The middle class is shrinking. Those in power have run up enormous debts on public credit while shoveling most of the money into private pockets. The corporations that have benefitted from this borrowing binge, meanwhile, leverage the global trade system to transfer their profits beyond the reach of national governments.

Meanwhile, we have been told lies by Democrats and by Republicans, divided into artificial camps and led into debates that are either irrelevant or so dramatically scripted that we fail to realize every choice leads to the same result: the dismantling of the social framework that defined and sustained the opportunity of the last century. National mobilization of resources has given way to radical individualism under a narrative that, in the wealthiest nation in the world, we must always expect less.

In this tumultuous time, we search for a way forward - a new Square Deal for the American people.

Friday, May 27, 2011

A Solution to Oil Speculation

I'm sure that you've noticed that oil prices have been rather high lately.  Maybe you actually track the price of oil, or maybe you just notice the impact when you go to fill up your car or truck. 

True, prices have come back down a bit recently.  Oil had hit $114 before dropping back to its current $100-a-barrel price tag, while gasoline prices have dipped back below $4.00 per gallon in most parts of the United States.  Compare those prices to what we saw a year ago, though, and the difference is very noticeable -- for you and for the broader economy.

Ordinary people point to energy traders and say that speculation is to blame.  Speculators, in turn, brush aside such claims and point to turmoil in Libya and the Middle East, the fuel appetites of China and India, and other aspects of the so-called fundamentals, supply and demand.

To be unequivocally clear, the traders are lying.  The high prices have everything to do with speculation.  There's a simple solution, but before I delve into that, I need you to understand why speculation is a problem with regards to commodities like oil, as well as how speculators operate in these markets. 

This will be a long explanation.  Bear with me.

Economics 101

When someone says that "supply and demand" are behind a rise in prices, what that person means is that more people have money to buy something at its current price than quantities exist to sell it to them.  When that happens, prices rise because sellers sense that some people who want to buy would actually be willing to pay more to get what they want.  They continue to rise until the quantity available matches the quantity of people willing to pay the new price. 

People unwilling or unable to pay the new price do not get what they set out to get -- but they could if they had more money.  If they are simply poor, then they can do nothing about the situation.  On the other hand, people who do have more money but had intended it for other purposes can reprogram their priorities and get what they want. 

This idea is central to a market economy.  The opposite model, a social economy, allocates things on the basis of need (or fairness).  Once someone has gotten his or her "fair share," he or she may not get any more because the desired product or service is rationed to make sure that everyone gets a fair amount.  In general, someone in a social economy may not reprogram priorities to obtain more of one product or service and less of another.

Back to oil.  Traders claim that market fundamentals are behind the rise in oil prices, but there are no actual shortages.  In fact, week after week, oil stockpiles have risen despite the turmoil overseas.  The price of oil, however, is not set on the basis of fundamentals.  Rather than waiting for actual shortages to materialize, buyers lock in the rights to particular quantities at particular prices well in advance.  These promises to deliver oil at a given price, called futures, are then bought and sold in a secondary market based on whether sellers are now looking for higher prices than they were yesterday.

There is nothing wrong with futures markets, provided that someone is looking to actually obtain something like oil, or wheat, or soybeans.  The whole point is to prevent a shortage.  But when the secondary buying and selling of these contracts is conducted largely or even almost exclusively by traders who have no intention, desire, or even ability to ever take delivery of the underlying commodities, the commodities market turns into a casino like the stock market.  Unlike the stock market, however, commodities are the raw materials that people and companies need to make things (oil, copper) or even just to live (food).

It is not desirable that people who have no interest whatsoever in obtaining raw materials needed to make things should drive up prices on those materials just because they missed the flight to Las Vegas. 

What Wouldn't Work

Some people have called for price caps.  However, price caps -- a form of rationing -- are not a good answer because behind the speculative bubble, there really are supply-and-demand fundamentals at work.  We don't see them most of the time because the speculators obscure them, but the 1970s give us ample evidence of what happens when a social economic model is applied to gasoline.  It isn't good.

There really is a problem, though.  As the 2008 collapse illustrated, the people involved in the casino atmosphere that is the twenty-first century financial system are so greedy, so completely arrogant in their certainty that whatever happens will only lead to another round of record bonuses if they win and taxpayer bailouts if they lose, that we would be foolish to imagine that they can or would restrain themselves.

