In a speech given on April 17, 2012, President Barack Obama took his place alongside rulers throughout history. He blamed speculators for causing economic disruption. He implicitly labeled their actions as the cause of high oil and gasoline prices. For thousands of years, kings and presidents and prime ministers have blamed speculators for their troubles. Speculators join Jews and immigrants and heretics as the most vilified groups in all of human history.
It is ironic to find Jews on this list. In the ancient Hebrew ceremony of Yom Kippur, a ceremonial goat upon whose head was placed the sins of the people was sent into the wilderness. The animal who bore the symbolic weight of man’s sins acquired the name of scapegoat. Through the ages, that title has attached to any person who is wrongfully shunned and demonized for the actions of others. The practice of the ancient Hebrews has given us the term used to define their modern ostracism.
Barack Obama is now casting speculators in the role of scapegoats. He is re-playing a political drama that was first staged at least as far back as the Roman emperor Diocletian. We must explore the thematic content of that drama in order to recognize it for what it is – political theater rather than economic policy.
The President’s Five-Point Plan for Combating Oil Speculation
President Obama announced a $52 million proposal for “oversight” of the market for crude oil. This would take the form of regulation of the market for oil futures, regulated by the Commodity Futures Trading Commission (CFTC), whose budget would be a prime beneficiary. The money would fund a six-fold expansion of staff, or what Mr. Obama called “more cops on the beat.” It would also buy improvements in technology used to monitor commodity markets. Penalties for “market manipulation” would be increased. Lastly, the “margin requirements” for speculation – that is, the downpayment required on speculative positions – would be increased.
The Circumstantial Case Against Obama
A plan of action based on a logical position is subject to scrutiny on two bases. The more superficial basis is circumstantial – are the facts giving rise to the plan accurate? On this basis, President Obama’s proposal is highly vulnerable. He has called for action while adducing absolutely no facts to support the call.
The Wall Street Journal (4/19/2012) declared that “On Tuesday, President Barack Obama gave a speech about … nothing…Nowhere in his remarks did the President claim that speculation is doing any harm. He did not cite any negative impact on the oil market. He did not say that speculators are manipulating oil prices, nor did he describe in even the vaguest terms the individuals or institutions that might be involved. He didn’t cite any research. Mr. Obama didn’t even, well, speculate about whether oil prices would be higher or lower if not for unnamed actors who may or may not be affecting the markets.”
At first glance, this empirical disconnect may seem extraordinary. It is actually strategic. Mr. Obama knows that acolytes on the left wing are supplying all the missing details noted by the Journal – or rather, purporting to do so. By ceding this role to them, Mr. Obama avoids taking responsibility for their shortcomings of fact and analysis. Still, the implications of Mr. Obama’s plan can be checked for conformance to fact.
The overarching theme of Mr. Obama’s speech was the crying need for “regulation” of the oil market. But the single overwhelming fact of life here is that the market for crude oil is an international market. The U.S. Congress and Executive branch dispose over domestic markets only. At most, the federal government can regulate only that portion of oil transactions occurring within U.S. borders. Oil makes the world go round; domestic U.S. transactions comprise only a fraction of the global whole.
As it happens, there is a market operating within the confines of the U.S., the NYMEX commodities exchange, which sponsors a futures market in oil. Mr. Obama referred to it specifically. It is not free of federal regulation. The CFTC regulates NYMEX; indeed, it voted last year on a rule intended to curb speculative excesses in commodity markets. In other words, regulation has already existed for years to achieve Mr. Obama’s general purpose and has passed a recent measure for his specific purpose. This naturally begs the question: Why is more money needed to do something that is already being done?
Perhaps the answer is that it isn’t being done well enough. Ponzi-type fraud is the simplest and – at least in principle – most easily detected and proved of all financial crimes. A regulatory agency can establish its effectiveness by either showing it deters fraud (e.g.; the absence of Ponzi schemes) or that it quickly detects and punishes it. Yet recent disclosures show that federal regulatory agencies fail both these tests. Not only have Madoff, Stanford, et al enjoyed long undetected runs, but regulators rebuffed attempts to expose them by private individuals. As the Journal pointed out, the CFTC itself was caught napping by the MF Global case, which involved appropriation of shareholder funds – another egregious financial crime of the type that regulation was designed particularly to prevent.
Mr. Obama implies that the proper reaction to regulatory failure is … more money allocated to the people and agencies that failed. Indeed, this has been the core position of government regulation for over a century, since the founding of the Interstate Commerce Commission in 1887. It is based on the principle that competitive markets are inherently faulty and that regulation is the only mechanism for correcting the faults. Yet the unspoken truth is that there is no theory of regulation that guides regulators in their task of correcting the mistakes of the market. This brings us to the second basis for examining President Obama’s proposal – its underlying logic.
