Economist's View

Energy Update

This is the Dallas Fed's Quarterly Energy Update:

Petroleum Products Rebound as Natural Gas Continues to Slide, by Jackson Thies and Mine Yücel, FRB Dallas: Although demand for oil remains weak, prices have rebounded from the lows of the first quarter (Chart 1). As of early May, the spot price for West Texas Intermediate crude (WTI) was near $54 per barrel, over 25 percent higher than the first quarter average of $42.88. If economic activity picks up in the latter half of the year, we can expect further firming in oil prices.

Gasoline Prices Rising
Following oil prices, gasoline prices are off their recent lows on declining refinery utilization and signs of stabilization in vehicle miles traveled (Chart 2). The onset of the summer driving season and increased travel will put upward pressure on prices. As of early May, prices are slightly over $2.10 per gallon, about 9.3 percent higher than the first quarter average, but over 40 percent below year-ago prices.

OPEC Production Held Steady
At the March 15 meeting, OPEC opted to hold production constant but encouraged member countries to further adhere to quotas. The International Energy Agency estimates compliance at 83 percent, and with the exception of Nigeria, all producers exceeding their quotas trimmed production in March (Chart 3). If OPEC reaches full compliance, it will trim an additional 700,000 barrels per day from the market.

Using the Crisis as an Excuse

Andrew Leonard had a post entitled The silliest Republican economic proposal yet. He may want to reconsider that call:

Republicans Propose 'No Cost' Stimulus, Fox News: SEAN HANNITY, HOST: And in "Your America" tonight, another economic plan is also emerging tonight. The Republicans have proposed an alternative to the president's $787 billion stimulus package, and it costs a little bit less. Zero dollars. And it also promises to create two million new jobs without any of your money.

Joining us Congressman John Shadegg and Senator David Vitter. They're here to explain.

All right. Now we keep hearing from the Democrats well, the Republicans, they need to — they need an alternative proposal. You have an alternative proposal.

Congressman Shadegg, we'll start with you.

JOHN SHADEGG (R), ARIZONA CONGRESSMAN: We do have an alternative proposal. It looks at the fact that we spent billions of dollars on this stimulus package taxing the American people and burdening future generations with little to show for it. And many of us believe it will not produce Americans jobs.

With unemployment rates going up how can we produce American jobs? And the answer is we have had a non-energy policy in this country for a very long time. The reality is we are giving jobs to oil fieldworkers and natural gas fieldworkers in Russia and Saudi Arabia and Venezuela, when we should be putting those people to work here in the United States.

HANNITY: Right.

SHADEGG: Now Senator Vitter and I have drafted a bill that says let's put Americans to work, let's pursue the fight we had last summer of an all of the above energy strategy, let's clear the bureaucracy out of the way, and let's move forward with American jobs, producing American energy. ...

So opening ANWR and easing restrictions on offshore drilling is (a) free (never mind the potential environmental costs, those don't count if you're a Republican), and (b) will create 2 million jobs by taking them from other countries (the jobs will come from commies and terrorists, foreigners in any case, so no problem there, no need to count the costs to those workers).

This is, of course, silly and simply a way to use the crisis to push a favorite Republican proposal, something they do routinely (a terrorist threat? looks like we need another tax cut...). But I'm curious why the standard Republican objection to attempted job creation through changes in taxes or spending - that the jobs will simply be taken from other industries - doesn't apply here (if the jobs do come from other industries, it's not "costless" as claimed). Or are there, as Democrats claim, idle resources sitting around just waiting to be put back to work? [Note: Comments point out - correctly - that talking about short-run tradeoffs for this policy is silly since most estimates don't anticipate much job creation from relaxing these restrictions, and the jobs that would be created don't appear for several years. That is, this does nothing to stimulate the economy to use idel resources in the short-run.]

'Discussion of “Oil and the Macroeconomy: Lessons for Monetary Policy"'

Janet Yellen discusses a report on "the macroeconomic implications of oil price movements":

Discussion of “Oil and the Macroeconomy: Lessons for Monetary Policy” by Janet Yellen, President, FRB SF¹: It’s a pleasure to discuss this thoughtful and comprehensive report on the macroeconomic implications of oil price movements.[2] Even though we are no longer faced with sky-high oil prices, the issues discussed here remain important and policy relevant. It is hard to believe that oil prices will not go up again sometime in the future, so it is vital that we learn from the last episode, both about how the economy is likely to be affected and how monetary policy should respond.

Perhaps not surprisingly, most of my discussion relates to the latter topic, namely the Fed’s policy response to the swings in oil prices over the last seven years.

"Super Contango"

A puzzle for you:

Super Contango, by Kevin Drum: Normally, it costs more to buy a barrel of oil for delivery six months from now than it does to buy a barrel of oil today. After all, if you're not going to take delivery of my oil until July, then I'm going to want the spot price of the oil plus the cost of storing it plus the cost of having to wait for my money. So maybe a barrel of oil that costs you $38 today will cost you $41 for delivery six months from now.

But instead of $41, what if the July price is $53? Then anyone who wants to can make a guaranteed killing. Accept the contract, buy a tankerful of oil, store it for six months, and then deliver it.  Even after the cost of storage and the interest on the loan you took out to buy the oil, you'll make a quick and easy ... profit.

Sounds nice, but since this profit opportunity is so obvious it should get arbitraged away almost instantly. In short, a situation like this should never happen — certainly not for long periods, anyway. But it has...

So what's going on? One possible explanation is that most of the easy storage is already full, so it's not really possible to make a quick buck on this even if you want to. But even if that's the case, there's yet another option: oil producers can pump less oil now (essentially "storing" it in the ground) and then pump it out in July for delivery at the higher price. But apparently they're not doing that. John Hempton figures there are two possible explanations: (1) they're already pumping at full capacity, so they can't promise to pump extra oil in July even if they want to, or (2) oil producers are so desperate for cash that they're willing to take money now even if it's way less than they could get for the same stuff six months from now.

#1 doesn't seem to be true. So that leaves #2: thanks to plummeting oil prices, OPEC countries are in serious economic turmoil and desperate for any cash they can get their hands on right now. Either that or else there's an option #3 that's not obvious. Any ideas?

"Oil Shocks Redux"

Alan S. Blinder and Jeremy Rudd survey theories that have been constructed to explain why the recent oil price shocks did not have as large an impact on the economy as the shocks in the 1970s:

Oil shocks redux, by Alan S. Blinder and Jeremy Rudd, voxeu.org: From the end of 2002 to the middle of 2008, the US economy was in the throes of a significant oil price shock. The dollar price of oil rose fivefold, with spot prices briefly hitting $145/barrel. Even adjusting for inflation, the rise in oil prices was stunning. At their peak, real oil prices stood about 50% above their previous record high – reached following the second OPEC oil shock of 1979-80. (After hitting its 2008 peak, the price of oil fell rapidly, tumbling over the past six months into the $30-$50/barrel range.)

Although the recent run-up in oil prices is comparable in magnitude to the first two OPEC shocks, its effects on the economy seem to have been very different. Textbook accounts of the 1970s and early 1980s blame “supply shocks” (which included sharp rises in the price of food as well as oil) for the prolonged periods of both high unemployment and high inflation, or “stagflation,” that followed. By contrast, the most recent increase in oil prices appeared to have very little effect on the expansion that followed the 2001 recession. (While the US economy did enter a recession at the end of 2007, this was widely attributed to the collapse in consumer and business confidence that attended the subprime crisis and subsequent financial panic.) Similarly, core consumer price inflation – inflation excluding food and energy prices – was relatively stable over this period, which again contrasts sharply with the earlier episodes.

One interpretation of the experience of the past several years is that it vindicates “revisionist” views of the role played by oil shocks (and other supply shocks) in precipitating the stagflation of the 1970s. According to this view – variants of which have been propounded by DeLong (1997), Barsky and Kilian (2002), and Cecchetti et al. (2007) – the root cause of the abysmal macroeconomic performance from 1973 to 1983 was poor monetary policy, not the oil shocks. For example, in DeLong’s account of the period, bad memories of the Great Depression (which left the Fed fearful of using tight money to fight inflation) and the Fed’s attempt to exploit what it viewed as a non-vertical long-run Phillips curve created a situation that made a burst of inflation inevitable. Likewise, Barsky and Kilian see a “stop and go” monetary policy as driving both the higher inflation and the higher unemployment of the 1970s and early 1980s. Indeed, Barsky and Kilian even go so far as to argue that expansionary monetary policies in the US and elsewhere led to both the rise in overall inflation and the rise in the price of oil and other commodities that were observed over this period – implying that the supply shocks themselves were merely symptoms of an underlying policy failure.

FRBSF: Oil Prices and Inflation

Do changes in oil prices impact core inflation? That is, do changes in oil prices - which are excluded from core measures - pass through over time and raise prices generally? According to this, the answer is no, at least in the U.S.:

Oil Prices and Inflation, by Michele Cavallo, FRBSF Economic Letter: As oil prices have climbed over the last several years, the memory of the 1970s and early 1980s has not been far from the minds of the public or of monetary policymakers. In those earlier episodes, rising oil prices were accompanied by double-digit overall inflation in the U.S. and in several other developed economies. Indeed, central bankers say they are determined not to let this experience recur, emphasizing that they intend to maintain their credibility with the public in securing low inflation and achieving stable and well-anchored inflation expectations. In pursuing these goals, a key measure policymakers often focus on is core inflation; this may seem surprising, since core inflation excludes energy prices, among other things. However, one justification for looking at a measure that excludes energy prices is that they are typically quite volatile; for example, after rising steadily and hitting a record of about $145 per barrel in July, oil prices then fell to under $100 per barrel in September. Temporary oil price increases do not tend to pass through to the prices of non-energy goods and services when the central bank is credible—that is, when inflation expectations are well-anchored—and, therefore, will not result in persistently higher overall inflation.

This Economic Letter examines the impact of rising oil prices on core inflation over the last decade for four economies: the U.S., the euro area, Canada, and the U.K. I find some evidence that rising oil prices have had a positive and significant effect on core inflation in the euro area, but I find no systematic evidence that rising oil prices have had a significant impact on core inflation in the U.S., Canada, or in the U.K.

Oil

Jeff Sachs says "current energy crisis will most likely worsen before it gets better":

Why the Oil Crisis Will Persist, by Jeffrey D. Sachs, SciAm: ...[F]undamental factors of supply and demand in the world economy will keep oil costly for years to come. ... Drilling in protected areas would provide little relief, and at horrendous environmental risks. Only a concerted move to new transport and energy technologies will relieve the pressures.

The greatest irony about the Bush Administration is that it correctly focused on energy needs at the start of its first term, but then got everything wrong in the strategy. Viewing the world through the eyes of Texas oilmen, it focused on gaining concessions to Iraqi oil fields and opening U.S. protected areas to drilling, while scorning fuel economy standards, renewable energy sources, and climate change mitigation. But the simple arithmetic of oil and carbon was always against the strategy.

World demand for conventional oil is outstripping world supply. ... There are few prospects for mega-discoveries that could keep up with fast-growing world demand. ...

The boom in global driving is likely to be relentless. ... If China attains just half of the U.S. per capita ownership of passenger vehicles, it would have ... roughly twice as many as the U.S. And that prospect is not a silly scenario. Vehicle production in China has already tripled... With ... massive house building on the spreading periphery of city centers, China seems intent on reproducing America’s metropolitan sprawl and commuter-based society. A similar, though still less dramatic trend, is getting underway in India. ...

Conventional oil has little prospect of keeping up with this soaring demand.

What then will give? Of course a grave economic crisis—war, global depression, economic collapse of one or more major economies—would cut oil demand the hard way. There are two much better alternatives. The first is a redesigned, far more energy-efficient automobile that uses ... electricity or hydrogen. Several variants of plug-in-hybrid and all-battery cars have been promised by major auto producers as early as 2010...

Many unresolved problems of cost, performance and infrastructure face these technologies, of course. Public funding for technological research, development and demonstration, and for supporting infrastructure, should certainly be deployed... Any electric or hydrogen option will require large-scale deployment of new low-emission electricity generation, such as solar, wind, nuclear, and coal plants that capture and sequester carbon dioxide.

The second alternative, equally important, is a gradual reconfiguration of city life, to reduce our dependence on automobiles... We’ve learned that sprawl is not good for energy dependence, air quality, biodiversity, human health or quality of life, including commuting time. ...

The current energy crisis will most likely worsen before it gets better. ... Yet it could also be the critical spur to action, prompting vital changes in technologies and lifestyles. It’s not too late to take the more productive path, but time is running out.

"Do Demand and Supply Still Drive Oil Prices?"

Environmental Economics takes up the question of what drives movements in oil prices, fundamentals or something else:

Do demand and supply still drive oil prices?, by Gernot Wagner: Amid all of Wall Street's woes, one bit of significant economic news almost fell through the cracks this week: oil prices increased $16 on Monday, temporarily trading as high as $25 over the previous closing price. This is an all-time record high. Surely, it can't just be demand and supply that determined the price - not on a day when the Dow just happens to fall 370 points. Or can it? [...read more...]

Speculation and Oil Prices

We’ve heard a lot about how speculation has caused volatility in oil and other commodity prices recently, and there are calls in Congress to put constraints on speculative activity in order to stabilize prices and markets, so let's go back to the issue of whether speculative activity has been the driving force behind commodity price movements, oil prices n particular.

To begin, it's important to recognize that not all speculative activity is the same, and not all of it is bad, and as we look into how to better regulate these markets, we need to keep the types of speculative activities separate so that we don’t stifle the good type of speculation as we try to eliminate the types that cause us troubles.

First, speculative activity can arise from attempts to profit from manipulating the price of a good, and some people believe this type of manipulative activity can explain much of the volatility in oil prices we have seen recently. This, obviously, is a bad type of speculation and we should prevent it to the extent possible.

Second, moral hazard combined with easy money can lead to an undesirable type of speculation. If market participants have ready access to funds, and if they believe losses will be covered, say, through a government bailout, then they may be willing to invest far more than is optimal in speculative ventures. If they hit it big, they win. If things go sour, the government covers their losses.

A third type of speculation we’d like to avoid is speculative bubbles, and this is probably what most people have in mind when they hear the term speculation. Speculative bubbles occur due to “bandwagon effects” where rumors or some other force causes prices to deviate from their underlying fundamental values in a self-feeding frenzy that drives prices upward in a bubble, or downward in a crash.

