The Speculator's Bootstrap and the Efficient Market
By Anthony de Jasay
Hieronymus Carl Friedrich von Münchhausen (1720-1797), also known as Baron von Munchausen, was a German nobleman who returned to his native Braunschweig after two decades of service in the Russian Imperial cavalry in the middle of the 18th century. He used to entertain dinner parties with deliberately caricatural tall stories of his adventures in far-flung lands. One of his exploits has become a much-used metaphor, now called the bootstrap theory, in the teaching of economics.
As the story goes, Munchausen found himself in a bottomless swamp, sinking ominously and looking round in vain for something firm to grab and pull himself out. Resourceful as he was, he took a thick handful of his own hair, raised himself by it and was saved. In later years as the story was retold, instead of his hair, it was his own bootstraps that he pulled to raise himself. Other such miraculous bootstrap stories figure in the economic folklore. Mancur Olson’s “encompassing group” is one such.1 Another is Henry Ford supposedly overpaying his workers so as to be able to sell them his cars and increase his profits.
The bootstrap theory of speculation is a real pearl among bootstrap theory. It does not figure in good textbooks, but is freely aired by the media, firmly held in popular opinion, and has an astonishing following among Eurocrats, banking regulators and high-ranking Finance Ministry officials.
In a nutshell, the theory tells us that speculators “attack” a price-sensitive commodity or asset in one of two ways. One is to buy it; the buying drives up the price; the speculator sells out and earns a profit. The other is that the speculator sells the commodity or asset that he may or may not possess; his selling drives down the price; he buys it back at the lower price and earns a profit. Both ways are reprehensible, immoral, anti-social, greedy, non-productive, destabilising and also unjust. They are the object of open hatred and hidden envy, and the targets of mostly unsuccessful attempts to regulate them. The second of the two, “short-selling”, is regarded as particularly wicked. There was once a lady who boasted to her friends that she had an exceptionally wise stockbroker. “What does he tell you to do?” she was asked. “He tells me to buy low and sell high”, she replied with a touch of superiority.
The speculator, if he is successful, lives by the same advice. He buys low and sells high, and never mind which comes first. The amazing feature of the bootstrap theory is that by buying, he can make the price go up high enough to let him sell at a profit. The same is true in the reverse order, when he sells, his selling depresses the price and he buys back. He can, in one word, conjure up the conditions that, repeated a few times, make him rich. It is beyond ordinary comprehension to fathom why everybody has not yet become a professional speculator, advancing on the fast track to fabulous fortune. This account is perhaps caricatural, but by not much so. It is widely held about the Bangladesh famine of 1974 that it was not due to any physical shortage of grain. The famine was the consequence of a lack of market access by the poor. In plain English, this must mean that a quite normal supply of grain, instead of flowing to the market, was held back and ended up in more than usually high stocks bought up by speculating merchants. The price was driven up, poor Bangladeshis suffered and died of famine2 and, since the story must have ended by stocks eventually reverting to normal, the merchants sold out at the higher prices. It is not clear who ultimately took the extra stocks of grain off the merchants’ hands at a high enough price. A bootstrap theory would not be a bootstrap theory if at some point did not become murky.
The assumption of rational choice requires the economic agent, an individual or a firm, to maximise the risk-adjusted present value of his net assets. If transactions costs were zero, he would be doing this by adjusting his portfolio every hour of every day to what in that hour promises to maximise its net present value. Significant transactions costs would reduce the frequency of adjustments to changing events, provoking portfolio adjustments only in response to major changes in incentives to do so. The term “risk-adjusted” is a somewhat glib way to evade the maze of complications that arise from expectations of future events, e.g. future prices of certain assets, not being single-valued. However, with all the respect due to a probability distribution some members of which promise gains and others promise losses, the least misleading approach to asset-value maximisation is that assets expected to appreciate will be held or bought while assets expected to depreciate will be held or sold. If the grain merchant is to pass for being rational, he must maximise his expected net assets and in order to do that, he must increase or reduce his stocks according to what he expects grain prices to do. In forming his expectations, he is assisted by a flow of information; the U.S. Department of Agriculture keeps him supplied with the best reports of the state of the wheat crisis and the likely harvest from the Ukraine, the U.S. and Canadian prairie states, to Argentina and Australia. Yet, if he saw no forecasts, felt that he had no clue what the price of wheat will do and kept his stock at the level that was neither higher nor lower than was convenient for running his business, he would be behaving as a rational maximiser who expected the price of wheat to move only a little either way. Logically, he would be behaving as a speculator and so did everyone else who held price-sensitive assets or was otherwise responsible for preserving and augmenting, rather than knowingly allowing to decline, their future value. Nobody can both say that he is acting rationally and that he will not speculate. Whether he likes to admit it to himself or not, the passive asset-holder is also speculating.
