True North

A reader asks whether a law proposed by some in Congress and Obama to limit oil speculation is a good idea? I was asked at a presentation yesterday how much of current oil prices I thought were speculation. Jim Hamilton has been trying to estimate that for about a month now, and my answer is the same as Jim's and Paul Krugman's -- if you are speculating and forcing price up above equilibrium, there ought to be a surplus that has to be stored somewhere (and storage isn't cheap.) Krugman's graph is instructive.

The story from foreign exchange markets, that we first learned from Milton Friedman, is that speculators stabilize rather than destabilize markets because they are providing new information to the price. If they were providing bad information and destabilizing prices, they would be buying high and selling low, not a good way to make money. Instead speculators are seen as buying when prices are lower than their best guess for equilibrium and selling when prices are higher than equilibrium. Both forces push the price towards the market-clearing level. Mark Perry has another graph that illustrates this.

Stopping speculators either stops the stupid ones from losing money or prevents stabilizing the price of oil. Why would government want to do either? If you're going to blame the speculators for anything, says Arnold Kling, blame them for keeping oil prices too low in 2006-07.

I am reminded in this of a story I always tell in principles classes (again, based on a chapter in Heyne's intro book): We are all speculators. Those who want to expand drilling now think the price is going to go up in the future without increased supply (and look at the flat supply from the last two years as evidence in favor of their view.) Those who don't want to expand drilling are speculating either on finding a warp drive or a willingness of Americans to drive in very dangerous cars. (I listened to a friend the other day happily discuss building an electric car with an old Karmann Ghia chassis with a fiberglass body. All smiles until I asked, "wouldn't that be dangerous?" "Well, I'd only drive it to the nearest town." "What share of accidents happen within two miles of home?")

Cross-posted and comments welcome at SCSU Scholars.