Fourth, speculation allows us to insure against expected future changes in supply or demand, that is, anticipated changes in the price. If we expect higher demand or lower supply of a good at some point in the future, that is, if we expect a higher future price, then speculators will take some of the good off the market today, store it for the future, and then sell it after the price rises. In this way, speculation provides insurance against the future fall in supply or increase in demand by having the good available to meet those changes.

Finally, there is stabilizing speculation, for example selling short near peaks in anticipation of price declines can dampen natural market volatility, and this is generally desirable. This type of speculation - short-selling - is under considerable scrutiny right now, but in general this dampens rather than enhancing market volatility and we ought to encourage the dampening variety.

So yes, by all means, limit the bad type of speculation through regulatory changes. But be sure to keep the types that help.

Moving next to commodity prices and speculation, I've taken the stance that there is little evidence of the first and third types of speculative activity, manipulation and bubbles divorced from fundamentals, and I don't think the second type - moral hazard - made a large contribution. I've argued fundamentals are the most likely source of most of the price variation, and by fundamentals I mean any new information that causes people to change their expectations of supply and/or demand, and I've taken a lot of criticism here over that stance, the stance on speculative bubbles in particular. So let me add this to the debate (see also See You Later, Speculator - WSJ.com):

Scott Irwin takes down Michael Masters, by Jim Hamilton: Econbrowser is pleased to host another contribution from Scott Irwin, who holds the Laurence J. Norton Chair of Agricultural Marketing at the University of Illinois. Today Scott offers a critique of a recent report by Michael Masters on the role of commodity speculation.

The Misadventures of Mr. Masters: Act II
by Scott Irwin

The impact of speculation, principally by long-only index funds, on commodity prices has been much debated in recent months. The main provocateur in this very public debate is Mr. Michael Masters, a hedge fund operator from the Virgin Islands. He has led the charge that speculative buying by index funds in commodity futures and over-the- counter (OTC) derivatives markets has created a "bubble," with the result that commodity prices, and crude oil prices, in particular, far exceed fundamental values. Act I of the Masters farce was his testimony to the Homeland Security Committee of the U.S. Senate in May of this year. Act II is now upon us in the form of a lengthy research report co-authored by his research assistant, Mr. Adam White, and his testimony this week to a subcommittee of the Energy and Resources Committee of the U.S. Senate.

My purpose in writing this post is to show that Mr. Masters' bubble argument does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters' argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC derivative markets.

John McCain's "Big" Economic Plans

Here's John McCain's big plan for the budget: make a whole lot of noise about eliminating of the piece of the budget pie representing earmarks (and remember that most earmarks simply mandate where monies will be spent, they don't create any new spending):

[Note: The OMB estimates earmarks to be 16.9 billion in 2008. Current federal expenditures for 2008 are not yet available, so the chart uses the 2007 value of 2880.5 billion from the BEA (the ratio is approximately one half percent, i.e. 0.59%). Since federal expenditures for 2008 will exceed those of 2007, this means that the area for earmarks shown in the diagram is overestimated, i.e. it is larger than the true value. The NY Times also notes that "earmarks ... make up less than 1% of the federal budget."].

All the recent controversy over McCain lying about Palin's earmark requests, as he did most recently on The View, is noteworthy for what is says about McCain's (lack of) character, but more generally it is misdirecting us from more important issues. Earmarks are only a minor part of the overall budget, and issues such as health care reform are much more important since rising health care costs will absolutely dwarf any savings from earmarks.

Here's the centerpiece of McCain's economic plan: drill for oil, then pretend like it will help at the pump:

[via]

I can't even see the sliver of yellow until after 2015, and even after that it's not much of a contribution. That's supposed to lower gas prices?

With such a solid foundation for the polcy porposals - a couple of slivers of pie - I can't imagine why the McCain campaign would resort to lies, deceptions, misdirection, and misleading characterizations to sell these "big" plans.

Update: Brad Delong has a slightly more detailed version of the first graph here (scroll down).

China, Iraq, Oil, and Geopolitical Stability

I think this is right, we should encourage this:

A new dynamic for the Middle East, econbrowser: Maybe it's time to try something new. And maybe it's already starting.

Last week the New York Times reported:

In the first major oil deal Iraq has made with a foreign country since 2003, the Iraqi government and the China National Petroleum Corporation have signed a contract in Beijing that could be worth up to $3 billion, Iraqi officials said Thursday.

Under the new contract, which must still be approved by Iraq's cabinet, the Chinese company will provide technical advisers, oil workers and equipment to help develop the Ahdab oil field southeast of Baghdad, according to Assim Jihad, a spokesman for Iraq's Oil Ministry. If the deal is approved, work could begin on the oil field within a few months, Mr. Jihad said.

And today the Guardian confirms that the deal was approved by Iraq's cabinet.

There are some Americans who regard expanding Chinese global influence with fear and suspicion. But I maintain that stability and prosperity for Iraq and the broader Middle East should be the primary U.S. objective at the moment. Although China of course has its own reasons to be interested in the region, those interests are undermined by terrorism and regional instability just as much as ours. And precisely because China is a distinct power with separate interests from the U.S., its status as a more neutral third party leaves it in a position to assist in restoring stability to Iraq and the region in ways that the U.S. cannot. The perception that the purpose of toppling Saddam Hussein was to benefit U.S. oil companies greatly undermines our capacity to bring peace to the region. One way the U.S. can signal that our goal is instead regional stability is by embracing a larger role for China in Iraq and the Middle East.

Some may ask, What good does it do Americans if Iraqi oil gets shipped to China? The answer is, it is a global market for oil... [P]rice depends on the total quantity produced globally and the total quantity consumed globally. More global production means a lower price, and which country consumes which oil is of little practical significance... But it matters a great deal for the price that American consumers pay for oil whether the Iraqi oil is produced or is not produced.

Others may worry that higher oil production today just leaves the world with less of this depletable resource for the future. But to this I would counter that the transition to a world when global oil production no longer increases each year will raise some tremendous geopolitical stresses. The more stability and cooperation we can have as we enter that phase, the better off we will be.

You've heard it said, "What's good for General Motors is good for the U.S." But I say, "what's good for Iraq and China is good for the U.S."

"More Speculation about Those Oil Speculators"

A Washington Post article claiming that one firm, Vitrol, "at one point in July,... held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange" reinforced the beliefs of those who claim that unregulated speculation is behind the recent swings in commodity prices.

Jim Hamilton throws cold water on this idea. He has other objections to the article, but here's the one relating to the 11 percent figure that has received so much attention:

More speculation about those oil speculators, econbrowser: I normally leave it to folks like Dean Baker to beat up on the press. But I can't resist shining a bright light on today's story about oil speculators in the Washington Post, which has also been discussed by Mark Thoma and Tyler Cowen. ...

What ... does [David Cho] dig up? The article continues:

Even more surprising to the commodities markets was the massive size of Vitol's portfolio-- at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.

That does sound like a lot, though enough details are left out to make me wonder what is actually being claimed here. Surely Cho doesn't literally mean "all the oil contracts," i.e., light sweet, Brent, heating oil, gasoline, and so on. If light sweet alone, are we talking about just futures, or futures plus options? Or is Cho possibly referring just to one very specific contract, such as the August CL futures contract? And were these positions held outright by Vitol or purchased on behalf of its clients?

Cho gets more quantitative a few paragraphs down:

By June 6, for instance, Vitol had acquired a huge holding in oil contracts, betting prices would rise. The contracts were equal to 57.7 million barrels of oil-- about three times the amount the United States consumes daily.

Again I'd like to know if we're including options somehow in this number. But more importantly, the claim that you can compare the number of notional barrels of oil implied by a futures contract if it were held to settlement with the number of physical barrels that the U.S. consumes repeats the egregious error committed by Michael Masters in his Senate testimony this May. You can't compare the outstanding NYMEX open interest with U.S. daily petroleum consumption numbers directly because they are measured in different units. Open interest is a stock-- it is measured in number of outstanding contracts at a particular point in time. Consumption is a flow-- it is measured in barrels per unit of time. You can't measure how many barrels of oil the U.S. consumes without specifying a time unit. We consume about 20 million barrels per day, or 14,000 barrels per minute, or 7.3 billion barrels per year. With which of these 3 numbers are we supposed to compare 57 million? Fifty-seven million sounds like a lot more than 14,000, and a lot less than 7.3 billion. You can make 57 million sound as big or as small compared with U.S. consumption as you want, because there's an arbitrary time interval associated with consumption that is not associated with open interest. If you want the futures volume to sound big, you compare open interest with daily consumption, as Masters and Cho both do.

Cho was trying the best he could to convince us that unregulated speculation was the cause of this summer's spike in oil prices.

But instead he convinces me that he really couldn't find much of a case.

Oil Prices and Speculation

The Washington Post says the scale of speculative activity in commodities markets is larger than previous estimates indicated:

A Few Speculators Dominate Vast Market for Oil Trading, by David Cho, Washington Post: Regulators had long classified a private Swiss energy conglomerate called Vitol as a trader that primarily helped industrial firms that needed oil to run their businesses.

But when the Commodity Futures Trading Commission examined Vitol's books last month, it found that the firm was in fact more of a speculator... Even more surprising ... was the massive size of Vitol's portfolio -- at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.

The discovery revealed how an individual financial player had gained enormous sway over the oil market without the knowledge of regulators. ...

Some lawmakers have blamed these firms for the volatility of oil prices... "It is now evident that speculators in the energy futures markets play a much larger role than previously thought, and it is now even harder to accept the agency's laughable assertion that excessive speculation has not contributed to rising energy prices," said Rep. John D. Dingell (D-Mich.). ...

Using swap dealers as middlemen, investment funds have poured into the commodity markets, raising their holdings to $260 billion this year from $13 billion in 2003. During that same period, the price of crude oil rose unabated every year.

CFTC data show that at the end of July, just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase. Dealers make trades that forecast prices will either rise or fall. Energy analysts say these data are evidence of the concentration of power in the markets.

CFTC leaders have argued that speculators are not influencing commodities' prices. If any new information arises during the agency's examination of swap dealer activity, officials said they would report it to Congress.

"To date, the CFTC has found that supply and demand fundamentals offer the best explanation for the systematic rise in oil prices," CFTC spokesman R. David Gary said, reading a statement that had been crafted by agency officials. "Regardless of their classification . . . the CFTC's market surveillance group scrutinizes daily the positions of all large traders, both commercial and non-commercial, to guard against market manipulation." ...

For most of the past century, regulators put limits on financial actors to prevent them from dominating commodity exchanges, which were much smaller than the bond or stock markets. Only commercial operations, such as farms, airlines, manufacturers and the middlemen that handle their trading activities, were allowed to buy nearly unlimited quantities. The goal was to allow these businesses to minimize the effect of price swings.

The first major change to this regulatory framework occurred in 1991, when Goldman Sachs, through a subsidiary called J. Aron, argued that it should be granted the same exemption given to commercial traders because its business of buying commodities on behalf of investors was similar to the middlemen who broker commodity transactions for commercial firms.

The CFTC granted this request. More exemptions soon followed...

A second turning point came when Congress passed the Commodity Futures Modernization Act of 2000. ... Critics have called this piece of legislation the "Enron loophole," saying Enron played a role in crafting it.

In the months after the act was passed, private electronic trading platforms sprang up across the country, challenging the dominance of NYMEX. ...

In the coming months, swap dealers expect to have yet another venue for oil speculation. The CFTC has stated it would not stand in the way of trading in U.S. oil contracts overseas in Dubai. ...

Many people have said that recent price movements make it clear a speculative bubble in the commodity markets has popped. I can't add my voice to that exact wording.

The term "bubble" has become watered down with popular usage in the press and elsewhere, but technically a speculative bubble is the result of price movements that are divorced from the underlying fundamentals (as with housing). Yet the stories I hear for oil price and other commodity movements mostly involve fundamental factors.

Let me say this another way. I've also heard that it can't be supply and demand that's pushing prices around. But even if there's a speculative bubble or market manipulation, it's still movements in demand and supply that are pushing up prices around. Demand skyrockets (or plunges in a crash), or perhaps supply is artificially constrained, it's just that the demand shifts are driven by non-fundamental factors. Supply and demand are still at work, it's simply a question of what is driving the shifts in the supply and demand curves, fundamentals or something else.

It's possible for the underlying fundamentals to shift quickly. The possibility of, say, a war can change very fast altering the outlook for future supplies and when it does  prices will change along with the change in the outlook, as they should. But that is not a bubble popping, that is a fundamental driving the price around. Big swings in fundamental factors that cause big swings in expected future supply or demand (and hence affect supply and demand today) can cause big swings in the price, and it can happen relatively fast.

I have yet to be convinced that the big swings in prices we have seen are due to prices departing from the underlying fundamental factors and then returning, i.e. that the price swing is from a speculative bubble in the technical sense (or maybe we are simply debating what we can count as a fundamental fundamental factor, but a technical bubble is still something different).

I don't deny, and never have, that speculation is at work in moving prices around, I've drawn diagrams in the past showing how a change in expected future conditions can change today's price. But I agree with the article, I just don't see the evidence of outright, intentional manipulation of the price. Holding large shares, or seeing large volumes alone are not enough to make that case, and it's hard for me to believe that manipulation alone can explain the size of the swings in price that have occurred in commodity markets. I also don't see the case for a more traditional speculative bubble (i.e. a price change driven by a departure from fundamentals rather than manipulation), but as I've said all along, this is hard to prove one way or the other and there could be some of this at work.

So maybe there was some manipulation attempts, I don't know, but if the evidence was strong we would have heard about it. And maybe there has been some departure from fundamentals, again it's hard to know with any certainty, but I still believe the majority of the price movements can, in fact, be explained by fundamentals as defined above.

I could be wrong, maybe there has been manipulation, or perhaps we've seen a more traditional speculative bubble, again in the technical sense, but so far I haven't seen enough evidence to be convinced that this is a better explanation for the preponderance of price movements than shifts in supply and demand driven by underlying fundamentals. But that doesn't mean we shouldn't keep investigating to see if the claim of no manipulation holds up against additional scrutiny, or if there is evidence for a more traditional type of speculative bubble.

Peak Inflation?

John Berry joins those saying there's no reason to panic about inflation:

Inflation's Peak Signaled by Tame Labor Costs, by John M. Berry, Commentary, Bloomberg: U.S. inflation reached its highest level in more than a quarter-century this summer. The good news is that the worst of the price increases probably is behind us.

The surge in commodities prices ... drove the year-over-year increase in consumer prices, to 5.6 percent in July. Now, with the prices of ... many ... commodities in retreat, the month-to-month changes in the consumer price index will settle down.

