Recent congressional testimony by hedge fund managers Michael Masters and George Soros has argued that the current volatility in oil prices is driven by speculation by institutional investors in commodities markets, and advocates increased government intervention in commodities markets. Director of economic policy studies Kevin A. Hassett notes the possibility that these speculators might actually provide long-term price stability, as they could be pulling future price increases to the present. Hassett argues that, although sweeping intervention in commodities markets such as the investment ban proposed by Joe Lieberman (I-CT) would be dangerous, limited congressional action to curb speculation is advisable.

Senior Fellow  Kevin A. Hassett

Every year there are a few memorable instances of U.S. congressional testimony that have an immediate impact on economic policy. This year's star performances were provided by hedge-fund managers Michael Masters and George Soros.

Their recent remarks were quite different in style. Masters demonstrated impressive data-geek skills. Soros was more conceptual, drawing on his many years of experience in financial markets. But each attempted to make the case that commodity prices are being driven higher by speculators.

There were signs last week that they convinced some crucial lawmakers. Democratic Senator Joseph I. Lieberman said he would propose a ban on "speculation" that would prohibit institutional investors from participating in commodities markets. Such a ban would dramatically alter the landscape. Is it necessary?

The argument for the ban goes like this. Financial institutions have recently begun to consider commodities positions as a core component of their portfolios. Masters refers to these investors as "index speculators" because of their investing strategy: They allocate their dollars across 25 key commodities futures, according to popular indexes such as the Standard & Poor's-Goldman Sachs Commodity Index and the Dow Jones-AIG Commodity Index.

When financial institutions load up on these futures, it drives up demand and perhaps current, or spot, prices as well.

Startling Numbers

Masters presented some startling numbers on the evolution of such investments in his testimony last month. He found that according to the Department of Energy "annual Chinese demand for petroleum has surged over the last five years to 2.8 billion barrels from 1.88 billion barrels, an increase of 920 million barrels. Over the same five-year period, index speculators' demand for petroleum futures has increased by 848 million barrels."

In other words, index demand for petroleum has gone up by about as much as Chinese demand.

Does speculation drive up prices, or lead to increased price volatility? Masters argues that it does, and urges Congress to discourage some institutional investment strategies. Such action would, he argues, lead to reductions in food and energy prices. Soros seconded this call to action, referring to a "bubble" in commodities markets.

But the case is hardly cut and dry. After all, an institutional investor doesn't actually want to consume the food or oil. He might buy a contract that delivers to him oil three months from now, but he'll want to sell it to a real consumer before the contract is up. In the end, market prices should depend on supply and demand, and should account for both ends of the transaction.

Inflation Hedge

Moreover, if a pension fund buys commodity futures, then it may well help provide its beneficiaries with a hedge against inflation. It's hard to see why discouraging that would be a good idea.

As a speculator moves in and out, he might increase harmful price volatility. Yet even here, the case is unclear. Indeed, the argument against Masters and Soros was first made by Milton Friedman in 1953. Friedman, in his classic treatise advocating flexible exchange rates, pointed out that speculation has to be stabilizing if speculators are making money. If speculators know that the price of something is going to go up a month from now, they buy today. If they are correct, they make money, and the price change is smoothed by the higher demand today.

It is easy to connect this argument to current oil markets, and to make the case that institutional investors have served the common good.

Beneficial Change

Institutional investors might, after all, have recognized early that world demand is going to drive oil prices up enormously in the future. By loading up on futures, they pulled some of the price increase forward to today. This change is beneficial for society, as it forces consumers to conserve sooner, and suppliers to search for new deposits.

Friedman's logic is irrefutable. If speculators are, as is popularly believed, brilliant tacticians who are making a killing, then their activities are stabilizing. Speculation is good.

If they are rubes who are going to lose it all, then there might be a role for a policy as draconian as Lieberman's ban. Speculation is bad.

Which way will it go this time? The answer will be revealed to us over time through prices. If prices plummet in the future, and that drop is exacerbated by a rush to the commodity market exits by institutional investors, then Masters and Soros will have been right. If prices stay high and even increase from here, then Friedman will have been right.

Congressional Hubris

Both eventualities seem possible. Hence, it would be the height of hubris for Congress to pass a sweeping ban on commodity investments by financial institutions.

Even the most committed free-market advocate would have to concede that Masters and Soros could be correct. This suggests there may still be an argument for policy tightening. Institutions can, after all, act like a herd and may be doing so unwisely now. Their performance during the subprime fiasco has hardly fed public confidence.

We have also learned that if these investments go sour, then the Federal Reserve or taxpayers may well end up funding costly bailouts, so acting early may be in the taxpayers' interest.

Thus, some congressional action to curb speculation may well be advisable, but only because it protects society from the possible financial catastrophe if futures markets make a sudden reversal. This should take the form of establishing reasonable position limits and tighter margin requirements, not an outright ban.

As convincing as Masters and Soros were, there are two sides to the speculation story.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.