There was a very good interview about the Black-Scholes equation on the Peter Schiff Show some time ago. Sadly I can't find it. He and his guest argue that without speculation and derivatives (such as credit default swaps, etc.) even more damage would have been done to the economy.
Basically a derivative is a claim on a claim.
Lets say I'm a wheat farmer. Sometimes my harvest is terrible, most of the times it's medium and sometimes it's great. If it's great - good for me! If it's medium I can survive and have a decent live. But if it's bad I die. Therefore I will try to find someone who agrees to pay a specific amount of money for my whole harvest before the summer starts. Because this guy, lets say the miller, is not an idiot it will be less money then the expected value of my harvest. But I'm willing to lessen my profits on average for additional security.
But now the miller has the risk of a bad harvest so why is he going to take that risk? Because he buys huge amounts of wheat every year from many farmers in different locations to sell the milled wheat as flour to bakeries. So by having multiple of these certificates he is using the strategy of hedging. He pays every farmer less than the expected value of his harvest and because of the law of big numbers he will make a profit even when some of the harvests are - as expected - bad because others will be very good. Of course that's only true if his risk calculation was correct.
As of know there were no derivatives. The certificates for the individual harvests didn't derive from any other certificate (which is the definition of a derivative). But there was specualtion going on which is always mentioned in combination with derivatives as possible root for this crisis.
But what exactly did this speculation do? It created certainty for the farmer but took away his chances for great profits in good years. So in a free market speculation is not a tool to increase risks but a tool to insure against risks and to bring prices to equilibrium level.
But know the miller begins to wonder what happens to him in a year with very bad weather in the whole region? He has obligations to pay the farmers even if the real value of the combined harvests is far less than the expected value. So he goes to an insurance company. He is willing to give up some of his expected profits in order to gain a little bit more certainty. So the insurance company insures every certificate to a negotiable sum for a fee. The insurance certificate for every harvest certificate is a derivative. And the insurance company might have a reinsurence policy at a reinsurer for every single insurence certificate they create. But that isn't a bad practice. It redcuces volatility in the market. Every actor in the market is willing to give up possible profits for security and without speculation this is impossible and without derivates it's only possible to some extend.
The derivate speculation in the housing market was just a symptom. There would have been just as much speculation as there was (maybe even more) but the risk wouldn't have been shared to many actors if there weren't any derivates. So it's likely that the housing bubble would have grown even bigger and caused even more suffering. It was because of the reactions in the derivative market that the bubble finally came to an end.
The big problem with many people is that they see the crisis as the problem. Austrian economists (the branch, not the nation, I feel obligated to say that
) know that this is not true. The problem is the framework that allows and encourages the boom - or even makes it inevitable due to prisoner dillemmas. The bust is nothing but the consequence of former bad behaviour. Let's be happy that the housing bubble burst because had it countinued even more ressources would have gone in a market where they are not supposed to be.
Just a random article I just googled on that topic:
http://www.forbes.com/sites/timworst...-increases-it/
Speculators buy when prices are low (additional demand that drives prices up) to sell when prices are high (additional supply that drives prices down). The argument that speculators in a free market (!) would cause food prices to skyrocket is insane. Why should speculators buy high priced food to sell it even higher? Increasing the price doesn't necessarily increase profits. If that were the case, why don't the farmers increase the prices in the first place? Are they not interested in higher profits for themselves?
In a free market, without governmental prisoner dillemmas, speculation is always decreasing
volatility and overall beneficial.
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