Investment | Basic Economics by Thomas Sowell | Ch. 13 | Part 2
Previously, in the first part of chapter 13, we began by talking about different kinds of investments and how interest rates work. In this part, we'll continue by exploring speculation, inventories, and assessing value.
If you want to see what my previous summaries are for this excellent book, please click here. Otherwise, let's begin!
Disclaimer: Because of the nature of this chapter and (probably) future ones, I must make it clear that NONE of what I write or summarize in any of my blog posts should be construed as financial advice of any kind. This is all here purely for educational purposes.
There are many forms of speculation. The most notable of these is stocks and shares, where people speculate that various companies, both private and public, will either turn a profit or not. However, there are other forms as well, such as movie scripts, works of art, currencies, and even things like looking for natural resources such as oil.
While virtually anyone can participate in speculation, there are, of course, people whose whole careers revolve around it. Like the middle men we talked about before, their job is essentially to speculate on behalf of other people. Since all investments involve risk, these professional speculators should theoretically reduce the risk for others by their research or other work, and thus over time gain profit.
Speculation isn't evil in itself. It's not the same as gambling. When someone gambles, they are creating a risk that isn't there (e.g. playing the slots or poker when you don't have to). Real speculation, on the other hand, acknowledges the inherent risk in a situation (e.g. whether harvest season will boom or bust), and attempts to help people in that situation to make a profit over time.
For example, if a speculator buys the wheat product of a farmer who has yet to plant, the speculator is offering that farmer a guarantee on his or her product at the current time. This allows the farmer not to have to worry about what the future price of the wheat is going to be, he can go ahead and plant. When he harvests and sells it to the speculator, the speculator has now either made a profit because the price has gone up, or made a loss because the price has gone down at the time of harvest. Even though people rarely always profit from every trade, over time, if the speculator understands markets or a specific product well, they will come out ahead. In this way, it can be a mutually beneficial relationship for the producer (i.e. farmer) and the speculator.
Speculators come in all shapes and sizes. As Sowell mentions, there are farmers in third-world countries who engage in global speculation, since it can be very profitable for them to do so. Additionally, they come from all kinds of walks of life, including agriculture, the food industry, fuel and mineral resources, etcetera. Often, those who do it individually are partaking in far more risk, while those who seek professional help are generally better off both financially and psychologically.
Economically, speculation is just another way to allocate resources — in these cases, knowledge — and can be thought of more as a risk management business rather than gambling.
Having inventories (i.e. storage) is another way to allocate the resource of knowledge. After all, if everyone had perfect knowledge, there would never be any waste or lack. But because no one knows everything, a general expectation is to have as much inventory so as to not run out, but at the same time small enough to reduce maintenance costs as much as possible.
Having too much or too little in a business's inventory is basically losing or wasting money. It's all about efficiently allocating resources. If a business has too much inventory (i.e. buying too much to sell), it will often become bankrupt due to too much spending. If it carries too little, it will not be able to effectively serve its customers, who will eventually go elsewhere, and thus again bankrupting the business.
Economically, good times means more predictability. Thus, in these good times, businesses are often able to keep their inventories in check, because they are better able to predict what they need. When things become unpredictable however (i.e. bad times like recessions), businesses often don't know, and so buy up more inventory than is usually needed. This often has the effect of increasing prices, because businesses are buying more and they are selling at higher prices to insure their larger inventories. During such times, even if products are selling a rapid rates, it often doesn't lead to more jobs, since the ratio of inventories vs. selling hasn't changed.
Many goods have lasting effects that are beneficial or detrimental beyond the initial moment of purchase. Thus, while the present value of something is shown in the price of a product or service at the time or purchase, that price may incorporate the potential future benefits or detriments of the good. In things like valuing homes or businesses, this kind of valuation is always in anticipation of such potential futures.
For example, if a city announces building a sewage treatment plant, the houses immediately surrounding where they plan to build the plant will almost immediately decline in value, even if the plant hasn't been built yet. This is because no one wants to live near a sewage plant, now or in the future.
