For well over twenty years in my various energy pricing and policy classes I have pointed out that every energy price spike leads to accusations of manipulation and gouging and a call for an FTC investigation . . . which is always announced with great fanfare but never finds anything–something that is announced sotto voce, if announced at all.
President Biden called on the Federal Trade Commission to investigate whether oil-and-gas companies are participating in illegal conduct aimed at keeping gasoline prices high, in the latest effort by the White House to respond to public concerns about costs for everything from fuel to groceries.
Sisyphus would understand the drill. “Time to roll the price gouging rock up the hill again.”
And for the most idiotic, demented hot take, let’s turn to Lizzie Warren, speaking on Joy Reid’s show (talk about a singularity of stupid*):
Prices at the pump have gone up. Why? Because giant oil companies like @Chevron and @ExxonMobil enjoy doubling their profits. This isn't about inflation. This is about price gouging for these guys & we need to call them out. pic.twitter.com/kxiQkC2tYa
Recall, this is about a change in prices. So if the change in prices is due to gouging by oil companies, it would have to be due a change in gouging behavior. (I think even Joy and Lizzie should be able to follow this, it’s so basic: but maybe I’m too generous.)
But let’s follow that thread. It would imply that until recently, oil companies were not exploiting the opportunity to “double their profits” by price gouging.
So what happened? Did one day a few months ago the CEO’s of Chevron and ExxonMobil et al have a V8 moment, and slap themselves on the forehead and say “Wow! I could have doubled my profits by jacking up prices!”
So if they could screw consumers at a whim by jacking up prices why did they let oil prices go to single digits in 2020? Why does the urge to gouge seem to wax and wane?
This is so incandescently stupid. But I guess I should consider the sources, and remember that this sort of incandescent stupidity spikes every time oil prices do.
If the FTC exhibits the integrity it has in the past, this investigation will end the way all the others have, with a whisper not a bang, stating that fundamentals are the driver. But there is no guarantee that the current FTC will indeed exhibit such integrity, given how degraded government institutions have become (not that they were ever paragons, but everything is relative). Political imperatives and narratives, not realities, rule the day.
* Lizzie was dean of Harvard Law School, and a professor of law there. Joy Reid went to Harvard. God save us from Harvard.
No, this is not a post about baseball, with an outfielder running to the wall only to watch a home run soar over his head. It’s about the copper market, where backwardation (a positive difference between the price for immediate delivery–“cash”–and a futures price) has soared, and inventories have gone yard.
The peak of the frenzy was Tuesday of this week, when at one point the cash-threes backwardation on the London Metal Exchange (LME) soared to $1050/tonne (them’s metric tons, y’all).
LME COPPER FUTURES moved into a record backwardation on Oct 19 as available stocks in exchange-registered warehouses declined to the lowest level since 1974: pic.twitter.com/9IuO6r3jou
That was apparently an intraday price, because the official PM cash-threes back on that day was a mere $382.
The LME is unique in that it trades contracts for specific dates, and so there is a “tom-nex” spread too: the difference between the price for delivery tomorrow, and the price for delivery the day after that. Last Friday, this “daily back” reached $175/tonne–meaning copper delivered Monday was worth $175 more than copper delivered Tuesday. The tom-nex remained over $100 on Monday and Tuesday.
Backwardation on COMEX copper has also jumped recently. Here’s the October 21-January 22 spread(HGV1-HGF2).
Meanwhile, inventories have plummeted, declining to a mere 14,500 tonnes on Tuesday, down from around 250,000 MT in late-August:
So what’s going on? Let me first consider a fundamentals-based story.
The spreads between futures with different maturities for a storable commodity send signals on how to allocate resources over time. When demand is high/supply is low today relative to what is expected in the future, it is optimal to draw down inventories, and prices move away from “full carry” (i.e., spreads that cover the cost of carrying inventory) to incentivize this drawdown. With extreme (but expected to be fleeting) temporal imbalances, it can be optimal to consume all inventories and meet future demand out of future production (because future demand is expected to be lower or supply higher than at present). These extreme temporal imbalances lead to large backwardations to punish storage.
Backwardation is supposed to attract metal but this week’s deliveries into LME warehouses have so far amounted to a meagre 9,775 tonnes despite the biggest incentive in the market’s history.
No! Backwardation punishes stockholding–it’s an incentive to move stuff out to be consumed today rather than hold it into the future when it is anticipated to be more abundant.
In some respects, what is going on in copper is similar to what happened in lumber, which I wrote about some months ago. The lumber market went into a huge back due to tight fundamentals and inventories were low.
The good news here is that these price signals indicate that the extreme imbalance is expected to be temporary: copper is scarce today relative to what is expected to be the case some months from now. That’s pretty much what happened in lumber.
So why the temporary scarcity (relative to expected future scarcity)? One plausible explanation is energy prices, which are high now going into the high-demand winter season in the Northern Hemisphere. Due to supply responses that can occur in a period of months but also the seasonal decline in heating and power related energy demand, these prices are likely to fall. Metals refining is energy intensive, so such a rise in energy prices pushes up the metals supply curve today relative to what’s expected in the future: this can produce exactly what we’re seeing in copper, and is also becoming evident in zinc, nickel, and aluminum.
China is of paramount importance in metals refining, so the artificial shortage of power there (caused by price controls and high fuel prices) is exacerbating this problem. Power cutbacks to intensive energy consumers are exacerbating the short term supply disruption.
This points out how the world is hostage to Chinese policy–and Chinese policy mistakes. China has become so important in this area not because it sits atop large, cheap supplies of ores. Low labor costs made it cheaper to locate refining there, even taking into account transport costs. But also, Chinese subsidies of various sorts–financial suppression that makes capital cheap and subsidized power prices–have attracted arguably excessive amounts of capital to metals refining there. And add to that the relative indifference of China to pollution–and metals refining can pollute the air, the water, and the earth: lower environmental standards lead to lower costs and a great incentive to locate production in China.
The fallout from a concentration of metals refining capacity in China is reverberating around the world right now. Not just copper but a variety of metals are going haywire because of the energy-driven supply disruptions in China. Magnesium is just another example.
The former is a fundamentals-based story (albeit one in which central planning has distorted the fundamentals). Is this all that is going on?
Corners can also cause soaring backwardations. The LME was sufficiently concerned about the situation in the market to impose a limit on the amount of daily backwardation to .5 percent of the cash price (which is still a 180 percent annual rate boys and girls). The cash-threes backwardation has fallen by almost two-thirds (to $116/MT today) in the days since.
Fingers have been pointed at Trafigura for loading out large amounts of inventory, thereby exacerbating the tightness. Trafigura says it did so to meet obligations to customers. This would be consistent with the fundamentals story.
