Krugman on Calvo on Commodities

In his discussion of the cause of skyrocketing commodity prices, which he attributes in large part to central bank behavior creating excessive liquidity, Guillermo Calvo said:

Absence of a substantial increase in physical commodity inventories has been mentioned as evidence of absence of speculative activity (by Martin Wolf and, more guardedly, Paul Krugman).[1] But that is not valid.

Paul Krugman replies:

Calvo on commodities: Guillermo Calvo is one of my favorite economists. But - you know there had to be a but - I just don't buy his latest missive. Still, it's important that we have this debate: something awesome is happening to oil and other commodities, and figuring out what it means is crucial.

So, a couple of points.

First, Calvo dismisses the argument that the absence of physical hoarding is evidence against a speculation/liquidity source of high commodity prices. "Suppose, for the sake of the argument, that the demand for commodities for current consumption or production is completely inelastic..." Well, that's assuming your conclusion.

When I think about speculation, I always start from Paul Samuelson's classic analysis in terms of intertemporal price equilibrium (a 1957 paper - and not available, as far as I can tell, online. Why isn't Weltwirtschaftliches Archiv on JSTOR?). Speculation can affect spot prices because it takes physical stuff off the market. Argue, if you like, that the inventory data are unreliable, or that stuff is being held in the ground; but don't tell me that physical quantities are irrelevant.

Second, Calvo argues that inflation risks stem mainly from excess liquidity. He's in good company there, but I won't join in that chorus. In general, I don't trust hydraulic metaphors for monetary economics. And we are in a world where central banks target interest rates, not monetary aggregates; the risk of inflation, if there is one, would come from Bernanke and Trichet keeping rates too low too long, not on what's happening to M2 or some broader M-something.

On a happier note, it's great to see top-flight economists weighing in on the crucial issues of the day. It's kind of like the Asian financial crisis of 1997-1998, which was bad for the world but a sort of golden age for policy-relevant theory.

I'm not sure I understand the statement that "the risk of inflation, if there is one, would come from Bernanke and Trichet keeping rates too low too long, not on what's happening to M2 or some broader M-something." The way to keep interest rates low is to increase the quantity of bank reserves and hence to pump up the money supply. So keeping the interest rate too low, too long is the same as pumping too much money into the system. Isn't it? What am I missing?

I thought the problem was measurement. We aren't sure how to measure money properly, exactly where to draw the line between assets that are liquid enough to count as money and those that do not have sufficient liquidity, so tracking monetary aggregates is difficult. But that doesn't mean the quantity of money, properly defined, isn't a source of inflation, just that we might have a hard time uncovering a stable relationship between money growht and inflation due to measurement difficulties. I don't meant to imply that targeting money and targeting interest rates are identical monetary policies if there are no measurement issues, they're not (and this argument is independent of the main debate, the source of the commodity price boom), I'm only saying that the quantity theory still holds in the long-run, MV=PY, and that as M grows, P grows.

Update: Maybe I should elaborate. The liquidity of an asset is not fixed, it varies with market conditions. When financial markets get in trouble as they have recently and markets seize up, the liquidity of some assets - those with lots of revealed uncertainty about their true value - will see their liquidity drop. As this happens, it is possible that assets that were "near money" and liquid enough to count in a broad definition of money, are no longer liquid enough to be part of the money supply and M drops.

It is also possible that as the Fed intervenes and backs some of these assets, the liquidity of the assets will increase once again as the markets come back to life. This would increase the volume of near money and, with a broad definition of M, cause on increase in the money supply and a reduction in interest rates (and, with respect to recent history, financial innovation can increase liquidity and thus increase the supply of money independent of the quantity of financial assets). Thus, it's possible for the quantity of money measured as the quantity of some fixed set of financial assets to be relatively constant, yet have the underlying money supply vary. Therefore, even though we haven't seen the traditional measures of reserves and M increasing substantially, that doesn't necessarily mean that money, broadly defined, hasn't varied substantially as the liquidity properties of financial assets have changed with financial market conditions.

Update: A bit more on this - I think I get it now. Krugman's point is that Calvo is, in effect, saying that the SWFs and others are pumping liquidity into the system, which will lead to inflation. SWFs might be able to add liquidity to the system if the Fed was, say, holding M1 constant, i.e. had a monetary target and didn't act to offset any movement in the interest rate (that's one thing I had in mind above in noting that a monetary target differs from an interest rate target). But what's actually happening is that the Fed has an interest rate target that is based upon its reading of economic conditions; basically that means that private actions that increase liquidity will automatically be offset by the Fed as it stabilizes the target interest rate. It's not that excess liquidity cannot create inflation, it can and will if Bernanke/Trichet ease too long (though the admonition that this is different from the 1970s comes into play here), it's a question about whether SWFs are actually adding liquidity to the system. Given that the Fed will neutralize any change in the interest rate, they won't be able to do that.

Comments

[Bruce Wilder]

Too hydraulic or too mechanical -- which is the worse metaphor?

Extended definitions of money are extended in time, so it is necessary to be thinking in terms of a yield curve, which reflects in the present, expectations of future values.