The bad news is that the drop in inflation won't be sudden... What's reassuring is the absence of signs that the surge in inflation has triggered a wage-price spiral. ... While that's hardly cause for celebration among workers who have seen their inflation-adjusted pay fall, some of that loss is being regained as the cost of gasoline comes down. ...

The break in commodity prices is ... good news for Federal Reserve officials, whose prediction that inflation would moderate was based largely on the expectation that such prices wouldn't rise forever. ...

Commodity prices haven't just stopped rising, they have declined. And so long as the outlook for economic growth is weak in the U.S. and Europe, and slowing in many other regions, a quick rebound in commodity prices seems unlikely.

Similarly, productivity growth was strong in the first half of this year, and while slower economic expansion in the second half probably means productivity gains will be smaller, they won't disappear. ...

While the U.S. inflation outlook has improved, there is still a risk that something goes wrong. And even if it doesn't, the Fed's 2 percent target for the overnight lending rate is too low to be maintained indefinitely.

That said, it's ''a good time to be patient, because I do think we will see better news on the inflation front,'' in part because of falling oil prices, Gary Stern, president of the Minneapolis Federal Reserve Bank, said yesterday in an interview.

Let's hope he's right.

Robert Pindyck on Energy Policy

Robert Pindyck is interviewed on the candidate's energy proposals:

A Q&A with MIT Professor Robert Pindyck, by Stephanie Schorow, News Office: This is the first in an occasional series in which MIT experts weigh in on the presidential candidates, their policy ideas and aspects of the campaign.

As jittery consumers contemplate the price at the pump, energy issues have become a major factor in the U.S. presidential race. Have the two major-party candidates forthrightly addressed the hard issues about the country's energy needs? ...

"Fuel Subsidies Drag Down a Nation"

Why lump-sum transfers are better than fuel subsidies:

How Fuel Subsidies Drag Down a Nation, by Robert H. Frank, Ecponomic View, NY Times: ...[M]any emerging economies employ subsidies that keep domestic fuel prices far below the world price. As a result, these countries consume far more fuel than they would otherwise.

By one estimate, countries with fuel subsidies accounted for virtually the entire increase in worldwide oil consumption last year. Without this artificial demand stimulus, world oil prices would have been significantly lower. ...

It would surely be unrealistic to expect other governments to abandon subsidies just so Americans who drive S.U.V.’s and live in big houses could benefit from lower world energy prices. But those governments might want to reconsider their policy in the light of overwhelming economic evidence that the subsidies create net losses even for their ostensible beneficiaries. ...

The problem is that when the price of a good is below its cost, people use it wastefully. In the case of a gallon of gasoline, the cost ... includes not just the price of buying the gallon in the world market — say, $4 — but also external costs, like dirtier air and increased congestion. The external costs are ... substantial. With reasonable estimates factored in for them, the true cost of using a gallon is clearly greater than $4. By contrast, the price of gasoline to users is simply the amount they pay at the pump. With a $2-a-gallon subsidy in effect, gasoline bought in the world market at $4 would sell for $2...

Consider how this difference might affect a trucker’s decision about whether to accept a hauling job. ... Suppose the job... requires 1,000 gallons of fuel, available at the subsidized price of $2 a gallon, for a total fuel outlay of $2,000. If the cost of the trucker’s time and equipment are, say, $1,000 for the trip, his narrow interests dictate accepting the job if the shipper is willing to pay at least $3,000. Suppose the shipper is willing to pay that amount but not more.

The problem is that if the trucker accepts the job at that price, the country as a whole will be worse off by more than $2,000. Although the $3,000 fee would cover his own costs, the government would end up paying $2,000 in additional subsidies for the 1,000 gallons consumed. On top of that, the trip would generate additional pollution and congestion costs. So the fact that the subsidy encouraged him to accept the job means that its net effect is equivalent to throwing more than $2,000 onto a bonfire.

Waste is always bad. ... Subsidy proponents cite the firestorm of political protest that would erupt if fuel were to sell at the international market price. That fuel subsidies are wasteful, however, implies that there must be less costly ways to keep the peace.

Consider again our trucker... Instead of paying $2,000 to subsidize his fuel, the government could give him a tax cut of, say, $1,000, and use the remaining $1,000 to help pay for public services. Because the trucker’s earnings from the hauling job were only enough to cover his costs at the subsidized fuel price, he would be $1,000 better off with the tax cut alone than with the fuel subsidy. The additional support for public services would augment this benefit. In short, a tax cut is always a better way to keep political protest at bay because ... it does not encourage shipments whose costs exceed their benefits.

If a United States president urged developing economies to eliminate fuel subsidies because they result in higher energy prices for Americans, the conversation would probably end very quickly. But this conversation might be reframed.

A good place to start would be to heed the same advice we’d like others to follow. Emerging economies are not the only ones in which prices at the pump substantially understate the true social cost of fuel. ... Adopting some variant of a tax on carbon ... would help eliminate this discrepancy.

That would set the stage for our next president to explain to other leaders why eliminating fuel subsidies would make the overall economic pie larger. Because the resulting efficiency gains can be redistributed so that everyone gets a bigger slice than before, the idea should be fairly easy to sell.

"Globalisation and the Costs of International Trade from 1870 to the Present"

Will the rising price of oil reduce international trade as some have suggested? According to this research, which uses a gravity model of international trade to answer the question, the answer is no, "only protectionism would seriously threaten trade":

Globalisation and the costs of international trade from 1870 to the present, by David Jacks, Christopher M. Meissner, and Dennis Novy, Vox EU: Most countries trade more on international markets today than ever before – both in absolute terms and as a proportion of their national output. How can we explain this phenomenal increase in international trade over the past few decades? Will the recent rise in oil prices reverse this trend of globalisation?

History provides us with a natural comparison. Beginning in the nineteenth century, the world saw a remarkable rise in international trade that came to a grinding halt during World War I and later on in the wake of the Great Depression. This “first wave of globalisation” from about 1870 until 1913 led to a degree of international integration – measured by trade-to-output ratios – that many countries only achieved again in the mid-1990s.

Taking a comparative perspective, we juxtapose the first wave of globalisation from 1870 to 1913 and the second wave after World War II. We also study the retreat of world trade during the interwar period from 1921 to 1939. We are interested in the driving forces behind these trade booms and trade busts. Was it changes in global output or changes in trade costs that explain the evolution of international trade?

Speculation and Bubbles

Suppose you think that a hurricane might disrupt oil flows in the future. What should you do today? Tropical storm Edouardo gives an example. As the storm approached, people believed there was a chance that oil flows would be disrupted in the future, and the current price began rising as a consequence. If you expect a higher price in the future due to reduced supply or any other reason, you should begin purchasing and storing oil now to take advantage of the higher price in the future, and the increased demand for oil drives today's price up.

This is speculation, the storm may or may not actually hit and disrupt oil supplies, but it's not the kind of speculation we should worry about. We want this kind of speculation - which reflects underlying fundamentals - to occur. The expectation of a supply disruption in the future causes the market to take actions today and store oil for when it will be needed, and this provides insurance against the potential supply disruption, insurance that reflects the probability that the storm will cause problems (the larger the expected fall in future supply, the bigger the price change, and the more that will be stored for the future).

In this particular case, the insurance wasn't needed, but it's still good to have:

''It is pretty much expected the storm is going to slowly weaken now for the rest of the day and overnight,'' said Mike Pigott ... of ... AccuWeather... ''It wasn't anything unusual or spectacular; there wasn't any kind of massive intensification that we saw with Dolly.'' ...

Crude oil touched a three-month low of $118 a barrel on speculation Edouard wouldn't curtail production. Six rigs and 23 platforms were evacuated in advance of the storm, the U.S. Interior Department said yesterday.

Royal Dutch Shell Plc, Europe's largest oil company by market value, said the storm was no longer a threat and it would start regularly scheduled crew changes for its off-shore facilities, according to spokeswoman Darci Sinclair.

Noble Corp., the third-largest U.S. offshore oil driller, may have crews back on two submersible rigs by tomorrow.

The kind of speculation we should worry about is "bandwagon behavior." This is speculation that is disconnected from fundamentals. For example, suppose that people become convinced that offshore drilling will have a large impact on future prices. Even though this isn't true, suppose people become convinced that it is true through some sort of misleading information campaign, perhaps abetted by a media more interested in hyping controversy than in informing people of the facts.

Windfall Profits Tax

Since the windfall profits tax is in the news again, this editorial by Andrew Leigh has a description of some of the issues that are involved (this is for coal in Australia, but the arguments are the same for oil):

... The arguments in favour of a windfall mining tax are easily stated. From a fairness perspective, the industry’s massive profits have come not through producing a better product or service, but because of an outside factor - China’s stratospheric economic growth. The coal leaving the docks today is the same stuff we sold a decade ago; it just happens to be six times as valuable.

From an economic standpoint, the strongest argument for a windfall tax is that it has the potential to be non-distortionary. A one-off windfall tax levied on past profits should not change firms’ behaviour, since it does not affect future costs and prices. For example, if the Australian government were to announce on July 1, 2009 that it was imposing a windfall tax on coal companies’ 2008-09 profits, there is almost nothing the companies can change about their future investment decisions that will cut their 2008-09 tax bill.

Now the counter-arguments. Morally, the mining companies would no doubt argue that they already pay company taxes. Moreover, they might point out that they made their investments in good faith, and responsible governments should not change the rules in the middle of the game.

These points deserve reasonable consideration. But if we regard Australia’s mining companies more like lottery winners than as toiling entrepreneurs, a windfall tax looks more reasonable. Taxing luck is fairer than taxing hard work.

The miners would also be quick to contest the claim that a windfall tax can have little economic impact on their future decisions. And it is true that as soon as mining companies hear of the tax, their decisions will change. As a result, surprise windfall taxes are more economically efficient than anticipated ones. This may be one issue on which a full and robust public debate does not lead to a better outcome.

Companies are also likely to raise the spectre of repeated raids on their revenue. Having been levied once, what is to stop a windfall tax being imposed again? To counter this, the government must be clear that the present minerals price increases are a once-in-a-lifetime event, and so is the windfall tax. The less credible this claim, the more the tax will deter future investment in the sector. ...

Robert Waldmann has more at Angry Bear. I'm not a big fan of the windfall profits tax proposal, relief for those who are struggling can be financed in better ways. But that's not all there is to Obama's energy policy. Beyond the proposal to address short-run needs by giving "every working family in America a $1,000 energy rebate" financed by the windfall profits tax, he also has a focus where it's needed, on finding solutions to the longer run energy challenges we face. From a speech given today:

New Energy for America, by Barack Obama: ...But the truth is, none of these steps will come close to seriously reducing our energy dependence in the long-term. We simply cannot pretend, as Senator McCain does, that we can drill our way out of this problem. We need a much bolder and much bigger set of solutions. We have to make a serious, nationwide commitment to developing new sources of energy and we have to do it right away.

A Solar Power Revolution?

Instead of all the drivel about offshore drilling from Republicans, this is what we need - technological solutions as described below. We aren't going to solve our energy problems, or even make a noticeable dent in them, by allowing offshore drilling. That's a ruse to capture votes. The solution lies in alternatives and conservation, and if the claims made below are correct, this looks like a big step in the development of solar power:

'Major discovery' from MIT primed to unleash solar revolution, Anne Trafton, News Office: In a revolutionary leap that could transform solar power from a marginal, boutique alternative into a mainstream energy source, MIT researchers have overcome a major barrier to large-scale solar power: storing energy for use when the sun doesn't shine.

Until now, solar power has been a daytime-only energy source, because storing extra solar energy for later use is prohibitively expensive and grossly inefficient. With today's announcement, MIT researchers have hit upon a simple, inexpensive, highly efficient process for storing solar energy.

Requiring nothing but abundant, non-toxic natural materials, this discovery could unlock the most potent, carbon-free energy source of all: the sun. "This is the nirvana of what we've been talking about for years," said MIT's Daniel Nocera ... senior author of a paper describing the work in the July 31 issue of Science. "Solar power has always been a limited, far-off solution. Now we can seriously think about solar power as unlimited and soon."

Inspired by the photosynthesis performed by plants, Nocera and Matthew Kanan, a postdoctoral fellow in Nocera's lab, have developed an unprecedented process that will allow the sun's energy to be used to split water into hydrogen and oxygen gases. Later, the oxygen and hydrogen may be recombined inside a fuel cell, creating carbon-free electricity to power your house or your electric car, day or night.

"Why Does Gasoline Cost So Much?"

This column concludes that recent increases in gas prices are due to stagnant oil supplies and growing global demand from emerging Asian economies, not speculation, and that these factors are likely to keep gas prices relatively high in the future:

Why does gasoline cost so much?, by Lutz Kilian, Vox EU: At the end of 2007, both gasoline and crude oil prices (adjusted for inflation) were at levels last seen in 1981 and they continued to climb throughout much of 2008. While Europe has been cushioned in part from these developments, as the dollar depreciated against the euro, the fundamental forces that drove up US gasoline prices have done the same in Europe.

With retail gasoline prices in the US persistently above $4 per gallon, the determinants of gasoline prices is no longer an esoteric topic best left to industry insiders. The debate has moved into the mainstream. Congressional committees as well as media pundits have advanced explanations and proposed policy changes to stem or reverse the increase in gasoline prices.

Why did this surge occur? To answer this, it is important to distinguish between:

• the price of gasoline and other motor fuels, and
• the price of crude oil in global markets.

A distinction often ignored in discussions of higher energy prices. In a recent Vox column, Francesco Lippi discussed the price of crude. My column focuses on the US gasoline market, which is an interesting case for understanding the underlying market forces because of the availability of high quality data for extended periods.

"Oil Prices and Economic Fundamentals"

Jim Hamilton looks at the question of whether changes in oil prices have been driven by fundamentals:

Oil prices and economic fundamentals, by Jim Hamilton: Oil was selling for $123 a barrel on May 7, and that's where it closed this week. Sounds like a calm and rational market, except for the fact that just last week it was going for $145. ...

Which price was right, $123, $145, or something else? Before you let anybody give you an answer to that question, try to get them to comment first on the following two facts. (1) According to the Energy Information Administration, China consumed 7.6 million barrels of petroleum each day of 2007, which is 860,000 barrels/day more than in 2005. (2) EIA also reports that the world as a whole produced 84.6 million barrels of oil per day in 2007, which is 30 thousand barrels per day less than 2005. ...

Now, how could it be that China is burning 860,000 b/d more than it used to, but no more is being produced? Well, it could be that there are errors in the consumption or production numbers, and both will likely be revised. Or it could be that we're drawing down global inventories. But the most natural inference is that somebody else in the world must have been persuaded to reduce their consumption of oil between 2005 and 2007 to free the barrels now being used in China. And indeed, according to preliminary EIA estimates, petroleum consumption in the U.S., Japan, and those countries in Europe for which data are now available fell by 760,000 b/d between 2005 and 2007.

