Speculators Get Blamed Once Again

It is an old hobbyhorse of economically ignorant politicians: when you don't like where certain prices are going, simply blame speculators.

The latest politician showing that he is not beyond using this populist trick is US president Obama. In the event he let's us unwittingly in on the fact that he holds very peculiar views on the process of price discovery. As reported by Reuters under the headline 'Obama blames speculators for rising fuel prices':


“I know that if you've got a limited budget and you just watch that hard-earned money going away to oil companies that will once again probably make record profits this quarter, it's pretty frustrating," he said.

Rising fuel prices are a persistent concern for the White House, which is concerned about their impact on the economy and on voters' wallets as Obama runs for re-election.

Average U.S. gasoline prices hit $3.84 a gallon last week, the most expensive since August 2008, as oil prices have soared above $100 a barrel. With pump prices already above the key level of $4 a gallon in U.S. cities like Los Angeles, San Francisco and Chicago, there is political pressure on Obama to act.

Obama said that global oil supply is adequate and that speculators are driving up prices significantly.

"It is true that a lot of what's driving oil prices up right now is not the lack of supply. There's enough supply. There's enough oil out there for world demand," Obama said.

"The problem is … speculators and people make various bets, and they say, you know what, we think that maybe there's a 20 percent chance that something might happen in the Middle East that might disrupt oil supply, so we're going to bet that oil is going to go up real high. And that spikes up prices significantly."


(our emphasis)

It is of course true that fuel prices and prices of other commodities have risen sharply. It is also true that speculators are buying lots of crude oil contracts, expressing their view that they expect even further increases in prices. This is the essential point – speculators act on their expectations of the future state of market data, not on the notion that currently, 'there is enough supply'. We would also doubt that the president actually knows how much is 'enough' supply. Since when has he become an expert on the oil market?

He is of course correct that 'people make various bets' in the markets, but to this is should be pointed out that the number of bets on falling oil prices is exactly equal to the number of bets on rising oil prices in the futures markets. The suspicion that events in the Middle East are imparting a price premium on crude oil may have some merit. Alas, opinions on this point differ and even if one were to concede that such a premium exists, no-one knows how big it is. Moreover the fact that 'something might happen in the Middle East that might disrupt oil supply' represents largely the long term outcome of the US government's (and by extension the entire West's) foreign policy in the region. If you prop up widely hated dictators for decades, you can not expect things to remain calm and under control forever.

Lastly, Obama makes it sound as though speculation in oil futures markets were somehow a nefarious activity. However, speculators do not get a 'free ride'. Successful speculation requires an ability to correctly estimate future conditions and it requires that the speculator risk his own capital. If his estimate of future conditions turns out to be incorrect, he will lose some or all of his capital. We can therefore state that in the long term, only the best speculators survive – i.e. the people most likely to correctly anticipate the future. Speculative activity is one of the most important facets of a free market economy. In fact, it is no exaggeration to state that without speculation, there can not be a free market economy (ultimately all entrepreneurial activities involve a degree of 'speculation' about the future). If not for the fact that speculators were driving prices both up and down, other actors in the economy  would not know to which uses to best direct their capital. High prices of a certain commodity are a signal to entrepreneurs that gives them an incentive to produce more of it. If this signal were absent, real shortages of the commodity concerned would eventually occur. 

We may concede that high commodity prices are negative for some and positive for other people. In the case of energy prices, the number of consumers hurt by higher prices is larger than the number of producers helped by them  (for speculators it is immaterial if prices are rising or falling – to them only the correct anticipation of future prices is important). Thus the populist, but economically illiterate garbage of blaming speculators for unpopular price increases is deemed to be a sure vote-getter. It is however a dangerous game to play. If speculative activities in the marketplace were to be curtailed as a result of this populist agenda, we would soon face major disruptions in the supply of the goods concerned and capital malinvestment would proliferate. That this danger is very real is revealed in the same Reuters article further below:

“U.S. Energy Secretary Steven Chu said on Tuesday he was concerned that rising crude oil and gasoline prices could undermine U.S. economic recovery.

Obama said the U.S. government was in a position to investigate unfair speculation.