If "peak oil" is nigh, there's no reason to build additional refining and distribution infrastructure for petroleum, because the physical quantities flowing through that infrastructure will never be greater than right now. If you are a "speculator" speculating that peak oil is now, you are, in effect, speculating that it is irrational to build additional infrastructure; the speculator, who built a warehouse (aka additional infrastructure) in these circumstances would be engaged in a self-contradictory bet.

As I read Calvo, he's saying that the speculation is based on the rational appraisal of the incentives facing Saudi Arabia and other large exporters/producers, who must balance their large holdings of oil reserves against their large holdings of dollars and dollar-securities. The speculators are speculating that the Saudis will, in the near-term, choose to leave more oil in the ground as the price rises. So, it is safe to bid up the futures prices, because a higher price will call forth lower, not higher production.

The speculator is not the one holding an inventory, here; the producer is doing that, and the "inventory" takes the form of unproduced raw petroleum in the ground. Well, really, there are two inventories -- the other composed of dollars and dollar securities. And, speculators do not hold the critical inventory of either. But, speculators can see two things: 1.) that the decision-making of the Saudis, and a few others, are the main effects on the relative values of petroleum and dollars; 2.) in a world, where the petroleum infrastructure has no slack, and buffer inventories are minimal, there's a good chance of chance events causing price spikes.

From the standpoint of a financial speculator, the very absence of inventories in the infrastructure pipeline are an incentive to speculation, because it creates the possibility of a big upside, when a typhoon or a war or a terrorist bombing, cause a price spike. If you own the future delivery of oil in that circumstance, you are suddenly very rich; and, if you are properly leveraged (using "free" dollars falling against yen, euro or yuan, in some sort of carry trade bet), the "downside" of a merely high price may be very mild.

[Bruce Wilder]

I'm reading my own comment, and wondering if I am clear enough. Should I ridicule Krugman's demand to see Samuelsonian speculator's inventories?

Because, I think peak oil implies that there is a disincentive to build the infrastructure to hold an inventory, a disincentive to maintain sufficient slack in the system, in general. And, the absence of sufficient inventories skews the risks associated with oil futures and spot prices, and that's a factor driving speculative bidding up of price.

Meanwhile, there are "inventories" of dollars. Does Krugman not want to see those? I guess not: too hydraulic to speak of reservoirs of dollars and dollar securities.

When Krugman was studying the Japanese situation in the 1990's, I wonder if anyone told him about the yen carry trade that developed around arbitrage of near-zero yen interest rates against other currencies, and the vast reservoir of uninvestable yen-denominated savings.

[hari]

Paul is a trade economist but he's not helping us to understand what the hell is going on with crude prices. Metaphors aside, I think Calvo is still right...liquidity is driving the speculation...including hoarding by non-traditional hedge funds and so on.

Mark is providing clarity on monetary aggregates and exactly what's the issue with BB/Trichet's rate policy - they're obviously part of the puzzle.

Inelasticity of supply under OPECs cartel management is legendary. No real inventory is kept except maybe by Saudis.
Yet cheating is also going on with OPEC quotas.

What's the role of non-OPEC suppliers (eg. Norway) in the speculative market right now?

I hope the meeting in Saudi Arabia will clarify exactly what gives with crude spot price.

[anne]

ttp://krugman.blogs.nytimes.com/2008/06/21/vertical-specialization-and-the-impact-of-oil-prices-on-trade/

June 21, 2008

Vertical specialization and the impact of oil prices on trade
By Paul Krugman

Wonkish post for the professionals, mostly.

I've written before * about the CIBC study suggesting that high oil prices, by making shipping much more expensive, may reverse a significant amount of globalization.

A new NBER working paper by Koopman et al provides some numbers for a thought I've had about this: that the effects of higher transport costs may be especially large because so much of world trade these days involves vertical specialization.

What the authors find is that on average, half the value of Chinese manufactured exports consists of imported inputs; in the higher-tech areas, the number is often more than 80%.

Here's my thought: in such cases, you want to think of transport costs in terms of a sort of effective rate of protection calculation, similar to the ones often used to show that third-world industries are much more protected than the nominal tariff rates might suggest.

Suppose that China engages in some export activity, but half the value is imported inputs. And suppose for the sake of argument that the price China can get for the final good in the export market is fixed by price of import-competing producers. Let the initial price be 100.

Now add transport costs that raise the price of anything shipped back and forth by 10%. This means that China has to cut its fob price to 91, so as to keep the cif price at 100. It also means that those imported inputs now cost 55, instead of 50.

And the result is that the value added China is able to collect falls from 50 — 100 minus 50 — to 36 — 91 minus 55. That 10 percent rise in transport costs in effect reduces the payoff to China from producing the good by almost 30 percent.

OK, you can question some of this: a lot of the inputs into Chinese production come from other Asian countries, so the transport cost won't be as big a deal as shipping to the US. But the double squeeze, both on export prices and input costs, is real: CIBC mentions Chinese steel, which is suffering from higher cost of acquiring Australian iron ore as well as higher costs of shipping to the US.