Here's the framework I would propose for answering the question of how much the price of oil should have risen since 2005-- the price of oil needed to go up by whatever it took to persuade places like the U.S., Europe, and Japan to reduce their consumption by the amount that China, the newly industrialized countries, and oil-producing countries were increasing theirs.

And how big a price increase would that be, exactly? Somebody who claims to know that would need to have more confidence in their estimate of the price-elasticity of oil demand than I have in mine. But if your answer is that a much smaller price increase than the one we observed would have been sufficient to produce the requisite decline in quantity demanded, that would seem to imply that, since price went up by much more than you believe was needed to reduce demand, the quantity demanded must have fallen by much more than was called for. One place that might have been expected to show up is in the form of an accumulation of inventories. The black line in the figure below shows the average seasonal behavior of U.S. crude oil inventories. The red line demonstrates that current inventories are if anything below normal. On what basis, then, could one insist that the quantity of oil consumed has fallen more than was necessary?

OK, suppose you believed that the price increase we actually saw-- from $42/barrel in January 2005 to $96 in December 2007-- was just the right amount to accomplish the task of balancing global demand and supply for 2007. Should the price have held steady from there in 2008? Figures reported by Rigzone imply that China imported an additional 8.97 million tons of crude and 2.96 million tons of refined product in the first half of 2008 compared with 2007:H1, which converts to a 480,000 barrel/day increase. Where's that supposed to come from? A U.S. recession, which many of us were anticipating in January, certainly would have brought demand down. But current U.S. GDP growth is likely to come in higher than many of us had predicted earlier, meaning if you gave one answer for the correct price of oil in January, you should be giving a higher value for that number today. On the other hand, the data coming in the last two weeks have raised the probability of a recession in Europe. If that occurs, it will bring a reduction in the quantity demanded from those areas even if the price begins to fall. Whatever the correct price of oil was two weeks ago, I think it's a lower value today.

What about the delayed response of quantity demanded to the price increases already in place? If that proves to be substantial (and I'm of the opinion that it will), U.S. petroleum consumption should continue to decline during 2008 even with no further price increases and no recession. There's also been some increase in global production this year, and more is expected. Won't that be enough to satisfy those new and thirsty Chinese vehicles? If so, $123/barrel may be way too high a price.

But don't forget, while you're doing these calculations, you'll need to meet Chinese demand for 2009, and 2010, and 2011.... Which, if you project the current trend and tried to satisfy entirely by cuts in U.S. consumption, would have us down to consuming zero barrels of oil in the United States in about 17 years.

Is the price of oil today too high given the fundamentals? Could be. Is it too low? Could be. But one thing I'm sure that's too high is the confidence on the part of those who insist they know the answer.

In that case, I'm glad my last comment on this topic was "I'm absolutely certain I could be wrong."

"What’s Causing Global Food Price Inflation?"

This research argues that India, China, and speculators are not the cause of the food price explosion, the cause is biofuel support policies. Thus, since the "OECD’s recent report on the economic assessment of biofuel support policies has clearly shown that their effectiveness is disappointingly low," the conclusion is that governments should reconsider their biofuel support policies:

What’s causing global food price inflation?, by Stefan Tangermann, Vox EU: Global food prices have exploded since early 2007, causing major social, political, and macroeconomic disruption in many poor countries and adding to inflationary pressure in the richer parts of the world.[1] Concerns about high food prices have been expressed at the highest political level, including during the recent G8 summit on Hokkaido.

What has caused the explosion of food prices? Several culprits have been blamed.

• Newspapers have cited an internal World Bank document as having found that 75% of the price increase was due to biofuels.
• Several governments and commentators see speculation as a major driving force.
• A widely held view has it that rapidly growing food demand in the emerging economies is pushing up global food prices.

Which contributions have these or other factors made to rising food prices?

"Drain America First"

Jeff Frankel says Republican proposals to increase oil extraction within our borders are at odds with both environmental and energy security goals:

Offshoring is a More Dubious Policy, When the Question is Oil Drilling, by Jeff Frankel: President Bush yesterday removed a long-standing executive moratorium on off-shore oil drilling..., a move also supported by presidential candidate John McCain. ... No doubt ... that it is a political stunt. A Congressional ban on offshore drilling has been in effect since 1981, so the President’s action is moot. ...

[B]oth parties are responding (unsurprisingly) to the American public’s great sensitivity to short-term prices for gasoline (in the summer) and home heating oil (in the winter). No doubt high prices are causing a lot of hardship. ...But market prices are high today for a reason. What is the market failure that would call for government intervention in the oil market?

"Why Oil Companies Don't Drill"

Theodore Seto, a professor of tax law and policy at Loyola Law School Los Angeles, notes the distortion in the tax code toward investment in oil exploration with "the U.S. tax rate on profits from petroleum and natural gas structures ... the lowest imposed on any type of corporate capital asset":

Why Oil Companies Don't Drill, Understanding Tax: U.S. oil companies are pushing hard to get Congress to allow the current Administration to issue more oil leases before its term expires. In response, skeptics have noted that three-quarters of the 90 million-plus acres of federal land already leased for oil drilling are not being worked. Oil companies deny this. Regardless of who is right, the number of operating oil rigs in North America declined across the course of 2007.

In the meantime, OPEC has raised its quotas by only 20% since 1998 – a measly 2% per year. World GDP grew by about 85% over the same period. The International Energy Agency reports that non-OPEC oil countries are also underproducing and predicts that they will continue to do so.

Everyone seems to be holding back. ... So what to do?

On the tax side, Congress has done almost all it can do to stimulate U.S. production.

A 2005 Congressional Budget Office study concluded that the effective 2002 U.S. tax rate on profits from petroleum and natural gas structures was the lowest imposed on any type of corporate capital asset: 9.2%. Profits from computers, by contrast, were taxed at an effective rate of 36.9%.

A 2000 study by the Institute on Taxation and Economic Policy concluded that in 1998, of all U.S. industries, petroleum and pipeline companies were taxed at the lowest effective rates: 5.7%. Health care companies, by contrast, were taxed at an effective rate of 32%.

If tax incentives were going to induce U.S. oil companies to drill, they probably would have done so by now. Interestingly, Sen. McCain and Sen. Obama both propose to eliminate oil production tax incentives. After all, if oil companies are not responding by increasing production, those breaks are just gifts from you and me to Exxon. ...

Remember that prices are a measure of value. If oil prices are going to be much higher 10 years from now, that means oil will be more valuable then than it is now. Valuable to us.

If so, should it really be our policy to drain U.S. reserves as quickly as possible? Or should our policy be to save at least some of those reserves for the day when gas is $10/gallon?

"just gifts from you and me to Exxon. ..."

Expectations and Oil Prices

Martin Feldstein says if we lower the expected future price of oil, that will lower the price today:

We Can Lower Oil Prices Now, by Martin Feldstein, Commentary, WSJ: Although most experts agree that financial speculation was not responsible for the surge in the global prices of food and energy, many people remain puzzled about the source of these remarkable price rises. Economics offers a simple supply-and-demand explanation and reason for optimism about the future of commodity prices. In the case of oil, economics also suggests how policy changes today that affect the future could quickly lower the current price of oil. ...

The relationship between future and current oil prices implies that an expected change in the future price of oil will have an immediate impact on the current price of oil.

Thus, when oil producers concluded that the demand for oil in China and some other countries will grow more rapidly in future years than they had previously expected, they inferred that the future price of oil would be higher... They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its initial rate. ...

Of course, a rise in the spot price of oil triggered by a change in expectations about future prices will cause a decline in the current quantity of oil that consumers demand. ... A rise in the expected future demand for oil thus causes a current decline in the amount of oil being supplied. This is what happened as the Saudis and others cut supply in 2007.

Now here is the good news. Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. In other words, it is possible to bring down today's price of oil with policies that will have their physical impact on oil demand or supply only in the future.

For example, increases in government subsidies to develop technology that will make future cars more efficient, or tighter standards that gradually improve the gas mileage of the stock of cars, would lower the future demand for oil and therefore the price of oil today.

Similarly, increasing the expected future supply of oil would also reduce today's price. That fall in the current price would induce an immediate rise in oil consumption that would be matched by an increase in supply from the OPEC producers and others with some current excess capacity or available inventories.

Any steps that can be taken now to increase the future supply of oil, or reduce the future demand for oil in the U.S. or elsewhere, can therefore lead both to lower prices and increased consumption today.

An Increase in Worldwide Demand for Oil

Another round on the oil market model, this time to show what happens when there is an increase in the world demand for oil due to some factor such as increased demand from developing economies. The point is to show that, in this simple model, the increase in demand would increase in the long-run equilibrium price, but it would not change the level of inventories in the long-run. There are also other results to note, e.g. the possibility of overshooting the new long-run equilibrium and mimicking a bubble.

Case 1: An Increase in the Expected Future Price of Oil

First, the continuous time version of an increase in the expected price. I did a discrete time-version of this yesterday, but the continuous time version of this case Paul Krugman did yesterday is much simpler, so let's use that. Here's a quick review of that case:

In this model, the initial equilibrium is at point a. Then, there is an increase in the expected future price or a drop in the interest rate that increases the stock demand, N^d, and the equilibrium moves to point b. At this point, the spot price is above the equilibrium value in the flow market shown on diagram on the right, and there is excess supply as indicated by the red line. This excess supply increases the stock so, as shown by the arrow, the stock supply curve begins shifting out. Eventually, the economy settles at the new equilibrium shown at point c.

Summarizing the results for an expected increase in the future price:

1. The spot price, p, rises in the short-run, but is unchanged in the long-run.
2. The stock of inventories, N, rises.
3. The long-run flow equilibrium is unaltered.
4. The change in inventories depends upon the horizontal shift in the stock demand curve. This can be related to the slope of the stock demand curve, but it is not necessarily the case that a steeper demand curve leads to a smaller horizontal shift.
5. Steeper flow supply and demand curves affect the size of the change in the spot price during the transition (and the slopes can affect the transition path for inventories), but this does not change the ultimate size of the inventory change since this depends only upon the size of the shift in the stock demand curve.

Case 2: An Increase in Worldwide Demand for Oil

Moving to the next case, what happens if there is an increase in the world demand for oil due to worldwide economic growth. This shifts the flow demand curve outward:

Starting at the equilibrium a, as the flow demand curve shifts out, this causes an excess demand for oil as shown by the red line on the diagram. This excess demand is met by reducing stocks, so the stock supply curve begins shifting left and the economy moves to point b. Thus, so far there is an increase in price, and a decline in inventories.

But this isn't the end of the story. Because the increase in flow demand is permanent, the increase in price is permanent, and this will increase the expected future price. The increase in the expected future price will shift the demand curve out as shown in the next diagram:

As the demand curve shifts out to reflect the higher expected future price, the price moves up to point c. At point c, the flow market has excess supply as shown by the orange line segment, and this pushes the stock supply curve outward as the excess flow supply is absorbed as new stocks. Eventually, the economy reaches point d which, compared to point a, reflects a higher price but no change at all in inventories. Notice that the spot price overshoots its long-run value as it moves from b to c, then back down to b.

Why does the demand curve go through the same point for inventories as before? Recall from Krugman's post that  N^d = N(i-(p^e-p)/p), where i is the interest rate, p is the spot price, and p^e is the expected future price. At the initial long-run equilibrium, it must be that p^e=p, otherwise there would be a tendency for something to change (and hence it wouldn't be a long-run equilibrium [Update: I should add that there is no mechanism in this model to force p^e=p, but adding this in is a simple fix, e.g. just add an equation that says dp^e/dt = f(p^e-p), f'<0, or go to a more complicated rational expectations set-up. In this model, the requirement that p^e=p arises from making the model internally consistent with the definition of a LR equilibrium]). Thus, at the long-run equilibrium, the stock demand is just N(i). That means that the long-run equilibrium for stocks is independent of the spot price and its expected future value. Thus, the inventory level will be the same as its initial value after the offsetting changes in p and p^e.

Summarizing the results for an increase in flow demand:

1. The long-run spot price rises.
2. In the short-run, the spot price can overshoot in the new long-run equilibrium. The model doesn't predict overshooting, the a-b-c-d progression shown in the diagram is just for exposition, the actual path can be different (e.g. there's no reason for the expected spot price to increase only after the economy reaches point b). But the model is consistent with overshooting, and therefore the change in the spot price can look like a bubble that is inflating, then deflating even though the change is driven purely by fundamentals, i.e. by a shift in world demand.
3. The level of inventories can change in the short-run, but is unchanged in the long-run. (However, in a more general model, there might be a change in, say, the interest rate or convenience yield and this would cause an additional shift in the stock demand curve and change inventory levels. But it's still possible for the variation in inventories to be small.)

Finally, this is just a "vintage" Branson-style exchange rate model applied to commodities, so if you are familiar with those models and the bells and whistles that can be added to them, or with alternative models, for the most part the results and intuition ought to carry through to this case.

Update: Paul Krugman in response to Tyler Cowen.

Another Iteration on the Speculation Model

Here's another iteration on the model of oil markets we've been developing. [Update: Paul Krugman comments on the model and provides a simple, continuous time version.]

Paul Krugman: Fuels on the Hill

Blaming speculators for high oil prices is a way to avoid facing the reality that things will have to change:

Fuels on the Hill, by Paul Krugman, Commentary, NY Times: Congress has always had a soft spot for “experts” who tell members what they want to hear, whether it’s supply-side economists declaring that tax cuts increase revenue or climate-change skeptics insisting that global warming is a myth.

Right now, the welcome mat is out for analysts who claim that out-of-control speculators are responsible for $4-a-gallon gas.

Back in May, Michael Masters, a hedge fund manager, made a big splash when he told a Senate committee that speculation is the main cause of rising prices for oil and other raw materials. ...

Many economists scoffed: Mr. Masters was making the bizarre claim that betting on a higher price of oil ... is equivalent to actually burning the stuff.

But members of Congress liked what they heard, and ... much of Capitol Hill has jumped on the blame-the-speculators bandwagon.

Somewhat surprisingly, Republicans have been at least as willing as Democrats to denounce evil speculators. But it turns out that conservative faith in free markets somehow evaporates when it comes to oil. For example, National Review has been publishing articles blaming speculators for high oil prices for years...

And it was John McCain, not Barack Obama, who recently said this: “While a few reckless speculators are counting their paper profits, most Americans are coming up on the short end...”

