s say that there are twenty apples, twenty oranges, twenty bananas and twenty pears. Let us also say that it takes the use of one unit of a piece of fruit to produce a single unit of another piece of fruit and so that, in equilibrium, the exchange ratio of the different fruits will be as follows:

20 apples:20 oranges:20 bananas:20 pears

I.e., that there is a final exchange ratio of 1:1:1:1. When one fruit trades for a single fruit, there are no profits and no losses. If the apple producer, for example, trades ten of his apples for ten oranges, he can use them in production for ten more apples – in short, the cost of ten apples has yielded a revenue of ten apples. The same is true of the orange producer – he has bought ten apples with oranges which he used to produce ten more oranges, a cost of ten oranges netted against a revenue of ten oranges. Total profit and loss is zero and the economy is in a state of equilibrium.

What happens if the above numbers are multiplied – i.e. if there are forty, sixty, one hundred, one thousand or one million of each fruit? Does it make any difference? Not at all as one fruit will still trade for one other fruit which can be used to produce another piece of fruit. No fruit will be able to sell at a loss (or at a profit) and nothing will remain unsold. More of each fruit in the same ratio simply indicates a more prosperous economy than one where there are fewer pieces of each fruit.

What about, however, where the ratio of fruits is altered? Let’s say that, instead of there being twenty of each fruit there are, in fact, 10 apples, 10 oranges, 30 bananas and 30 pears. It still takes one of each fruit to produce one other fruit (i.e. the demand curve has not shifted). So what has happened to our exchange rate? It will be as follows:

10 apples:10 oranges:30 bananas:30 pears

In other words, 1:1:3:3. So now, one apple will still trade for one orange, but for three bananas or three pears. But as the production of one piece of fruit still requires only one piece of another fruit there will now be relative profits and relative losses. The apple producer, for example, can now use one apple to buy three bananas with which he will make three apples – a cost of one apple versus a revenue of three apples. The same is true of the orange producer. The poor banana producer, however, suffers. He has to spend three bananas to purchase one apple with which he can only produce one banana – a cost of three bananas versus a revenue of one banana. The same is true of the pear producer. We therefore have an instance of there being two fruits – bananas and pears – that are unable to sell for enough in order to cover their costs. But this is not a general glut, for we also have two fruits whose revenue more than covers their costs. Resources will flow out of banana and pear production and into apple and orange production, increasing the number of apples and oranges while decreasing the number of bananas and pears. The result of this is that the purchasing power of apples and oranges will fall again and that of bananas and pears will rise again, reducing the profitability of the first two industries and the losses of the latter two. This will continue until an equilibrium is restored with an exchange ratio of 1:1:1:1 and no industry is either profitable or loss making.

The result then is that there can never be a general glut of all goods, but rather specific gluts of particular goods that were not preferred mirrored by specific shortages of other goods. And as we know from our analysis of Say’s Law above these costs are ultimately expressed in terms of other goods relative to each other, i.e. the exchange ratio will widen as their values diverge.

How does this happen on the real market? Obviously gluts and shortages don’t just appear as they did in our example above; but rather, they result from the ever-shifting demand curves of consumers which have to be foreseen by entrepreneurs. For example, if entrepreneurs invest heavily in apples when in fact the public wants oranges, the capital that would have produced oranges is diverted to apples. The resulting glut of apples and relative shortage of oranges may mean that it takes five, ten or twenty apples in order to demand a single orange. If this low selling price for apples is insufficient to pay the costs of production while the high selling price for oranges results in a bumper profit for the foresighted entrepreneurs who stuck to producing oranges, then it follows that resources will flow out of apple production and into orange production until an equilibrium is restored where both apples and oranges will exchange at a ratio where they are both able to cover their costs of production.

However, as the valuations of consumers are always changing the hypothetical state of equilibrium will never be reached and there will always be relative gluts of some goods that have been overproduced and relative shortages of goods that have been under-produced.

Nothing about any of this is a cause for alarm – it is the task of entrepreneurs to adjust the structure of production to the tastes of consumers and in the normal run of the mill, so to speak, nothing about this will cause any great or dire need for concern. What we shall see, however, is when there is monetary intervention in the forms of inflation and credit expansion, very wide dislocations between the goods that are demanded and those are supplied occur, leading to extreme gluts and shortages. The analysis of these instances is no different from simple dislocations, but what will be revealed is that any attempt to “boost demand” merely ends up perpetuating the production structure that is failing to meet the ends of consumers in the favour of those producers who are selling loss-making goods.

Simple Inflation

At any one snapshot of time there is a fixed stock goods in the economy. Let us return to our hypothetical fruit economy with the same stock of goods and the same exchange ratios so that

20 apples will buy 20 oranges, or 20 bananas, or 20 pears.

In other words there is once again exchange ratio of 1:1:1:1. In the economy where money has to be earned, no one can spend without first producing real goods. So if a melon producer now produces sixteen melons and (once again, assume that one melon exchanges for one piece of any other fruit) and decides to purchase with them sixteen apples, the stock of goods in the economy will now be four apples, sixteen melons, twenty oranges, twenty pears and twenty bananas. The exchange ratios will be thus:

4 apples:16 melons:20 oranges:20 bananas:20 pears

While apples have now become more expensive relative to any other fruit (a whole five oranges, for example, is now needed to purchase one apple whereas before only one was needed), melons have become cheaper relative to any other good. Overall, therefore, what has been lost in apples has been gained in melons.

The additional purchasing power of apples caused by the demand of the melon producer spurs the apple producer into producing more. What can he do? As he has sixteen real melons he can use these in the production of sixteen more apples, thus restoring the total stock of goods to twenty apples, twenty oranges, twenty bananas and twenty pears. There has therefore been a productive exchange on the market. What was demanded by the melon producer in apples was supplied by him in melons, permitting the apple producer to fund his subsequent production of more apples. Crucially, however, as the purchasing power of other fruits was not diminished the profitability of these industries did not decline and they could carry on as before.

The fact that all of the exchanges take place in the real economy through the medium of money is of no consequence to this analysis. For in reality, the melon producer would have sold his melons to a third party, X, for money and then used the money to purchase the apples. X might have used the melons to produce pomegranates and then the apple producer uses his money received from the melon producer to buy pomegranates, the latter being used by him to produce more apples. The important point is that goods are trading for other goods and that the production of new goods must be funded by other goods.

What happens, then, when new money is printed? Is it possible for economic prosperity to be delivered by the printing and spending of new money? Let us return to our original array of goods – twenty apples, twenty oranges, twenty bananas and twenty pears. If the Government prints more money it has to spend it on these existing goods. Let’s say that, with the new money, it decides to buy sixteen apples. Does this new money in the pockets of apple producers entice it to spend more, which in turn causes their suppliers to spend more and so on until we reach ever dizzying heights of prosperity? No. For the problem is that no new real good has been supplied by the Government in return for its purchase and consumption of apples. Whereas the melon producer compensated for his consumption of apples by producing melons, all that has happened when the Government has printed more money to spend on apples is that the total of stock of all goods has declined by sixteen apples. As the stock of apples has declined relative to other goods the purchasing power of apples has risen accordingly. Instead of twenty fruits now trading for twenty others we now have:

4 apples:20 oranges:20 bananas:20 pears

What is the result of this? As the purchasing power of apples has now risen it means that this industry has become extremely profitable – with a single apple can be purchased five of any other fruit which can be used in production of five more apples, i.e. a cost of one fruit producing a revenue of five. All of the other industries, however, have now suffered relatively rising costs and lower revenues as they will each have to spend five fruits to gain one apple which will in turn produce only one of their particular fruit. What happens, once again, therefore is that resources will shift out of the orange, banana and pear industries and into the apple industry, reducing the relative surplus of the first three fruits and relieving the relative scarcity of apples. This process will stop when none of the industries can make either a profit or a loss, i.e. when one fruit again exchanges for one fruit. The shortest way for this to occur is for the apple producer to purchase four oranges, four bananas and four pears and to use them in the production of a total of twelve apples. The resulting array of goods will now be as follows:

16 apples:16 oranges:16 bananas:16 pears

What therefore is the result of the inflation? It is simply a reduction of the total number of goods available in the economy. Whereas before there were twenty pieces of each fruit now there are only sixteen. The Government, in failing to compensate for its consumption of apples with a supply of real goods in return, has simply reduced the total stock of goods by sixteen fruits. The earliest receivers of the new money, therefore, have received a benefit – the Government by being able to buy apples it hasn’t paid for in other goods and the apple producer by being the favoured receiver of the Government’s new money is ensured continuous profitability as its selling prices rise before its buying prices do. For everyone else, however, who receives the new money later, buying prices have risen faster than selling prices. They experience losses and a relative degree of impoverishment. Finally when the effects of inflation have worked themselves through the economy the result is a net loss for the economy as a whole.

