Gas prices are high and Americans want the villains responsible held accountable. Congress doesn't want to be blamed, though it certainly deserves a portion for refusing policy changes that would make a difference even in the long run. So, to deflect attention Congress has joined in the finger-pointing, and the easiest targets are "speculators."

Yet surprising voices are rising not to defend speculators but at least to set the record straight. For example, Paul Krugman of Princeton University recently wrote in The New York Times effectively deflating the view that speculators are to blame. As he put it, "the hyperventilation over oil-market speculation is distracting us from the real issues."[1]

Speculators may be easy targets--they may even deserve a bit of the blame for high energy prices--but speculators perform a vital role in financial markets and, unlike congressional actions, any harm speculators do will prove both fleeting and self-correcting. Congress should get back to the real issues, like getting the government out of the way of increasing domestic production.

Various and Sundry Causes

There are many possible contributors to high energy prices. Growing world demand and an almost complete lack of excess supply capacity play the major role. Such tight-spot markets mean that even small shifts in current or expected future supply or demand can have exceptional effects on prices.

Very unstable political and geopolitical conditions in producing countries such as Nigeria, Venezuela, and the Middle East (especially Iran) play obvious roles in current prices. Concerns over whether production will decline rapidly in Russia and Mexico also weigh on prices. And all these effects are magnified by the lack of global excess capacity.

Some commentators point to excessively loose monetary policy by the Federal Reserve, arguing that this has contributed to the decline in the U.S. dollar and pumped up global prices for a wide range of commodities. While inflation has picked up worldwide, this charge seems to be just another case of convenient Fed bashing. For all its powers, the Fed is the central bank to the United States, not the world. The European Central Bank, for example, has chosen a different path.

The Role of Speculators

To some, there is something unseemly about making money by betting on future outcomes. When we do this in the office pool, well, that's acceptable. And when we do this by buying a share of stock, a corporate bond, or a mutual fund, then we tell ourselves that's investing, not speculating. But if you are taking on risk in the hopes of getting a higher return, then you have joined the ranks of speculators.

Speculators accept risk that somebody else doesn't want. And speculators are rewarded for accepting risk if they prove right, and they lose money if they get it wrong.

Consider an important example today. Airlines have enormous demand for fuel. Those that can do so often hedge against a rise in the price of oil. The price of oil may or may not rise. The risk exists in any event. The question is: Who is going to bear the risk?

The airline doesn't want to bear the risk of higher oil prices. That's not their business. But at the right price, the speculator will take that risk. So the speculator contracts with the airline to deliver an amount of oil (or jet fuel) at a certain place and time and for a fixed price. The speculator, of course, does not have the oil. Rather, at the appointed time, the speculator buys the oil on the spot market for delivery. If the spot price is then below the price contracted with the airline, the speculator makes money. If not, the speculator loses. Either way, the airline's price is locked in.

Without the speculator on the other side of the transaction, the airline can't hedge its risk. This is the first important lesson about speculators: For every contract, there are two parties--in this case, one party with risk they don't want and one party willing to accept the risk at a price.

Speculators also play vital roles in agriculture. Today, a farmer needs to know about seed and fertilizer and equipment and adverse price movements. So the modern farmer is likely also something of a financial adept, buying and selling contracts to supply grain long after it's been planted. If the farmer doesn't hedge his supply price, then he's the one bearing the risk. Speculators, on the other hand have no need for the grain, but they are willing to bear the risk by committing to a price in advance.

So speculators operate on both sides of a market. They can buy what they don't need from someone wanting to lock in a sales price, or they can sell what they don't have by contracting with someone wanting to lock in a purchase price.

A Few Voices of Reason

In addition to Krugman's comments on speculators noted above, other important voices have spoken up. For example, Robert Samuelson writes, "Speculator-bashing is another exercise in scapegoating and grandstanding. Leading politicians either don't understand what's happening or don't want to acknowledge their complicity."[2] Samuelson echoes Krugman that prices have risen for many commodities with futures markets and for some without. It is tough to argue that speculators in futures markets are to blame for high prices when prices are high without futures markets. Others casting doubt on the role of speculators in pumping up oil prices include The Economist magazine: "Speculators do play an important role in setting the price of oil and other raw materials. But they do so based on their expectations of future trends in supply and demand, not on whims."[3] Sebastian Mallaby writes in The Washington Post, "The most basic problem with this claim [that speculators are to blame] is that a speculator can buy paper oil [or futures contracts] only if someone else sells to him."[4] In other words, if it is all speculative activity, then there has to be a speculator betting that prices will go down for the upward-betting speculator to place his bet. Even The New Yorker has a piece clearing the air of oil speculators. James Suroweicki wrote: "[T]here's little convincing evidence that the oil market is being significantly manipulated."[5] Whatever chicanery is occurring--and we can assume there is some--has only a marginal effect on prices at the pump.

Congressional Involvement

Congress is considering at least 10 bills addressing speculation, one of which, H.R.6377, has already passed the House and is heading for the Senate floor. This bill directs the Commodity Futures Trading Corporation (CFTC):

to utilize all its authority, including its emergency powers, to curb immediately the role of excessive speculation in any contract market within the jurisdiction and control of the Commodity Futures Trading Commission, on or through which energy futures or swaps are traded, and to eliminate excessive speculation, price distortion, sudden or unreasonable fluctuations or unwarranted changes in prices, or other unlawful activity that is causing major market disturbances that prevent the market from accurately reflecting the forces of supply and demand for energy commodities.

This legislation would make sense under some circumstances, none of which are present. For example, one would have to distinguish between excessive speculation and non-excessive speculation and between unwarranted changes in prices and warranted changes in price. In both cases, all one can wish the CFTC is "good luck."

Where the legislation best demonstrates its flawed approach is in the presumption that any and all relevant and "excessive" speculation is occurring in markets within the jurisdiction of the CFTC. Congress should be aware that futures markets are part of the global financial system and that this trading activity can and does occur worldwide. So any limitation on speculative activity the CFTC might attempt to enforce would simply mean the activity would move offshore, helping to build up foreign capital markets to compete more effectively with U.S. markets.

More Productive Solutions

If speculators and other market participants are right, then current high oil prices are justified by current and especially expected conditions. Any of a number of events might occur to justify the current price or even a much higher price. If the market is right, then the high prices have signaled to consumers and producers how they need to change behavior.

On the other hand, if today's high prices turn out to be the result in part or in whole of a speculator bubble, however unlikely, speculators will pay a high price for their mistakes as they will be on the wrong side of the bet.

In either event, Congress must recognize that speculators play a vital role in the operation of financial markets and that financial markets are now fully global in scope, so efforts to restrict speculation will succeed in the United States only because the activity will shift entirely abroad. It should focus on improving the stability and strength of U.S. markets by, for example, reducing excessive regulation rather than destabilizing the markets with imprecise new regulations that would render U.S. financial markets even less competitive.