Why are politicians so eager to pin the blame for oil prices on speculators? Because it lets them believe that we don’t have to adapt to a world of expensive gas.

Indeed, this past Monday Mr. Masters assured a House subcommittee that ..[i]f Congress passed legislation restricting speculation,... gasoline prices would fall almost 50 percent in a matter of weeks.

O.K., let’s talk about the reality.

Is speculation playing a role in high oil prices? It’s not out of the question... Whether that’s happening now is a subject of highly technical dispute. (Readers who want to wonk themselves out can go to my blog and follow the links.) Suffice it to say that some economists, myself included, make much of the fact that the usual telltale signs of a speculative price boom are missing. But other economists argue, in effect, that absence of evidence isn’t solid evidence of absence.

What about those who argue that speculative excess is the only way to explain the speed with which oil prices have risen? Well, I have two words for them: iron ore.

You see,... its price is set in direct deals between producers and consumers. So there’s no easy way to speculate on ore prices. Yet the price of iron ore, like that of oil, has surged over the past year. In particular, the price Chinese steel makers pay to Australian mines has just jumped 96 percent. This suggests that growing demand from emerging economies, not speculation, is the real story...

In any case, one thing is clear: the hyperventilation over oil-market speculation is distracting us from the real issues.

Regulating futures markets more tightly isn’t a bad idea, but it won’t bring back the days of cheap oil. Nothing will. Oil prices will fluctuate in the coming years ... but the long-term trend is surely up.

Most of the adjustment to higher oil prices will take place through private initiative, but the government can help the private sector in a variety of ways, such as helping develop alternative-energy technologies and new methods of conservation and expanding the availability of public transit.

But we won’t have even the beginnings of a rational energy policy if we listen to people who assure us that we can just wish high oil prices away.

The Speculation Continues...

As I continue to gather thoughts on the speculation question... [i.e. the question of whether speculation is driving up oil and other commodity prices, previous entries: Speculative Nonsense, Once Again, More Speculation, Even More Speculation, Speculation Continued..., An Answer?] [Update: New version of model here]:

Steve Waldman added another piece to the speculation model, so let me show how it fits into the graphical model that is being used to illustrate ideas.

First, let's review the model of speculation and inventory storage. I'll use Brad DeLong's pictures to illustrate. In the left-hand panel of the first picture shown below, the interest plus storage line (which I'll denote as i+s) represents the marginal cost of holding inventory, and this is always positive since interest rates and storage costs cannot be negative (I show how to add interest rate determination to the model here). The expected appreciation line, E=(expected future price - spot price)/(spot price), represents the expected marginal benefit from holding speculative inventory. If benefits exceed costs (E>s+i), inventories will increase, if costs are greater than benefits (E<s+i), inventories will decrease, and when they are equal (E=s+i), inventories will stabilize. Note, however, that inventories cannot be negative.

The spot price, in this case, is determined in the right-hand panel by the flow supply and demand curves for the good (say oil). However, at this spot price, and given the expected future price, expected appreciation (E) is negative. Since the benefit is expected to be negastive, and the costs (i+s) are positive, no inventory is held. [Note for now that, since i+s (interest plus storage) is always positive, if E is negative no inventory will ever be stored in this version of the model. Even if E is positive it has to be large enough to cover the interest plus storage costs before any inventory will be held for speculative purposes.

Okay, now let's generate inventory storage. We need to do (at least) one of three things. First, we could let the expected future price go up shifting E to the right. Second, demand could shift in. Third, supply could shift out.

Taking the first case, an increase in the expected future price, this shifts the E curve to the right. Looking at the diagram above, as E shifts out the intersection of the blue lines in the left-panel moves up and, when it crosses the dotted line showing the spot price, speculators are at the indifference point on storing inventory. This is shown in the next diagram (the orange line is the new E curve after the increase if the expected future price):

Now, if expectations rise even further, then the E curve will shift out even more. As it does, and speculators begin demanding some of the good for storage, the spot price is driven upward (and is hence determined by speculators as the label in the graph indicates). The result, after E is done shifting (and it turns from orange to blue), is the equilibrium below:

Thus, this shows how an increase in the expected future price can cause the equilibrium to move from one where there is no storage to one where there is. So, when higher future prices are expected, we should see both inventories and the spot price rising.

How else could we go from the first to the third diagrams, i.e. from no storage to storage? Go back to the first diagram above. Now, imagine either the demand curve shifting in (demand falling) or the supply curve shifting out (supply increasing). All we need is for the spot price to fall (holding the expected future price constant), and either change will accomplish that. As the spot price falls, the horizontal dotted line in the first diagram showing the spot price will also fall, obviously, and you can see that it will eventually hit the intersection of the two blue lines in the left-hand panel. i.e. it will hit the point of indifference over speculative inventories. Here's how the graph would look for an increase in supply:

Speculation Continued...

The debate over whether speculation is an important factor in oil markets continues. Here's a round up of today's debate (so far):

Jim Hamilton: How big a contribution could oil speculation be making?

I do believe that speculation has been another factor that contributed to recent high oil prices. However, a key element of the bubble story is that there needs to be a very limited response of quantity demanded to the price increases, which the most recent data persuade me is no longer the case. Some of the estimates I've been hearing of the size of the contribution speculation is currently making to the price are therefore difficult to defend. Here I explain why, essentially elaborating on Paul Krugman's theme.  ...

Arnold Kling: My Model of the Oil Market: Option Value

Near the end of a "tiny theoretical paper," Paul Krugman writes,

the actual data we have on crude oil don’t show the signatures of a market driven by speculative demand. Inventory data don’t show a big accumulation; and the market has mostly been in backwardation, not contango.

...My model of the oil market treats inventories and oil in the ground as the same. I don't care whether it is sitting in a storage tank or sitting under the Saudi sand--it's all part of the stock of oil. To look for shifts between under-sand oil and in-tank oil as evidence one way or the other on speculation does not strike me as compelling...

Arnold Kling: My Question for James Hamilton

...My question is: what were speculators thinking a year ago, when oil prices, including prices for futures contracts expiring in 2008, were substantially lower than spot prices are today? ...

If you believe Hamilton's view of fundamentals, and you believe my view that it's the job of speculators to anticipate fundamentals, then what you should blame speculators for is keeping prices too low in 2006 and 2007 (in fact, in all previous years).

That is, in fact, the most plausible story. But it could be that today's speculators have it wrong, and that today's futures price for June of 2009 over-estimates the realized spot price that we will observe then. And if speculators do have it wrong, I do not know where to look for evidence of that.

Tyler Cowen: Exasperating Paul Krugman

Krugman writes here on why speculation is not driving higher oil prices and offers a simple model here.  I agree with Krugman's conclusion but not his reasoning.  Arnold Kling responds here and basically Arnold is right...

Paul Krugman: Confusions about speculation

OK, Tyler Cowen weighs in — but I think that he partly misunderstands my point. ...

Also, I see that Arnold Kling has a question for Jim Hamilton. Here’s my answer...

In the stories where speculation is playing a large role, and storage somewhere (in ground or in tanks) occurs, how do you explain the large run up in, say, agricultural commodities which cannot be left "in the ground" until later? There's no evidence of substantial inventory accumulations for commodities generally. Perhaps Arnold and Tyler can explain this, but it seems problematic to me. And what about Krugman's point about iron, how is that explained?

If prices suddenly come crashing down and stabilize at a lower level, I'll change my mind (and Krugman's distinction in the post linked above between bubbles and speculation is important to keep in mind here), but for now I don't find the speculative bubble story as the most likely cause of (most of) the oil price run up, or the increase in the price of commodities more generally.

Even More Speculation

Paul Krugman with even more on speculation:

Speculation and Signatures, by Paul Krugman: I’m trying to get my own thoughts on the oil stuff clear; so for the econowonks, a tiny theoretical paper for your enjoyment and/or detestation.

After reading the paper, which explains when you would and would not expect to see inventories, what contango and backwardization mean, and importantly the signatures of speculation, some of you may wonder how monetary policy fits into the model. Here's a quick first pass at showing how this works (the two graphs in the top row mimic the graphs in Krugman's model in the paper, I'm adding the money-demand money supply diagram much as Krugman and Obstfeld do in their analysis of exchange rates in their book on international economics):

In this graph, starting in the upper left-hand diagram. E is the expected appreciation in oil prices, i.e. E=E(p, pf)=(pf-p)/p, where p is the spot price and pf is the future price. E is decreasing in p and increasing in pf. The line s+i represents the sum of interest foregone on stored inventory, i, and the actual storage cost, s. The storage cost is exogenous to the model, and the interest rate is assumed to be set by monetary policy. (Think of E as the expected benefit and s+i as the cost, the equilibrium (pf-p)/p = s+i sets the marginal cost of holding one more unit in inventory equal to the marginal benefit).

The diagram on the upper right is the flow supply and demand diagram for oil. The distance ab, the excess of flow supply over flow demand at the initial spot price of p₁, is the initial level of inventories. [The supply and demand curves are drawn relatively flat for ease of illustration.]

The diagram in the bottom row is the supply and demand diagram for money. Real money demand is L(y,i), nominal money demand in PL(y,i), and as usual L is increasing in y and decreasing in i. The money supply is M, and it is controlled by the monetary authority. It is assumed the i is the policy variable, so that M takes whatever value is needed to hit the target value of i for a given level of money demand.

The initial target for the interest rate is i₁. At i₁, the spot price of oil is p₁ and inventories are ab. Now let the monetary authority ease up and lower the interest rate to i₂. This will cause the i+s line to shift to the left, and this in turn will increase the spot price of oil to p₂. At the higher price of p₂ inventories increase from ab to cd, so the net result of easing is to increase the price of oil in spot markets, and to increase inventories. Thus, an increase in liquidity from an easing of monetary policy would have an increase in the spot price and increases inventories as a signature.

Intuitively, the model starts in equilibrium with (pf-p)/p=s+i. Then, i falls due to the increase in liquidity causing (pf-p)/p>s+i. Since the benefits of speculation now exceed the cost at the margin, there is more demand for oil to be put into inventory, and this drives up the spot price until (pf-p)/p=s+i once again.

[I should add that if the market is in backwardization, which Krugman argues has been the case recently  - see figure 3 in Krugman's paper and the associated discussion - then variations in the i+s line will not change the equilibrium. Thus, in this case changes in the target interest rate will not change the spot price or change inventories (which are zero, again, see figure 3 and picture the i+s line shifting left or right).]

There are lots of thought experiments one can conduct with this model, e.g. ask what might happen if pf goes up, y goes down, etc., and I should stress that this is partial or short-run equilibrium, for example there are no feedback effects through the aggregate price level P or output y, both of which are held constant in the analysis, and if p is permanently higher, pf might increase as well (and these sorts of "chase your tail" mechanisms can lead to bubbles, e.g. pf goes up for some mysterious reason shifting E to the right, this causes an increase in p, which could increase pf if it's thought to be permanent, which increases p, then pf again, etc., until it eventually peaks and then comes crashing back to fundamentals), but this should give some idea of how it all fits together.

More Speculation

Thomas Palley takes a contrary position on speculation and oil prices:

Beating the Oil Barons, by Thomas Palley: Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories... The fact that inventories have not risen supposedly exonerates oil speculators. ...

But, contrary to economists’ claims, oil inventories do reveal a footprint of speculation. Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity. ...

Whereas oil speculators have gained, both the US and global economies have suffered and been pushed closer to recession. In the case of the US, heavy dependence on imported oil has worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.

But some unilateral populist action is possible. A major form of gasoline storage is the tanks in cars. If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand. Given lack of storage capacity, this could quickly lower prices and burn speculators. [uncut version]

Paul Krugman might respond with:

Iron Resolution, by Paul Krugman: Chinese steelmakers have agreed to a 96 percent increase in the price they pay for Australian iron ore.

One interesting point about this case is that, as I understand it, iron ore isn’t traded on an international exchange; trade takes place through bilateral deals between producers and consumers. In other words, there isn’t any easy way to speculate on future iron ore prices.

Yet ore prices are surging like oil prices. A bit more evidence against the speculative frenzy hypothesis.

Arnold Kling says:

Oil Speculation: Paul Krugman Mis-speaks, by Arnold Kling: Paul Krugman writes,

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.

He can't mean that. Think of the foreign currency market. If speculators bid up the future price of Japanese yen, then the spot price of Japanese yen will go up. And you won't see any particular pattern of inventories among currency dealers. The inventory issue is much closer to a red herring than to the decisive empirical data that Krugman maintains it to be. ...

My views on the oil market are almost the exact opposite of Krugman's. I believe that the futures price has to be the key determinant of the spot price. Because oil is a non-renewable resource, the oil market has to reflect expectations for demand and supply over the entire future time horizon, and those expectations ought to be embedded in futures prices. ...

I agree with Krugman that blaming oil speculators for the high price of oil is unhelpful. The politicians make it sound as though there has been a sudden outbreak of greed among oil speculators. Instead, there has been a change of expectations about future supply and demand. From what I can tell, there was no real news to cause this change in expectations. Either speculators were badly wrong six months ago or they are badly wrong today. It is more likely that they were wrong six months ago, but the probability that they were closer to correct then is far from zero. [Full Post]

Paul Krugman might follow this up with:

Various notes on speculation, by Paul Krugman: First, Friedrich von Schiller was right. ... Right now I see well-trained economists getting ... hung up on the financial relationships between spot and futures. Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods.

Second, some ... have asked me why my inventory argument didn’t apply to the housing bubble. The answer is that a house is a durable good, which unlike oil, which you have to burn, isn’t used up by the consumer; what we consume are housing services — in effect, consumers rent houses, from themselves if they happen to be homeowners.

To see the equivalent in housing of what the oil bubble types think they’re seeing in oil, we’d have to have seen a sharp rise in rental rates. It didn’t happen. [graph]

Third, some people have asked what I said about the California energy crisis of 2000-2001, perhaps history’s greatest example of market manipulation. I first broached the manipulation issue in California screaming, written in December 2000. I didn’t really figure it out, however — I was still giving too much credence to the conventional wisdom about underinvestment — until The Price of Power, published in March 2001. The Real Wolf, published a month later, pulled it all together.

During that whole period, I was pretty much the only voice in a major news outlet even suggesting that market manipulation might be a central factor.

And here’s the thing: I applied pretty much the same reasoning to that crisis that I’m applying now. The only way market manipulators could have been driving up prices was by keeping physical supply off the market. And they were in fact doing just that: there was huge unused generating capacity, consistent with the idea of deliberate withholding. Some years later we would actually get hold of control room tapes in which Enron traders called plants and told them to shut down, and boasted about cutting off Grandma Millie’s power.

