Lately, speculators have come under attack by Barack Obama. The president blames them for raising prices on oil and gasoline, and he has proposed new restrictions on oil traders. But this is a wrong turn on the road to a healthy economy.
Back in 1958, onion farmers were concerned that speculators were taking advantage of them. They were especially concerned about the extreme volatility of onion prices, which could often double in a short period of time and then drop to a level below the cost of production. Farmers aimed their ire at the Chicago Mercantile Exchange, the principal futures market for commodities. They thought if futures trading in onions was banned then speculators would not create so much price volatility and farmers would benefit. At the behest of Congressman Gerald Ford (R-Mich.), Congress banned futures trading in onions—the only commodity for which trading is prohibited by law.
Four years after the ban, Stanford agricultural economist Roger Gray examined the impact on onion prices. He found that, contrary to the farmers’ expectations, onion price volatility had actually increased. Gray compared onion price volatility into four periods: 1922-41, a period in which there was no futures trading; 1942-49, when futures trading was only developing; 1949-58, an era when futures trading was robust; and 1958-62 when futures trading was banned.
Gray’s analysis showed conclusively that onion price volatility was far greater during the period when futures trading was undeveloped or nonexistent than during the period when it was robust. This is exactly the result predicted by economic theory. As Gray put it, “An organized futures market widens the opportunity to buy a commodity during the harvest surplus and sell it for later delivery, hence the diminution of in seasonal price range was to be expected on a priori grounds.”
This stands to reason. Speculators make their money by anticipating price changes. If they anticipate future shortages, they will buy now and bid up prices. If they anticipate a future surplus, they will sell now and put downward pressure on prices. Thus the whole purpose of commodity speculation is to moderate volatility—raising prices when they would otherwise be lower and reducing them when they would naturally be higher.
As the famous economist Milton Friedman once explained, the only way speculators could possibly increase commodity price volatility is if they are systematically wrong—buying high and selling low, which is the opposite of how they try to behave and make a profit. If they were wrong too often they would lose money and go out of business.
Said Friedman, “Speculation is stabilizing rather than the reverse…. People who argue that speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators lose money.”
It’s also worth remembering that those who produce commodities have a legitimate interest in wanting to hedge their prices. They may want to lock in a sale well before harvest so that they are guaranteed a profit. For hedging to work, however, there have to be speculators on the other side of the trade who are willing to buy without knowing for sure what the price will be when the commodities are available for delivery. In some cases, the speculator is also hedging; a manufacturer may wish to lock in the price of a key commodity used in production so that he can estimate his future costs with precision.