Speculation & Oil Price Fluctuations

Commodities tend to fluctuate a lot more in value than do prices of for example services or finished goods. Why is that? One popular explanation is that speculation is the root cause of it.

A more plausible theory is however that the cause is a low short-term price elasticity for demand and supply. The flip side of a low price elasticity is that changes in demand (or supply) not caused by price movements will cause very big price fluctuations.

If say, 5% of demand suddenly for some reason (say a sharp cyclical downturn) disappears and say that a moderate price decline will only cause an increase in supply or decrease in demand of a few tenths of a percentage points, then it is clear that in order to avoid surpluses, prices must decline really dramatically.

That was exactly what we saw both in the great run up in the price of oil to early July 2008 and in the dramatic (75%) price decline that we saw until December 2008.

How then do we know if a certain price fluctuation is due to speculation or other factors? The answer to that question is: by looking at inventory changes. In order for speculators to increase/lower prices they must increase/lower inventory levels. The reason for that is that if they take long positions in futures contracts they are left with two choices. Either they unwind that long position in which case they will lower the price to the level where it would have been if they hadn't taken that long position in the first place, or they'll have to keep the delivery they paid for as inventory. Meaning that in order for speculation to affect the price, inventories must increase.

If you look at the evidence (For the original data go here and then click "Complete History XLS) , you can see that in the months before the July 2008 peak, inventories fell significantly(about 50 million barrels below year ago levels), while in the coming 5 months inventories rose sharply (shifting to being nearly 50 billion above year ago levels). Since then they have been more or less flat adjusted for seasonal patterns. This means that speculators helped reduce the price increase that we saw until July 2008, and then helped reduce the price decrease until December 2008. The increase in price we've seen after that was by contrast purely driven by underlying supply and demand movements.

So while Paul Krugman was right noticing that inventories are now higher than a year ago, he completely misses the point. That inventory build up was happened not during the latest price rally but during the preceding price decline. Meaning that it was during the dramatic price decline that speculation helped raise prices, not during either the preceding or following rallies. Adjusting for likely base effects, inventories have if anything declined during the recent rally.

China vs America

Interesting column from Larry Kudlow about how China continues its relative increase in importance due to its less socialist policies. An excerpt:

"There’s no question that current government policies for taxes, spending, and regulation are causing the U.S. to lose competitiveness in the global race for capital, prosperity, and growth.

Of course, China has been moving in the direction of free-market capitalism for years. To some extent, this shows the positive benefits of America’s free-trade policies and its open-mindedness in helping nurture not only China growth, but also middle-class prosperity worldwide....

....Fortune magazine recently reported that the number of U.S. companies in the world’s top 500 fell to the lowest level ever, while more Chinese firms than ever made the list. Thirty-seven Chinese companies now rank in the top 500, including nine new entries. Meanwhile, the number of U.S. firms has fallen to 140, the lowest total since Fortune began the list in 1995. This is not good.

China also surpassed the U.S. as the world’s biggest automaker in the first half of 2009, with June sales soaring 36.5 percent from a year earlier. The Chinese registered 6.1 million car sales for the first half of the year. That way outpaced American sales, which were only 4.8 million.

And China has no capital-gains tax. It only has a 15-to-20 percent corporate tax. The U.S., on the other hand, is raising its cap-gains tax rate to 20 percent. It’s also increasing its top personal tax rates."

The Value Of Fed Independence

Fed governor Donald Kohn argues against Ron Paul's bill to audit the Fed:

"History provides numerous examples of non-independent central banks being forced to finance large government budget deficits. Such episodes invariably lead to high inflation."

Damn good thing the Fed is "independent" (as it happens, Paul's bill would not remove its "independence" in decision making, it would only make it easier for others to see what they're doing) then, so that we won't have to experience announcements by the Fed that they will help finance the large budget by buying $300 billion of longer-term Treasuries.....

Kohn's argument reminds me of former Fed chairman Arthur Burns' statement that the Fed needs to do what the President wants, or it will lose its independence....

