The internet company I didn’t start

Felix Salmon writes this morining in exasperation:

Let Me Pay to Send Email!

What I’d love is some mechanism whereby I could pay “postage” of a few cents, maybe to charity, on selected emails I send. That would be a very strong indication my message was not spam, and should be let through. But I fear coming up with a universal standard for such a mechanism is practically impossible.

A few years ago, a good friend and I were toying with the idea of a tech start-up. (This was post-crash, but we’re both really unreconstructed new economy types.) I offered a proposal that I thought had a very short shelf life. Someone surely would do something like this, soon. Hah!

We would start an e-mail service that would require mail to be “stamped”. You could sign up for it like any e-mail service, but if anyone sent mail to your address and it didn’t have a stamp, it would bounce with an explanation of how to supply postage. No new standards or internet infrastructure would be required.

The receiver of the mail would set the postage rate and get the money. That is, you do not pay a postal service for delivering mail (that’s free in the internet age), you pay the recipient for the burden your correspondence places upon her attention. When mail is delivered, it would include a convenient link whereby you could refund the postage to the sender with a single click. Among frequent correspondents, the postage would be refunded as a matter of course. It would serve as a guarantee of nonabusiveness, but would rarely be paid. Therefore, people could set their postage rates fairly high without losing mail they care about. (One could set-up whitelists of senders whose postage would reimburse automatically, and blacklists of senders whose mail and postage are both refused. Importantly, postage need not vouch for the identity of a sender, but need only associate a letter with an account from which postage has been properly drawn.)

Mail from strangers would not ordinarily be reimbursed, and would serve as a potential source of revenue for people whose attention is in great demand. Although senders would have no guarantee that mail with postage would actually be read, recipients would be encouraged to set a rate at which they’d be willing to give a quick read to a one or two page letter. Famous people could give out real e-mail addresses freely, and use the price mechanism to control the quantity of mail they actually have to sort through. Ordinary blokes would have a means to reach the powerful and famous, at a price. (Of course, senders might often plead poverty and beg that the postage be reimbursed. But mailing would be at senders’ risk. If a recipient is unimpressed with a letter, by default they pocket the cash.)

Also, various kinds of businesses might sprout up using incoming mail as a payments mechanism. These might range from informal consulting gigs (experts on various topics who generally respond to paid questions, that’d be very nice for open-source software support for example) to the email equivalent of 1-900-SEX-LINEs. Whatever. Let a thousand flowers bloom.

A scheme like this could be implemented incrementally, without changing any internet standards. Mail service providers would offer POP, IMAP, or web e-mail access, but would require that incoming mail to have an encrypted header or attachment indicating an account from which postage could be drawn (up to some amount, for a limited period of time, for a specific letter). If the token is present and payment succeeds, the mail is delivered to the user. If not, it is bounced. Mail service providers would earn revenue by taking a fraction of unreimbursed postage payments. Because a monopoly mail service provider is implausible and undesirable, the business model here would be to build software and a payments infrastructure, à la MasterCard, something aspirant competitors would prefer to use than to reconstruct. The goal would be postage interoperability. On the software side, the hardest part would be making postage-payment convenient. One could start decently but imperfectly (e.g. how e-mail-to-fax services bill), but hope to get embedded in popular e-mail clients. Initially, one would market the service as a free, secondary, spam-free e-mail account, and try to get some prominent people to offer publish addresses and postage rates. No one need abandon their traditional, free e-mail accounts, but if managing spam is as costly to others as it is to me, there’d be plenty of incentive to encourage correspondents to migrate in order to reduce the need to monitor open spools.

Legitimate commercial correspondents and opt-in mailing lists would expect to have postage reimbursed, but could not enforce that via the mail system. They would have to establish a contractual relationship prior to mailing, stating that unreimbursed postage payments from certain addresses could be billed back to the recipient. That’s a feature, not a bug. Attention is too scarce a resource to commit as lightly as with a webform checkbox set by default.

Ideas like this have been bouncing around the internet for a long time. I don’t pretend this is particularly novel. I don’t know that it could work. It astonishes me, though, that, as far as I can tell, no one has ever made a serious attempt to do this kind of thing.

Update: In the comments, Richard Serlin points to a very nice, similar proposal by Marshall Van Alstyne. (I know there are more out there, somewhere in the archives of Slashdot.) In Alstyne’s proposal the recipient opts to take, rather than opting to reimburse, which might be a better “choice architecture“. That way you don’t piss your friends off just by having forgetten to click a link.