But . . .
It is not unknown for firms with large inventory holdings to remove them from the LME to create an “artificial” tightness, or to provide a cover story for a corner. Moreover, if a single firm owns enough inventory to be able to deplete stocks materially on its own, it doesn’t take too large a paper position for it to have a literal corner. Or even if one firm hasn’t cornered, a small number of firms with large physical and paper positions can have a nice little oligopoly that allows them to exercise market power, of which large backwardations are a symptom–and a source of profit. Think of how much money the holder of a large prompt position could make rolling that over at $100+ per day, day after day.
Put differently, fundamental tightness can create market power, and the exercise of this market power can greatly exacerbate backwardations.
The sharp drop in the cash-threes back after the LME intervened lends some plausibility to this explanation. However, a definitive diagnosis requires a deep dive into who was doing what that is not possible based on currently available public information. I am just laying out possibilities here.
Exercising market power in a tight market is sometimes referred to as a “natural corner” and has given some firms that have exercised market power a “get out of jail free” card in the United States.
I’ve just completed a paper on “natural squeezes” that critiques this flaw in US manipulation law. I’ll post it soon.
But when all is said and done, what is going on in copper now is possibly such a natural squeeze: a temporary tight supply and demand situation exploited to exercise market power. Maybe someday we’ll find out.
Churchill called Russia “a riddle, wrapped in a mystery, inside an enigma.” Those following the natural gas market, particularly in Europe, during the Great Spike of 2021 have no doubt agreed wholeheartedly. What is Russia’s (specifically Gazprom’s) game? Why haven’t they increased sales/output to profit from the spike? Because they can’t due to output constraints? Or because China is outbidding Europe for supplies? Or because they need to build domestic stocks?
Or because they are deliberately withholding output for some strategic purpose, a la 2006?
Yesterday Putin unravelled the riddle/mystery/enigma quite a bit: it’s the latter.
Specifically, Putin said Russia would be more than happy to send Europe more gas. But, only via Nordstream 2, not via currently operating pipelines, through Ukraine in particular. Too expensive to send via Ukraine, you see.
Nordstream 2 was just completed, at the insistence primarily of chief Putin-Versteher, Angela Merkel (whose energy policies have been boneheaded from start to finish), and against the determined efforts of Trump and Congressional Republicans. Biden caved recently on the issue and, waived Trump-imposed sanctions, thereby allowing the completion of the pipeline.
The Nord Stream 2 gas pipeline is not exempt from European Union rules that require the owners of pipelines to be different from the suppliers of the gas that flows in them to ensure fair competition, a German court ruled on Wednesday.
The Duesseldorf Higher Regional Court rejected a challenge brought last year by the operators of the Gazprom-backed (GAZP.MM) project to carry gas from Russia to Germany under the Baltic Sea. They had argued the rules were discriminatory.
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“Russia’s Gazprom will be forced to auction pipeline capacity, which could delay deliveries further,” said Refinitiv gas analyst Xun Peng.
EU rules require the companies that produce, transport and distribute gas within the bloc to be separate, or “unbundled”. They aim to ensure fair competition in the market and to prevent companies from possibly obstructing competitors’ access to infrastructure.
This means that the company transporting the gas must auction its capacity to third parties.
Gazputin no likey!
And now he has a desperate gas short, winter-dreading Europe by the balls.
Did you really think he would pass on an opportunity to squeeze?
So he’s squeezing. Hard. The threat is clear: if you want more gas, cave to me on unbundling.
“Nice little continent you have here. Shame if something happened to it. Like, you know, freeze.”
In other words, Putin is not the Riddler, or a mystery, or an enigma after all. He is just playing to type. Where type includes adding sanctimonious snark to sugarcoat his threat.
Putin hasn’t changed a bit. The circumstances have changed, and Putin, in his oft-proven opportunistic fashion, is playing the scorpion in Aesop’s fable the Frog and the Scorpion. “I couldn’t help it. It’s in my nature.” Gazputin is back, baby.
For precisely this reason the Europeans–and Merkel in particular–have no one to blame but themselves. They are the ones who put the scorpion on their backs. One would think this sting would be a lesson. But given how many times they’ve been stung in the past, and continued in their course, that will almost certainly not happen. So I for one am shedding no tears.
Back oh-so-long ago, during the California electricity crisis and its aftermath, I would say that California wanted to deregulate its power market in the worst way, and succeeded. (Wanting to keep up my ESG score, I recycled this line to describe Gibbering Joe’s Afghanistan exit.)
The main design failure of California’s restructuring (a more accurate description than deregulation) of its power market was that it capped retail prices for the two largest utilities in the state (SoCal Edison and PG&E) while requiring them to acquire power at market-determined wholesale spot prices. (San Diego Gas and Electric had met criteria to allow it to enter into long term forward purchase contracts and as I recall was not subject to the same retail price cap.). Thus, SCE and PG&E were massively short wholesale (spot) power. When those prices spiked, due mainly to fundamental factors, the utilities hemorrhaged cash and hurtled towards bankruptcy. Their financial distress led to further dislocations in the California market (and the western US power markets generally).
The world is currently undergoing what is being called an “energy crisis,” focused on power markets, and their inputs, mainly natural gas and coal. There are two parts to this “crisis,” one fundamentally driven, the other driven by ill-conceived regulatory and political factors redolent of California circa 1999-2001.
The most pronounced indicator of the fundamental-driven stress is the price of liquified natural gas (LNG), which has reached dizzying heights.
That price spike is in early “shoulder” months, boys and girls. Lord knows what the peak demand months have in store.
And that’s the nub of the problem: storage.
Historically, natural gas has been a “spikey” commodity. The shale boom mitigated spikeness in US natural gas prices, but periodic price spikes are an inherent feature of storable commodities. The truly motivated can read about it in my book, but the CliffsNotes version is this. It is optimal for inventories to run out periodically: if inventories were never exhausted, some of the commodity would never be consumed, which makes no sense. So “stockouts” will occur periodically. When they do, it is impossible to accommodate demand increases or supply declines by drawing down on inventory. Instead, prices bear the entire burden of adjusting to a demand shock (for example). Thus, periodically stocks will be tight, and when they are, a demand increase causes prices to rise dramatically (because inventories can’t cushion the blow).
The cover illustration in my book, based on a purely theoretical model of a storable commodity market, illustrates the point. Note the periodic spikes.
That is, price spikes are inherent in storable commodities.
The magnitude of the price spikes is amplified by the nature of natural gas production and consumption. Both demand and supply are extremely inelastic. The inelasticity effects optimal storage decisions, but when natty inventory constraints bind, inelasticity means that price impacts of shocks are extreme.