Ukraine's Great Depression

At long last, Ukraine has finally released its first quarter GDP numbers, showing a full 20.3% decline for the volume definition compared to the previous year. Since Ukraine's terms of trade also deteriorated, with the export price index only increasing 17.2% versus 31.2% for the import price index, the decline in real income for the Ukrainian people is even greater.

This means that Latvia loses the first place many believed it had in terms of economic contraction, as Latvia's real GDP "only" contracted 18%.

Now I suppose that most economic pundits will call for Ukraine to devalue its currency to solve its problems, like they did for Latvia. Or maybe not given that Ukraine has already applied that alleged remedy of allowing its currency to collapse.....

Texas vs. California

Texas and California are in many ways very similar, being first of all very big states (second and third respectively in terms of geographic size, second and first in terms of population and output), also having roughly similar climates and both having very large Hispanic immigrant (to a large extent illegal immigrant in both states) populations.

Yet, economic performance differs greatly. The unemployment rate in Texas is significantly below the national average, whereas it is significantly above in California. While both California and Texas has significant net immigration from abroad, Texas also receives a net inflow of people from other states, whereas native born Americans are fleeing California. And while California's severe budget problem seems like a never ending story, Texas, while suffering from the general cyclical downturn, has only limited budget problems.

So why is Texas so much more successful than California? When it comes to the budget deficit, many blames California's constitution that allows voters to approve spending projects without approving the kind of tax increases (or spending reductions in other areas) which are needed to finance them. That is to some extent true when it comes to the budget problem, but since California already has higher taxes than just about all other states and since normal budget rules given the overwhelming Democratic majority would simply mean even higher taxes that is not the solution to its underlying economic problems.

In addition to high spending, California also suffers from excessive regulation, including a much higher minimum wage and far more draconian "climate change"-related regulations.

In its latest issue, The Economists highlights the greater relative success of Texas and readily acknowledge that fact and the causes of it, yet still throws in a disclaimer of "it still seems too early to cede America’s future to the Lone Star state".

The first reason for this is their claim that the growing Hispanic population in Texas will make it more left-liberal, and so end Texas' low tax policies. Perhaps, but I don't think it will happen soon, given the overwhelming majority against for example a state income tax today, and at any rate California is also changing in that direction so it too will become even more leftist. And at any rate, regardless of whether politics change in the future, there can be no denying that Texas low tax policies have been more successful.

The other argument is that there are still a lot of bright people in California. Which is true, but there are also many in California which are not so bright, and there are a lot of people in Texas that are bright. And returning to what should be the point of the story, California's policies are causing a net outflow of people, while Texas's are causing a net inflow of people.

Chinese Car Boom Continues

Passenger vehicle sales in China increases 48%, confirming how China is surpassing the United States as the world's largest car market. This also confirms that the Chinese economy continues to expand, even as most other economies contracts.

Today's Chart

About the assertion from Paul Krugman and other Al Gore-supportersthat global warming is going faster than anyone could have expected. This chart really says all you need to know about the validity of that statement-and the credibility of those who utter it. From the web page of climate scientist Roy Spencer.

Ed Glaeser's Pathetic Defense Of Greenspan

Ed Glaeser, economics professor at Harvard University, dismisses the theory that Alan Greenspan's low interest rate policy caused the housing bubble with this argument:

"Mr. Greenspan’s loose monetary policy may have been a mistake, but low interest rates cannot readily explain what happened to housing prices. Real rates actually rose slightly between 2002 and 2006. "

Huh? In 2002, the housing bubble was inflating, in 2006 the housing bubble was deflating. So, by his own criteria of relevant evidence, he is supporting the theory he is trying to deny. Apparently, Harvard doesn't have high standards when it comes to basic reasoning abilities or logical coherence. Needless to say, Glaeser was as clueless as most professors were in predicting the current crisis.

