Month: June 2008

Oil and the Future

On oil I will make one point adding and one point detracting from Tyler’s analysis.  First, on speculation remember that demand and supply are both very inelastic so relatively small changes in either can make a big differrence.  That means that speculation, if that is what you want to call it, can shift prices a lot without being very significant in total demand.  Because of this point Krugman’s analysis is quite right for iron ore but a little off for oil – indeed Krugman’s analysis of oil is difficult to square with his analysis of the California electricity crisis.

My disagreement with Tyler is an agreement with Caplan. 

Bryan Caplan notes that commodity prices always have fallen back down in the past and argues that is likely to happen again in the future.  I say no, the current price is your best (rough) estimate of scarcity (adjusting for storage costs), don’t expect mean-reversion, future returns (but not prices) are a random walk, and extrapolation is a dangerous method to apply to financial time series.   

No, two points.  First, commodities are not stocks and nothing need be a random walk.  Imagine, for example, that you can produce 10 units of commodity X but no more (fixed production).  Thus you produce 10, 10, 10…. Now you know that a big technological innovation is about to increase production possibilities to 20, 20. 20…..   Does the price today necessarily fall?  No.  Price today is determined by supply and demand, supply is fixed and if substitution across time isn’t very easy (you still have to get to work today, right?) then demand doesn’t have to fall much with expectations of future supply.  Thus the price is high until it drops, even if everyone expects the drop.

Finally, on oil – who really cares what the price is?  The issue is energy, not oil.  I am confident that the long run price of energy will fall.      

Why you should throw books out

I’m guest-blogging for Penguin just a bit, to promote the paperback edition of Discover Your Inner Economist.  Here is my post on why you should throw books out.  Natasha, alas, does not agree and sometimes she pulls them out of the trash and scolds me.  But here is an excerpt in my defense:

Here’s the problem. If you donate the otherwise-thrashed book
somewhere, someone might read it. OK, maybe that person will read one
more book in life but more likely that book will substitute for that
person reading some other book instead.

So you have to ask
yourself — this book — is it better on average than what an attracted
reader might otherwise spend time with? No I’m not encouraging
"censorship" of any particular point of view, but even within any
particular point of view most books simply aren’t that good. These
books are traps for the unwary. A lot of books don’t make the cut of
"above average to those readers they will attract" and of course since
you’ve spent some time with the volume you ought to be in a position to
know. (But note the calculation is tricky. Sometimes a very bad book
can be useful because it might appeal to "bad" readers and lure them
away from even worse books. Please make all the appropriate
calculations here.)

Note that the smarter and more discriminating are your friends, the higher the standard your book donations to them must meet.  Toss it!

Oil splat

It would take too long to sum up the dialogue, by this point you are either following the discussion or not.  A few points:

1. Bryan Caplan asks a good question: "You know now that the price of oil will be flat for five years, then
fall by 10% per year every year thereafter. Everyone else thinks the
price will be flat forever."  Can you profit?  Yes, by rolling over your short positions and constructing a synthetic long-term bet, even if the current futures markets extend for only three years or for that matter one year.  Fischer Black said so, so in other words you do have a chance to put your money where your mouth is.

2. Arnold Kling wonders why so many commodity prices have risen at the same time.  I’ll repeat that fundamental value — and thus the concepts of speculation and bubble — are trickier and vaguer with commodities than in stock markets.  I’ll say that "expectations" have driven the general rise in commodity prices.  If those expectations turn out to be wrong, we can call it all a bubble; if they turn out to be right, then it hasn’t been a bubble.  What should we call it in the meantime?  We’re not going to solve that problem in any factual way.  Make your bets, as they say.

3. Bryan Caplan notes that commodity prices always have fallen back down in the past and argues that is likely to happen again in the future.  I say no, the current price is your best (rough) estimate of scarcity (adjusting for storage costs), don’t expect mean-reversion, future returns (but not prices) are a random walk, and extrapolation is a dangerous method to apply to financial time series.  (For instance every time the stock market has fallen it has bounced back up again but that does not mean you can earn supernormal returns by buying on the downticks; even Shiller finds only small gains here.)  I love Julian Simon too but don’t let him overrule Eugene Fama.

