Wednesday, June 25, 2008

You Don't Mess with the Krughan

In response to Arnold Kling's June 24th post:

Arnold, you're not wrong in saying that your misinterpretation of a Krugman quote is wrong. The problem is that Krugman never meant what you think he meant.

Here's the quote you refer to:

"Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price"

You're interpreting it as though Krugman said it has no effect on the spot price. He didn't say that. He said it has no direct effect on the spot price. And just two sentences later he goes on to say, "Any effect on the spot market has to be indirect...".

What did Krugman mean by all of this?

The Futures market and price is clearly related to the spot price, and can clearly affect it. You don't have to get all flowery and philosophical to see the key direct way, which is through arbitrage. The futures price cannot get too much higher than the spot price or else there will be arbitrage opportunities that are easy to see and will be jumped all over, bidding the futures price down and the spot price up.

For example, suppose the futures price of oil in one month were $140, and the spot (today) price were $130. An investor with good credit and access to funds could sign a futures contract to sell 100 million barrels in one month. Then, he could borrow $130 million and use it to buy 100 million barrels of oil.today. He would store the oil for one month, and then sell it at the price guaranteed in the futures contract, $140/barrel. With no risk, he would guarantee himself a profit of millions because interest costs on the $100 million he borrowed for one month, and the storage costs of the oil for one month, will be less than the $10 million difference between 100 million barrels bought at $130, and sold at $140.

Arbitrageurs will jump all over this and keep buying at spot and selling at futures until the futures and spot prices get close enough that the difference between them won't be big enough to pay the interest and storage costs. So, the futures price can never get too much higher than the spot price. And when the futures price is bid up – perhaps by speculators, this will pull up the spot price with it – but notice how; through arbitrage, through speculators buying on spot and holding in storage – hoarding! Just like Krugman said.

Speculation is only going to boost the spot price if there is some hoarding.

But an important issue, still, is how much hoarding is necessary. I discussed this in my June 17th post, and Columbia economist Guillermo Calvo eluded to it as well in a June 20th post; the amount of hoarding necessary to push up the price a lot depends on how inelastic the supply and demand curves are in the short run, or very short run.

If you look at Krugman's graph in his May 13th post , he has the supply and demand curves drawn pretty diagonally, indicating a lot of elasticity in both the supply and demand. The empirical reality in the very short run might, however, be that those lines are very inelastic, very close to straight vertical lines. In that case, when you boost the price, the gap between them that develops is very narrow, indicating that not that much has to be hoarded.

So, if supply and demand in the short run, or very short run, are inelastic enough, then perhaps a small enough amount would have to be hoarded that it could go undetected by the oil inventory records. Theoretically, this is possible, but I'm just not expert in oil inventory recording and the empirics of oil elasticity, so I can't really say how likely this is in the real world.

In any case, Krugman is right that speculators can only hurt us if they're hoarding. That's the only way they can affect the price, and this is true for anything. Speculators helped bubble up housing because they bought homes and held them for like a year or more. They held them, hoping the price would keep going up. They didn't sell them the next day, and when they did start selling them that really helped deflate the bubble. Speculators helped bubble up tech stocks in the late 90s because they bought them and held them for like a year or more, hoping the price would keep shooting up. If they sold them the next day, they would not have contributed to that bubble.