I’m still waiting for evidence that physical withholding is going on in the oil market.

Update: And Paul Krugman might also respond with:

Speculation and Signatures, by Paul Krugman: I’m trying to get my own thoughts on the oil stuff clear; so for the econowonks, a tiny theoretical paper for your enjoyment and/or detestation.

"Speculative Nonsense, Once Again"

I think it would be fair to describe Paul Krugman as frustrated:

Speculative nonsense, once again, by Paul Krugman: OK, one more try. ...[T]he 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 EIA; 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.

Update: 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.

Where's the incentive to hoard?

Update: Also see Free Exchange.

FRBSF: Speculative Bubbles and Overreaction to Technological Innovation

From the SF Fed, the relationship between speculative bubbles, technological innovation, and capital misallocation:

Speculative Bubbles and Overreaction to Technological Innovation, by Kevin J. Lansing, Economic Letter, FRBSF:

Bubbles are often precipitated by perceptions of real improvements in the productivity and underlying profitability of the corporate economy. But as history attests, investors then too often exaggerate the extent of the improvement in economic fundamentals. —Greenspan (2002)

The magnitude of short-term movements in asset prices remains a challenge to explain within a framework of rational, efficient markets. Numerous empirical studies have shown that stock prices appear to exhibit "excess volatility," that is, prices move too much to be explained by changes in the underlying fundamentals, such as dividends or cash flows. Another prominent feature of asset prices is the intermittent occurrence of sustained run-ups above estimates of fundamental value, so-called speculative bubbles, that can be found throughout history in various countries and markets (see Lansing 2007).

The dramatic rise in U.S. stock prices during the late 1990s, followed similarly by U.S. house prices during the mid-2000s, are episodes that have both been described as bubbles. The former was accompanied by a boom in business investment, and the latter by a boom in residential investment. Both booms were later followed by falling asset prices and severe retrenchments in the associated investment series, as firms and investors sought to unwind the excess capital accumulated during the bubble periods. Coincident booms in asset prices and investment also occurred during the late 1920s—a period that shares many characteristics with the late 1990s. In particular, both periods witnessed major technological innovations that contributed to investor enthusiasm about a "new era." This Economic Letter examines some historical links between speculative bubbles, technological innovation, and capital misallocation.

Paul Krugman: Driller Instinct

Mr. McCain’s energy gambit:

Driller Instinct, by Paul Krugman, Commentary, NY Times: Blaming environmentalists for high energy prices, never mind the evidence, has been a hallmark of the Bush administration.

Thus, in 2001 Dick Cheney attributed the California electricity crisis to environmental regulations that, he claimed, were blocking power-plant construction. He completely missed the real story, which was that energy companies — probably some of the same companies that participated in his secret task force... — were driving up prices by deliberately withholding electricity from the market.

And the administration has spent the last eight years trying to convince Congress that the key to America’s energy security is opening up the Arctic National Wildlife Refuge to oil drilling — even though estimates ... suggest that ... would make very little difference to the energy outlook...

But it still comes as a surprise and a disappointment to see John McCain joining that unfortunate tradition.

I’ve never taken Mr. McCain’s media reputation as a maverick seriously,... on most issues, he’s a thoroughly conventional conservative. On energy policy, however, he has ... seemed to show some independence. Most notably, he voted against the really terrible, special-interest-driven 2005 energy bill, which was backed by the Bush administration — and by Barack Obama.

But that was then.

In his Monday speech on energy, Mr. McCain tried to touch all the bases. He talked about conservation. He denounced the evils of speculation... A weird aspect of the current energy debate, incidentally, is ... that many of the same market-worshipping conservatives who first denied that there was a dot-com bubble, then denied that there was a housing bubble, are utterly convinced that nasty speculators are responsible for high oil prices.

The ... news, however, was Mr. McCain’s call for more offshore drilling... This was a reversal of his previous position, and it went a long way toward aligning his energy policy with that of the Bush administration.

That’s not a good thing.

As many reports have noted, the McCain/Bush policy on offshore drilling doesn’t make sense as a response to $4-a-gallon gas: the White House’s own Energy Information Administration says that ... even at peak production its impact on oil prices would be “insignificant.”

But what I haven’t seen emphasized is the broader picture: Mr. McCain has now aligned himself with an administration that, even aside from its blame-the-environmental-movement tendencies, has established an extensive track record as the gang that couldn’t think straight about energy policy.

Remember, they didn’t just insist that the Iraqis would welcome us as liberators;... administration officials were also adamant that regime change in Iraq would add millions of barrels a day to the world oil supply, driving oil prices way down...

So why would Mr. McCain associate himself with these characters? The answer, presumably, is that it’s a cynical political calculation. I’m reasonably sure that Mr. McCain’s advisers realize that offshore drilling would do nothing for current gas prices. But they may believe that the public can be conned...

And Mr. McCain may also hope to shore up his still fragile relations with the Republican base..., many people on the right ... believe that all our energy problems have been caused by sanctimonious tree-huggers. Mr. McCain has just thrown that constituency some red meat.

But I very much doubt that Mr. McCain’s gambit will work. In fact, it’s almost certainly self-destructive. To have a chance in November, Mr. McCain has to convince voters that he isn’t just Bush, continued. Energy policy is one of the areas where he could best have made that case.

Instead, he has ceded the high ground on energy to Mr. Obama, and linked himself firmly to the most unpopular president on record.

"Market Power, Asset Allocation, and Oil Prices"

Steve Waldman:

Market power, asset allocation, and oil prices, by Steve Randy Waldman: In response to a (somewhat ridiculous) proposal that we "sue OPEC" over high oil prices, Mark Thoma writes:

[I]t's unlikely that [monopoly power] is the factor behind the run-up in prices. ...

I think there may have been a change over the last few years in the market power of oil producers, for structural reasons. Traditionally, OPEC has suffered from the usual problem that makes large cartels unwieldy: Under agreements to restrain production, members individually have an incentive to cheat and sell larger-than-agreed upon quantities at still artificially high prices. But that assumes that the production quotas are significantly beneath the capacity of most members to produce. More subtly, it also assumes that each country gains by producing more rather than less oil, if cartel prices are maintained. Both of those assumptions may no longer hold.

As the global oil market has grown, demand may have outpaced individual countries' capacity to supply, either because investment in new projects has not kept pace, or because nations have hit domestic "peak oil". (See Indonesia for an extreme example.) Other countries may desperately need money in order to fund current spending, so it is widely known they will produce as much as they can, regardless of quotas. Ironically, as long as the total capacity ... is well below global demand at the cartel's target price, the certainty of their output may enhance the ability of discretionary producers to control the quantity produced.

It'd always be easier for a cartel of five or six producers to exercise market power than a cartel of, say, thirteen. But that's especially true when cartel members have little incentive to cheat. ...[O]il producers ... spend far less than the oil revenue they receive. For Saudi Arabia, selling a barrel more of oil is a portfolio choice: revenue from the marginal barrel will be saved, not spent, so the question becomes whether it is wise to shift some of the Kingdom's current allocation out of oil and into some asset that can be purchased with currency. For countries that have very little non-oil savings, mere diversification would encourage oil sales. It is unwise to have all ones eggs in one basket, and oil producers remember all too well that world prices can go down as well as up. They'd want to store their national wealth in an "efficient portfolio", one that maximizes their return on risk by including a variety of investments.

But as oil producing nations have accumulated vast reserves of financial assets, switching from oil-in-the ground to stocks, bonds, or bank accounts is no longer so sure a bet. ... Central banks and sovereign wealth funds of oil-producing nations already hold hundreds of billions of dollars worth of Western financial assets. They might already have reached or exceeded what they view as an optimal allocation of their national wealth into these securities. Of course, producers are still not well diversified, and it's pretty clear that sovereign wealth funds are looking for alternative assets that might hedge their exposure both to oil and Western paper. But allocating into less liquid, unfamiliar categories of assets is slow work if you want to do it well. Perhaps current oil revenues outstrip oil producers' capacity to find good investment opportunities, and they view oil-in-the-ground as a better second-best asset than dollars in the bank.

Ten years ago, oil producers did not have vast hoards of dollars and euros, and required oil revenue to meet budgetary needs. World demand was low enough that cheating by OPEC members could corrode producer pricing. It was hard to exercise market power. Now, cheaters don't matter, and discretionary producers may be indifferent or worse to the prospect of selling a barrel more of oil at current prices.

(In a sense you might not call this market power at all, as price equals marginal cost, that is to oil producers, the assets they can buy for the dollar price of a barrel of oil are worth no more to them than a barrel of oil left in the ground.) ... [...more...]

"Sue OPEC"

Should we sue OPEC for anti-trust violations?:

Sue OPEC, by Thomas W. Evans, Commentary, NY Times: The president of the United States has the power to attack, and perhaps destroy, the Organization of the Petroleum Exporting Countries, the illegal cartel that has driven the price of oil over $130 per barrel. ... The president need simply allow the states to seek relief in the Supreme Court under our antitrust laws.

The oil ministers of the OPEC countries meet periodically to set production quotas ... and in the process establish an artificially high price for crude oil. Under our antitrust laws, this is illegal. Two years ago, Amy Myers Jaffe, an energy expert at Rice University, estimated that the real production cost was $15 a barrel, at a time when the price was approaching $60. Recently, an OPEC spokesman said the price could be $70 a barrel — a little more than half the current price — if speculation and manipulation could be eliminated.

Despite this illegal conduct, ... “under the current state of our federal laws the individual member states of OPEC are afforded immunity from suit brought for damage caused by their commercial activities when they act through OPEC.” ...

Fortunately, there is another way to sue OPEC. Even if actions by individual citizens fail, a seldom-used provision of Article III of the Constitution grants original jurisdiction to the Supreme Court over lawsuits brought by states against “foreign states”...

The attorneys general of the various states should sue OPEC as ... a foreign state. (A joint action by the attorneys general is the method the states used to collectively sue tobacco companies, Microsoft and health maintenance organizations.) ... If the states won the case, the court could recover substantial damages based on assets and commercial activities of OPEC member nations in the United States.

Still, even though the states are allowed to sue OPEC in the Supreme Court, they might not prevail. There are significant separation of powers issues. ...

That’s where the president ... comes in. If the Supreme Court decided to defer to the policies of the political branches, the states could ask the president to issue a statement permitting the lawsuit to go forward... This pathway was established in a statute passed by Congress in the wake of Cuba’s expropriation of American sugar interests. ...

Moreover, confronted with the likelihood of huge damages and restraint of its illegal conduct, OPEC, or some of its members, might seek a settlement establishing production goals that would provide a price closer to actual costs. The probable reduction in the price of heating fuel and gas at the pump might exceed the amount of the current federal stimulus package.

If the president allowed the states to sue OPEC, his actions would undoubtedly anger political leaders in the Middle East and create the need for diplomatic initiatives to limit the fallout. But how stable is the Middle East right now? And isn’t starting a lawsuit better than starting a war?

And, from the LA Times, Sue OPEC (same title, but different authors, different editorial pages):

As the national average price of gasoline raced toward $4 a gallon and airlines laid off workers by the thousands because of rising jet fuel costs, the House of Representatives took action: It overwhelmingly passed the Gas Price Relief for Consumers Act of 2008. The bill would have ... permitted the U.S. Justice Department to charge the Organization of the Petroleum Exporting Countries with violating American antitrust laws.

Even before the 324-84 House vote last month, President Bush pledged a veto, saying OPEC might retaliate against U.S. interests overseas or cut oil production further. But he didn't have to make good on that promise. Senate Republicans held the line for him, last week threatening a filibuster... That effectively killed the bill and, for now, any hope that the United States would finally start treating oil the same way it does computer chips, vitamins, rubber and all other products. ...

If monopoly power is distorting these markets, then sure, we should fix that just as we should fix other market failures (e.g. not fully internalizing environmental costs into production decisions). However, it's unlikely that this is the factor behind the run-up in prices. Monopoly power explains the level of prices, i.e. why price is $8 rather than $5, but it doesn't explain the change in prices, i.e. why the price would change from $8 to $12. There are ways to tell this story, e.g. a war or some other event giving a cartel the cover it needs to raise prices and blame it on external factors, but I don't think that's what's going on in oil markets today, at least I don't think this is a significant factor behind the oil price increases.

For these reasons, if we fix the monopoly power problem, it's unlikely that oil prices will suddenly plummet. Even if monopoly power is a factor, it's unlikely it's as important as the growth in world demand. And while I don't put a lot of faith in the speculation story, I'd be more likely to believe speculation was the cause of the price run up than I would monopoly power.

I don't mean to downplay monopoly power, I've been frustrated that we seem to have lost focus on this aspect of markets over the last few decades, and we don't worry enough about market power in public policy. And maybe breaking up OPEC would bring down the price noticeably (for now, world growth will continue to put upward pressure on oil prices). If so, then we should eliminate the monopoly power, there's no reason to pay more than is necessary (though if we impose carbon taxes to correct other problems in these markets, the price will go back up again, the difference will be who gets the extra revenue).

But I'd also hate to see the oil price discussion get diverted by false hopes. Breaking up OPEC might bring prices down some, but it won't bring back the good old days and the longer term problems remain. At some point we have to face that things are changing, that we have to adjust - we can't keep hoping for a return of the low oil prices of the past because those days aren't coming back (no matter how many holes we drill in Alaska or off our coasts). Maybe technology will save us, but that too will require that we face reality and devote the resources and effort needed to fully investigate and develop alternative energy sources.

The "Enron Loophole"

From Marketplace:

Deflating the oil bubble, by Michael Greenberger: ...Host Kai Ryssdal talks with former commodity regulator Michael Greenberger about ways to keep tabs on speculation.

Kai Ryssdal: ...The [Commodity Futures Trading Commission is] in charge of regulating oil markets in this country and Congress has been after the agency to do something -- to do anything -- about oil and gas prices, what lawmakers perceive to be speculation, in particular.

Michael Greenberger used to run the ... [Division of Trading and Markets for the Commodities Futures Trading Commission. He now teaches law at the University of Maryland.]

Ryssdal: Why is it so hard to figure out what's going on in commodities markets -- oil specifically?

Greenberger: Well, the reason it's hard to figure out is about 30 percent of our crude oil energy futures are traded in what is called a dark market -- that is a market that was deregulated in December of 2000 at the behest of Enron. Prior to that legislation..., all energy futures traded in the United States or affecting the United States in a significant fashion were regulated ... under a very careful regime that had been perfected over about 78 years and many observers believe that because those markets are not being policed, malpractices are being committed and traders are able to boost the price virtually at their will.

