Pageant of Ignorance

by Don Boudreaux on July 18, 2008

in Myths and Fallacies, Politics, Prices

Here’s a letter that I sent on Monday to the Washington Post:

Re Robert Novak’s “Oil Paranoia” (July 14): We humans have a long and embarrassing history of blaming devils for distressing aspects of reality that we don’t understand.   Droughts, floods, plagues, and erupting volcanoes have all been ascribed to the machinations of unseen super-powerful entities – as ill-defined as they are ill-intentioned – who manipulate a reality to which they are immune but to which we mortals must inevitably bend.

Today’s witch hunt for speculators who allegedly are driving oil prices to heights unconnected with the realities of supply and demand is just the latest entry in this pageant of ignorance.

Sincerely,

Donald J. Boudreaux

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{ 23 comments }

indiana jim July 18, 2008 at 11:09 am

Yes, and where is the angst over the short selling speculators who over the past several days have contributed to the fall the barrel price of crude?

Methinks July 18, 2008 at 11:38 am

Yes, and where is the angst over the short selling speculators who over the past several days have contributed to the fall the barrel price of crude?

That angst is currently directed at that short selling speculators who have contributed to the fall in the price of financial institutions.

as one trader put it: "We can't buy oil and we can't sell financials".

Let's just put in price controls and be done with it already…so, we can get to the backlash to price controls faster.

Ryan July 18, 2008 at 12:04 pm

I can't wait to buy your book when it's no longer priced in the stratosphere. I love your witty and sardonic prose. Keep fighting the good fight!

True_Liberal July 18, 2008 at 5:04 pm

I think you would readily accept the fact that the housing "bubble" came about by increased demand, supported by unrealistic (unscrupulous?) marketing and lending practices.

The buyers can only be described as "speculators" (whether witting or unwitting). If speculators thus affected housing prices, why do you resist admitting this in the oil market?

BoscoH July 18, 2008 at 5:23 pm

I think you would readily accept the fact that the housing "bubble" came about by increased demand, supported by unrealistic (unscrupulous?) marketing and lending practices.

I wouldn't accept that those were either the only or predominant causes. Low interest rates and loans structured to keep payments low drove up prices. If you wanted a nice place to live and these made it possible, it's a bit disingenuous to yell fraud or speculation after-the-fact.

L. Shane Carlson July 18, 2008 at 5:34 pm

"pageant of ignorance" – that is a classic, you are a true poet.

Terry July 18, 2008 at 8:34 pm

Let's tell Delta Airlines. I had to listen to a "Stop Oil Speculators" tirade just to confirm a flight today. Delta apparently believes that speculators are the source of all their problems.

piperTom July 18, 2008 at 9:30 pm

Methinks (11:38:57) wants your book, but "on the cheap." I hope you have a thick skin, Honored Sir Don, because I have to say 'me too."

And thank you for the onion* story, a few days back. I strongly suspected that speculators were not causing our difficulties. Now, with both you and Mike Munger assuring me, I only have to worry about the Real Culprit: Congress.

*onion: strongly flavored roots, not The Onion.

Methinks July 18, 2008 at 9:38 pm

The buyers can only be described as "speculators" (whether witting or unwitting). If speculators thus affected housing prices, why do you resist admitting this in the oil market?

Because the housing market is illiquid and short selling is impossible. Illiquid markets and those where short selling is either prohibited or impossible are more prone to bubbles. Prices can deviate significantly from fair value because positive opinions about future prices are over-represented.

The oil market is extremely liquid and short selling is unlimited. Markets with those characteristics allow both positive and negative opinions to be represented and large persistent deviations from fair value are impossible. Note how quickly the market adjusted to the changes in expectations just this week.

Curious July 19, 2008 at 2:13 am

I was just wondering though. Should the fact that the price of oil fell by $8 in a day not indicate that speculators might have some role to play in today's prices? Unless demand suddenly fell or supply increased substantially (neither of which seem to be the case), it seems that speculators are a plausible cause of this.

vidyohs July 19, 2008 at 8:42 am

I seriously doubt that more than one or two people in Congress really are intent on doing something positive. The rest are simply doing what they do best, dodge resposibility and point fingers.

