False Signals

In a money economy, each good has a price expressed in terms of dollars. But what's important is not the price itself, what's important is relative prices, the price of one good in terms of another. If milk has a price of $4 and gasoline has the same price, $4, then we know that buying one gallon of gasoline means giving up one gallon of milk. If purchasing milk is the highest valued alternative to purchasing gasoline, then this measures the cost of the purchase. Thus, the cost of a good is what you give up to get it, and this is measured as a relative price.

Relative prices provide important signals to both producers and consumers. They give consumers a means of deciding how to optimally allocate their purchases, and they direct the flow of resources to their most profitable locations. Because of this, it's important that price signals be as accurate as possible.

When there are sluggishly adjusting prices in an economy, accurate signaling becomes a problem since some relative prices will slip out of alignment with their optimal values, and this causes a misdirection of resources across sectors. The wrong mix of goods is produced and consumed, and the outcome is suboptimal.

Inflation can make this worse because it accelerates the rate at which relative prices fall out of line with optimal values. If all prices are perfectly flexible and adjust instantaneously in response to any shock, then inflation isn't a problem since relative prices will always be maintained at their proper values. But if prices aren't perfectly flexible, or there are other rigidities, then the Fed has to worry about keeping inflation from distorting relative prices and causing problems.

So one job of the Fed is to make sure that the price signals in the economy are as pure as possible, and that is the point behind inflation targeting. It's a way of trying to maximize the information content of relative prices so that resources are directed, as much as possible, to where they would go under ideal circumstances.

But think about commodity prices, oil perhaps. Is the run up in prices a true signal of scarcity? Is the price increase accurately reflecting underlying conditions? If so, then this is not the kind of a change in prices that the Fed should try to mute even if there is a temporary increase in the inflation rate because of it. It's signaling to substitute away, to bring more supply to market, to innovate, to drive less, etc. It's a change in relative prices that is providing an important signal to consumers and producers.

But if the increase is due to speculation, that's a different matter. In that case, the increase in price is providing a false signal to market participants and that distorts resource flows. Here the Fed would, if it could, want to try to temper the increase in prices and institute other changes as needed to allow fundamentals to take over once again.

The intense debate right now about whether the increase in oil prices and commodity prices more generally is due to fundamentals or due to speculation that is driving prices away from fundamentals - i.e. whether or not there's a bubble - shows how hard it is for the Fed to identify and do something about bubbles as they are inflating. Do we have a bubble in commodity markets or not? Is it the Fed's fault? Are prices going up partly from fundamentals and partly from speculation? Then how much of each? (I think some people use the word speculation when what they really mean is that oil producers have excessive market power that allows them to increase prices almost at will. Market failure can also cause distorted prices, but except for financial market regulation, this is outside the Fed's purview, so, while it's important to maintain competitive markets, that's for another discussion.)

We can't always have zero (economic) profit in every market at every point in time. In order for resources to be attracted to their best uses in a dynamic economy, there have to be profits - there has to be a pie to fight over - and sometimes that pie will be huge if there has been a large shock to a particular market and there will be lots of money to be made. That's not a bubble, that's the market doing what it's supposed to do and we don't want to get in the way of the market's ability to move resources where they are needed the most (though there may be reasons to slow the adjustment down at times, but that's another discussion as well). It will look a lot like a bubble when there is a large amount of excess supply or demand, but popping it would be a mistake.

Thus, while I certainly think would certainly be desirable for the Fed to pop speculative bubbles, practically it will be hard to do and mistakes can be costly. If, somehow, they are relatively certain that a bubble exists, action is warranted, but this is likely to be a rare event.

Comments

[Leverage]

Relative prices need to be able to freely adjust upward and downward to allocate resources efficiently. The main danger seems to be that high leverage can cause catastrophic credit default when relative prices adjust downward. Limiting leverage to some reasonable percentage may be the only solution. Bubbles cannot be reliably identified, and stopped. Even if they could, non bubble prices would still need to be able to freely adjust downward without catastrophic results.

High leverage is dangerous to the credit system.

[Enigma]

Mark,
The intense debate right now about whether the increase in oil prices and commodity prices more generally is due to fundamentals or due to speculation that is driving prices away from fundamentals

Did you hear about the recent Senate Committee inquiry about institutional speculations on the commodity futures market? Some experts were grilled. The most eye-popping testimony was by a guy called Michael Masters. He is a hedge fund manager and has insider knowledge of the industry. His answer really made the senators sit up tight. A summary of Michael Master's testimony can be found at Who is to blame for surging food and oil prices?