This is why going short natural gas (or shorting the calendar spread especially in the winter) is referred to as a “widow maker” trade.
There are lots of widows out there today. In essence, a hard winter of 2020/2021 depleted stocks. The 2020 COVID demand collapse and subsequent price crash (JKM traded at $2.20/mmBTU in May 2020) cratered drilling, constraining current supply (as wells drilled then would have been producing now) making it difficult to build stocks. Warm summer weather in 2021 drained stocks and impeded stock build. Outages in Norwegian production, and a wind drought in the UK (which required greater utilization of gas generation) stoked demand. Stocks are now at historically low levels, setting the stage for even bigger spikes this winter.
The gas market–due to LNG–is now international, meaning that shocks in any region impact prices around the world. Asia (especially China) and Europe are now playing tug of war for gas, and prices are spiking in both places.
Since gas and coal are substitutes, the price spike in gas is resulting in a price spike in coal:
Oil can also be used to generate power, although this has become relatively rare in recent years. However, the spikes in gas and coal are making fuel switching to oil more attractive, and additional gas/coal price spikes in the winter will likely result in more use of oil in electricity generation, which will put upward pressure on oil prices too.
This is all fundamentals driven, and exactly what occurs periodically in storable commodities. There’s nothing really that can be done about it, policy wise. But that won’t stop governments from trying.
You’ve no doubt read of energy “shortages” in recent days and weeks. Well, low supplies and high prices are not a “shortage” per se. A true shortage is a failure for a market to clear, resulting in queueing for the good. That is, a shortage occurs when the price is kept to low, leading to a gap between the quantity demanded and the quantity supplied.
Think gasoline lines in the US in the 1970s.
That’s where regulation comes in. Various regulations, adopted for political economy reasons, create shortages and the other dysfunctions currently observed in world energy markets.
Take China. The authorities have implemented power rationing. The reason commonly given is a “coal shortage.” Yes, coal prices are high in China (and the world), but that doesn’t create a true shortage. What has? Power prices are capped. The big increase in input costs (both coal and LNG) mean that Chinese generators can’t sell profitably, so they restrict output, leading to a true shortage.
What this means is that the shadow price of power–the price that market participants would be willing to pay for an additional megawatt–is (a) above the regulated price, and (b) above the market clearing price. Consumption would be higher in the absence of the price cap.
High coal prices do not reflect a “shortage”, properly defined. Yes, they represent constrained supplies, but that is not a shortage.
And do not forget that China’s coal supply constraints (and high prices) are in large part a result of their brilliant central planners. China imposed quotas on coal production some years back. The reason was–wait for it–coal prices were too low. Now the government is winking at the quotas in order to encourage production–because prices are too high.
The UK is experiencing another echo of California. Several of its retail gas suppliers have imploded because they are required to sell at a capped price and chose to cover their sales commitments by purchasing wholesale spot. The price cap made no sense: competition among retail suppliers would have kept prices in line. Adding the price cap just put the competitive retailers at risk of bankruptcy. (Admittedly, such can occur when retail prices are not capped if retailers offer fixed prices to consumers and don’t hedge, as occurred in Texas this last winter. But price caps make that outcome more likely.)
The UK is also suffering a true shortage of gasoline–excuse me, petrol–a la the US in the 1970s. A true shortage, because there are lines:
Scarcity of truck drivers to distribute fuel is at the root of the problem. But that can’t lead to a true shortage–lower supplies and higher prices yes, but not a shortage with people waiting in line. So what gives?
A sudden demand increase of this magnitude can lead to true shortages–queueing–if prices do not rise to clear the market. This raises the question of why petrol sellers didn’t increase prices. I’m not aware of formal caps, but I surmise that fear of allegations of “gouging” led retailers to choose to allow customers to pay the high price implicitly (through the time cost of sitting in line) rather than raise price to reflect the sudden (and perhaps contrived) scarcity.
For storable commodities like natural gas, coal, and refined petroleum products, price spikes can last for some time. That’s what we are experiencing today: it’s just one of those spikes like on the cover of my book that happen in commodity markets. Given that we are going into a peak demand season with constrained supplies, the prospect for a continuing spike–and indeed, a higher spike–is very real indeed.
Governments can’t change this fundamental reality. Market prices are sending a signal about underlying conditions. Governments don’t like the message the prices are sending, and will try to do something about it. Alas, their knee-jerk response–to shoot the messenger by capping prices–will make things worse, not better. But because governments can’t help themselves, look for many 1970s energy market flashbacks in the coming months.
I grew up in the 70s. I never did acid then (or ever!), but man am I experiencing flashbacks. Feckless progressive Democrat presidents. (Though Carter, while an idiot, was at least compos mentis, which is more than can be said of Señor Senile Joe Biden.) Crime. (I’m betting on a comeback of the Charles Bronson revenge and Clint Eastwood Dirty Harry genres.) All in all, the 70s sucked, and I am not nostalgically hoping for a reprise–I’m dreading it actually.
One of the things that sucked worst was inflation. The 1970s were the inflation decade (although it peaked in 1980-1981). In recent months, the price level measured by the CPI, PPI, and GDP deflator has been up substantially. CPI, for example, is up about 4.5 percent on a year-on-year basis. This has raised concerns about a return of 70s-style inflation. Are these concerns justified?
The jury is out, but there is reason for concern.
First, it is important to distinguish between one time changes in the price level and inflation. Inflation is a long term upward trend in the price level, rather than a single stair-step jump in the price level.
The impact of the pandemic (or, more accurately, the draconian policy response to the pandemic) has created the conditions for a one-time step up in the price level. The economic recovery from the pandemic is a positive aggregate demand shock. Moreover, it has occurred against the backdrop of constrained supply conditions that resulted from the pandemic. Upward shifts in supply and demand lead to a higher price level, ceteris paribus.
One would think that these are effectively one-time shocks–hopefully the pandemic is a one-time thing, and therefore the recovery from it is too. Furthermore, supply conditions should ease. (We are already seeing that in some sectors, such as lumber, though not in others, such as semiconductors. Policy, namely paying people not to work in some states, may impede the easing of supply conditions). Thus, one would expect that this is one time, and at least partially transitory, jump in the price level rather than inflation qua inflation.
That said, there are reasons for concern. Most notably, the fiscal diarrhea in the US, and the willingness of the Fed to finance (i.e., monetize) that spending is freighted with inflationary potential.
In the post-Financial Crisis era, the Fed mitigated the inflationary impact of QE and other expansive monetary policies by paying interest on reserves. So the inflationary threat that I worried about in 2009 (and asked Ben Bernanke about) never materialized. But that’s no reason for complacency. We dodged a bullet once, but that doesn’t mean we will always do so. Massive deficit spending accommodated by the monetary authority is highly likely to result in inflation, sooner or later. (I am inclined to favor Thomas Sargent’s fiscal theory of the price level.).
