Grasping Reality on TypePad, by Brad DeLong

Linda Beale:

Duffie on speculative trading: Darrell Duffie, a finance professor at Stanford's business school, argues "In Defense of Financial Speculation" (Wall St. J., Feb. 24, 2010, at A15).... [S]peculators are beneficial. Here's his argument. 1) speculators absorb risk that others don't want, permitting investors to hedge their positions; 2) speculators provide information about investments--if they buy, fundamentals appear favorable; if they sell, fundamentals are not. That information helps market prices be more accurate; 3) speculation--defined as "accurately forecasting an investment's fundamental strength or weakness"--is not the same as manipulation--defined as "when investors 'attack' a financial market in order to profit by changing the value of an investment....

Are Duffie's arguments strong enough to think, as he suggests, that curbing speculation in the credit default market isn't necessary? Note that item 2 stems directly from the "efficient markets hypothesis"--that markets price items appropriately through sharing of information. But what we know suggests this isn't true. We have an entire vocabulary for talking about the fact that without stabilizing intervention and protective regulation, market pricing--and the kinds of speculation that Duffie praises--tends to lead to market bubbles. The housing markets are a good example...