It's very scary! I hope they do something about it!

[Bruce Wilder]

Some random thoughts:

1.) Repeating one my favs: there's more to the organization of the economy than allocative efficiency. Lots of prices are sticky, as they say, and the realization of economic risk in variation between expected transaction results and actual transaction results is typically attenuated, in the insurance provided by rent-earning assets (on the real side) aka equity ownership (on the financial side). There are good reasons for doing this, that have to do with the requirements of good technical or organizational management.

One good argument for inflation-targeting is that a reliable expectation of a steady rate of inflation helps separates monetary inflation out of the noise of other uncertainty, for managers, who would otherwise have to separate the signal of varying rates of monetary inflation out of the noisy and multifarious data they receive.

2.) The price of anything is the cost in units of currency; price is the cost of anything relative to the cost of the money.

It is not implausible to believe that the cost of dollar money, for a number of holders of a great deal of dollar money, does not seem at all high. Credit is scarce but not capital. A run on central banks?

It is an argument, where the money mechanism is hard to specify plausibly. But, that's the point; the money mechanism is shifting. When you are the King of Saudi Arabia, and you begin to doubt why you hold all of these dollars, the money mechanism is, itself, in doubt. A debt-based currency transmutes into a commodity-based currency, with a sudden change in value relative to real consumption or investment goods.

For some key actors in the world, the basis for believing dollars are a reliably scarce, albeit artificial "commodity" has been undermined somewhat. Not fatally or completely, by any means. But, the perception of relative scarcity of dollars has shifted.

Both the willingness to re-capitalize the banks and the bidding up of commodities reflects this shift. They are of a piece with a diminished American prominence in the economic world, going forward, and a declining American standard of living.

The high dollar price oil, of wheat, of nickel represent an allocation signal, all right. The signal screams allocate away from dollars.

3.) There's probably some value in distinguishing between "real inflation" -- a rise in some key costs relative to the income of labor -- and "nominal inflation" aka pure monetary inflation.

"Real inflation" implies something beyond the control of the central bank, which demands reallocation of resources, particularly real investment resources.

[a]

Just to state the obvious, mistakes are even more costly in the other direction, allowing a bubble to inflate and not doing anything about it, as the misallocation of capital becomes enormous. Those McMansions are going to be enormously expensive to heat or to cool now that energy prices have quadrupled or quintupled.

But anyway, I think criticism about the Fed is not so much that it did or did not see a bubble, and how it reacted. It's that the Fed did things which it shouldn't have done (rescue measures in 1987 and with LTCM, cutting interest rates in a panic after the Dotcom bubbles and after 9/11), which then naturally caused a bubble. That is, the Fed has sent multiple signals to the market that it rescues the market when speculation has gone bad. This makes speculation profitable without having costs.

(Yes yes LTCM went bankrupt. But it saved the asses of countless IBs who had helped LTCM in its speculative tendencies or were in speculative markets which should have been disrupted but were not. Goldman would have been near bankruptcy had LTCM been allowed to go under in a disorderly fashion.)

[hari]

First, Fed must target not only core inflation but broad indicators of inflationary pressure to stabalize CPI.

Second, excess injection of (Fed) liquidity may have sparked the commodity index (link to senate hearings confirms my original contention that speculators are fostering the commodity index). The hedge funds and other's have no where to go with their huge cash holdings....The argument that China and India are responsible for it is far fetched.

Third, based on ECB policy experience with inflation targetting (for a decade now), it may be possible to see Fed/ECB cooperation across the atlantic to blunt short-term inflationary pressures. Long term, monetary policy may not be the right intrument to contain inflation and galloping CPI. Fiscal policy may be the tool for it and politics must come around to recognize and legislate what's required to stablize macrolevel developments.

My own instinct is that domestic politics will not allow serious discussion of the coming stagflation and its consequences - until its too late!

