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.


24 Responses to “The Lieberman plan: “Let them eat dollars.””

  1. This is slightly off-topic, but when I hear that the big banks are buying physical commodities and storage facilities themselves–Morgan Stanley is the largest owner of heating oil in Maine, or whatever–and then I read about Lehman losing a bunch of money on its Inland Empire real estate investment, and, of course, always in the back of my mind is the memory of those fun days at UBS watching management dive head-first into exotic options and credit derivatives and the asset-backed securities market, trying at all costs to get our league table rankings up…

    Well. You get my drift.

  2. anon writes:

    “(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.)”

    I would be interested in understanding a real world example of this in the oil market, including the effect of the futures price on the spot price.

  3. RueTheDay writes:

    “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.”

    That is correct. However, it assumes that both parties are price-takers. While such an assumption is largely correct, there have been a number of situations recently where a well respected firm (that presumably also has a trading position in oil) announces that it is forecasting the price of oil to be at $xxx by a certain period, and this then becomes a self-fulfilling prophecy.

  4. Fullcarry writes:

    In light of the governments insistence on using core CPI as its favored measure of inflation it sure seems cruel to deny the small guy the ability to hedge his food and fuel exposure.

    Great post as always Steve.

  5. Nemo writes:

    Much of the money in long-only ETFs is neither speculation nor hedging; it is diversification. It is not a belief that the commodity going up, nor is it a belief that the commodity is less volatile than the currency. It is simply a belief that the commodity is uncorrelated with other asset classes.

    Or would you characterize diversification as a form of hedging?

  6. Benign Brodwicz writes:

    Joe should get a job with TIAA-CREF, they’ve been trying to make us eat dollars for years.

  7. MK — It could be a bubble, in the sense that a sharp price move might shake people’s conviction in the relative values of dollars and oil. That’s not an easy thing to say. If it is a bubble, all the late chasers will get stuck with the bill. If the dollar is hopelessly worthless relative to oil, it’s better late than never. Without more volatility to test people’s convictions, it’s really hard to know.

    But the financials might be fully hedged. That is, if they are building storage capacity plus capacity to deliver, and if they are getting good spot deals, (which they very will might, because spot markets are messy and dealmaking matters) it is a heads I win tails you lose bet. They store the oil and sell it forward at a profit given current prices and storage/delivery/financing costs. When roll time comes around, they compare the profit of delivering immediately to the next roll price less total storage costs. Eventually they pull the trigger for a profit. At least that’s how things are supposed to work.

    Hedged shorts can become speculators when, at current prices, delivery is more profitable than rolling, but they choose to not deliver, and become an unhedged long hoping the futures price will appreciate. If they’re right, by locking in a higher futures price they can do better than the foregone profit from the undelivered prior contract. If they’re wrong, well, speculators who bet wrong get hurt. But, if the holders of oil are producers, there’s a bias in the decision, to speculate or not to speculate when there’s a contract I could profitably deliver. Not speculating, delivering the contract, satisfies real demand and limits price appreciation, while speculating into the next contract helps fan the flames. Since they are also selling in the spot market, or writing over-the counter contracts benchmarked to futures prices, oil producers have added incentive to speculate a bit, going briefly unhedged until prices appreciate to where I can lock in at least my foregone profit. If there is any “market manipulation” in oil, I think it is this sort of behavior by producers, failing to deliver when they would achieve greater risk-free profits from doing so than from rolling, in tacit understanding that other producers will do the same. The best way to combat such a tacit cartel would be to bring new players into the market interested in short-term transactional profits rather than maximizing the value of a large pool of production capacity. It’d be nice if financials took on that role, collecting arbitrage profits as large and as early as possible. It’s hard to know what they would do. If they’ve secured sufficiently much access to cheap physical oil, their incentives might line up with producers. If the oil they store and sell forward represents most of their capacity, they might lean against the bubble, potentially popping it as cartel speculators get burned when futures prices fail to continue to rise…

    anon — Does the above (disorganized, thinking aloud) help? It’s worth pointing out that there is no perfect relationship between futures and spot prices given geographical dispersion of the physical spot product, and frictions (transport/storage/delivery capacity constraints as well as industry structure/incentives to arb as outlined above) that restrain arbitrage. In a frictionless world, futures prices and spot prices would converge exactly, and the relationship between the two would be set by costs of storage, projected “convenience yields” (opportunities to profit by lending the commodity prior to delivery), and the risk free interest rate. In a world with frictions, there is no one spot price, lots of different grades of fuel, different transport options and costs from and two different places, etc. Hopefully, the theoretical, frictionless pricing holds at least approximately. But “approximately” hides a lot of play for fortunes to be made or lost.

