Paul Krugman was gracious enough to acknowledge our past differences on the matter of commodities speculation, which was specifically about oil markets. It was the subject of a long running
argument conversation between his blog and mine in spring 2008, which I recapped in ECONNED.
In brief, Krugman contended that the skyrocketing oil prices of early 2008 were the result of fundamental factors (and we pointed out that we were puzzled by his stance, since he, unlike the vast majority of Serious Economists, has been willing to call some past bubbles in their making). As he reiterates on his blog today, if the prices exceed the level dictated by supply and demand in the real economy, a standard microeconomic analysis would expect there to be inventory accumulation, aka hoarding.
Ironically, a reader has a guest post near completion on the oil markets, and we want to briefly recap our prior work here. Our objection to the standard textbook analysis was that it does not take market structure into account. As we detailed then, there are ways to store oil that do not show up in the official inventories, which have very limited capacity and are actually not terribly convenient. In addition, Krugman has maintained that those (like Mike Masters) who point to the volume of money flowing into commodity indexes just don’t get it. Since futures prices eventually converge to cash markets prices, you need to tell a story that involves the physical markets to make a case on speculative impact that sticks.
In oil, however, that is not how the futures markets work. Most of the oil sold is not based on spot market prices (which have been manipulated successfully in the past) but under long term contract based on futures prices, with the most widely used formula a weighted average of futures prices. So at least over the intermediate term, demand for most of the oil traded is inelastic and the futures market determines the price at which most oil is purchased.
I’m glad that Krugman is weighing in with a revised take and narrowing his argument to agricultural commodities. It’s big of him to take criticism and incorporate it into his work. I am a teeny bit troubled, however, that the construction of his post might lead his readers not familiar with our work to think our past objection was based on a weight of money argument.
Note finally I have not yet come to a point of view on the ag complex. There are clearly some commodities where supply drops are significant and a large price increase is not hard to understand. However, this is far from universal, and I want to dig a little deeper into how some of these markets work.