[paine]

mark
thanx for the plain english lay out

i know for one with your depth of insight
this degree of simpling down
can feel like running over broken glass

but its nakedness
i think
shows where the public collective mind
can get a purchase on
these complex activities

the shaggy dog called pricing power
gets my
best of show

"... some people use the word speculation
when what they really mean is
... oil producers have excessive market power
that allows them to increase prices almost at will.."

two points

if some or any relative prices can be raised at will
what algorithm or set of algorithms
best captures those price makers
price making process
how much long run strageeery short run politically exceptable opportunity

one word for point two

wind fall profits

ie profits that are rents because the process of real supply re allocation needs only n incentive profit of enterprise not n plus m
m = wind fall profits and rents

is the oil price surge built
built on a conjunction of favorable alibis and fabrications

[paine]

"High leverage is dangerous to the credit system"
hey the credit system is dangerous to the credit system

tell me where
high becomes too high ???

leverage is the soul of the credit system
it is an acceleration device
to move real resources around faster
where influx exceeds what "local "profits can fund .....

possible iron debt to equity ratio
headline

faster growing healthy baby
thrown out high window
with spec scam bath water

[paine]

spec use vs real production capacity use

credit to increase real supply
all the rest is
waste in-equity
criminality and ....
toxic froth

to avoid ???

almost by category
leverage for super near zero sum
credit influxing
to build higher
the already too many story high
babel-oid
tower of paper titles

the hi fi security
buy /sell game
is without ....merit

[paine]

i agree with bruce
a fairly accurate and reliable
set of future inflation rates
like a siimilar set of future interest rates
helps a manager plan
how sensitive the plans out come may be to thse rates
will obviously vary eh ???

then again
indexed contracts are nice too

[MG]

What if inflation targeting to ensure the information content of relative prices requires mispricing the rate of interest? Will not that lead to resource misallocation (i.e. over or under investment, changing the rate of extraction of increasing cost resources)?

[paine]

on the dive of the imperial dollar

i think bruce may be too choleric

its good for the global system

[Real Person from the Real World]

No one comments about how marketing based and engineered pricing skews things. You sell chocolate at $1/lb which is 50% cocoa and tastes good. Then someone comes along and says I have *special* chocolate that are "72%" cocoa from mexico and from africa and one is $75/lb, and the other is $100/lb, even though they are bitter they are "gourmet" and organic and better because they have more cocoa. The gourmet chocolate force the $1/b to come up with a competitive product of say, $25 to $50/lb, regardless of the fact the underlying value is the same. And who really understands the real costs in creating a piece of software? What are FAIR prices?

[trader walt]

"A summary of Michael Master's testimony can be found at Who is to blame for surging food and oil prices?
It's very scary! I hope they do something about it!"

Several years ago, China tried to buy Unocal oil company but the US prevented it citing national security grounds.
Then governmental institutions and other funds began buying energy futures contacts as an alternative. What's so scary about that? What did you expect them to do?

[hari]

Bloomberg reported last week on outstanding CDS (swaps) and its impact on credit market should defaults and bankrupticies follow....It's scary to try to understand that these CDS - in $Trillions! - are not easy to identify and may bring down the credit markets.

[hari]

Re-reading Mark's short essay on inflation targetting, I come to the conclusion that Fed will be forced to target inflation, as a priority, and develop a systematic approach to managing macropolicy based on headline inflation.

Globalization and emerging international trade paradigm shift makes it more likely that imports will impact how inflationary pressure develops overall. That's why I suspect current inflationary pressure especially on mainland China and India will eventually lead to revaluation of their trading currencies.

It's *false pretense* to imagine the global trading system is somehow *fixed* - against US national interest - with rising oil prices and other commodities.

Fed/ECB cooperation on targetting *headline inflation* can facilitate broadening the baseline of policy-making framework and provide (may be) alternative ways and means of managing global economy. Yet, if my argument is correct, it can work if China, India and Brazil are part of the process and allowed (as EU does within emerging EU-27) to more or less work from the same page. Multilateralism is not a science; it's called political economy of the world.

[bullbust]

All that demand for oil from China, driving oil prices to the moon? China came into existence sometime after Aug 2007?

http://www.marketwatch.com/tools/quotes/intchart.asp?symb=CL08M&sid=2005271&dist=TQP_chart_date&freq=1&time=9

NOT. The shenanigans by the Fed started then ..in Sep 2007. Reducing interest rates, liquidity, TAF, accepting crap as collateral at the discount window.

Forget China. Right in front of you, the Fed is running the biggest con job to benefit Wall Street hedge funds and banks.

[bullbust]

http://www.interfluidity.com/posts/1211451502.shtml

A run on central banks?