This would be the effect of a one-shot inflation – the structure of production being left relatively intact but at a lower level. Things are much worse, however, when the inflation is continuous. For now, the Government keeps on buying apples with its newly printed money and not refunding this consumption with any real goods. What will happen, therefore, is that apples will be in continuous short supply relative to other goods and resources will continuously shift out of the production of other fruits and into apple production. The fruits furthest away in the supply chain from apples will suffer the most and eventually go out of business as their fruits remain permanently in high supply relative to the artificially created shortage of apples. There will be a permanent change in the structure of production in favour of the Government and its preferred suppliers at the expense of everybody else, resulting in an overall loss and reduction of total goods.

The Business Cycle

Whereas in our example of simple inflation the dislocation to the structure of production took place between different consumer goods, when it comes to the business cycle the disharmony caused is that between the demand of two classes of goods – consumer goods and capital (producer) goods. The artificial credit expansion fuelled by monetary inflation deludes entrepreneurs into thinking that more resources should be channelled into producing capital goods and fewer resources should be devoted to producing consumer goods, against the real wishes of consumers. Resources flow out of consumer goods and into capital goods. The end of the monetary inflation reveals the illusion – consumers did not have a rate of time preference and consequent rate of saving that makes the investment in capital goods profitable. The resources devoted to the production of capital goods should have been directed towards the production of consumer goods. There is, therefore, a specific glut of capital goods and a specific shortage of consumer goods. From Say’s law what this means is that consumer goods will command a high selling price in terms of capital goods and capital goods will command a low selling price in terms of consumer goods. Resources need to flow out of capital good production and into consumer good production until an equilibrium is restored where both are meeting their costs.

Indeed, economic crises are always crises of capital and not of consumer goods. This fact is often masked by the nominal price inflation of the boom accompanied and the subsequent deflation of the bust as the supply expands and contracts respectively. During the boom it is true that all prices, those of capital and consumer goods, rise and so there is a tendency to think that there is an all round prosperity. But what is really happening is that the prices of capital goods rise faster than those of consumer goods, so that there is a shift in the real price relationship (expressed in terms of goods) between consumer goods and capital goods. Once the bust happens, there is a corresponding deflation of all prices leading to the apparent view that the entire economy is suffering. But the reality is that the prices of capital goods decline faster than those of consumer goods so that, in real terms, the prices of consumer goods rise and those of capital goods fall as resources move out of the latter and into the former.

Indeed it is ironic that under-consumptionists view the alleged “problem” of the bust as a lack of consumption causing economic stagnation. For the reality is that there is no problem with consumption at all and it is in fact the desire for consumption that has been frustrated during the boom. If anything there needs to be less consumption and more saving so that the relative shift of goods out of the capital goods industry is less severe and at least some of the projects that were embarked upon in the boom may have a chance of achieving profitability (hence Government deficit spending – rampant consumption – only makes the bust even more painful). But unless that is desired by consumers it is futile to go on inflating and pumping in more credit as the structure of production that is so out of kilter with the desires of consumers is simply perpetuated as a lifeless zombie.

The Demand for Money

Up until now we have been considering cases where the relative gluts and shortages in the economy are between real goods with money serving only as an intermediary between goods. However money, or more accurately, the desire to hold money is itself a good that serves an end in its own right. Money is the most marketable of all goods and holding it provides a degree of reassurance that holding other goods does not. The desire to hold a larger cash balance, all else being equal, therefore reveals a degree of uncertainty on the part of its owner, an uncertainty that is hedged by the ability to quickly use cash to exchange for whatever goods and services are needed in the period of uncertainty. Holding money therefore in and of itself providers a satisfaction in much the same way as a real good does. So what happens, then, when the relative gluts and shortages involve not surpluses of goods against shortages of other goods, but surpluses of goods against shortages of money? In other words, when the demand to hold cash rises? Surely now our under-consumptionists can hold validly that everything will remain unsold as everyone scrambles to soak up more cash and the whole economy will collapse into a depressing slump?

The simple, and orthodox, “Austrian” answer to this apparent problem is that if the demand for cash suddenly rises then everyone must sell goods. The sudden influx of goods onto the market increases their supply resulting in a reduced price of each good in terms of money. But in terms of the ratio of goods to goods there needn’t be any change at all. For example, if the following exchange ratios existed before the demand for cash rises:

1 apple          sells for         20p

20p              buys             1 orange

The ratio of the apple to the orange is 1:1. But if the demand for cash suddenly rises such that the money prices of all goods declines then the following exchange ratio may result:

1 apple          sells for         10p

10p              buys             1 orange

Whereas the exchange ratio between goods and money is now lower, the exchange ratio between goods is the same. Exactly the same real trade in terms will therefore take place, just at lower money prices.

Indeed it is for this reason that deflation is not a problem for the running of business. For what matters for businesses is neither rising nor falling prices but the differential between their revenues and their costs. If both their revenues and their costs are falling then it is still possible to make a profit and to expand business. Indeed, the period between the dawn of the Industrial Revolution and the eve of the New Deal era was generally one of a long, secular deflation and this was the most productive period in the whole of human history.

However the story is not so straightforward for it is in fact true that a greater demand to hold cash changes the structure of production but not its level. As we noted earlier, cash is it self a good and the demand to hold cash is itself an act of consumption. An increase in the demand for it is, therefore, an increase in consumption and results in a higher societal time preference and a rise in interest rates. Indeed this makes intuitive sense. If the holding of a cash balance is a hedge against uncertainty, a higher degree of security will be accompanied by a willingness to engage in more roundabout methods of production and to exchange present money for assets that promise to pay a greater amount of money in what is, relatively, a certain future. If that certainty disappears, however, people begin to prefer liquidity today rather than liquidity tomorrow, curtailing their investment in future goods and selling them for cash now. Societal time preference and, therefore, the rate of interest rises. The selling price of the monetary commodity – e.g. gold or silver – will rise while its costs of production will fall, so that resources will shift into the gold or silver mining industry in order meet the new demand for money. There is therefore no reduction in production, merely a shifting of production out of lengthier, roundabout production processes and into the production of a) the monetary commodity, and b) lower order producer goods and consumer goods that can quickly be bought with the hoarded money when adverse conditions arise2.

Societal Profits and Societal Losses

The foregoing analysis gives the impression that a profit that appears somewhere in the economy (i.e. a relative scarcity) must be offset by a loss somewhere else in the economy (i.e. a relative glut). Is it true, therefore, that societal profits are always mirrored by societal losses?

Accounting profits are an excess of revenue over cost – that a firm has paid out less money that what it has received. Losses are the opposite, a firm paying out more money than what it receives in revenue. If all cash income was added to a firm’s profits and all cash expenditure added to its losses then it would be true that societal profits would equal societal losses as no firm could receive more in revenue than it paid out in expenditure without somebody, somewhere, paying out more in expenditure than they received in revenue in order to fund this difference. Indeed, the social function of all entrepreneurs is to arrange the structure of production in a way so that it best meets the needs of consumers. The decisions they make have to be made in advance, resulting in an appraisal of what it is that consumers will value tomorrow. They subsequently set about incurring costs by purchasing factors of production that they arrange into a production structure that they think will best meet the needs of consumers. If all of the entrepreneurs managed to arrange, on day one, the production structure exactly as consumers wanted it on day two, come that latter day revenue would exactly equal cost. The entrepreneurs would have utilised just the correct quantity of factors and have produced just the right quantity of specific goods that consumers were willing to pay for. No one entrepreneur would have bought too many producer goods and deprived an alternative end of their use, nor would any entrepreneur have bought too few producer goods and permitted too much of their use to alternative ends3. In reality, however, this state of apparent perfection is never reached and the resulting structure of production is never completely in tune with the valuations of consumers. Every structure of production is begat by a forecast, a prediction, or empathetic understanding of the businessman for his clients. It therefore never quite hits the mark and some goods will be relatively over-produced while others will be relatively under-produced. If a firm overproduces then the revenue it received was insufficient to pay for the factors of production, in other words that there were competing ends that were bidding up the prices of these factors and that the firm starved these ends of their means of production. A loss cannot materialise therefore without a corresponding underproduction elsewhere, meaning that revenue for these latter goods was more than sufficient to pay for the factors of production, in other words that these entrepreneurs did not bid up the factors enough to starve the loss-making ends of superfluous production.

