The value of organized speculation

Book I GopightN

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THE CAUSE AND EXTENT OF THE RECENT INDUS- TRIAL PROGRESS OF GERMANY. By Earl D. Howard.

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THE VALUE OF ORGANIZED SPECULATION. By Harrison H. Brace.

HOUGHTON MIFFLIN COMPANY

Boston and New York

XIV

THE VALUE OF ORGANIZED SPECULATION

THE VALUE OF ORGANIZED SPECULATION

BY

HARRISON H. BRACE

Author of " Gold Production and Future Prices '

BOSTON AND NEW YOKK

HOUGHTON MIFFLIN COMPANY

COPYRIGHT, I913, BY HART, SCHAFFNER 8c MARX ALL RIGHTS RESERVED

Published April IQ13

Preface

This series of books owes its existence to the generosity of Messrs. Hart, Schaffner & Marx, of Chicago, who have shown a special interest in trying to draw the attention of American youth to the study of economic and commercial subjects. For this purpose they have delegated to the undersigned committee the task of selecting or approving of topics, making announcements, and awarding prizes annually for those who wish to compete.

For the year ending June 1, 1911, there were offered: —

In Class A, which included any American without

restriction, a first prize of $1000, and a second prize of $500.

In Class B, which included any who were at the time

undergraduates of an American college, a first prize of $300,

and a second prize of $200.

Any essay submitted in Class B, if deemed of sufficient merit, could receive a prize in Class A.

The present volume, submitted in Class A, was awarded the second prize in that class.

J. Laurence Laughlin, Chairman, University of Chicago.

J. B. Clark,

Columbia University.

Henry C. Adams,

New York City.

Edwin F. Gay,

Harvard University.

Author's Preface

In this short monograph the attempt is made to consider in a spirit of fairness the much controverted question of the value of organized speculation. The undertaking is a difficult one from the fact that the exchanges themselves are in a formative stage, as is also public opinion concerning them; and the positions taken by the respective disputants are far apart.

The question of prices is an abstruse one ; and, in the subject under discussion, we must attempt to discriminate between the price-making factors which are general in their effects and those which are peculiar to the exchanges. Yet the elements which determine prices blend into one another almost indistinguishably. As regards the general effects of organized speculation upon business, the matter is beset with further complications; and it is almost impossible to express one's self with accuracy about the various phases which the facts assume, without appearing to make contradictory statements.

Upon a commercial exchange the weaknesses of human nature are exhibited at every point. The hopes and fears of the persons involved, the peculiar nature of an organization which leaves individuality untrammeled, but at the same time gives opportunity for the display of the mysterious psychology of a crowd, as well as the temptations of the gambling spirit, are among the factors to be considered. All these and other determinants act and react upon one another in great complexity. It is impossible to reduce the discussion to a few simple formulas and rules, or even from an extensive consideration of statistics to formulate a machine-made plan for accurately describing the head, the brain, — the nervous system of our modern commerce.

viii AUTHOR'S PREFACE

The writer therefore asks the indulgence of his readers if he be obliged in some cases to point out that causes and effects are so intermixed that definite conclusions cannot be reached in regard to particular departments of the subject, or if he fail to reduce his discussion of ever varying human moods and passions to the regularity of a mathematical diagram.

Organized speculation is important in the present. It will become of much greater importance in the future. As hinted in the text, it contains within itself suggestions for the solution of social problems which are the present-day puzzle of statesmen and philanthropists. It is worthy of the study of specialists in economics, in ethics, and in psychology; and it is of such practical importance that it should receive attention and consideration from all classes of the people. In order to help, even if it be but little, in awakening a wide interest in the discussion of the subject, the writer has attempted wherever possible to use the popular style.

Harrison H. Brace.

Chicago, December, 1912.