...
Some of us think that something's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else....

I can't tell you where the inventories are, except to wonder why anyone would put them where they would be counted. Hoarders tend to get nervous, and not advertise their hoards. (But this is pretty obvious.) Perhaps producers of storable commodities who lose faith in paper quietly hold back production. Interestingly, people who no longer trust the very core of the financial system remain comfortable with collateralized, centrally-cleared futures exchanges. These are well designed to manage credit risk, but they can default, have defaulted, and will default in extremis. I heartily endorse Cassandra's suggestion that they step up their margin requirements, ASAP.

None of this is any good at all. Capital devoted to precautionary storage would be better employed building new enterprises, laying a foundation for tomorrow's prosperity. But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging". People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl.

[Alex Tolley]

Enigma: "A summary of Michael Master's testimony can be found at Who is to blame for surging food and oil prices? It's very scary! I hope they do something about it!"

If it were just this, then there is no problem. As Krugman argued, this would require inventory build up (no evidence) of the bubble will pop as the futures expire. I've argued elsewhere that this could only work if producers withhold production to ensure prices stay high - using futures to bring forward the price rises by creating artificial demand signals.

I'm more persuaded by the argument that oil prices are high because increasing demand is pushing up against supply. I'll even buy the argument that supply restrictions are partially deliberate by the larger producers. However the correct response is to reduce demand for oil.

A quite calculation shows that the a Toyota Prius getting ~ 45 mpg and doing 15000 miles/year saves ~ 93 barrels of oil over 5 years. This would be worth nearly $10000. Surely ensuring a federal tax subsidy of some reasonable fraction of this cost would help stimulate demand for the vehicle while simultaneously reducing demand on the major use of oil in the US - transportation. If this reduced demand reduced the price too, the tax costs could be offset, even recovered and we wouldn't be sending our $ to the producers.

[donna]

Oh, cmon, our economy no longer works that way. Stuff is "on sale" half the time at significantly lower prices, if you don't like the price on something, wait a week and it's cheaper elsewhere. Price is meaningless anymore. NO information content whatsoever.

We pay a fortune for gas and are told the oil companies are making record profits. We see corporate executives making millions but are told there is no money for employees. We have the state of California with tax breaks for yachts and airplanes but are told there is no money for teachers and schools.

What are we supposed to think but that we are being scammed?

[Bruce Wilder]

MG: "What if inflation targeting to ensure the information content of relative prices requires mispricing the rate of interest? Will not that lead to resource misallocation (i.e. over or under investment, changing the rate of extraction of increasing cost resources)?"

I would advise thinking in terms, not of "the" interest rate, but of the yield curve. The central bank is managing the value of money looking forward through time, balancing the value of money now against the prospective value of money expected in the future as income from loans (debts), taxes, and returns on business investments in real assets. The scarcity of money, which gives money its value, is a completely artificial construction of government, founded on faith and credit in the ability of government to collect tax revenues sufficient to fund the national debt, the value of which debt in money terms the central bank is managing when it buys or sells treasury securities for cash. The yield curve has as its fulcrum the value of cash, and its other points are the values of national debt instruments of various duration. Thus, the management of the value of money through time.

The central bank, generally, wants the yield curve to have a lovely, pleasant slope, which slope enables financial intermediaries to use modest leverage to borrow at low short rates and lend profitably at somewhat higher long rates. A lovely, pleasant slope implies a steady rate of inflation: it is inflation which buries the cash fulcrum of the yield curve deep.

My general advice to central banks would be:
1.) invert the yield curve at the economy's peril; inverting the yield curve squeezes the leveraged intermediaries, reducing their activity and, at an extreme, putting them in peril.
2.) if the yield curve flattens "spontaneously" don't scratch your bald heads like morons puzzling over the "global savings glut" or bubbles, get busy and do something.

[Bruce Wilder]

A lot of economists persist in talking about "sticky prices" like they were a bug, not a feature. The thinking seems to be that the economy would adjust toward an ideal full-employment equilibrium so much faster, and without the error-prone hand of government, if only business people were quicker to adjust prices, as if the problem is that businesses don't know how to print new menus cheap.

Prices are held fixed, because prices are administered, and prices can be administered because a huge portion of the national income flows as rents or quasi-rents or anti-rents (don't even ask) to resources, which are not being re-allocated. Sticky prices reflect the pervasive importance of dedicated sunk cost investments in the economy, the returns on which have a high rent (or quasi-rent) component.