So is it true, then, that every successful, profitable businessman is riding high on the losses of someone else? That for every entrepreneur arriving to work in a chauffeur-driven limousine another has been relegated to taking the bus?

Not at all, for it is entirely possible for societal-wide profits (and societal-wide losses) to emerge. This is owing to the capitalisation of durable producer goods. As a durable good is expected to produce revenue-generating consumer goods not immediately but also into the future, the capitalisation of a producer good is the market value of that asset’s future revenue, discounted to allow for the fact that these revenues are future revenues and not present revenues. At the point of purchase, therefore, the good is not recognised as an expense of the purchaser but as an asset (and correspondingly the cash that paid for it will show up on the asset side of the balance sheet of the vendor). No cost at all is shown in the accounts of anybody. Rather, the cost of the good is recognised incrementally over its lifetime as it depreciates, i.e. its use in furnishing consumer goods renders lower its ability to produce goods in the future. Entrepreneurs therefore face a choice – to increase present production and increase present sales revenue but at the same time incur the cost of heavier depreciation charges; or to reduce production and preserve the capital value of the asset but reducing sales revenue. Once again, the entrepreneur has to appraise how many goods to produce today and how many to leave for production tomorrow. If the revenue received from expanding production is exactly equal to the depreciation charge of the capital good (plus other costs) it means that he has exactly produced the favoured amount of present goods at the expense of future goods. The market was willing to pay in present goods precisely what it lost in future goods. What, though, if there is a profit? This means that the revenue received is greater than the cost of depreciation, in other words, the entrepreneur withheld from production more present goods than the market was willing to pay for. Future production will therefore be higher but at the expense of present production. And correspondingly, if there is a loss it means that revenue was insufficient to pay for the cost of depreciation – the entrepreneur produced too many goods in the present when they were more valuable in the future.

Societal-wide profits and losses therefore emerge when collectively entrepreneurs under and overproduce, respectively, present goods. Profits represent entrepreneurial saving – the deferment of present production for future production – whereas losses represent entrepreneurial dis-saving – the ravaging of future production for the sake of present production. And as we know it is saving that is the hallmark of capital accumulation, the increase in production and ultimately a higher standard of living. Dis-saving, however, results in capital consumption, a decrease in future production and ultimately a lower standard of living4.

Does this mean, then, that “vicious” entrepreneurs can simply withhold from present production increasing numbers of goods, driving the profit rate higher and higher and spreading widespread misery? No, for in the first place this ignores the non-capitalised factors of production. If an entrepreneur reduces production in order to drive up profits then he also has to reduce his demand for these latter factors – including non-durable producer goods but especially labour. The cost of these factors will therefore decrease, leading to competitors to employ them, restore full production and reduce the market share of the abstaining entrepreneur. The same would also be true of a cartel. If entrepreneurs in concert decided to restrict production, swathes of non-capitalised factors would become available and eventually the cartel would break when one of the entrepreneurs takes advantage of the opportunity this affords. But the main effect of societal profits is that they afford the ability to expand production. For if depreciation charges are lower than revenue then it means that comparatively less has to be spent on maintaining the existing stock of capital. Entrepreneurs can therefore do one of two things – either expand the existing capital stock, in which case production of the same consumer goods will be increased, thus lowering their price and capturing market share from competitors; or they can invest in more roundabout production processes that will afford the ability to provide more newly introduced consumer goods that have never appeared before. A variant on the second option is that, as entrepreneurial saving represents a fall in societal time preference rates, the interest rate will also fall and new entrepreneurs whose projects were too costly before will now offer to borrow the saved funds and invest them in their more roundabout processes of production. Hence you get the famous “Hayekian triangle” – a production structure that becomes longer and thinner as resources are directed out of producing and maintaining the existing capital stock into producing new capital.

Indeed entrepreneurial profit is simply the corollary of private saving. In both cases an excess of revenue over cost means that consumption is denied to the present in favour of the future, these funds being diverted to new, higher stages of production that result in a greater outlay of consumer goods. The greater the profit margin in the lower stages then the greater this effect will be.

Obviously the opposite happens when profits are reduced – more has to be devoted to maintaining the existing capital structure with comparatively less being used on expansion. If losses are experienced then capital is actively being consumed as there are no funds at all left over to replace the existing stock once it is fully depreciated. Production therefore declines along with the standard of living.


It is clear then that under-consumptionist theories are nothing but a tissue of falsehoods. In summary:

  • Goods ultimately trade for other goods and the production of one good requires the use of other, real goods;
  • General gluts cannot arise on the market; only specific gluts and specific shortages which will become apparent through the price system and ultimately through the exchange ratio between goods;
  • It is the task of entrepreneurs to ensure that these gluts and shortages do not arise, the pricing, profit and loss system regimenting them in the fulfilment of this important function;
  • The business cycle is a specific glut of capital goods and a specific shortage of consumer goods on a wide scale; that the pricing, profit and loss system has been distorted by credit expansion leading entrepreneurs to believe that the economy can support a larger capital structure than it really can;
  • Increased demand for money does not have any effect on the level of production and is no cause for alarm; it may affect the specific structure of production but this is wholly in line with the valuations of consumers.
  • Profits and losses do not offset each other – societal profits and societal losses are possible. Societal profits indicate a lowering of the societal rate of time preference, leading to capital accumulation and the expansion of production; losses indicate a raising of the societal time preference rate, leading to capital consumption and a decrease in production.


1We are, of course, ignoring for the purpose of this illustration the issue of constancy. For more on this see Ludwig von Mises, Human Action, pp. 102-4.

2Whether an economy is operating with a fiat money or a commodity money is what makes the difference between whether an increased demand for cash will leave the time-structure of production unchanged (as in our first scenario laid out above where the exchange rate of goods remains equal) or whether the time-structure will be changed. See Jörg Guido Hülsmann, The Demand for Money and the Time-Structure of Production, Ch. 31 in Jörg Guido Hülsmann and Stephan Kinsella (eds.), Property, Freedom and Society, Essays in Honor of Hans-Hermann Hoppe. See p. 322 for an explanation of how the shift in the time-structure of the economy that occurs under commodity money (but does not under fiat money) better serves the needs of consumers than a production structure that is left as it was before. All we need to note here is that with either fiat or a commodity money the level of production does not change and that there is consequently no depression of business brought about by under-spending or under-consumption.

3This is the hypothetical “equilibrium” state that seems to be the shibboleth of mainstream economists.

4It is, therefore, supremely ironic, let alone wildly inaccurate, that opponents of the free-market charge profit-seeking with the depletion and destruction of the Earth and its natural resources. This fallacy stems from always focusing on the fact that entrepreneurs want to maximise revenue while completely ignoring the fact that they also have to minimise costs. Profit indicates a saving of resources, not their depletion – the entrepreneur has advanced fewer goods than the market was willing to pay for. By incurring costs lower than revenue he has saved resources, not decimated them. It is precisely those assets over which full private property rights (and hence, their capitalised value) are available to the capitalist-entrepreneur that are not in short supply or at any risk of being depleted. For the ever present urge to reduce costs means that they cannot be depreciated more quickly than the market is willing to pay for, otherwise losses will be incurred. Those resources over which there are no private property rights, however – in particular forests, fish stocks, “endangered” animals – are precisely the ones where we experience a depletion. With no one able to enjoy the capital value of these assets and to incur the cost of their depletion against their revenue there is no reason to avoid their decimation.

View the video version of this essay.