Such future consequences are what make the difference between economics and politics. Economists always have the future benefits or detriments in view, because the value of a product or service or society depends on it. Politicians, however, rarely look beyond whether their policies are keeping people happy so as to get themselves elected. Whether that happiness results in benefits or detriments in society is rarely considered.
In this way, economics is checked by present value.
The discovery and use of natural resources also has effects on its present value. In the case of oil, its present value (and thus, price) is dictated by whether anyone wants to or is able to use it, both now and in the future. This is despite whether the actual resource is predicted to run out, since we don't know if we have discovered all the pockets of oil around the world.
Exploring for and drilling oil is extremely costly. this is because even exploring for oil has to obey the laws of supply and demand. If you already have more oil than you want to find, you may just keep using the oil you have, instead of looking for more. But as existing supplies of oil are slowly used up, people begin to look for more.
Oil is an interesting topic, because the average person is inundated with tales of it being non-renewable. This is true. Technically, however, the sun is also non-renewable. But the fact is that we don't really know just how much oil there is in the earth. We're constantly finding more and more pockets as we explore.
This is similar to the use of iron and coal (to make steel). Despite both iron and oil being used in abundance, and even more in the past century than ever before, we still keep finding more iron ore reserves, just as we do with oil. But no one is really making a fuss about running out of iron, despite steel being used in large quantities even today.
Of course, ultimately, these resources will eventually run out. The problem comes when we try to predict when they will do so. Since we don't know how much there is in the earth, this is basically an impossible task. All we do know is that technology improves, thus enabling us to find more and better ways to extract and use the resources we currently have. Prices for these resources, in the meantime, will always be subject to the laws of supply and demand.
In this way, politics meets economics in an interesting way. While politics is concerned with the quantities of a resource (again, a generally unknowable problem), economics is concerned with prices, cost, and present values. As Thomas Sowell says, these things must also “be considered if practical conclusions are to be reached.”
It's not unexpected to think of crypto when talking about speculation these days. In fact, the two are almost synonymous, given the state of cryptocurrency today.
Sowell's take on speculators in particular — that professional speculators are basically middle men who take the risk away from speculation for the general public — is intriguing. It would explain why so many institutional investors have not yet dipped their toes into the blockchain space.
In the present climate, especially given today's (12/17/2020) very volatile market, it's difficult to see where any professional speculator would be able to de-risk their clients. Almost every single crypto asset is tied to Bitcoin. Thus, when Bitcoin rises, everything generally rises. If Bitcoin falls, rarely will another coin rise. When the entire market is so correlated to a single asset, there is actually no stability. Investors cannot de-risk, because there is no asset they can exchange from or to in order to alleviate the risk.
That is, until you consider stablecoins. Stablecoins could be the de-risking asset. After all, because of just how liquid and easily they are to exchange, their volatility is less than even currencies traded on 4X markets.
Yet, I think stablecoins do something very strange in the crypto space that isn't reflected in normal market exchanges. At least, not on the same timescale.
Since stablecoins are so liquid and stable, and the rest of the market is correlated to Bitcoin, there is no need for institutional investors to get into other coins outside of Bitcoin. It's actually quite rare (and unpredictable) for a coin to rise more than Bitcoin. It's even rarer for that coin to not fall back to below its peak before Bitcoin overtakes it in rising. Why would institutional investors put much into other coins, when Bitcoin is much more predictable, and thus reliable?
In this case, the slowness of Bitcoin (and in some ways Ethereum) is actually an advantage. Because it's so slow, and costs so much to transfer around, investors are incentivized to hold onto it more than trade it. This is becomes an active component in reducing supply, thus increasing its value.
Additionally, in most investors' minds, even institutional ones, Bitcoin is basically synonymous with all of crypto. If you were to ask a financial guru, some may have heard of Bitcoin, and even a couple will know about Ethereum or XRP. But the rest of the space have never even heard of USDT or USDC or DAI, let alone the plethora of other coins out there.
And so, we have come upon the main problem for altcoins. If pro speculators are indeed a sort of de-riskers, as Sowell says, then I think altcoins actually have a really long way to go before they can de-couple from Bitcoin. Most likely, the only way to do this is to have such a high volume of trade due to the utility of the altcoin that such utility would keep the coin afloat, even when the price of Bitcoin dumps.