4. Mark Thoma has an exhaustive post on convenience yield.  The models used are too piecemeal and they allow "inventories," "convenience yield," and "speculation," to serve as free-floating, not necessarily attached concepts.  The discussion here pays insufficient attention to Holbrook Working, who knew that convenience yield was front and center of the entire analysis, just as "the demand for money" is the centerpiece of the quantity theory.  Working himself didn’t even think that "speculation" was a well-defined concept in commodities markets; even if he went too far there the concept remains murky.  The current discussions are mixing fundamental conceptual definitions with some broader institutionally-motivated definitions and thus none of the results quite match up.

5. Contra Paul Krugman, invoking convenience yield should not be thought of as an Ptolemaic epicycle or a fudge factor.  The demand to hold oil is the starting point of the whole analysis, see also Jeffrey Williams’s work.  The upshot is that if speculation were driving the current price, it would be consistent with either a premium of the futures price over the spot or vice versa; invoking convenience yield to explain the relatively cheap futures is what you might expect in the first place, speculation or not, bubble or not.

6. Interfluidity has the most careful and accurate exposition of the relevant market relationships, mostly because he sticks closely to the Holbrook Working tradition. 

7. The bottom line is that when it comes to the key substantive questions about the oil market – why are prices so high — the correct answer is the Lachmannian one: "expectations."  If you push one step further on that, and try to evaluate or "source" those expectations, the correct answer is "we don’t know."  Jim Hamilton hints at some of this — and the imprecision of the "inventories" term — in this insightful post.

Addendum: On other practical matters, this new Op-Ed by Paul Krugman is essentially correct, although his claim that speculation is impossible in the iron ore market shows, better than anything else, the oddity of his semantic choices.


Here is a fascinating article from The New Yorker, mostly about itching but not just.  Here is my favorite part:

A new scientific understanding of perception has emerged in the past few decades, and it has overturned classical, centuries-long beliefs about how our brains work–though it has apparently not penetrated the medical world yet. The old understanding of perception is what neuroscientists call “the naïve view,” and it is the view that most people, in or out of medicine, still have. We’re inclined to think that people normally perceive things in the world directly. We believe that the hardness of a rock, the coldness of an ice cube, the itchiness of a sweater are picked up by our nerve endings, transmitted through the spinal cord like a message through a wire, and decoded by the brain.

…Yet, as scientists set about analyzing the signals, they found them to be radically impoverished. Suppose someone is viewing a tree in a clearing. Given simply the transmissions along the optic nerve from the light entering the eye, one would not be able to reconstruct the three-dimensionality, or the distance, or the detail of the bark–attributes that we perceive instantly.

…The images in our mind are extraordinarily rich. We can tell if something is liquid or solid, heavy or light, dead or alive. But the information we work from is poor–a distorted, two-dimensional transmission with entire spots missing. So the mind fills in most of the picture. You can get a sense of this from brain-anatomy studies. If visual sensations were primarily received rather than constructed by the brain, you’d expect that most of the fibres going to the brain’s primary visual cortex would come from the retina. Instead, scientists have found that only twenty per cent do; eighty per cent come downward from regions of the brain governing functions like memory. Richard Gregory, a prominent British neuropsychologist, estimates that visual perception is more than ninety per cent memory and less than ten per cent sensory nerve signals.

And sorry, readers, for shouting in the header; sometimes I get carried away.  By the way, don’t let defenders of naive realism tell you that any attempt to contradict it is self-refuting.  Science proceeds in pieces, cross-tested in various ways, and the sum total of those pieces can revise our understanding away from naive realism without producing self-contradiction.

RSS queries

As many of you know I am anti-RSS but I would like to understand the phenomenon better.  So I have a few questions for you.  What feature in an RSS reader do you not have but long for?  What would cause you to switch from one reader to another?  Would you ever consider a reader that forced ads on you, bundled up with the delivered post?

Don’t worry, we’re not planning or even contemplating changes in our RSS feed, I simply would like to learn.

Assorted links

1. Something else happens, via Bruce Charlton

2. "Civil War," an excellent new paper by Chris Blattman and Edward Miguel

3. Convenience yield, an excellent introduction; by the way Jeffrey Williams is a good author on the intuitive properties of futures and forward markets as they relate to storage.