Reallocation of resources in response to changing prices is a matter of making new sunk cost investments. It is not the prices that are unnaturally and mysteriously sticky; it is the dedicated sunk cost investments that are sticky. (That's what "dedicated" implies -- that the next best use is lousy, and the difference between the best use, to which the sunk cost investment is dedicated, yields lots more income (rent) than the next best use.)

Business firms are organized to manage, as residual income, the return on the sunk cost investments. In jargon, firms are strategic and rent-seeking, not profit-maximizing.

Putting my soapbox away, now.

[kharris]

Perhaps the Fed has a better hope of preventing the conditions under which bubbles are prone to develop. The combination of easy money and poor regulatory oversight seems potent, and the Fed has some say over both. The point has also been made that some prices are more prone to stickiness than others. The real estate market, for instance, is less likely to clear in short order than the stock market. So the Fed might want to be more sensitive to the possibility of real estate bubbles than stock bubbles.

If we were faced with a stark black-or-white choice, it would be tough, but I think there is room for improvement in dealing with bubbles that does not involve the Fed having to decide in the fate of every supposed bubble. It can do better about not forstering bubbles and it can be selective in choosing which markets need most anti-bubble attention.

There has been a glorification of financial markets, a pretense that if the last basis point on a swaption isn't just right, somehow there is a significant loss in welfare. That seems to be at least part of the reason (excuse?) for the lack of enthusiasm for regulation. I have a hard time believing we need financial obligations that are many multiples of global output in order to optimize welfare.

Enigma,

The Master's testimony has drawn lots of attention, but we need to remember he is just a guy. The fact that he has a glamour finance job doesn't mean he can see behind the veil any better than the rest of us. That's why there's a debate.

hari,

Why is the claim about demand growth far-fetched? The textbook view is that the speculation argument is far-fetched. Why is the textbook wrong?

[Spectator]

Why is the obvious so hard to see? Excess liquidity, credit, and leverage cause bubbles. Is it a case of too much information causes muddled thinking? Or that many do not want to see the truth, when they have been on the wrong side of this issue.

The Fed caused these bubbles with easy money and moral hazard. There is a pervasive view that there is no cost to liquidity and unlimited credit and leverage. Little wonder this theft of people's purchasing power continues. Posts like this only serve to muddy the waters.

[robertdfeinman]

I'm puzzled.

First, I don't see how "speculation" in oil works. I understand speculating in oil futures, but that is sort of a separate market. Lots of trading is between firms, not in the futures market. Speculation also implies the ability to control the quantity of commodity. The Hunt brothers tried it with silver and failed. It might be possible to do it with gold since most of it is held in reserve, but no one can hoard oil.

Therefore if oil prices are rising it would seem that the principal reason is because demand exceeds supply. This would imply that producers are under producing. This may be because delaying sales will see further price increases in the future as the gap between supply and demand widens, or it may mean that they have reached the limits of production and can't really supply more (at least with present facilities).

In either case the "speculators" are the oil producing states. A market "failure" as Mark Thoma stated. If invading Iraq didn't work what makes people think that jawboning Saudi Arabia is going to produce results?

Second, prices for liquid fuel are about the least sticky of any common commodity. The oil itself is priced daily, and gasoline stations change prices every day if necessary. Perhaps airlines have a problem raising fares, but not fuel suppliers. So if the market isn't behaving according to expectations I don't think sticky prices can be seen as a factor.

If I'm missing something I'd love to be enlightened.

[Brooks]

In the case of oil/gasoline prices, it is also important to note the false signals due to externalities (environmental impact; incremental Defense spending -- and lives lost in incremental war -- etc.) not being fully reflected in the price.

[Hot Corner]

In the case of oil/gasoline prices, it is also important to note the false signals due to externalities (environmental impact; incremental Defense spending -- and lives lost in war -- etc.) not being fully reflected in the price.

[FreedomLover]

Just repeat:

It's evil Republicans stealing milk from the mouths of babes to fatten the oil execs already bloated pockets.... We all KNOW this to be true right?

[Bruce Wilder]

My hero, Stirling Newberry, has important news you can use, FreedomLover.

