Commodity Prices, Again: Are Speculators to Blame?

In the 1955 movie version of East of Eden, the legendary James Dean plays Cal. Like Cain in Genesis, he competes with his brother for the love of his father, a moralizing patriarch. Cal “goes long” in the market for beans, in anticipation of an increase in demand if the United States enters World War I. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father to make up money lost in another venture. But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.” Cal has been the agent of Adam Smith’s famous invisible hand: By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the British Army). The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to do.

Among politicians, pundits, and the public, many currently are trying to blame speculators for the recent boom in oil and other mineral and agricultural products. Are the soaring prices their fault?

Sure, speculators are important in the commodities markets, more so than they used to be. The spot prices of oil and other mineral and agricultural products — especially on a day-to-day basis — are determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price. That is speculation. But it need not imply bubbles or destabilizing behavior.

The evidence does not support the claim that speculation has been the source of, or has exacerbated, the price increases. Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode. Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers). In other words they may have delayed or moderated the price increases, rather than initiating or adding to them. One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them. Clearly speculators are the conspicuous scapegoat every time commodity prices go high. But, historically, efforts to ban speculative futures markets have failed to reduce volatility.

One can distinguish three kinds of speculation in the face of rising prices. First, there is the “bearer of bad tidings” like Cal in East of Eden. The news that, in the future, increased demand will drive prices up is delivered by the speculator. Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service, by delivering the right price signal that is needed to get real resources better in line with the future balance between supply and demand. Without him, the subsequent price rise would be even greater, because supply would be less. But it does not appear that speculators played this role in the commodity boom that started earlier this decade: as already mentioned they, if anything, lagged behind the spot price.

Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price. This type of speculator again adds to the efficiency of the market, and dampens natural volatility, rather than adding to it.

Third, in some cases, when an upward trend has been going on for a few years, speculators sometimes jump on the bandwagon. Market participants begin simply to extrapolate past trends. Self-confirming expectations create a speculative bubble, which carries the price well above its equilibrium. The markets don’t always get it right. Examples of previous speculative bubble peaks include the dollar in 1985, the Japanese stock and real estate markets in 1990, the yen in 1995, the NASDAQ in 2000, and the housing market in 2005.

It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior), about which people tend to worry. As noted, there is little evidence that destabilizing speculation has played a role in the 2001-2008 run-up of commodity prices. So far, that is. Just because the boom originated in fundamentals does not rule out that we could still go into a speculative bubble phase. The aforementioned bubbles each followed on trends that had originated in fundamentals (respectively: rising US real interest rates, 1980-84; easy money and rapid growth in Japan, 1987-89; US recession, 1990-91, and Japanese trade surpluses; the ICT boom in the late 1990s; and easy US monetary policy after 2001).

It is not hard to identify in economic fundamentals the origins of this decade’s boom in commodity markets: easy money in the US; rapid growth worldwide, but especially in China and India; instability among oil producers, especially in the Middle East; misguided ethanol subsidies; drought in Australia, etc., etc. Even so, a bubble could take hold yet.

Good International Exposure for Obama and McCain

Senator Obama is on a vist to the Middle East and Europe. Senator McCain went to visit Colombia earlier in July. These trips suggest a seriousness of purpose that American presidential candidates often lack. They offer us hope that the candidates want to learn how to do the job well. Furthermore, they offer a hyper-attentive world grounds for hope that the next president will have a higher level of interest in other countries than did his predecessor.

So far as I know, it is unprecedented for the two party candidates to do foreign policy trips before the election. I can think of three reasons why we are seeing this now. First, because the primary elections started early this year, there is a hiatus between the end of the primaries and the party conventions. Thus the candidates can spare the time to go abroad. Second, foreign policy has risen much higher on the agenda of concerns of typical American voters, since September 11, 2001, and since the invasion of Iraq. (And of course Obama wants to put to rest McCain’s past jibes about not having visited Afghanistan and Iraq.) Third, Barack Obama and John McCain are not the usual inward-looking, domestically-oriented parochial governors that we all too often get as presidential candidates. Both are US Senators, and both in their youths had very formative adventures in foreign countries (both in Southeast Asia, as it happens). Thus both, if nothing else, have the cosmopolitan outlook that a world leader needs.

