How speculation became respectable: early theories on financial and commodity markets

Abstract

Around the 1860s, technological advancements in transport, communication and warehousing, contributed to the emergence of world markets for many staple commodities (e.g., cotton, wheat). At the same time, the economic needs of the companies involved in this commercial revolution stimulated the growth of markets for securities and shares. The growing complexity of global markets created propitious conditions for the emergence of a class of professional speculators. Initially, the frenzy that accompanied this process seemed to confirm traditional views, which identified speculation with gambling. With time, however, a new scientific literature emerged. Focussing on the last decade of the nineteenth century up to the early 1920s in the UK and US, our analysis brings to light how contributors to this new literature made the case for speculation against conventional wisdom. In so doing, they were not blind to the downside effects of speculation as a possible source of resource misallocation. Nevertheless, they chose to emphasise its constructive side, basing their arguments on the case of commodity markets, where the idea of a long-run equilibrium price to be attained by speculation appeared plausible. They employed the same arguments in the case of the stock exchange, downplaying differences between the two markets although they were well aware of them. Thus economists played a crucial role in convincing policymakers of the beneficial effects of the new speculative instruments, against the hostility of a large part of public opinion. Futures and their use for the purpose of short selling, the most controversial of the new trading practices, were gradually accepted and regarded as legitimate commercial transactions. On the other hand, options continued to attract suspicion for a long time and to be kept in a limbo between disreputable and acceptable operations. The paper expands the existing literature on the subject by providing the first systematic reconstruction of the shared analytical arguments that, in spite of differences between authors and contexts, contributed to making speculation gradually accepted in the UK and US.

Keywords:

• Speculation
• futures
• financial history
• Henry C. Emery

JEL CODES:

• B17
• B31

1. Introduction

Around the 1860s, technological advances in sea and land transport and communication (e.g., the laying of the Trans-Atlantic cable in 1866) contributed to the emergence of world markets for many staple commodities, and in particular cotton and wheat. By establishing official grading systems rigorously defining the qualities of the deliverable, contracts could be drawn up for the provision, within a specified future period, of given quantities of commodities which possibly had yet to come into existence. Concomitantly, the growing financial needs of the companies involved in this commercial revolution stimulated the expansion of financial markets, originally devoted to trading public debt securities and a few joint-company stocks.¹

From the growing complexity of global markets emerged a class of professional speculators capable of anticipating market conditions, which local traders might find difficult to foresee and assess, and of relieving producers and manufacturers of the risks deriving from consequent price fluctuations.

Initially, the frenzy that accompanied the transformation of markets seemed to confirm the traditional views, which dated back a long time (Banner 2017) and identified speculation with gambling, a disreputable and often illegal zero-sum game, enriching the few to the detriment of the majority. Many condemned speculation for increasing inequality, enticing people away from legitimate enterprise, stimulating their greed with the promise of quick riches, and exposing inexperienced small investors to the risk of bankruptcy.²

With time, however, the growth of stock exchanges and organised commodity markets gave rise to a new literature, which emphasised the positive connection between speculation and business, and the distance of both from gambling.

Is there any difference between speculation and gambling? The terms are often used interchangeably, but speculation pre-supposes intellectual effort; gambling blind chance. Accurately to define the two is difficult […] The former has some elements of chance; the latter some of the elements of reason. We define as best we can. Speculation is a venture based upon calculation. Gambling is a venture without calculation. The law makes this distinction: it sustains speculation, and condemns gambling. All business is more or less speculative. The term speculation, however, is commonly restricted to business of exceptional uncertainty. The uninitiated believe that chance is so large a part of speculation that it is subject to no rules, is governed by no laws. This is a serious error. (Nelson 1902: 21 quoting an unknown writer)

The proportions of this new literature are impressive. Focussing on securities and the stock exchanges, for example, and confining himself to works in English, Huebner (1910) lists 125 general works on the subject, 61 legal sources (treatises and major court cases), and a great many leading magazine articles, handbooks, manuals, financial periodicals and news services. This new literature saw speculation as a permanent and necessary feature of organised markets and discussed it taking two main lines. One line, of a vernacular nature, provided investors with practical information about markets, warnings against traps on the path of inexperienced investors, and considerations on market psychology.³ Thus, it aimed at transforming speculative investing into a reputable activity, based on rational evaluation of probable risks and profits by well-informed savers (Preda 2009). The second line in this literature, of an academic/legal nature, addressed speculation from a system-wide perspective, emphasising the social gains and its contribution to the smooth working of the economy through enhancement of the allocative function of prices. Both lines, with some inevitable overlapping, distanced themselves from traditional opinions about the evils of speculation, without dispensing with them altogether.

This work focuses on the second line, and in particular on the British and US literature between the last decade of the nineteenth century and the early 1920s. During this period, as we show in this paper, academic experts in the UK and the USA developed an “idem sentire” about speculation on organised commodity and security markets, in spite of substantial differences between the two countries in the context of transformations of the world economy.⁴ Our research expands upon the existing literature on the subject,⁵ by providing the first systematic reconstruction of this idem sentire and the crucial role it played in overcoming resistance by legislators and public opinion against the use of the new speculative instruments, perceived by many as ruinous for people and businesses.

