The Definition of Speculation, Part II (it gets worse)

In my last post I defined speculation as "buying commodities for the capital gain from anticipated increases in their prices rather than for their use," following Kindleberger's Manias, Panics, and Crashes.

According to Hyman Minsky however, speculative is only the middle type of three types of finance: hedge, speculative, and Ponzi.  Minsky, for those unfamiliar, is the late American economist whose genius was unappreciated in his lifetime but has suddenly become quite trendy to quote in relation to the recent economic bubble and crash.


Minsky's three types of finance are defined in reference to debt that the "investor" is assumed to have taken to fund his investments.  In other words, it does not cover self-funding investments.  His model is nonetheless quite useful, as the reality is that most economic activity is funded by debt, be it mortgages, small-business loans, or larger bond floats that are done by major corporations or governments.


Hedge finance, then, is defined as purchasing an investment asset for which the anticipated operating income (rent, dividends, etc.) is sufficient to pay both the interest and principal on the debt incurred to acquire the asset.  Regardless of what happens to the value of the asset, the hedge financier is covered.  He might not make a killing, but he will not go bankrupt; he is "hedged."


Speculative finance is where the anticipated operating income is sufficient only to pay the interest, but not the principal, on the debt incurred to acquire the asset.  The speculative financier can only pay down the principal and avoid bankruptcy by borrowing more money, in the form of new loans or renegotiated terms with the original lender.  He is OK as long as the asset value appreciates and he is able to get new loans, but if the asset value depreciates (as it inevitably does when a bubble bursts), he will have a liquidity crunch and both be forced to sell at a loss and potentially face other consequences of not being able to pay back his loan.


The final type of finance, Ponzi finance, is where the anticipated operating income does not even cover the interest.  The Ponzi financier finds himself falling into ever greater indebtedness as he borrows new money to pay merely the interest on the old, and will find himself in deep trouble as soon as others realize what he is up to, unless he is so lucky that the asset value appreciates fast enough to allow him to sell and pay back all of his creditors.


According to Minsky, when the economy sours, some of the individuals and firms in the hedge category get pushed to the speculative category as their income goes down, while some of the players in the speculative category find themselves in the Ponzi category.  This is precisely what happened in 2008-9 with many of the banks who had liquidity crises as their payments from their CDOs started shrinking as defaults rose.


The original Ponzi, by the way, was not particularly successful at his eponymous scheme, only managing to keep his hustle going for a few months before it crashed.

The Definition of Speculation, as Opposed to Investing (by some really smart economists)

In a book so mind-blowingly insightful that I had to stop marking because the whole page was turning red, I read the most concise, precise, comprehensive, and accurate definition for speculation: "buying commodities for the capital gain from anticipated increases in their prices rather than for their use."

As an example, buying oil or wheat to have fuel or grain is not speculation, but buying them to trade them to someone else after their value rises is.  Note that it is only speculation if the gain on the commodity is a capital one rather than an operating (or ordinary income) one.  In other words, if you are a distributor, retailer, broker, or trader of oil or wheat, you are not speculating.  The precise difference between a capital gain and an ordinary gain on a commodity can be fuzzy in some cases, but in general is quite clear.

Once speculation is defined that way, the next step is to consider the special case where the commodity is a stock. Stock is definitely a commodity: one share of a given class of stock in a given company is completely exchangeable for another share of the same class of stock in the same company. Most other securities are commodities as well.

In the case of a security, a capital gain is the result of income from selling the security at a higher price than paid for it.  Operating income is the dividends or payments from the security during the period that it is held.

This definition might miss a few cases in its simplicity, such as growth stocks that don't pay dividends, but it's pretty much spot on.

The books is Manias, Panics, and Crashes by Charles Kindleberger.  Kindleberger was a professor of economics at MIT for 30 years, and his book is widely cited by other books on market cycles such as Bull! by Maggie Mahar, which is where I read about it.

Amazon Arbitrage: Part 2

A couple of weeks ago I wrote a post called "Amazon Arbitrage" about how I found an item that was $70 pre-shipping on Amazon.com for $32 post-shipping on Amazon.co.uk.  Turns out the joke's on me.

I got an email this morning informing me that Amazon was "unable" to obtain the book, which was just published in June.

Apparently sales they must have not done a lot of sales because it is ranked #1,005,832 on Amazon.com and #137,153 on Amazon.co.uk.  By comparison, Man Walks into a Pub: A Sociable History of Beer, also by Pete Brown ranked #395,371 in the US and #11,254 in the UK.  (It is also #6 under the category of Books > Food & Drink > Drinks & Beverages > Beer, which we don't even have in the US).

Full text is below:
---------------------

Dear Customer,

Greetings from Amazon.co.uk.

We regret to inform you that we have been unable to obtain the following item:

 Pete Brown "Hops and Glory: One Man's Search for the Beer That Built the British Empire"

This item has now been cancelled from your order #203-2653883-6631506 and we can confirm that you have not been charged for it.

We are no longer able to offer this item for sale. Our supplier has informed us that this item has been discontinued and is no longer available.

Please accept our apologies for any disappointment or inconvenience caused.

If you took advantage of a promotional offer when placing this order, this cancellation may affect your order's eligibility for that offer.  If you discover this to be the case, please contact customer service so that we may investigate.  You can send an e-mail to customer service from the following URL:

http://www.amazon.co.uk/contact-us

This item may be available from an Amazon.co.uk Marketplace seller. The availability of the item will be indicated in a blue box that says "More Buying Choices" on the top right-hand side of the product's information page. The links in this box lead to lists of new, used, refurbished and collectable copies of that particular item. To buy the item click the yellow "Buy from Seller" button and fill in the requested information to complete your purchase.

To view the current status and the costs associated with your order, please visit Your Account (http://www.amazon.co.uk/your-account).

Thank you for shopping at Amazon.co.uk, we hope to see you again.

Please note: This e-mail was sent from a notification-only address that
cannot accept incoming e-mail. Please do not reply to this message.

Sincerely,

Customer Service Department
Amazon.co.uk
http://www.amazon.co.uk