Traditionally new presidential candidates do not think much about foreign policy during their campaigns. This is especially true of governors who have only domestic experience. But, regardless of the candidates, in most election years the American public cares little for international affairs, and is far more concerned about domestic issues.

Once new presidents take office they ften have to go through a period of “breaking in” in the area of foreign policy. International events often take them by surprise and disrupt all their fine platforms and plans. This period can be very costly to the country. Think of John Kennedy’s first-year failures in his initial summit meeting with Premier Khrushchev and in the Bay of Pigs invasion. Think of George W. Bush’s first-year failures in ignoring warnings that Al Qaeda would strike in the US or that an invasion of Iraq would be fraught with danger. A little international exposure before they took office would have served them well. So perhaps the excessive length of this election cycle has a silver lining after all !

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“No Atheists in Foxholes.”? No Libertarians in Financial Crises.

Someone this week asked me what I thought of policy-makers who ex ante profess a free-market ideology and acute sensitivity to the dangers of moral hazard from financial bailouts, but who toss that ideology overboard when faced with a financial crisis. The reference was to Treasury Secretary Henry Paulson’s lobbying this week in support of a rescue for Fannie Mae and Freddie Mac, the two big home mortgage agencies, following on the rescue of Bear Stearns in March. My reply was: “They say there are no atheists in foxholes. Perhaps, then, there are also no libertarians in financial crises.”

There are more egregious cases than Hank Paulson of inconsistencies between ex ante promises by policy-makers not to bail out and ex post bailouts when disaster strikes. (Indeed, some amount of change in position may even be rational for an office-holder, though I would draw the line at false statements.) I reserve my disdain for those who go around lecturing others on the evils of bailouts, only to out-do the officials they criticized when their own turn in the hot-seat comes.

An example I have in mind concerns the members of the starting team in the Bush Administration who had lectured the Clinton Administration on the evils of its allegedly excessive bailouts of emerging markets in the 1990s, only to engage in worse when they themselves were faced with the Argentine crisis that began in 2001. There was no particular reason to rescue the Kirchner government. Argentina in 2003 would have been the perfect place to refrain from rolling over an IMF program, thereby putting a limit on the moral hazard problem. The Clinton Treasury had done this with Russia in August 1998 despite high costs in terms of systemic contagion. Yet the Bush White House continued to push the IMF to bail out Argentina. Apparently the failing lay in simple inexperience and lack of awareness that any such choices are always difficult. (See pages 9-11 of my article on Managing Financial Crises, in the Cato Journal, Summer 2007.) The Administration was very much following in the footsteps of the Reagan Administration, which talked tough at first when the international debt crisis hit in 1982 but which then participated in comprehensive IMF-led bailouts of Latin American debtors who had been pursuing far worse macroeconomic policies than the emerging market governments of the 1990s crises.

Incidentally, before writing this blog post, I checked into the World War II origins of the sentence “There are no atheists in foxholes.” I discovered to my surprise that this expression was intended, and is still considered, as a put-down of atheists, and that their lobby protests its use.

Of course the proposition is not literally true; indeed some soldiers lose their pre-existing belief in God when confronted with the horror of war. But let us stipulate that those who suddenly face death more often find religion than lose it. What strikes me as odd is that the expression is apparently normally interpreted as meaning that people who profess atheism don’t really mean it, and that their true colors come out under pressure. I had, apparently erroneously, thought rather the reverse. (Indeed, Richard Dawkins argues that vast numbers of people who would no more bet on the existence of God than on the existence of the Easter Bunny, nonetheless call themselves “agnostics” rather than atheists, to avoid rocking the boat.)

