Chapter VI: Speculation and Crises

An unavoidable element of risk enters into all modern business. In the old handicraft stage of industry goods were made upon order; demand preceded supply very definitely, and there was little possibility of mistakes in production. Nowadays, as we have seen, production is for a distant and often uncertain market. It is carried on by machine methods and roundabout processes; sometimes the result is a very remote one and the uncertainty of success is correspondingly great. Production is not based upon order, but upon a forecast of the possible demand, upon a future market. Chance and change are inseparable from productive enterprise--natural chances from the elements, political changes, as war or unfavorable legislation, industrial mistakes or sickness or death of oneself or others, and economic changes, as the invention of a new machine or a change in fashion. These are the unavoidable incidents in industry and are not 52 under the control of the individual business. Some of them, however, are so regularly recurrent that they can be foretold on a large scale for any industrial society, and can be guarded against by insurance. Everyone recognizes the desirability of having such risks as those of fire, shipwreck, lightning, death, etc., assumed by certain individuals or companies who make a business of such risk-taking. A small premium is paid by the individual for protection, and he is freed from anxiety from mischance and is able to devote his whole energies and capital to his business; the insurance company has specialized in this one department and by equalizing the chances over a wide field has practically eliminated them. In doing this it performs a service of recognized and undoubted social value.

There is another kind of risk-taking the social utility of which is not at first sight so clear. Among the chances of productive enterprise are those due to the rise and fall in the prices of the raw materials, the labor, and the finished product between the time when the process of production is begun and the time when it is completed. Every farmer, every manufacturer, every student even who invests capital in his own education, is to some extent a speculator. Along certain lines he can protect himself by insurance, but that is not possible in all. Is there no way, then, by which he can guard himself against price fluctuations and assure himself of the legitimate gains of his business? This, it may be answered, is the function of the speculator in modern business, and in performing this service he is benefiting society in much the same way that the insurance company does. We must, however, clearly distinguish between legitimate and illegitimate speculation; we are discussing only the former.

One way in which the speculative risk attaching to price fluctuations is reduced for the manufacturer and assumed by the speculator is by the establishment of a continuous open market, as the stock and 53 produce exchanges. If a miller, for instance, engages to deliver flour a year hence and expects to begin milling in six months, he must know at what price he can buy his wheat when he needs it, or his anticipated gain may be turned into a loss by an unexpected rise in the price of wheat. He is able, however, to buy a “future” in wheat on the produce exchange from some broker who makes a specialty of this business. He buys his needed wheat now for delivery six months hence, and on the basis of this price is able to accept an order for his flour a year from now, allowing himself a fair profit as a miller but wholly eliminating the speculative risk of price fluctuations. Or a building contractor, before making an estimate of the cost of erecting a structure, will secure options at definite prices from dealers on the materials he will require. So, too, in the iron and steel business it is customary for manufacturers to contract in advance for materials at the same time that they accept orders for the delivery of the finished products. In all these cases the business of dealing in futures is assumed by a particular class, who have developed a special skill and ability in forecasting price variations, and who can do so very accurately. It is not a matter of luck or chance, but the result of wide knowledge and careful study. “To foretell the price of wheat one must know the rainfall in India, the condition of the crop in Argentina, must be in touch as nearly as possible with every unit of supply that will come into the market.” Sometimes the speculators make mistakes, but they are certainly less apt to do so than men who are without their special talent and training.

The social value of this service lies in the equalization of demand and supply between the present and future that is thereby effected. Let us take as an illustration the case of the miller cited above. If at the time he accepts the order for flour the price of wheat is high, he will be inclined to charge a high price. But the wheat broker, foreseeing that there is going to be an abundant crop six months 54 hence, engages to sell him his wheat for future delivery at a low price, and he is thereby enabled to sell his flour at a lower price. At the same time the price of the wheat on hand at the present time, instead of being held and sold at famine prices, is consumed for present needs at moderate prices. The operations of the wheat brokers in such a case have a very steadying influence on prices, preventing the oscillation between very high prices in times of scarcity and very low prices in times of glut. It must be admitted that dealings in futures are highly speculative; “but it must be remembered that it is not merely the dealings in futures, but the future itself, that is uncertain. If such dealings can be confined to the men most competent to make accurate predictions, their tendency will clearly be to lessen the uncertainties of business.”[8] But closely connected with legitimate speculation or risk-taking by a specialized and trained class, there is, as our stock and produce exchanges are actually conducted, a large amount of illegitimate speculation, and to this we may now turn for a brief consideration.

