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Demand, supply and speculators

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Demand, supply and speculators

Joe Stiglitz, a Nobel laureate and the spokesman for liberal economists worldwide, has stated that the financial market fiasco in 2008 should have laid to rest, once and for all, the myth that markets are inherently stable and efficient. I fully concur with him. By implication, rules that are enforced are critical for markets to function well. With this too I agree.

However, Stiglitz added that there are very few economists who still support the myth. Unfortunately, on this he is wrong. Two years after the near financial market meltdown, more and more economists are returning to the business as usual model: markets function best when they are subject to few rules. The financial market fiasco was the result largely of bad regulations and weak enforcement.

Nowhere is the disconnect between reality and theory more pronounced than in the oil market. Despite unprecedented sharp movements in crude oil prices during various periods since 2007, economists and others continue to argue that these movements reflect shifts in demand and supply.

Vincent Reinhardt, a scholar in residence at the American Enterprise Institute, blamed the latest oil price shock on Ben Bernanke’s low interest rate policy. In his commentary in the May 21 Financial Post, Reinhardt argued: “both the net rise and the volatility of oil prices over the past nine months were not likely to have been a surprise to him. Rather, they are a predictable by-product of the Fed’s expansion of its balance sheet in its policy known as quantitative easing.”

Such hogwash – if predictable, has Reinhartd made a killing in the oil markets?

At least Reinhardt did not try to explain the run-up and volatility in oil prices using a simple demand-supply model. But he downplayed the key role of speculators, claiming that they acted rationally in response to an irrational monetary policy: “Investment flows into commodity-related vehicles has stepped up noticeably. This has been reinforced by the Fed’s policy of keeping short-term nominal interest rates near zero, which keeps it cheap to do some of that trading on borrowed funds”.

The net rise and volatility of oil prices have been driven by speculators, not basic demand and supply. The best way to deal with speculators that make markets unstable is to tax financial market transactions – introduce a Tobin tax.

In an editorial in the May 23 Globe and Mail, Andrew Miall, a geology professor at the University of Toronto, suggested that the sharp movement in oil prices is “just supply and demand”.

He too did not see the contradictions in his arguments. For example, he stated “that global demand for oil will overtake supply in the next few decades.” According to rudimentary demand-supply analysis, this condition whereby supply exceeds demand should result in very low prices.

Later in his article he stated: “Oil prices at the wholesale level are determined by futures trading…Note the word “futures”. Prices are speculative, as they are designed to be, in order to factor in the issues of supply and demand.”

Speculation plays the key role, and speculators supposedly consider supply and demand. If so, why would oil prices rise when supply is expected to continue to exceed demand for the next few decades? Maybe Miall should stick to geology and not try to start a new career as a real, Stiglitz-type economist.

Bar Chilton, the Commissioner of the US Commodity Futures Trading Commission, pointed out in a recent speech: “There are more speculative positions in commodity markets than ever before. The number of future equivalent contracts held by these types of speculators increased 64 per cent in energy contracts between June of 2008 and January of 2011…Rather than help to fairly discover and make the price, these speculators shake and bake the price up or down, depending on which side of the market they’re in”.

It is too bad that Stiglitz is not right and that economists continue to believe in the fairy-tale of markets. Gambling in Las Vegas has some negative spillover effects. Gambling in global financial markets can have devastating negative spillover effects.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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