Introduction

The Chance Element 4

Guarding against Risk 5

The Place of the Speculator 5

The System adopted 7

Evolution and History 8

CHAPTER I The Commercial Exchange 15

The Method of doing Business 19

The Orders 21

Distributing Quotations and News 25

Describing the Market 29

Margin Trading 31

Future Delivery 32

Short Selling 34

Borrowing 36

Substitution 37

Cancellation of Trades 39

Ringing Out ,j 40

Book Accounts 43

The Clearing-House 44

A Distinguishing Feature 45

Speculators classified 46

CHAPTER n

The Minor Fluctuations 51

Extreme Fluctuations 54

A Market with Two Sides 59

The Excitability of Speculators 64

A Summary 65

Depressing Prices 65

The Demand and Supply 67

The Temper of the Speculators 71

CONTENTS

Comers 78

The Commodity in Store 80

The Street Supply of Stocks 85

Different Nations and Classes 87

Cotton Exchanges 89

Summary of the Upward Tendencies 92

The Complication of Prices — A General View 94

Summary of the Three Price Tendencies 96

CHAPTER ni

Prices (continued) Some Fallacies considered ... 97

The Underlying Fallacy 100

Selling Four Times 102

The Offers to sell 104

Philanthropy 105

The Payment of Differences 107

The Interest of the Parties 108

The Strength of the Parties 112

Different Seasons , 115

Statistical Fallacies 120

The Question of Commissions 121

Clearing-House Transactions 123

Hedging misunderstood 125

Restricting Trade 126

Commerce is Natural « 127

The Legitimacy of Fluctuations 128

Summary of the Last Two Chapters ....... 138

CHAPTER IV

A Continuous Market 141

Panics 144

Amateurism again 145

Hedging 151

The World Market 159

The Directive Function 162

The Directive Influence of the Securities Market .... 163

General Business Predictions 165

Some Exceptions considered 167

A Reduction in Costs 169

The Husbanding of Resources .*" . . 176

Publicity 177

Summary of the Chapter .......... 178

CONTENTS xi

CHAPTER V

The Gambling Spirit 180

A Charge that is True 184

Corporate Dishonesty 186

False Rumors 189

The Crop Killer 191

Some Discrepancies and Contradictions 193

The Test 197

A Summary 198

A Historical Explanation 199

CHAPTER VI

A Natural Development 203

The Problem 204

A Crippled Market 205

Monopoly 205

A Four-sided Contest 214

A Democratic Institution 220

A Monopoly of Commissions 221

Real Gambling 222

Unorganized Speculation 225

Speculative Business 227

Evasion 230

Reforms in Method 233

Exchanges that are not Exchanges 235

Eliminating Uncommercial Practices 238

Eliminating Amateurism 242

Summary of the Chapter 250

Conclusion

Summing Up — Important Facts to be Emphasized — The Faults of Organized Speculation as it exists

To-Day — Its Value ln its Ideal Form .... 253

The Value of Organized Speculation as shown by Present Tendencies 257

Postscript — Present Legislative Tendencies 262 xii CONTENTS

Table I. Yearly Range of Wheat Prices at Chicago . . . .269

Table II. Yearly Range of Corn Prices at Chicago . . .270

Table III. Yearly Range of Cotton Prices at New York (cents per pound) 271

Table IV. Mean Monthy Price Contract Wheat (cash) at Chicago, 1901-1910 (cents per bushel) 272

Table V. Mean Monthly Price No. 2 Corn (cash) at Chicago, 1901-1910 (cents per bushel) 272

Table VI. Average Monthly Price Middling Upland Cotton at New York, 1900-1909 (cents per pound) . . . . . .273

Table VII. Mean Monthly Price Contract Wheat (cash) at Chicago by Years ending June 30 (cents per bushel) . . . 273

Table VIII. Visible Supply of Wheat in Millions of Bushels by Years ending June 30 274

Table IX. Mean Monthly Price No. 2 Corn (cash) by Years ending June 30 (cents per bushel) 274

Table X. Visible Supply of Corn in Millions of Bushels by Years ending June 30 275