    RTD — If firms are not price-takers, than there must be some kind of monopoly/market power that prevents competition from forcing price down to expected marginal opportunity cost. There certainly could be, as outlined above, if there is a game being played by producers that amounts to a tacit cartel, there would be monopoly power over price. Publicly announced price targets could help provide benchmarks around which to organize that kind of behavior. Of course “expected marginal opportunity cost” is kind of a slippery phrase, one way of saying what I just said is that, given scarcity rents, public price targets help to define expected marginal opportunity costs. (And expected marginal opportunity costs would have to include the “secondary” effects of transacting on the value of the rest of ones production capacity.)

    Nemo — Though I should have made it clearer (I’d have had to have talked about the covariance as different assets as well as their volatility with respect to consumption bundles), I most certainly do consider mere diversification to be a form of hedging. Typically (though not always) purchasing diversifiers reduces ones expected return, but reduces portfolio variance relative to your benchmark. That is, mere diversifying trades risk for return, as is typical of hedging. (It’s harder to characterize parties who expect an asset to perform better than the rest of their portfolio and covary little or negatively with other assets — they are expecting both to shed risk and enhance profit, so they are both speculators and hedgers by my lexicon, maybe depending somehow on motivation. But, absent unusual information, these opportunities should be pretty rare for most investors, if markets are not outrageously inefficient. (Markets might be outrageously inefficient, but most investors, particularly professional money managers diversifying into an asset class, probably form expectations as though they are reasonably efficient.)

    FC — Thanks.

    Benign — Throw enough dressing on them, and try not to notice if GW’s face doesn’t quite live up to the slang term “lettuce”. (At least cake tastes good, ya gotta give that to Marie Antoinette.)

    I’m running and not editing, so if I got something wrong in the stream of consciousness futures market conjecturing above, apologies in advance!

  8. Mike writes:

    Isn’t Yves Smith a man?

  9. anon writes:



  10. anon writes:

    “anon — Does the above (disorganized, thinking aloud) help?”

    Yes, it does, thanks very much.

    I think I’ve understood your various examples in this post and the last.

    I think you’ve generalized the definition of speculator nicely to any participant (producers, consumers, and financials) who at any point in time choose to have a mismatch between an asset and a liability, relative to oil. So financials who buy boldly into futures en masse can be considered hedgers to the degree that their investors have some exposure to future oil linked liabilities. And producers who hold on to unhedged inventory can be considered speculators.

    My conclusion is that futures market “speculators” must be able to affect inventories of oil in order to have an influence on the spot price (including the case where a short unexpectedly delivers oil, reducing inventories, thereby affecting the spot price.)

    Apart from that, I don’t see how the futures market affects the spot market. I can only see it when qualified / evidenced by associated inventory adjustment.

    Plus, of course, there is the ongoing aspect of changes in physical supply and demand for spot oil, ex inventories.

    The corollary is that one can envisage a market of mass long futures buying by investors (e.g. ETFs) that doesn’t affect the spot price at all, absent settlement intersection with physical delivery. Beyond that, it becomes a technicality to interpret just what sort of marginal effect the futures market is having on the spot market due to the various exceptions to this rule.

    Similarly, producers may withhold oil either in the ground or through inventories, whether or not they use the futures market to hedge their long position. But it is the supply or inventory effect that affects spot prices, not the futures strategy per se.

    I don’t see how the regular rolling of futures positions (sell nearby, buy distant) has a direct effect on the spot price.

    Regardless of the classification of futures market activity – speculation or hedging – the important distinction is the effect on the futures market itself versus any associated effect on the spot market.

    So DeLong’s (I think) contention seems right to me – evidence of the effect of speculation on the spot price must include inventory change (which is apparently lacking at this time).