The facilities offered by the open markets on the exchanges and the practice of dealing in futures are taken advantage of by many who, without any special training or opportunities of knowing the market, simply bet on the price movements. Brokers are willing to buy and sell produce or stocks for their customers if the latter will put up with them a margin of about 10 per cent to protect them from loss. It is therefore possible for a person with little capital and no knowledge to speculate on a margin, buying what he does not want and selling what he does not own. In practice it is impossible to distinguish between those dealings in which actual delivery is intended (legitimate speculation) and those in which no such delivery is contemplated (gambling), and consequently most efforts to regulate 55 transactions on the exchanges have failed to accomplish their purpose. The purification of their methods would seem to lie with the members of such exchanges themselves. The contention has often been made that these fictitious transactions in such commodities as wheat or corn or cotton create an artificial reduction in prices, since the professional gambler usually sells short or “bears” the market, and that this injuriously affects the farmer. This is manifestly untenable, since every fictitious sale must be balanced by a fictitious purchase. What actually takes place is simply a bet between the two parties to such a transaction on the actual course of prices and of itself does not affect prices, except in the unusual case of a “corner.” There is, however, great possibility of evil in the presence of a crowd of uninformed speculators, for they can greatly increase the power of an unscrupulous operator who can persuade them to follow his lead. Their presence, too, increases the temptation to such a man to rig the market. Under present conditions the abuses of speculation are more in evidence than the economic advantages. How to confine speculation to the small group of risk-takers who have special training and aptitude for it, and to prevent gambling on the stock and produce exchanges is one of the economic problems of the day.

One of the most striking phenomena of modern industry is the frequent and violent convulsions of business known as crises. They are characteristic of all commercially advanced countries and are generally most marked in those countries which are most advanced. They are a product of modern methods of capitalistic production and are essentially a phenomenon of the nineteenth century. A crisis in its last analysis is the result of a lack of adjustment between production and consumption, due primarily to mistakes in production. It is significant that crises usually occur in periods of business prosperity when credit is easy, prices high, and employment general. 56 Such a period of business prosperity and rising credit may have been begun by a series of good harvests. The demand for manufactured commodities increases, prices rise, manufacturers enlarge their factories or engage in new enterprises, wages and profits go up. Many speculators, seeing the rise, and thinking it will continue, borrow money to buy goods with the expectation of selling again at a profit. Credit operations are expanded to a dangerous extent, and when at last a shock to confidence occurs the house of cards collapses and a painful liquidation and readjustment of industry ensues. The state of trade, in the words of Lord Overstone, “revolves apparently in an established cycle. First we find it in a state of quiescence--next improvement, growing confidence, prosperity, excitement, over-trading, convulsion, pressure, stagnation, distress, ending again in quiescence.”

The immediate occasion of a crisis is always a shock to credit or confidence. Such a shock, begun perhaps by the failure of a bank or merchant, creates a demand for ready money. No one is sure that his neighbor will remain solvent. Everyone accordingly tries to secure himself against loss by enlarging his cash reserve and thus lessens the supply for others. Now modern industry is carried on by means of credit. There is at no one time enough money in the country to meet all obligations expressed in terms of money. Considerably over three-fourths of the larger commercial transactions in the United States are carried on by means of credit. If everyone tries at the same time to get actual cash, there is simply not enough money in the country to go around. This increase of demand and diminution in the supply of money forces up the interest rate on short-time loans. Money--actual cash--is needed by many people to meet immediate engagements and they are willing to pay almost any price for it. In the last panic the rates for call money went up to over 100 per cent 57 and in many cities in the United States clearing-house certificates and other substitutes for money were issued for use in ordinary retail trade. But even at high rates money can often not be borrowed. Many merchants and manufacturers are compelled to sell their goods at a sacrifice in order to obtain it. Vast quantities of goods and securities are thrown on the market just when investors and consumers feel least able to purchase. The result is a fall in prices. Such a fall in prices lowers profits. Enterprises have been started and engagements made on the supposition that prices would continue at the old high level. When they fall it is impossible to pay interest out of current earnings. Foreclosures and readjustments take place. There is a general liquidation and reorganization of industry. When interest contracts have been adjusted, then the effect on wages begins to be felt. As long as a manufacturer is struggling to maintain his credit he will keep his factory going, but when he has failed and perhaps been foreclosed, then the factory stops. Men are thrown out of work, and wages--the price of labor--fall. Labor troubles usually mark the end of such a period of readjustment.