If high oil prices persist, we could be seeing a large drop in world trade.

* http://krugman.blogs.nytimes.com/2008/06/17/the-world-gets-bigger/

[hari]

Paul's reference to Asean financial meltdown (1997-98), in which he was professionaly involved, gives me the idea he is leaning on global liquidity chasing inelastic crude volumes on (Lon/TIC) futures market; but he's (still) not prepared to call it. Coward!

[anne]

[Please be careful in trying to link to the papers Krugman cites, for an attempted linking caused my computer to crash. Mark Thoma's link present no problem.]

[hari]

If you add transport cost to mainland China's value added on exports, inevitably Chinese inflation will (now) be exported, if not already. It's also probable Yuan valuation will rise to counter imported cost of basic materials.

I was listening to Chinese VP during the meeting with Paulson and it occured to me this technocrat (VP appointed only recently by NPC) is not reluctant to discuss currency valuation to counter cost of imported goods used in manufacturing on the mainland.

And don't forget BBs counterpart was part of the Chinese Strategic Dialogue delegation to Anapolis.

[hari]

If you add transport cost to mainland China's value added on exports, inevitably Chinese inflation will (now) be exported, if not already. It's also probable Yuan valuation will rise to counter imported cost of basic materials.

I was listening to Chinese VP during the meeting with Paulson and it occured to me this technocrat (VP appointed only recently by NPC) is not reluctant to discuss currency valuation to counter cost of imported goods used in manufacturing on the mainland.

And don't forget BBs counterpart was part of the Chinese Strategic Dialogue delegation to Anapolis.

[ECONOMISTA NON GRATA]

Paul:

It may be worthwhile mentioning the the price of, say, crude oil in the EU, is risen 267% between 12/31/01 and 05/30/08, while here in the US the price is up 542% during the equivalent time frame... 267 vs. 542....? Gee, I wonder if there are some monetary and fiscal policy issues we should be looking at.

I don't know, call me "old fashioned" if you wish, I won't be offended.

Now, let's see if Ben and Hank's pony can do more than just one trick. They had better get that horse in shape... That's what I'm saying.........

Best regards,

Econolicious

[Bruce Wilder]

Doesn't leverage have something to do with the supply of money, in its extended definitions?

The Fed flattens or inverts the yield curve, it forces a de-leveraging, which forces financial assets to flow through market transactions and be re-valued accordingly.

Leveraging up cannot change the real flow of market-value services from the underlying real assets, and so, should not be able to inflate the real value of the corresponding financial assets, but the financial assets are valued in nominal terms, and depend on expectations for the nominal market-value of the flow of real services. Which, I suppose, is why unstable rates of inflation are a critical concern.

[anne]

Hari:

"I was listening to Chinese VP during the meeting with Paulson and it occured to me this technocrat (VP appointed only recently by NPC) is not reluctant to discuss currency valuation to counter cost of imported goods used in manufacturing on the mainland."

Please explain further. What then might this mean?

[hari]

Inflation is rampant in China...currency valuation maybe one way to contain it now given the crude bubble.

Note also Indian inflation is now in double digit! Gov is under attack from all sides including left-parties who support UPA coalition. National election due next year.

Both emerging markets depend on crude supply from Gulf region. Roughly more than two-thirds of their crude supply is imported.

[anne]

China will not revalue under pressure, that I am completely sure of. There is little speculative currency pressure since there are exchange controls, while China prefers to deal with inflation selectively. Inflation may seem "rampant," but China has limited the adverse effects by sector and general growth continues. Food prices are a controlled problem. The Chinese economy is too diverse to use a singular control method.

[hari]

After the last NPC session, critical super-ministries have been created for simple purpose of minimizing time lag in policy implementation. Meanwhile, focus of leadership is to bridge the rual-urban income divide. If left uncontrolled, income inequality may become the source of social unrest on mainland.

NPC session atually enforced further centralization of macropolicy to focus on stabalizing growth. Young technocrats were promoted to replace grandies; IT is facilitating managament of national economy.

[MG]

There is much debate on whether inventories should be increasing if speculators bid oil prices above physical market clearing levels. Paul finds no inventory build; hence he believes the market price is correct. Also if commercial players were holding stocks resulting from prices being too high, they would have to be compensated with an upward sloping forward price curve, which we do not observe.

I would accept Bruce's argument that producers are reducing output to prevent inventory builds, except that producers appear to be at capacity.

There is a group that would be willing to hold stocks, however. Consumers and distributors in countries with price controls have an incentive to hoard if they expect controls to be relaxed (as China did partially this week). Their stocks would also be nearly invisible to market analysts. If prices were raised to world levels, consumption would decline and these inventories would be drawn causing world prices to drop.

[hari]

MG - correct!

China is raising domestic price to reflect global prices.
It ain't there yet...but getting closer with 17% increase.

[hari]

The Saudi's are now claiming the real source of crude oil bubble is speculation on Futures Market (TIC), according to IHT(Paris). And it seems all OPEC members are not equally enamoured about the meeting called by the Saudi's - there's apprarent internal discord on increasing supply also.

