Robin, I like the way that you approach the problem and I am pleased 
that you continued this topic, which I believe stopped short of being 
fully articulated. Your post is, as I see it, an effort to apply what I 
would call early neoclassical economics such as that practiced by 
Phillip Wicksteed, by the intellectual descendants of J. B. Clark and 
some of the intellectual descendants of Marshall, and by the Austrians 
following Menger and Bohm Bawerk. In my view, economics needs more of 
this, since this economics has been neglected in the rush to 
mathematicize and quantify. At the same time, I am not sure that your 
post gets us very far in helping to explain bubbles or booms or in 
formulating a basis for policy intervention. I explain by referring to 
passages in your post.

On 4/14/2010 8:19 AM, Humberto Barreto wrote:
> Presuming that a disconnect between productivity and
> prices has been shown to be instrumental in the Very
> Long Run successes of the capitalist market system, it
> remains to be shown that the pernicious disconnect between
> productivity and prices that occurs in "bubbles" is different
> from that which is functionally positive in the
> successes of the system. Indeed, there are two things
> that remain to be shown. The first is "the need to distinguish
> bubbles from booms", as Sumitra Shah put it. The
> second is the need to show that in a capitalist market
> system bubbles are invincibly twinned with expansion
> based on Very Long Run advances in productivity.
> The first of these is the subject of this note.
>    

> Some definition of terms is necessary. Whatever general
> use has ascribed to the term "market speculation", in what
> follows it refers to buying and selling in one market. But
> this requires explanation. Productivity, of course, is the
> ability, either directly or derivatively, to satisfy consumer
> preferences.
>    

Productivity is a key concept in your discussion. I would define 
productivity in early neoclassical economics in terms of the theorem, or 
principle, of consumer sovereignty -- a theorem that neatly summarizes 
the marginal productivity theorem of distribution and the Austrian 
theory of value and cost. The theorem holds that under the conditions of 
a pure market economy, actions of the entrepreneur role (as distinct 
from that of the monopolist owner of a factor of production) are always 
in the best interest of the consumer role. This theorem is based on (1) 
the division of actors under market economy conditions into roles and 
(2) a channeling of (a) all price setting and "active" action into the 
entrepreneur role, while delegating (b) all "passive" responding 
behavior to the roles of the owners of the factors of production and the 
consumer-saver. Speculation is a characteristic of the entrepreneur 
role. The reason for using this taxonomy is to help avoid errors in 
reasoning that result from the propensity to mistake ideal types for 
roles that participate in performing fully integrated functions in the 
process of satisfying consumer wants.

> Arbitrage occurs when purchases in one market are sold
> in another. If the price of some good is lower in
> one market than in another, it will be profitable for agents
> to buy in the low price market and sell in the high price
> market. Increased demand in the low price market will
> raise the price there and the consequent increased supply in the
> high price market will lower the price there. Eventually separated
> only by transaction and transportation costs, prices in both
> markets will be the same. An equilibrium price is established
> at a level that reflects the productivity of the good in question.
> Market speculation occurs when something is purchased in one
> market and sold in the same market. In such a case an equilibrium
> price is not be established. Rather an increase or decrease in
> the price will occur until the disconnect between the price and
> the productivity of the good becomes so obvious that
> all in the market expect the direction of price change to reverse.
> For example, consider the case of short selling in a futures
> market in which the price is declining. The very act of
> selling in the future drives the price down at that time.
> When the future becomes the present the seller can purchase
> the asset at a lower price than that at which he sold it. He
> does so and sells, thereby buying and selling in the same
> market and earning a "profit". Short selling, buying and selling
> in the one future market drives the price of the good down and away
> from an equilibrium that would represent its value based on
> material supply and demand. Selling long in a rising price
> market drives the price up and away from its material value,
> that is, its value based on productivity.
>    

I believe that this characterization of the market process misconceives 
the consequences of speculation. The equilibrium price is never a real 
price. It is always an imaginary construction created by the economist 
for the purpose of helping to describe the entrepreneurial acts that 
cause a particular price (and the corresponding other aspects of the 
exchange in question). Arbitrage, by your definition, is one possible 
consequence of speculation that the economist envisions. It is not, of 
course, an aim of the speculator. It also is an imaginary construct used 
to represent an outcome of market interaction.