The General Theory of Regulation
The general theory of government regulation of business is that there is no general theory of government regulation. Well-known public-utility economist Alfred Kahn wrote The Theory of Regulation some forty years ago. It was an interesting book that provided many useful insights, but did little in practice to advance the cause of regulation. It applied only to so-called decreasing cost industries or “natural monopolies,” which we now realize are roughly as scarce as hen’s teeth. It essentially assumed that regulators possessed all relevant information about the industries they regulate, when in reality the central problem of regulation is that they don’t, can’t, don’t seek to and wouldn’t try to implement Kahn’s ideas even if they did.
What should regulators try to do, anyway? Mr. Obama implies that their chief task should be to prevent speculators from making money because speculators’ profits somehow come “at the expense of millions of working families.” Now this is not self-evidently true. It is a hypothesis to be proved or disproved using either logic or empirical evidence or both. (In fact, it is utter nonsense, as shown below.) But even if it were unimpeachably true, it wouldn’t make the case for regulatory intervention. Every economics textbook states that economists do not possess a basis for elevating the happiness of one person over that of another. There is no inherent reason to suppose that speculators are evil and “working families” are good, that the gains of the former should be redirected to the latter. Congress redistributes income from the many to the few every single day – from taxpayers to “family” farmers (actually corporate farmers), from consumers of imported goods to shareholders of import-competing businesses, from taxpayers to shareholders of “green businesses, etc. As often as not, money is taken from (relatively) poor people and given to (relatively) rich ones. Mr. Obama tacitly or explicitly approves of these transfers.
Should regulators try to lower oil prices? If so, how should the price go? And how should regulators bring it there? It’s no good claiming that regulators should somehow duplicate the result that would prevail in a competitive market, because regulators do not possess the omniscience and omnipotence necessary to produce this outcome. The only way to do it is to allow a competitive market to operate – the very thing that regulators cannot do.
When you have no idea what you are trying to do, it is not surprising that the results of your activity are unfavorable. The economic specialty called “industrial organization” devotes a subset of its time to studying the effects of government regulation. Its verdict is mostly negative. Yet this is Mr. Obama’s go-to solution, a recourse he deems promising enough to feature in a presidential address during an election campaign.
The Left-Wing “Theory” of Oil-Market Speculation
There remains the long-bruited left-wing hypothesis – largely unstated but relied upon by the President – that the market for crude oil is controlled or at least dominated by speculators. The closest Mr. Obama came to referencing this theory was this passage from his speech: “We can’t afford a situation where speculators artificially manipulate the market by buying up oil, creating the perception of a shortage and driving prices higher, only to flip the oil for a quick profit.” Since this is all we have to work with, all we can do is work with it.
Taken at face value, this is gibberish – it makes as much sense as if Mr. Obama had said “speculators will levitate five hundred feet in the air, magnetically transfer the cash from working families’ wallets into their own pockets and then fly away to their resorts in Timbuktu.” If all speculators had to do in order to make money was buy something, wait for the price to later rise because they bought it, then sell it at a profit – well, the speculative profession would be crowded with entrants. What a deal!
Of course, speculation doesn’t work that way, as any curious onlooker will discover if they try it. In the first place, the oil market is the world’s biggest market, possibly excepting the one for illicit drugs. In order to drive up the price significantly, the volume of buying must be immense – far beyond the resources of any one bank, hedge fund or international financier. Not only that, but to keep the price high, the buying must continue day after day, week after week and month after month. Mr. Obama refers to “speculators” as if they were a unified group, acting in concert. A cabal of speculators able to pull off this operation would defy everything economists know and teach about cartels, which virtually always fail unless unified under the aegis of a single government. (As the history of OPRC demonstrates, separate governments are no more able to coordinate their actions than are separate individuals.)
But if this improbable feat could be accomplished, that would suffice to produce Mr. Obama’s “market manipulation,” right? Wrong. This gigantic buyer’s cartel would be driving up the price it paid for the oil it bought – in effect, bidding against itself. (Mr. Obama’s wording even admits this, although it is hard to believe that he knows or cares about the literal truth of his words.) And when the time came to sell and reap the profits of their diabolical scheme, the cartel would find that their sales drove down the price they received – and along with it, any profits they might earn. In order to influence price in the first place, the cartel would have to conduct huge transactions. But the very size of their purchases and sales would work against them by forcing them to pay more and receive less than the prevailing market price. Just try to make big money under these conditions! In real life, market traders bend over backwards to avoid influencing price with their transactions for this reason. Successful speculators do not cause price volatility; they hitch a ride on volatility created by other factors. And their actions do not hurt ordinary people – they help them.