This stage marks the end of the crisis and the beginning of a period of depression or “hard times,” which continues for a longer or shorter period. The panic of 1893 was followed by a long-continued depression which lasted until 1897, a period which was marked by low prices and slack work. In 1898 began a revival of business and an era of marked prosperity set in which continued for almost ten years, interrupted only slightly by a “Wall Street panic” in 1903. In October, 1907, a severe crisis occurred, recovery from which, however, has been remarkably rapid. The periodicity which has attended crises in the past is so marked--occurring as they have at intervals of about ten years--that many writers consider them inevitable. As the easiest way to answer this question we may take up three main theories as to the 58 causes of crises.

A much quoted, but now generally discredited, theory is that of W. S. Jevons, a noted English economist, who ascribed crises to sun-spots. Every ten years and a fraction there occur outbursts of electrical and heat energy on the sun, which we call sun-spots. These result in increased heat waves, which affect the crops on the earth, causing enlarged harvests in Europe and the United States and drought and famine in India and the tropics. The large harvests and good prices start a wave of prosperity and speculation, which culminates inevitably in a panic and depression, until a recurrence of the heat phenomenon starts the cycle again. The theory states some undoubted facts, but no causal connection between sun-spots and crises can be traced, as the latter are too irregular and the two do not always coincide. Were this theory true crises would be beyond human control.

A second theory, or group of theories, are those which attribute crises to over-production. Under modern conditions of industry a small group of men direct industry and determine what shall be produced. They try to estimate future demand and to adjust production to consumption, but they often make mistakes. They divert capital into unproductive industries, they produce the wrong things and create a comparative glut in certain lines, and when they cannot sell their goods at a profitable price they fail and precipitate a crisis. Industry must then be reorganized and frequently control be put in the hands of other men. A variation has been given this theory by the socialists, under the leadership of Rodbertus, who insist that the reason that there is over-production is because of the institution of private property. Since the capitalists own all the tools of production they pay the laborers only starvation wages. The latter cannot possibly buy all that is produced and commodities consequently heap up in the warehouses until they are thrown upon the market to be sold at any price. Then a panic occurs and a readjustment of production. 59

The last of these theories regards a crisis as essentially due to a failure of credit. It is seen that a large part of modern industry is carried on by borrowed capital, by roundabout processes and for a distant market and not upon order. That is, the success of a business depends upon its ability to sell its goods when produced. Now the aggregate volume of transactions that can be carried on in a year, so runs the theory, depends upon the efficiency of the credit system; that is, in general, upon the freedom with which banks are willing to loan money to people who engage to repay it in the future out of their ventures. If for any reason the banks reduce this accommodation the amount of business that can be transacted upon borrowed capital is lessened. Either some transactions must stop or prices must fall. Either of these events causes commercial disaster. The contraction of credit makes it impossible to get the goods into the right hands, and so we have the phenomena of over-production in a great many lines. As exchange and transportation have developed and markets widened, crises have become more universal. According to this theory, they are inseparably connected with the use of credit and can be controlled only by a more careful granting of credit by the banks to industrial managers. Another phase of the credit theory is presented by those who insist that the cause of crises is the rhythmic overestimation of the profits to be secured out of certain lines of production, or their over-capitalization. The new enterprises are financed by the banks on the basis of this mistaken over-capitalization, their organizers engage to pay rates of interest which they cannot earn, and the crash inevitably follows. This is often called the over-capitalization theory, and is essentially psychological in its character.

There is no doubt as to the truth contained in this last theory. It helps to explain the rhythmic periodicity of crises. After every 60 period of business depression confidence revives and hope is renewed; overestimation of the success of new ventures is inevitable. Then follows a mistaken investment of capital in certain lines of production, as in railroads in 1884, and a relative over-production at profitable prices of certain commodities. The true explanation seems to be found in a combination of the over-production and over-capitalization theories.

The practical problem that presents itself in this connection is the question as to whether it is possible to prevent the recurrence of crises. In view of the explanation just given it would seem that they must be regarded as unpreventable as long as industry is carried on under the competitive capitalistic system of production and the modern credit system. Moreover, crops differ in amount from year to year and probably always will. Human production and human genius are unequal. Crises may be regarded as the price a progressive society pays for its advance, and they may be expected to recur pretty regularly at periodic intervals. Their disastrous effects may, however, be greatly lessened by wise currency legislation, by greater care in granting credit, and by greater wisdom in the direction of individual effort.