The people never learn.

Sam Grove July 19, 2008 at 10:53 am

Politicians routinely fall at the bottom of trustworthiness polls, yet somehow they manage to be seen as saviors to the downtrodden.

Again I recommend Orsen Scott Card's book Treason.

Methinks July 19, 2008 at 9:00 pm

Unless demand suddenly fell or supply increased substantially (neither of which seem to be the case)

That's where you're wrong. The probability of an attack on Iran fell significantly and oil inventories (released weekly) showed a build of 3 million barrels rather than the expected draw. The build in inventories is an indication of a fall in demand and the lower probability of an attack on Iran signaled a lower probability of a supply constraint. Speculators adjusted quickly by lowering their oil price expectations.

vidyohs July 19, 2008 at 9:58 pm

Methinks,

Question.

Regarding the post by curious in which this was written:
"Should the fact that the price of oil fell by $8 in a day not indicate that speculators might have some role to play in today's prices?"

Would it be appropriate to say that the $8 drop was something that speculators had to respond to rather than something they caused?

Methinks July 21, 2008 at 9:27 am

Vidyohs,

I think it would be more accurate to say that the $8 price drop resulted from oil market participants' response to new information which changed expectations for the oil price. The response was to a change in information, the result was a change in oil price. It doesn't matter whether those market participants are speculators or not, they all have to respond to the same information and it is the information and change in expectations that drive the oil price and not the the type of participants in the oil futures market (which is what I think you were implying and I agree with you).

Bruce July 21, 2008 at 9:41 am

Just to play Devil's advocate for a moment. Let's assume that there is some speculative premium in the price of oil that cannot be currently quantified. It may be 50% of the barrel price – as Dick Morris recently stated in a speech. It might also be negligable, which seems to be the majority opinion on this board.

Here is my suggestion: why not raise the margin requirements for oil investing to 50% (from the current 5%), consistent with equity investments? One way or the other, it seems that this would expose most of the speculative premium in the current market price of oil as the dramatic returns afforded by highly leveraged positions would be eliminated.

If Professor Boudreaux is right, prices should remain stable. In this case the margin requirement can be reduced back to 5% and the theory of the evil speculator will be disproved. If others, like Dick Morris, are correct one would expect to see a sharp drop in the price of oil. I see that as a win/win.

Am I mistaken in my reasoning?

vidyohs July 21, 2008 at 10:31 am

Methinks,

Thanks for the reply.

I really am ignorant about how it actually works, that is why I am here on this blog and why I read the hosts, yourself, Mesa Econoguy, et. al, because I learn. All I have is that street level knowledge 66 years have given me.

I asked not to imply but to find out if I was correct in that it seemed intuitive that the $8 drop could not be laid at the feet of speculators anymore than an $8 jump could have been.

It seemed obviously unlikely (counter-intuitive) to me that the mysterious gang of speculators that are controlling the oil supply (T.I.C.) got together and agreed to begin buying and selling at an $8 reduction.

Just further proof in my mind that when you, the hosts, et. al., say speculators aren't causing the increases, you are speaking reality.

Methinks July 21, 2008 at 12:46 pm

Vidyohs,

Your intuition is pot on, then.

Your quest to learn about things puts your understanding at well above that of congress, currently conducting the latest version of the Spanish Inquisition. Intoxicated by their own massive ignorance, they are thrusting the full weight of government's coercive power to root out the evil witches who will surely be the cause of their next lost election. As usual, those evil sorcerers are somewhere in the uncontrolled decisions of the masses.

Makes me feel all warm and fuzzy toward or public serpents…uh..servants.

Methinks July 21, 2008 at 12:57 pm

Just to play Devil's advocate for a moment. Let's assume that there is some speculative premium in the price of oil that cannot be currently quantified.

Let me play devil's advocate for a moment and ask a more relevant question. What if fairies wore purple dresses, flew in posses of 10 and granted wishes to pretty people?

Fantasy?

No more fantastic than your question.

