The Commodities Futures Trading Commission (CFTC) is
considering new restrictions on �excessive speculation� in markets for oil,
natural gas and other energy products. It is about time they do.
Similar regulations already exist in markets for
agricultural products such as wheat, corn and soybeans. The historical record
shows that these have been relatively successful in preventing manipulation by
a few large players and excessive speculation, without hurting market
efficiency in agricultural products.
Predictably, the CFTC moves have some folks riled up. These
critics claim that any attempt to regulate speculative trading would be
anti-free market. Others have noted that speculation is an essential force that
helps the markets move towards equilibrium. Therefore, any attempt to constrain
speculation will retard market innovations and reduce benefits such as risk
sharing, liquidity and efficiency.
These critics miss the point. Contemporary research by
economists and study of business and economic history reveals that speculative
trading can be both healthy and unhealthy
for market integrity and efficiency. Although without a healthy presence of
traders and speculators, markets cannot function efficiently, but excessive
speculation can be problematic for market stability and efficiency.
The recent painful collapse of the real estate bubble in the
United States which led to a global financial meltdown should, at the minimum,
serve as a reminder of the dangers inherent in non-regulated markets that can
spin out of control. Economists of all shades agree that markets do not always
move towards an equilibrium. A growing group believes the assumption of
equilibrium in economic models may have to be jettisoned for more realistic
assumptions. It is time to question the conventional wisdom.
Last year, the price of crude oil soared to an all time high
of $147 per barrel, more than a 200 percent increase in a relatively short time
span. The steep and rapid rise in crude price came as a complete surprise to
most experts. Nevertheless, numerous industry experts and professional
economists concluded that the price spike was not a temporary aberration caused
by a herd reaction of speculators, but was indicative of fundamental changes in
market demand and supply. Factors such as high demand in India and China were
mentioned. Even top-notch economists like the Nobel Laureate Paul Krugman ruled
out the existence of a bubble, given the low inventory levels in crude oil.
The consequences of the sustained rise in crude oil prices
were harsh on the global economy. Since crude oil and energy are crucial
ingredients in the production of agriculture products, the impact on food
prices was predictable and debilitating. Food riots broke out in many
developing nations with millions of low income families squeezed in a vicious
crisis from the escalating price of rice and other essentials.
Fortunately, most experts were wrong. The spectacular
increase in crude oil prices was, in fact, the result of self-fulfilling
expectations by traders that led to a speculative price bubble. Fundamentals such
as a sustained increase in demand from economic growth in India and China
played a relatively minor role. A market bubble is created and sustained by
easy money and excessive speculation from an influx of unsophisticated traders.
Traders who take long positions in markets infected by a price bubble are not
acting irrationally, but the market outcome is highly inefficient. Rational
traders can behave with a herd mentality, causing irrational outcomes. A bubble
is not sustainable, and when conditions are right it collapses. Once the crude
oil price bubble popped in 2008, prices fell rapidly until they were below $35
a barrel, a dizzying collapse of more than $111 dollars per barrel in a few
months. Typically, a collapsing bubble overshoots before finding the true
Today, those who oppose the proposed CFTC regulations have
presented various arguments. First, some argue that it is a mistake to try to
separate the two types of traders, speculators from hedgers, since both add
liquidity. Second, some hold that since speculation is a market force, it must
be allowed unimpeded. Third, the argument is made that speculation is harmless.
Another argument that is often heard is that regulation impedes markets, is anti-capitalistic
and, therefore, is always harmful. Finally, some agree that market gyrations
can be painful, but believe that attempts to control these fluctuations can be
even more harmful.
None of these arguments stand up to close scrutiny. The case
for judicious regulations is well established in economics. First, it is
relatively easy to separate and regulate trading motivated by a desire to
spread the risk, and trading for profit motive only. This is already achieved
by appropriate regulations in the US agricultural markets, and in other nations.
Second, economists who have studied speculative price bubbles realize that at
some point retail investors who are generally unsophisticated wade into the
market, creating greater instability. Third, even though normally speculative
forces lead to improved market efficiency, these same forces can sometimes
cause the markets to spin out of control, if excessive speculative funds come
in. According to some estimates, at the peak of the crude oil bubble, demand
was several times what could be justified by fundamentals. Contrary to the
common view, speculation can be destabilizing eventually creating millions of
victims including small businesses and retail traders.
Capitalism and free markets were never meant to be free of
all rules. Adam Smith the father of modern economic science was well aware
of the need for public sector controls of the private economy. After publishing
his magnum opus, The Wealth of Nations,
he served as a senior customs official. Good regulations play the same role in
markets, as good traffic laws play in transportation. They ensure efficiency
and safety of all participants. It makes little sense to allow price bubbles to
grow unimpeded and wait to clean up the mess after the bubble pops. Good
regulations can prevent bubbles from forming, and can pop these before they
grow too big.
In case of the recent run up in the crude oil markets, by
intelligently using the Strategic Oil Reserves, policy makers could have
intervened to prevent the rise and collapse of the 2007-2008 crude oil bubble,
saving the economy from much grief. This would have been justified on national
security grounds (would have reduced the flow of dollars to unfriendly oil
exporting nations), and would have been good for consumers and investors in
A market bubble creates and feeds on artificial scarcity --
by giving appropriate signals, policy makers can influence unrealistic
expectations and puncture a growing bubble. Such aggressive and pro-active
management of a bubble may save the economy billions. As a result of cutting
edge research, policymakers now have a number of tools in their arsenal to
identify and shoot down price bubbles. This includes reducing leverage by
raising margin requirements, raising interest rates to reduce excessive
liquidity, making fundamentals more transparent, and warning against the
dangers of irrational exuberance.
If only the Federal Reserve and regulators, such as the CFTC,
had the necessary tools and the political will, perhaps today the US economy
would not be in such serious trouble with over 12 million Americans unemployed.
The mismanagement of our economy in recent years has seriously impacted our
credibility as the leader of the world�s free market economies.
The CFTC and other regulators, by moving to curb excessive
speculation while preserving the ability of traders to conduct their normal
business, are finally moving in the right direction. Good regulations
strengthen, not weaken, free markets. Excessive speculation leading up to a
price bubble can be disastrous to the safety and health of markets and millions
of participants. The simplistic choice between judicious regulations and market
efficiency is a false choice. It is possible to regulate markets to prevent
debilitating booms and busts, and preserve incentives for innovations and
To prevent future bubbles, it is crucial that regulators and
politicians learn the right lessons from recent debacles, such as the dot.com
bubble and the collapse of the housing and financial markets (derivative)
bubbles. Further, regulators in the United States must coordinate proposed new
regulations with regulators in Europe and Asia for closing loopholes and
Quddus is a Professor of Economics and Dean of the Business School at Prairie
View A&M University, Texas. He has a Ph.D. in economics from Vanderbilt
University and writes on economic development, entrepreneurship, and history of
economic ideas. He can be reached at email@example.com.