Table XI. Average Monthly Price Middling Uplands Cotton in New York by Years ending August 31 (cents per pound) . . 275

Table XII. Visible Supply of American Cotton in Millions of Bales by Years ending August 31 276

Table XIII. Relative Prices of Stocks compared with Relative Railway Dividends and Net Income by Years ending June 30, 1891-1909, Arithmetic Means 276

LIST OF DIAGRAMS

I. Yearly Range of Wheat Prices at Chicago 1865-1910 . . 56 II. Yearly Range of Cora Prices at Chicago 1865-1910 . . 56

III. Yearly Range of Cotton Prices at New York 1830-1909 . 57

IV. Prices of Wheat and Corn 1901-1910 and of Cotton 1900-

1909 averaged by Months 117

V. Average Prices of Wheat and Average Visible Supply (reversed) years ending June 30 133

VI. Average Prices of Cora and Average Visible Supply (reversed) years ending June 30 134

VII. Average Prices of Cotton and Average Visible Supply (reversed) years ending August 31 135

VIII. Relative Railway Dividends, Net Income and Prices of Stocks

years ending June 30 137'

THE VALUE OF ORGANIZED SPECULATION

THE VALUE OF ORGANIZED SPECULATION

INTRODUCTION

The subject of this essay will appear to most minds a strange one. "What can be gained," the extremist will ask, "from a discussion of the value of organized speculation, when it is perfectly obvious that it has no value and only leads to human misery? Surely, it needs no argument to prove that suicide should not be encouraged or that defalcations in positions of trust are not desirable." "What," exclaims the ardent sentimentalist, "can be more plain than that it is all pure gambling? And why not sweep the whole accursed thing away, instead of discussing the question of its possible usefulness?"

But organized speculation, though it be the common scapegoat, still survives: and though Germany, for instance, has made drastic attempts to change the methods by which certain commodities and securities are dealt in on the bourses, yet she has met with no real success. In the meantime exchanges prosper; their memberships become more and more valuable; and they build more and more costly palaces in which to conduct their business. May it not be that prejudice is the cause of much of this outcry? And are we perfectly certain that the frequent charges made have been conclusively proven? Thus, is there any proof for the charge that transactions upon the board of trade have nothing to do with actual commodities, and that no deliveries are made on future contracts? Surely, some of the statements so often heard are unfounded; and random assertions made without investigation should not be accepted as truth.

n

If the business of speculation were not the subject of prejudice, it would be the only business which has not, at one time or another, been under suspicion. War, at one time, was considered as the only proper calling for a gentleman; and trade was thought to be quite degrading in its effects. Even greater than the prejudice against merchants was that against money lenders, tax collectors, or bankers. We find the actor at certain periods looked down upon. Even the profession of letters has been considered an inferior one; and there are those who argue that one of the reasons which led Sir Walter Scott to deny he wrote the Waverley Novels, was that he did not wish to be known as a professional author.

The writer of this holds no brief for the board of trade or the stock exchange. He merely asks the reader to examine with him the arguments that may be urged in regard to the value of organized speculation, considering at the same time those disadvantages which serve to diminish that value, or even, in some respects, to overshadow it.

The Chance Element

He who would abolish chance from human affairs will have an impossible task. The truths that underlie the world may be imagined; but when we come to practical affairs, we find that there is an element of risk in all things. The first hunter who sought to entrap game found that his catch at different times was unequal. The agriculturalist is engaged in a calling in which there is certainly a great amount of risk. Such factors as drought, moisture, and other elements which determine whether crops shall be good or bad are governed, many of them, by the purest chance. In undertaking any business enterprise, the careful business man in his calculations always allows for the risk which he well knows that he must face.

Guarding against Risk

It is natural that the world should seek to eliminate this risk; and much of the progress in the sciences and practical arts is due to increasing knowledge of the comparative risks of different courses of action. By studying every factor necessary to the accomplishment of a particular task, the head of an industry is able to select that course which will be least fraught with danger.