1 Comment

One of the most vilified activities associated with the capitalist economy is that of speculation. Even in a world where managers of large multinational firms and wealthy shareholders are denigrated as evil, greedy and exploitative, the full brunt of the most concentrated ire is directed towards the class of persons branded as speculators. Indeed they are a convenient scapegoat for a whole host of (often contradictory) symptoms of an ill economy or financial system – rising prices, falling prices, volatility of prices, inflating bubbles, bursting bubbles, price gouging, supply shortages ad infinitum. Even successful investors and their mentors – Warren Buffett and Benjamin Graham respectively, for instance – are keen to point out how their methods differ from speculation and reserve the word for describing arbitrary, capricious, and undisciplined trading. More than any other aspect of the free market, then, it would appear that speculation is in need of the most detailed clarification and defence. What will be elaborated is that speculation is endemic not only to all exchange, trade, business, production, etc. but also to the very nature of human action itself. Further, following an explanation of the different ways in which it is possible to speculate, it will be demonstrated that no principled distinction can be made between anyone who tries to “buy low and sell high” and that perceived differences that are used as grounds for criticism are instead based on the relative difficulty in visualising the true economic effects of some speculative activities.

Valuation and Human Action

Humans act because they wish to direct the scarce resources at their disposal to and end that is more highly valued than the alternative use to which those resources may be put. If this was not true humans would not act. All human activity, whether it is brushing one’s teeth or purchasing a bag of groceries right up to selling a house or trading billions of dollars worth of securities on the financial markets are all carried out because the acting individuals perceive that the value of the outcome is higher than the value of the alternative. I brush my teeth because the act, I believe, will produce clean teeth that I value more highly than doing something else while retaining dirty teeth. I buy the groceries because I value them more highly than the money I am using to pay for them and other things that I could have bought. I buy a house or securities on the financial markets for the same reason.

However all valuation is ex-ante, that is we must decide what the valuations of our outcomes are before we act. We do not act out all of the different things we could do with our resources and then cherry-pick the one that actually yields the most valuable outcome. Rather we have to anticipate that the resources chosen and the method of our action will actually bring about the end that is sought and that this end will indeed have the value that we believe it will have. In short, we speculate on the outcome of our actions and all of our actions are, therefore, speculative.

Different actions have differing degrees of speculation, particularly when we have experience of the outcome. Most people will be fairly confident as to the results of brushing their teeth, both in terms of the physical product and the value it has. It’s not likely that after the act of brushing the teeth will be in a condition we did not expect, nor are we likely to regret what we have done and wish we had done something else. Further we are not likely to have undervalued the outcome ex-ante and end up wishing that we had devoted even more resources to produce more of the outcome. Other actions, however, are less certain. When a person buys a new product from the grocery store he doesn’t necessarily know whether the enjoyment of the taste and the satiation of hunger will outweigh the money spent on it. In order to mitigate this uncertainty he may at first be reluctant to devote too many resources to it, perhaps only displaying a willingness to purchase it when its price is reduced. After he has eaten it he may feel that he made a satisfactory trade and that he is glad that he purchased the good for the amount of money he gave up; alternatively the meal may be so ghastly that he deeply regrets the experiment and, if he could go back in time, would keep the money and not buy the product. However another possibility is that it might be so enjoyable that he regrets not having spent more money on the good and that the other uses to which he devoted another part of his money ended up being wasted as a result.

The point, though, is that all valuation of our actions is made ex-ante and that they are, therefore, speculative. Even with a commonly repeated act such as brushing one’s teeth there is no certainty. What if the time you devoted to brushing your teeth caused you to miss something important on the television and that, if you had your time again, you could go back and leave the brushing until after the show had finished? Speculation is, therefore, not only an essential and undeniable aspect of human action, one that we are immutably bound to using, but the very generator of human action itself – it is the impulse of our belief that we are moving on to something better with each act that causes us to act. It is no exaggeration to say, therefore, that speculation is at the heart of the nature of human living. Everyone is a speculator.

Market Participants and Exchange

Having established, therefore, that speculation is the anticipation of value arising from an action that is greater than that which preceded the action, let us narrow our focus to where speculation is typically used as nomenclature for these activities of valuation – the marketplace. But are we to crown only those traders who stare at price charts on six computer screens all day as “speculators” or is the scope of the definition much wider?

The “free market” (a much-abused term usually deployed by those opposed to it to signify disconnection from and lack of control by “ordinary” people) is an abstraction for people, individuals, voluntarily buying and selling. But why do they buy and sell, or to use a more precise phrase, why do they exchange? Here we come to a second important law of human action – that in order for two individuals to exchange goods, each must value the good that he receives more highly than the good he gives up. If A owns good a’, B owns good b’ and they agree with each other to exchange these two goods then it must be because A values good b’ more highly than he values good a’ and B values good a’ more highly than he values good b’. If this was not true why would the exchange happen? If the good you wished to acquire you viewed as equal in value to the good that you give you up why bother to exchange it? If it is of equal value what are you gaining from the action? Any doubts about this truth can easily be purged by considering one’s own experiences. You work to earn money but you cannot eat money and it cannot provide you with shelter, clothing, etc. At some point you need to buy goods that will remedy these deficiencies and you do this because the goods become more valuable for you than the money. Conversely the vendor of the goods wants your money more than he wants the goods.

It follows therefore that if market participants are attempting to gain value through trade, and the value can only be anticipated in the way that was outlined above then aren’t all market participants speculating? Aren’t we all expecting that what we gain from an exchange will be of greater value than that which we gave up but live with the fact that our expectation might either turn out to be true, turn out to be really true to the extent that we wished we’d exchanged more or turn out to be so untrue that we really wished we had not made the exchange? Everyone in the marketplace is therefore a speculator and all market transactions are speculations – speculations on what is gained in exchange will be more valuable than what is given up.

Let us concentrate, however, on the market participants who buy and sell, i.e. the relationship of exchange does not end with their purchases as in the case of a consumer. Consumers, after all, are expecting psychic gain. When a consumer purchases a steak he is expecting the enjoyment gained from eating it to be greater than the money he gains from it. With other market participants, however, the goods they exchange are not for their final enjoyment – they are to be bought with the desire to sell them again in due course. Here we have the starkest and simplest way of determining a gain in value from an exchange – that the price at which you bought a good is lower than the price at which you sell it. All market participants other than consumers aim at this end. And once again the participants can only expect that the good will sell at a price higher than the price at which it was bought. All market participants are, therefore, speculators and the object of their speculation is the variation in price of an economic good. It does not matter who you are – a corner shop, a restaurant, a bank, a large multinational firm, a derivatives trader – all speculate that the price at which they purchase the factors of production will be lower than the price at which they sell the final article to their customers. Price movement, therefore, is king to the speculator.


It is an economic law that the market price is a function of the supply of an economic good and its demand. If the market price is at a level where the quantity of the good that is demanded is equal to its supply then the price is said to be at the equilibrium price, or the “clearing” price. As the quantity demanded equals the quantity supplied all willing market participants – buyers and sellers – are satisfied at this price. All of the willing buyers go home with however many units of the good they wished to buy and all the willing sellers go home with however many units of money they wished to sell for.

It follows, therefore, that if there is a change in supply or demand then one set of people must become unsatisfied. If, at the current price, demand increases but supply remains constant there are now, suddenly, not enough willing sellers to supply the goods to all of the willing buyers. The result is that price must rise to a point at which the willingly supplied stock can be rationed to the sudden influx of new willing buyers at the old price. Conversely if supply increases but demand remains equal then price must fall to a level at which the increased supply can find new, willing buyers who were not prepared to pay the higher price.

Disequilibrium in the relationship between supply and demand therefore causes prices to change. It is the ongoing and varying disequilibrium that causes the price movements in goods that we commonly associate with speculators – in stocks, bonds, currencies, commodities, real estate etc. But the currents of supply and demand are common to all prices, even those that appear to hardly change at all from day to day.

As we already established a speculator in the marketplace is a person who “speculates” on the prices of goods – he believes that the price which he pays for a good today will be lower than the price that he is able to sell it for in the future. But, as we just explained, this can only happen if there is disequilibrium in the relationship between supply and demand. What follows, therefore, is an important, applied economic law that is seldom realised by even the market participants themselves: that anyone who buys goods in the marketplace with the desire to sell them at a higher price at a later date is necessarily intending to buy at a price level where demand already or shortly will exceed supply, necessitating a rise in price, and to sell them either when price reaches equilibrium or when supply exceeds demand. All persons who buy and sell aim to do so at these points. All market participants are therefore speculators on the disequilibrium between supply and demand. There are no exceptions to this law – every investor, entrepreneur, manager, businessman, capitalist, shopkeeper, distributor, agent, anyone you can think of who wants to “buy low” and “sell high” must and can only find the places where demand and supply are in disequilibrium. It follows that the buying and selling where the disequilibrium is greatest will yield the most handsome profit margins.

