Gene Epstein Economics Beat Column in Barron’s

Barron’s Online            
Monday, June 30, 2008

A Simple Old Reg That Needs Dusting Off
Fixing the inflation problem.

IN ITS STATEMENT ACCOMPANYING ITS DECISION last week to leave the short-term interest rate unchanged, the Federal Open Market Committee expressed concern about "the upside risks to inflation," specifically mentioning the "continued increases in the prices of energy and other commodities."

Meanwhile, the Homeland Security and Governmental Affairs Committee held Capitol Hill hearings on "Curbing Excessive Speculation in the Commodity Markets."

The connection between the two events was little noticed but is direct: Something can be done about the higher prices of food and fuel — the source of the inflation that concerns the Federal Open Market Committee. Much as I hate to agree with any politician who blames the speculator whenever goods get too dear, which usually amounts to shooting the messenger, Homeland Security Committee Chair Joe Lieberman unfortunately had a point when he accused speculators of "artificially inflating the prices of food and fuel futures."

The remedy for restoring stability, however, is far simpler than Senator Lieberman seems to realize. Instead of acting on his resolve to "introduce comprehensive bipartisan legislation to address excessive speculation," his committee should simply demand that the Commodity Futures Trading Commission enforce rules that have been on the regulatory books since 1936.

The rules the CFTC should enforce are position limits that specify the maximum number of contracts in a given market that any single speculative entity can hold. These limits, which generally amount to about 2% of all contracts outstanding, are set for a good reason: The commodity markets are too small to absorb an excess of speculative dollars. Even at current inflated prices and a near-record level of trading interest, the total contract value on all domestic commodity exchanges comes to only $960 billion. By way of comparison, even at current depressed prices, the total market capitalization of all domestically traded stocks tops $13 trillion.

But as though commodity markets were as large as stock markets, a new breed of commodity index "investor" has taken speculative buying way beyond anything domestic commodity markets have ever seen. These commodity indexers ignore individual market fundamentals, instead flooding liquidity into markets based solely on the weightings dictated by one or another commodity index benchmark. The flood has become a torrent. For example, based on commodity trader Steve Briese’s calculations, "long" bets by the indexers in wheat account for nearly 60% of the 2007 domestic wheat crop.

Some analysts still insist that, despite the huge volume of speculative bets, prices are merely reflecting supply-demand fundamentals. (For an alternative view, see "Oil Bubble" in last week’s Barron’s.) But even if the bulls are right, they should have nothing to fear. To avoid all possible dislocations, let position limits imposed on the indexers be phased in — say, over a period of six to nine months. Then, if the fundamentals really do justify these lofty price levels, the absence of this speculative liquidity will hardly make a difference.

The indexers circumvent position limits by trading through dealers that belong to the International Swaps and Derivatives Association. These "swaps dealers" serve as market-makers for the index funds, while laying off their speculative risk on the organized commodity markets. Back-of-the-envelope calculations I did with Briese show a huge retrenchment if speculative position limits currently on the books were imposed on the swaps dealers. For example, in corn and soybeans, they would have to rid themselves of at least half the value of their current long positions in these two commodities.

Swaps dealers’ positions in crude oil are not available. But based on the standard commodity indexes, it is possible to make rough estimates. Briese estimates that their long bets on the New York Mercantile crude oil contract could account for more than a third of all long contracts, or the equivalent of nearly 90 days of U.S. consumption. Apply proportionately similar position limits in force for soybeans and corn, and there, too, at least half these long bets would have to be covered.

The CFTC currently exempts swaps dealers from position limits on the basis of an argument that would bring the commissioners a flunking grade in Econ 101. Contrary to the CFTC, the swaps dealers are not "hedgers," since hedgers are clearly defined as those who take offsetting positions in the physical commodity. In their role as market-makers for the index funds, the swaps dealers are taking offsetting positions, but they are obviously not dealing in the physical commodity.

History teaches that regulatory commissions often become hostage to the very industry they’re supposed to regulate. In that regard, it’s worth noting that CFTC Commissioner Jill Sommers is a former Head of Government Affairs at the International Swaps and Derivatives Association.

Say that legislators do ride herd over the CFTC by requiring that it enforce position limits. Even if, as proposed, the rules were phased in slowly, Briese fears an anticipatory collapse in prices that could drive the swaps dealers into bankruptcy. While that would hardly be welcome, the decline in food and energy prices would provide welcome relief to consumers.

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