Arnold Kling is exasperating Paul Krugman

Krugman writes here on why speculation is not driving higher oil prices and offers a simple model here.  I agree with Krugman’s conclusion but not his reasoning.  Arnold Kling responds here and basically Arnold is right although his #2 on the Hotelling principle is trickier than his exposition indicates.  The key two points in response to Krugman are: a) oil in the ground can substitute for inventories and thus speculation can be driving prices higher without it showing up in measured inventories; here’s that reasoning in more detail, and b) when risk and liquidity premia are changing, the relationship between the spot price and futures price is obscure and difficult to interpret.  In particular a futures price for oil below the spot price does not refute the speculation hypothesis or even provide much evidence against it.

The more general point is that if a bubble, or lack thereof, could be read so easily from the available numbers, bubbles would be scarcer than they are.  There’s also a tricky problem in defining a bubble when there is two-way feedback across price and expectations and "fundamental value" at any one point in time itself depends on the marginal unit of supply and thus it depends supplier decisions and expectations.

My apologies to those whom I am exasperating.

If Krugman’s cited data don’t do the trick, why do I agree with his conclusion that speculation is not the villain?  The simplest alternative story, again blogged by Arnold, is that the earlier low price of oil was an anti-bubble of sorts and one which now has been corrected by market forces.  It was a kind of collective blindness, akin to the view that real estate prices would continue rising in value.  No, I can’t prove that is true but I find it the most plausible story, with p (truth) = 0.57.

Addendum: Note that most asset bubbles are based on the psychological property that bullishness is more common than bearishness in asset markets, if only for ESS reasons.  This same general bullishness can drive "anti-bubbles" or artificially low prices in oil markets (high oil prices are bad for good times) even though yes I know that sounds funny and we are used to bubbles bringing artificially high prices.

Second addendum: Paul Krugman responds.


Tyler, are you sure your exasperation with Krugman isn't due to habit?

Krugman does allow that options prices can indirectly affect supply by affecting on producers' decisions to produce more oil. Arnold Kling's explanation that we should blame inept speculators for not realizing this sooner is probably true, but it not an alternate explanation of why the current run-up in price is due to speculation.

I think if anything, financial market speculation puts pressure on producers to produce more.

But that certainly doesn't mean there isn't a bubble.

In a comment at Arnold's, I wrote:

[Commentor Rich is] definitely right about the higher value of the option on pumped and stored stocks [versus in ground storage], but the problem is that increasing pumping capacity drives down the price. The speculating is most likely being done on the assumption that pumping capacity will not increase. Current backwardization implies that speculators believe demand will fall slightly or production will incrase slighly, but apparently they don't expect much change.

Of course, unless people have found a way to borrow on the current value of the oil, it would be irrational to not pump oil because it will drive down the price. Knowing that to get the money you'll have to pump the oil and bring down the price, it just doesn't make sense. But bubbles don't happen because people behave rationally.

Can you explain more in more detail how you arrived at the value p(truth)=.57?

By my calculations, the probability that you are right is closer to .5623. I think you muse have made a rounding error.

end blockquote...


You can't really define a "fundamental value" for a commodity. There is no income stream, no yield, no dividends, no market capitalization (long and short positions offset each other), none of the things that give guidance in valuing stocks, bonds and other assets. The price of a commodity is inherently speculative: it only generates cash value for you on the day it's sold, so until that day, how do you really know what it's "inherently" worth?

See Commodity Bubbles & Speculation (Capital Spectator)

Whoops, forgot to sign the above post.

The speculator or oil trader is buying something in the market.

But it is not oil in the ground.

Oil in the ground does not meet the specification of the futures contract.
The contract calls for oil of a certain quality to be delivered at a specific point in geography and time.

Consequently, oil in the ground can not be a substitute for inventories as far as the futures market is concerned.

Maybe the Saudis are actually cutting production....

I'm pleased that I saw the mechanism for oil in the ground acting like stored inventory before the big gun economists started talking about it ... but as to whether this "is" a bubble, only time will tell. If prices fall it is, if they don't it was (an unfortunate episode of) price discovery.

Cue Nassim Taleb and the fallacies of prediction.

Since the U S Dollar is the pricing signal for oil, has anyone approached price speculation as speculation on the future value of that dollar. The future of course being any period from the next moment on.

Incidentally, little has been made of the fact that an increasing percentage of oil production is being retained in the producing areas, for uses there.

Bob, thanks. Don't think speculators have been driving prices anywhere but down 'til recently. Storage in the ground is a very different beast. If there's a bubble there, it might not even pop for decades.

I'll read the study.

hmm...looks like Krugman really put the smackdown on you there Tyler. Care to respond?

Has there ever been a cornering of the market that worked? I guess I mean a non-governmental, private speculative example.

If speculators are driving up the price, could they keep it up without rivaling the reserves of OPEC? If they can't keep it up, and it was driven up, will it not fall? Then, isn't it the speculators who will deserve our sympathy?

I'd say the value of a commodity is the marginal utility of what can be done with it. I'd speculate the price reflects the current bottleneck to growth is energy (as well as the bottlneck of force projection). If energy prices do end up constraining growth, then the prices will also come down and you probably should have bought bonds.

Speculators don't set out to lose money. Who does? Or, who's big enough not to care. I could imagine that certain governments may also be getting jittery about buying treasuries and want commodities as a store of wealth that is inflation protected. No idea how to investigate that. And hey, did anyone figure out exactly why the dollar dropped so much?

It's refreshing to see Krugman on the side of sound economics. We shouldn't be the ones now blaming greedy capitalists just out of a Pavlovian reflex to disagree with him.

Tyler, Krugman is totally kicking your ass.

That trader's arguments aren't very cogent, coherent, or convincing. He reminds me a bit of a businessman who says "What's all this nonesense about supply and demand determining prices? Prices are determined by me and my sales managers in regular meetings!"

Since his arguments are not very cogent or coherent, it's hard for me to know just how to respond, but I'll try. He basically argues that spot markets do pay attention to what goes on in futures markets, using that information for price-setting, production, purchasing, and inventory decisions. And that's all undoubtedly true. But they don't do this because the futures traders are the cool kids and they want to slavishly follow whatever random prices the cool kids are shouting out. They do this because they believe that the futures markets are paying attention to and integrating information about supply of the actual commodity and demand for actual delivery.

As long as the futures markets really are doing a good job of integrating information about the supply of and demand for the real stuff, that works fine. The spot markets appear to follow the futures markets, even though both are really being set by supply and demand. But suppose that the collective wisdom of the futures traders turns out to be wrong: they think that prices will rise, and get into a speculative bidding cycle that does not actually reflect increased demand or constrained supply. For a short time, the spot markets may follow, but rather quickly it will become apparent that there is a lot of excess inventory at that price, and the spot price will fall. On the futures side, the speculators need to sell before the delivery date on the contract, so by that time at the latest they disover they need to drop their price in order to sell. All this plays out within one contract period, at most.

The Hunt brothers are in fact an excellent example. Once it because clear that they had no inventory capacity and had bought their contracts on margin, so that they were neither materially nor financially capable of taking delivery on the scale that the markets had assumed, it became clear the supply of actual silver was not in fact constrained relative to the demand for actual silver. The spot and futures market prices collapsed. All this played out over about 3 months in 1980.

It is so interesting thing.

It is enlightening!

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