The mills of our nation’s legal system grind slowly indeed, but they often sprint ahead of economic theory.
The Commodity Futures Trading Commission last week charged a set of hedge funds with illegally manipulating oil prices in 2008. A story from Thursday’s paper reported that, in 2008, Saudi Arabia warned the United States that price hikes were due to speculation, since that kingdom was pumping near capacity.
And the government, in announcing its second take of GDP for the first quarter of 2011, cited high energy prices as a drag on economic growth. The natural question is whether speculation rather than fundamentals of oil production and consumption are driving the price increases that slow the economy and vex consumers.
Despite all this, there is no consensus among economists that markets for oil or other major commodities can be manipulated to any great extent or that speculation can cause significant economic harm. The idea that markets are basically efficient in that prices respond to new information about fundamental factors of supply and demand remains widely accepted within the discipline.
There are intertwined questions here. What good, if any, do commodity speculators do for society? To what extent can commodity markets, either for immediate or future delivery, be manipulated by insiders or outsiders? Can bubbles develop in commodity futures markets, and what happens when they pop? Finally, artificial bubbles or overt manipulation aside, can strong price trends feed back into cash prices?
This is too much to cover in one column. But let’s begin with the questions of whether either contracts for future delivery and speculation in such contracts can be useful to society.
Start with the simple case of a wheat farmer who would like to get $5 per bushel at harvest some months hence. She would be willing to sacrifice the possibility of any price higher than $5 to guarantee that she not get less than that. A flour miller would like to have wheat at the same future time, but not pay more than $5. He would give up the chance of even cheaper wheat for the assurance of not having to pay more than $5.
It is easy to see that society is better off if we let the two parties contract to trade the wheat for $5. Both parties will be able to operate more efficiently if they can eliminate this risk. Nor is it hard to see that establishing exchanges where buyers can meet sellers to trade standardized quantities under standardized terms would reduce transaction costs and further benefit society.
This is a case where both parties have a direct, symmetrical business interest in reducing risk, one benefiting if price does not drop and the other benefiting when price does not rise.
Note that this symmetry is not present in another common situation where someone wants to reduce risk, that of insuring a house against fire or other perils.
The homeowner has a direct interest in not losing his property. But no one could benefit directly from the house burning down. Lacking any counterparty with offsetting interests, the only way a homeowner can reduce risk is if some speculator is willing to take on that risk for a price. We call such speculators “insurance companies,” and we are better off for their existence.
It is not a leap, therefore, to see that society may be better off if people without a direct interest can take on the risk of adverse price changes in markets for oil or grain. If only those who directly produce or consume wheat are allowed to contract for future delivery, there will be far fewer potential participants for anyone in some part of the wheat industry who wishes to reduce risk. The market will be far less liquid. Risk-averse producers and consumers will allocate resources less efficiently.
This is the basis for the general belief among economists that speculation, per se, does not harm society as a whole. Indeed, it can make an economy more efficient.
This commonly accepted argument then takes a leap of faith, however. If you cannot distinguish speculation that is socially useful from speculation that is not, then speculation should be subject to little control other than to ensure honest dealing between willing partners. That is the argument economists usually make.
Recent news articles make much of the fact that some 70 percent of oil futures transactions are made by parties who neither produce nor process nor use crude or refined petroleum. I was surprised it was that low. In currency futures markets, the speculative proportion is probably more than 95 percent.
Nevertheless, one commonly hears proposals to ban anyone without a direct interest in either the production or consumption side of commodities from trading in futures markets. This would be misguided, to say the least.
This does not mean, however, that all actions by speculators in commodities markets are beneficial or that the outcomes of such markets never hurt society. But those are subjects for other columns.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.