Update History:
  • 18-June-2008, 7:45 p.m. EDT: Added update re Serlin’s pointer to Van Alstyne’s proposal.

The Lieberman plan: “Let them eat dollars.”

What distinguishes a speculator from a hedger? Here’s the New York Times:

Unlike hedgers — the farmers, miners, refineries and other commercial interests that actually make or use the commodities themselves — the speculators, like day traders in the stock market, are simply trying to profit from changing prices.

But that’s not really right. Conceptually, a hedger is a party trying to shed risk, usually accepting some cost to do so, while a speculator willingly takes on risk, hoping to profit.

If we take nominal dollars as investors’ unit-of-account, then all noncommercial interest in commodities is “speculation”, as the Times implies. People are pouring money into commodities because they believe commodity prices will rise in US dollar terms. Since holding cash is risk-free (in nominal dollar terms), all investment is speculation unless it’s offsetting some commercial risk.

But if we more realistically view investors’ planned consumption bundles as their unit-of-account, the recent interest in commodities is better characterized as hedging than speculation. Investors perceive the value of currency to be more volatile than stored commodities, relative to the goods and services they hope to consume. It would be inefficient for investors to store commodities directly, so they hire professionals to store on their behalf by purchasing financial futures. (In properly functioning futures markets, when more money wants to go long than short, an invisible hand seeks out those capable of efficient storage, and compels them to fill warehouses in order to meet the excess demand.)

What Joe Lieberman proposes to do, then, is best understood not as barring speculation by institutional investors, but as barring hedging, as forcing investors to accept risks that they would prefer to shed.

Yves Smith writes that Senator Lieberman’s proposal is “a Nixon-goes-to-China moment”. I am wrong far more often than Yves Smith is, but I’m gonna go out on a limb here and say she’s mistaken. The Senator fron Hedgefundistan is acting very much on behalf of his constituents. Smith writes:

Opponents may argue that this will simply drive investing in commodities overseas. Perhaps, but funds regulated under the Investment Company Act of 1940 (most US fund managers) don’t have that sort of latitude, and ERISA investments could similarly be reined in quite easily. And it’s US investors, plagued by (until recently) an ever falling dollar who have had particularly strong reasons to look to a hedge like commodities.

As a move to drive any speculative froth out of commodities, this one isn’t bad (but one wonders how all those commodities index funds get unwound). Although some have called for increases on margins at commodities exchanges, that hurts commercial actors as well as speculators. A move like this focuses on the underlying issue more directly.

Goldman in particular would suffer, since as the biggest manager of commodities funds based on its index, GSCI, it not only earns fees, but as we have discussed elsewhere, earns even more from an unsavory but hugely profitable practice called “date rape” around the monthly futures contract roll.

Now before the wealth-holding class howls that they’ve just been done a dirty by being deprived of inflation protection, there is an asset class that, unlike commodities, supports productive investment. and provides inflation protection, namely, infrastructure investments. The cash flow from infrastructure projects (toll roads, airports) goes up over time, as do the payouts, so they have fairly secure cash flow that increases over time. Although there is some debate about how to view them, they seem closest to an inflation-indexed bond (although any investor would need to study the ability of the enterprise to increase charges versus the drivers of operating expenses).

Many investment funds may be prohibited by charter or regulation from participating in overseas commodity markets, but Senator Lieberman’s hedge fund constituents and their wealthy accredited investors are not. The “wealth-holding class” would evade these restrictions quite easily, by funneling money through Connecticut businesses. This would be a growth-enhancing regulation for Stamford.

Meanwhile, retirement funds and retail ETF investors would be stuck with currency-denominated securities, and forced to bear any loss of purchasing power. Infrastructure as an asset class might or might not be a reasonable inflation hedge, as might stock (in the long run, equities are said to pass through inflation), TIPS, or any number of other assets. But that’s fundamentally a decision for individuals to make. If infrastructure is a good choice, let the hedge funds buy it. But so long accredited investors (and savvy individuals with direct futures market accounts) have access to commodity exposure, it is inequitable to prevent the beneficiaries of ordinary investment funds from enjoying the same.

The United States economy is suffering the aftermath of poor aggregate investment decisions over a period of many years. Losses will have to be taken on those investments. The “wealth-holding class” responsible for the misdirection of capital will do what it can to shift losses to dispersed and relatively powerless little guys. I’d be glad to see the government take a more active role in addressing America’s economic crisis. But most of the proposals out of Washington so far, including this idea from Senator Lieberman, give options to banks and wealthy investors while shoving costs and constraints onto everyone else. Trying to address the “commodity bubble” by restricting so-called speculation is a fool’s game. If it’s a bubble pop it, if it’s a response to real risks, address those. Blaming speculators is like combating global warming by banning thermometers.

