If you think $135 oil is a speculative bubble, that the only basis for current prices is want of a pin, here’s a plan. If you’re right, there’s a market failure. Those with access to physical oil are accommodating the bubble for some reason, when they could, should in theory, sell forward in quantity and insist upon delivery, forcing speculators who cannot accept physical oil to close their positions at desperation prices. Note you don’t have to overwhelm all the specs. Prices are set at the margin. You just have to sell with intent to deliver contracts representing somewhat more than demand for actual delivery to force oil off a cliff and crush the specs like bugs. If private arbitrageurs won’t do this — perhaps those who can, don’t, because they benefit more from high headline oil prices than they lose from foregoing a one-time arb &mdash then perhaps government should step in.

The US Strategic Petroleum Reserve could sell $135 oil forward in very large quantities, and refuse to close its contracts prior to delivery.

If you are right, and oil is an ordinary speculative bubble, then prices will fall sharply, and the petroleum reserve will be able to recover all the oil it sold cheaply, turning a profit for taxpayers.

But, if you are wrong, and oil prices are due to either current fundamentals or informed speculation on future supply and demand, then players interested in consuming or storing the product will step in as prices begin to fall and start buying. Prices would fall a little, but the drop would be transient, and the petroleum reserve would take a loss when it eventually repurchases to replenish.

It’d be a gamble. But if you think this is a bubble, a quick Federal pricking would be far less damaging public policy than curtailing unleveraged speculation. If you’re not so sure it’s a bubble, if you think it’s possible that current or future supply and demand justify current prices, then you should definitely not be banning speculators, who are doing the good work dissuading us from squandering what is precious. If you think current prices are a monetary phenomenon, that selling oil forward trades a valuable commodity for depreciating paper, then you don’t think this is a bubble at all, and limiting speculation is just a way of preventing would-be speculators from evading an inflation tax and spreading disquieting news.

I don’t know whether current oil prices a speculative bubble or not. Maybe, maybe not. Maybe the best way to find out is with the help of a nice long pin.

While chatting with a commenter on the previous post, I went back to the Mathematica notebook where I had played with the numbers, and found an error in my arithmetic that is, as they say, “material”. I erroneously used 68%, rather than 67%, as the late 90s participation rate, when I asserted that unemployment would be 8% today if participation returned to previous levels. The correct value is 6.6%.

That is, if an additional 0.8% of the “civilian noninstutional population” became active job seekers, but no net new jobs were created, the reported unemployment rate would be 6.6%. (The numbers, which hopefully I’ve correctly transcribed for a change, are May 2008 data from the June 6 release of BLS employment situation, Table A-1.) That’s still a big jump from 5.5%, but it’s a far cry from 8%, which sounds like a nasty recession.

To say I regret the error would understate the red-faced heart-thumpingness of the thing. Sorry!

Much of the chatter surrounding the latest BLS release has focused on a spike in the denominator of the unemployment statistic, the fraction of the population either working or actively looking for work. Courtesy of the indispensible FRED…

About a year ago, David Altig (whose macroblogging I miss very much) wrote the following:

[Since 2000] you would be justified in claiming a broad-based decline in the number of people choosing to participate in U.S. labor markets. But I use the word “choosing” intentionally, as I’m convinced that the post-2000 changes in labor force participation rates (or employment-to-population ratios, if you like) reflect trends that are largely independent of the business cycle.

Much turns on the question of why people chose not to participate in the labor force this decade. A “business cycle” explanation, as I read Altig, would mean that people left the labor force because there weren’t employment opportunities. They couldn’t find a job, and became “discouraged workers”, in the lingo. I agree with Altig that this is unlikely. However, unemployment statistics (very uneconomically) ignore price, and stagnant real wages over the period undoubtedly had something to do with the decline in participation. People chose not to work because they decided the money wasn’t worth their time.