We regard the arguments elaborated in this context as an early, relevant and successful exercise in persuasion, based on three elements. First, emphasis on similarities between futures trading and arbitrage in space led to underlining the contribution of the new instruments to efficient resource allocation in the commodity market. Second, downplaying differences between commodities and shares made it possible to extend arguments in favour of speculation to the stock exchange. Third, episodes of fraud and market manipulation were presented as exceptional and of little consequence in the long run. It will not escape notice that this way of justifying speculation inaugurated a tradition which has seen economists presenting novelties on financial markets as spontaneous and beneficial developments of already accepted practices, which regulators, excessively worried by a few market scandals, should not oppose in the general interest.⁶

The second contribution offered by this paper is to show how early arguments in defence of speculation, shared by academic experts in the UK and the US, were not exempt from doubts about market efficiency, although subsequently they were dropped. Indeed, early defenders of speculation were not blind to the risk that, apart from fraud and manipulation, interaction between professional and amateur speculators might obscure “fundamentals” for a significant period of time, especially in the case of securities. This gave rise to reservations about the advantages of some speculative instruments (e.g., options) and about easy market access for small investors, paving the way to what much later became a clear division between mainstream and heterodox positions on speculation. The former maintain substantial confidence in the constructive role of speculators in directing markets towards efficient resource allocation. The latter, aware of differences in power and information and doubtful about the relevance of “fundamentals,” regard destabilising speculation as the product of the normal functioning of the markets and not a consequence of episodic fraudulent behaviour (Hayes 2004). In the period we examine, we show that the dividing line between supporters and detractors of speculation was not as clear-cut as it would become after the publication of Keynes’s General Theory with its description of “casino finance” (Keynes 1936, Ch. 12). Given the importance of Keynes’s ideas, it is not surprising that many recent contributions on the early Anglo-Saxon theory of speculation revolve around their origin and development. A large literature focuses on this topic and in particular on Marshall’s influence on Keynes in connection with H.C. Emery (Dardi and Gallegati 1992; Bateman 2006; Lawlor 1994, 2006; Carabelli and Cedrini 2013).⁷ It is beyond the scope of this paper to enter into the analysis of Keynes’s ideas, which in the period we examine were still forming and certainly not as influential as they would become in later years. We acknowledge the influence of Emery’s book (Emery 1896), based on his Columbia PhD thesis, which has been credited since its appearance as being “without doubt the most thorough work on speculation written in English” (Ryan 1902, 337). Emery’s reputation as one of the first academic experts in the economic and statistical analyses of speculation lived on in the following decades.⁸ However, as we emphasise in this paper, Marshall and Emery’s contributions are best understood in a wider context, where expert opinions on speculation evolved in parallel with the institutional and regulatory environment. A reconstruction of this context has required combining chapters in books on political economy (e.g., Hadley 1904; Young 1999 [1924]; Marshall 1919), treatises (e.g., Giffen 1877; Brace 1913), articles specifically dealing with speculation on organised market (e.g., Emery 1900; Lavington 1912, 1913) and official sources.

Based on these sources, which offer a comprehensive overview of early theories on organised speculation formulated in the Anglo-Saxon world, the rest of the paper is organised as follows. In Section 2, we explore the earliest examples of the use of scientific arguments in defence of speculation in futures on commodity markets. The main argument in this respect is based on a metaphor that sees speculation as the “transport” of commodities over two separate points in time. Like transport in space, speculation levels prices over time, enabling producers and consumers to protect themselves against intertemporal price risks. In Section 3, we show how the extension of these arguments from commodities to stocks hinges on emphasising similarities between the two asset classes, while downplaying differences between them regarding, in particular, the notion of equilibrium price and the relevance of asymmetric information. Section 4 explores how early theories about speculation on the stock exchange and commodity markets provided a basis to defend short selling against public opinion, vested interests and in some cases legislators and government, but they did not go as far as defending the use of the options. Section 5 concludes the paper.

2. From transport in space to transport in time: speculation on organised commodity markets

The creation of world markets as a consequence of innovations in transport and communications around the 1860s triggered a structural change, which was not confined to the growth in the number and size of transactions nor to the considerable reduction in the weight of non-speculative relative to speculative transactions. The real change was the rise of a class of professional speculators whose main activity was to foresee and take advantage of price changes as traders only occasionally did: “the peculiar feature is not that speculation has increased, for that is a necessary accompaniment of increased trade, but that speculation has become the business of a special class […] instead of all traders speculating a little, a special class speculates much” (Emery 1896, 108–109).

In their efforts to defend speculation against accusations of being a harmful activity no different from gambling, the early authors presented speculation in stocks as a mere extension of the more familiar and easily defensible speculation in agricultural commodities, where the practice by public bodies of redistributing staple goods over time had been justified by natural fluctuations in supply and had been common since very ancient times. In this respect, the prudent sovereign who accumulated grain in times of abundance to hand it out to the people in times of scarcity stands as the first example of benevolent speculator acting in the public interest. In the same context, the greedy merchant who hoarded scarce commodities to drive up their prices personified the evils of speculation.

The intertemporal dimension related to the separation between sowing, harvesting and consuming, and the presence of inescapable fluctuations in prices linked to changes in available supplies over the year underlay the idea that speculation in agricultural commodities was a natural economic institution. Indeed, confronted with these factors, as from the sixteenth century European traders organised markets which made ample use of forward contracts, the market of Antwerp being the most famous example in this respect.⁹

Two main advantages were identified as resulting from the activities of professional speculators: reduction in the breadth of price fluctuations and insurance against price risks. Speculation stabilises prices by smoothing out temporary divergences between demand and supply, thus performing a service whose utility, following a largely adopted analogy, is comparable to that of means of transport. Means of transport transfer commodities from one point in space to another, from where they are abundant and prices low to where they are more needed and prices high.¹⁰ Similarly, following the price signals, speculation transfers commodities from one point in time to another.