[Bruce Wilder]

anne: "China will not revalue under pressure, that I am completely sure of. There is little speculative currency pressure since there are exchange controls . . . "

Just eyeballing, it seems to me that the RMB has appreciated about about 17% against the dollar since going off the peg in 2005. Not as much as the Euro, certainly, but I think, maybe, more than the Pound. So, it seems to me, that China has been revaluing right along. Maybe, in a Goldilocks fashion overall -- rising against the dollar, but falling against the euro, but still the yuan is rising against the dollar steadily. So, in response to pressure or no, China has been steadily revaluing against the dollar.

[Uncle Billy Drills Into Mt. Pelerin]

This bothers me: "even though we haven't seen the traditional measures of reserves and M increasing substantially"

The reserves part I understand. M1 and M2 I understand. But M3, the part with the substantial increase, conveniently disappeared back in 2006. To say we haven't seen "M" increase seems incredibly disingenuous. We haven't seen "M" increase because the part that did increase "substantially." Most of that appears to be a result of large increases in reverse repos. If you decide you don't want to call that money anymore, you'd better have a better explanation than the one that was given officially.
Reverse repos can be pieced together from other fed reports (one hopes accurately) but what about the other components, including eurodollars? I haven't been able to find these numbers.

To the man on the street, it looks like we've created a monster that we can no longer control and that we barely understand. There are probably a few very bright people at Goldman Sachs, for example, that have a very good handle on all this.

[JKH]

"I'm not sure I understand the statement that "the risk of inflation, if there is one, would come from Bernanke and Trichet keeping rates too low too long, not on what's happening to M2 or some broader M-something." The way to keep interest rates low is to increase the quantity of bank reserves and hence to pump up the money supply. So keeping the interest rate too low, too long is the same as pumping too much money into the system. Isn't it? What am I missing?"

Finally a highly respected economist who seems to get how the Fed actually operates, in my view. (With all due and very sincere respect, I mean Krugman, unfortunately.)

The Fed doesn't inject money into the system to keep rates low. The only relevant provision of funds is about $ 10 billion in balances that the banks keep with the Fed for clearing and residual reserve purposes. It's tiny, stable, and virtually irrelevant to growth in the broader money supply.

Krugman has it exactly right. The Fed controls the Fed funds rate. Thats what affects commercial bank lending behaviour and that's what affects money supply.

Other types of textbook explanations such as the 'reserve multiplier' are invariably wrong.

[anne]

Bruce Wilder"

"Just eyeballing, it seems to me that the RMB has appreciated about about 17% against the dollar since going off the peg in 2005. Not as much as the Euro, certainly, but I think, maybe, more than the Pound. So, it seems to me, that China has been revaluing right along."

Right, perfect.

[anne]

Nice stuff here.

Remember, China will only price selectively.

[Mark Thoma]

JKH - think you missed what my question was. Here's a graphical explanation from long ago showing just what you are talking about:

http://economistsview.typepad.com/economistsview/2007/08/a-significant-l.html

What you describe is the current textbook version, e.g. Mishkin (who shows the endogeneity of money under an interest rate target graphically). But, although it may change (see here, graph here), reserves are still manipulated through open market operations. Presentation is another issue, i.e. whether to use the IS-LM framework to illustrate this. Mankiw argues that's okay. I prefer to actually show the reserve market graphs.

For a more advanced treatment, Walsh's chapter 9 is good on this, e.g. the modernization of Bernanke's classic paper on identifying monetary policy shocks. It has both a full graphical treatment as well as the underlying mathematical model, and it's fairly easy to follow.

Anyway, don't worry, the current operating procedure is well understood (though they do keep adding new twists to make it interesting, e.g. the recent move toward asset composition management as well as managing the total quantity of assets under the Fed's control).

[See here too - it's a graphical depiction of an email from Paul Krugman on this topic.]

[JKH]

Mark Thoma 6:19 p.m.

Thank you very much for the links. I shall study them.

Make that 2 highly respected economists :) at least (hedge)

I’m not an economist but have some background in this area. It seems to me that the general notion of the Fed “printing money” is regularly exaggerated in the broader financial media etc. in terms of its technical accuracy and application to the reality of monetary economics. I think the distortion is not particularly useful to the public understanding of how the financial system works.

It also seems to me that Volcker targeted the fed funds rate in order to target money supply growth. The second objective has changed over the years but the first, the facilitating modus operandi, has not. I find that media coverage of this aspect tends to disassociate Volcker from the targeting of interest rates, which seems incorrect to me because of this.

[Mark Thoma]

Prior to 1982, and even after to that to some extent, the exact policy procedure is hard to model consistently, though over time it does appear to have converged to a Taylor rule type structure. For that reason, empirical studies often limit the estimation period to post 1980 or 1982 depending, or break data at 80 or 82 for robustness. There's often a big difference between these time periods (and an important debate exists over the stability of the Taylor rule coefficient on inflation before and after 1982).