FD: I’m an evil speculator, but as an individual who trades futures directly, Senator Lieberman’s proposal wouldn’t prevent me from escaping the little people’s inflation. That said, the only commodities I’m long are precious metals. I’m short Ag comodities via a retail ETF. I lose money all the time, so taking anything I say as investment advice is just dumb.

The arbitrageur of last resort

If you think $135 oil is a speculative bubble, that the only basis for current prices is want of a pin, here’s a plan. If you’re right, there’s a market failure. Those with access to physical oil are accommodating the bubble for some reason, when they could, should in theory, sell forward in quantity and insist upon delivery, forcing speculators who cannot accept physical oil to close their positions at desperation prices. Note you don’t have to overwhelm all the specs. Prices are set at the margin. You just have to sell with intent to deliver contracts representing somewhat more than demand for actual delivery to force oil off a cliff and crush the specs like bugs. If private arbitrageurs won’t do this — perhaps those who can, don’t, because they benefit more from high headline oil prices than they lose from foregoing a one-time arb &mdash then perhaps government should step in.

The US Strategic Petroleum Reserve could sell $135 oil forward in very large quantities, and refuse to close its contracts prior to delivery.

If you are right, and oil is an ordinary speculative bubble, then prices will fall sharply, and the petroleum reserve will be able to recover all the oil it sold cheaply, turning a profit for taxpayers.

But, if you are wrong, and oil prices are due to either current fundamentals or informed speculation on future supply and demand, then players interested in consuming or storing the product will step in as prices begin to fall and start buying. Prices would fall a little, but the drop would be transient, and the petroleum reserve would take a loss when it eventually repurchases to replenish.

It’d be a gamble. But if you think this is a bubble, a quick Federal pricking would be far less damaging public policy than curtailing unleveraged speculation. If you’re not so sure it’s a bubble, if you think it’s possible that current or future supply and demand justify current prices, then you should definitely not be banning speculators, who are doing the good work dissuading us from squandering what is precious. If you think current prices are a monetary phenomenon, that selling oil forward trades a valuable commodity for depreciating paper, then you don’t think this is a bubble at all, and limiting speculation is just a way of preventing would-be speculators from evading an inflation tax and spreading disquieting news.

I don’t know whether current oil prices a speculative bubble or not. Maybe, maybe not. Maybe the best way to find out is with the help of a nice long pin.

Arithmetic error

While chatting with a commenter on the previous post, I went back to the Mathematica notebook where I had played with the numbers, and found an error in my arithmetic that is, as they say, “material”. I erroneously used 68%, rather than 67%, as the late 90s participation rate, when I asserted that unemployment would be 8% today if participation returned to previous levels. The correct value is 6.6%.

That is, if an additional 0.8% of the “civilian noninstutional population” became active job seekers, but no net new jobs were created, the reported unemployment rate would be 6.6%. (The numbers, which hopefully I’ve correctly transcribed for a change, are May 2008 data from the June 6 release of BLS employment situation, Table A-1.) That’s still a big jump from 5.5%, but it’s a far cry from 8%, which sounds like a nasty recession.

To say I regret the error would understate the red-faced heart-thumpingness of the thing. Sorry!

Unemployment and the credit cycle

Much of the chatter surrounding the latest BLS release has focused on a spike in the denominator of the unemployment statistic, the fraction of the population either working or actively looking for work. Courtesy of the indispensible FRED

About a year ago, David Altig (whose macroblogging I miss very much) wrote the following:

[Since 2000] you would be justified in claiming a broad-based decline in the number of people choosing to participate in U.S. labor markets. But I use the word “choosing” intentionally, as I’m convinced that the post-2000 changes in labor force participation rates (or employment-to-population ratios, if you like) reflect trends that are largely independent of the business cycle.

Much turns on the question of why people chose not to participate in the labor force this decade. A “business cycle” explanation, as I read Altig, would mean that people left the labor force because there weren’t employment opportunities. They couldn’t find a job, and became “discouraged workers”, in the lingo. I agree with Altig that this is unlikely. However, unemployment statistics (very uneconomically) ignore price, and stagnant real wages over the period undoubtedly had something to do with the decline in participation. People chose not to work because they decided the money wasn’t worth their time.