The speculator of to-day makes his money chiefly by taking advantage of differences of price between different times, rather than between different markets. It is not so much the difference in the price of wheat in Chicago and in Liverpool which furnishes the source of his profits, as the difference between its price in Chicago this month and next month (Hadley 1904, 105)

The fact that futures contracts rarely imply actual delivery of the commodity does not diminish their contribution to reaching the equilibrium price. Arguments in defence of speculation on commodity markets were honed to address the recurrent objection that speculation, making use of futures contracts, artificially boosted demand and supply, driving prices away from fundamentals. Against this view, which often enjoyed popular support, it was argued that demand and supply on the part of the speculators are no less “real” in terms of their impact on the market than demand or supply by producers and consumers who claim delivery of the commodity. In this respect, speculative activities are part of the process which leads prices to the level which reflects the real needs of the economy, directing resources towards their most productive uses, without depressing (inflating) prices, as producers (manufacturers) often complained. Far from disturbing the pricing mechanism, speculation is seen as enhancing its effectiveness. Building on a large information network and endowed with superior skills in interpreting information, professional speculators foresee equilibrium values and lead prices to fluctuate around them.

If the speculator foresees a rise, he buys wheat to-day with the hope of selling at an advance. If he foresees a fall, he contracts to make future deliveries at to-day's prices, in the hope that he can secure the means of filling those contracts at rates low enough to leave him a profit. This is the type of transaction which forms the bulk of the business on all the leading exchanges of the world. When such speculation anticipates an actual demand, it is of great service to the community (Hadley 1904, 105).

Competition among speculators enhances the process of reaching the “true” price, making it faster, more accurate and less costly in terms of gathering and processing price-sensitive information.

Therefore, defenders of speculation regarded price volatility, and in particular price fluctuations between minimum and maximum points, as related to the intrinsic characteristics of commodity supply and demand and not determined by speculation itself. This led them to reverse the causality relation: it is not speculation that causes volatility, but “natural” volatility which causes speculation. Speculation is particularly effective in smoothing out seasonal variations in prices related to the agricultural production cycle and bringing about adjustment to a new price, following unexpected events, slower than in an “excited market.” Consequently, price fluctuations may become more frequent as a result of the reactions of the market to the continuous flow of information, but may also be less violent, like “countless waves of the sea in fair weather” compared to “billows in a storm” (Emery 1896, 121).

Emery provides some data to corroborate these claims about the stabilising effect of speculation on prices.¹¹ At the same time, however, he claims that “statistics can hardly be used to furnish either proof or disproof of the foregoing estimate of the effect of speculation. Any general opinion on the subject must rest rather upon its own reasonableness than upon statistical verification” (Emery 1896, 123 our italics). This claim strengthens the case for theoretical justifications of the price-stabilising effect of speculation, given the impossibility of reaching conclusive proof by comparing data on commodities traded in speculative markets with other commodities, or market conditions before and after the onset of professional speculation.

But even if the price stabilising effect of speculation were denied, as it often was at the time, a second line of defence emerges in the literature and points to another benefit. This is the insurance service that futures trading by professional speculators provides to non-speculative agents who need hedging facilities against the risks of price fluctuations. One of the accusations brought against speculation has always been that of creating risk instead of reducing it. In this respect, it would partake more of the nature of gambling—gamblers assume an unnecessary risk exclusively for their own amusement—than of insurance, which protects against unavoidable risks. The distinction is not always clear-cut, but pro-speculation literature argues that the price of commodities is naturally unstable because supply is irregular and the risk of a change in price is a real risk against which traders, producers and manufacturers need protection. The classical example, which we encounter in Marshall (1919, 259–260), Lavington (1913, 40–41), Young (1999 [1924], 330–331), is that of the manufacturer who buys raw materials spot and sells the same amount at the same price for future delivery for the time when the manufactured goods are ready for sale. If the price of raw materials falls and the price of the manufactured goods goes with it, what the manufacturer loses on selling his products will be gained by the rise in the price of the future; if the price rises, the loss on the future will be offset by the higher price of the manufactured goods. As a result of this insurance activity, the margin between producer and consumer prices narrows and non-speculative trading profits diminish in line with diminishing risks. At the same time, the possibility of hedging against adverse price fluctuations increases the value of stocks of commodities as collateral, facilitating the holding of them. The conclusion is that “speculation is not an unnatural device of man’s invention, but a normal means of meeting economic needs” (Emery 1896, 294).

The possibility that speculators might contribute to market efficiency by providing hedgers with insurance services was also explored by Knight (1921), who argued this activity might lead to reduce individual risk and not only to transfer it from one party to the other.

There is in this respect a fundamental difference between the speculator or promoter and the insurer, which must be kept clearly in view. The insurer knows more about the risk in a particular case—say of a building burning—but the real risk is no less because he assumes it in that particular case. His risk is less only because he assumes a large number. But the transfer of the ‘risk’ of an error in judgment is a very different matter. The ‘insurer’ (entrepreneur, speculator, or promoter) now substitutes his own judgment for the judgment of the man who is getting rid of the uncertainty through transferring it to the specialist. In so far as his knowledge and judgment are better, which they almost certainly will be from the mere fact that he is a specialist, the individual risk is less likely to become a loss, in addition to the gain from grouping (Knight 1921, 258–259).