It's probably true that prior to 1979 the Fed targeted an interest rate - the automatic debt monetization stories told about the 1960s often rely on this. But there was a brief period from 79-82 where a monetary aggregate rather than an interest rate was the Fed's target variable, that's the general belief (when you fix M, i is more variable, when you fix i, M is more variable, as M was fixed from 79-82, we saw more variation in i-rates than we were used to). That was an intentional response to the high inflation at the time.

There are two classes of targets, aggregates (M1, M2, non-borrowed reserves, borrowed reserves, total reserves, things like that) and interest rates (ff rate generally, but others are possible). It's easy to show that if you control one, you cannot control the other (you can't control two lights independently with just one switch, that's the basic intuition), so the Fed must decide between targeting i or targeting M (though they have tried simply keeping both within certain bounds, called a combination policy - another complication from the past that makes this hard to sort out since the Fed does not tell us, even ex-post, exactly what it's procedure was). Mostly they have chosen i, we think, but not always, e.g. 79-82.

Anyway...

[Liquid]

We aren't sure how to measure money properly, exactly where to draw the line between assets that are liquid enough to count as money and those that do not have sufficient liquidity..."

When it comes to commodities, or similar investment grade inflation hedges, more than just liquid money must be considered. Pension funds can sell large blocks of stock to diversify into a commodities fund. The amount of money in checking accounts doesn't really factor significantly into this type of inflation hedging. Liquid money measures are more useful for guessing demand for consumer items.

[Michael McKinlay]

Commodities ? 2 Phenomena apply ...

1. America's current $700 billion plus trade deficit causing dollars to wash around the world and commodities are priced in dollars.

2. Peak Oil and especially Peak Export Oil ... The reports are out, both by the US Government, the IEA and the EIA and production of crude has stalled, only " liquids" ( that are mush less energy dense ) are rising ( think ethanol ). Oil production is now at about as high as it will ever get while demand is increasing. Scarcity.

[roger]

Krugman's position is consistent with his insistence that Bernanke's response to the "credit crisis" was correct. And, of course, ignoring the signals sent by Bernanke's willingness to lower interest rates not because of some fundamental change in the economy, but simply because of surface volatility in the stock market. When you suddenly lower rates on Sunday because you fear that the market will have a bad day Monday, you have, so to speak, trashed your brand.

I imagine Krugman is going to stick to his story. To me, the story is one of an overactive Fed. Last August, when it responded to Wall Street's pleas for action, it operated as though it were a sovereign government. And its actions since, up to and including the outrageous Bear Stearns deal, have usurped democratic governance in favor of a technocracy that has been captured by the institutions it should be regulating. It is pretty simple: the Fed decided that the citizenry should bear the financial burden for the failures of the financial sector wealthiest. Inflation and unemployment are the result. Unemployment probably would have increased if the Fed hadn't acted, and the economic slowdown had started, as it should have, last august - but inflation in what counts around the household would be much lower.

The "Thomas Friedman" rule has tacitly governed us for the last fifteen years - that governments should simply stay out of economics. At most, the state is allowed to do negative things - tax more here, tax less there. I think this era is going to come to a crashing end. Tragedy's end in satyr plays - and the Friedman rule might have ended in the farce of mailing out tax credits this spring, as the state, in the face of a crisis in energy that cries out for a massive program of research and development, chose, rather, to divvy up 160 billion dollars in 600 dollar segments so that consumers could put some money down on their credit card debt for all the Chinese toys and tickets to disneyland they'd racked up. What incredible blindness - it is as if Roosevelt had responded, in 1942, to the need to build up America's military power by - tax credits for consumers.

But, of course, if you are going to continue the Great Moderation, aka, the Era of Widening, abysmal Inequality, you have to pretend that anything the state does can be done by the private sector better. Voodoo economics, after all, would be nothing without voodoo slogans to accompany it.

[jamzo]

re: oil derivatives

a relevant and interesting post on another blog

http://www.dhafirtrial.net/2008/06/21/a-secret-oil-gusher-inside-citigroup/

\Two Federal Agencies Are Culpable in Oil Price Manipulations

By PAM MARTENS Counterpunch 6/21/08

If you want to flush out market manipulation, don’t turn to the sleuths in Congress. They’ve been probing trading of the oil markets for two years and completely missed a company at the center of the action. During that period, a barrel of crude oil has risen from $50 to $140, leaving a wide swatch of Americans facing a choice this coming winter of buying food or paying their heating bill.

The company that Congress overlooked should have been an easy suspect. It launched the oil trading career of the infamous fugitive, Marc Rich, pardoned by President Clinton in the final hours of his presidency. It was at one time the largest oil and metals trader in the world. In the late 90s it bought up 129 million ounces of silver for legendary investor Warren Buffet’s company, Berkshire Hathaway, in London’s unregulated over-the-counter market. In 1990, it was one of the first entrants into an ill-fated Russian oil venture called White Nights. In 2005, while part of Citigroup, the largest U.S. banking conglomerate perpetually scolded for obscene executive pay, it handed its chief and top oil trader, Andrew J. Hall, $125 Million for one year’s work. According to the Wall Street Journal, that was five times the pay package for Chuck Prince, CEO of the entire Citigroup conglomerate that year and $55 Million more than the CEO of Exxon-Mobil.