Futures contracts are the easiest derivative to price. They are spot price of oil + cost of storage + interest. All three components are known. If a speculative premium cannot be quantified it is only because the person doing the quantifying isn't capable of fourth grade arithmetic. If demand for futures contracts is driven up (reflect a "speculative premium"), speculators will seek to profit from that premium by shorting contracts right to the point where that premium is eliminated. The only way for that premium to exist is to reduce liquidity in the oil futures market by jacking up margin requirements (driving marginal players out of that market and reducing participants) and by other restrictions on the number of market participants.

Go ahead and try that. Reducing liquidity is the fastest way known to man to ensure that a speculative premium will exist for more than 10 seconds.

Bruce July 21, 2008 at 3:22 pm

Methinks,

I wonder if you would have posted similarly 3 years ago during the peak of the housing bubble or 10 years ago during the peak of the tech bubble? You will likely counter that the assets in question and the markets on which they trade are dissimilar, which is true. But the short term irrational behavior of those markets is not dissimilar.

You seem to discount the possibility of the market acting irrationally in the short term. If I follow your logic, market irrationality should be eliminated by "fourth grade arithmetic" and, on the blackboard at least, it is. The theory is correct, it just fails in practice. After all, one would assume basic arithmetic (Benjamin Graham's basic formula of PE and Equity/Asset ratios for example) would have applied eight years ago to stock valuations and yet somehow the Nasdaq composite topped 5000 with a P/E of 388. Where were all the short sellers and value investors bringing equilibrium to the market during that run? Were they out chasing purple fairies? (Sorry to be snarky but you introduced the purple fairies to the thread)

Further, who is to say that the current 5% margin requirement provides the correct amount of liquidity to the market? Is it not posssible that 5% is too low just as 50% might be too high? The debt and equities markets manage to function on 50% margin requirements and don't seem to lack for participants. Is it also not even within the realm of possibility that today's 5% margin purchases of oil futures are tomorrow's sub prime mortgage portfolios? Naahhh! No chance that an institutional investor would ever make THAT kind of mistake and be caught short when the market corrects. Can anyone be certain that today's oil investors are more savvy and rational than Bear Stearns CDO portfolio managers were?

Having said all that, I don't believe in the myth of the evil speculator. I do believe in the reality of the irrational short term market and I think (and I admit there is a distinct possibility I may be wrong) that the 5% margin requirement contributes to that irrational behavior and should be raised.

In the long run, the market will correct; it always does. The question is how long can we wait for the market to once again act rationally. Not that I'm a big fan of Keynes, but he was right when he said "the market can stay irrational longer than you can stay solvent".

It is not often that I disagree with your opinions or those of our hosts, but this time I think you may be mistaken in rigidly defending the status quo.

Methinks July 21, 2008 at 6:01 pm

I wonder if you would have posted similarly 3 years ago during the peak of the housing bubble or 10 years ago during the peak of the tech bubble?

Nope. I can tell you exactly what I did say about the housing market three years ago – "What the hell are these Bozos thinking Who is giving them the bad crack?" and continued to rent.

I can tell you exactly what I said during the tech bubble: "I don't know if these prices reflect the real value of the stocks, since this is new technology and so much of the valuation of these tech firms is in FGV, it's difficult to disagree with either the lowest or highest valuations. It is worrying, though, that anything at all with a "dot com" at the end of its name is enthusiastically embraced by the market." I gave this answer as part of the an interview question for an equity research position (yes, I go the job).

There are some key differences in dot com stocks and the housing market. And these differences make all the difference in whether there will or won't be a bubble.

The housing market is extremely fragmented, illiquid and impossible to short. This makes it impossible to correct prices and it is prone to bubbles. The oil futures market, in contrast, is not fragmented, extremely liquid, easy to price and has no short restrictions.

The dot com boom resulted from new technology and there was a lot of disagreement about fair value. Imagine trying to guess the impact of television or computers when they first came out. The valuations that those two technologies would have traded at had people known the impact would have been much higher had the impact been correctly guessed at the time that technology first hit the market. Opinions about the impact of the internet and associated technologies varied widely and it was difficult to identify market saturation ahead of time. These kinds of markets are prone to bubbles as well.