The two positive functions of the speculator on commodity markets, of the prophet and of the risk-bearer, to borrow Keynes’s famous distinction (Keynes 1923, 260), are given equal weight in the early scientific literature on speculation. The speculator is a prophet thanks to the knowledge of the market he has acquired and feeds with a constant flow of information which he collects and rightly interprets. He is a risk-bearer thanks to his capital, which gives him broader shoulders to bear the risk from which he relieves producers and manufactures. His profits derive from both activities even if it is hard to reconcile them with the then prevailing theory of income distribution based on the marginal productivity of factors:

The assumption of speculative risks is a special function, as shown firstly by the fact that it is not a necessary part of the function of any of the three classes commonly recognized, the labourers, the capitalists, or the entrepreneurs; secondly, by the fact that it is the sole function of a class which does not have the characteristics of any of the classes just named […] They are not determined by any marginal efficiency or marginal sacrifice of the speculators (Emery 1900, 112–113).

If justifying the profits that speculators derive from anticipating changes in prices is difficult in general, it becomes impossible if those profits are seen as deriving from market manipulation by the speculators themselves. The early scientific literature on speculation does not rule out the possibility of professional speculators occasionally interfering with prices in their own interest, e.g., by “cornering” the market.¹² It tends, however, to downplay the relevance of these phenomena in a market which was becoming too large to be controlled by individuals and too transparent to keep the considerable purchases (and sales) required by manipulation secret for a long time. In this context, manipulation of commodity markets “requires immense capital, coolness and courage, and the greatest practical skill” (Emery 1896, 454) and even when it occurs, its effect on prices, which in the end depend on demand and supply, is necessarily transitory.

The increasing dimension of world markets is seen as the best defence against corners and its openness protects non-speculative agents from fraudulent spreading of false information. At the same time, it can be an obstacle to those speculators who try to act as contrarians when they think that markets are not governed by fundamentals. Contingencies can be such as to make it too costly for professional speculators to hold large amounts of commodities or fund equivalent positions on the futures market. In this case, private speculators fail to perform their price-stabilising functions. This is the conclusion that Keynes reached several years later in a different historical and intellectual context:

Experience teaches those who are able and willing to run the speculative risk that when the market starts to move downwards it is safer and more profitable to await a further decline […] Even if it would pay [the speculative purchaser] to buy at the existing price on longer-period considerations, it will often pay him better to wait for a still lower price (Keynes 1938, 449).

This led him eventually to lose confidence in the price-stabilising power of speculation, which in turn led him to propose the establishment of publicly managed buffer stocks for the main commodities traded on the world market, as discussed elsewhere (Paesani and Rosselli 2014).

3. From commodities to securities: professional and amateur speculators on the stock exchange

As Marshall remarked, securities, like commodities, are homogeneous, not quickly perishable and subject to considerable price fluctuations. Strong competition on both sides of the market is another feature which the stock exchange shares with most commodity markets (Marshall 1919, 256). Observing these similarities, the early authors extended their defence of speculation from commodities to securities, albeit with significant qualifications.

Regarding the contribution of speculation to steadying prices, the main difference between commodities and securities concerned the possibility of identifying a normal price reflecting fundamentals. With commodities, information about demand and supply, storage and transport costs and other observable factors made it fairly easy to estimate that price and anticipate its changes. With securities, on the other hand, dependence of prices on expectations of future earnings made it more difficult to do so.¹³ Insofar as professional speculators succeeded in buying (selling) stocks on the correct anticipation of rising (falling) price levels, this would hasten market adjustment and lessen the extent of price fluctuations. Over time, this would lead safe securities with a steady price record to emerge and signal themselves to investors in search of sound investment.

It is a great mistake to think that steady securities are independent of the speculative market. It is true enough, as often urged, that there is little speculation in the securities of many first-rate corporations that are listed on the exchanges. […] [M]any of the quiet securities of to-day have been active enough in the past. Each new enterprise must stand the test of criticism, and unless unusually sound will be the subject of active speculation. […] The particular investment has been put through the ordeal and come out whole. It then becomes a field for the private investor (Emery 1896, 153).

The presence of professional dealers (such as “jobbers” on the London Stock Exchange), who hold stocks of securities, “to which they add when sales are pressed, and which they diminish when purchases are in excess” (Giffen 1877, 39), enhances the effectiveness of this selection process. In this way, professional speculators not only stabilise prices and insure against market risk—two roles they also perform on commodity markets – but they also increase the liquidity of securities and thus their value as collateral, reducing the premium which investors require.

Awareness of these advantages is to be seen in early theories of speculation, and in particular in the work of Frederick Lavington who analysed the risks faced by capitalists in supplying funds to business. If organised speculation did not exist, the supply price of capital would be higher since the capitalist should be rewarded both for uncertainty about future returns and for financial insecurity, i.e., the risk of being unable to meet his payment commitments.¹⁴ Holding liquid reserves is a way of hedging against financial insecurity but it implies a loss of interest. Dealers offer a more efficient solution. They do so by increasing the marketability of securities and the availability of resources in case of emergency. The income of dealers arises partly from this service and partly from their ability to correctly foresee market movements thanks to superior intelligence (Lavington 1913, 41–43).