But it’s also important to consider a credit cycle explanation for why people left the workforce. One has the luxury of choice when one can afford to do without employment. During a credit expansion, many people have that luxury, because one can live off of borrowing and asset appreciation. You can quit your shitty job and withdraw some home equity while you write the great American novel, focus on your music, or raise your children. You can go to school, even though you lack savings, because student loans are plentiful.

But when credit conditions tighten and asset prices fall, work becomes less optional. Quitting the rat race and pursuing your passion starts to recall the phrase “starving artist”, and not in a charming way. Dad might decide he needs a job to make ends meet, even if that means putting the kids in day care.

Some argue that the US economy is structurally immune from the wrenching spikes in unemployment that used to accompany recessions, because employment has transitioned from volatile manufacturing to more mellow services. See, for example, this excellent analysis from Calculated Risk. CR chooses 8% unemployment as his threshold for a “severe” recession. But the US economy need not lose a single job more to bring unemployment to that level. If participation rose back to the levels of the late 90s without a commensurate increase in new jobs, we’d be there already we’d be at 6.6% unemployment right now. [Note: In my original calculations, I mistakenly entered 68%, rather than 67%, as the late 90s participation rate, significantly exaggerating the effect. My apologies for the error!]

When we ended welfare as we know it, back in the nineties, the slogan “Choose to work” might have captured the spirit of the times. It’s ironic that more than a decade later, the apparent health of the American economy depends largely on how many people continue to choose not to work, now that the credit spigot has dried up.

Update History:
  • 10-June-2008, 12:30 p.m. EDT: Struck an corrected erroneous calculation of 8% unemployment if we returned to late nineties participation. Fixed a period that meant to be a comma.

“Double bottom line” VC job

A very good friend of mine is putting together a venture capital fund devoted to “double bottom line” companies in financial services. In particular, this fund will invest in new business models for providing services to the “underbanked” (whom my friend quaintly insists on referring to as poor people). He’s looking for people with a strong background in finance and investment who would be into this kind of thing. The job would be in New York. If you’re interested, please write something about yourself to (Please don’t write to me, I don’t know anything more than I’ve already written.)

It’s easy to be cynical about all this, and Interfluidity ain’t a job site, but this is someone I know, and what he does he does well. My apologies for the ad-ish-ness. I promise not to make a habit of it.

Supply side fairy tales

Greg Mankiw offers a strong endorsement of a proposal to cut the corporate income tax from 35 to 25 percent, claiming “It is perhaps the best simple recipe for promoting long-run growth in American living standards.” (Hat tip Mark Thoma.) A good case can be made for cutting or even eliminating the corporate income tax. But Mankiw’s argument does not cohere.

Let’s start positive. Mankiw is right to point out that the “incidence” of the corporate income tax might not in fact be as progressive as its proponents would wish. He quotes studies suggesting that workers end up paying 70% to 92% of the taxes in the form of lower wages. I’m skeptical of those numbers, but it is surely true that some fraction, perhaps even a large fraction, of the corporate tax burden falls on workers and customers rather than presumptively wealthier investors. Mankiw does us all a service by reminding us of this.

Then he tells us a fairy tale:

A cut in the corporate tax… would initially give a boost to after-tax profits and stock prices, but the results would not end there. A stronger stock market would lead to more capital investment. More investment would lead to greater productivity. Greater productivity would lead to higher wages for workers and lower prices for customers.

First, if as Mankiw has argued, the lion’s share of tax burden falls on workers, the “boost to after-tax profits and stock prices” would have to be correspondingly small. You can’t have it both ways — either investors pay the tax, and stocks would be more valuable without them, or workers pay the tax, and stockholders are mostly indifferent. Perhaps Mankiw doesn’t think that workers pay the tax after all.

Suppose there would be a surge in profits and stock prices, either because the corporate tax does burden stockholders, or out of irrational exuberance by cigar-smoking plutocrats. What then? Would “a stronger stock market… lead to more capital investment”? The tax change can’t affect the economic opportunities available to firms. It can only affect investment decisions by reducing firms’ cost of capital. As long as firms are correctly valued, the cost of equity depends on investor expectations going forward, not the level of the stock market today. Counterintuitively, if investors expect high future stock returns, that implies an increase in the cost of equity, and less corporate investment as existing opportunities face a higher “hurdle rate”. Steepening return expectations only lead to more capital investment if they reflect an improvement in the opportunities available to firms. That is beyond the power of a tax cut.

Unreasonably high stock prices can, of course, encourage capital investment, as managers try to exchange overpriced paper for valuable projects, but the quality of investments under those circumstances is questionable at best. Surely, Mankiw does not think we should jolt stock markets into a bubble, because then firms will invest willy-nilly to preserve value before investors come to their senses?