But the most expedient method, even after it has been carefully selected, has risks associated with it which cannot be eliminated and which must be guarded against by some form of insurance or a system that is analogous to insurance. There are such perils as those of fire, storm, and death which are guarded against directly by insurance, the method being to spread them over a greater area. Thus risks are so distributed that losses in one area are compensated by insurance premiums in another. The different forms of insurance that have been invented are remarkable for their number and variety; nevertheless, there are many important risks that cannot be directly provided for in that way, but in the case of which a system analogous to that of insurance must be used. These are the general risks of business, which are infinite in the variations that they assume.

The Place of the Speculator

Some of these general risks, which cannot be borne by insurance, can yet be undertaken by a class of business men who specialize as speculators. These are the risks of fluctuations in prices due to changing conditions in different periods of time, and the handling of them constitutes the most important function of the speculative exchanges. In the case of the prices of the majority of commodities, these speculative risks are bound up with general business conditions in such a way that they cannot be separated from the other causes of expense and assumed by any special class. But by speculation, and particularly by the machinery of organized speculation, many of these risks can be thus segregated and transferred.

It should be noted, however, that while the function of the speculator is similar in many respects to that of the insurer, the method by which his influence is applied to the world of commerce is quite different. It is not through a contract whereby he agrees to indemnify the public against loss that the speculator acts; but he performs his function by buying and selling in the market. When he believes that prices are low, he purchases. When he believes that prices are high, he sells. This he does in the pursuit of his own selfish interests; but, in so doing, his purchases and sales have an important influence upon prices, and indirectly upon the whole field of commerce.

Thus it is readily seen that the action of the speculator affects only indirectly the demand and supply of actual commodities and securities. What he buys at one time as a speculator, he must at some other time sell; for the immediate effects of his speculations are neither to produce commodities nor to consume them. He neither adds to the permanent supply nor subtracts from it. But for the moment, at the time of a purchase or sale, he exercises an important influence upon the temporary demand and supply, with far-reaching effect upon ultimate production and consumption. Or, to look at the question in a slightly different aspect, he distributes the demand and supply over different periods of time.

To sum up the above description in a definition, we have

the following: Speculation is the forecasting of changes in

value, and buying or selling in order to take advantage of

them. 1 It is unnecessary, however, in this place to discuss

the question to what class of producers the speculator

1 Cf. Report of Governor Hughes's Committee on Speculation in Securities and Commodities, p. 3; Emery, Speculation upon the Stock and Produce Exchanges of the United States, p. 96; Chamberlain, The Principles of Bond Investment, p. 8.

belongs — whether, for instance, his services are a part of those performed by the capitalist or by the entrepreneur. That there is risk and that some one must bear it seems obvious; and the particular risks that the speculator bears are as important as any.

The System adopted

It is quite natural that the organizing tendency of modern commerce should be availed of by speculators as well as others ; and the form which speculation takes when organized is that of operations upon an exchange. It should be noted, however, at this point that there are different kinds of organization. There is the form which aims to crush out individual initiative wherever possible; and there are other forms in which the uniting force is applied in such a way that, while there is constraint at certain points, yet in most respects freedom of action and individual initiative are greatly increased.

An exchange organization is of this latter class, for its tendency is to promote commercial freedom rather than to smother it. A clique or pool may exist upon an exchange in the same way that one may exist in outside commerce. But the exchange organization is entered into for the purpose of promoting, not of stifling, competition; and its machinery is so arranged as to give the opposing price-making factors the freest play.

It would, therefore, be quite fallacious to compare the organization of a commercial exchange to that of an army, whose constituent units are drilled to act in unison against a common enemy for the accomplishment of a particular purpose. A better use of the simile will be found in comparing the exchange to an organization formed for the purpose of conducting gladiatorial combats, in which the rules are so carefully framed that any one can have a chance to demonstrate any superiority he may have, and where only the fit survive.