Part of the reason that inflation didn’t occur post-2008 was that money velocity plunged. Part of this was due to the Fed paying interest on reserves, which led banks to hold them (lend them to the Fed in effect) rather than lend them to private individuals and firms. But expectations, and the self-fulfilling nature thereof with respect to inflation, likely played a role too. In the gloomy aftermath of 2008 people expected low inflation (or even deflation), which made them more willing to hold rather than spend money balances–which results in low inflation, thereby validating the expectations and perpetuating the equilibrium.
But expectations are fickle things, and as a result there can be multiple equilibria. Fed board members have strenuously argued that the recent spurt in prices is a one-time stair step phenomenon, not the harbinger of inflation. But if the spurt results in an upward shift in inflationary expectations by the hoi polloi, people will be less willing to hold money balances at the existing price level, so they will try to reduce (i.e., spend) them, which leads to inflation–thereby validating the expectations.
Thus, it’s not so much what the Fed believe that matters. It’s about what you and me and other individuals and firms believe. Combine a negative fiscal picture with a surge in prices and it’s quite possible that inflation expectations soon will no longer be “anchored” at low levels, but will surge to higher levels, which would result in inflation no longer being anchored at low levels.
So although I think that the recent surge in the price level is of the one-time variety, that doesn’t mean everyone will think the same way. And if everyone doesn’t think the same way we may see a 70s rerun. The dire fiscal picture contributes to such worries.
When the subject of inflation comes up, as Dr. Commodities I’m often asked whether commodities are a good hedge. Intuitively it makes sense that they should be, but historically, they have not been. Commodity prices are much more volatile than the price level, and not that highly correlated. That is, relative prices move around a lot even when the price level trends upwards.
I think that availability bias is a big reason why people focus on commodity prices–they are readily observable, on a second-by-second basis, because they are actively traded on liquid markets. Other goods and services, not so much. But just because we can see them easily doesn’t mean that they are reliable beacons for the price level overall, or changes therein.
This brings to mind why we should really fear a return of 70s-style inflation (or worse, heaven forfend).
When sitting in (the great) Sherwin Rosen’s Econ 302 course at Chicago on a cold morning in February, 1982, I was startled when Sherwin’s normal rather droning delivery was interrupted by him shouting and pounding his right fist into his left palm: “And that’s the problem with inflation. IT FUCKS UP RELATIVE PRICES!!!!”
Some prices are stickier than others, meaning that inflation pressures can impact some goods and services more and sooner than others–thereby causing changes in relative prices.
This is a bad thing–and why Sherwin dropped the F-bomb about it–because relative prices guide resource allocation. If you fuck up relative prices, as inflation does, you interfere with resource allocation, leading to lower incomes and growth. Inflation has adverse real consequences.
So we should definitely fear an acid flashback to 70s inflation. And although I do not believe the recent surge in prices is a harbinger thereof, I think that there is a material risk that we may all experience such a flashback–even if you didn’t grow up in the 70s.
Especially if it’s lumber. Not so much if it’s timber or logs.
Lumber prices have been on a tear recently. The CME lumber futures price has risen inexorably for weeks:
The softwood lumber PPI has increased 73 percent from April of last year, when Covid cratered all markets (including all commodity markets in particular) to March of this year. As the graph above shows, the price increase in the last month alone will add almost 100 precent to that. The plywood PPI is up 43 percent. The PPI for logs, timber, and pulpwood has not risen nearly as much over the April 2020-March 2021 period–only 7 percent.
So what’s going on? This podcast has a pretty good explanation, which comports with the analysis that follows. My main objection is that it repeatedly refers to the market as “broken.” No. A market is broken when it sends the wrong price signals. It is not broken if it sends the right signals, even if you don’t like them. That’s what’s going on here. Prices are signaling a major change in demand patterns that is straining a productive capacity oriented to the old patterns.
The podcast claims that log and timber prices are down. That’s not consistent with the PPI data, which does demonstrate some uptick in log/timber prices. I have also seen reports that timber/log prices are firm in western Canada. But it is obvious that the spread between lumber and timber has widened dramatically.
Which provides a perfect opportunity to apply what I teach in my commodities classes: Find the bottleneck. In a reasonably competitive market, the spread between two commodities, one that can be transformed into the other, equals the cost of that transformation. Sawmills transform logs into lumber, so if the spread between the prices of these things blows out, that shows you where the bottleneck is–at the mills.
The podcast largely confirms that. The sawmill sector has contracted and consolidated in recent years for a variety of reasons. The Covid-induced economic shock of last year also led to the idling of capacity. Now demand has come roaring back. There is a building boom, driven by an exodus from cities and a substitution of things for services. The turnaround has been so abrupt that sawmill capacity has not been able to adjust to keep up. It of course takes a long time to build new mills, and the decision to do that depends on expectations about long-term demand. It is quicker and more economical to restart idle mills, and to add shifts, and that is happening. But it can’t happen overnight.
A transportation bottleneck is exacerbating the problems. Shortages of railcars and trucks are limiting the ability of sawmills to satisfy demand. These shortages reflect in part a commodities boom generally. Chinese demand for US ag products (which has sent corn prices soaring) is contributing to that, but the transportation sector has been robust generally since its doldrums of a year ago. In that time the Dow Jones Transportation Average is up 128 percent off its Covid bottom, and is 40 percent above its pre-Covid collapse level.
Transportation bottlenecks tend to widen spreads at all levels of the value chain, from timber farm to mill, and from mill to lumber yard.
Lumber inventories are at barebones levels, as one would expect in such circumstances. When the supply-demand balance is tight today relative to what is expected in the future, the efficient thing to do is to draw down inventories and to consume everything that is being produced. This is leading, exactly as theory would predict, to a pronounced backwardation in lumber prices:
Note there’s an almost 30 percent backwardation going out six months. That’s very steep. Very Although I wouldn’t put too much weight in the distant deferred prices (given the absence of volume and open interest) one, it appears that the curve flattens out after the six month point.
So what’s going on is commodity economics 101. A surge in demand after a sharp fall (which led to reductions in transformation capacity) caused the lumber market to hit constraints–constraints in the amount of available inventory, and constraints in the capacity to transform a raw product (timber) into a consumable one (lumber). This in turn caused spreads (calendar spreads and the spread between finished and raw prices) to blow out. Market participants are responding to these price signals. The backwardation suggests that the constraints will ease by the end of the year. That of course is a forecast based on current information. Things could change.