Methods of Speculating

We are now getting closer to the area where the most common grumbles about the act of speculation lie – that the speculator just buys something, sits on his rear end, waits for the price to rise and then sells it. “But what on earth has he done?!” cries the typical lament. “What value has he contributed? How has he improved the situation at all and why should I pay this person a ludicrously high profit?!” Such vitriol is usually reserved for certain types of market occupation – investors, bankers, middle men, and agents for example. But we must remember that all market participants are speculators and so there is more than one way of anticipating where and how the supply and demand for a good will change. Further, as will be demonstrated, all speculators, in whichever occupation they are working, must, if they are successful, add value.

What, then, are the methods of speculating? What is the focus of the individual speculator when he is buying low and selling high? They are one of three things – that the speculator must either a) transform the good into another good, b) change the location of the good or c) change the time of an economic good. Little needs to be said about a) except that it always involves a material transformation of a combination of goods into the final good; b) is effected  by transporting the good from one location to another; and c) by buying it, withholding it from circulation and selling it at a later date.

In practice, of course, it is an economic fiction to treat these aspects entirely separately; for a start all methods of speculation must take place through time. Further we could argue that a change of time or a change of location is also a change of form – that, for example, oranges in Florida are a different economic good from oranges in London, or that Christmas trees at the height of summer are a different good from Christmas trees on December 25th. However from the point of view of the physical actions and preoccupations of the speculator they are separable and analytically different methods of speculating. How then do these methods of speculation take advantage of changes in supply and demand?

If a speculator transforms an economic good then he takes pre-existing goods and turns them into another good, a finished product for sale. It is easy to envisage this as almost every manufacturer fits into this category, whether he is a sole trader or a large factory. A carpenter takes wood, tools, varnish and his labour and produces may be a table or a chair. A printer takes plain paper, ink, staples or binding fluid, and labour and turns out a book. A car plant or plane manufacturer takes hundreds of factors of production in order to turn out their products. Such transformation can take place with previously produced goods or with land (in the economic sense). The carpenter’s wood, for example, has already been transformed from a tree into a plank, whereas a farmer has to take land, seeds, water sunshine and labour and turn them into crops. Further, the transformation is not limited to tangible goods but also to services. A taxi driver will take a vehicle, fuel, a payment meter, his labour and produce with them a journey for a customer. Nothing physical that the customer can hold in his hand results, but the factors have combined to yield a valuable, intangible good.

How is it, then, that a transformation produces the all important increase in value, indicated by aiming for selling the produced good at a price higher than the price of the individual factors? It can only be by buying factors that are in low demand relative to supply and transforming them into a good that is in high demand relative to supply. The several economic effects of this service are important. First, it discovers an economic inefficiency that is ripe for correction – factors that are used to produce a good that is highly valued are, in and of themselves, relative undervalued. The larger the profit margin the greater the extent of this disequilibrium. Secondly, such a discrepancy means that the factors, because of their cheapness, will be directed towards production processes with less valuable ends and will be conserved with less zeal. Hence factors that could be used to produce a highly valued end are, in and of themselves, being wasted on lesser ends. When the speculator begins to buy these factors he creates for them an additional demand. This additional demand drives up their prices, rendering them too costly for other, less valuable ends and diverting them instead to the more valuable ends. Hence resources are no longer wasted. Finally this discovery of the discrepancy and its subsequent correction, yielding a large profit margin, will encourage competitors to enter the field. Thus, the factors will be bid up even more thus driving their price up further while the supply of the finished product will increase, hence lowering its price in turn. Profit margins therefore decrease as the increasing cost of factors approaches the decreasing selling price of the final good. Investment will continue to increase and the industry to expand until profit margins no longer justify it and funds are attracted to other projects whose discrepancies and imbalances have now become relatively more pressing. Hence speculation – the discovery of imbalances between demand and supply – prevents the waste of resources by identifying wide profit margins and closing them. As result the scarce factors of production are directed to their most highly valued end. And this is the essence of economic efficiency, getting the greatest value out of scarce resources1.

However, there is no guarantee that the speculator’s buying prices will be higher than his selling prices. Just as the consumer does not know in advance whether the new product he bought from the grocery store will end up being worth the money spent, so too does the speculator not know whether the price of the good he sells will be higher than that of the goods that he combined to produce it. It may be that his customers are satisfied with the product and will purchase it at a modest premium, in which case he identified a discrepancy in the market but it was relatively minor. He has provided a service but the factors of production clearly have very competitive alternative ends into which they could be drawn, otherwise their price would have been lower and the profit margin higher. The speculator has therefore done an important service, but not one of tremendous magnitude. Alternatively the customers may be absolutely delighted with the new product and rush to buy it as quickly as possible. Demand is so high that the speculator can barely keep up with orders and the only way to ration the existing stock is to raise the price. The increase in price will, therefore, increase profit margins. Hence the speculator here has identified a very wide and serious imbalance in the economy, a pressing and urgent desire of his customers for a product whose factors were highly under-utilised. Or, the undesired outcome, the speculator finds that he cannot sell his finished product for more than the factors of production and that he therefore makes a loss. He has, erroneously, diverted factors that were in high demand relative to supply and transformed them into something lower in demand relative to supply. Hence the factors have been wasted as the high demand for these factors indicates that there were more pressing needs to which they could be diverted. However, the waste is quickly cut short because no market participant wishes to or even can sustain losses. At some point, even if he persists with the loss making enterprise, there will a come a time when he runs out of money. He therefore loses the ability to continue to divert resources to wasteful ends and his proven lack of talent for speculation eliminates him from that role in the economy. The successful speculators however, in gaining profit, are able to command more resources than they were before. Their successful identification of where to divert the scarce factors of production means that they are trusted with being able to do so again with more. But if they make one error in identifying the desires of the consumers they will begin to make losses. They must therefore be continually successful in identifying the most pressing needs of valuable economic resources.

As we have already said speculation is necessarily forward looking – the anticipation that the value yielded by an act is greater than that of what persisted before. When it comes to the speculator who buys and sells goods what we see is that the valuation runs in a direction reverse to that of the sequence of events. The first speculator in what could be a very long chain of production is motivated by the valuation of the final consumer (who may not appear to buy for many months or even years) that is expressed through the chain by the valuations of all the other speculating intermediaries and directly by the particular speculator who will purchase his product from him. All speculators are, therefore, acting ultimately in the service of the final consumer by ensuring that scarce resources are directed to their most pressing needs.

Having explained the economic effects of speculation with reference to speculators who transform economic goods the remaining categories can be elaborated relatively swiftly. However with transformation it is relatively straightforward to visualise the productivity of the speculator; indeed the word speculator is seldom associated with what are perceived as routine businesses. This, as we have shown, is a misunderstanding as all actions are speculative and calculably so when they involve buying in order to sell for money. However with speculators who change either the location or the time of a good understanding of precisely what is going on becomes more obscure, resulting in the perception that either these types of speculator are either adding no value or, worse, are actively destructive and exploitative. These beliefs will be demonstrated to be false.

With the speculator who changes the location of an economic good we have the first case of the dreaded middleman – the agent, the dealer, the distributor and the marketer. These people buy an economic good, do absolutely nothing to change it and then sell it for a higher price, so the argument goes. If however, they are not adding value then it raises the question of why people are willing to pay the mark-up. Are the speculators simply ripping people off or is there a genuine reason why they are able to sell their goods for higher than the price at which they bought them?

Let us take the example of the distributor. He buys goods in one location, transports them to another and sells them at the latter. But why is he able to sell them at a higher price at the final location? Going back to our analysis of prices it can only be because the goods at the original location are in lower demand relative to supply whereas the goods at the final location are in higher demand relative to supply. In other words the speculator has identified an imbalance in the market – goods at one location are plentiful and lowly valued relative to another location and the speculator steps in to correct this imbalance. This is straightforward to perceive with goods that can only be manufactured or produced at certain locations on the Earth either because of climate or because of the ease of access to raw materials. Let us assume that a certain good, oranges, can only be produced in Spain. At that place there is a very heavy supply of the oranges as the crop ripens – baskets and baskets of them are stacked up in the groves. Oranges may be so abundant that they exchange for pennies and people devote their use to meet all sorts of ends – eating, juicing, garnishing, animal feed etc. However at other places on Earth – let’s say, London – oranges are not produced at all and are in very short supply. Consequently they trade for a very high price and as soon as someone gets his hands on an orange he will conserve it and take extra care to make sure he devotes it to his most highly valued use (lets say eating). It is unlikely that you would find Londoners using this rare fruit as animal feed.