But it’s also important to consider a credit cycle explanation for why people left the workforce. One has the luxury of choice when one can afford to do without employment. During a credit expansion, many people have that luxury, because one can live off of borrowing and asset appreciation. You can quit your shitty job and withdraw some home equity while you write the great American novel, focus on your music, or raise your children. You can go to school, even though you lack savings, because student loans are plentiful.

But when credit conditions tighten and asset prices fall, work becomes less optional. Quitting the rat race and pursuing your passion starts to recall the phrase “starving artist”, and not in a charming way. Dad might decide he needs a job to make ends meet, even if that means putting the kids in day care.

Some argue that the US economy is structurally immune from the wrenching spikes in unemployment that used to accompany recessions, because employment has transitioned from volatile manufacturing to more mellow services. See, for example, this excellent analysis from Calculated Risk. CR chooses 8% unemployment as his threshold for a “severe” recession. But the US economy need not lose a single job more to bring unemployment to that level. If participation rose back to the levels of the late 90s without a commensurate increase in new jobs, we’d be there already we’d be at 6.6% unemployment right now. [Note: In my original calculations, I mistakenly entered 68%, rather than 67%, as the late 90s participation rate, significantly exaggerating the effect. My apologies for the error!]

When we ended welfare as we know it, back in the nineties, the slogan “Choose to work” might have captured the spirit of the times. It’s ironic that more than a decade later, the apparent health of the American economy depends largely on how many people continue to choose not to work, now that the credit spigot has dried up.

A very good friend of mine is putting together a venture capital fund devoted to “double bottom line” companies in financial services. In particular, this fund will invest in new business models for providing services to the “underbanked” (whom my friend quaintly insists on referring to as poor people). He’s looking for people with a strong background in finance and investment who would be into this kind of thing. The job would be in New York. If you’re interested, please write something about yourself to doublebottomline@yahoo.com. (Please don’t write to me, I don’t know anything more than I’ve already written.)

It’s easy to be cynical about all this, and Interfluidity ain’t a job site, but this is someone I know, and what he does he does well. My apologies for the ad-ish-ness. I promise not to make a habit of it.

Greg Mankiw offers a strong endorsement of a proposal to cut the corporate income tax from 35 to 25 percent, claiming “It is perhaps the best simple recipe for promoting long-run growth in American living standards.” (Hat tip Mark Thoma.) A good case can be made for cutting or even eliminating the corporate income tax. But Mankiw’s argument does not cohere.

Let’s start positive. Mankiw is right to point out that the “incidence” of the corporate income tax might not in fact be as progressive as its proponents would wish. He quotes studies suggesting that workers end up paying 70% to 92% of the taxes in the form of lower wages. I’m skeptical of those numbers, but it is surely true that some fraction, perhaps even a large fraction, of the corporate tax burden falls on workers and customers rather than presumptively wealthier investors. Mankiw does us all a service by reminding us of this.

Then he tells us a fairy tale:

A cut in the corporate tax… would initially give a boost to after-tax profits and stock prices, but the results would not end there. A stronger stock market would lead to more capital investment. More investment would lead to greater productivity. Greater productivity would lead to higher wages for workers and lower prices for customers.

First, if as Mankiw has argued, the lion’s share of tax burden falls on workers, the “boost to after-tax profits and stock prices” would have to be correspondingly small. You can’t have it both ways — either investors pay the tax, and stocks would be more valuable without them, or workers pay the tax, and stockholders are mostly indifferent. Perhaps Mankiw doesn’t think that workers pay the tax after all.

Suppose there would be a surge in profits and stock prices, either because the corporate tax does burden stockholders, or out of irrational exuberance by cigar-smoking plutocrats. What then? Would “a stronger stock market… lead to more capital investment”? The tax change can’t affect the economic opportunities available to firms. It can only affect investment decisions by reducing firms’ cost of capital. As long as firms are correctly valued, the cost of equity depends on investor expectations going forward, not the level of the stock market today. Counterintuitively, if investors expect high future stock returns, that implies an increase in the cost of equity, and less corporate investment as existing opportunities face a higher “hurdle rate”. Steepening return expectations only lead to more capital investment if they reflect an improvement in the opportunities available to firms. That is beyond the power of a tax cut.