A more charitable interpretation would be that Mankiw meant that investors’ required return for stock investments wouldn’t increase as much as the after-tax value of investment opportunities would, effectively reducing the equity cost of existing opportunities. But if the after-tax opportunity values would improve (they wouldn’t, if workers bore the tax), there’s no reason to think investor return requirements wouldn’t increase as well. Just as it’s hard to say who a tax will ultimately fall on, it’s hard to know a priori how the proceeds of an investment tax break will be split between reinvestment, consumption, and safety. Some of the tax windfall would (thank goodness!) go towards delevering to reduce risk, and some would be withdrawn and spent by investors. How much actually goes to new capital investment would depend upon investor preferences, credit markets (which set the cost of safety), and the quality of potential new projects.

In theory, when firms do not have productivity-enhancing new projects at the ready, they return funds to investors. But, in the aftermath of first the dot-com bubble, and then a massive credit & housing bubble, it’s worth asking what actually happens when the economy experiences positive shocks to the supply of capital. Perhaps, in a world where agents are informationally limited and distinct from the owners of capital they deploy, it is not always optimal to increase the rate at which capital is made available to firms and investment professionals, when the same wealth might otherwise be consumed or held for future use. We might illustrate this to supply-siders as a “Laffer Curve”, with an optimal cost of capital above which productivity-enhancing investments are foregone, but below which wealth-destroying projects are funded. I think we’ve been on the wrong side of that curve for much of the past decade, so before I get excited about policies that purport to deliver growth by increasing incentives to save and invest, I’d like to see evidence that if we had more capital at hand, we’d use it well rather than employing well-paid intermediaries to destroy stuff in crazy schemes.

Supply side economics is a nice story, a hopeful story. It offers a clean, plausible policy framework: encourage investment, always and everywhere, and prosperity is sure to follow. But this decade has been about a pure a test of that idea as we could hope for. Capital in the United States was incredibly cheap, and what did we do? We destroyed a lot of wealth. We don’t need more capital (although we might soon, if our foreign backers get skittish). We need more discriminating capital. In the meantime, the only thing I’m sure “works” about the supply side story is that it shifts the tax burden from richer to poorer. I’d rather that stop working so well.

Postscript: It is always deflating to see good ideas supported by poor arguments. I’d enthusiastically support eliminating the corporate income tax entirely, if the change were paid for by new taxes at least as progressive as the corporate income tax was intended to be. But my reasons are different from Mankiw’s. Currently, the portion of corporate earnings payable to shareholders is taxed as corporate income, while the portion of earnings payable to debt holders is not taxed at all at the corporate level. (The accountants don’t call the latter earnings at all, but that is semantics.) This differential tax treatment effectively pays firms to borrow funds rather than raise new equity when they need cash, which is bad public policy. Corporate leverage has social costs, “negative externalities”, in terms of financial stability. To the degree government interferes in the capital structure decision at all (and I’m not arguing that it should), policy should favor equity financing since equity-funded firms are better able to internalize the costs of their misfortunes than are highly leveraged firms. So, three cheers for a progressively funded abolishment of the corporate income tax!

Alas, Mankiw proposes increasing gasoline taxes to replace the lost revenue. While there is much to be said for a higher gas tax, it fails the progressivity test. (Poorer people spend a much larger share of their income on fuel than do the affluent. Surely a Pigouvian would delight in redistributing the proceeds of a carbon tax as a flat transfer back to citizens to offset that unfair burden. A rebated carbon tax could be wildly popular, and help save the planet too.)

If, instead, we funded the change by increasing the highest marginal tax rate, or better yet, by creating a new top tax bracket, eliminating the corporate income tax would be a grand idea.


A dramatic explosion and electrical fire somewhere in Texas took Interfluidity down for much of the weekend. (Thank goodness no one was hurt, and all things considered both The Planet and American Powerblogs have done a pretty good job managing the outage.)

The post that follows this one will be less timely than I’d like. It was intended for publication Saturday. Oh well.

I don’t usually do link posts, but while I’m here I thought I’d call your attention to John Phipps on China and Gabriel Mihalache on models.

Claims on claims, not claims on commodities

Poor, abused readers — I am making a recycling bin of your eyes!