I had always taken the expression to mean that mankind’s hunger for religious beliefs comes from a desperate desire for divine intervention – or, failing that, comfort – when confronting death. Something more along the lines “There are no unsoiled underpants in foxholes.” I am in sympathy with the character in a novel who said “That maxim, ‘There are no atheists in foxholes,’ it’s not an argument against atheism — it’s an argument against foxholes.”

So what’s my point? Not to argue that governments should intervene always (nor that they should intervene never). The lesson for government officials is that wherever they choose to draw the bailout line – one hopes the line strikes an intelligent balance between the short-run advantages of ameliorating a serious financial crisis and the longer-run disadvantages of moral hazard — they should think through the system ahead of time. They should take the appropriate regulatory precautions during the boom times, which correspond to the bailouts that will inevitably come during the busts.

Long ago, the United States worked out the approximate right answer for banks: there will always be rescue of small depositors ex post when banks run into serious trouble, and so under our system, (i) deposit insurance provides formal guarantees ex ante and (ii) banks must pay the price ex ante through reserve requirements, capital requirements, and active regulatory oversight. What we now need to do is design the analogous sort of system for non-banks.

It should not come as a surprise to high officials that there are such things as financial crises anymore than it should come as a surprise to soldiers that there are such things as bombs. Human nature must be accepted for what it is. But in the case of high officials, it shouldn’t be necessary for them to alter their fundamental beliefs when crisis strikes, in the absence of truly unforeseeable developments.

Offshoring is a Dubious Policy, When the Question is Oil Drilling

President Bush yesterday eliminated a 27-year executive moratorium on off-shore oil drilling (NYT, 7/15/2008, p.A13), a move also supported by presidential candidate John McCain.

‘The Democrats responded:’

‘(1) that this was an election-year stunt, ‘

‘(2) that the move would be too small to make a difference ‘

‘(3) that it would bring no downward pressure on oil prices at the crucial short-term horizon, and ‘

‘(4) that it would not ultimately help move the country in the direction of energy security.
‘The Democrats have the right answer, but are perhaps giving the wrong reasons.’

No doubt they are right that it is a political stunt. ‘A Congressional ban on offshore drilling has been in effect since 1981, so the President’s action is moot. ‘But making a political point in this way is in itself fair game. ‘The Republicans are trying to blame high oil prices on the Democrats. ‘Similarly, the Democrats’ response could well be the right one from the viewpoint of political gamesmanship.’

But I should try to stick to economics in my blog, rather than politics. ‘The issues can be slippery; but let’s take the bit in our teeth and drill down on what would make for good for policy.’

On grounds of good economic policy the Democrats’ chosen arguments seem to me beside the point. ‘It is true that the oil in the offshore sites would not be enough to have much effect on the world price. ‘It does not amount to much as a percentage of world reserves, which is the relevant metric for determining the effect on price. “The Department of Energy estimates that there are eighteen billion barrels of technically recoverable oil in offshore areas of the continentail United States that are now closed to drilling…[A]t current rates of consumption, eighteen billion barrels would satisfy less than seven months of global demand.” (The New Yorker, Aug. 18, 2008, p. 28.) ‘But if one believed there were no cost to more domestic oil drilling, then one should conclude that every little bit helps. ‘Basic economic theory tells us to judge proposals by the ratio of benefits to costs, not by the absolute magnitude of the benefits.’

Regarding point (3), both parties are responding (unsurprisingly) to the American public’s great sensitivity to short-term prices for gasoline (in the summer) and home heating oil (in the winter). ‘No doubt high prices are causing a lot of hardship. (And even if it takes ten years to develop new oil reserves, the knowledge that the oil was coming should put a bit of downward pressure on prices today.) ‘But market prices are high today for a reason. ‘What is the market failure that would call for government intervention in the oil market?”

