WEBVTT NOTE Futures, Prices and Production 1 00:00:00.000 --> 00:00:10.600 Okay, so I'm going to talk about futures. My goal here is to recall basically what the 2 00:00:10.600 --> 00:00:18.680 required conditions for futures to emerge in the first place are and to explain which 3 00:00:18.680 --> 00:00:24.960 role they can have in the social fabric from the point of view of economic theory. I will 4 00:00:24.960 --> 00:00:34.400 I will particularly concentrate on the second part, since some of you already heard about the conditions of emergence, 5 00:00:34.400 --> 00:00:42.200 especially my German advisor who is here, and we French people are expecting me to bring something new. 6 00:00:42.200 --> 00:00:46.200 We French people tend to comply with the German occupier. 7 00:00:54.960 --> 00:01:01.960 So as far as the conditions for the emergence of derivatives are concerned, 8 00:01:01.960 --> 00:01:06.960 I will particularly stress the importance of uncertainty and entrepreneurship, 9 00:01:06.960 --> 00:01:10.960 as Ludwig von Mises understood them. 10 00:01:10.960 --> 00:01:18.960 And it will lead me straight to their social function, namely how the use of futures or forwards 11 00:01:18.960 --> 00:01:25.640 and improve the overall division of labor via the transfer of uncertainty bearing. 12 00:01:25.640 --> 00:01:35.880 So let me first take a simple example of a future, which will allow me to define what 13 00:01:35.880 --> 00:01:38.680 this kind of thing is. 14 00:01:38.680 --> 00:01:46.280 So let's say we have two persons, A and B. They sign a future or forward contract today, 15 00:01:46.280 --> 00:01:56.680 Which means A is, for example, the buyer and B is the seller of some quantity of, say, 16 00:01:56.680 --> 00:02:01.360 corn for a certain futures price. 17 00:02:01.360 --> 00:02:08.680 That is, they both agree today on doing a transaction in the future at a predefined 18 00:02:08.680 --> 00:02:14.560 price and the transaction will actually occur, the two sides of the transactions will occur 19 00:02:14.560 --> 00:02:17.440 at this future date. 20 00:02:17.440 --> 00:02:23.160 So three things of interest for us can happen. 21 00:02:23.160 --> 00:02:31.400 Either the spot price, that is, either the spot price in the future, in the regular spot 22 00:02:31.400 --> 00:02:41.200 market is the same than the future price, or it is higher, or it is lower. 23 00:02:41.200 --> 00:02:48.280 Meaning what happens because of the difference if it exists in these two prices, one partner 24 00:02:48.280 --> 00:02:55.400 in the exchange will have made a speculative gain and the other the equivalent loss. 25 00:02:55.400 --> 00:03:00.440 Now the question is why would these two people engage in such a transaction in the first 26 00:03:00.440 --> 00:03:02.280 place? 27 00:03:02.280 --> 00:03:10.120 The typical textbook answer is that we have here, we may have here someone who is a hedger 28 00:03:10.120 --> 00:03:40.120 and someone who is a speculator, that is, the hedger wants to protect himself against the possibility that, say, in my example, it would be the corn producer, he wants to protect himself against the possibility that the price of corn will fall in the future and the speculator, his partner, might think this price will actually rise 29 00:03:40.120 --> 00:03:50.120 And if I can get it, if we can decide on the price today for the transaction to occur in the future, 30 00:03:50.120 --> 00:03:57.120 which will be lower than the spot price in the future, then I will make a gain. 31 00:03:57.120 --> 00:04:09.720 So if such conditions happen, there is room for ex-ante beneficially, mutually beneficial future transaction. 32 00:04:09.720 --> 00:04:18.120 Now, what does this presuppose? That's the important thing from the point of view of pure economic theory. 33 00:04:18.120 --> 00:04:23.920 At the very least, in my example, it presupposes that the futures price is unknown. 34 00:04:23.920 --> 00:04:39.920 Which means more generally that for a future transaction or actually any derivative transaction to occur, A and B or any partner must live in a world of uncertainty. 35 00:04:39.920 --> 00:04:51.920 The whole demand and supply schedules for these contracts are based on some expectation of the future spot prices. 36 00:04:51.920 --> 00:05:03.920 These schedules are fundamentally based or derived from the expected exchange value of the underlying products in this example column. 37 00:05:03.920 --> 00:05:19.920 So we have this fundamental condition of uncertainty because we cannot even think of speculation and these kind of activities without uncertainty, of course. 