The following is modified from a monstrosity I began and abandoned over a month ago, thinking about futures markets. Michael Masters’ allegations regarding “index speculators” and the CFTC’s investigation of price manipulation in the oil market only make sense if the arbitrage between future claims and physical stuff fails to work as advertised. The most clear example arbitrage failures have been with agricultural products, where cash market prices and prices of supposedly equivalent expiring futures contracts have simply not converged. It is to that (now ancient in blog-years) controversy that this suggestion was originally addressed, but I think it applies to the more recent hullabaloo as well. I’m sorry that the links and context are somewhat dated.

For those of you who have been in the financial equivalent of outer space (that is, for those of you with a life), commodity futures markets have been misbehaving recently. I don’t want to get into it, but see here and here and here and here and here and here. The problem is that textbook arbitrage constraints are coming loose, the prices of things are wriggling free from one another in incoherent ways, and smashing up farmers in their confusion. Arbitrage is to finance what gravity is to physics. The movement of the spheres makes no sense, has no meaning, if rational relationships between prices aren’t maintained.

The universe is blessed with diligent quantum smurfs who ensure the constancy of gravity for us. But arbitrage is left in the frail hands of humans, and frequently our institutions are not up to the task. Fortunately, institutions are fixable. The trouble with commodity futures is that, although all the world can see that, say, spot and future corn seem inconsistently priced, relatively few actors — those with ready access to good, wholesale corn and the means and expertise to store and deliver it — can actually make the trade that would force prices and cosmic spheres to realign themselves. There are limits to arbitrage.

So, a suggestion: As an alternative to delivering actual corn to one of various warehouses in Illinois, permit those short a futures contract deliver a note issued by a kind of “corn bank”, entitling the bearer to a quantity of that very same corn on demand from the bank’s warehouses. Futures exchanges would regulate and certify competitive commodity banks, delivery of whose notes would constitute contract fulfilment [1]. At the same time, exchanges would host accessible cash markets in these zero-maturity notes (against which there would be negative accruals to cover storage costs, but lets put this technical detail aside for now).

At first glance, this proposal is a kind of nonsolution: Sure, convergence failures in futures markets would trivially disappear, as financial investors would purchase and hold underpriced spot claims and short overpriced futures (or vice versa) if the futures and spot prices were misaligned. But today’s convergence failures would just reappear in the form of overpriced deliverable notes relative to the cash price of the commodities they represent. Why would that help?

Financial markets are fundamentally information processing devices. Their purpose is to help investors place capital (or risk) where it can do the most good (or least harm). Thus, it matters very much whether the structure of a market reveals or obscures relevant details about an economic problem. This was a fatal flaw of the late securitization boom — there’s nothing wrong with securitization per se, it’s a great idea actually, to get previously obscure investments priced by broad and deep capital markets. But capital markets aren’t magic. If the securities hawked are complicated bundles of mathematical formulas of incompletely described uncertain securities, “market prices”, while they last, may not prove reliable. (OT: See this great post by Going Private about the CDO securitization process).

Trading claims on deliverables rather than direct obligations to deliver would open the arbitrage process to all financial investors, rather than relying on small groups of potentially collusive firms. Mysterious convergence failures would disappear. Rather than going “WTF?” and convening at the CFTC, we’d observe commodity banks eager but unable to sell simple IOUs for commodities at prices well above their cost because they lack storage or shipping capacity. A phenomenon of high finance would unmask itself as an easy to remedy operational problem, with a clear business case attached. Of course, people in commodity industries already understand the bottlenecks they face, and eventually they’ll find the financing to do whatever needs to be done. But clarity matters. A couple of months ago, farmers and grain elevators faced a “liquidity crisis” — their traditional funding sources, banks, were skittish due to the credit crunch, and other capital sources don’t understand their business well enough to jump in with quick money. With a more transparent informational architecture, capital would cure bottlenecks faster. Time is always of the essence, both from a broad economic perspective, and to farmers who are struggling to meet margin calls on volatile futures contracts when all they want to do is lock-in a price for corn.

This scheme would also render market manipulation more visible, by eliminating complexity at the interface between opaque, dispersed cash markets and liquid, transparent futures markets. If futures prices spike somehow, spot note price would rise, which ought to cause banks to compete for cheap access to the physical commodity. If prices seem “too high”, regulators could focus on spot market conditions (are commodity banks competitive? are producers withholding output? are precautionary inventories rising at banks? is there unusual non-bank-intermediated demand, either by current users or speculators?). Arbitrage relationships hold quite well among predictable, liquid paper assets. With a simple market for spot claims, regulators could focus on the present, and let the future take care of itself.