Sweden's New Inflationist Strategy

In this post at the Naked Capitalism blog, the new inflationist strategy of the Swedish Riksbank is discussed. The facts appears to be mostly correct, though it is misleading to claim that Sweden has price deflation. While the official CPI is in negative territory that is only because it counts interest rate cuts as price cuts (Meaning that in the short term, interest rate changes will have the opposite effect of the intended). Looking at the EU-harmonized price index which lacks that distortion instead, the HICP, Sweden has an inflation rate of 1.7%, significantly above the euro area average.

Anyway, what the Riksbank decided was to reduce its main interest rate from 0.5% to 0.25% and start with quantitative easing. There's nothing unusual or new about that these days, as near zero interest rates and quantitative easing are the rule rather than the exception for central banks in advanced economies. What was unusual was that this decision meant that the interest rate on bank deposits in the central banks was cut to -0.25%. That's right, a negative interest rate. The reason why they now have a negative deposit rate can be found in the reason why it is considered nearly impossible to bring market interest rates below zero: namely that people would then start to withdraw their money. By having a negative deposit rate, the Riksbank hopes to discourage banks from keeping the money they receive from quantitative easing as reserves. Instead, they want the banks to create more credit, something which in turn will increase money supply, something which in turn will increase inflation.

The most radical inflationist in the board, Lars E.O. Svensson, has advocated currency market intervention to bring down the exchange rate of the SEK, which in turn is meant to increase import prices and inflationary expectations. The rest of the Riksbank board decided against it, probably because other countries could interpret this as a way to subsidize exports and discourage imports, rather than as a way to increase inflation. The strategy they are now pursuing will also lower the exchange rate of the SEK, but probably not by as much and not in such a conspicuous way.

One interesting question that the Riksbank's negative deposit rate this raises is why the Fed insists on paying a positive interest rate on bank reserves. If you want to achieve inflation, which the Fed wants, then that is counterproductive as it encourages banks to keep the money at the Fed instead of lending them out to the public. As I've pointed out repeatedly, the monetary base has no direct effect on the real economy. It only has an indirect effect to the extent it helps increase the money supply. But as long as the banks keep the money they receive from the Fed's asset purchases at the Fed, money supply is not affected.

I am not sure why the Fed insists on having a positive deposit rate, since it counteracts the inflationist effects of their other schemes, but one possible reason is that it wants to subsidize the banks and boost their profits. By paying interest on their deposits, the Fed is essentially giving away money to the banks. Another possible reason is that they think that large reserves are essential to restore confidence in the banking system.

Defining Savings

Robert Murphy and Robert Wenzel have a dispute over the definition of savings. Wenzel appears to define savings as "demand for capital goods" while Murphy defines it in the traditional sense, as preserving (saving) a right to consume. In Wenzel's definition savings is thus defined as capital expenditure, whereas in Murphy's definition it is defined as refraining from consumer spending. The practical difference being that holdings of physical (paper/metal) cash and even bank deposit holdings that the banks don't lend isn't considered as savings under Wenzel's definition whereas it is considered as savings under Murphy's definition.

Murphy is clearly right on this subject. "Savings" means uhm well saving, (or preserving if you will) something, in this context meaning the claim on consumer goods. That is something that can be achieved by any act that refrains from consumption, including for example holding paper money, holding gold, holding stocks or holding bonds or bank deposits.

But isn't there a difference between putting money in a jar and using it for capital expenditure. Yes, but that's why you have words like "investment" and "capital expenditure", to differentiate between different forms of savings.

As Murphy points out, Wenzel's definition creates the absurd situation where someone who has deposited money in a bank really doesn't know whether or not he has saved until he knows whether or not it has been lended. And indeed that's not really sufficient, as he also must know whether or not the loan has ceteris paribus causally made the borrower invest in capital goods. It furthermore would imply that if the borrower didn't use it for capital expenditures, but for consumer expenditures, then people who saves their income really aren't saving. What is really going on is that the people lending (depositing) money to the bank are saving while the people borrowing from the bank are dissaving, but if you define savings as "capital expenditure" you would not be able to understand that these transactions involved some people saving and other people dissaving.