    But I still can’t connect the dots on the proportionality of recent changes in both the dollar and Euro price of spot oil. It seems to imply that the marginal demand for spot oil has been incredibly price inelastic (in all currencies) between, say, US $ 70 and US $ 140. If it’s not speculation, it seems to be a mania of spot price fear and related price inelasticity.

    (Unfortunately, I clearly lack the non-linear genius of those (anti-Fed) readers who understand the mathematics of this so readily and transcendently.)

  11. anon writes:

    From Mauldin:

    “The only reason to raise rates would be to protect the dollar from a serious collapse. I think it more likely the Treasury would intervene in the markets to prevent such a collapse. Dennis Gartman, at dinner Wednesday night, suggested that if the administration really wanted to get the market’s attention, they could intervene in the currency markets and release oil from the Strategic Petroleum Reserve at the same time. While it would only be a temporary fix, it would make speculators nervous. However, they might consider such an experiment preferable to having the Fed raise rates during the middle of a slowdown/recession.”

  12. Benign Brodwicz writes:

    I hope we can all agree that in a single period model speculation can raise futures prices without any inventory response, and that this can serve as a stylized representation of short-term events…. and that bubbles pop. Also, the motivations of the suppliers are not so simple–the Saudis are increasing production.

  13. Boy is there a lot to talk about here.

    anon — yeah, I think a speculator is anyone with a position unhedged, either by other positions or by future consumption or production plans. Financials who buy spot oil and sell it forward for a predictable profit are hedged arbitrageurs, until and unless they decide not to complete the arbitrage, and hold the oil for another round without immediately selling forward. Then they are “gap speculators”, and I think they are key to oil prices right not. These are players who speculate, but hope to do so only for a brief period of time. They let their hedges expire without offloading physical oil, but instead wait until price momentum permits them to establish a new hedge that locks in greater profit. In any “greater fool” strategy, the art is to join the bubble, but be exposed to risk in it only briefly, to limit the probability that you are unhedged when it gives. That’s the game I think those long physical oil are playing right now. (I want to hedge myself a bit, by adding the condition “if oil is a bubble”. Dollar (or even Euro) prices don’t mean very much right now, given the loosened coupling between currencies and goods & services. I want to look at the price of oil in terms of other commodities before opining definitively that it is a bubble.)

    Whether or not speculators can affect spot prices without affecting inventories is a murky question. Krugman’s clean supply/demand graph hides the complexity of spot markets. What is the spot price of oil? It depends on the grade you want, where you are, who you know, and how good at operations management you are. Even putting all these complexities aside, inventories are absolutely not measurable. A reasonable definition of inventory build-up in this context is the difference between the quantity of physical oil consumed in a period and the maximum achievable production capacity given existing infrastructure. We can estimate the former, but we have no idea about the latter, so we really cannot say whether inventory is building. If you haven’t seen it, check out the impulse response graph by US producers to a negative oil shock by Francesco Lippi (via Mark Thoma). US suppliers diminish production following negative supply shocks (as opposed to positive demand shocks), indicating either producer speculation or tacit cartel price manipulation, depending on how you want to spin it. In either case, reduced production qualifies as inventory build in this context.

    The overall picture is that all markets have to clear, so in theory you can look at spot in isolation (as Krugman did), and say here’s supply, here’s demand, the price is determined by these curves period, unless someone is building inventory. That’s true. But building inventory doesn’t show up (as it did in Krugman’s sketch) as a third line in the graph. It shows up as a spike in demand (people buy oil to fill warehouses) or a decrease in supply (it’s harder to get producers to sell their oil). We can’t distinguish “real” from “speculative” shifts in supply and demand in real time. And we can’t just look at tanks and tankers, because that’s only one form of storage, and almost certainly the most minor one if in fact this is a speculative phenomenon.