38 00:05:19.920 --> 00:05:43.920 To be more specific, we have to realize that we are talking about uncertainty in the Misesian sense as separated from what Mises and Knight called risk, which belongs to the realm of frequency distribution, class probability. 39 00:05:43.920 --> 00:05:48.920 I will not go into details here and just assume you're familiar with it. 40 00:05:48.920 --> 00:06:11.920 What is the importance of this? The importance is that if we don't make the difference between the two kinds of uncertainties, and typically this is what neoclassical people might be tempted to do, we will falsely characterize derivatives as insurance products. 41 00:06:11.920 --> 00:06:19.720 If you remember Mises' night exposition on the difference between uncertainty and risk, 42 00:06:19.720 --> 00:06:28.320 one implication is that insurance is possible with events which belong to a class of homogeneous events. 43 00:06:28.320 --> 00:06:31.320 So it's the realm of class probability. 44 00:06:31.320 --> 00:06:39.320 Since here we are talking about speculating on future prices, we are talking about social events. 45 00:06:39.320 --> 00:06:46.560 First, prices are social events which cannot belong to a class of homogeneous events. 46 00:06:46.560 --> 00:06:56.440 Therefore, it's not insurance, properly speaking, partners are dealing with. 47 00:06:56.440 --> 00:07:05.480 Now, the other conditions for the emergence of futures, we need uncertainty but we also 48 00:07:05.480 --> 00:07:16.920 also need divergent expectations of future prices, as was suggested in my example, or 49 00:07:16.920 --> 00:07:26.800 at the very least, differences regarding preferences toward uncertainty bearing. 50 00:07:26.800 --> 00:07:33.420 Someone has to be more comfortable somehow than the other. 51 00:07:33.420 --> 00:07:41.180 Another condition which is of interest is the question we have to wonder if capital is required 52 00:07:41.180 --> 00:07:48.540 because that's the intriguing feature of the forward transaction I presented before. 53 00:07:48.540 --> 00:07:54.700 No resource is transferred when the two people commit to the exchange. 54 00:07:54.700 --> 00:08:01.180 So we might think, hey, is this not an example where we don't actually have capital involved? 55 00:08:01.180 --> 00:08:16.180 Well, the reason is that these are purely exchange of future goods versus future goods as opposed to traditional investments which are exchange of present versus future goods. 56 00:08:16.180 --> 00:08:20.180 Does this really mean that no capital is required? 57 00:08:20.180 --> 00:08:29.180 That it is conceivable to engage in such transactions without capital at inception of the contract, not having to spend money in these transactions, 58 00:08:29.180 --> 00:08:36.260 Transactions does not change the fact that for, A, in my example, the buyer of the forward, 59 00:08:36.260 --> 00:08:45.020 the money he spends at maturity on corn is an investment for which capital is then required. 60 00:08:45.020 --> 00:08:50.660 This speculator entrepreneur, whatever he does, selling the corn maybe the next day 61 00:08:50.660 --> 00:08:58.020 or the same day on the spot market or using it in some production process maybe to sell 62 00:08:58.020 --> 00:09:06.100 product later, is spending some money in order to obtain an income later, this is investment. 63 00:09:06.100 --> 00:09:11.260 Plus viewed from the point of view of the whole process of production, both the buyer 64 00:09:11.260 --> 00:09:23.620 and seller are investors in an implicit partnership, unless the buyer is himself a consumer. 65 00:09:23.620 --> 00:09:27.740 This does not contradict, by the way, the Rothbardian idea that there is no such thing 66 00:09:27.740 --> 00:09:34.300 I think as a resource-less speculator or entrepreneur, which you could think, 67 00:09:34.420 --> 00:09:49.100 since A, the speculator, in my example, is, as we will see, a specialist in uncertainty-bearing. 68 00:09:49.100 --> 00:10:02.100 But, the thing is, incomes of entrepreneurs or speculators, negative or positive, profits or losses, 69 00:10:02.100 --> 00:10:08.100 must be residuals of at least two transactions, one consisting in buying and the other in selling later. 70 00:10:08.100 --> 00:10:16.100 And this is not really different in this case. Buying in this context is capital investment, 71 00:10:16.100 --> 00:10:21.700 and investment, however short the period separating both acts can be. 72 00:10:24.020 --> 00:10:33.620 Plus, as a contingent requirement, participants will be all the more eager to engage in such deals 73 00:10:33.620 --> 00:10:42.180 to the extent that their partners is thought as credible and to be credible you might need to show 74 00:10:42.180 --> 00:10:52.180 that you have some capital that could be used to pay for a loss, for example. 