The degenerate case of Freedom is one which does not regard how well others are doing as important, or postulates that there is no second order matrix of relative goods. Since it is easy to construct the first, and to empirically show the second, the degenerate case of Freedom rests on denial of mathematics or history, or both.

The degenerate case of liberty is the reverse, it is the worship of the Nash Equilibrium itself, without regard to the positive feedback state. This degenerate case leads to paralysis. These degenerate cases can produce an oscillator: those who fear change clinging to degenerate co-dependency, and those who chafe at the co-dependency wanting disruptive unilateral action for its own sake.

I don't think I need to say that this is a death spiral, and it is the death spiral that American politics finds itself in at present. The Republican Party, and the Right more generally, worships unilateral action for its own sake, such as the invasion of Iraq, the Democratic Party, and the Left more generally, worships interdependence. Both assume that their preferred state leads to a positive feedback.

This is where the physical challenges, and social equilibria intervene against them: pure "Freedom", especially in its degenerate form, does not lead to any more oil in the world, nor does it lead to an improved [Life Cycle Analysis return on energy use] in the face of global warming. Pure interdependence is vulnerable to disequilibria, and thus, when established, eventually there is a political coalition that votes to gamble on a land rush mentality, destroying whatever positive progress was made during the previous period, simply because it is not sufficient to maintain political cohesion.

Or to say it another way, every time degenerate Liberty saves up a little money, degenerate Freedom goes to the casino, plays rigged games, chases scantily clad women and crawls back home, drunk, broke, and needing a prompt course of treatment for a Sexual Transmitted Disease.

The Neo-Conservative era has been an oscillation between these two states, with a resulting relatively static state for most developed world workers, and a perilous trade off for those in industrializing states. Life isn't so bad in new China, if you don't mind Asthma and picking bits of your children out of the school that collapsed on them.

[Bruce Wilder]

My previous comment was entirely a quotation from the linked Stirling Newberry essay.

[ampersand]

First, I don't see how "speculation" in oil works...

Therefore if oil prices are rising it would seem that the principal reason is because demand exceeds supply. This would imply that producers are under producing...

In either case the "speculators" are the oil producing states. A market "failure" as Mark Thoma stated.

That is one confused mess. Think like nornal humans. Forget about the mythical rational man.

Why would any producer of oil produce more? To echange it for bits of paper from the Fed which is gauranteed to buy less tomorrow than today? At least keeping oil in the ground is better than a gauranteed loss. Sure innovation may reduce demand for oil in the long run, but in the long run everyone is dead.

Why would any one who currently have this Fed paper keep holding it? The Fed thinks that the rational man is going to spend it, since it's worth less tomorrow. The normal human is going to exhcange it for something which will preserve his purchasing power. Exchange it for something which cannot be diluted.

And sure as night follows day, Wall Street will act as middleman in this mad rush to exchange devaluing paper for goods.

And just like the housing bubble rationalizations - incomes went up, interest rate is low, land control is creating scarcity of land, tehre is a svaings glut - the economists will trot out a new set of explanations for oil prices (of course with a tiny bit of truth) to justify this Wall Street toll collection.

What exactly is the explantion from economists about the price bubble is housing?

Has anyone ever heard an explanation for that, which jives with the rational man, efficient-market-knows-everything wonderland of economists?

After reading "Do you Care", one has to ask. Do economsists care about the havoc they create with their crackpot theories?

says...

Mark Thoma:

"The intense debate right now about whether the increase in oil prices and commodity prices more generally is due to fundamentals or due to speculation that is driving prices away from fundamentals - i.e. whether or not there's a bubble - shows how hard it is for the Fed to identify and do something about bubbles as they are inflating."

That reminds me of Joseph Stiglitz. Stiglitz began wondering almost immediately as oil prices began to rise from 2001, where was the investment by oil companies. I wondered similarly. As prices rose and investment lagged it became clear that only direct subsidies would spur investment in exploration and development no matter the price and profit levels. Oil company executives always argued they could not count on prices being high enough to invest as expected, but time and further price increases, and the past, showed that untrue.

[anne]

No one I know thinks the generally high price of oil is a speculative matter, no matter the debate. The proof is not there in the way of inventory storage, while the price movement has been years in the making. Stiglitz was right to wonder at the relative lack of investment, and while a friend in Australia who owns an oil company wondered at relative lack of American investment in African oil development there was no suggestion there was endless oil to be discovered anywhere.

Sorry, that was me but somehow my computer lost my name.