Ryssdal: You're not really telling me that seven years on, we're still paying the price for Enron, are you?

Greenberger: Well, this has been called the "Enron Loophole" and there are many legislators working very hard to close that loophole ...[and] bring the speculation under the kind of time-tested controls that were used until Enron had its way and amended the law...

Ryssdal: So what's Congress going to do?...

Greenberger: Well, there are several proposals..., but the bottom line is the speculators will, in the end, be policed. We will know who they are, what they're doing, what their controls are, what effect they're having on the market. Maybe we'll find out that there's nothing there.

Ryssdal: So just to be clear, you do think that we're in a bubble, then?

Greenberger: I believe it and I'm certainly not alone in my belief. If you talk to anybody who trades in these markets on a regular basis, they will tell you that the markets are completely dysfunctional and out of control because of speculative activity.

Ryssdal: How long is it going to take then if we are, as you say, in a bubble, for it to work its way through and us to get back to something more realistic for the price of a barrel of oil, whether its 50 bucks or 80 bucks?

Greenberger: From my own experience as a commodity regulator, I believe that if the Bush Administration were serious about its regulation, we could begin seeing prices drop within a month. If we don't get the kind of regulation that has been done for decades and the market proceeds along the pace its proceeding, we will have to go through a very, very serious recession. The question is do you want to deflate the bubble by that kind of suffering or do you want to deflate the bubble by applying tight U.S. regulatory controls? ...

Gas Prices and the Urban Land Market

Richard Green:

$4 per gallon gasoline and the urban land market, by Richard Green: Over the past six years, the price of gasoline has risen about $2 per gallon. What does this mean for relative urban land prices?

Let's say the average household makes five one-way trips per day--for work, shopping, entertainment, etc. Let's also say that the average car gets 20 mpg in city driving. Each mile of distance to work, shopping, etc. is therefore now 50 cents per day per household more expensive than before. A household living immediately adjacent to work and shopping should then be willing to pay $5 per day more in rent than a household 10 miles away compared with six years ago, all else being equal. This becomes $150 per month, or $1800 per year. Assuming a five percent cap rate for owner occupied housing, this translates to $36,000 in relative change in value. Given that the median house price in the US is about $220k, this is kind of a big deal.

The assumptions here are pretty crude (particularly the ceteris paribus assumption), but if gas remains at its current real price, we will see the shape of US cities change.

On a larger scale, another potential reorganization is that producers may shift production closer to the markets where the goods are sold as transportation costs increase with energy prices (though see Brad Setser). If so, it's possible that higher energy costs could cause producers to shift production to Mexico, and this in turn could reduce the flow of illegal immigrants into the U.S.

Update: Follow-up from Richard Green here.

The Effects of Oil Shocks

From Vox EU, could the surge in oil prices "be good news for developed economies' industries"?:

Oil prices: risks and opportunities, by Francesco Lippi, Vox EU: Recent research by Jim Hamilton shows that the correlation between the price of oil and US production is unstable; it was negative and high in the 1970s but much smaller in more recent years.[1] Nevertheless, the recent surge in oil prices gives rise to worries in Western economies – memories of the recessions of the ‘70s and early ‘80s are still vivid.

Can the 1970s be compared to the current situation? What hypothesis justifies a comparison, and what do the data say about it?

Supply and demand in theory, demand in practice

Most analysts attribute the increase in the price of crude oil to growing demand from Asian economies. Economic theory suggests that the real effect of an oil price increase depends on its underlying fundamentals. If it stems from a change in supply conditions – as was the case with the Iranian revolution, the first Gulf war, or policy tightening by OPEC – the resulting price increase depresses economic activity, as energy inputs are more expensive. But if higher oil prices stem from increased demand by emerging economies, production in other economies like the US is subject to both a negative effect – due to the higher price of energy – and to a positive effect – greater demand for US goods and services by the growing emerging economies. According to this scheme, the weak relationship between oil prices and the US business cycle in recent years reflects oil demand shocks, while the episodes in the ‘70s and ‘80s can be ascribed to oil supply shocks.

Stiglitz: Rethink the Sources of Growth

Joseph Stiglitz says we need to change our ways:

The world must rethink the sources of growth, by Joseph E. Stiglitz, Commentary, Project Syndicate: Around the world, protests against soaring food and fuel prices are mounting. The poor – and even the middle classes – are seeing their incomes squeezed... Politicians want to respond..., but do not know what to do. ...

Hillary Clinton and John McCain took the easy way out, and supported a suspension of the gasoline tax... Only Barack Obama stood his ground and rejected the proposal... But if Clinton and McCain were wrong, what should be done? One cannot simply ignore ... those who are suffering. ...

When George Bush was elected, he claimed that tax cuts for the rich would cure all the economy’s ailments. The benefits of tax-cut-fuelled growth would trickle down to all...

Tax cuts were supposed to stimulate savings, but household savings in the US have plummeted to zero. They were supposed to stimulate employment, but labour force participation is lower than in the 1990’s. What growth did occur benefited only the few at the top.

Productivity grew, for a while, but it wasn’t because of Wall Street financial innovations. The financial products being created didn’t manage risk; they enhanced risk. ... Millions of Americans will likely lose their homes and, with them, their life savings.

At the core of America’s success is technology, symbolised by Silicon Valley. The irony is that the scientists making the advances..., and the venture capital firms that finance it were not the ones reaping the biggest rewards in the heyday of the real estate bubble. ...

The world needs to rethink the sources of growth. If the foundations of economic growth lie in advances in science and technology, not in speculation in real estate or financial markets, then tax systems must be realigned.

Why should those who make their income by gambling in Wall Street’s casinos be taxed at a lower rate than those who earn their money in other ways? Capital gains should be taxed at least at as high a rate as ordinary income. ... In addition, there should be a windfall profits tax on oil and gas companies.

Given the huge increase in inequality in most countries, higher taxes for those who have done well – to help those who have lost ground from globalisation and technological change – are in order, and could also ameliorate the strains imposed by soaring food and energy prices. ...

Two factors set off today’s crisis: the Iraq war contributed to the run-up in oil prices..., while bio-fuels have meant that food and energy markets are increasingly integrated. ...

Huge agriculture subsidies ... have weakened agriculture in the developing world... Rich countries must reduce, if not eliminate, distortional agriculture and energy policies, and help those in the poorest countries improve their capacity to produce food.

But this is just a start: we have treated our most precious resources – clean water and air – as if they were free. Only new patterns of consumption and production – a new economic model – can address that most fundamental resource problem.

The list of criticisms and proposals sounds somewhat like a campaign speech. And that makes me wonder, four years from now, what will be different?

"Crude Awakening: Behind the Surge in Oil Prices"

Stephen P. A. Brown, Raghav Virmani, and Richard Alm of the Dallas Fed look at why oil prices are so high, and whether the high prices are likely to continue. It's a more optimistic view than many. Their bottom line is "Absent supply disruptions, it will be difficult to sustain oil prices above $100 (in 2008 dollars) over the next 10 years" (comments at Real Time Economics and The Big Picture):

Crude Awakening: Behind the Surge in Oil Prices, by Stephen P. A. Brown, Raghav Virmani and Richard Alm, Economic Letter, Vol. 3, No. 5, May 2008, Federal Reserve Bank of Dallas: The first few months of 2008 saw crude oil prices breach one barrier after another. They topped $100 a barrel for the first time on Feb. 19, then rose past $103.76 about two weeks later, surpassing the previous inflation-adjusted peak, established in 1980. In April and early May, oil prices pushed past $110 and then $120 a barrel and beyond.[1]

These milestones reflect a new era in oil markets. After the tumult of the early 1980s, prices remained relatively tame for two decades—in both real and nominal terms (Chart 1). This long stretch of stability ended in 2004, when oil topped $40 a barrel for the first time, then embarked on a steep climb that continued into this year.

Two from Jeff Frankel: Whether We are Currently in a Recession and the Impact of Monetary Policy on Commodity Prices

There are two different topics to choose from, so let's start with the latest news on GDP. Today, GDP growth for the first quarter was revised upward from .6% to .9%. How does this affect the odds that we are currently in a recession? Jeff Frankel is a member of the NBER's Business Cycle Dating Committee:

Despite Positive First Quarter, Odds of 2008 Recession Are Still Above 50%, by Jeff Frankel: The Commerce Department this morning revised upward its estimate of first quarter growth in real GDP to 0.9% (precisely in line with the expectations of economic forecasters).

As a member of the Business Cycle Dating Committee of the NBER, I am asked frequently if the country is entering a recession, or if we have already done so. I cannot speak for the Committee, and I am not a professional forecaster. But I can give my views, for what they are worth.

It is hard to say that we entered a recession in the first quarter, without a single negative growth quarter, let alone two of them. Even so, three minor qualifications to that 0.9% remain: 1) The number will be revised again, and could move in either direction. 2) A bit of the measured growth consisted of an increased rate of inventory investment, which was almost certainly not desired by firms and is likely to reverse in the 2nd quarter 3) As Martin Feldstein has pointed out, the QI growth number is defined as the change for the quarter as a whole relative to QIV of 2007; within QI, the information currently available suggests that GDP fell from January to February to March.

The reason why many suspected a QI turning point in the first place is employment, which is virtually as important an indicator to the NBER BCDC as is GDP. Jobs have been lost each month since January. Total hours worked is my personal favorite, because in addition to employment it captures the length of the workweek, which firms tend to cut before they lay off workers. This indicator too has been falling.

And of course there are the longer run indicators that have been very worrisome for almost a year: depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, etc.

The economy is a four-engine airplane flying at stall speed, skimming along the top of the waves without yet going down. ... The big question mark is the consumption engine. Is the long-spending American household taking a hard look at its diminished net worth and taking steps to raise its saving rate above the very low levels of recent years?

We are already clearly in a “growth recession.” All in all, I put the odds of an outright recession sometime this year at greater than 50%. That number is meant to add together: (1) the odds that it will turn out that we have already entered reached the turning point and (2) the odds that the sharp recent expansions in monetary and fiscal policy will succeed in postponing the recession, but only until later in the year. Come the fall, if demand starts to slow, I can’t see either the Fed delivering a second big dose of interest rate cuts (as they were able to in the 2001 recession, when the dollar was strong and inflation under control), nor the government delivering a second big dose of tax cuts (as they could in the 2001 recession, when the budget outlook was strong and debt under control).

Next, a different topic. Jeff Frankel defends his argument that high commodity prices are the result of easy monetary policy:

Monetary policy and commodity prices, by Jeffrey Frankel, Vox EU: In a speech delivered last week, Federal Reserve Vice Chairman Donald L. Kohn addressed a theory to which I am partial: the theory that low real interest rates have contributed to the continued rise in prices of agricultural and mineral commodities, including oil, over the last year. He said:

“Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.”
(Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008).

As real interest rates have come down over the last year, real commodity prices have accelerated upward despite declining economic growth, as shown in Figure 1, where the commodity price has been inverted so that one can see the correlation visually.

"The Invisible Hand Is Shaking"

I recently talked about relative prices as signaling mechanisms in the economy, and how distortions in these signals relate to Fed policy (see False Signals). Part of the discussion noted that "Market failure can also cause distorted prices, but ... this is outside the Fed's purview, so ... that's for another discussion." Conveniently, Robert Frank takes up this issue:

The Invisible Hand Is Shaking, by Robert Frank, Economic Scene, NY Times: Adam Smith's modern disciples are far more enthusiastic about his celebrated invisible-hand idea than he ever was. ...

If you believe, with Smith’s modern disciples, that unfettered pursuit of self-interest always promotes society’s interests, you probably view all taxes as a regrettable evil — necessary to pay for roads and national security, but also an unwelcome drag on economic efficiency. The problem, according to this view, is that taxes distort the price signals through which the invisible hand guides resources to their best destinations.

Smith’s more nuanced position supports a different view of taxes. When market prices convey accurate signals of cost and value, the invisible hand promotes the common good. But prices often diverge from cost and value and, in those cases, taxes can actually help steer resources toward more highly valued uses. ...

The production and consumption of many ... goods ... generate costs or benefits that fall on people besides buyers and sellers. Producing an extra gallon of gasoline, for example, generates not just additional costs to producers, but also pollution costs that fall on others. ...[M]arket forces cause production to expand until the seller’s direct cost for the last unit sold is exactly the value of that unit to the buyer. But because each gallon of gasoline also generates external pollution costs, the total cost of that last gallon produced is higher than its value to consumers.

The upshot is that gasoline consumption is inefficiently high ...[, a] classic breakdown in the invisible hand when a product’s market price doesn’t reflect all its relevant social costs and benefits. In such cases, the simplest solution is to discourage consumption by taxing it.

Doing so would not only raise revenue to pay for public services; it would also make the allocation of society’s resources more efficient...

Efficiency is important because any policy that enlarges the economic pie necessarily lets everyone have a bigger slice than before. Economists opposed suspending the gas tax because doing so would make the economic pie smaller.

Of course, when millions of voters feel the pinch of rapidly rising prices, politicians find it hard to stand idly by. But as the late economist Abba Lerner once remarked, the main problem confronting the poor is that they have too little money. The best solution is not to reduce the prices they pay, but rather to bolster their incomes — for example, by selectively reducing the payroll tax for low-income workers or increasing the Earned Income Tax Credit. Suspending the gas tax would encourage rich and poor alike to do more ... driving. It would also promote sales of fuel-intensive vehicles. Because the gas tax reduces waste, it actually makes more resources available to help low-income families.

Gasoline is one of a host of goods whose production or consumption generates costs that fall on outsiders. ... That the invisible hand often breaks down is actually good news. After all, we need to tax something to pay for public services. By taxing forms of consumption that generate negative side effects, we could not only generate enough revenue to eliminate budget deficits, but also help steer resources toward their most highly valued uses.

Because such taxes make the economy more efficient, it makes no sense to object that they impose hardships on low-income families. Again, an efficient policy is one that maximizes the size of the economic pie. And with a bigger pie, it’s always possible for everyone to get a bigger slice.

With regard to the size of the pie and who gets what, this is not the only basis for arguing for income redistribution, but I think you can base redistributive policy on a market failure argument, i.e. that distribution mechanisms have failed to reward factors of production according to their contributions to the production process. Some have received too much and others too little, and more could be done to counteract this so that we have a better chance to realize the possibility of everyone getting "a bigger slice."

Paul Krugman: Stranded in Suburbia

Paul Krugman is in Berlin:

Stranded in Suburbia, by Paul Krugman, Commentary, NY Times: I have seen the future, and it works.

