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April 18, 2012, 12:02 a.m. EDT
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By Aaron Brown
NEW YORK (MarketWatch) "” With crude oil nearing the highs it reached in the 2007-08 commodity boom, there is the usual spate of editorials blaming "speculators" for the prices.
It never seems to register on the authors that for every buyer there is a seller, so there's no reason for transactions to push the price systematically up or down.
No one thinks that if you bet me $20 the Yankees will win the World Series it makes any difference to the baseball season, and if Yankee manager Joe Girardi blamed his team's defeat on my bet he would be properly laughed out of baseball. But somehow it's OK to write that if you bet me $20 that oil prices will go up, you're responsible for people paying $4 a gallon for gasoline.
I think the misunderstanding begins with the silly fairy tale about futures markets existing so farmers and millers can fix a price for the farmer's crop ahead of the harvest. No farmers were involved in setting up futures markets, and they have usually been suspicious of them or tried to have them shut down.
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Farmers have signed agreements with local crop buyers as long as they have sold crops for money, everywhere in the world. Modern futures markets only arose in the 1850s, starting in a few cities on the Mississippi River. A crop buyer agrees to the exact crop the farmer is raising, in whatever quantity the harvest produces, and takes nearby delivery. A futures contract requires standardized terms the farmer's crop is unlikely to meet, and requires the farmer to guess his harvest yield and deliver to a faraway transportation hub.
Millers do use futures markets, but they sell grain, they don't buy it. In a standard transaction, a miller goes to a local grain elevator and contracts for the precise type and grade of grain he wants, delivered to him or a convenient location. Then he goes to the futures markets and sells standard contracts for future delivery of the grain. He gets grain today and promises to deliver grain in the future. He has borrowed grain.
Why doesn't he borrow money instead and use it to buy the grain? He would, if there were plenty of credit and good money available. In the 1850s futures markets were invented because there wasn't enough gold and silver money in the American West, and government regulations had destroyed the banking system that could have provided credit. From 1900 to 1970, with a currency linked tightly to gold and a sound banking system, futures markets lost their economic prominence. When the U.S. dropped the gold standard and introduced persistent high inflation and complex taxes with high marginal rates in the 1970s, futures exploded in volume and expanded from agricultural products to financial products. Things calmed down a bit from 1983 to 2008, but with a broken banking system, uncontrolled government deficits, and greatly expanded financial repression, futures markets are once again a preferred alternative to money transactions.
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The farmer-miller fiction usually goes on to claim the purpose of futures markets is price discovery and hedging. But why did people in 1850 suddenly decide they needed second-by-second price quotes for a few grains, and not things like coal, iron, land, or gold that had far more economic importance, or for that matter, interest rates, foreign exchange, or equity prices? And why did it happen in primitive backwaters instead of London or New York? Why did the futures markets stimulate tremendous economic innovation? Why do traders yell and scream, and get in fistfights, and get rich if all that's going on is agricultural price discovery? What people needed in 1850 "” and this is very clear from reading the history and considering the development of these markets "” was financing for commodity-related businesses, not price discovery or hedging.
The miller cannot use grain futures contracts to hedge his risk. His concern is the value of milling services, the spread between the price of flour and the price of grain. If grain prices go up due to an increase in demand, there will be more demand for milling services and his profits should increase. So he could hedge by selling grain. But if grain prices go up due to a decline in supply, there will be excess milling capacity. He would hedge this by buying grain. Not only doesn't he know which way to hedge, grain prices are actually a small part of his business risk compared to energy, labor, tax, and capital costs, none of which were traded on futures markets at the time (and only energy is traded today).
Similar to the farmer, if the miller wants to lock in a price, he goes to a local grain elevator that can supply what he actually needs when he actually needs it, not a futures market for a standardized product he cannot use, with delivery time and place chosen by the counterparty.
Since the miller is going short futures contracts (that is, promising to deliver grain in the future), the "speculator" going long (that is, promising to accept grain in the future) is actually lending grain. This is the opposite of hoarding. A hoarder stores commodities today with the intention of selling them in the future, reducing currently available supply and increasing future available supply. The futures speculator makes more of a commodity available today and reduces future supply. The illogic of the anti-speculator crowd is demonstrated when they blame both activities for increasing the price of commodities. In fact, the price of commodities is influenced by both current and future supplies, and there is no first-order effect of shifting consumption around in time.
Up to this point, I expect no disagreement from anyone who has thought about this for more than a minute. But there is an objection that takes a little more subtlety to answer. It seems as if the speculator going long grain is not lending anything, not making anything more available today; he's just betting on price movements. He's not doing anything in the future either, because he will roll his contract when it comes due (replace it with a contract farther in the future) or settle for cash, not accept grain.
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CORRECTED
BOE voted 8-1 to leave asset buys unchanged
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