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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.
Posted by Tyler Cowen on June 25, 2008 at 12:35 PM in Economics | Permalink
Comments
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.
Posted by: MostlyAPragmatist at Jun 25, 2008 1:17:10 PM
"could be read so easily from the available numbers, bubbles would be scarcer than they are"
That's what I was thinking, though not so eloquently thought. If the price was raised above rational levels by speculators, then a bunch of speculators are about to lose money. And if the pros can't see this, then how the heck is Barack Obama going to see it, or Krugman going to see it's not?
My theory is that the anti-bubble resulted from a lack of understanding of growth afforded by globalization masked by the tech boom/bust/recession. No proof for that theory. But I go on undaunted. Now that we are seeing the promise of the new economy fulfilled, investors are scrambling.
Posted by: Andrew at Jun 25, 2008 1:21:30 PM
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.end blockquote...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.
Posted by: aaron at Jun 25, 2008 1:27:09 PM
MostlyaPragmatist, I am not exasperated with Krugman (or anyone else for that matter), he is perhaps exasperated with me! Krugman has one of the very best econ blogs and you all should read it.
Posted by: Tyler Cowen at Jun 25, 2008 1:28:48 PM
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.
Posted by: cw at Jun 25, 2008 1:29:08 PM
The traditional story is that bubbles are more common than "anti-bubbles" because it's much easier to go long than to go short in many markets. Consider the ease of buying a house in 2005 (going long) to the difficulty of betting against house price increases. This argument is common in the asset price literature.
Posted by: cure at Jun 25, 2008 1:34:55 PM
Worked?
Posted by: at Jun 25, 2008 1:39:24 PM
I'd argue that an anti-bubble is what drove higher rates on US treasuries/interest rates in the 60-90s.
Posted by: nelsonal at Jun 25, 2008 1:40:21 PM
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)
Posted by: at Jun 25, 2008 1:47:42 PM
You can't really define a "fundamental value" for a commodity.
False. At the very least, all commodities take some resources, capital, and (most importantly) time to extract. For example, food requires the time of a farmer, capital (in the form of farm equipment) and resources (like fertilizer, water, etc.). At the very least, the value of the commodity is the sum of the value of these three things (time, resources, capital).
Posted by: at Jun 25, 2008 2:09:34 PM
Whoops, forgot to sign the above post.
Posted by: quanticle at Jun 25, 2008 2:10:21 PM
"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."
You'd think so. But the existence of a bubble can be read from the data. Take the two biggest ones in the past decade: stock and housing. Dean Baker for one wrote up a paper, kept going on and on about it, blogged about it. But no one listened. Now there isn't any significant bubble in the oil price, yet everyone is yelling about it, but the people who spotted the last two huge bubbles don't agree that the price of oil is anywhere near a significant factor in its current price.
Posted by: Dush at Jun 25, 2008 2:31:54 PM
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.
Posted by: spencer at Jun 25, 2008 2:46:58 PM
0.57 eh? Not 0.58?
Posted by: Sameer Parekh at Jun 25, 2008 3:39:56 PM
Maybe the Saudis are actually cutting production....
Posted by: jorod at Jun 25, 2008 4:14:11 PM
From a non-economist, non-mathematician perspective: we haven't even scratched the surface of what most Europeans are paying for gas. Do we really have such a sense of entitlement that we believe we can demand low prices? I guess so.
Posted by: Carolynp at Jun 25, 2008 5:06:44 PM
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.
Posted by: odograph at Jun 25, 2008 5:08:56 PM
"At the very least, the value of the commodity is the sum of the value of these three things (time, resources, capital."
Plain wrong.
Posted by: Sécessionniste at Jun 25, 2008 6:28:34 PM
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.
Posted by: R. Richard Schweitzer at Jun 25, 2008 7:30:21 PM
I need a few hours to read and digest all of the back-and-forth here, but if I might jump the queue and alert readers to my new study at IER that argues against increased regulation of speculators.
I conclude that speculators aren't driving prices, using commercial inventory data. In a footnote, I very quickly deal with the possibility of storing oil in the ground by not pumping it, but I didn't give it the attention Cowen et al. are giving it here.