Given this storied history and two years of congressional testimony on oil trading skullduggery, one would expect to find volumes of current information available about this oil trading juggernaut. Instead, this company’s activities are so secret that its web site (www.phibro.com) is a one page affair and lists only the addresses, phone and fax numbers of its offices in the U.S., London, Geneva, and Singapore. No officers’ names, no bios, no history, no press releases. And while the Wall Street firms of Goldman Sachs and Morgan Stanley have been fingered by Congressman Bart Stupak (D-Mich) for gaming the system, Phibro has completely escaped scrutiny during a seven year period when crude oil has risen an astonishing 697%.

Phibro is the old Philipp Brothers trading firm that has resided secretly and quietly on Nyala Farms Road in Westport, Connecticut as a subsidiary of the banking/brokerage behemoth, Citigroup, since the merger of Traveler’s Group and Citicorp (parent of Citibank) in 1998. Traveler’s Group owned Phibro at the time of the merger. Despite the fact that Phibro has provided Citigroup with $2 billion in revenue over the past three years, the 205-page annual report for Citigroup in 2007 carries only the following one-sentence footnote on commodity income that acknowledges the existence of this company. “Primarily includes the results of Phibro Inc., which trades crude oil, refined oil products, natural gas, and other commodities.”

Combing through government archives, the first noteworthy appearance of Phibro occurs on April 6, 2001, when the Wall Street law firm of Sullivan & Cromwell sent a letter to the Commodity Futures Trading Commission (CFTC), the Federal regulator of oil and other commodity trading, acknowledging that it was representing “the Energy Group.” The letter was noteworthy because it delineated just who had teamed up to grease the oil rigging in Washington: namely, two investment banks (Goldman Sachs and Morgan Stanley); a house of cards that would later collapse (Enron); a proprietary trading firm inside a Frankenbank (Phibro inside Citigroup); and two real energy firms (BP Amoco and Koch Industries).

What the Energy Group had long lobbied for and finally received from its Federal regulator was the breathtaking ability to trade oil contracts and oil derivatives secretly in the over- the-counter (OTC) market, thus avoiding the scrutiny of regulated commodity exchanges, their CFTC regulator, and Congress. The April 6, 2001 letter was essentially to say thanks and interpret the new rules as favorably as possible for the Energy Group.

The change in the law occurred via the Commodity Futures Modernization Act of 2000 (CFMA) and is called the Enron Loophole. (Since Enron’s trading room went belly up along with the company, and Phibro is still trading oil secretly all over the world, it should perhaps now be called the Phibro Loophole.)

On June 3 of this year, Dr. Mark Cooper, Director of Research for the Consumer Federation of America, correctly outlined the problem to the Senate Committee on Commerce, Science and Transportation:

“The speculative bubble in petroleum markets has cost the economy well over half a trillion dollars in the two years since the Senate [hearings] first called attention to this problem…Public policies have made these markets the playgrounds of the idle rich, while consumers suffer the burden of rising prices for the necessities of daily life. We have made it so easy to play in the financial markets that investment in productive long term assets are unattractive…The most blatant mistake occurred when Congress allowed the Commodity Futures Trading Commission to forego regulation of over the counter trading in energy futures…Because there is no regulation of this huge swatch of activity, regulators have little insight into what is going on in energy commodity markets…Large traders who trade in commodities in the U.S. ought to be required to register and report their entire positions in those commodities here in the U.S. and abroad…If traders are unwilling to report all their positions, they should not be allowed to trade in U.S. markets. If they violate this provision, they should go to jail. Fines are not enough to dissuade abuse in these commodity markets because there is just too much money to be made.”

The only correction I would make to the otherwise flawless argument above is that Wall Street is far from the playground of the “idle” rich. Wall Street executives spend every waking minute (and I’ve heard even dream about) how they can separate us from our money, our homes and a voice in Washington. How appropriate that Citigroup’s slogan is “the Citi never sleeps.”

Let’s say the CFTC was not a compromised regulator, was not an audition stage and revolving door for million dollar jobs in the industry it regulates. Let’s say it genuinely wanted to report back to Congress on just how big a player Citigroup is in the oil markets. According to a February 22, 2008 filing with the Securities and Exchange Commission (SEC), Citigroup has over 2,000 principal subsidiaries (meaning it really has more but it’s not naming them). Of these, a significant number are secret offshore entities where records are unavailable to regulators. (For a mind boggling look at this sprawling octopus click here: http://www.sec.gov/ )

So the CFTC can’t get its hands on all records and even in jurisdictions where it can, it first has to know under what names, out of a possible 2,000, Citigroup is trading oil and then aggregate the positions.