The actions of the speculator who steps in in this case differ in no way at all from the speculator who transforms goods. His buying action will drive up prices in Spain that curbs the relatively wasteful uses to which oranges are directed; his selling action will drive prices down in London, allowing more people to enjoy the fruit and to devote it to a wider number of uses than they could before. The height of his profit is determined by and will demonstrate the height of the economic imbalance between the two locations, encouraging competitors to also enter the field and continue the buying in Spain and the selling in London, thus reducing profits. This will continue until the return no longer justifies the costs of transportation2. Therefore just as where the transforming speculator brought about a unity in price between the factors of production and the final product the speculator in location brings about a uniform price for goods across all places (less transportation costs). Thus economic resources are not just channelled to their most highly valued form but also they are transported to their most highly valued location.

Economically the speculator in location is no different from the speculator in form its just that the focus of his operation, his expertise, is location and not form and it is, hence, analytically easier to deal with them in these categories. However he does take factors – oranges in Spain, wooden crates, trucks, fuel and labour – and transforms them into oranges in London and the latter is really a different good from the original. Hence he has produced a good in a different form except that this is not evident from the physical quality of the final good. It is this obscurity that leads to questioning over the added value of this type of speculator’s activity.

It could also be said that a further benefit of the speculator is that he eases the burden of the previous producer. For example, by buying the oranges from the farmer the speculator relieves the latter of having to find a market for his product. The farmer receives a definite price now rather than having to, himself, arrange for transportation, marketing and whatever else in order to sell his product elsewhere on the planet. He can therefore concentrate his time and resources on farming the oranges. The car manufacturer sells to a dealer so the latter then takes on the burden of having to sell them to consumers. The same is true also of those who change the form of goods – the carpenter relieves the lumberjack from having to fashion the wood into tables and chairs; the goldsmith does need to learn how to fashion jewellery as the jeweller will buy the gold from him and do it instead. Hence the more speculators there are trying to analyse differences between buying and selling prices in different markets then the greater becomes the extent of the division of labour – each market participant only needs to concentrate on and consider a very small section of the entire economy and may be completely unaware of where his factors came from and where his final product will end up. Such specialisation leads to enormously greater productivity and, indeed, is the very raison d’être of the extent to which humans have, at least in some parts of the world, achieved a standard of living far in excess of that when they first walked the Earth.

Finally let us turn our attention towards the speculator who changes the time of an economic good. Here lies the, apparently, most lazy and undeserving of all speculators – the person who buys something, holds it then sells it a higher price while having added nothing of any value whatsoever. Such a point of view again overlooks an analysis of supply and demand3. If the speculator buys at a time when prices are low it must be because the demand for the good is low relative to its supply. Nevertheless the speculator is anticipating that demand will rise at a point in the future, a point that will cause prices to rise and allow him to sell at a profit. If the speculator is correct, therefore, then it means that the good in question will become, in the eyes of the consumers, scarcer than it was before. Something that today is relatively valueless will tomorrow become desperately sought after. The speculator’s buying actions therefore serves to remove the good from circulation at a point when demand is low. This removal prevents it from being wasted by a diversion to a less urgent use today when it will be needed for a more urgent use tomorrow. Once prices have risen as a result of the anticipated increase in demand, the speculator releases the good for sale on the market again, but now only those that most value the good will be willing to pay the higher price. Hence the resource will be devoted to its more urgent uses. Speculators in time therefore conserve resources in times of plenty and release them in times of scarcity. It is almost exactly like the squirrel who, during the summer and the autumn when nuts and fruits are in abundance, abstains from consumption of a part of them and stores them away. Come the winter and the spring when these goods are scarce he has plenty to consume that he would not have had but for his saving and storage. Indeed, seasonal products or products that have a long period of production (the longer the production period the more uncertain the final selling price of the good) are those that are ripest for speculation in time. The general effect of this speculative activity on the market is a reversion of prices to the average. If we assume, for the sake of simplicity, a constant demand for wheat during the year, at harvest time there is plenty of wheat to satisfy this demand and so prices will be very low. Wheat will be so cheap that people will gobble it up and devote it to minor and un-pressing needs on account of its abundance. However in the winter wheat will be very scarce and will therefore command a high price. There will not be enough to go around and what little there is will be devoted only to the most urgent needs. However in summer the speculator, by introducing additional buying pressure when prices are low, will drive prices up towards the average annual price and in winter, by introducing selling pressure when prices are high, will push prices back down to the average. The result, therefore, is a stable, annual price for wheat throughout the entire year in spite of the seasonal variations in supply. This is why consumers are able to pay the same price throughout the year for grocery products that are produced with seasonal factors of production.

Similarly to other forms of speculation the height of the difference between the buying and the selling prices determines the scale of the economic imbalance, most noticeably after poor harvests. In these years speculative action, reaping handsome profits because the price rises so high, serves to conserve what little of the crop there is for those who need it most urgently.

Of course those speculators who behave contrary to what supply and demand are doing – those who sell when prices are low and hence drive down the price even further when the good is in hot supply, or those who buy when prices are high thus choking off even the most willing buyers from being able to purchase the good – will quickly lose funds and go bust, ending their short reign of destructive buying and selling. For no speculator, in the long run, can change the ultimate direction of prices; every speculator who buys at some point has to sell. His buying pressure that raises prices today will become selling pressure that lowers them again tomorrow. The overall price and its movement can only be determined by original supply of a good by its producers and the final demand by its consumers. The alleged volatility of prices and bubble formations that are allegedly caused by speculative activity will be dealt with below.

A further benefit of speculation in time is the correction of momentary price discrepancies. A seller offers a good for sale at a price below the market clearing price where demand outstrips supply. The speculator purchases the good and offers it for resale at the market price, pocketing the difference as profit. By purchasing at the lower price the speculator ensures that sub-marginal buyers are not able to get their hands on it and divert it to less urgent uses; by selling it at the higher price he conserves the good for the marginal and supra-marginal buyers who will divert it to more urgent uses. Conversely a buyer may offer to buy a good for higher than the market price where supply exceeds demand. Here the speculator will short sell the good, borrowing it and selling it at the higher price before buying it back at the market price and returning it to the lender. This means that sub-marginal sellers are not able to sell their goods ahead of the marginal and supra-marginal sellers, ensuring that the former cannot crowd the market with wasteful surpluses that will find no buyer at the high price.

It should be clear that the speculators’ profits in cases of momentary price discrepancies are funded entirely by the erroneously dealing sellers who sell too low or the erroneous buyers who buy too high. They must bear the penalty for trading at a price level where supply and demand are not in equilibrium. Those buyers and sellers who are prepared to trade at the market price do not suffer at all; indeed buyers are benefited by the prevention of a shortage of stock resulting from prices below equilibrium and sellers by the prevention of surplus stock resulting from prices higher than equilibrium. Of course if the speculator himself is on the wrong side of these trades then he is the one who is punished with losses. If he, for example, suspects that the current price is below the market price whereas it is in fact at or above the market price, he will buy and then attempt to sell at an even higher price. But at this price there are few, if any buyers, willing to purchase all of the stock from sellers who are willing to sell at this level. The only way the speculator can compete with the other sellers is to lower his price until all the stock can be sold at a level that fills every demand to buy. Depending on how erroneous his original price was he may break even or suffer a loss. Repeated losses will deplete the speculator’s funds until he has no wherewithal to speculate further and he is prevented from causing any more distorting activity on the market.

A final benefit is similar to that of the service that the speculator in location provides the orange grower – by finding a market for the product the latter is relieved of the risk and burden of having to do so and can concentrate on farming the product. Similar concerns face those who sell goods with a length of production that is relatively long and which may in and of itself be fraught with uncertainty. Once again crops are a good example. The farmer has to begin production and incur expenditure on factors in the spring whereas he will not reap the harvest and make an income until six to nine months later, during which any number of intervening events could occur that will affect the amount and quality of the final good. In steps the speculator who will, say, at the start of the growing season offer a definite price to the farmer for his whole crop, regardless of how it turns out at the end of the harvest. The speculator, of course, believes that the final crop will be of a quality and quantity that will enable him to earn a profit on what he paid to the farmer. The farmer, in turn, is willing to forego this profit so that he can purchase factors of production and begin work safely with the knowledge that the costs will be covered by a fixed amount of revenue in the future. Hence the risk of future prices is transferred from the farmer to the speculator.