Unreasonably high stock prices can, of course, encourage capital investment, as managers try to exchange overpriced paper for valuable projects, but the quality of investments under those circumstances is questionable at best. Surely, Mankiw does not think we should jolt stock markets into a bubble, because then firms will invest willy-nilly to preserve value before investors come to their senses?

A more charitable interpretation would be that Mankiw meant that investors’ required return for stock investments wouldn’t increase as much as the after-tax value of investment opportunities would, effectively reducing the equity cost of existing opportunities. But if the after-tax opportunity values would improve (they wouldn’t, if workers bore the tax), there’s no reason to think investor return requirements wouldn’t increase as well. Just as it’s hard to say who a tax will ultimately fall on, it’s hard to know a priori how the proceeds of an investment tax break will be split between reinvestment, consumption, and safety. Some of the tax windfall would (thank goodness!) go towards delevering to reduce risk, and some would be withdrawn and spent by investors. How much actually goes to new capital investment would depend upon investor preferences, credit markets (which set the cost of safety), and the quality of potential new projects.

In theory, when firms do not have productivity-enhancing new projects at the ready, they return funds to investors. But, in the aftermath of first the dot-com bubble, and then a massive credit & housing bubble, it’s worth asking what actually happens when the economy experiences positive shocks to the supply of capital. Perhaps, in a world where agents are informationally limited and distinct from the owners of capital they deploy, it is not always optimal to increase the rate at which capital is made available to firms and investment professionals, when the same wealth might otherwise be consumed or held for future use. We might illustrate this to supply-siders as a “Laffer Curve”, with an optimal cost of capital above which productivity-enhancing investments are foregone, but below which wealth-destroying projects are funded. I think we’ve been on the wrong side of that curve for much of the past decade, so before I get excited about policies that purport to deliver growth by increasing incentives to save and invest, I’d like to see evidence that if we had more capital at hand, we’d use it well rather than employing well-paid intermediaries to destroy stuff in crazy schemes.

Supply side economics is a nice story, a hopeful story. It offers a clean, plausible policy framework: encourage investment, always and everywhere, and prosperity is sure to follow. But this decade has been about a pure a test of that idea as we could hope for. Capital in the United States was incredibly cheap, and what did we do? We destroyed a lot of wealth. We don’t need more capital (although we might soon, if our foreign backers get skittish). We need more discriminating capital. In the meantime, the only thing I’m sure “works” about the supply side story is that it shifts the tax burden from richer to poorer. I’d rather that stop working so well.

Postscript: It is always deflating to see good ideas supported by poor arguments. I’d enthusiastically support eliminating the corporate income tax entirely, if the change were paid for by new taxes at least as progressive as the corporate income tax was intended to be. But my reasons are different from Mankiw’s. Currently, the portion of corporate earnings payable to shareholders is taxed as corporate income, while the portion of earnings payable to debt holders is not taxed at all at the corporate level. (The accountants don’t call the latter earnings at all, but that is semantics.) This differential tax treatment effectively pays firms to borrow funds rather than raise new equity when they need cash, which is bad public policy. Corporate leverage has social costs, “negative externalities”, in terms of financial stability. To the degree government interferes in the capital structure decision at all (and I’m not arguing that it should), policy should favor equity financing since equity-funded firms are better able to internalize the costs of their misfortunes than are highly leveraged firms. So, three cheers for a progressively funded abolishment of the corporate income tax!

Alas, Mankiw proposes increasing gasoline taxes to replace the lost revenue. While there is much to be said for a higher gas tax, it fails the progressivity test. (Poorer people spend a much larger share of their income on fuel than do the affluent. Surely a Pigouvian would delight in redistributing the proceeds of a carbon tax as a flat transfer back to citizens to offset that unfair burden. A rebated carbon tax could be wildly popular, and help save the planet too.)