Two U.S. agencies that investigate potential energy market manipulation – the Commodity Futures Trading Commission (CFTC) and Federal Trade Commission (FTC) – recently agreed to share information on potential probes.

"We're going to be monitoring gas stations to make sure there isn't any price gouging that's taking advantage of consumers," Obama said.

The CFTC is also weighing new rules that would slap "position limits" on big commodity traders that would cap how many futures and related swaps contracts any one company can control. The rules, which have been under debate since commodity prices first surged to records in 2007 and 2008, are aimed at tempering wild price swings.

"There is a Wall Street premium on gas prices today," CFTC Commissioner Bart Chilton, a strong advocate for imposing position limits, told Reuters.”


Whenever a politician invokes the term 'price gouging', know that you are  subjected to flimflam. High prices are the market's way of increasing supplies and rationing demand. At times so-called 'price gauging' can actually save lives, as David Brown notes in this article on the behavior of prices during force majeure emergency situations. Legal decrees fixing prices below what the market would  bear will simply result in shortages.

As regards CFTC commissioner Bart Chilton and his intention to 'introduce position limits' on futures exchanges in order to curtail the alleged 'Wall Street premium' on prices, this is a very bad idea indeed. It may well lead to a fall in prices in the near term by forcing large speculators to sell some of their positions. This will however invariably affect prices in the longer term, as lower prices in the here and now will lead to fewer supplies being produced and coming to the market in the future. Instead of helping commodity consumers the measure will end up hurting them. Bart Chilton is a hero among some of the 'silver bugs' who contend that a cartel of dealers has been suppressing silver prices (a contention that is rather difficult to defend these days given that the silver price has soared by more than 1,000% over the past decade). They completely misunderstand Chilton's intent and will be sorely disappointed if he really gets his way. Chilton has no intention of curtailing the activities of commercial hedgers – the very group that is the biggest holder of short positions in silver futures – he wants to curtail the activities of speculators, i.e. the group that has been on the buy side of the silver market over the past decade.

Chilton's initiative is also likely to simply move trading activities from US futures exchanges to competing exchanges elsewhere. One of the few  major competitive advantages of the US – namely its deep and liquid capital markets – will be put at unnecessary risk.

Lastly, neither Obama nor Chilton ever mention the major driver behind rising commodity prices: monetary pumping by the central bank. It is of course possible for certain prices to rise when speculators expect a supply shortfall in specific commodities. Alas, a broad-based increase in prices that grips the entire spectrum of commodity prices is a sure sign that the money supply is being pumped up and that newly printed money is rippling through the economy. So if Obama is really serious about wanting lower prices, he should consider abolishing the Federal Reserve and return the production of money and the determination of what serves as money to where it belongs: the free market.



West Texas Intermediate Crude Oil – a price increase politicians love to hate. Note that the large speculative net long position in WTI futures is at least partly offset by short sales in Brent oil futures, which currently trade at a historically very large premium – click for higher resolution.



A weekly chart of silver: it appears that the alleged 'price suppressors' don't have things very well in hand. About ten years ago, silver traded at $4/oz. – yesterday, it clocked in at $44 – click for higher resolution.



CFTC commissioner Bart Chilton wants to introduce position limits to get the 'Wall Street premium' out of commodity prices.

(Photo via: Brendan Hoffman/Bloomberg)



The Fed Proposes New Mortgage Standards

In another example of how dysfunctional our system of State Capitalism has become, Reuters reports on the Fed's new proposal regarding mortgage lending standards.  Some of you may want to avoid drinking coffee while reading this. There's a danger you may end up braying with laughter.

Writes Reuters:

“Lenders would be required to make sure prospective borrowers have the ability to repay their mortgages before giving them a loan, under a proposal released by the Federal Reserve on Tuesday.”


Say what?  Lenders should make sure that their borrowers can repay their loans? What a novelty!

If lenders making bad decisions could actually go bankrupt, would they perhaps have enough incentive to make sure that borrowers can actually repay their mortgages?

Maybe all we need to do is, you know, apply the rules of free market capitalism?