So things ain’t broke. Indeed, what is happening in the lumber and timber markets is a symptom of a robust economic recovery, at least in the housing and goods sectors. It also reflects an apparent ongoing structural shift post-Covid (and post urban disturbances of the last year), namely, a desire to move out of cities driven by the recognition that more people can work remotely, and the declining amenities of cities (largely the result of lockdowns and their aftermath, and an upsurge in crime). Such an abrupt and seismic shift inevitably bumps up against constraints determined by past investments tailored to accommodate the old consumption patterns. That affects prices, and prices signal the need for new investments to alleviate the bottlenecks. This too shall pass, and within some months the bottlenecks will ease, as. participants all along the value change respond to the extraordinary price signals we see today.
Platts’ attempt to change the contract makes sense. Dated “Brent” is an increasingly, well, dated benchmark due to the inexorable decline in North Sea production volumes, something I’ve written about periodically for the last 10 years or so. At present, only about one cargo per day is eligible, and this is insufficient to prevent squeezes (some of which have apparently occurred in recent months). The only real solution is to add more supply. But what supply?
Two realistic alternatives were on offer: to add oil from Norway’s Johan Sverdrup field, or to add non-North Sea oil (such as West African or US). Each presents difficulties. The Sverdrup field’s production is in the North Sea, but it is heavier and more sour than other oil currently in the eligible basket. West African or US oil is comparable in quality to the current Brent basket, but it is far from the North Sea.
Since derivatives prices converge to the cheapest-to-deliver, just adding either Sverdrup or US oil on a free on board basis to the basket would effectively turn Dated Brent into Dated Sverdrup or Dated US: Svedrup oil would be cheaper than other Brent-eligible production because of its lower quality, and US oil would be cheaper due to its greater distance from consumption locations. So to avoid creating a US oil or Sverdrup oil contract masquerading as a Brent contract, Platts needs to establish pricing differentials to put these on an even footing with legacy North Sea grades.
In the event, Platts decided to add US oil. In order to address the price differential issue, it decided to move the pricing basis from free on board (FOB) North Sea, to a cost, insurance, and freight (CIF) Rotterdam basis. It also announced that it would continue to assess Brent FOB, but this would be done on a netback basis by subtracting shipping costs from the CIF Rotterdam price.
The proposal makes good economic sense. And I surmise that’s exactly why it is so controversial.
This cynical assessment is based on a near decade of experience (from 1989 to 1997) in redesigning legacy futures contracts. From ’89-’91, in the aftermath of the Ferruzzi soybean corner, I researched and authored a report (published here–cheap! only one left in stock!) commissioned by the CBOT that recommended adding St. Louis as a corn and soybean delivery point at a premium to Chicago; in ’95-’96, in the aftermath of a corner of canola, I advised the Winnipeg Commodity Exchange about a redesign of its contract; in ’97, I was on the Grain Delivery Task Force at the CBOT which radically redesigned the corn and beans contracts–a design that remains in use today.
What did I learn from these experiences? Well, a WCE board member put it best: “Why would I want a more efficient contract? I make lots of money exploiting the inefficiencies in the contract we have.”
In more academic terms: rent seeking generates opposition to changes that make contracts more efficient, and in particular, more resistant to market power (squeezes, corners and the like).
Some anecdotes. In the first experience, many members of the committee assigned to consider contract changes–including the chairman (I can name names, but I won’t!)–were not pleased with my proposal to expand the “economic par” delivery playground beyond Chicago. During the meeting where I presented my results, the committee chairman and I literally almost came to blows–the reps from Cargill and ADM bodily removed the chairman from the room. (True!)
The GDTF was formed only because a previous committee formed to address the continued decline of the Chicago market was deadlocked on a solution. The CBOT had followed the tried-and-true method of getting all the big players into the room, but their interests were so opposed that they could not come to agreement. Eventually the committee proposed some Frankenstein’s monster that attempted to stitch together pieces from all of the proposals of the members, which nobody liked. (It was the classic example of a giraffe being a horse designed by committee.). It was not approved by the CBOT, and when the last Chicago delivery elevator closed shortly thereafter, the CFTC ordered the exchange to change the contract design, or risk losing its contract market designation.
Faced with this dire prospect, CBOT chairman Pat Arbor (a colorful figure!) decided to form a committee that included none of the major players like Cargill or ADM. Instead, it consisted of Bill Evans from Iowa Grain, Neal Kottke of Kottke Associates (an independent FCM), independent grain trader Tom Neal, and some outsider named Craig Pirrong. (They were clearly desperate.)
In relatively short order we hashed out a proposal for delivery on the Illinois River, at price differentials reflecting transportation costs, and a shipping certificate (as opposed to warehouse receipt) delivery instrument. After a few changes demanded by the CFTC (namely extending soybean delivery all the way down the River to St. Louis, rather than stopping at Peoria–or was it Pekin?), the design was approved by the CBOT membership and went into effect in 1998.
One thing that we did that caused a lot of problems–including in Congress, where the representative from Toledo (Marcy Kaptor) raised hell–was to drop Toledo as a delivery point. This made economic sense, but it did not go over well with certain entities on the shores of Lake Erie. Again–the distributive effects raised their ugly heads.
The change in the WCE contract–which was also eminently sensible (of course, since it was largely my idea!) also generated a lot of heat within the exchange, and politically within Alberta, Manitoba, and Saskatchewan.
So what did I learn? In exchange politics, as in politics politics, efficiency takes a back seat to distributive considerations. This insight inspired and informed a couple of academicpapers.
I would bet dimes to donuts that’s exactly what is going on with Platts and Brent. Platts’ proposal for a more efficient pricing mechanism gores some very powerful interests’ oxen.
Indeed, the rents at stake in Brent are far larger than those even in CBOT corn and beans, let alone tiny canola. The Brent market is vastly bigger. The players are bigger–Shell or BP or Glencore make even 1997 era Cargill look like a piker. Crucially, open interest in Brent-based instruments extends out until 2029: open interest in the ags went out only a couple of years.
My surmise is that the addition of a big new source of deliverable supply (the US) would undercut the potential for delivery games exploiting “technical factors” as they are sometimes euphemistically called in the North Sea. This would tend to reduce the rents of those who have a comparative advantage in playing these games.
Moreover, adding more deliverable supply than people had anticipated would be available when they entered into contracts last year or the year before or the year before . . . and which extend out for years would tend to cause the prices for these longer dated contracts to fall. This would transfer wealth from the longs to the shorts, and there is no compensation mechanism. There would be big winners and losers from this.