A definition might then be framed as follows : Organized speculation is a system of bringing together speculators and other traders with a view to facilitating the freest trading among them, so that many of the risks of commerce may be segregated and borne by a class who specialize in the undertaking. The effect of this system, and particularly its value to the community, will form the subject of this essay.

Evolution and History

Little light can be thrown upon the subject by merely using our imagination as a basis for reasoning in regard to what must have been the place of speculation in past ages. It doubtless originated in the earliest forms of trading. Even among people in a low state of commercial development, it would be natural for those with a little more aptitude for commerce than the rest to take advantage of fluctuations in values, as did Joseph in Egypt. Little, however, can be learned from a study of the rudimentary forms of exchanges, since the types which developed later are quite different in character.

More significant for our purposes is the appearance of exchanges such as the Royal Exchange in London. This exchange was built through the generosity and public spirit of Sir Thomas Gresham, and was formally opened by Queen Elizabeth in 1571. The plan of the building was suggested by a bourse which had recently been erected at Antwerp, and exchanges of a similar character made their appearance in many commercial centres. The feature which differentiates this form of exchange from previous types is the fact that it involves the conscious application of the exchange idea in the erection of a building or the formal designation of a locality for the trading.

This comparatively early type of the modern exchange had a wide scope in the character of its dealings, for merchants in a number of different commodities and securities, as well as shipowners, underwriters, and others, were all accommodated within its walls. There was speculation in the exchanges and market-places in the early days in the same way that there was speculation outside of them; but, in the types of exchanges just discussed, there was no special organization of speculation, nor was there that provision for specialization in different departments which is the characteristic of modern development. Hence we find dealers in different kinds of commodities and securities leaving the Royal Exchange and establishing exchanges of their own. So thorough has been the hegira that, at the present time, the Royal Exchange has a deserted appearance, and is used for only one important kind of financial operations, — the dealing in foreign bills.

When the different interests represented upon the Royal Exchange were separating, each provided in its new organization for the particular necessities and conveniences which it needed; and, to accommodate certain classes of trade, the latest type of exchange made its appearance, namely, the modern speculative exchange or the one in which speculation largely predominates. Although the other kinds of market-places and exchanges exist in abundance at the present day, it is this latest development, the large, wealthy, important speculative exchange, which is ever in the public eye and is intimately associated with organized speculation.

It was with the development of the commercial corporation in its modern form and with the funding of national debts that the appearance of stock-brokers was first noted. In London they first met at the Royal Exchange with other business men as just described. They were assigned to a particular part of the building, and even in those early days of the seventeenth century, there were doubts as to the legitimacy of the business ; yet those who dealt in stocks were so numerous that they could not all be accommodated in the place assigned to them and they crowded the others. Finding themselves unwelcome, the stock-brokers were among the first to withdraw and did business at different times in Change Alley, at coffee-houses, and at the Bank of England.

The first distinctive organization took the form of a club among brokers who frequented a certain coffee-house, but the present organization of the London Stock Exchange may be said to date from 1773, in which year the exchange occupied a building of its own and adopted many of the features which now characterize it.

In New York a little later than at London the advantages of organization became apparent. The favorite meeting-place for stock-brokers in the early days was near a buttonwood tree which stood in front of 68 Wall Street; and in 1792 the brokers entered into an agreement in regard to the rates of commissions to be charged on stock transactions. It was not, however, till 1817 that a comprehensive organization of the New York Stock Exchange was effected.

In every other country, as well as in the United States and England, speculation took the organized form as soon as the stage of evolution was reached at which trading in stocks and securities became of any considerable importance; and the history of the stock exchanges is the history of the modern financial system. In their early days they were occupied principally with the large increase of public debts and the wars that made them necessary. At the time of the Napoleonic wars, Nathan Mayer Rothschild was a prominent member of the London Stock Exchange. The anecdote is often told of how he witnessed the battle of Waterloo, and, after assuring himself that the Allies were victorious, secured a boatman who took him across the English Channel with such expedition that he arrived in London in advance of all others from the scene of war, and was able to avail himself of his knowledge of the issue of the battle in making advantageous trades upon the stock exchange.