Instead, we have have a situation where such lenders can not go bankrupt, but are instead bailed out on the backs of tax payers and all the holders of dollar-denominated savings that get diluted by the Fed's money printing. This in turn apparently makes it necessary that the monetary bureaucracy draw up grandiose 'proposals' that require the banking cartel to act as though it were actually operating in a free market setting, instead of acting like the fascistic combine it actually is.

You simply couldn't make this up.

While the new rule seems likely to put a brake on mortgage lending, it is a typical example of the bureaucrats closing the barn door long after the horse has bolted. As such, the action is likely to further undermine the housing market's chance of recovery. Private sector mortgage lending – already dead as a doornail – will remain so for years to come.  As the new regulations inter alia specify:

The rule would establish minimum underwriting standards for most mortgages and lenders could be sued by the borrower if they do not take the proper steps to check a borrowers ability to repay the loan.

The law does provide protections from this type of liability if a loan meets the specific standards that are part of a "qualified mortgage."

In its proposal, the Fed is seeking comment on two possible ways of defining a qualified mortgage.

Under the first scenario the loan could not include interest-only payments, a balloon payment and regular payments could not result in the principle of the loan increasing. Under the alternative, the loan would have to meet all the standards laid out under the first option and meet additional requirements such as having the lender verify a borrower's employment status and debt obligations.

The proposal lays out a general standard for complying with the rule, including verifying a borrowers income, their employment and the amount of debt they have.

Mortgage originators who serve rural and underserved areas would be allowed to give out loans with balloon payments.

"This option is meant to preserve access to credit for consumers located in rural or underserved areas where creditors may originate balloon loans to hedge against interest rate risk for loans held in portfolio," the Fed said in a statement.


The fact that borrowers are put in the position to sue lenders is a typical nanny-state type regulation – it is essentially saying: borrowers can not be held responsible for their actions – they are too stupid to think for themselves and realize when a loan is too big for their ability to repay. Many people of course were too stupid to realize this during the boom and many lenders did  make irresponsible loans and encouraged irresponsible behavior. There were in fact many instances of outright fraud. It is not disputable that all of these things happened. This breakdown of morals and of responsibility is a rather typical side effect of an inflationary boom – inflationary policy is by its very nature anti-virtue and pro-irresponsibility.

Not one of these new regulations would be required if we were to simply state: from now on, there will no longer be any bailouts. If a lender makes imprudent loans and becomes insolvent, we will let him go bankrupt. There will no longer be such a thing as 'too big to fail'.

In other words, all that needs to be done is to hew to the rules of free market capitalism. Alas, in that case there would of course no longer be a need for the bureaucrats tasked with creating this mountain of regulations. They would have to look for a real job and do something productive.


Insider Trading – A Recent Case Study

We have previously written an essay that looked at insider trading and asked why such trading should be considered criminal at all. As we noted at the time, there is no ethical or free market case to be made for criminalizing trading based on an informational advantage. There is only a case to be made for companies to be able to protect their trade secrets. If a company's rules provide that certain information its employees are privy to may not be shared with third parties, such employees are apt to be held liable in a civil case.

However, at present the government also pursues insider trading as a criminal offense. As we pointed out, there are simply no clearly discernible standards as to when an informational advantage is considered legal and when it is no longer considered legal by the government. As a matter of fact, the Supreme Court has tended to side more often with those accused of 'insider trading' than with the SEC and prosecutors over the question of whether trading on non-public information ferreted out by aggressive research should be punishable by law.

Due to the fact that there are no clear standards, the government can 'pick and choose' whom it decides to indict. There are no clear rules and thus there is no level playing field. Prosecutors are as a result tempted to go after high profile 'perpetrators' mainly to further their own careers.

The Wall Street Journal has published a thoughtful article by Jonathan Macey, a professor at Yale Law School and a member of the Hoover Institution Task Force on Property Rights on the recent Galleon case, entitled 'Deconstructing the Galleon Insider Trading Case'.  Macey bemoans precisely the deficiencies of the law as it is currently applied that we also high-lighted. He notes that the courts have long held a view that seems quite different from that held by the SEC. He writes:

“The prosecution of Mr. Rajaratnam is not an isolated fight but rather part of an ongoing doctrinal war pitting the rather extreme views of the Securities and Exchange Commission against the carefully considered law of insider trading articulated by the Supreme Court. The SEC does not draw a distinction between trading on the basis of legitimate albeit unorthodox research and illegal trading on the basis of improperly acquired proprietary information. But it should.

