speculation: stabilizing or destabilizing?

In the Panglossian world of academic finance, all markets are self-regulating and all participants are rational economic agents with the same information and motivations.

Commodity trading, where there are two different classes of market participant, with different knowledge levels and goals, really doesn’t fit in this model,.  On the one hand, farmers and miners, who are typically large corporations, want to guarantee a minimum level of cash flow for their operations.  They do so by selling a certain portion of their output for future delivery through any of a variety of kinds of commodity contracts.  The firms are deeply knowledgeable about the products they produce and sell, and they employ highly paid professional traders to do their commodity trading.  These are the hedgers.

And then there’s everyone else.

An obvious question is why someone would take the other side of the hedgers’ trades, given their superior information and high degree of trading skill.  Clearly, however, someone does, since we know that companies are routinely able to hedge their output.  Academics call these counterparties speculators.

To the academic world, it follows that speculators are a stabilizing influence.  They help to regularize the cash flows of potentially highly cyclical companies; commodities futures/forwards prices would also be higher than they are if speculators didn’t step in to take the other side of the hedgers’ trades.

In its most basic form, that’s the academic theory.

One trouble with the theory is that it’s just a generalization of the way commodities markets worked a generation ago, mixed in with the semi-religious belief in an “invisible hand” that ensures a favorable outcome in economic affairs. Worse, the basic metaphor no longer fits the facts–if it ever did.  Two examples:

1.  the silver market.  The broadening of commodities trading access to large numbers of private individuals, and the rise of commodities-oriented ETFs that give indirect access to a larger, less-affluent group, mean that some commodities markets are no longer dominated by hedgers. The “other guys” are now running the show.  And their recent behavior in silver is, to my eye, anything but stabilizing.

2.  the oil market.  Oil is an extremely economically important commodity.  Demand is highly inflexible.  Supply and demand are finely balanced.  As a result, it’s possible for speculators–whether private individuals, hedge funds or the commodity trading arms of commercial and investment banks–to be only a small fraction of all trading but still exert enough upward pressure on prices to make them, say, 10% higher (or lower) than they otherwise would be.  Prices might be stable in the sense that they don’t fluctuate much.  But a movement of this size means a major redistribution of wealth around the world.  Great for oil-producing countries, not so hot for everyone else.

In these instances, at least, speculators are a destabilizing force.

The recent ad hoc action of commodities exchanges in raising margin requirements appears to have pricked speculative bubbles in a number of commodities.  But I think it would be better for all of us if we had better regulation and a coherent framework for action.

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