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Speculators “R” Us: Commodities Markets Need Institutional Investors Like Us

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Congressional committees on both sides of Capitol Hill hold hearings this week on “excessive” speculation in the commodities markets, with members of Congress on both sides of the aisle looking for someone to blame for rising oil and food prices. Financial speculators are popular culprits these days, despite the fact that global supply and demand largely drive prices. Instead, our representatives in the House and Senate should be looking for solutions to rising commodities prices by diversifying our sources of energy and food and thus directly addressing economic fundamentals.

Let’s begin with some basic financial facts about investing in any financial marketplace, including the futures and options markets for basic commodities such as oil and food. When Southwest Airlines, for example, hedges its oil prices by buying futures contracts because it bets that prices will rise, it needs somebody on the other side who will bet the opposite. That counterparty is usually a financial investor—a hedge fund, big investment bank, or institutional investors—not another commercial airline. These investors in turn are betting that there are other speculators out there that will buy the contracts if they no longer want them. Southwest Airlines and other commercial purchasers of commodities need those financial counterparties in the marketplace.

This activity has been characterized by some as speculation, but that is a loaded term. The fact is that financial markets only work efficiently when there are many different kinds of investors “speculating” simultaneously on price increases and decreases. Frequent buying and selling is necessary for the smooth functioning of any marketplace, especially one in which institutional investors, such as private money managers, banks, and pension plans, need to hedge their investments. Institutional investors buy and sell commodities contracts not because they want to own the underlying oil or corn, but because they want to diversify their investments for the benefit of their primary customers—us.

Similarly, money managers and mutual funds buy company stocks based on the wishes of people investing their 401(k) money—and they do not invest because they actually want to run those companies, but because they want to take advantage of price increases when these stocks appreciate. No one would think of banning institutional investors from the stock market because they “speculate” in stocks.

Yet it’s fashionable on Capitol Hill these days to blame large investment banks and hedge funds, pension funds and 401(k) money managers, for the rising price of commodities. Any effort to outlaw some financial investments by these and other institutional investors, however, would have serious unintended consequences. Congress would make a real mistake if it tried to institute a blanket ban on commodity investments by institutional investors.

To effectively end speculation, Congress would have to impose a very large tax on financial transactions or effectively prohibit those transactions. This would eliminate a large part of the secondary market, reducing liquidity in the marketplace and contributing to more price volatility. If the objective of reining in “speculation” is more volatility in oil and food prices, then limiting buying and selling of commodity futures is probably a good way to go.

But that’s not a good way to go. Institutional investors, including private and public sector pension plans that use commodity investments, use them as a diversification strategy and as an inflation hedge in their efforts to deliver retirement income security to millions of hard-working public servants and private sector workers. They are not trying to drive up oil and food prices for a quick buck.

There are probably a number of ways to enhance the operation of commodity markets, for example through more transparency when hedge funds trade, but outright banning commodity investments for large institutional investors, as some have proposed, is the wrong approach. If Congress is serious about bringing down the cost of oil and food, they need to encourage our economy to diversify our sources of energy and food. Interestingly, a number of the entities, such as public pension plans, that are being attacked as “speculators” right now are leading the effort in financing long-term commitments to alternative fuels and energy efficiency and could be important partners in this effort.

Members of Congress must understand that demand for oil will only abate (and prices fall) over the long term when U.S. consumers have a variety of alternative energy sources to power their transportation needs. Congress can spur that energy transformation in a variety of ways, as my colleagues at the Center for American Progress have presented in detail. That’s the way to cope with rising commodities prices. Forget about the speculators.

Christian Weller is a Senior Fellow at the Center for American Progress. To read his reports and analysis on financial markets, please go to the Economy page of our website. To read the Center’s policy prescriptions to build a low carbon economy, please go to our Energy and Environment page.

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