On May 6 of this year, Tyson Slocum, Director of the Energy Program at the nonprofit watchdog, Public Citizen, testified before Congress on yet another roadblock preventing a meaningful investigation of oil price manipulation:

“Thanks to the Commodity Futures Modernization Act, participants in these newly-deregulated energy trading markets are not required to file so-called Large Trader Reports…These Large Trader Reports, together with the price and volume data, are the primary tools of the CFTC’s regulatory regime…So the deregulation of OTC markets, by allowing traders to escape such basic information reporting, leave federal regulators with no tools to routinely determine whether market manipulation is occurring in energy trading markets…The ability of federal regulators to investigate market manipulation allegations even on the lightly-regulated exchanges like NYMEX [New York Mercantile Exchange] is difficult, let alone the unregulated OTC market.”

Next comes what can only be described as an act of insanity on the part of the Federal Reserve. After allowing for the repeal in 1999 of the depression era investor protection legislation known as the Glass-Steagall Act in order to let Citigroup house retail bank deposits, investment banking, insurance, stock brokerage and speculative proprietary trading under one roof (the perfect storm that intensified the Great Depression) the Federal Reserve decided on October 2, 2003 that Citi wasn’t scary enough. It needed to allow this company that had already been named in hundreds of lawsuits for securities frauds and manipulations and could not remotely manage itself as a financial firm to ramp up its oil trading business by allowing it to take possession of crude oil on tankers because it would “reasonably be expected to produce benefits to the public.” Here are excerpts from the Fed’s release suggesting the expansive plans Citi had in the oil storage and transport business:

“…Citigroup has indicated that it will adopt additional standards for Commodity Trading Activities that involve environmentally sensitive products, such as oil or natural gas. For example, Citigroup will require that the owner of every vessel that carries oil on behalf of Citigroup be a member of a protection and indemnity club and carry the maximum insurance for oil pollution available from the club. Citigroup also will require every such vessel to carry substantial amounts of additional oil pollution insurance from creditworthy insurance companies. Furthermore, Citigroup will place age limitations on vessels and will require vessels to be approved by a major international oil company and have appropriate oil spill response plans and equipment. Moreover, Citigroup will have a comprehensive backup plan in the event any vessel owner fails to respond adequately to an oil spill and will hire inspectors to monitor the loading and discharging of vessels. Citigroup also has represented that it will have in place specific policies and procedures for the storage of oil… The Board believes that Citigroup has the managerial expertise and internal control framework to manage the risks of taking and making delivery of physical commodities… For these reasons, and based on Citigroup’s policies and procedures for monitoring and controlling the risks of Commodity Trading Activities, the Board concludes that consummation of the proposal does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally and can reasonably be expected to produce benefits to the public that outweigh any potential adverse effects.”

Voting in favor of this unprecedented action was then Federal Reserve Chairman Alan Greenspan as well as current Chairman, Ben Bernanke.

Could the Fed have been more wrong about Citigroup having “the expertise and internal controls to integrate effectively the risk management…?” Two years later, in March 2005, the bipolar Fed had this to say about Citigroup: “Given the size, scope and complexity of Citigroup’s global operations, successfully addressing the deficiencies in compliance risk management that have given rise to a series of adverse compliance events in recent years will require significant attention….”

Today, the situation is as follows: Citigroup has taken $42 billion in credit losses and writedowns in the past year, just announced that more writedowns are coming, and the Fed has an intravenous money feeding tube hooked up between its vault and this banking/brokerage/subprime mortgage lending/oil trading mad scientist experiment.

In addition to the secretive Phibro oil trading unit, Citi has formed Citigroup Energy and moved it to Houston. In a help wanted ad placed in Canada it described itself as follows: “Citigroup Energy is a global energy trading, marketing and risk management company based in Houston with offices in Calgary, New York, London, and Singapore. Our goal is to become the premier global energy commodities marketing and trading organization. Currently our capabilities include trading and marketing derivatives/structured products in power, natural gas, crude and crude products.”

Enron also called itself the “premier” energy trading organization. Apparently impressed with that model, Citigroup Energy has hired a significant number of former Enron traders.

Pam Martens worked on Wall Street for 21 years. She has no securities position, long or short, in any company mentioned in this article. She writes on public interest issues from New Hampshire. She can be reached at pamk741@aol.com.

[jamzo]

also relevant from bloomberg news

India Minister Blames Oil Surge on Speculators, Urges Price Cap

By Anil Varma

June 22 (Bloomberg) -- The near doubling of oil prices in the past year was driven by speculators, not an increase in demand, India's Finance Minister Palaniappan Chidambaram said.

Producers and consumers should ``wrest control'' of trading in the oil by agreeing to restrict prices, Chidambaram told energy ministers in Jeddah, Saudi Arabia, according to speech notes e-mailed from his ministry.

Crude oil touched a record $139.89 a barrel on June 16 as investors bought commodities to hedge against a weakening dollar and concern mounted that demand is growing faster than supply. Chakib Khelil, president of the Organization of Petroleum Exporting Countries, said today there isn't a supply shortage.

``Surely demand and supply cannot explain what has happened over the last 12 months,'' Chidambaram said. ``Oil prices were $70 a barrel in August 2007 and how is it that they've doubled when there has been no dramatic change in demand?''

Oil prices surged as financial institutions invested in the commodity through ``unregulated and highly opaque'' transactions, he said.