[1] Exchanges would insist upon these notes being non-fractional claims against actual inventory, as the exchange’s clearinghouse would ultimately guarantee the notes. These would be depreciating, negative carry notes (due to storage costs), so investors without use of the commodity would shed notes quickly, keeping inventories minimal, unless they wish to finance storage for precautionary or speculative purposes (which inventories would be transparent and measurable). Banks would compete both on the price (reflecting their quality of access to the dispersed cash market) and storage fees (reflecting operational efficiencies).

If you think it’s the “index speculators”…

Michael Masters’ testimony regarding the role of speculation in commodity prices has drawn a lot of comment since last week. [See, for example, Cassandra, James Hamilton, Tim Iacono, John Mauldin, Michael Shedlock, Yves Smith.] According to Masters’, portfolio investors’ increasing participation in commodities via futures markets has been driving a speculative price boom, over a period of years.

I have to say, I am very skeptical of Masters’ view. Perhaps I have drunk too deep of the Kool-Aid of orthodox finance, but, as the saying goes, “for every long there’s a short”, and Masters does very little to explain who is taking the other side of what he presents as a one-way bet, a virtual cornering of the commodity markets. We’ll come back to this, because the shorts are the most interesting characters in our story. But before we go much further, we might as well opine a bit on the debate du jour, is “speculation” driving commodity (and especially oil) prices?

This question annoys me, because people rarely define what they mean by “speculation”. Are you concerned about…

  1. Traditional speculators, making active predictions about future supply and demand, and determining that commodity are underpriced relative to other goods and services.

  2. Nervous hedgers, who respond to recent price volatility by taking larger-than-usual precautionary positions in order to manage operational risk.

  3. Portfolio diversifiers, who allocate some fraction of their portfolios to commodities in a price-insensitive way, as it becomes ever more convenient to do so, and the investment profession comes to view commodities as an attractively uncorrelated “asset class”.

  4. Momentum investors, chasing recent price rises into a classic speculative bubble.

  5. Inflation hedgers and monetary skeptics, who view the purchasing power of financial assets as increasingly volatile, or who expect a decline in the purchasing power of financial assets, but who do not view commodities as undervalued relative to other goods and services.

  6. Corporatist governments, who seek to shed market risk by obtaining non-market access to commodities (vertical integration), or whose policies amount to speculation on future market conditions. Examples include countries that restrict food or commodity exports in response to high prices; China, whose state-affiliated firms purchase stakes in suppliers of essential commodities; Saudi Arabia whose purchase of GE Plastics looks to capitalize on preferred access to petrochemicals; oil producers generally, when they produce below capacity; and the United States with its strategic petroleum reserve. All of these practices have the potential to reduce supply to unaffiliated commodity users who rely on public markets.

It takes all kinds to make a market, and I think that we’ve got the whole menagerie. Also, we shouldn’t forget this story, from Jeff Matthews (ht WSJ):

…the fact that a) world oil demand is up 12 million barrels a day since 2000, and non-OPEC oil supply is up only 4 million barrels a day since 2000, and b) America decided to convert food into ethanol at the very moment that c) China’s demand exploded.

See James Hamilton for a fuller exposition of the case that oil price fundamentals are driving prices.

Masters fingers as the villain “index speculators”, a Frankenstein combination of Types 3 and 4 above. There outta be a law agin’ them, he suggests to Congress. Pension funds should be barred from commodity investing, loopholes that have undermined speculator position limits should be closed, and the increasingly meaningless distinction between commercial and noncommercial traders should be resurrected in CFTC reports. Okay.

But what if the price-setting speculators are not momentum-driven index funds, but “traditional speculators”, correctly predicting that prices are below long-term fundamentals? Then limiting commodity speculation would prolong the mispricing, and cause us to waste resources that are kept artificially cheap. Alternatively, what if (as I suggested in the previous post) commodity prices are being driven by monetary fears? Then banning pension funds from commodities would amount to barring the exits, forcing workers to watch helplessly as their retirements are devalued away. If “fundamentals” are driving prices, or a flight by official actors from market to non-market means of resource allocation, limiting speculation would do no good, but would obscure the news by interfering with price transparency. The only circumstance under which limiting “speculation” might be a good idea is if the dominant tale is a momentum-driven speculative bubble. Which could, of course, be the case. Or not.

Which brings us back to the shorts. “Irrational exuberance” isn’t enough to cause a speculative bubble. There needs to be something else that discourages rational traders from taking irrational traders’ money when they buy overpriced assets, “limits to arbitrage” in the lingo.