In this country the Civil War, with its far-reaching effects upon commerce and finance, was an important event in the history of the exchanges. The period of the war was a time of great expansion of organized speculation; and the speculative spirit engendered then has continued to the present day and is among the factors which have made this country the one in which speculation in stocks most widely prevails. 1

The great work of Wall Street, however, has lain in the development of the producing power of the country; and at every stage, the speculative markets have occupied a prominent place. First the application of steam power to navigation resulted in a wonderful development of commerce and the formation of numerous companies. The completion of the Erie Canal in 1825 further accentuated this development, and helped to increase the importance of New York as a commercial centre and a speculative market. The great growth of the banking business about the time mentioned and the trading in bank stocks which ensued was also a prominent feature of speculative dealings.

When the building of railways was begun, Wall Street may be said to have entered into its most important work. Whether the activities of the speculators were for good or ill, the history of organized speculation during the greater part of the nineteenth century is most intimately associated with the development of the railway system. Later the organization of industry by combining widely separated interests has to some extent usurped the attention which had before been given to the stocks of railways; and the wonderful activity of Wall Street in the early part of the twentieth century has been closely associated with the trading in industrial securities.

In European stock exchanges the financing of transportation and industrial companies has not been so prominent at any time as in this country. Among the reasons for this difference is the fact that machine production and the large 1 Cf. Bryce, The American Commonwealth, vol. n, chap. cvn.

corporations necessary to it are not so important as in America. Furthermore, railway lines do not take the place of ordinary highways to the extent that they do in this country; and in Europe railways are more frequently built and operated by governments. Also, the supply of capital has been so great that it sought an outlet in other lands, so that organized speculation in Europe has concerned itself more especially with securities of different kinds originating in countries of backward development in out-of-theway parts of the world, and the fluctuations in commerce and production in those countries have been quickly reflected in the European stock exchanges. For instance, the Baring panic upon the London Stock Exchange in 1890 had its origin in unfortunate financial conditions in Argentina. The European exchanges, moreover, have continued to pay great attention to the funded debts of different nationalities. And the issues of war and peace, the rivalries of dynasties and the alternations in military and naval supremacy of the different nations furnish the explanation for most of the important events in their history.

There appears to have been an even less degree of realization of the possible future course of evolution in the early commodity exchanges than in the first type of the modern form of stock exchange. In those exchanges the development of which can be traced to early times, it is found that the idea of a speculative market did not exist at first, and that the facilities for organized speculation were added to other methods for furthering commerce in an already existing association. Even at the present day we find in some cities that the terms "Board of Trade," "Chamber of Commerce," and "Produce Exchange" are applied to associations which have no speculative market and which exist only for developing local industries and commerce; while in other cities these names are applied to associations in which the speculative element overshadows all others.

The inconveniences to which our forefathers were subject, because of the lack of organization in the process of fixing the prices of commodities, can scarcely be realized. At present any man may enter an exchange as a member or through a broker and become a market factor to the extent of the amount of the commodity which he is willing and able to carry. The condition that prevailed before exchanges assumed their present prominence offers a pitiful contrast, when it is remembered that formerly the small dealer was at the mercy of the great magnate or merchant, with no system for giving dealers of his class any voice in determining the flow of commerce. How could any man know what price to place upon wheat, for example, at a time when famine prevailed in one province and a surfeit in an adjoining one, and when there were no systematic arrangements for utilizing the few facilities for communication and transportation that were at hand? Prices in the early days could not at best have been other than the haphazard guesses of those who were not experts and who had every f acility for taking advantage of the weaker commercial units. There is some excuse, then, for the fiats and decrees of governments in early times in fixing prices, as the facilities were lacking for scientifically fixing them according to true commercial standards.