Regardless of how that particular issue turns out, though, I still think I raised some good objections to Masters' testimony in the piece, so if you're interested in that you might take a look.
Posted by: Bob Murphy at Jun 25, 2008 9:16:35 PM
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.
Posted by: aaron at Jun 25, 2008 9:39:53 PM
Still wading through this stuff, but at this point I wanted to mention that I think Krugman got tangled up in knots with the housing analogy. From a blog post I just wrote:
Anyway, for some reason Krugman is looking at rents, and since they are flat he concludes that investors weren't driving the change in house prices. (I really think I must be misunderstanding Krugman here, because who would deny that investors drove up prices? But it sure sounds as if that's what he was saying!)
So regardless of whether I'm misunderstanding Krugman's position, I show in this study that we can contrast the current oil market from the housing market in the early to mid-2000s. In other words, using the hoarding approach, I don't see any buildup of oil inventories in the EIA data, but I do find a fairly strong relation between house prices and the rate of vacancy in rentals; as the Case-Shiller home price index skyrocketed, so too did the vacancy rate shoot up. This makes perfect sense: Investors are buying homes not to live in, or even rent out, but to fix up and "flip" the following year or two. If enough speculators are doing this, on average a higher fraction of the housing stock would be vacant.
I think this would have been a much easier answer than what Krugman did. If I have understood his position, then my only explanation is that (1) he foolishly believed a critic who challenged him by saying, "But the data don't show a buildup in housing!" and then (2) tried to explain why the hoarding argument doesn't apply to housing, even though it applies to oil.
So Krugman, it does too apply to housing. And the data show it clearly. You shouldn't have believed your critic who said the data don't illustrate the hoarding argument in the housing bubble.
Posted by: Bob Murphy at Jun 25, 2008 11:02:34 PM
hmm...looks like Krugman really put the smackdown on you there Tyler. Care to respond?
Posted by: js at Jun 26, 2008 12:47:20 AM
The speculators-drive-prices argument has always seemed doubtful, because unless a futures speculator is willing to actually take delivery, he has to sell his contract before the delivery date. However much his buying pushed up the price, his selling will push it down, so unless speculators are actually accepting delivery (i.e. accumulating inventory, which is what happened in the housing bubble), it's diffucult to see how they could drive up prices.
I don't yet fully comprehend the arguments and counter-arguments that have been offered here, but I'm glad to see this being disucssed by people who do comprehend this simple picture and are trying to move beyond it.
Recall Tyler's view that you can improve an estimation by not refining your model, but instead by examining your biases. Applied here, that theory would seem to weigh in Krugman's favor. He could easily please his readers by piling on to the evil-rich-people bashing so popular on the left, or at least hold his tounge while other Democrats do (and indeed in the past, on other issues, he has done so). Such a bias analysis would imply that, on average, speculators are probably responsible for less evil that Krugman imagines them to be. Since Krugman is arguing their effect is neutral, that would go so far as to imply that speculators are probably effectively driving prices down a bit. ;-)
Posted by: David Wright at Jun 26, 2008 4:27:33 AM
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?
Posted by: Andrew at Jun 26, 2008 5:04:21 AM
Before Krugger bugger becomes our buddy, we must realize that even the blind squirrel eventually finds a nut, and speculators and gamblers are right often enough to make gambling enticing.
In other news, S. Korea just lifted it's ban on US beef, does that make Krugger bugger think our food safety system is back on track?
Posted by: Andrew at Jun 26, 2008 6:26:44 AM
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.
Posted by: bb at Jun 26, 2008 9:36:09 AM
Blame is a irrational word, but there is no doubt if factors into public understanding.
I think the final factor is end-user demand ... the price folks are willing to pay. They don't want to touch the "blame" issues in that with a 10 foot pole ;-)
Posted by: odograph at Jun 26, 2008 11:13:33 AM
Tyler, Krugman is totally kicking your ass.
Posted by: meh at Jun 26, 2008 2:11:47 PM
Tyler, Krugman is totally kicking your ass.
Really? This trader doesn't think Krugman understands markets very well.
Posted by: Dirty Frank at Jun 26, 2008 7:57:54 PM
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.
Posted by: David Wright at Jun 26, 2008 8:46:52 PM