    benign — You’ll have to flesh out a bit what your 1 period model looks like. It’s hard to think in one period. On a given day, it’s certainly true that price insensitive long interest in futures markets will drive up trading prices, as people need to be induced to take up unhedged positions on the short side. But those unhedged shorts, who were responding to long demand and probably are not interested in holding speculative short positions will fairly quickly try to lock in a profit by hedging, with some other financial position if available, or more slowly with physical exposure. Liquidity providers selling to long speculators are probably doing deals, making arrangements with producers for call options on oil to hedge their exposure, struggling to make operational arrangements so they could take and deliver if necessary. Producers writing calls have to hedge by making sure they can deliver if the options are exercised, either by storage, or planning for conditional excess capacity (which is equivalent to storage). All of this takes time, so in the day of a price spike, it is fair to say that speculation has changed prices without changing inventories. You might argue that the period since last August is like a long day, prices have moved faster than than operational arrangements those moves compel. Could be. But still, the forces at play are fairly instantaneous. The minute an unhedged long bids up a price, at the margin somebody is more likely to withhold then to sell spot oil than they were before.

  14. RueTheDay writes:

    I think there’s a fundamental shift taking place here, and it seems to represent a perversion of the way the market ought to function.

    Historically, an increase in the price of a commodity (e.g., oil, wheat) would lead to increased investment in productive capacity (e.g., bringing additional oil fields and farms online), to create more of that commodity and bring it to market. That’s the whole premise behind an upward sloping supply curve. That doesn’t seem to be taking place, at least not to the extent one would expect. Instead, the financial capital that would have been used to that end is being used to simply purchase the commodity in question (via index funds, for example) and hold on for a capital gain.

    I have to think this through a little more, and I’m sure a reasonable explanation could be assembled around the NPV of an uncertain stream of distant future cash flows from physical investment in oil field or farming projects versus short term gains in the commodities markets. It still seems to be a case of the invisible foot getting in the way of the invisible hand.

  15. RTD — Beautiful: “It still seems to be a case of the invisible foot getting in the way of the invisible hand.” But…

    I think you need to distinguish between commodities. Small farmers are price takers, and are definitely shifting production from lower priced to higher priced crops. But energy producers may not be price takers. Individually and through tacit collusion, they may have market power.

    And for producers whose resources are bound to a single fixed-supply commodity (e.g. Saudi Arabia rather than a farmer who can pick crops), the relevant question isn’t the price in absolute terms, but today’s price versus future prices, combined with a discount rate based on how productively financial assets from a sale can be stored. An oil producer rationally cuts back production today if she believes prices will be higher tomorrow than the future value in real terms of saved funds. (The whole Hotelling thing, right?). So, even if prices are rising, but you view financial discount rates as falling or even negative, you’re better off not producing.

    If it’s collusion, we should break it. But if it’s producer timing, that’s the invisible hand doing what it should be, no invisible foot required. Until we persuade oil producers that they have something productive in real terms to do with their cash, they’re better off slowing down. Since many oil producers are peg/politically constrained to investing great sums in USD financial assets, well, I wouldn’t be producing breathlessly under the circumstances.

  16. RueTheDay writes:

    Steve: Just to clarify – I’m making two distinct arguments here. My first post was about market power, particularly with regard to OPEC and to the big trading firms manipulating markets with their predictions of ever higher prices. My second post is unrelated to that and is attempting to highlight what I see as money chasing commodities directly rather than investing in productive capacity to bring new supplies of those commodities to market.

    For example, let’s say there’s a shortage of rice, causing the price to increase. Economic theory predicts more entrants into the rice producing business, bringing about greater supplies of rice. What happens though, if rice itself (as opposed to rice paddies) becomes viewed as an investment, and those potential entrants choose to use their financial capital to take long positions on the commodity and continue to roll them over, rather than using it to build new rice paddies?

  17. anon writes:

    The oil world is becoming somewhat clearer to comprehend as a result of your writing, thanks. You’ve described two critical factors that I had not appreciated:

    a) The ability of financial investors (e.g. pension funds) to control long positions in physical oil. This seems fundamental to the whole discussion. I had assumed that investor participation in commodities as an asset class (e.g. oil) was done primarily through the futures market (e.g. buying futures and rolling from there). If this were the case, it would be difficult to understand how their participation was affecting the spot price. This was the motivation behind my interest in how the futures price can affect the spot price.

    b) The inability to track above ground inventories of physical oil. In this case, Krugman’s analysis becomes misleading, as you describe.