Lavington is aware that if a dealer succeeds in monopolising price-sensitive information, he may be tempted to exploit this advantage. Fostering competition among dealers and circulating information lessens this risk but is not free from problems of its own. Heightened marketability, driven by a rising number of dealers, attracts new investors into the market, who are often unexperienced and not equipped to deal with financial risks. As the presence of amateurs increases, so does the level of noise and the number of fitful speculative operations.¹⁵ In this context, the “unreasoning excitement of a crowd,” triggered by amateurs observing the moves of professionals, can lead prices to deviate persistently from fundamentals. As Irving Fisher observed

The error, whatever it is, when committed by a person of influence, is like an infection; it is caught by hundreds of others and transmitted to thousands. A great mob of easily led investors, eagerly searching for "straight tips" which may bring instant wealth, make their mistake in common, and when the mistake is disastrous they try, en masse, to escape. A sudden rush of all the passengers on a ferry-boat to one side will produce a "list" in the boat's position, and sometimes cause it to capsize, though the independent movement of the individual passengers will seldom or never produce disaster (Fisher 1906, 296)

Analysis of the problems stemming from interaction between professional and amateur speculators is central to all early theories of speculation as well as early descriptions of stock exchanges.¹⁶ Part of the problem consists in outright market manipulation, which is more likely to affect securities newly issued by companies without a solid reputation.¹⁷ The market for these securities is likely to be relatively small and therefore more easily rigged. Besides, security prices depend not only on sensitive information, which may affect expectations about future earnings and dividends, but also on decisions taken by interested parties. Company directors may take action to boost the company’s security prices, possibly triggering spurious speculative outbursts. These factors enhance the activities of “malignant” speculators, who manipulate prices in their interest, distorting the market to the detriment of unaware investors and amateurs.¹⁸

Apart from deliberate manipulation, a second type of destabilising speculation can stem from interaction between professional speculators and amateurs. Citing the opinion of Hartley Withers, journalist and stock exchange observer, confirmed by that of businessmen on the London Stock Exchange, Lavington notes that

[D]eliberate manipulation by powerful interests is of little importance in the London market. […] The evil appears to arise to a far more important extent from the continuous qualitative changes in many securities, and the consequent extreme difficulty in estimating their value. As a result of this any change of price originated perhaps by professional speculators, re-acts upon public opinion and produces an unreasoning speculative activity which results not in correcting, but actually in reinforcing that change (Lavington 1913, 49).

In this context, security prices lose their directive role altogether amidst bouts of excess volatility. Thus, we enter a world where the security prices respond to conventional opinion rather than to objective (if less than perfect) information about the earning potential of the underlying securities.¹⁹

The presence of big institutional investors, with their knowledge of markets and adequate financial strength, provides the first line of defence against the risk of “unreasoning speculative activity.” Moreover, the sheer force of numbers, operating on the buying and the selling side, makes it more likely that price movements in one direction will trigger movements in the opposite direction.

Combining these arguments takes us back to the idea which prevailed among economists and policymakers that while manipulation and bouts of excess volatility are possible, their importance should not be exaggerated. The conclusion was that speculation maintains its directive role and “cannot be curbed without damaging the machinery by which stock exchanges carry out their important social functions.”²⁰

The fact that it was neither possible nor advisable to separate speculation from other forms of investment crops up repeatedly in policy debates on the functioning and role of organised markets from the 1870s onwards. Futures and their use for the purpose of short selling, the most controversial of the new trading practices, were gradually accepted and regarded as legitimate commercial transactions. On the other hand, options continued to attract suspicion for a long time and to be kept in a limbo between disreputable and acceptable operations.

4. The debate on speculative instruments: the case of short selling and options

While theory justified speculation, extending to the stock exchanges the arguments in favour of speculation on commodities, the actual development of futures markets as they emerged in the 1870s, followed the opposite route: from securities to commodities. Over the nineteenth century, commodity transactions became increasingly disconnected from the actual physical commodity bought and sold. First there was the practice of employing only samples of the commodity, while leaving the bulk of it in the warehouses and transferring only the warehouse receipts to the purchasers; trading by samples allowed for buying and selling the commodity which was yet “to arrive” at the market of destination on the exchanges. However, even if the traded amount was physically in a different place, the seller was still the owner, albeit temporary, of a material good. With time the dematerialisation proceeded and the standardisation of commodities came together with the standardisation of contracts. The former made the object of the transaction not a commodity represented by a sample but a mere description of its quality assessed by third parties according to a definite scale; the latter, by limiting to specific quantities and dates the amount traded and the time of delivery, left price as the only variable to be determined in the transaction. At this point “By rendering commodities fungible, commodity trading came to resemble securities trading, and exchanges consciously built upon these practices to create the new system of futures trading.” (Engel 2015: 294)

The transformation of the Chicago grain market from forward to futures trading occurred almost simultaneously with the New York cotton market. The beginning of organised trading in grain futures in Chicago can be dated to 1865, when the Board of Trade established rules concerning contract settlements and grievance procedures (Poitras 2003, 34). Approximately in the same years, futures trading in cotton began in New York (Santos 2008). Between 1875 and 1905, organised commodity futures exchanges appeared in the US, Canada, Europe and Latin American (Levy 2006, 308, fn. 4), although Chicago in the US for grain and Liverpool in the UK for cotton acquired early prominence for volumes transacted and the role of grain and cotton in the global economy.

Widespread public opinion regarded this expansion with hostility. Agricultural producers resented the fact that prices were made in foreign markets dominated by dealers in futures, depriving them of a say they felt they were morally entitled to. They accused speculation of depressing prices, flooding the markets with goods that did not yet exist. Industrial manufacturers (e.g., millers) expressed similar concerns about speculative purchases leading prices to rise.