Financial Traders

The financial trader is the speculator in time par excellence. He will buy financial securities that are claims upon real assets, withdraw them from circulation and sell them again for a higher price. Everything essential that needs to be known about this type of individual has been covered in the previous discussion. Nevertheless as the financial speculator in particular is the least understood and most vilified of all market participants some additional elaboration would be beneficial.

The consumer, as discussed above, bases his buying decisions upon whether the object of his purchase gives him greater satisfaction that the sum of money with which he parts for it. His gain is a psychic profit, one that cannot be measured or demonstrated but one that is, in his own mind, either satisfied greatly, somewhat or not at all. It follows therefore that his buying decision is dependent upon the quality of the good that he buys – if it is food it needs to have a nutritional value and taste the benefit of which exceeds the cost that was paid for it. But what of the person who sells it to him? If you are a fishmonger is it your preoccupation (aside from providing advice and recommendations or from utilising a degree of empathy with your customers) that salmon is delicious and nutritious and will provide a great deal of benefit if consumed? Or are you more concerned with the fact that consumers are willing to buy it at the price you offer and, in order to meet this demand, are you not concentrating on where you can source it at the lowest possible cost? A café owner doesn’t care whether coffee is good, bad, or ugly nor does a carpenter care about whether tables and chairs are nice to sit on; indeed both may utterly abhor the products that they produce. The focus of their operations is to recognise that consumers demand these things and they meet these demands by purchasing the factors of their production at the lowest possible cost, raising the price for these factors and hence choking off their diversion to less urgent desires of the consumers. What emerges therefore is a symbiotic relationship where the desire to earn profits on the part of the trader is harmonised with the desire of the consumer to acquire a good that will satisfy him.

If we turn, however, to the financial markets the same relationship is present between what we might call pure financial traders and investors. The latter is inherently concerned with whether the capital goods which he purchases will best serve the needs of consumers. If he must decide whether to invest in either companies A, B or C he must determine which of them (if any) is utilising (or will utilise) its assets in the best possible way in order to fulfil the demand of its customers. Even though, therefore, the investor is, like all market participants, a speculator in supply and demand and ultimately derives his entrepreneurial profit from imbalances between the two, there is an inherently qualitative dimension to his operation, similar to that of the consumer himself.

The market capitalisation of a company represents the discounted value of the company’s future profits – that is the present value of all of the future profits, necessarily discounted because a good available today is of higher value than the same good available at some point in the future. If you were to buy a whole company what you have really bought and what you are really paying for is the entire future profits of the company discounted to reflect the fact that you cannot enjoy these profits today but must wait for their generation at some future date.

However, the medium of such investment activity is normally financial securities – stocks and bonds being the most obvious and prolific – which are merely ways of scattering the ownership of a company across many different investors, each of whom owns a portion of the company’s future profits4. However these securities are themselves traded on an independent market and markets, as we know, are formed by the demand of buyers and the supply of sellers. There is, therefore, a supply and demand for ownership of these “pieces” of companies. This supply and demand is driven by investors and their views of whether a particular company will best serve the needs of consumers. It follows, therefore, that if a great number of investors believe that a company will be particularly illustrious and successful in performing this function the demand for its securities will be very high relative to their supply. If however, the investors believe the contrary – that the company is wasteful and has little or no prospect of earning a profit – there will be an eager rush to sell its shares and hence demand will be very low relative to supply. This is what, proximately, causes some share prices to be “high” and others “low” – the opinion of investors of whether the company concerned will generate future profits. Notice that this market operates entirely independently of the operations of the company itself; although the share price should, theoretically, follow the success of the company, they can and do diverge because investors change their minds as to the ability of the company to generate future profits. All this proves is that the investment operation is speculative – that it is looking forward to a future state that is uncertain and that this future state may turn out very differently from that which was hypothesised5.

There is, therefore, an investors’ market where people will buy not consumer goods like meat, bread or coffee but securities in companies. But this market operates just like the consumers’ market and it is wholly based on the supply and demand for the products that are traded. If coffee is suddenly demanded very highly then in step the speculators – caring not of the reasons for the consumers’ desires – who buy, and hence bid up the prices of, the factors of coffee production to ensure that less urgent needs are choked off from their use in order to ensure that they can be devoted to this very pressing need of the consumers that has emerged. But exactly the same happens on the market for securities. In just the same way that consumer demand for coffee might rise because they believe it to be delicious and nutritious, so too at any one time investors might increase their demand for shares of Company A on the belief that A has a strong prospect of earning future profits.

In, therefore, steps our financial speculator. In just the same way as the speculator in consumer products has to speculate on the demand and supply of these products, so too does the financial speculator speculate on the demand and supply – of the investors – for financial securities. In just the same way that the café cares not for the underlying qualities of coffee but only for the fact that it is in heavy demand, so too does the financial speculator care little for the qualitative prospects of the company from which the security is derived to earn future profits; he cares simply for the security’s supply and demand driven by investors. He will buy the security if he believes that, at this price level, demand for the security outstrips supply leading to an inevitable price rise; in other words, if investors who believe that the company will generate good future profits outnumber those investors who do not. He will sell the security when it reaches a price level where supply and demand are in equilibrium, or he will short sell if he believes that the supply of the security is in excess of its demand, i.e. if investors who believe the company will generate good future profits are outnumbered by those who do not.

It follows, therefore, that the majority of investors may be totally erroneous as to their opinions of the company; they may all want to buy a complete turkey of a company in the mistaken belief that it will be handsomely profitable, or, alternatively, they may sell the golden goose. The financial speculator cares not about whether these companies really have an underlying ability or lack thereof to generate future profits; his focus is entirely on whether the investors believe that they do and the consequential supply and demand that is generated for the securities6.

What economic benefits does such a speculator achieve? More or less they are identical to those of all other speculators. If the speculator predicts that demand for a security will be very high then not all of the investors who wish to buy can do so at the current price. The speculator’s additional buying will therefore cause a price rise that occurs sooner than it would otherwise have done so. In the same way that bidding up the factors of production diverts their use from less urgent needs, so too will the financial speculator begin to choke off demand from incompetents – not merely dabblers and gamblers or those with insufficient funds to purchase at the higher price but also those who are less certain or have been less scrupulous in forming their belief that the company is a worthwhile investment. The rise in price therefore reserves the supply of the security for the investors whose belief in the company’s prospects to earn returns is so strong and committed that they believe that even a purchase at this higher price is justified and will be covered by these future returns. It is to these people whom the speculator will sell. Conversely, when the speculator believes that supply of a security is in excess of demand – i.e. that the majority of investors believe that the company will not, at this security price, earn a future profit that justifies it – he will short sell it. As not all willing sellers can sell at this high price due to the lack of demand, the speculator’s actions in driving down the price will again choke off the less competent sellers – those who are less certain or have been less scrupulous in forming their belief that the company is a turkey – and the resulting fall in price to where demand is higher means that investors whose belief in the lack of the company’s prospects to earn returns is strong can now find a demand to sell to. It is from these people whom the speculator will buy to cover his short sale and, indeed, his aim – if he is to achieve the highest profit – is to buy from the very last of these investors, when the price movement is necessarily at the lowest it will go.

In sum, therefore, the financial speculator provides the committed investor, the one most dedicated to directing resources to where they are most urgently desired by the consumers, a supply of securities when the latter wishes to buy and a demand for them when he wishes to sell. There is, therefore, no substantive difference between the relationship of a shop with a customer and a financial speculator with an investor. It is merely that the service of the financial speculator, by ensuring that security prices most quickly reflect the underlying supply and demand, is not to directly channel resources to where they are most urgently needed but to facilitate the ability of the investors to do so.

It should be clear that the most lucrative investment operation is one that takes note of this speculative ability. For if one wishes to make the highest profit it pays to combine the two operations – by a) finding those companies that will best meet the needs of consumers and generate the highest profits, and b) whose securities are trading at a price where demand is far in excess of supply and hence are due for an inevitable price rise. It is for this reason that the famous philosophy of value investing – buying the most profitable companies at prices below that at which the investor believes represents their discounted profit stream – is so successful. Indeed, it is analogous to a consumer being able to buy at wholesale rather than retail prices – you are buying the same value but at a lower price hence the differential between the price and your reward is greater. As the first chapter to one introduction to value investing is titled, “Buy Stocks like Steaks…On Sale”7.