Recent left-wing refinements have focused narrowly on the futures market for crude oil. At one time, so their argument goes, this market was dominated (“70% of activity” is the phrase used) by commercial hedgers such as businesses trying to reduce their risk by buying future oil at a guaranteed price. But in “recent years” (quoting from accounts such as that in the Miami Herald), this ratio has reversed, with “70% of activity” being taken over by speculators conducting “hundreds of billions” of dollars worth of transactions beneficial to Wall Street either due to brokerage fees or speculative profits.
This theory is no more soundly based than the generalized theory vaguely referenced by Mr. Obama. A hedging transaction requires somebody to take the other side of the transaction. In classical theory, that is a speculator. Thus, a 70% share claimed by hedgers suggests the likelihood of a 70% share (at least) to speculators as well; there was no halcyon period during which speculation was absent from the futures market. (Actually, there is also the possibility that arbitrageurs may provide liquidity for hedgers, but this complication does not salvage the left-wing position.) Ironically, the restrictive rule passed by the CFTC last fall was cited by one Democrat who voted for it as potentially detrimental to liquidity for commercial hedgers, according to the Journal.
Moreover, the prospect of a futures market “captured” by speculators turns out to be less fearsome than implied by the left. Even if a speculative cabal somehow succeeded in driving up the futures price of crude oil, the matter would not end there. Once the futures price exceeded the spot price by an amount exceeding the costs of storage, end-users would have an incentive to buy oil and store it for sale at the elevated futures price. Their sales on the futures market would drive the price down until the differential between spot-market and futures-market prices for crude oil was restored to an appropriate level. After all, speculators are not the only people in the world allowed to make profits from buying and selling. Arbitrageurs can do it, too. Unlike speculators, they are running zero risk, so they are a sure bet to act anytime spot and futures prices get out of line.
So much for the dreaded speculative takeover of the crude-oil futures market.
The Economic Theory of Speculation
Risk is a fact of life. It is defined in economics as variability of future outcomes. Part of it relates to possible variations in future prices. Farmers have to plant crops without knowing what crop prices will be in the future. Businesses will need to buy oil in the future, but do not know what the oil will cost then.
Speculators are people who specialize in bearing risk. By buying something now and holding it (or contracting to buy it in the future, giving somebody else the incentive to produce and hold it), they arrange for it to be available in the future. If it becomes scarce in the intervening time, its price will rise. They will sell it and make money. Their sales will tend to reduce the price and increase the future quantity available. Thus, the ordinary people – consumers of the good in question – gain from their activities. If speculators did not act, price would be lower today and higher in the future than if they did. Thus price volatility, or the amplitude of price fluctuations, goes down, not up, because of their actions.
To be sure, it is difficult to perceive the beneficial actions of speculators in a gigantic market like crude oil because speculators do not act in concert and their purchases are not ordinarily enormous enough to influence price on a daily basis. The exception occurs when external events threaten supply disruptions, causing end-users of oil to become speculators. That is, people who ordinarily buy on a daily or weekly basis may make unusually large purchases to avoid getting caught short due to interruption in supply. Although this state of affairs in inherently temporary, it can last for several months. (Older readers may recall the days of gas lines and rationing in the 1970s and early 1980s, when drivers did the same thing while buying gas for their cars.)
The fact that ordinary people can become speculators is the tipoff to the fact that speculation is not evil ipso facto.
Mr. Obama’s Motives
The scapegoat was originally used to lift the burden of sin from the community. Now it is used to falsely deflect blame for sin onto another. The role of scapegoat is played by anonymous players called “speculators.” The actual sinner is government in general and the Obama administration in particular.
Government in general has collected more in taxes from ExxonMobil during 2004-2009 ($59 billion) than the company earned in profits ($40.5 billion). It has allowed the company a smaller allowance for depreciation (6%) than is available to most manufacturers (9%). So-called subsidies to the oil industry, such as the oil-depletion allowance (really just depreciation of an asset), amount to almost 50 times less than those enjoyed by “green” energy firms that were given loans and loan guarantees by the Obama administration. Gasoline prices have been kept continually high by requirements for dozens of so-called “boutique” blends in the several states of the U.S. The administration has refused to facilitate the transmission of oil produced using shale-derivative processes by blocking approval of the Keystone Pipeline.
Economics and morality are separate disciplines, but occasionally their paths intersect. Few professionals witness the cold-blooded and deliberate murder of truth as often as do economists. The scapegoating of speculators is a political drama that is Biblical in its origins, proportions and implications.