U.S. Energy Secretary Samuel Bodman rejected yesterday calls to put greater control on the markets, and said a shortage of supply was responsible for pushing oil prices higher. He rejected the argument that speculators are leading the markets to record levels.

The market needs between 3 million and 4 million barrels a day of spare oil production capacity, compared with the 2 million barrels a day available, he said. The International Energy Agency estimates that world oil use this year will climb 800,000 barrels a day, or 1 percent, as demand increases in emerging markets.

To contact the reporter on this story: Anil Varma in Mumbai at avarma3@bloomberg.net.

Last Updated: June 22, 2008 05:34 EDT

[reason]

MV=PY is an identity not an explaination for anything. It was used by Friedman to predict that ASSUMING V was relatively constant and Y is constrained by capacity constraints increasing M (assumed to be under Central Bank control) will increase P. All well and good, but I suspect in the long run financial innovation may well undermine the control of M and change V.

[hari]

@ Jamzo -

Reinforces argument I made here (last week) that CFTC is unable to advise Congress on what's actually happening with regard to *speculative crude bubble* on OTC. Phibro I knew from before...but the rest of the story is telling in how Citi has more or less cornerd commodity/crude market under Rubinomics!

Lond/TIC spot crude market price - 30% of global traded volume - translates into gas pump (retail) price and is totally *unregulated*. What matters for traders is the *volume* registered on Futures Market (not necessarily the strike price). Traders don't take physical delivery on *futures market* - it's the way they hedge against market fluctuations. [I suppose one could buy now a stake/volume for delivery later in 2009 or so].

CFTC regulatory oversite is critical to identify if the crude futures market is being manipulated or not. And, if they don't have the capacity to do it under present setup, it may be the weakest link in the regulatory chain for commodities world-wide. Principally because information technology and electronic transactions represent difficulties to CFTC regulatory oversite in current crude bubble market.

[ash]

I am still trying to make sense of Calvo's argument and Krugman's response.

The mechanism by which Calvo asserts that the money supply growth - which he argues is the cause of the high commodity price inflation - is high is via the portfolio shift of SWFs: they abandon T-Bills so the yield has to rise to make them willingly held. This implies upward pressure on the Fed Funds effective rate. The author's argument is based on the link between the T-Bill rate and the Fed Funds effective rate. To me it is as if Calvo argues that it is not the SWFs themselves which cause the increase in the rate of growth of the money supply, but the response of the Fed to their portfolio shift. The Fed keeps the rate close to the target by conducting OMOs, so if there is upward pressure on the Fed Funds then it must conduct OMOs and increase monetary base. But then I think maybe I have not fully understood the argument because, as Mark Thomas says:

"Krugman's point is that Calvo is, in effect, saying that the SWFs and others are pumping liquidity into the system, which will lead to inflation."

Under Krugman's argument the SWFs are themselves increasing liquidity and the Fed responding in a contractionary way.
Could someone perhaps elaborate and tell me whether, the "who is adding liquidity" question is relevant or misunderstood on my part? And could someone be more specific about how the link between the T-Bill rate and Fed Funds rate might work? Thanks!

[anne]

http://krugman.blogs.nytimes.com/2008/06/23/speculative-nonsense-once-again/

June 23, 2008

Speculative Nonsense, Once Again
By Paul Krugman

OK, one more try.

First of all, I don't have a political dog in this fight. I'm happy to believe that crazy speculation distorts markets. And I do think it's likely that oil prices will come down, for a while, once consumers have a chance to respond more fully to high prices by changing their driving habits, switching to smaller cars, etc..

But the mysticism over how speculation is supposed to drive prices drives me crazy, professionally.

So here's my latest attempt to talk it through.

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won't. What direct effect does this have on the spot price of oil — the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn't make any difference.

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that's true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.

Any effect on the spot market has to be indirect: someone who actually has oil to sell decides to sell a futures contract to Joe Shmoe, and holds oil off the market so he can honor that contract when it comes due; this is worth doing if the futures price is sufficiently above the current price to more than make up for the storage and interest costs.

As I've tried to point out, there just isn't any evidence from the inventory data that this is happening.

And here's one more fact: by and large, futures prices over the period of the big price runup have been slightly below spot prices. The figure below shows monthly data from the Energy Information Administration; * as the spot price shot up, the futures price (that's contract 4, the furthest out) actually lagged a bit behind. In other words, there hasn't been any incentive to hoard.

As I've said, I don't have a political dog in this fight. But the nonsense in this debate makes me want to shoot someone in the face.

I see that Michael Masters, about whom I had some flattering things ** to say a few days ago, is now telling Congress that gasoline will go back to $2 a gallon *** if we crack down on speculators. He forgot to mention that cold fusion will solve all our energy problems any day now.

[Figure] Where's the incentive to hoard?

* http://tonto.eia.doe.gov/dnav/pet/pet_pri_top.asp

** http://krugman.blogs.nytimes.com/2008/06/21/calvo-on-commodities/

*** http://www.marketwatch.com/news/story/gas-could-fall-2-if/story.aspx?guid=%7B2673C102%2D68E0%2D41D9%2D9C9A%2D10EE2E723948%7D