It is these things that stirred up the hornets, I am almost sure. I don’t envy Platts, because Dated Brent clearly needs to be fixed, and fast (which no doubt is why Platts acted so precipitously). But any alternative that fixes the problems will redistribute rents and stir up the hornets again.
In 1997 the CBOT got off its keister because the CFTC ordered it to do so, and had the cudgel (revoking contract designation) to back up its demand. There’s no comparable agency with respect to Brent, and in any event, any such agency would be pitted against international behemoths, making it doubtful it could prevail.
As a result, I expect this to be an extended saga. Big incumbent players lose too much from a meaningful change, so change will be slow in coming, if it comes at all.
In the aftermath of the Texas Freeze-ageddon much ink and many pixels have been spilled about its causes. Much–most?–of the blame focuses on Texas’s allegedly laissez faire electricity market design.
I have been intensely involved (primarily in a litigation context) in the forensic analysis of previous extreme electricity market shocks, including the first major one (the Midwest prices spike of June 1998) and the California crisis. As an academic I have also written extensively about electricity pricing and electricity market design. Based on decades of study and close observation, I can say that electricity market design is one of the most complex subjects in economics, and that one should step extremely gingerly when speaking about the topic, especially as it relates to an event for which many facts remain to be established.
Why is electricity market design so difficult? Primarily because it requires structuring incentives that effect behavior over both very long horizons (many decades, because investments in generation and transmission are very long lived) and extremely short horizons (literally seconds, because the grid must balance at every instant in time). Moreover, there is an intimate connection between these extremely disparate horizons: the mechanisms designed to handle the real time operation of the system affect the incentives to invest for the long run, and the long run investments affect the operation of the system in real time.
Around the world many market designs have been implemented in the approximately 25 year history of electricity liberalization. All have been found wanting, in one way or another. They are like Tolstoy’s unhappy families: all are unhappy in their own way. This unhappiness is a reflection of the complexity of the problem.
Some were predictably wretched: California’s “reforms” in the 1990s being the best example. Some were reasonably designed, but had their flaws revealed in trying conditions that inevitably arise in complex systems that are always–always–subject to “normal accidents.”
From a 30,000 foot perspective, all liberalized market designs attempt to replace centralization of resource allocation decisions (as occurs in the traditional integrated regulated utility model) with allocation by price. The various systems differ primarily in what they leave to the price system, and which they do not.
As I wrote in a chapter in Andrew Kleit’s Energy Choices (published in 2006) the necessity of coordinating the operation of a network in real time almost certainly requires a “visible hand” at some level: transactions costs preclude the coordination via contract and prices of hundreds of disparate actors across an interconnected grid in real time under certain conditions, and such coordination is required to ensure the stability of that grid. Hence, a system operator–like ERCOT, or MISO, or PJM–must have residual rights of control to avoid failure of the grid. ERCOT exercised those residual rights by imposing blackouts. As bad as that was, the alternative would have been worse.
Beyond this core level of non-price allocation, however, the myriad of services (generation, transmission, consumption) and the myriad of potential conditions create a myriad of possible combinations of price and non-price allocation mechanisms. Look around the world, and you will see just how diverse those choices can be. And those actual choices are just a small subset of the possible choices.
As always with price driven allocation mechanisms, the key thing is getting the prices right. And due to the nature of electricity, this involves getting prices right at very high frequency (e.g., the next five minutes, the next hour, the next day) and at very low frequency (over years and decades). This is not easy. That is why electricity market design is devilish hard.
One crucial thing to recognize is that constraints on prices in some time frames can interfere with decisions made over other horizons. For example, most of the United States (outside the Southeast) operates under some system in which prices day ahead or real time are the primary mechanism for scheduling and dispatching generation over short horizons, but restrictions on these prices (e.g., price caps) mean that they do not always reflect the scarcity value of generating or transmission capacity. (Much of the rest of the world does this too.) As a result, these prices provide too little incentive to invest in capacity, and the right kinds of capacity. The kludge solution to this is to create a new market, a capacity market, in which regulators decide how much capacity of what type is needed, and mandate that load servers acquire the rights to such capacity through capacity auctions. The revenues from these auctions provide an additional incentive for generators to invest in the capacity they supply.
The alternative is a pure energy market, in which prices are allowed to reflect scarcity value–and in electricity markets, due to extremely inelastic demand and periodic extreme inelasticity of supply in the short run, that scarcity value can sometimes reach the $1000s of dollars.
Texas opted for the energy market model. However, other factors intervened to prevent prices from being right. In particular, heavy subsidies for renewables have systematically depressed prices, thereby undercutting the incentives to invest in thermal generation, and the right kind of thermal generation. This can lead to much bigger price spikes than would have occurred otherwise–especially when intermittent renewables output plunges.
Thus, a systematic downward price distortion can greatly exacerbate upward price spikes in a pure energy model. That, in a nutshell, is the reason for Texas’s recent (extreme) unhappiness.
As more information becomes available, it is clear that the initiator of the chain of events that left almost half the state in the dark for hours was a plunge in wind generation due to the freezing of wind turbines. Initially, combined cycle gas generation ramped up output dramatically to replace the lost wind output. But these resources could not sustain this effort because the cold-related disruptions in gas production, transmission, and distribution turned the gas generators into fuel limited resources. The generators hadn’t broken down, but couldn’t obtain the fuel necessary to operate.
It is certainly arguable that Texas should have recognized that the distortion in prices that arose from subsidization of wind (primarily at the federal level) that bore no relationship whatsoever to the social cost of carbon made it necessary to implement the kapacity market kludge, or some other counterbalance to the subsidy-driven wrong prices. It didn’t, and that will be the subject of intense debate for months and years to come.
It is essential to recognize however, that the underlying reason why a kludge may be necessary is that the price wasn’t right due to government intervention. When deciding how to change the system going forward, those interventions–and their elimination–should be front and center in the analysis and debate, rather than treated as sacrosanct.
There is also the issue of state contingent capacity. That is, the availability of certain kinds of capacity in certain states of the world. In electricity, the states of the world that matter are disproportionately weather-related. Usually in Texas you think of hot weather as being the state that matters, but obviously cold weather matters too.
It appears that the weatherization of power plants per se was less of an issue last week than the weatherization of fuel supplies upstream from the power plants. It is an interesting question regarding the authority of ERCOT–the operator of the Texas grid–extends to mandating the technology utilized by gas producers. My (superficial) understanding is that it is unlikely to, and that any attempt to do so would lead to a regulatory turf battle (with the Texas Railroad Commission, which regulates gas and oil wells in Texas, and maybe FERC).