    Everything else flows from these factors, and it becomes obvious how investors along with producers can affect the spot price of oil. Your examples showing tactical choices with respect to futures market hedging and other strategies are then quite clear. Whether investors are classified as speculators or hedgers, or whether they hedge their long positions in the futures market, is less relevant than their potential to affect the spot price of oil through physical positions. Moreover, the distinction between producer and investor becomes almost as misleading as the distinction between hedger and investor, insofar as the potential effect of physical market access on the spot price of oil is concerned.

    It is equally obvious how producers can affect the spot price if they store oil instead of selling it. As with financial investors, whether or not they take open unhedged (i.e. speculative) long positions or hedge their positions in the futures market with arbitrage profit, is less relevant than understanding their potential influence on the physical market and spot market price.

    To clarify further, my underlying question was whether or not financial investors could affect the spot price of oil as a result of their presumed (erroneously) exclusive activity in the futures market. This is somewhat different than the (more real world) question you addressed, which was “Whether or not speculators can affect spot prices without affecting inventories”.

    If you can’t track inventories, then you have no way of knowing how producers and investors are affecting the supply of oil on the spot market through inventory hoarding. So Krugman’s neat supply/ demand/ wedge graph becomes irrelevant. And if, as you say “the maximum achievable production capacity given existing infrastructure” is unknowable, making inventories unknowable, then obviously the contribution to the spot oil price from either producer or investor hoarding of physical oil is unknowable.

    It seems from widely reported figures that trend growth in global supply has been decelerating, while natural demand from developing countries has been accelerating. Obviously the net effect must be upward price pressure. But trend growth has still been reasonably smooth, albeit flattening, as I recall. Inventory hoarding, whatever its true nature and effect, doesn’t seem to be in evidence as some recently observable kink in the ongoing trend of global consumption. The hyperbolic price action over the past 6 months still seems wild and crazy relative to this fairly smooth trend line of reported consumption, which by definition should be net of true inventory hoarding.

  18. PrintFaster writes:

    To me the real problem with commodities is that there is not enough physical goods around to float the speculation. You have a situation with commodities unlike stocks where the futures investment can far exceed the spot quantities traded.

    With stocks, shorts are limited to the number of stocks held in broker hands. With commodities, there is no limit to the shorting, and the long positions.

    This creates a hideously unstable situation where all the money is fast, speculative funds.

    Were I king, I would limit outstanding contracts to no more than 2x the typical amount closed, or in warehouses at settlement. Anything more is insane. It is legalized betting. Perhaps there should be a Las Vegas stock exchange for such activity.

    I suppose one way to handle it, would be for commodity speculators to be treated as gamblers in their tax treatments. Taxes liens would be filed immediately on settlement. This would apply to pension funds or banks too. Classify them as gambling would eliminate speculation from pensions and fiduciary organizations.

  19. groucho writes:

    “June 16 (Bloomberg) — On Wall Street, where just about everyone has lost confidence in financial assets, Goldman Sachs Group Inc. and Morgan Stanley are making money the old-fashioned way: Buying and selling commodities.

    Goldman and Morgan Stanley are expected by analysts to report the best second-quarter earnings of the world’s biggest securities firms this week, having limited their losses from the collapsing credit market. They also lead Wall Street in commodities trading, where crude oil futures doubled in the past year and the price of products from gold to corn soared to record highs.”

    I see a political/geopolitical conundrum coming quickly this fall. Israel wants to take out Iran’s reactors before Bush is gone. While domestic politics calls for an oil crash ~2 months before the election.

    What type of deal can be put together to accomplish both of these objectives at the same time?

    Keep an eye on aircraft carrier movements, Saudi production and GS oil futures.

  20. pogo writes:

    Lieberman Makes Risky Bet in Speculation-Ban Bid: Kevin Hassett

  21. Kady writes:


    I am a long time fan.

    You say in this post that “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 would love it if you could either point to concrete examples of this or engage in a theoretical discussion of what they can do to disperse their loses as described. It goes to the core of something I’ve been thinking about, but I have yet to come up with any real compelling evidence to back up such a statement.

