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.

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.

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
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