75 00:10:52.180 --> 00:11:07.180 Okay, so I'm late, unfortunately, for the second part, but now we are interested in consequences of the emergence of futures. 76 00:11:07.180 --> 00:11:26.180 So, the obvious is that we will have a different distribution of income, but the essential feature of the whole process I want to stress is that we had in this operation a further degree of specialization in uncertainty bearing. 77 00:11:26.180 --> 00:11:38.660 The relevant quote in Mises' Human Action is this one, quote, 78 00:11:38.660 --> 00:11:43.660 The futures market can relieve an entrepreneur of a part of his entrepreneurial function. 79 00:11:43.660 --> 00:11:52.280 As far as an entrepreneur has insured himself, and he puts square quotes for insured, through 80 00:11:52.280 --> 00:11:57.880 suitable forwards transaction against losses he may possibly suffer, he ceases to be an 81 00:11:57.880 --> 00:12:03.040 entrepreneur and the entrepreneurial function devolves on the other party to the contract. 82 00:12:03.040 --> 00:12:08.560 The cotton spinner who, when buying raw cotton for his meal sales, the same quantity forward 83 00:12:08.560 --> 00:12:12.780 has abandoned a part of his entrepreneurial function. He will neither profit nor lose 84 00:12:12.780 --> 00:12:17.480 from changes in the cotton price occurring in the period concerned. 85 00:12:17.480 --> 00:12:23.480 Now, it is tempting to say, let's just apply the law, the Ricardian law of association here. 86 00:12:23.480 --> 00:12:30.480 The forward, we could say the forward contract by placing the risk on those who want to bury it, 87 00:12:30.480 --> 00:12:37.480 makes possible for corn producers, in my example, to concentrate on what they do best 88 00:12:37.480 --> 00:12:42.480 and spend resources in acquiring relevant knowledge on possible future prices. 89 00:12:42.480 --> 00:12:46.480 And this is the specialty of the speculator who could not exert his talents to the same extent 90 00:12:46.480 --> 00:12:51.480 to some extent, if he also had to care about the specific knowledge required to produce gold. 91 00:12:52.480 --> 00:12:56.480 And all this should lead to a more productive economy and higher overall output. 92 00:12:56.480 --> 00:12:59.480 However, it's more complicated. 93 00:12:59.480 --> 00:13:06.480 The reason is that we have to think for a moment of the Ricardian law of association. 94 00:13:06.480 --> 00:13:15.440 It tells us that when each person specializes into the production for which he has relative, 95 00:13:15.440 --> 00:13:21.040 if not absolute, advantage, advantageous subsequent exchanges can occur. 96 00:13:21.040 --> 00:13:26.480 In other words, in isolation, one might be able to produce a quantity X of something 97 00:13:26.480 --> 00:13:33.800 or a quantity Y of something else so that he has an internal exchange ratio of X divided 98 00:13:33.800 --> 00:13:44.040 by Y. With specialization and exchange, each one can obtain a better ratio of exchange. 99 00:13:44.040 --> 00:13:49.920 That's the idea. However, this whole thing presupposes you can express the contribution 100 00:13:49.920 --> 00:13:58.960 in terms of a physical productivity schedule, which is X and Y in my example. But if we 101 00:13:58.960 --> 00:14:18.960 If we take seriously Mises and the entrepreneur, this will not do, so the relationship between the uncertainty bearer and his partner, the hedger or maybe the laborer in other cases than with derivatives, cannot be characterized this way. 102 00:14:18.960 --> 00:14:47.960 So we are in a conundrum which, well I will not have to explain in detail, but I think Frederic Bastiat provided a solution talking about associations purely in terms of difference of taste in uncertainty bearing and insisting on the general distaste and discomfort that uncertainty brings. 103 00:14:48.960 --> 00:15:12.960 So, just to conclude, the two laws can go actually together. We have to think of the relationship between the hedger and the speculator, under what I would call Bastiat's law. 104 00:15:12.960 --> 00:15:42.960 And you have pairs of exchangers where this law applies and this is still connected to the Ricardian Law of Association since the entrepreneur or speculator makes possible, relieves the labourer or hedger, whatever, the one who gets rid of uncertainty bearing, relieves him from this burden which means he can push forward 105 00:15:42.960 --> 00:16:01.960 And further is specialty which is expressible in physical terms, therefore the overall division of labor between these specialists is enhanced and overall productivity can be higher. Thank you very much.