There is also the question of whether in an energy only market generators would have the right incentive to secure fuel supplies from sources that are more immune to temperature shocks than Texas’s proved to be last week. Since such immunity does not come for free, generator contracts with fuel suppliers would require a price premium to obtain less weather-vulnerable supplies, and presumably a liability mechanism to penalize non-performance. The price premium is likely to be non-trivial. I have seen estimates that weatherizing Texas wells would cost on the order of $6-$9 million per well—which would double or more than the cost of a well. Further, it would be necessary to incur additional costs to protect pipelines and gas processing facilities.
In an energy only market, the ability to sell at high prices during supply shortfalls would provide the incentive to secure supplies that allow producing during extreme weather events. The question then becomes whether this benefit times the probability of an extreme event is larger or smaller than the (non-trivial) cost of weatherizing fuel supply.
We have a pretty good idea, based on last week’s events, of what the benefit is. We have a pretty good idea of the cost of hardening fuel supplies and generators. The most imprecise input to the calculation is the probability of such an extreme event.
Then the question of market design–and specifically, whether weatherization should be mandated by regulation or law, and what form that mandate should take–becomes whether generation operators or regulators can estimate that probability more accurately.
In full awareness of the knowledge problem, my priors are that multiple actors responding to profit incentives will do a better job than a single actor (a regulator) operating under low power incentives, and subject to political pressure (exerted by not just generators, but those producing, processing, and transporting gas, industrial consumers, consumer lobbyists, etc., etc., etc., as well). Put differently, as Hayek noted almost 75 years ago, the competitive process and the price system is a way of generating information and using it productively, and has proved far more effective in most circumstances than centralized planning.
I understand that this opinion will be met with considerable skepticism. But note a few things. For one, a regulator’s mistakes have systematic effects. Conversely, some private parties may overestimate the risk and others underestimate it: the composite signal is likely to be more accurate, and less vulnerable to the miscalculation of a single entity. For another, on the one hand skeptics excoriate a regulator for its failures–but confidently predict that some other future regulator will get it right. I’m the skeptic on that.
Recent events also raise another issue that could undermine reliance on the price system. Many very unfortunately people entered into contracts in which their electricity bills were tied to wholesale prices. As a result, the are facing bills for a few days of electricity running into the many thousands of dollars because wholesale prices spiked. This is indeed tragic for these people.
That spike by the way, is up to $10,000/MWh. $10/KWh. Orders of magnitude bigger than you usually pay.
It is clear that the individuals who entered these contracts did not understand the risks. And this is totally understandable: if you are going to argue that regulators or generators underplayed the risks, you can’t believe that they typical consumer won’t too. I am sure there will be lawsuits relating in particular to the adequacy of disclosure by the energy retailers who sold these contracts. But even if the fine print in the contracts disclosed the risks, many consumers may not have understood them even if they read it.
One of the difficulties with getting prices right in electricity markets which has plagued market design is getting consumers to see the price signals so that they can limit use when supply is scarce. But this will periodically involve paying stratospheric prices.
From a risk bearing perspective this is clearly inefficient. The risk should be transferred to the broader financial markets (though hedging mechanisms, for instance) because the risk can be diversified and pooled in those markets. But this is at odds with the efficient consumption perspective. This is not a circle that anyone has been able to square heretofore.
Moreover, the likely regulatory response to the extreme misfortune experienced by some consumers will be to restrict wholesale prices so that they do not reflect scarcity value. That is, an energy only market has a serious time consistency problem: regulators cannot credibly commit to allow prices to reflect scarcity value, come what may. This means that an energy only market may not be politically sustainable, regardless of its economic merits. I strongly suggest that this will happen in Texas.
In sum, as the title of the book I mentioned earlier indicates, electricity market design is about choices. Moreover, those choices are often of the pick-your-poison variety. This means that avoiding one kind of problem–like what Texas experienced–just opens the door to other problems. Evaluation of electricity market design should not over-focus on the most recent catastrophe while being blind to the potential catastrophes lurking in alternative designs. But I realize that’s not the way politics work, and this will be an intensely political process going forward. So we are likely to learn the wrong lessons, or grasp at “solutions” that pose their own dangers.
As a starting point, I would undo the most clearcut cause of wrong prices in Texas–subsidization of wind and other renewables. Alas, even if stopped tomorrow the baleful effect those subsidies will persist long into the future, because they have impacted decisions (investment decisions) on the long horizon I mentioned earlier. But other measures–such as mandated reserve margins and capacity markets, or hardening fuel supplies–will also only have effects over long horizons. For better or worse, and mainly worse, Texas will operate under the shadow of political decisions made long ago. And made primarily in DC, rather than Austin.
One metaphor that might shed some light on how seemingly small events can have cascading–and destructive–effects in financial markets is to think of the financial system as consisting of borgs programmed to ensure their survival at all costs.
One type of borg is the clearinghouses/CCP borg. The threat to them is the default of their counterparties. They use margins to protect against these defaults (thereby creating a loser pays/no credit system). When volatility increases, or gap risk increases, or counterparty concentration risk increases–or all three increase–the CCP Borg responds to this greater risk of credit loss by raising margins–sometimes by a lot–in order to protect itself.
This puts other borgs (e.g., Hedge Fund Borgs) under threat. They try to borrow money to pay the CCP Borg’s margin demands. Or they sell liquid assets to raise the cash.
These actions can move prices more–including the prices of things that are totally different from what caused the CCP Borg to raise margins on. This can cause increases in volatility that triggers reactions by other Managed Money Borgs. For example, these Borgs may utilize a Value-at-Risk system to detect threats, and which is programmed to cause the MM Borg to reduce positions (i.e., try to buy and sell stuff) in order to reduce VaR, which can move prices further, triggering more volatility. Moreover, the simultaneous buying and selling of a lot of various things by myriad parties can affect correlations between prices of these various things. And correlation is an input into the borgs’ model, so this can lead to more borg buying and selling.
All of these price changes and volatility changes can impact other borgs. For example, increases in volatilities and correlations in many assets that results from Managed Money Borgs’ buying and selling will feed back to the CCP Borgs, whose self-defense models are likely to require them to increase their margins on many more instruments than they increased margins on in the first place.
This is how seemingly random, isolated shocks like retail trader bros piling into heavily shorted, but seemingly trivial, stocks can spill over into the broader financial system. Borgs programmed to survive, acting in self-defense, take actions that benefit themselves but have detrimental effects on other borgs, who act in self-defense, which can have detrimental effects on other borgs, and . . . you get the picture.
This is a quintessential example of “normal accidents” in a complex system with tightly coupled components. Other examples include reactor failures and plane crashes.
I note–again, reprising a theme of the Frankendodd Years of this blog–that clearing and margins are a major reason for tight coupling, and hence greater risk of normal accidents.