The producers’ opposition to futures markets was particularly fierce in the United States, where the protests calling for the suppression of futures markets eventually found the support of some political forces at both state and federal level. Several states attempted to make short-sales and futures contracts illegal by equating them to gambling, while legal cases arising from conflicts between brokers and clients called into question the legitimacy of “time contracts.” The issue finally reached Congress. With the support of the Populist Party launched in 1891, in 1892 two Congressmen, Hatch and Washburn, introduced a bill which was known as an anti-option bill but actually aimed at the suppression of futures markets. Thousands of petitions calling for the prohibition of “speculative gambling in grain” (Lurie 1979, 109) were addressed to the committee which oversaw the related hearings and bore the telling title of “Committee on Fictitious Dealings in Agricultural Products.” The bill received the support of the majority of the Congress but did not pass for technical reasons. Emery wrote against it, defining the bill “a blow at an essential part of the modern machinery of commerce” (Emery 1895, 84). After all, Emery merely gave authoritative expression to the point of view of the Chicago Board of Trade²¹, to the effect that speculation cannot affect long-run prices, and that “checking the evil while retaining the good” was possible through self-regulation and internal rules of the Exchanges to punish fraudulent behaviour and drive away small incautious speculators. The case against the anti-option bill drew strength from Germany’s experience and the activities of the German agrarian party, which the American populist movement tried to imitate. In 1896, in the context of a sharp fall in commodity prices (notably sugar and grain) followed by the bankruptcy of several banks, legislation was passed in Berlin prohibiting the purchase and sale of grain and flour futures, mandating a public register of all “speculators,” and prohibiting term-dealing on mining and industrial shares. In 1909, after much turmoil, with increased fluctuations in prices and migration of German futures trading to London and Antwerp, the law was repealed for securities and in 1911 for commodities. This case was frequently quoted as an ante litteram “natural experiment,” which showed how the abolition of futures was not only impossible but, far from providing the much sought-after price stabilisation, achieved the opposite result (Emery 1896; Marshall 1919, 261).

The end of the populist movement and, above all, a reversal of the price trend put an end to attempts to ban futures trading in the US. Legitimisation of futures contracts was definitively sanctioned by the US Supreme Court in 1905 (Levy 2006). But the theory had already provided strong arguments in defence not only of futures contracts in general, but also of the controversial practice of the short selling that they entailed. It was common practice among economists to defend the idea that short selling contributed to reducing the size of price fluctuations (Brace 1913, 65). The defence of short selling revolved around two arguments. Firstly, in a market dominated by bulls, the possibility to sell short by knowledgeable dealers anticipating price falls might curb price rises and speed up adjustment once the market turns around. In this way, short selling can reduce the risk of speculative bubbles. Secondly, short sales, even if taking place in a bear market, still involve a forward purchase either of goods for delivery or futures contract of the opposite sign. These purchases place a floor below prices, preventing them from falling with no limit. Indeed, Marshall himself, in his notes on Emery’s book, approved and added fuel to Emery’s opinion that short-selling is effective in bursting speculative bubbles:

As Emery says p. 121 shortsellers do good in checking rise of price due to a wave of confidence: so when the fall comes it is less than otherwise. But Emery seems to treat this as a point; it is the point. If land could have been shortsold Melbourne crisis would have been less […][Emery] goes too far when he says ‘In a real estate boom only the sanguine affect the price on the rise and only the gloomy on the fall’. But he is right in saying that ‘at one end prices are more recklessly inflated and at the other more needlessly depressed than would be possible in an organised speculative market’.

The example of land speculation in Melbourne was especially dear to Marshall as particularly illuminating in showing how short selling can prevent bubbles. If it had been possible to sell land short “as soon as prices had gone a little beyond their reasonable level, the sellers would have enriched themselves, and conferred on Melbourne as a whole a benefit many times as large as their own gains” (Marshall 1919, 265, fn. 1).

On the stock exchanges speculation met with as much suspicion as on the commodity markets. In the United Kingdom, in 1860 Parliament repealed the Barnard Act of 1734, which outlawed forward dealings in shares if the seller did not maintain with continuity possession of the shares until completion of the transaction. Subsequently, in the London Stock Exchange “much of the trading was of a technical or speculative nature, operators buying what they could not afford or selling what they did not possess in the expectation of reversing the deal for a profit” (Michie 1986, 180). Given that transactions were settled fortnightly and monthly, and trading was “for the account,” i.e., on margin with no need to pay or make immediate delivery, investors were encouraged to purchase (and speculate on) stocks. Although it was only in 1895 that courts decreed futures trading as a legitimate commercial transaction which was entitled to enjoy the protection of law, the London Stock Exchange claimed that self-regulation was sufficient and that no government intervention was needed. Indeed, in 1878 the parliamentary Commission on the London Stock Exchange, which had been appointed in response to public complaints, had reported that

we recognise a great public advantage in the fact that those who buy and sell for the public in a market of such enormous magnitude in point of value, should be bound in their dealings by rules for the enforcement of fair dealing and the repression of fraud, capable of affording relief and exercising restraint far more prompt and often more satisfactory than any within the reach of the courts of law. (BPP 1878, 5)

And the same committee had concluded that:

the dealers with whom the large majority of purchases and sales are effected are entirely unable, at the time of making them, to distinguish between bargains made with them for the purpose of speculation and those which arose from the desire to invest money or to sell securities. In such a state of things we do not think it is practicable to make bargains entered into for the purpose of speculation or gambling any more illegal than they are at present and we do not propose any change in the law. (BPP 1878, 21)

This position remained substantially unchanged in the following decades.