[anne]

Similarly with food; though I was woefully slow to give proper attention to United Nations reports of crop limits, nonetheless the reports have been there for years and again the absence of evidence of speculative stores of foods suggest price increases will not easily be reversed.

[Eric Dewey, Portland OR]

Both scarcity and speculation are likely to be operating here - which is probably why it's not clear whether there is an oil bubble or not.

It seems very disingenuous for economists to claim that bubbles can't be recognized, although I'd be sympathetic to any economist who was both willing to acknowledge that the issue is grounded in the collective relative value judgements of billions of individuals and to accept the logical consequences of that (i.e. that it may be impossible to create accurate macroeconomic models without trillions of terabytes of data on the relative economic decisions of those individuals).

However, I'm willing to grant that it is extremely problematic to take action on a recognized bubble - not because we wouldn't be able to understand the basic direction of the economic effect of it's collapse, but because taking any action requires that more recent participants in the bubble will likely be wiped out economically.

And that is not an economic judgment, but a political one.

The most appropriate action an entity like the Fed should take when they spot a bubble is to be honest with the public and indicate that they believe a bubble exists, provide a thorough explanation of why they believe that to be the case, and explain the policy actions that they believe will be necessary should the bubble persist - and then to take those actions when they deem it appropriate.

Once the Fed, as a responsible outside observer of economic events, indicates that a bubble appears to exist, market participants have a choice to make.

Our recent market problems come from our leaders not being willing to accept the consequences of being honest with us about our economic situation. As long as that is the case, there can be no economic stability. Period.

What is amazing to me is how everyone, including trained economists, still seems to believe that there is some external absolute value to money that is independent of our confidence in it's purchasing power.

Increasingly it seems clear that the actual value of money comes from having good information about what other people value. Money, prices, markets are all nothing more than markers that tell each of us individually (to the degree we're paying attention) about the state of our economic power to meet our basic needs, relative to the economic power of others.

(At least, that's what I think I'm learning from regularly reading this blog and the incredibly well-read commenters...)

[Bruce Wilder]

As far as the analysis of oil price movements is concerned, a useful supplement to the peak oil hypothesis is a recognition that oil processing and distribution is a long and elaborate "pipeline".

If we are near the peak of raw petroleum production, the incentives to invest in the pipeline are muted in a way that distorts the incentives to speculate or hoard. The prices for using a gas station or a refinery or an ocean tanker or other components of the "pipeline" are administered prices.

The over-utilization of the "pipeline" means the "pipeline" is fragile. Think about the probable effects on U.S. gasoline and fuel oil prices, of a major Gulf of Mexico hurricane this Summer. What are the incentives to speculate or insure against such calamities?

I have questions, not answers here -- just thinking aloud to develop some intuition and receptivity.

But, my instincts suggest that there are probably multiple price equilibria for crude petroleum, and that the falling fx value of the dollar, the currency of choice in oil transactions, does have the effect of boosting the equilibrium price of oil, and gives major exporters an incentive to shade their current rates of production lower, particularly the rates of production from low-marginal cost, high-rent sources.

That's not speculation that leads to obvious hoarding further down the "pipeline", which would be of dubious value in any case, because the "pipeline" has so little slack, and there's no incentive to invest in "pipeline" capacity.

But, it does raise the possibility that the price of oil will prove volatile in this era of peak oil.

Getting the U.S. out of Iraq, so the Iraqis can get their civil war over and done with, and their oil production up from 2.5 mbd to 8 mbd, would also have an appreciable effect. Just sayin, having oilmen in the White House was probably not the swiftest move ever by the American body politic.

[Spectator]

This is the part of the movie when we realize the police chief is one of them. The Fed and it's cabal of economists will serve their masters, the financial industry.

Expect more liquidity, credit, and leverage, to keep their house of cards from imploding all at once. Fighting inflation will be pure open-mouth policy as it has been. Fat chance it has from clowns whose credibility sinks daily. I'm just trying to figure out how much worse it can get. I've just vowed never to go to Spain and London again, after I saw the costs for our little trip this summer.

[Spectator]

Just saw Steve Waldman's post in today's links that beautifully describes the loss of confidence in the Fed.

Can the establishment continue to pretend they have no hand in runaway inflation? I know they'll try.

[Enigma]

Alex Tolley:

... build up (no evidence) of the bubble will pop as the futures expire.

