July 31, 2008
On July 30, a bill to regulate futures failed in the House. Under special rules, a two-thirds majority was required. It missed by nine votes. It is expected that similar bill will be introduced before the end of the year under rules requiring only a majority. Republicans opposed the bill on a technicality. There is little doubt that a similar will pass. This will be bad for both freedom and efficiency, but that is normal whenever Congress votes to do anything.
Are speculators driving up commodity prices? No. Whenever prices rise, politicians and journalists blame speculators. This is universal. It has been going on for centuries -- as long as governments and central banks have inflated their currencies and produced bubbles.
To understand the commodity futures market and its relation to retail consumer prices, we must begin with the insight of the original Austrian School economist, Carl Menger. He made that the fundamental breakthrough in the history of modern economics.
Menger explained retail prices in terms of competition among consumers. Consumers set prices. Producers do not. Consumers compete against consumers, and producers compete against producers. Out of this competition comes an array of consumer prices.
Sellers can offer goods and services for sale at particular prices, but until consumers make purchases at this price, the suggested price is irrelevant. This is because consumers set prices. This is the fundamental insight of Austrian School economics regarding pricing.
When you go onto an automobile showroom, you see cars with stickers on the windows. There will be a price. This is the famous MSRP: manufacturer's suggested retail price. It is the starting point for negotiating. It is a ballpark figure. In a falling market, this price will set broad limits.
The same is true of the sale of a home. The costs of production are irrelevant. What is relevant is the number of buyers who are ready and able to buy the home.
This insight overturned the theory of classical economics, namely, that costs determine prices. From Adam Smith until Karl Marx, economists argued that labor costs set prices. Other economists argued that general costs of production set prices. Menger denied this theory. He argued that costs are determined by competition among producers.
Producers attempt to forecast future conditions of supply and demand. They search for bargains in the capital markets. When they find these bargains, they buy them. They use them for the production of final goods. Then they offer these final goods for sale. The costs of production rise because more producers make the same forecast regarding future conditions of supply and demand. Then they go in search of producer goods, including raw materials, labor, land, and tools. They bid against each other in a free market for capital goods. This is why the costs of production rise. The costs of production rise over time to meet expected future retail prices.
Menger said that the classical economists had cause and effect backward. Classical economists argued that rising costs of production lead to rising consumer prices. Menger argued that it is the expectation of rising future consumer prices that leads to the increase in the costs of production.
Modern economics was born with this insight. He made it in 1871. From that time forward, especially within the camp of Austrian School economics, economists have explained rising consumer prices in terms of rising consumer demand. They do not explain rising consumer prices in terms of rising costs of production.
Consumers compete. They bid away resources from each other by offering the highest bid, market by market. High bid wins. The outcome of this constant bidding process is an array of prices. It is constantly changing.
Instinctively, most investors side with the classical economists. They look at rising cost of production, especially the price of commodities, and they conclude that this will force up consumer prices. They are incorrect. This will not force up consumer prices. It is the producers' expectation of rising consumer demand, leading to higher consumer prices, that is causing the increase in the price of capital goods, raw materials, land, and even labor.
With this as background, we must look at the question of the role of hedge funds in bidding up the price of commodities. There is no doubt that there is increased demand in the commodity futures market for ownership of long positions in commodities. A long position is a legal right for the owner of the long contract to buy a specified amount of a commodity at a future date and take delivery. But almost no holder of a long contract ever takes delivery. He sells the contract instead.
This is why the futures market is mostly a speculators' market. It sends information about expected prices, but the actual sellers of commodities are only minor participants. They sell their commodities to users of these commodities. They use the futures market to lock in their their selling price months in advance. They sell short. If the price rises, what they gain from selling their crop or output they lose on the contract. If the price falls, what they lose on their crop they gain on their contract.
The contracts are legal obligations of shorts to deliver a commodity at a specified price at a future date. There cannot be a long position without a short position; a person does not agree to buy a specified quantity of a commodity unless there is another party to the agreement. There must be a long for every short. This is the long and short of the commodities futures market.
Long investors who believe that commodity prices will rise in the future enter the market, almost always with leverage, meaning that they do not pay 100% of the purchase price of the commodity to be delivered. If a large number of investors show up, trying to take a long position, will scare off investors who want to take a short position. This will not scare off all of them, but it will scare off a lot of them. The only people who will take a short position are people who believe that commodity prices will fall, despite the entrance of new investors who want to buy a long contract.
As the supply of shorts decreases, because of the shorts' fear of too many longs entering the market, this raises commodity futures prices. Why? Because of supply and demand. There are more people seeking to buy a long contract at today's price than there are shorts willing to bet against them. So, the price of the contracts rises. It rises because there are fewer suppliers of short contracts.
The commodity futures market is like every other competitive capital market. There is nothing theoretically different in a commodities futures contract, a stock market contract, an options market contract, and so forth. It is the competition of buyers versus buyers, facing the competition of sellers versus sellers, that sets every price in every market at all times. There are no exceptions. This is how the free market works.
The entry of lots of longs scares off some shorts. The shorts are willing to guarantee delivery of the commodity, even though they will sell their contract before they are required by the contract to deliver it. They are increasingly in short supply. With reduced supply (shorts) and rising demand (longs), the price of the contracts increases.
Economic theory does not distinguish between leveraged buyers, leveraged sellers, and the source of the funds. Prices on any given market reflect existing rules governing the market. If practices change, but the rules do not change, then there will be increasing uncertainty regarding the outcome. This has nothing to do with economic theory. How the contracts are financed is irrelevant to the fundamental fact of economics, namely, that competition among consumers on the one hand and sellers on the other hand is what sets final prices. Consumers compete against consumers; sellers compete against sellers. It does not matter for economic theory how buyers and sellers are financed. What matters is competitive bidding in a free market. This is true of retail sales. This is true wholesale sales. This is true of commodity futures markets. High bid wins.
If buyers of gasoline around the world decide that the price of gasoline is too high, and they cut back on their purchase of gasoline by 10%, the retail price of oil will fall. This will be telegraphed (an ancient image) to retail sellers by a fall in the futures price. It does not matter how many people are involved in the oil futures market. It does not matter whether the participants on the long side are financed by banks. What matters is that consumers decide to reduce consumption because the price is too high. Investors' rival expectations of consumers' buying habits are what set prices in the commodity futures market.
Any argument that obscures this relationship will lead investors into error. Do not be blinded by discussions of how the rules are enforced on the commodity futures market. Unless you are an investor in that market, the rules are irrelevant for you. Whatever happens on the commodity futures market, consumers are in charge -- not longs, not shorts, and not the regulators.
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