The obligation to actually deliver the security or commodity implied by any future contract, even if rarely exercised, justified their use (and legalisation). If this was the case, contracts which allowed one of the parties to unilaterally avoid the obligation to deliver or which did not provide for any delivery at all, were bound to raise doubts. This was the case of options—or rather “privileges” as they were called at the time—which remained in a legal limbo much longer. Many manuals (e.g., Castelli 1877; Higgins 1896) described them in detail as evidence of the paramount role they already played in organised markets, but those engaged in their trade failed to enjoy not only the protection of law but even that of the internal rules of the exchanges. The Chicago Board of Trade, like other exchanges, could not enforce a contract based on a “privilege.” Options were forbidden by the law, banned from the floor of the commodity exchanges and traded after hours. The reason for this hostility was their association with fraudulent practices, although their utility as insurance was recognised (Emery 1896, 145). Options exposed sellers to potentially unlimited risks if prices did not fulfil their expectations. Sellers, whose number was limited by the size of the funds required by this trade, would therefore enter the option market either posting quotations far from the ruling price, in order to reduce the risk of the option being exercised, or, when doubtful that the markets would move in their preferred direction, did not hesitate to resort to manipulation to achieve this result. Buyers, on the other hand, could be tempted to over-trade by the possibility to exercise the option if it were in their interest to do so, paying at worst the small option price. Observers regarded these conditions as propitious to gambling. Emery, after considering the few advantages that options could bring to the business community, concluded that in spite of its possibilities for better purposes “The privilege may be safely regarded as an unnecessary and undesirable form of contract” used by “the least desirable element in the market and largely for ‘gambling’ purposes” (Emery 1896, 185–186). Marshall once again follows him:

There are a few cases in which dealings in options are part of legitimate trade. But there appears to be more force in the arguments for prohibiting them by law, than for prohibiting a simple buying or selling of futures; for they are relatively more serviceable to the gambler and the manipulator than to the straight forward dealer. (Marshall 1919, 257, fn. 1)

Part of the opposition to options, even by those who endorsed futures, was that options allowed people endowed with little capital and often just as little judgement and information to become “foolish gamblers” adding noise and confusion to the market.²² Combining these arguments with general distrust of organised speculation, as discussed above, goes some way towards accounting for the hostile attitude of legislators to options. A Milwakee court declared them legal in 1902, but hostility against them remained. In 1922, for example, U.S. Congress enacted the Grain Futures Act, which de facto prohibited options (Young 1999 [1924]).

However, the fact that options enabled small speculators with little capital to enter the market was not perceived as a problem by all. Brace (1913), for example, considered, “as a question of practical morals” and from the point of view of the “social value of organised speculation”, that options enabled unskilled traders to enjoy the pleasure of “playing the market”, knowing in advance the maximum loss they might incur. However, it would take time to find scientific arguments to justify options on the basis of their economic benefits. By the end of the nineteenth century all US stock and produce exchanges still banned option trading (Poitras 2009b, 34).

This confirms the point made above regarding the parallel evolution of expert opinions on speculation and the institutional and regulatory environment. As the defence of organised speculation by economists upheld the legitimisation of futures trading and short-selling their doubts about the economic benefits of options reflect their confinement to the fringes of official trading and their use by unprofessional traders.

5. Conclusions

In this paper, we reconstruct early analytical arguments on the costs and benefits of speculation on organised commodity and security markets put forward by economists in the UK and the US. From our analysis it emerges that they all agreed on the following points.

First, fair assessment of speculation requires disentangling economic arguments from moral considerations. Second, economic benefits exceed costs, as professional speculators provide society with the useful services of improvement in the quality of price signals, insurance against price fluctuations and liquidity of outstanding stocks. Third, the negative side of speculation emerges in connection not only with the well-known phenomena of manipulation but also, more importantly, in relation to the possibility that, in a speculative market, fundamentals might lose their function as anchor for prices.

We can reduce the different degrees of optimism/pessimism shown by the authors considered in this paper regarding the merits of speculation to the awareness that the intrinsic weakness of speculative markets derives from the trade-off between the need for a large number of agents (to ensure liquidity and multiplicity of opinion) and the fact that the higher that number is, the more likely a large proportion of speculators is to consist of “foolish gamblers” who ruin themselves and damage the market. In this respect, study of the early theories of speculation relates to the broader debate on the merits of markets without barriers as factors of social promotion and equal opportunities.

Acknowledgments

We wish to thank Guido Erreygers, Marc Flandreau, Donald MacKenzie and Janette Rutterford for their comments on previous versions of this work. We thank also two anonymous referees for their comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Funding

This research benefited from the support of the “Mission: Sustainability” research program funded by the University of Rome Tor Vergata.

Notes

1 On the emergence of the cotton futures market, see Cifarelli and Paesani (2016). On the nexus between innovation in communication and the development of futures trading on organized commodity markets, see Engel (2015) among others. On the expansion of financial markets see Michie (2007), Chs. 4 and 5.

2 “Gambling, stock-jobbing form most powerful leagues/With Speculation‘s numerous intrigues;/Intrigues that add not to the nation’s store,/But for the rich defraud the helpless poor.” Popular poem in the US during the 1791–1792 bubble, quoted in Banner (2017, 21).

3 Crump (1875), Aubrey (1897), Nelson (1902), Conant (1904, Ch. 3, 88–116), Withers 1948 [1910], exemplify this literature in the UK and the US.