4. The Japanese equivalent of the Hummer.

5. How to hire new people, by Auren Hoffman

6. Whose incomes are growing riskier?  It’s only about five percent of the distribution.

Grand New Party

The authors, Ross Douthat and Reihan Salam, invited me to their book party at Borders — and I wanted to meet them — but no I must stay home and read and blog their book!  (I wrote this post last night.)  If there was rush hour road pricing, as indeed they propose, I would have been there in a flash but no I am munching on cherries on my sofa.

The subtitle is "How Republicans Can Win the Working Class and Save the American Dream" and the Amazon link is here.  Their favored policies include the following (with varying degrees of enthusiasm/utopianism on their part):

1. Family-friendly tax reform.

2. Sprawl is OK or at least it could be with rational traffic management policies.

3. Government reinsurance for catastrophic health care expenses, plus they consider the Brad DeLong health care plan.

4. Abolition of the payroll tax for many lower-income earners.

5. Allocate money to public schools on a student-weighted basis, as is done in San Francisco.

6. Reallocate funding toward lower-tier state universities and away from flagship schools.

7. Don’t expect old-style unions to come back.

That is only a sampling.  The broader vision is that the Republicans can and must find a way to be more friendly to the non-rich.  Personally I don’t see any reason to tie all of this to the Republican Party but I agree with most of their proposals.  There’s a great deal of common sense here and it stands as one best general policy books in a long time.

The deep question is why something like this hasn’t already happened.  You’ll find the superficial "Republicans are just pro-corporate crooks" answer from bloggers like Kathy G.  Another possibility is that Republicans don’t get much electoral credit for pro-poor initiatives (just as many voters simply won’t believe that "Democrats can be tough").  The more competitive political messaging becomes, the more this constraint binds and so the policies of upward redistribution are more likely to be enacted by Republicans in the resulting political equilibrium.  If the authors are to get their way somehow this dynamic must be reversed.

Addendum: I’ve met Reihan only in passing and I have not had substantive correspondence with either of the authors.  Nonetheless the authors thank me in the conclusion for having saved them from "all manner of errors"; maybe this is another instance of the influence of blogs.

Second Addendum: You’ll find links to video and audio on the book at Ross’s blog.

Obama’s iPod

Thank you all for your contributions, here is my new insight into Obama, it won’t be new for long:

said that, growing up, he listened to Elton John and Earth, Wind &
Fire but that Stevie Wonder was his ultimate musical hero during the
70s. The Stones’ track Gimme Shelter topped his favourite songs from the band. His
selection also contained 30 songs from Dylan. "One of my favourites
[for] the political season is [Dylan’s] Maggie’s Farm. It speaks to me
as I listen to some of the political rhetoric."

…The jazz legends Miles Davis, John Coltrane and Charlie Parker were also included…

The worship of Dylan and Wonder and be-bop jazz is consistent with my view of him as a detached, universalist cosmopolitan.

Will mankind survive the death of the sun?

In reference to my Bloggingheads appearance, one loyal MR reader emails me:

you said don’t be certain, be 90-10 or 60-40 then [you] said 1-99 that humanity dies out when sun’s gone.

Yes, I believe the chance is very small that humanity survives the death of our sun or even gets close to that point.  I’ll give it p = .005.  But what’s the chance I think that is the correct p or even in the neighborhood of the correct p?  Maybe 60 percent.  Of course my p estimate could go either up or down and after I apply meta-rationality p = .005 is where I end up, for better or worse.  I expect that fragile estimate to undergo lots of revision as I age, read more, etc.  I just don’t know if it will go up or down, thereby satisfying one of Robin Hanson’s canons of rationality (or some approximation thereof).

Why am I skeptical?  The Fermi paradox, for one thing, plus I observe that humans aren’t very good at solving large-scale collective action problems.  Our environment may be more fragile than we had thought and that’s without even considering the impact of man.

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.

My favorite song

Ever, with explanation and the MP3 link on the left.  And here are the lyrics.

Addendum: The guy actually has the best practical idea I’ve heard yet for your time travel trip back to 1000 A.D.  If you have a decent voice, use the catalog of the Beatles and others to become the greatest minstrel the world has seen.  It’s the low capital costs and low cooperation requirements that make the idea so appealing.