Charting, “Gambling” and Asset Bubbles

Let us conclude by laying to rest some additional myths associated with the financial trader. The speculator’s primary tool of price charts and its associated array of mathematical studies that are derivatives of price (used in methods that are collectively known as “technical analysis”) lead the casual observer to declare that all speculators do is follow a few patterns or look at a few studies and then repeat this over and over in order to rake in huge and “unjust” profits. But to assume this is to make the cardinal error of treating human activity like that of unconscious matter, that when any pattern or mathematical progression repeats it signifies a buy or sell signal that, unfailingly, will produce profits. Such nonsense detracts from the central task of the speculator, one that has been stressed over and over in the above – to find imbalances in the relationship between supply and demand. All he is doing, just like any other speculator, is finding the prices where supply and demand are in the largest disequilibrium except that he finds these areas by interpreting price charts. There is nothing technical or mathematical about this process; it is, rather, an entrepreneurial skill just like any other. Every profitable trader knows that there is not a single technical or mathematical study that, taken alone, will yield consistent profitable trading activity; indeed it is the fastest way to run down a trading account. Rather, the speculator learns what supply and demand imbalances tend to look like on a price chart and he trades only in these areas. But he knows that human action is not uniform and repetitive and he does not expect every instance of his analysis to provide the same result. Rather, he condenses his interpretative techniques to a handful of rules that he applies with a probabilistic approach to discovering where supply and demand are most in disequilibrium, risking a small percentage of his funds by stopping out of a trade in cases where he is wrong. The most skilled traders can keep such losses to a minimum to the extent that they simply become a cost of doing business; indeed with proper risk-management skills that ensure his losses are small and his profitable trades are large his interpretative methods may even allow him to make losses on more occasions than he makes profits. But regardless of his precise win/loss ratio recognition of the fact that a trading method does not work one-hundred percent of the time (a point on which all successful traders will agree) proves that there is nothing about trading from charts that can be scientifically or quantatively determined. The only science is in the fact that disequilibrium in supply and demand causes prices to rise or fall; interpreting where these points lie on a price chart is a rare, entrepreneurial skill.

Nor can it be said that financial traders are “gamblers”, that is that their returns are based on pure luck. The point of this essay has been to demonstrate that all market participants are speculators, they all, fundamentally, are doing the same thing regardless of their specific methods and preoccupations, and the economic effects of their actions are always the same. There is, therefore, no way in principle to distinguish one type of speculator from another. If a financial trader is a gambler on rising or falling prices then so is every business, every shop, every carpenter, and every plumber in the world. But even if financial traders or any speculators were simply gamblers then what harm would it do? Every speculator, as we have noted, must one day sell after he has bought. He is not a producer of original supply or final demand, rather he greases the market towards prices where the original suppliers and final demanders are in equilibrium. If he is successful in doing this he sells for a profit; if he is not then he sells for a loss. If the former then he has aided economic efficiency by moving supply and demand towards its equilibrium price, whatever his methods. Consequently he is trusted with more funds on which to make larger and more important speculations in the future. If he loses then it is the opposite – he has harmed discovery of the equilibrium price, but his resources for doing so are limited. If he keeps making losses then very quickly the market will wipe him out and his means for causing ill economic effects are curtailed. However if these losses happen through gambling then the situation is just like that of any speculator who applies faulty methods, whether they are laziness, sloppiness or simply a lack of entrepreneurial talent. There is no way to separate a gambling speculator from one that is simply bad.

Finally, let us consider wild speculative bubbles that, during boom years, inflate away like an aphrodisiac balloon until they finally pop, ushering in a recession or depression following a crash in prices. This is not the place to discuss at length the cause of the business cycle by artificial credit stimulation. But if such artificial stimulation distorts the underlying fundamentals of the economy – by making longer and more roundabout production processes appear more attractive and diverting resources unsustainably into capital projects – then this is not the fault of the speculator. Remember that every speculator is always in the position of having to sell after he buys. He cannot, therefore, affect the overall or average price level of the speculative good. In buying capital goods at the start of the boom, the very ones that he knows will be sucked up by all the freshly created and loaned money that is emerging from the artificially low interest rate environment, he merely moves prices quicker to where they are already heading as a result of all this newly printed money. The boom therefore happens quicker, but it is only in response to the anticipated demand that has been falsely stimulated by credit creation. The same happens at the bust phase – by selling or short selling the speculator simply lays bare the fact that demand and supply, at such inflated prices, cannot continue to be in equilibrium in the absence of continued credit expansion. His action at the peak of the market and on its slide down liquidates the boom’s malinvestments quicker and, uninterrupted, provides a painful but much speedier recovery to a sound and stable economy than otherwise would be the case. Speculation exists to serve the direction of supply and demand in the economy whatever causes this supply and demand to occur on the part of market participants. If the directions of supply and demand are distorted by destructive interventions then their consequences are not the fault of the speculator. Proper blame should be laid at the door of the easy credit policy which still, regardless of the continuing economic malaise since 2008, is the favourite of governments and central banks everywhere.


In sum therefore, it may be said that:

  • All human actions are speculative and therefore everyone is a speculator;
  • That all consumer choices are speculations;
  • That all market participation – buying and selling – is speculative;
  • That speculative activities are beneficial to channelling the scarce resources of the Earth to their most urgent needs and uses by harmonising supply and demand;
  • That it is not possible to distinguish, in principle, between different speculative activities on the market; and that, further, differences between types of speculator usually centre on the fact that a lack of physical change to a good is falsely regarded as a lack of added value;
  • That common myths regarding the nature and alleged destructiveness of financial trading in particular are entirely false.

1 We might also point out that the higher prices of the factors will also be preceded by speculative action for them as well, and investment will also be drawn towards increasing the supply of these factors that is now justified by their increased price. Hence their factors also will increase in price, and so on and so forth right back through the chain of production until prices for all of the factors and their respective finished product approach equilibrium.

2 If this equilibrium is reached oranges will still trade at a premium in London because of these costs.

3 For the avoidance of doubt we are not referring here to the premium placed on present goods vs future goods as a result of the law of time preference; we are discussing here real changes in the supply and demand for a good.

4 Shareholders and bondholders fulfil the same economic function as each other – they both advance investment funds to the company. The difference is that they do so merely on different legal terms and acquire different rights through the respective relationships.

5 Earnings announcements are typical examples of where the share price diverges from the company’s ability to earn future profits. If earnings are good the share prices normally rocket on the news whereas if the are bad they plummet. But today’s earnings have nothing to do with tomorrow’s. If today’s are bad it might be that the company still has the ability to pull itself together and deliver a result tomorrow; or it might really be a turkey and still continue to lose money. If, on the other hand, today’s results are good this might be the best that it ever gets and tomorrow will only generate lower profits or even losses; or it might just be the start of a long and prestigious career of generating truly handsome returns. All of these options are possible yet nearly always investors react as if good news today is good for tomorrow and bad news today is bad for tomorrow.

6 These facts should put an end forever to so-called efficient market hypothesis (EMH). The hypothesis is based upon a misunderstanding of why markets are said to be “efficient”, a term itself that is vague and stifles clarity. Markets are “efficient” because they harmonise the supply and demand for goods through the price mechanism, in other words goods are directed to where they are most highly sought and, a fortiori, their most highly valued ends. But the efficiency of markets has nothing to do with the underlying valuations that drive this supply and demand. These are products of the human mind, the result of desires and choices, and the notion that prices respond “efficiently” to publicly available information suggests that the impact of this information upon such human choice and desire is uniform, predictable and quantifiable. The theory’s weakness is similar to that of a strict adherence to the quantity theory of money in attempting to explain how increases of the supply of money affect the so-called “price level”. Further, the entire reason why profits are earned in an economy is because future valuations are not known, nor are they available in publicly disseminated information; it is, rather, the task of entrepreneurs to bear the risk of predicting them through their understanding of their customers’ sentiments. A million investors, acting on all of the publicly available “information”, may dump the stock of a company that, tomorrow, will earn sky-high profits. The one investor who goes against this grain and buys all of the sold stock is the person who reaps the “excess” reward that EMH states is impossible or at least unlikely.

7 Browne, Christopher H, The Little Book of Value Investing.

View the video version of this essay.