Despite the court's rejection of the view that all trading on the basis of material nonpublic information is illegal, the SEC persistently litigates this issue. In landmark cases like U.S. v. Chiarella (1980), Dirks v. SEC (1983), and U.S. v. O'Hagan (1997), the court has distinguished trading on the basis of information that was legitimately ferreted out from trading on the basis of information that has been wrongfully obtained through fraud or theft.

The SEC long has contended in litigation and in regulation that trading on the basis of any information advantage, no matter how obtained, is illegal. It takes the view that even if a trader does legitimate research to get information about a company, then that person should have to disclose that information before trading. Such a rule would destroy the incentives of analysts and traders to do research.

Decades ago, Justice Lewis Powell, speaking for the court in Dirks v. SEC, made clear that traders should be free to collect information and trade on it. Imposing a duty to abstain from trading in a stock "solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market." The court added that it is "commonplace for analysts to ferret out and analyze information and this often is done by meeting with and questioning corporate officers and others who are insiders."

The Supreme Court recognizes that if a person acquires information in the course of legitimate business activities, like research or mining sources appropriately, then he has a right to that information and should be able to trade without disclosing it. The government, on the other hand, espouses a socialist philosophy that valuable information belongs to the people—regardless of how it was obtained.


For decades, the SEC has kept the insider-trading rules vague and undefined. This ambiguity increases the SEC's power and allows government lawyers to pick and choose among prosecution targets.”


(our emphasis)

The marketplace is not some socialist Utopia as the SEC apparently thinks it should be, and we certainly shouldn't wish for it to become one.

As we pointed out in our previous essay on the topic, market participants who are not in possession of an informational advantage will still profit from the activities of those who are. This is because the activities of better informed traders will influence prices in the short term and thus give other market participants a hint that something may be afoot  – whereas, when no such trading activities take place, everybody will simply be surprised when new information suddenly comes to light. Traders not in advance possession of such information won't be able to avoid the profits or losses that accrue to all shareholders once the information comes to light. As a result, no-one is actually protected by these regulations. In the main they seem to serve to hand the bureaucracy near-dictatorial powers.

This is of course the same bureaucracy that is today known for having ignored actual frauds such as the Madoff Ponzi scheme or the fraudulent scheme of banker Allen Stanford for many years, in spite of being made aware of damning circumstantial evidence – cases where a timely intercession may actually have protected investors from suffering losses.

As noted above, the current situation with insider trading rules is such that no-one really knows for sure when research goes beyond the bounds of what the bureaucracy still considers legal. The very least market participants should expect is legal certainty on such matters. We aren't holding our breath, but perhaps there is some hope. As one commentator at the WSJ perceptively remarked :

“Every eager prosecutor wants to fry a big-fish in order to advance their opportunities for a Federal Judgeship or some other position down the line.


The SEC and the FBI put together the cases, but it's the US Attorneys who deem them worthy of criminal prosecution in court. The problem there is that in the US Attorney's office, you don't have really anyone who's ever been in finance, has ever been an analyst or sat in on a road show. They have no concept of how information moves through the industry so they tend to try to prosecute everything, because that's their job, plain and simple. This wave of prosecutions, as harmful as it may be in some ways, will also help define what constitutes insider trading. The more cases the Justice Department loses, the fewer it will bring of the same nature. Notice that after the Bear Stearns Hedge Fund managers were cleared of criminal negligence, no other cases came claiming Hedge Fund guys tried to defraud their clients by engineering the '08 crash? The US Attorney's office is absolutely risk-averse. They will only bring cases they think they can win. The more cases are brought, the more clear the line will become.”


(we have edited the post for typos)



Galleon's Raj Rajaratnam – as Jonathan Macey argues, he has clearly violated the law in some cases, but the scope of the prosecution's case goes well beyond that.

(Photo via; Brendan McDermid/Reuters)



The First Hints of More Money Printing To Come

Lately, Federal reserve officials have taken pains to alert the markets to the fact that 'QE2' is indeed going to end in June. Alas, that would automatically bring about a shrinking of the Federal Reserve's balance sheet as time goes on,  as securities currently held mature. Moreover, since bank lending to the private sector continues to contract, there would be the prospect of outright monetary deflation taking hold at some point.