Oil futures, by contrast, are not a new, difficult to price asset. In fact, it is a very old, exceptionally easy to price asset.

You seem to discount the possibility of the market acting irrationally in the short term.

No, I don't. I'm just saying that "short term" in a liquid, easy to price market lasts about a second.

Benjamin Graham's basic formula of PE and Equity/Asset ratios for example

I hate to tell you this…but, Graham & Dodd's fancy and loooooooong formulas are a lot less intuitive and precise than the formula for futures pricing. One of Graham Dodd's pricing formulas is rocket science compared to futures.

Further, who is to say that the current 5% margin requirement provides the correct amount of liquidity to the market? Is it not posssible that 5% is too low just as 50% might be too high?

The "correct" amount of liquidity is always as much as possible. The more opinions, the more sure you are of the price, the tighter the market and the lower the transactions cost. The margin should be low enough that it maximizes the number of market participants to increase liquidity and high enough that participants can't get so levered that large numbers of them can blow themselves up when trades go against them. The right amount of leverage is rightfully determined by the leverage providers because a lot of things are taken into consideration when extending leverage.

"It is also not even within the realm of possibility that today's 5% margin purchases of oil futures are tomorrow's sub prime mortgage portfolios?"

Simply put: highly unlikely. Unlike housing loans, the assets backing these loans are very liquid and can be disgorged quickly to meet margin calls. Leverage is a whole side discussion on its own. But, that's not the context in which you brought up margin. That's a whole different conversation. You wanted to increase margin to reduce trading – i.e. liquidity. That's a stupid reason to jack up margin. While the buyer is using that margin to buy futures, the seller is using that margin to sell futures. Incidentally, a reduction in liquidity in the oil futures market will translate into higher margin requirements (depending on how much the liquidity is reduced) to compensate for the lowered ability to disgorge large positions without moving the market around. In these markets, unlike the housing markets, margin is sort of self-regulated.

In the long run, the market will correct; it always does. The question is how long can we wait for the market to once again act rationally.

In the deep, broad, easy to price, extraordinarily liquid oil market? 10 seconds would be "the long run". Your question assumes an irrational market. I should mention that you have presented no evidence that the oil futures market actually is behaving irrationally.

Not that I'm a big fan of Keynes, but he was right when he said "the market can stay irrational longer than you can stay solvent".

I love that quote. It's particularly true of illiquid markets. Also true in the short run when volatility picks up in markets due to some catastrophic event like the Russian debt default.

I also love "in the long run, we're all dead", which is also a quote attributed to Keynes. I should remember that one more often when I get frustrated.

but this time I think you may be mistaken in rigidly defending the status quo.

Well, okay. Fine. Let's restrict trading in oil futures and see what happens. I don't have a long commute and I live well within my means, so I can afford it :)

Vidyohs July 21, 2008 at 8:30 pm

"Well, okay. Fine. Let's restrict trading in oil futures and see what happens. I don't have a long commute and I live well within my means, so I can afford it :)
Posted by: Methinks | Jul 21, 2008 6:01:52 PM"

Good summation, but can I say Ouch on the cost of travel?

Houston may not be as populated as NYC but it is one big ass city in area and it takes me an hour to just get across the city on the freeways, no lights and no traffic tie-ups. And, girl, I don't drive slow.

I pass all my expenses on to my customers, who I assume pass it on to the lawyers (I hope), but this is so new I don't know when I may be required to eat a bigger share of the fuel costs.

Instead of waiting to prove a point, I suggest we refresh that Tree of Liberty with the blood of a few tyrants. :-) Of course I, I , I would never pull a trigger. Bigger :-)

Methinks July 21, 2008 at 9:32 pm

Vidyohs,

You are hilarious ("And, girl, I don't drive slow.")!

I used to spend some time in Houston and Dallas when I was an oil E&P analyst. Oh, the humidity! But I do love Texas. There's just a whole layer of BS that never seems to settle on a West Texas wildcatter. Know what I mean?

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