It is, as I said, one possible consequence. If it were the only 
consequence of speculation, it would be part of a market process that  
the economist envisions ending with a final, or equilibrium, price. 
Israel Kirzner is known for his elucidation of such a process.

A second consequence, that the economist cannot (or should not) neglect 
is that a speculation may prompt further entrepreneur action that would 
otherwise not occur -- that is, that would not occur if it were what you 
define as arbitrage. Thus, for example, short selling may either be 
arbitrage _or_ it may fall into the _other_ speculation category.

This distinction between two types of speculation is perhaps captured 
best in a Schumpeterian conception of the market process in which one 
type of speculation is defined as equilibrating (arbitrage) while 
another is defined as innovative.

> While this is easy to see in the case of future markets, the
> analysis applies to virtually any market. For example, the
> market for financial or real estate assets provides opportunities
> for market speculation. Of course, the dysfunction is not caused
> solely by the act of buying and selling in one market.
> Expectations about the future direction of price changes are
> also involved. The timing of purchases and sales is involved.
> Time and space do not of themselves separate markets.
> A complex structure of information flows and transactions costs
> is involved, and they can render markets dysfunctional in
> different ways and different degrees, leaving prices more or
> less disconnected from productivity. Bubbles, however, are
> caused by market speculation in which the direction of price
> changes and not material supply and demand determine price.
> Demand feeds on itself, and not on the productivity of the
> thing demanded.
>
> Now, when expansion takes place in a "boom", understood
> in the Shah sense, prices rise because the productivity of
> goods and associated assets is presumed, often correctly, to be
> rising. In an expansion rooted in invention and innovation,
> increased productivity is the cause of rising demand and
> rising prices. Anticipated material supply interacts with
> demand to determine price. In a bubble, however, demand
> interacts with demand to form a dysfunctional price; and to
> open a door to the "predatory" behavior Veblen attributed
> to the business class.
>
> This establishes a distinction between bubbles and booms.
> What remains to be shown is that in a capitalist market system
> booms and bubbles are invincibly twinned.
>
> Robin Neill
> [log in to unmask]
>    

Once the market process is defined in this Schumpeterian way, one can go 
on to expand the conception of a non-arbitrage type of speculation. This 
type of speculation may lead (1) to future actions that are 
equilibrating as future speculators perform arbitrage-type speculation. 
Or it may lead (2) to future actions that do not fall in the economist's 
class of arbitrage-type speculation. I take it that your effort to 
distinguish between a "bubble" and a "boom" is based on this kind of 
taxonomy.

A boom, in your sense, is caused by non-arbitrage speculation that leads 
to arbitrage speculation. It is the result of an innovation. A bubble, 
in your sense, is caused by non-arbitrage speculation that leads to 
non-arbitrage speculation.

If my interpretation is correct, what remains is to follow up with some 
explanation of  the choices entrepreneurs make that lead to a bubble.


My next comment is about the relationship between your use of the terms 
"bubble" and "boom". By a bubble, people ordinarily presume a series of 
non-arbitrage speculations that lead away from an equilibrium price. On 
the other hand, because the concept of a bubble carries the connotation 
of an ultimate "bursting," there is an implicit assumption that, after 
some time, there will be a tendency toward the equilibrium price, which 
is consistent with your definition of arbitrage.

Your definition of a boom also seems incomplete, since business cycle 
theorists use the term "boom" in a model that is followed by a "bust."

Pat Gunning

Professor of Economics
Groton, Connecticut
http://www.nomadpress.com/gunning/welcome.htm