4 Regarding commodities, as Findlay and O’Rourke (2003, 42) recall, “The UK and northwest Europe were net importers of primary products, and net exporters of manufactured goods. North America still exported primary products, but rapid industrialization there was leading to a more balanced trade in manufactures over time.” This implied that producers played a larger role on organized commodity markets in the US relative to the UK, while London remained the pre-eminent capital market in terms of size before the First World War, although New York grew continuously.

5 On the rise of this literature see Goss and Yamey (1978), Leathers and Raines (2008), and Berg (2011) among others.

6 As MacKenzie (2008) argues describing the process that led to the end of the ban on trading in options and futures in foreign currencies in the 1970s in the US, economists played a crucial role in convincing public authorities of the beneficial effects of the new speculative instruments. For a recent critical reflection on ex-post rationalization of financial innovation by economists, see Zingales (2015, 1340–1342): “A common belief in our profession is that all that we observe is efficient. [..]I am not aware of any evidence that the creation and growth of the junk bond market, the option and future markets, or over-the-counter derivatives are positively correlated with economic growth.”

7 Emery worked as instructor and professor of political economy at Bowdoin college from 1892 to 1901, and professor of political economy at Yale from 1901 to 1909. In 1909, he was made chairman of the United States Tariff Board, but returned to his chair at Yale in 1913 until 1915. As Lawlor (1994, 191) recalls, Emery’s book on speculation on commodity markets and the stock exchange “was the text on which all the turn-of-the-century academic discussion of speculation centred. […] It is to Emery’s book not Marshall that Keynes’s original attempt to apply his theory of probability to financial market speculation can be traced.” Carabelli (2002) acknowledges Keynes’ debt to Emery as well as underscoring a few differences, which she traces to Keynes’s own views on probability and the distinction between speculation and gambling, which is “a cognitive distinction not a moral or ethical one” (Carabelli 2002, 174).

8 “There has never been written in this country a better work on ‘Speculation on the Stock and Produce Exchanges of the United States’ than that of Professor Henry Crosby Emery “(McMath 1925, 365). “H. C. Emery set the pattern followed by dozens of authors.” (Bakken 1966, 18). “In the four years since his book Speculation on the Stock and Produce Exchanges of the United States came out (1896), Emery already had attained the status of a leading authority on speculation, perhaps without peer” (Vaughn 2005, 224).

9 On Antwerp and its role in the history of exchange-traded derivative security contracts, see Poitras (2009a, 6–14) among others. The Japanese futures market for rice is another notable case in point. See Bakken (1966, 8–14) and, more recently, Berg (2011, 246–247).

10 Many authors employ the transport metaphor. See for example, Lavington (1913, 39–40), Carver in (Emery 1900, 118).

11 Marshall, who praised Emery’s empirical analysis (see fn. 18 below), in Industry and Trade makes reference to reports which show the beneficial effects of speculation in reducing the amplitude of price fluctuation (Marshall 1919, 261, fn2). For evidence of the relevance of Emery’s empirical analysis of the influence of speculation on commodity prices, see Usher (1916) and more recently Turnovsky (1983).

12 Reference to corners, situations that consist in obtaining sufficient command of a particular commodity or stock with the aim to compel short-sellers to cover their transactions at artificially inflated prices, formed an integral part of the scientific literature on speculation. See, for example, Emery (1896, 173–175), Marshall (1919, 263), Brace (1913, 78–80).

13 The idea that equilibrium security prices must reflect the discounted value of future dividends and earnings was already well established at the time early theories of speculation were being formulated. Giffen (1877), which Emery refers to on the issue of security values, is as an early case in point. Fisher (1907, Ch. XIII) is another example in this respect.

14 “Uncertainty is a disutility for which a payment must be made in addition to the net rate of interest” (Lavington 1912, 399).

15 During the same period, the US bucket-shops, where people bet on the prices of the New York Stock Exchange, increased the confusion between legitimate speculation and gambling (Hochfelder 2006).

16 On the characterization of professional vs. amateur speculators see, among others, Crump (1875, Ch. 3), unpublished notes by Marshall in Dardi and Gallegati (1992), Emery (1896, 187–188).

17 The same problem had arisen with the issue of government bonds by states of uncertain reputation, which defaulted on their debts. On this, see the report of the Committee “appointed to inquire into the circumstances attending the making of contracts for loans with certain Foreign States, and also the causes which have led to the non-payment of the principal moneys and interest due in respect of such loans” BPP 1875.

18 Marshall’s notes on Emery define speculation malignant “when endeavours are made to move the opinion of others in the direction opposite to that which the speculators believe to be the true one. This end is bad in itself but it cannot generally be pursued with any success without means that are detestable.” See Marshall’s manuscript notes on Emery of 16 August 1904, in Marshall Papers, in Marshall Library of Economics, Section 5 “Late Notes in Bundle” 13/2.

19 For a comparison between this case and conventional theories of speculation, see Chick (1992) among others.

20 Raines and Leathers (2000, 57), make this point as they review the position of different neoclassical economists on rational markets and speculation. In this context, two papers on stock market speculation and the need for public regulation, presented in front of the American Economic Association by Emery himself (Emery 1915) and Untermeyer (1915), clarify the close link between the defence of speculation and the claim that it is impossible to separate it from investment.

21 See the evidence of H.H. Aldrich, representing the Chicago Board of Trade, that the futures market “is the result of a great many years’ experience in business […] it has come as an evolution just as the clearing house for the banks has come. It is the facility for doing business” Fictitious Dealings in Agricultural Products, Testimony taken before the Committee on Agriculture, Government Printing Office, Washington 1892.

22 On early popular involvement in US financial markets, see Hochfelder (2006) among others.