I note further that it is precisely the self-preservation instincts of the borgs that makes it utterly foolish and clueless to say that creating stronger borgs with more powerful tools of self-preservation, and which interact with other borgs, will reduce systemic risk. This is foolish and clueless precisely because it is profoundly unsystemic thinking because it views the borgs in isolation and ignores how the borgs all interact in a tightly coupled system. Making borgs stronger can actually make things worse when their self-preservation programs kick in, and the self-preservation of one borg causes it to attack other borgs.
Why do teenagers in slasher flicks always go down into the dark basement after five of their friends have been horribly mutilated? Well, that makes about as much sense as a lot of financial regulators have in the past decades. Despite literally centuries of bad historical experiences, they have continued to try to make stronger, mutually interacting, borgs. Like Becky’s trip down the dark basement stairs, it never ends up well.
The vertigo inducing story of GameStop ramped it up to 11 yesterday, with a furore over Robinhood’s restriction of trading in GME to liquidation only, and the news that it had sold out of its customers’ positions without the customers’ permission. These actions are widely perceived as an anti-populist capitulation to Big Finance.
Well, they are in a way–but NOT the way that is being widely portrayed. What is going on is an illustration of the old adage that clearing and settlement in securities markets (like the derivatives markets) is like the plumbing–you take it for granted until the toilet backs up.
You can piece together that Robinhood was dealing with a plumbing problem from a couple of stories. Most notably, it drew down on credit lines and tapped some of its big executing firms (e.g., Citadel) for cash. Why would it need cash? Because it needs to post margin to the Depositary Trust Clearing Corporation (DTCC) on its open positions. Other firms are in similar situations, and directly or indirectly GME positions give rise to margin obligations to the DTCC.
The rise in price alone increased margin requirements because given volatility, the higher the price of a stock, the larger the dollar amount of potential loss (e.g., the VaR) that can occur prior to settlement. This alone jacks up margins. Moreover, the increase in GME volatility, and various adders to margin requirements–most notably for gap risk and portfolio concentration–ramp up margins even more. So the action in GME has led to a big increase in margin requirements, and a commensurate need for cash. Robinhood, as the primary venue for GME buyers, had/has a particularly severe position concentration/gap problem. Hence Robinhood’s scramble for liquidity.
Given these circumstances, liquidity was obviously a constraint for Robinhood. Given this constraint, it could not handle additional positions, especially in GME or other names that create particularly acute margin/liquidity demands. It was already hitting a hard constraint. The only practical way that Robinhood (and perhaps other retail brokers, like TDAmeritrade) could respond in the short run was trading for liquidation only, i.e., allow customers to sell their existing GME positions, and not add to them.
By the way, trading for liquidation is a tool in the emergency action toolbook that futures exchanges have used from time-to-time to deal with similar situation.
To extend the plumbing analogy, Robinhood couldn’t add any new houses to its development because the sewer system couldn’t handle the load.
I remember some guy saying that clearing turns credit risk into liquidity risk. (Who was that guy? Pretty observant!) For that’s exactly what we are seeing here. In times of market dislocation in particular, clearing, which is intended to mitigate credit risk, creates big increases in demand for liquidity. Those increases can cause numerous knock on effects, including dislocations in markets totally unrelated to the original source of the dislocation, and financial distress at intermediaries. We are seeing both today.
It is particularly rich to see the outrage at Robinhood and other intermediaries expressed today by those who were ardent advocates of clearing as the key to restoring and preserving financial stability in the aftermath of the Financial Crisis. Er, I hate to say I told you so, but I told you so. It’s baked into the way clearing works, and in particular the way that clearing works in stressed market conditions. It doesn’t eliminate those stresses, but transfers them elsewhere in the financial system. Surprise!
The sick irony is that clearing was advocated as a means to tame big financial institutions, the banks in particular, and reduce the risks that they can impose on the financial system. So yes, in a very real sense in the GME drama we are seeing the system operate to protect Big Finance–but it’s doing so in exactly the way many of those screaming loudest today demanded 10 years ago. Exactly.
Another illustration of one of my adages to live by: be very careful what you ask for.
Margins are almost certainly behind Robinhood’s liquidating some customer accounts. If those accounts become undermargined, Robinhood (and indeed any broker) has the right to liquidate positions. It’s not even in the fine print. It’s on the website:
If you get a margin call, you need to bring your portfolio value (minus any cryptocurrency positions) back up to your minimum margin maintenance requirement, or you risk Robinhood having to liquidate your position(s) to bring your portfolio value (minus any cryptocurrency positions) back above your margin maintenance requirement.
Another Upside Down World aspect of the outrage we are seeing is the stirring defenses of speculation (some kinds of speculation by some people, anyways) by those in politics and on opinion pages who usually decry speculation as a great evil. Those who once bewailed bubbles now cheer for them. It’s also interesting to see the demonization of short sellers–whom those with average memories will remember were lionized (e.g., “The Big Short”) for blowing the whistle on the housing boom and the bank-created and -marketed derivative products that it spawned.
There are a lot of economic issues to sort through in the midst of the GME frenzy. There will be in the aftermath. Unfortunately, and perhaps not surprisingly given the times, virtually everything in the debate has been framed in political terms. Politics is all about distributive effects–helping my friends and hurting my enemies. It’s hard, but as an economist I try to focus on the efficiency effects first, and lay out the distributive consequences of various actions that improve efficiency.
What are the costs and benefits of short selling? Should the legal and regulatory system take a totally hands off approach even when prices are manifestly distorted? What are the costs and benefits of various responses to such manifest price distortions? What are the potential unintended consequences of various policy responses (clearing being a great example)? These are hard questions to answer, and answering them is even harder in the midst of a white-hot us vs. them political debate. And I can say with metaphysical certainty that 99 percent of the opinions I have seen expressed about these issues in recent days are steeped in ignorance and fueled by emotion.
There are definitely major problems–efficiency problems–with Big Finance and the regulation thereof. Ironically, many of these efficiency problems are the result of previous attempts to “solve” perceived problems. But that does not imply that every action taken to epater les banquiers (or frapper les financiers) will result in efficiency gains, or even benefit those (often with justification) aggrieved at the bankers. I thus fear that the policy response to GameStop will make things worse, not better.
It’s not as if this is new territory. I am reminded of 19th century farmers’ discontent with banks, railroads, and futures trading. There was a lot of merit in some of these criticisms, but all too often the proposed policies were directed at chimerical wrongs, and missed altogether the real problems. The post-1929 Crash/Great Depression regulatory surge was similarly flawed.
And alas, I think that we are doomed to repeat this learning the wrong lessons in the aftermath of GameStop and the attendant plumbing problems. Virtually everything I see in the public debate today reinforces that conviction.