  22. Kady — The Fed’s taking on roughly half a trillion dollars in financial sector risk. Already those investments are an opportunity cost to taxpayers in financial terms (if the Fed were maximizing returns, it wouldn’t make these investments), and any nonperformance will be made taken from funds otherwise due taxpayers. The FHA, FHLB, Fannie Mae and Freddie Mac are backstopping risks previously borne by private investors. Individuals banks might have been permitted to fail (harming bankers and investors). These entities cannot fail. Taxpayers will bail them out. Suppose a banker has funded a mortgage that will soon default. The “owner” managers to find a buyer, only because FNM will now fund more and bigger loans than before. The banker loses less, gets paid more than he otherwise would have. What does the banker do with the money? Suppose he invests it in FNM-guaranteed bonds. Then his old loan, along with lots of others go bust. Oh well. The taxpayer takes the loss, he gets paid off, even though he funded the original unreasonable price. In the end there’s a strong possibility that less affluent people will pay higher taxes or suffer lower real wages due to inflation to cover nationalized losses, while wealthier investors hedge the extra inflation and avoid the taxes. Inflation is the most insidious tax, because it can’t be made progressive (it harms most workers with the weakest bargaining power), and doesn’t necessarily even help debtors who otherwise would have defaulted. (It’s nice not to have to declare bankruptcy, but poorer debtors might be better off in real financial terms taking the reputational hit and cutting losses than having inflation reduce their real wages while making it possible to continue to pay their debts.)

    Obviously, Bear Stearns creditors converted what would have been large private losses to public risks. If those go manifestly sour, or if they don’t break because we tolerate more inflation than we otherwise would have, that is a public cost.

    (BTW, d’ya think the Fed would be tolerating current ~5% by government CPI stats inflation if the banks weren’t weak? Continuing inflation is a cost to low bargaining power workers and a benefit to troubled bankers.)

    There are more subtle, games. When bank recapitalize with juicy-for-institutional-investors mandatory convertible deals, they stiff 401-K index fund holders with dilution while giving nice probable cash flows to the new investors. If the new capital is sufficient to “save” the banks, you might argue that this is only fair. But if the new capital turns out only to delay a reckoning for a couple of years, the dividend payments during the preferred period will more than cover net capital invested (after investors short the common stock to hedge their position), the net effect will have been to shift even greater losses to common stock holders and taxpayers, while current “recapitalizers” come out more than whole. I expect that index fund investors, misled by a very smug consensus among finance professors, will be a private class of relatively unsophisticated patsy when the losses are ultimately tallied.

  23. anon writes:

    More from Krugman on my favorite question – the effect of futures on spot:

    June 23, 2008, 4:38 pm

    Speculative nonsense, once again

    OK, one more try.

    First of all, I don’t have a political dog in this fight. I’m happy to believe that crazy speculation distorts markets. And I do think it’s likely that oil prices will come down, for a while, once consumers have a chance to respond more fully to high prices by changing their driving habits, switching to smaller cars, etc..

    But the mysticism over how speculation is supposed to drive prices drives me crazy, professionally.

    So here’s my latest attempt to talk it through.

    Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil — the actual price people pay to have a barrel of black gunk delivered?

    The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.

    Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.

    Any effect on the spot market has to be indirect: someone who actually has oil to sell decides to sell a futures contract to Joe Shmoe, and holds oil off the market so he can honor that contract when it comes due; this is worth doing if the futures price is sufficiently above the current price to more than make up for the storage and interest costs.

    As I’ve tried to point out, there just isn’t any evidence from the inventory data that this is happening.

    And here’s one more fact: by and large, futures prices over the period of the big price runup have been slightly below spot prices. The figure below shows monthly data from the EIA; as the spot price shot up, the futures price (that’s contract 4, the furthest out) actually lagged a bit behind. In other words, there hasn’t been any incentive to hoard.

    As I’ve said, I don’t have a political dog in this fight.

    But the nonsense in this debate makes me want to shoot someone in the face.

    Update: I see that Michael Masters, about whom I had some flattering things to say a few days ago, is now telling Congress that gasoline will go back to $2 a gallon if we crack down on speculators. He forgot to mention that cold fusion will solve all our energy problems any day now.

  24. Matthew Paradise writes:

    Just trying to get all this mumbo jumbo 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.”

    So, a hegde fund is an economic entity set up with the purpose of shedding risk..!?