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Nixonian Fallacy

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By Sebastian Mallaby
Monday, June 30, 2008

A few years back, when "subprime" generally referred to beef, economists used to congratulate themselves on their progress since the 1970s. Central banks had learned to tame inflation. Politicians had learned to appreciate the folly of price controls. Thanks to the economics profession, policymakers had grown wiser.

Well, inflation has returned. And politicians are out to control prices again, this time in futures markets.

You see this most clearly with oil prices. Barack Obama worries that "unregulated energy speculators may be distorting the market." John McCain complains that "while a few reckless speculators are counting their paper profits, most Americans are coming up on the short end." On Thursday a measure demanding a clampdown on oil trading passed the House402 to 19.

So it's time for a quick refresher: Richard Nixon's early-1970s price controls were a disaster. Administering the controls on energy alone took an estimated 5 million man-hours per year and punished motorists with gas lines. Repeating this experiment by clamping down on oil trading is like burning your hand on a gas stove and then sitting on a barbecue.

Would-be Nixons argue that hedge funds and their ilk are piling into oil futures, driving prices above "reasonable" levels. They note that in 2000, speculators owned just over a third of the "paper oil" traded on the New York Mercantile Exchange but now own more than two-thirds. This buying pressure on paper oil is said to be pushing physical oil up. Stop the speculation, they say, and prices would revert to normal.

The most basic problem with this claim is that a speculator can buy paper oil only if someone else sells to him. For every trader who bets on a price rise, there must be another who bets the opposite. So an increase in the number of speculative players does not show whether prices will move up or down. Think of a youth soccer team: If it adds two extra players it doesn't become more likely to win, because its opponents will add two players as well.

What matters is who those players are: Will they aggressively push the ball up the field, or will they retreat? Sometimes the bulls are more eager than the bears, and prices spiral upward. But this is not some autonomous force that comes out of nowhere. If the bulls have the upper hand, it's generally because supply and demand favor higher prices. The fundamentals of physical oil drive the psychology around paper oil more than vice versa.

Why do I think that? Financial behavior often influences the real economy. In the recent mortgage bubble, for example, financiers made mortgages available to people who had been ineligible: They changed the fundamentals of demand for housing. But oil speculation is not like that. Investors who buy paper oil do not alter the demand for physical oil. Every paper claim they buy is a paper claim they will later sell, because they have no intention of converting their paper into real oil stocks. Oil is too expensive and cumbersome to store. A speculator is not going to show up in Cushing, Okla., when his futures contract matures and drive away with a tanker truck full of oil.

The uncertain connection between speculation and price trends is clear in recent history. The Commodity Futures Trading Commission reports how much paper oil is bought and sold by commercial users -- oil companies, refiners -- and how much is bought and sold by speculators. During the first seven months of 2007, speculators as a group tripled the amount of paper oil they owned, buying it from commercial players. But since last August, speculators as a group have not added to their positions -- yet this was when oil prices went skyward.

It would be too much to claim that futures prices don't influence players in the physical market. But to the limited extent that speculators' influence is real, this is probably a good thing. If speculators see that oil suppliers are headed for trouble and that oil demand is trending up, they express their expectation of a higher price via the futures market. This can deliver a valuable message: Governments and consumers had better adjust before shortages get even nastier.

Just as in Nixon's day, government's response to runaway prices would have unintended consequences. The most popular proposals would limit how many contracts a speculator can buy or sell on a futures exchange, and prevent trading with mostly borrowed money. But the more you restrict trading on U.S. exchanges, the more you drive trading into the shadowy world of the unregulated swaps market or onto offshore rivals. In the 1980s, Japan tried to prevent futures traders in Osaka from speculating on the Nikkei stock index. Nikkei futures trading thrived -- in Singapore.

Most fundamentally, Nixon's heirs forget that the "speculators" they attack are often trying to reduce risk, not embrace it. Pension funds have piled into oil because they are trying to protect themselves from inflation. Small investors who load up on retail oil funds are mostly doing the same. I know my family will consume several thousand dollars' worth of oil this year, so I logged on to Fidelity's Web site and locked in my price. Does Congress think I'm irresponsible?

smallaby@cfr.org


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