The most obvious market failures are the externalities that characterize air pollution and emission of greenhouse gases. ‘These of course are reasons for higher prices, not lower. ‘I am struck every time I see an article on politicians’ commitment to action on global climate change sitting side-by-side in the newspaper with an article on their opposition to oil price increases. ”” ‘

I realize that higher energy taxes are politically out of the question at this point. ‘But I could imagine legislation that would automatically raise energy taxes if and when oil prices fall, thereby putting a floor at recent levels and providing industry with the clear incentive to undertake the long-term investment in energy-saving equipment and technology that we badly need. ‘Rebate the proceeds by fixing the AMT, or removing the payroll tax on low-income Americans, one answer to the income distribution point. ‘In any case McCain’s proposal for a gas tax holiday is a spectacularly bad idea.’

The other obvious market failure that might justify government intervention in the market is national security, and here we come to argument number (4), and the central point of my post. ‘While Americans need to recognize that achieving complete energy security is an impossible goal, it should indeed by a national objective to reduce our dependence on imported oil. ‘We could thereby reduce our need to fight messy wars in the Mideast and to coddle unpalatable autocrats worldwide. ‘But, in the first place, conservation — not new drilling – is the largest and most sustainable component of such a strategy. ‘In the second place, as high as world energy prices are now by historical standards, this is not the worst-case geopolitical crisis that we should be seeking to protect our economy against. ‘That worst-case scenario is a prolonged loss of world access to Gulf oil stemming from some combination of military conflict with Iran, anti-Western popular uprisings in the region, terrorism, and/or nuclear or radiological weapons. ”’

Once the long-term goal of “energy security” policy is properly seen to be amelioration of the economic effects of such a disaster, the Republican policy of “Drain America First” is seen to be precisely the wrong response.

The British made this mistake: when they found oil and gas in the North Sea, they pumped it out as fast as possible. This was in the 1980s and 1990s, when they didn’t particularly need it. The result is that today — when the UK is trapped in an unwanted war in Iraq and world oil prices are far higher — North Sea reserves are largely depleted.

”We don’t want to maximize current domestic production. ‘Rather we want to increase conservation, leaving much of the remaining oil underground (or underwater) for decades, until we really need it, until we are so desperate that the economic benefits really do outweigh the costs. ‘The big costs are chiefly environmental, of course.”’

”The ban on off-shore drilling was originally enacted in response to damaging coastal oil spills; in the years since then we have also learned that the atmospheric damage from oil consumption is far greater than we had realized.

But the Republicans have sometimes been keen on giving oil companies access to nationally owned reserves at prices that are even below market costs, let alone market costs plus an appropriate premium placed on environmental externalities. (‘Same as hard-rock mining for mining companies, subsidized water for farmers, and grazing rights on federal lands for ranchers. ‘But the hypocrisy of the self-reliance rhetoric in Western states — “get Washington off our backs” – is another story for another time.)”’

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UAE and Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil

The possibility that some Gulf states, particularly the United Arab Emirates, might abandon their long-time pegs to the dollar has been getting increasing attention recently (for example, from Feldstein and, especially, Setser). It makes sense. The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries. The economic dynamism — most striking in Dubai – is admirable and fascinating as a longer term phenomenon, but also now clearly shows signs of overheating. Indeed inflation has risen alarmingly, as predicted. Among other ill effects, it is producing unrest among immigrant workers. An appreciation of the dirham and riyal is the obvious solution.

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies. This would be an improvement. Kuwait, for example, made this switch a year ago.

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as they have in recent years, monetary policy is constrained to be looser than it should be. Similarly, when oil prices fall generally (not just against the dollar), as they did in the 1990s, monetary policy is constrained to be tighter than it should be. A floating exchange rate regime is the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall, thus accommodating the terms of trade shocks. But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy.

Today’s reigning orthodoxy is to add an inflation target as the new nominal anchor. But this doesn’t solve the problem, if the targeted price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg. I have laid out the case elsewhere (including also for the case of Iraq). I call the proposal PEP, for Peg the Export Price. I was pleased to see that the FT mentioned this option approvingly yesterday (“Dollar-pegged Out,” July 7):

“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak.”

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