James Hamilton, the distinguished economist and author of the Econbrowser blog, is delivering a paper (for the pdf file click here) to the Brookings Institution that discusses the causes of the 2007-08 oil price shock and its impact on the subsequent recession. This is a wide-ranging, thoughtful piece and he tackles some of the tough issues, including the role of speculation:
With hindsight, it is hard to deny that the price rose too high in July 2008, and that this miscalculation was influenced in part by the flow of investment dollars into commodity futures contracts. It is worth emphasizing, however, that the two key ingredients needed to make such a story coherent— a low price elasticity of demand, and the failure of physical production to increase— are the same key elements of a fundamentals-based explanation of the same phenomenon. I therefore conclude that these two factors, rather than speculation per se, should be construed as the primary cause of the oil shock of 2007-08.
I think this is about right — there were real fundamentals behind the oil run-up, but speculation made it unnecessarily worse. I do think Hamilton is showing the academic economist’s bias of underestimating that which can’t be measured — speculative influences — in favor of the more easily measurable supply and demand statistics, but it’s notable and laudable that he does recognize that speculation played a role. In my own Congressional testimony about the commodity speculation’s role, I stated that the issue was not just the degree to which investment inflows had already influenced prices, but also the degree to which they would in the future:
In all these considerations, one can argue in good faith whether index speculators create a large or a small impact. Those that believe there is only a minimal influence should consider a future when these index speculators will command far greater assets.
In his piece, Hamilton tries to quantify the impact that the oil runup had on the recession. He concludes with the belief that we would not have entered the recession without the oil price shock. Clearly, the energy price bubble has had a huge cost. Hamilton also does not include the damage caused by the disruptions in other commodity markets. In some of these areas, notably the cotton and grains markets, the impact of speculation was far more dramatic and, to my mind, evident. The bubble and subsequent bust exacerbated by speculation has had profound economic and human costs.
It is disappointing and troubling that the speculative tools that contributed to that run-up (commodity swaps) and the closely related speculative tools that created so much systemic risk in the financial system (credit default swaps) remain largely unregulated. Hamilton argues that the fundamentals behind some of the energy price increases will rise again in an economic recovery. Our policymakers need to have addressed the regulatory deficiencies if we are to avoid a replay of 2008’s speculative excesses and their subsequent disastrous costs.