It would be nice to simply "ban" speculators, but we really can't do that.  The futures market does serve a purpose, and while we could theoretically from trading futures anyone who did not have an interest in taking delivery, it would not be long before flashing dollar signs brought about alliances between the traders and actual commodity interests so that they could keep playing.

Fortunately, there is another option: make it expensive for them to play.

Commodities and the Currency Markets

The commodities markets are enormous.  They span the globe and include hundreds of billions or even trillions of dollars -- money that the traders do not themselves have in the long run.  How do they fund their bets?

You have probably heard a lot of talk recently about the "gold standard."  The United States has not had a specie currency -- a paper money supply convertable to a fixed quantity of some rare substance like gold -- for nearly a century, and neither have most other countries in the world.  Until 1971, however, nations themselves did balance their transactions with one another using gold, a mechanism known as the Bretton Woods system.  The use of gold as a stabilizing medium meant that exchange rates between nations were essentially fixed.

In August 1971, Nixon ended convertibility of U.S. dollars into gold, dismantling the Bretton Woods system.(1)  From that point on, countries have balanced their accounts with U.S. dollars based solely on perceived stability of the world's largest national economy.  This arrangement is what is meant when someone says that the U.S. dollar is the world's reserve currency.

Again, back to oil.  Commodities are traded in U.S. dollars.  When exchange rates were pegged in gold, this pricing was ceremonial.  Today, because currencies rise and fall on an instantaneous basis, the price of oil in dollars is at any given time going up or down to holders of non-U.S. currency.  Supply and demand for oil futures (not specifically for oil) thus makes these contracts cheaper to buy in dollars when the dollar is weak and more expensive when the dollar is strong.

Traders are thus able to fund their bets in the oil market by treating oil as a mirror surrogate to the dollar: when dollars are strong, they borrow foreign currencies against the high exchange rate and buy oil, and when dollars weaken, the value of the oil goes up relative to their purchase prices.

What Would Work

Many noteworthy economists and national leaders have in recent years recognized that the nature of the commodities market vis-a-vis the currency market is the real culprit for surges in oil prices.  In 2007, China joined the chorus in calling for oil to be priced according to a so-called basket of currencies

In practical terms, this would mean creating a new currency instrument whose value fluctuated as a function of the total exchange rate of all currencies.  Imagine that we were to make such an instrument.  Since it would be a world instrument, let's call it the Terra Bill.

Since at any given time outside of complete pandamonium a rise in one currency is offset by a fall in another, the Terra Bill would be much more stable in its value than the U.S. dollar.  No one would actually spend Terra Bills; this would not be a "one-world currency."  Rather, it would be used to decipher the balance between nation -- a foundation for something like Bretton Woods, but replacing gold because gold has actual uses and therefore is not purely a medium of exchange.

For speculators, the Terra Bill would be... well, terrible.  They would still want to play in the commodities markets, and they still could, but they would be unable to cover the bets for doing so with the movement of the currency market because these movements would be absorbed and normalized in the price.  Only actual demand spikes or supply lapses would yield substantial changes.

For the rest of us, including manufacturers, military logisticians, traveling salesmen, retirees on road trips, and commuters, such an arrangement would break the chains that tie down our lives and our economy.  We would still have every incentive to move away from oil dependency, but oil will continue to be of industrial value for the foreseeable future.  Oil companies wouldn't mind.

Why won't we make this change?  For the easy answer to that, one need only notice that our last Treasury Secretary and our current Treasury Secretary moved fast to shovel $700 billion into the pockets of bankers who could not even be bothered to hold back record bonuses a year after their antics brought the world to the brink of ruin. 

Look at the urgency and resources poured in by financial services lobbyists who succeeded in watering down the Dodd-Frank bill.  Notice that the Consumer Protection Bureau is already called by some "too powerful."  Consider even that Barack Obama was elected in the wake of an economic meltdown but made his first priority the pursuit of health care reform.

Basket-of-currency pricing of commodities is an idea that would benefit virtually everyone except Wall Street.  And that's why it isn't going to happen.

(1) While the downsides mentioned here are real, maintaining the Bretton Woods system was by 1971 essentially impossible because gold itself came to command a higher market price than its intended peg relative to the dollar.  The reasons for this are very complicated and anyone interested in fully understanding it should consider graduate coursework in economics.

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