Naturally, this prospect can not please the helicopter pilot. Thus there are now the  first rumors circulating that a shrinking Fed balance sheet won't be countenanced. We will apparently get 'QE Lite' to forestall this possibility, just as Jim Rickards predicted a little while ago.

As Bloomberg reports:

“Federal Reserve Chairman Ben S. Bernanke may keep reinvesting maturing debt into Treasuries to maintain record stimulus even after making good on a pledge to complete $600 billion in bond purchases by the end of June.

The Fed chief’s top two lieutenants said this month the economy and inflation are too weak to warrant the start of a monetary-policy reversal. Investors and economists including David Kelly at JPMorgan Funds see that as a signal the Fed will keep its balance sheet at current levels by replacing about $17 billion a month in maturing mortgage debt with Treasuries.

Ending the reinvestment policy and the $600 billion program at the same time would be like quitting stimulus “cold turkey,” said Kelly, who is based in New York and helps oversee $400 billion as chief market strategist at JPMorgan. “It does make sense to reinvest for a while,” he said. “Then they could watch how bond yields react to that.”


Fed officials are starting to debate what steps to take after completing the purchases, a program dubbed QE2 for the second round of quantitative easing. Policy makers were divided at their last meeting on March 15, with a “few” officials saying tighter credit may be warranted this year, while a “few others noted that exceptional policy accommodation could be appropriate beyond 2011.”

Janet Yellen, the Fed’s vice chairman, said April 11 that surging commodity costs over the past year are “unlikely to have persistent effects on consumer inflation or to derail the economic recovery and hence do not, in my view, warrant any substantial shift in the stance of monetary policy.”

William C. Dudley, president of the Federal Reserve Bank of New York and the FOMC’s vice chairman, said April 1 that the recovery is “still tenuous,” while Bernanke said April 4 that higher commodity prices may have just a “transitory” effect on inflation.

Bernanke last month identified ending the reinvestment policy as one of the Fed’s tools for exiting stimulus and draining reserves from the financial system.

The Fed chief may be asked how long the reinvestment policy will be maintained in a press conference April 27, and “he’ll probably say that will depend upon the tone of the economic indicators in the months ahead,” said James Kochan […]


We can't have 'cold turkey' of course. That would reveal the scale of capital malinvestment the Fed's monetary pumping has engendered rather quickly. However, there is good reason to believe that merely halting the further expansion of credit and money will suffice to bring a number of uneconomic activities that depend on the expansion to a halt.

Thus  the famed 'tone of economic indicators' is likely to deteriorate markedly once QE2 ends. Be therefore prepared for even more monetary pumping after a brief pause. Wealth destruction at the hands of hubristic interventionists will  likely continue apace until the markets themselves stop them. The same goes for the deficit spenders in Congress – as Lew Rockwell remarks in 'The Budget Battle', one should expect very little by way of actual spending cuts from the recent budget debate. Writes Rockwell:

“Watching the public debate on the budget, we are reminded of two boys on the floor playing with toys. One has a bear and the other has a dinosaur. They are forever threatening the other kid with taking the toy away. One warns he will take away the dinosaur (military spending) and the other says he will grab the bear (domestic spending). They pull and tug and eventually settle the dispute so long as each gets to keep his favorite.  Oh, and one other thing: both toys belong to other children.

That’s the public debate, which should strike anyone as preposterous on its face. If the goal in this crisis is to balance the budget without raising taxes, everything has to be cut regardless of political ideology. But of course that’s not what political parties do. The goal of a political party is to shovel the largess in the direction of its constituent supporters while punishing the loyalists of the other party, which is attempting to do the same. The tit-for-tat is always resolved the same way: more for both sides, from third parties.”


This strikes us as a very apt description of the process.



Ben Bernanke: don't worry, there won't be any monetary  'cold turkey'.

(Photo via: AP)



Janet Yellen: forget about rising commodity prices. Easy money is here to stay anyway.

(Photo via: Price Chambers/Reuters)



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