Now, this is an old conversation in academic finance, especially with respect to the stock market. Heck, go chat with Brad DeLong and Robert Waldmann about noise traders, they’re right here in the blogosphere. We’ll dispense with the details here, and recite the pithy Keynes quote…

The market can stay irrational longer than you can stay solvent.

If a stock is overvalued, to correct the mispricing, you must sell it short. Even if you are right that it is overpriced, if the speculative mania continues, red ink on your short position might drive you out of the market and into poverty long before your foresight is vindicated. On the stock market, unleveraged “longs” can safely buy and hold, but “shorts” are forever at the mercy of the lunatics, hoping and praying that starry-eyed optimists don’t go even more batshit insane. Sane people sit on the sidelines, allowing enthusiasm to run unchecked, for a while.

But there’s a problem with applying this story to commodities. At least in theory, shorts in commodity futures needn’t face the same risks as stock short-sellers. Commodity futures are time-bound and perfectly hedgeable. If you are a commodity producer, and know that futures prices are way too high, you can sell your own product forward into the market. If prices move irrationally against you, your only cost is the foregone opportunity of a speculative gain. If cash prices are out of sync with inflated futures markets, then anyone (in theory) should be able to get into the act, purchasing physical commodities and storing them for future delivery, thereby locking in a certain gain, a perfect arbitrage. If you think that the commodity boom is a speculative bubble, then you have to explain not only who is buying, but why all that speculative interest doesn’t attract knowledgeable sellers who hold the price to “fundamentals”.

A while back, Yves Smith pointed out the possibility that…

the volume of futures contracts is so large relative to the actual deliverable commodity that arbitrage (via taking physical delivery) won’t force convergence of futures prices to cash prices at contract maturity.

In other words, in this messy real world, speculative interest could overwhelm the arbitrage mechanism designed to tether futures prices to fundamentals, for a while. But that begs another question. If you buy Masters’ story, then we are in the midst of a speculative bubble that has been building over a period of years, not a sudden spike. So why haven’t arbitrageurs increased their capacity to store and deliver goods, as speculative demand has slowly ramped up? The opportunity to profit is tremendous, especially if there are hordes of paper speculators who have no choice but to liquidate or roll their positions every few months. People with access to the physical commodity could profit from more than the ordinary arbitrage. At every roll, they have the entire community of “index speculators” over a barrel. Shorts are under no obligation to let speculators close out their positions at inflated “market prices”, or even estimated “fundamental values”. They can force longs to accept prices that overshoot downward, exacting a price for release from obligations that paper speculators are incapable of fulfilling, the obligation to accept delivery. If you think Masters is right, you have to explain why, year after year, those taking the short side have been willing close their positions at a loss rather than forcing more deliveries. Why haven’t shorts entered the market who are capable of calling index speculators’ bluff?

Hmm. Let’s turn once again to Smith:

Remember, you can arbitrage futures to physical only if you are permitted to do so (only certain traders, known to have access to the storage and transport, are allowed to take or make physical delivery) and can actually obtain the relevant commodity.

So, there are potentially barriers to entry for bluff-callers. Who are these “certain traders” permitted to make delivery? I don’t know, but one would imagine that commodity producers would be prominent among them. So, for the conspiracy-minded among you, here’s a theory: Producers’ core asset is not the stock of goods they have for sale today, but their potential to produce and sell a stream of commodity out into the indefinite future. It might be worth it for producers to bear an opportunity cost by not exploiting futures trades aggressively — that is by letting specs close positions at artificially bid-up prices — in order to inflate the apparent value of their enterprises, especially when producers intend to borrow funds, sell equity, or make stock-based acquisitions. Managers whose compensation is equity-linked might be particularly enthusiastic. Depending on how numerous and competitive the community of enterprises capable of physical delivery on prominent contracts, there might be a tacit cartel on the producer side, accommodating speculative futures prices, while managing spot supply so that cash market prices (which are less consistent and transparent than futures prices) are not outrageously out of line with futures market benchmarks.

Is this really going on? I have no idea. As I said initially, I can see all kinds of reasons why commodity prices might be rising, besides “irrational speculative bubble”. But I do know this. If it is the “index speculators”, if it is a speculative bubble, then those who blame workaday money managers asset-allocating into commodities are buying the con and blaming the patsies. If there’s a speculative bubble, the mystery — and the target of any reasonable policy interventions — lies on the short side. Sooner or later, the lemmings going long will take care of themselves.

Update History:
  • 29-May-2008, 3:30 p.m. EDT: Eliminated a superfluous “so” (only one of many).