Blaming the Messenger

Commodity speculation is in the news again. The Obama version of the CFTC is apparently about to issue a report blaming the volatility of oil prices on “index speculators” (via Market Watch):

Speculators’ index trading is “creating price disruptions for producers and consumers,” said Sen. Carl Levin, D-Mich., late last month after the release of a 247-page report documenting how index traders have made large purchases on the wheat-futures market in Chicago and pushed up futures prices over the past few years.

It’s time for regulators to “change course, rein in commodity index traders and clamp down on excessive speculation that is disrupting commodity prices,” he added.

Besides considering taking away the special exemption, the CFTC, the U.S. futures market regulator, is also thinking of adopting position limits on all commodities, not just in agriculture. The move could curb the growth of some major commodity exchange-traded funds.

The CFTC “must seriously consider setting strict position limits in the energy market,” said CFTC Chairman Gensler at Tuesday’s hearings, adding that he has called his staff to research and outline “every authority available to the agency” to protect the markets and the public.”

The market is sending the world a message and politicians either don’t want to hear it or they don’t understand it. The message is this: if you do things that make the future more uncertain, “speculators” will attempt to protect themselves from the uncertainty. The problem isn’t that individuals and institutions want to protect themselves, the problem is the uncertainty. What do I mean by uncertainty?

If we send large numbers of American soldiers to the very center of a major oil producing region, “speculators” are likely to wonder if the supply of oil might be disrupted. If politicians and the environmental lobby bleat incessantly about “peak oil”, “speculators” might wonder if that will make oil more valuable in the future. If Congress prevents exploration for new sources of energy over the course of several decades, “speculators” might wonder if the reduced supply will affect the future price. If the government runs massive budget deficits, “speculators” might wonder if the massive new supply of government debt could have a negative effect on the value of the dollar. If the Federal Reserve doubles the size of its balance sheet, “speculators” might wonder if that also could have an effect on the value of the existing stock of money. Speculators are reacting to forces beyond their control.

In particular, the stability of the dollar is known to have an effect on the volatility of commodities. As I said last November in my article A New Bretton Woods:

The result of the first Bretton Woods conference was a system that pegged the US dollar to gold with the other major currencies pegged to the dollar. This system, while having many flaws, was a source of economic stability for 26 years. Other periods of fixed exchange rates (primarily fixed to gold) also produced more stable economic systems than floating rate regimes. This stability can be observed in the low volatility of commodity prices during the fixed periods. During the period of the pure gold standard from 1880-1913 (when the Federal Reserve was established) the standard deviation of commodity prices was roughly 4.5. During the free float period from 1914-1926 the standard deviation at least doubled (there are differences depending on which commodity index is used). During the Bretton Woods era from 1945 to 1971 commodity price volatility was reduced again to a standard deviation of about 8. Since 1971 volatility has again risen to about 15. (Cuddington and Liang 2003)

Congress has the following powers delegated to it in the Constitution (Article 1, Section 8):

The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States;

To borrow money on the credit of the United States;

To regulate commerce with foreign nations, and among the several states, and with the Indian tribes;

To establish a uniform rule of naturalization, and uniform laws on the subject of bankruptcies throughout the United States;

To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures;

To provide for the punishment of counterfeiting the securities and current coin of the United States;

To establish post offices and post roads;

To promote the progress of science and useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries;

To constitute tribunals inferior to the Supreme Court;

To define and punish piracies and felonies committed on the high seas, and offenses against the law of nations;

To declare war, grant letters of marque and reprisal, and make rules concerning captures on land and water;

To raise and support armies, but no appropriation of money to that use shall be for a longer term than two years;

To provide and maintain a navy;

To make rules for the government and regulation of the land and naval forces;

To provide for calling forth the militia to execute the laws of the union, suppress insurrections and repel invasions;

To provide for organizing, arming, and disciplining, the militia, and for governing such part of them as may be employed in the service of the United States, reserving to the states respectively, the appointment of the officers, and the authority of training the militia according to the discipline prescribed by Congress;

To exercise exclusive legislation in all cases whatsoever, over such District (not exceeding ten miles square) as may, by cession of particular states, and the acceptance of Congress, become the seat of the government of the United States, and to exercise like authority over all places purchased by the consent of the legislature of the state in which the same shall be, for the erection of forts, magazines, arsenals, dockyards, and other needful buildings;–And

To make all laws which shall be necessary and proper for carrying into execution the foregoing powers, and all other powers vested by this Constitution in the government of the United States, or in any department or officer thereof.

Congress has already either abdicated or delegated many of these responsibilities and they have certainly ignored the fact that this is a definitive list of what they are allowed to do – everything else being reserved to the states – but, right in the middle of this list is the one that reads:

To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures;

Congress has the power to limit the volatility of commodities by merely doing what they are already empowered to do. Why don’t they?

I am the evil “index speculator”. At times I might hold as much as 25% of my portfolios in commodity indices. If I knew the value of the dollar would be stable, I wouldn’t need to. Why? Because if the effects of inflation are removed, commodity prices are actually declining over time:

Using the longest dataset publicly available (The Economist’s index of industrial commodity prices), we analyze the behavior of real commodity prices over the period 1862-99, and have two main findings. First, while there has been a downward trend in real commodity prices of 13 percent per year over the last 140 years, little support is found for a break in the long-run trend decline in commodity prices. Second, there is evidence of a ratcheting up in the variability of price movements. The amplitude of price movements increased in the early 1900s, while the frequency of large price movements increased after the collapse of the Bretton Woods regime of fixed exchange rates in the early 1970s.

Obviously, if I didn’t have to worry about inflation, I wouldn’t need to hold commodities as an asset class. And since inflation is actually the decline in the purchasing power of money – not the price increases that are the result – stablizing the value of the dollar is the only way to assuage my concerns. The market is not at fault here and more regulations will not solve the problem. Regulations are what politicians advocate when some previous policy of theirs has failed. If you doubt that, just think about Fannie Mae and Freddie Mac.

If the CFTC imposes more stringent position limits, trading will just move to a less regulated outlet. It will cost our commodity exchanges business and drive up the cost of hedging. That will effect not only us “index speculators” but also all the businesses who use the commodity exchanges to protect themselves from the volatility that is a direct result of the policies of Congress and the Federal Reserve. And the price of oil and all other commodities will continue to be determined by supply and demand. That is one law Congress can’t repeal.

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