Securitization Doesn't Seem That Secure For The Rest Of Us

In my post on rising prices and trying to pin the blame on somebody, the evidence against speculators creating the bubble seemed weak. On one side was Chief Investment Strategist for Charles Schwab Liz Ann Sonders , who in the interview with the Wall Street Journal seemed to bring the issue up and take it away in the same breath.

There's also a lot of speculation in commodities, and that type of money can turn very, very quickly on a dime. And I think we may be unwinding some of those speculative trades that had been sort of chasing economies on the upside on dollar on the downside. So I do think there is some relief.

Then there was the New York Times article on energy analyst Mr. Daniel Yergin's testimony before Congress.

“There is a shortage psychology in the financial markets and that is reflected in the price of oil,” Mr. Yergin said in the interview. “You are seeing a lot of people who have never invested in commodities who are now piling into the market. But calling it speculation is way too simplistic.”

What role financial institutions — pension funds, mutual funds, and hedge funds, among others — are playing in driving up the price of oil to nearly $140 a barrel remains a key question. Regulators in Washington have acknowledged that they do not have enough information on speculative trading in commodity markets. Even though the evidence is incomplete, speculators have nonetheless become prime targets for legislative action.

A bit more web-mining showed me, however, that my was complacency regarding the commodities market unfounded. Speculation in the commodities market is a serious issue but not so much because of the speculators.

Mack Frankfurter wrote a 3 part article on The Commodity Conundrum: Securitization and Systemic Concerns I, II, III. Longer, I know than the usual web-scan, but worth the trouble if you want to get an understanding of the issues.

First, let's address the oil bubble speculation. Not everybody it seems agrees with Mr. Yergin.

Oil executives told Congress that speculation might be responsible for half the current cost of oil. Leaders from five top companies agreed that current supply and demand levels should place the price near $55 a barrel, instead of the roughly $100 a barrel in recent days.” As reported by Lisa Desjardins, CNN Radio, April 3, 2008.

Mr. Frankfurter has a number of other well documented examples as to why the changes occuring now are a new paradigm. What was more interesting was Mr. Frankfurter's reasons why behind the changes, because in explaining his theory he also did a good job of explaining the basics.

Back to Futures Basics
Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.

Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, a legacy of academic disagreement supports the claim that, on an inflation-adjusted basis, the same cannot be said about commodities.

So, it is not that we have more speculators, whether rational and less so, in the market but that the fundamental assumptions underlying the market process have changed. Its not the number of players at the poker game or how they play their own cards, its how the stakes of the game has changed. There is no way I am going to summarize Mr. Frankfurter's work better than this, so if you want details read the report, the entire report.

Mr. Frankfurter's solution to all of this:

It is time to rein in excessive market speculation which is occurring on the “dark exchanges’ and support the transition of unregulated commodity speculation back into the domain of the regulated futures industry.

The Center for American Progress also has a piece on this subject Speculators “R” Us: Commodities Markets Need Institutional Investors Like Us, which seems to fall in line.

However, from the ascendancy of my amateur armchair, I would still not focus on the speculation bubble as the most important economic factor currently effecting businesses.

My choice would have been the weak dollar, which has I realize now has good aspects and bad aspects depending upon where you are in the economy. Those good aspects could disappear quickly. The Center for American Progress also has a story on the weak dollar or as they put it Bush's Weak Dollar .

The real villian though would be the Current Account Deficit. The Center for Amercian Progress can arguably be accused of having a slanted perspective, the National Bureau of Economic Research far less so. Here is their telling article:

America's Unsustainable Current Account Deficit

The amount of foreign capital inflows required to sustain an American economy in which both the government and individuals eschew savings and spend beyond their means -- and imports far exceed exports --has soared to record highs. But even if the foreign appetite for U.S. Treasury securities and other U.S. assets continues to grow, a day of reckoning for what economists call our "current account deficit" is likely to arrive soon. And the price will be paid in a currency drop that will significantly reduce domestic economic growth.

That's the conclusion of a study by NBER Research Associate Sebastian Edwards. In Is the U.S. Current Account Deficit Sustainable? And If So How Costly Is Adjustment Likely to Be? (NBER Working Paper No. 11541), Edwards provides a detailed analysis that culminates in blunt answers to these questions: No, it is not sustainable and the adjustment, if history is any guide, is likely to be "painful and costly," causing U.S. economic output, measured as gross domestic product or GDP, to plummet. "

My rationale for looking at this is that whatever pathway we take, whether we truly think that free trade is the greater good for the greatest number of people or fair trade is the only way to insure economic justice, those efforts have to take place in an arena defined by these parameters. It is my personal belief that it is important for change-agents and social-entrepreneurs to understand them.