But the problem is, those Index Speculators do not let their futures expire just like that. They tend to roll over their position again and again.

I've argued elsewhere that this could only work if producers withhold production to ensure prices stay high - using futures to bring forward the price rises by creating artificial demand signals.

I would argue that even if producers attempt to flood the market with supplies, someone with enough liquidity (e.g. those SWF) can still push the price up through the futures market.

That happened in Sept 11 when the Dow plunged initially. Then a mysterious and aggressive buyer (usual suspect- PPT) went long on the stock futures. Eventually, the stocks recovered partially as the speculators took advantage of the arbitrage opportunity brought about by the mis-pricing between futures and stocks.

[MG]

Enigma:

Sorry, I don't get it. Let's say physical demand and supply are balanced at price p. A speculator takes a long position in futures driving prices to p*>p. Expiration rolls around. He either takes physical delivery or sells his position (whether he rolls it forward or not doesn't matter; the deferred contracts don't expire until next month). If he takes delivery, he's holding inventory. If he sells, why would anyone pay him more than p if that is the price that balances the market.

[paine]

much price dynamics modeling
reminds me
of teaching a parrot to speak

[john c. halasz]

But paine, that's been done.

http://www.usatoday.com/tech/science/2008-05-12-einstein-parrot_N.htm

[Trance]

http://www.cnbc.com/id/15840232?video=747947551

[paine]

"if prices aren't perfectly flexible...
then the Fed has to worry
about keeping inflation
from distorting
relative prices and causing problems "

uneven relative rates of adjustment
....stickiness ... would seem
to be a problem
at any speed of price level change

so how much would
the speed of level change
exacerbate
how much ameliorate
efficient adjustment
this has no intuitively obvious answer i think

[paine]

"researchers worry, however, that the very use of human-language terms may cause researchers to infuse the birds' speech with too much human meaning"

voila !!!!

[paine]

to get the kinetics right
for a set piece of dynamic adjustments
but without using causal profit max algorithms
that leaves the model without motivations
it leaves
homo econo mobilii
without their mammonic soul

[Bruce Wilder]

Paine: so how much would
the speed of level change
exacerbate
how much ameliorate
efficient adjustment
this has no intuitively obvious answer i think

Yeah, I don't get that, either. As, I wrote earlier, it seems you have to think price stickiness is a bug, not a feature. It would seem to me that well-expected inflationary price changes might occur at their own necessary and steady pace, even while relative price changes continued on their sometimes sluggish course. That ought to be testable.

But the economy of my imagination is one where many prices are administered, and many markets do not clear -- in other words, something vaguely like the actually existing economy. I cannot fathom how the economy of my imagination compares to the economy of, say, Michael Woodford's imagination.

[Enigma]

MP:

Let say supply=demand at price p (it's May now). Let's say that a speculator buys at price p* due for delivery at June. Let's say p* is much higher than p + carry cost C.

Then an arbitrage opportunity for people to buy the physical commodity at price p and sell futures at p*. Since it costs the speculator C to hold on to the physical commodity, he will make a profit, which is p*-p-c.

[Winslow R.]

Paine quotes leverage:

"High leverage is dangerous to the credit system"
hey the credit system is dangerous to the credit system

tell me where
high becomes too high ???

leverage is the soul of the credit system
it is an acceleration device
to move real resources around faster
where influx exceeds what "local "profits can fund "

As someone who is pushing the idea of an overly concentrated leverage problem, I'll give my two cents.

Leverage does create an acceleration device, giving those with access to leverage, an amplified affect on the economic decisions made in an economy.

Why should one person, or one corporation, be able to leverage sway 50x what their real equity suggests? Are they 50x smarter, luckier, or just 50x better connected?

Our economy has fewer people making decisions as wealth concentrates. To add to the problem of wealth consolidation, or perhaps an attempt to compensate for it, we have a few more people making highly leveraged decisions.

How much is too much?

The government/fed is willing to destroy a percentage of asset values, something it can do, perhaps encouraged by the vulture capitalists willing to swoop in and purchase assets for pennies on the dollar.

Remember about a year ago, wall street types calling for an overdue 10 -20% correction in the stock market?

The question becomes, how large of a percentage of asset values is the government/fed willing to destroy?

Give me that number. 20%?

That 20% should be the down payment required of borrowers (hedge funds included) by the banking system.