O.K., I know that these days you’re supposed to see the future in China or India, not in the heart of “old Europe.”

But we’re living in a world in which oil prices keep setting records... And Europeans who have achieved a high standard of living in spite of very high energy prices — gas in Germany costs more than $8 a gallon — have a lot to teach us about how to deal with that world.

If Europe’s example is any guide, here are the two secrets of coping with expensive oil: own fuel-efficient cars, and don’t drive them too much.

Notice that I said that cars should be fuel-efficient — not that people should do without cars altogether. In Germany, as in the United States, the vast majority of families own cars... But the average German car uses about a quarter less gas per mile than the average American car. By and large, the Germans don’t drive itsy-bitsy toy cars, but they do drive modest-sized passenger vehicles rather than S.U.V.’s and pickup trucks.

In the near future I expect we’ll see Americans moving down the same path. We’ve already done it once: over the course of the 1970s and 1980s...

Can we also drive less? Yes — but getting there will be a lot harder.

There have been many news stories in recent weeks about Americans who are changing their behavior in response to expensive gasoline...

But none of it amounts to much. For example, some major public transit systems are excited about ridership gains of 5 or 10 percent. But fewer than 5 percent of Americans take public transit to work, so this surge of riders takes only a relative handful of drivers off the road.

Any serious reduction in American driving will require more than this — it will mean changing how and where many of us live.

To see what I’m talking about, consider where I am at the moment: in a pleasant, middle-class neighborhood consisting mainly of four- or five-story apartment buildings, with easy access to public transit and plenty of local shopping.

It’s the kind of neighborhood in which people don’t have to drive a lot, but it’s also a kind of neighborhood that barely exists in America, even in big metropolitan areas. Greater Atlanta has roughly the same population as Greater Berlin — but Berlin is a city of trains, buses and bikes, while Atlanta is a city of cars, cars and cars. ...

Changing the geography of American metropolitan areas will be hard. For one thing, houses last a lot longer than cars. Long after today’s S.U.V.’s have become antique collectors’ items, millions of people will still be living in subdivisions built when gas was $1.50 or less a gallon.

Infrastructure is another problem. Public transit, in particular, faces a chicken-and-egg problem: it’s hard to justify transit systems unless there’s sufficient population density, yet it’s hard to persuade people to live in denser neighborhoods unless they come with the advantage of transit access.

And there are, as always in America, the issues of race and class. Despite the gentrification that has taken place in some inner cities, and the plunge in national crime rates to levels not seen in decades, it will be hard to shake the longstanding American association of higher-density living with poverty and personal danger.

Still, if we’re heading for a prolonged era of scarce, expensive oil, Americans will face increasingly strong incentives to start living like Europeans — maybe not today, and maybe not tomorrow, but soon, and for the rest of our lives.

Paul Krugman: The Oil Nonbubble

Is the high price of oil price due to fundamentals or speculation?:

The Oil Nonbubble, by Paul Krugman, Commentary, NY Times: “The Oil Bubble: Set to Burst?” That was the headline of an October 2004 article in National Review, which argued that oil prices, then $50 a barrel, would soon collapse.

Ten months later, oil was selling for $70 a barrel. “It’s a huge bubble,” declared Steve Forbes...

All through oil’s five-year price surge, which has taken it from $25 a barrel to last week’s close above $125, there have been many voices declaring that it’s all a bubble, unsupported by the fundamentals of supply and demand.

So here are two questions: Are speculators mainly, or even largely, responsible for high oil prices? And if they aren’t, why have so many commentators insisted, year after year, that there’s an oil bubble? ...

Imagine what would happen if the oil market were humming along, with supply and demand balanced at a price of $25 a barrel, and a bunch of speculators came in and drove the price up to $100. ...

Faced with higher prices, drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production.

As a result, the initial balance between supply and demand would be broken, replaced with a situation in which supply exceeded demand. This excess supply would, in turn, drive prices back down again — unless someone were willing to buy up the excess and take it off the market.

The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding...But ... inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn’t the result of runaway speculation; it’s the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China. The rise in oil prices ... had to happen to keep demand growth from exceeding supply growth.

Saying that high-priced oil isn’t a bubble doesn’t mean that oil prices will never decline. ... But it does mean that speculators aren’t at the heart of the story.

Why, then, do we keep hearing assertions that they are?

Part of the answer may be ... that many people are now investing in oil futures — which feeds suspicion that speculators are running the show... But there’s also a political component.

Traditionally, denunciations of speculators come from the left of the political spectrum. In the case of oil prices, however, the most vociferous proponents of the view that it’s all the speculators’ fault have been conservatives — people who you wouldn’t normally expect to see warning about the nefarious activities of investment banks and hedge funds.

The explanation of this seeming paradox is that wishful thinking has trumped pro-market ideology.

After all, a realistic view of what’s happened over the past few years suggests that we’re heading into an era of increasingly scarce, costly oil.

The ... odds are that we’re looking at a future in which energy conservation becomes increasingly important, in which many people may even — gasp — take public transit to work.

I don’t find that vision particularly abhorrent, but a lot of people, especially on the right, do. And so they want to believe that if only Goldman Sachs would stop having such a negative attitude, we’d quickly return to the good old days of abundant oil.

Again, I wouldn’t be shocked if oil prices dip in the near future — although I also take seriously Goldman’s recent warning that the price could go to $200. But let’s drop all the talk about an oil bubble.

Menendez: "Thank God" Economists Don't Make Public Policy

Sen. Bob Menendez (D-NJ) is a coauthor with Clinton on the gas tax bill:

To me, the claims being made about this proposal are the same as saying tax cuts pay for themselves. Even if it has popular appeal, even if it wins votes and elections, economists are in wide agreement in saying that the proposal is misleading as stated by the campaign, and generally a bad idea. When literally all the experts around you are telling you that what you are saying is misleading (at best), yet you declare you are going to say it anyway, that’s no better than the Laffer curve stuff. Sure, it’s not much money, but what if this were attacking Iran instead and she declared she was just going to do it anyway? That’s a bigger deal, and refusing to listen to experts - dismissing them as out of touch and elitist - tells us something important.

I have refused, for the most part, to get into Dem vs. Dem issues, and I’ve focused on McCain, but the statement she made irked me. Economics has been undermined enough, and part of it has come from people at think tanks and elsewhere who aren't economists, but pretend to be, promoting ideas like tax cuts are self-financing in op-eds, TV appearances, the NRO, and elsewhere. It has confused people, the media turns it into a he said-she said issue rather than denouncing the falsehoods and misleading statements, and people are left confused and wondering if economists know what they are talking about. When Republicans do this, it ticks me off. Economics has been undermined enough by clowns pretending to be economists, and I won’t help our side undermine the profession even further.

If they want to do public policy without talking to economists, good luck with that. I'm tired of being told I don't understand how average Americans feel. The point here is that this is a lousy way to help people. It's not that we don't care, or don't understand, it's that we do care and understand all to well and we'd like to see policies put into place that actually have a chance to help people. Promising things that aren't likely to happen - telling people they will get relief when it will likely be a pittance (the $70 figure they cite is not supported by the underlying economics) - simply leads to disappointment and disenchantment with politicians. All we are asking is that promises have a chance to be realized. Let's help the people who need help, but let's do it in a way that is effective rather than in a way that plays off their difficulties and fears, but does not really address their needs.

"I'm not Going to Put my Lot in with Economists"

Greg Mankiw:

The Legacy of Bailouts, by Greg Mankiw: Alan Blinder makes the case for more regulation of financial institutions. The key passage:

It will, for example, substantially reduce the profitability of investment houses and, therefore, reduce their scale. But that’s the price you pay for access to a publicly financed safety net.

That is why some economists cringe when Wall Street firms are bailed out. Beyond the obvious equity issues about risking taxpayer money to help rich guys, there is the problem of efficiency. If you start bailing the firms out when they lose, you have to regulate the gambles they take. You can no longer count on the creditors to limit the firms' leverage, as the creditors are counting on Uncle Sam if things go wrong. But the more regulated these firms are, the lower their productivity will be.

The bottom line: The Bear Stearns bailout may have saved the economy from an episode of financial contagion in the short run, but in the long run it will likely leave us with a more regulated and less vibrant financial system.

I disagree. Lack of effective regulation opened the door for this crisis, and if the Fed had not intervened, there was a strong possibility that the financial system would have had a severe meltdown. Maybe not, but the chance was there and it wasn't a chance most people were willing to take.

Suppose we do nothing and there was a meltdown as feared. One need only look back at the aftermath of the Great Depression to see what happens to regulation after such an event - there was a strong regulatory response. Given the choice between a bailout and the level of regulation that comes along with it, and a crash and the much larger amount of regulation that would follow, it's hard to see why choosing the path that, in a probabilistic sense, gives a smaller likelihood of a major crash and a smaller regulatory response would be objectionable. Financial markets screwed up and they know it - that was quite evident this week at the Milken Institute Global Conference - and they accept that more regulation is needed. The choice isn't between no regulation and some regulation, there will be a regulatory response and the question is how large and effective it will be.

The chance that there would be a financial meltdown had the Fed remained passive instead of intervening is why the statement below from Hillary doesn't make a lot of sense. The equivalence she draws between the financial market bailout and lifting the gas tax is false. The Fed intervened to prevent a financial meltdown, and that helped all of us. There were costs, but the benefits - avoiding a large crash - were far larger.

There is no such necessity for a gas tax, the system won't crash and burn if we do not lift gas taxes for the summer, and the calculation is different. With the financial bailout, we had little choice but to accept some costs in order to prevent far larger costs associated with a meltdown. But given that intervention was needed, the policy that was implemented did not have obvious problems, every economist on the planet did not jump up and say there's a better way to do this! Some did, but the objection was to intervening in financial markets at all. Most agreed this was the best way to proceed if they accepted that that intervention was needed, though there were a few voices advocating variations on the policy. With the gas tax, it is just the opposite - there are no economists I know of that support the policy, not one. Even if they support the idea behind it, giving relief to lower income households, they do not support this particular means of addressing the problem:

Clinton Pushes Back on Gas Tax ‘Pushback’, by Matt Phillips:  Hillary Clinton’s sit-down with George Stephanopoulos on ABC’s “This Week,” quickly delved into her plan to suspend the federal gas tax during the peak summer driving season.

Stephanopoulos ... played a clip of Sen. Barack Obama criticizing the plan. Obama quoted New York Times columnist and Princeton economist Paul Krugman’s assessment that the idea is “pointless and disappointing,” and asked the New York senator to name “a credible economist who supports the suspension.”...

“Well I’ll tell you what, I’m not going to put my lot in with economists,” Clinton said, a response in line with some of the populist notes she’s been hitting in recent stump speeches on the gas tax.

She argued that the policy, if designed properly, could be effective. ... “But let’s step back for a minute George. You know, it’s really odd to me that arguing to give relief to the vast majority of Americans creates this incredible pushback,” she said, “When the federal government, through the Fed and the Treasury gave $30 billion in a bailout to Bear Stearns I didn’t hear anybody jump up and say, ‘That’s not going according to the market, that’s rewarding irresponsible behavior.’ We’ve got to get out of this mindset, where somehow, elite opinion is always on the side of doing things that really disadvantage the vast majority of Americans.”

First, people did complain about the bailout - see above for one, and many of the complaints hit directly on her main point, that "I didn’t hear anybody jump up and say, ‘That’s not going according to the market, that’s rewarding irresponsible behavior’." If she didn't hear that, or if none of her economic advisors did, then they aren't listening. That message was loud and clear.

The "if designed properly" part is strange too. Is she saying that as it stands, it's not a good idea, but she's pushing it anyway? Or is she saying that, as she has designed it, it is a good idea? Either way, it's bunk. She also says, "it’s really odd to me that arguing to give relief to the vast majority of Americans creates this incredible pushback." It's not giving relief that is causing the pushback, there are ways to give relief that don't give up on our environmental goals and have better efficiency properties, e.g. a lump-sum rebate to lower income households. The pushback is about the form of the policy, not the idea behind it.

I'll have to vote soon - Hillary or Obama - and mail in my ballot (we vote by mail here). I've had a bit of trouble deciding, but this will help.

Update: See also Brad Delong, Robert Reich, Richard Green, Ezra Klein, Ryan Avent, and Kevin Drum.

"What to Do About Gas Prices?"

Jonah Gelbach emails that he has signed on to post periodically at Economists for Obama:

What to Do About Gas Prices?, by Jonah Gelbach: As an economist, as a person who worries about climate change, and as someone who believes the Democratic Party's electoral success is very important, if only to spare us more of the damage that the GOP has done over the last quarter-century of its hammer lock on federal policy, I find political discussion of gas taxes to be extremely frustrating to watch.

Democratic politicians regularly use high gas prices as a club with which to beat Republicans. I understand that politicians use the issues they think will work. And the nexus between oil company profits and GOP officials whose policies have been awful for most people in the bottom four quintiles of the income distribution (and probably plenty in the top one) has got to be pretty tough for Democratic candidates and officials to resist.

But the fact of the matter is that gas prices should be high. They should be high for the very simple and now very obvious reason that the pressure on the world's climate needs to be reduced. Our country's foolish policy of keeping gas prices low while providing implicit (and sometimes explicit) subsidies to the vehicles that get the worst mileage should have ended many years ago. Demand-side pressure on gas prices is finally pushing gas prices into the range they should have been for many years.

But that last paragraph tells only part of the story. One effect of the low-gas price policies we've pursued for so long is that it's induced many people to buy very fuel-inefficient cars and trucks. These are the people who are getting nailed hardest in the wallets by today's high gas prices, and I don't blame them for being upset. If you drive a vehicle that gets 18 miles per gallon for 12,000 miles a year, then you use about 670 gallons of gas a year. Even a $1.00 per gallon increase in the price of gas over a period of one year alone therefore translates into more than the stimulus tax rebate that a single person with sufficient income will receive over the next month. A married couple each of whom drives such a car 12,000 miles a year will receive a smaller rebate than the one-year cost of a $1 per gallon gas price hike.

By any reasonable standard, the increase in gas prices translates into real money for a huge number of people in this country, especially under current economic conditions.

But since the reason this is true is that American consumers have been induced to buy inefficient gas guzzlers, with serious environmental consequences, policies that would reduce the price of gas should be the last thing we consider. (On this score, the gas tax holiday that Sens. McCain and Clinton have proposed at least has the virtue that it would likely do very little, leading to at most a very small change in the price of gas; McCain's proposal would add to the deficit by increasing windfall profits of oil companies, while Clinton at least has proposed a new windfall profits tax to undo her proposal's provision of windfall profits.)

So what to do?