The incentive to buy or sell resides in expectations about future prices. Buying into a price when it is in an updraft and selling it when the updraft is ending and the price is about to peak, as well as doing the reverse in a downdraft, is not only profitable to the speculator who correctly anticipated the future course of the price, but will also reduce the amplitude of the movement. The greater the volume of correctly timed speculation (i.e. successful speculation), the more the amplitude of price movements is flattened. In the limiting case, where all the potentially profitable speculative positions have been adopted, the marginal speculator just breaks even. The trough is lifted and the peak is depressed by the buy-low-sell-high activity, and instead of an up or down swing, the future price stays horizontal. The successful speculators in fact bring about what banking regulator, public finance officials and leader writers are desiring, namely greater asset price stability. Accused of all that is destructive and sinful, the successful speculator is in fact a social benefactor.
The almost trivial insight that successful speculation is the result of the correct anticipation of future asset prices, including the asset prices that would prevail if speculators did not correctly anticipate them and by so doing did not smooth them out, does not spare much mercy for the bootstrap theory. It does not altogether wipe it out, though. If asset price expectations have strongly positive elasticity Munchausen could generate a buying spree for the asset by buying it and cause an uptick in its price, or a selling spree by selling it and provoking a downtick. With the elasticity of expectations strongly positive, an uptick would cause the public to revise its price expectation strongly upward, and doing the reverse when seeing a downtick. The crowd behaves like a flock of sheep or perhaps a stampeding herd of cattle, magnifying the boom or bust of the price. Munchausen could then profit from the price movement he brought about for that purpose. Very elastic asset price expectations could be partly responsible for such events as the forced abandonment of the European exchange rate mechanism by the British pound in 1992, the near-crash of Spanish government security prices in 2012, more generally, asset price “bubbles” and stock market crashes. However, no such spectacular movements can plausibly be ascribed to expectations generated by some initial price move alone, any more than the trigger can make the gun shoot unless the explosive charge is ready for it.
In winding up this simple attempt to clear away some popular misunderstandings, it could be tempting to look at how the theory of efficient asset markets and of speculation fit together. The central thesis of the efficient market theory is that stock prices at all times fully reflect (i.e. are fully accounted for, and fully warranted by) the sum of information commonly available to the market (except, presumably, insider information not commonly available). If this thesis is taken strictly, it must mean that when the body of information is given, all stocks are correctly priced in the sense that the marginal buyer is just deterred by the price from buying and the marginal seller from selling. No trade is taking place and every asset holder is in equilibrium, happy with what he is holding. When a fresh item is added to the body of available information, the market price of the representative security must adjust to it instantaneously, so that it is high enough to deter the marginal buyer from buying and low enough to deter the marginal seller from selling, with both of them finding themselves in a new equilibrium. For this to be the case the fresh information must move the price expectations of the marginal buyer and the marginal seller in the same direction and to the same extent. Under this very strong condition, the market is efficient in the sense that the representative security is never mispriced, triggering either buying or selling.
At first sight, this looks rather absurd and a second sight confirms the diagnosis of the first. The market is efficient because no asset is over- or under-valued and none requires to change hands. This also means that the market is stone dead and for all the good it is doing, it might just as well be shut down. The same assets stay in the same hands rather than as we prefer to believe, ending up in the hands of the investors who are willing to pay the highest price for the chance of reaping the fruits they the “speculator”, expect it to yield. If a market must really be classified as efficient or inefficient—an exercise of uncertain merit or validity—it might be wise to nudge the debatable judgment towards the type where speculation is rampant and unrestricted.
See Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge: Harvard University Press, 1965) and The Rise and Decline of Nations (Yale University Press, 1982).
Upper estimates of deaths, including those who died from starvation as well as from the diseases which spread in the aftermath, go as high as 1.5 million.
The State is also available online on this website.
For more articles by Anthony de Jasay, see the Archive.