If, instead, we funded the change by increasing the highest marginal tax rate, or better yet, by creating a new top tax bracket, eliminating the corporate income tax would be a grand idea.

A dramatic explosion and electrical fire somewhere in Texas took Interfluidity down for much of the weekend. (Thank goodness no one was hurt, and all things considered both The Planet and American Powerblogs have done a pretty good job managing the outage.)

The post that follows this one will be less timely than I’d like. It was intended for publication Saturday. Oh well.

I don’t usually do link posts, but while I’m here I thought I’d call your attention to John Phipps on China and Gabriel Mihalache on models.

Poor, abused readers — I am making a recycling bin of your eyes!

The following is modified from a monstrosity I began and abandoned over a month ago, thinking about futures markets. Michael Masters’ allegations regarding “index speculators” and the CFTC’s investigation of price manipulation in the oil market only make sense if the arbitrage between future claims and physical stuff fails to work as advertised. The most clear example arbitrage failures have been with agricultural products, where cash market prices and prices of supposedly equivalent expiring futures contracts have simply not converged. It is to that (now ancient in blog-years) controversy that this suggestion was originally addressed, but I think it applies to the more recent hullabaloo as well. I’m sorry that the links and context are somewhat dated.

For those of you who have been in the financial equivalent of outer space (that is, for those of you with a life), commodity futures markets have been misbehaving recently. I don’t want to get into it, but see here and here and here and here and here and here. The problem is that textbook arbitrage constraints are coming loose, the prices of things are wriggling free from one another in incoherent ways, and smashing up farmers in their confusion. Arbitrage is to finance what gravity is to physics. The movement of the spheres makes no sense, has no meaning, if rational relationships between prices aren’t maintained.

The universe is blessed with diligent quantum smurfs who ensure the constancy of gravity for us. But arbitrage is left in the frail hands of humans, and frequently our institutions are not up to the task. Fortunately, institutions are fixable. The trouble with commodity futures is that, although all the world can see that, say, spot and future corn seem inconsistently priced, relatively few actors — those with ready access to good, wholesale corn and the means and expertise to store and deliver it — can actually make the trade that would force prices and cosmic spheres to realign themselves. There are limits to arbitrage.

So, a suggestion: As an alternative to delivering actual corn to one of various warehouses in Illinois, permit those short a futures contract deliver a note issued by a kind of “corn bank”, entitling the bearer to a quantity of that very same corn on demand from the bank’s warehouses. Futures exchanges would regulate and certify competitive commodity banks, delivery of whose notes would constitute contract fulfilment [1]. At the same time, exchanges would host accessible cash markets in these zero-maturity notes (against which there would be negative accruals to cover storage costs, but lets put this technical detail aside for now).

At first glance, this proposal is a kind of nonsolution: Sure, convergence failures in futures markets would trivially disappear, as financial investors would purchase and hold underpriced spot claims and short overpriced futures (or vice versa) if the futures and spot prices were misaligned. But today’s convergence failures would just reappear in the form of overpriced deliverable notes relative to the cash price of the commodities they represent. Why would that help?

Financial markets are fundamentally information processing devices. Their purpose is to help investors place capital (or risk) where it can do the most good (or least harm). Thus, it matters very much whether the structure of a market reveals or obscures relevant details about an economic problem. This was a fatal flaw of the late securitization boom — there’s nothing wrong with securitization per se, it’s a great idea actually, to get previously obscure investments priced by broad and deep capital markets. But capital markets aren’t magic. If the securities hawked are complicated bundles of mathematical formulas of incompletely described uncertain securities, “market prices”, while they last, may not prove reliable. (OT: See this great post by Going Private about the CDO securitization process).

Trading claims on deliverables rather than direct obligations to deliver would open the arbitrage process to all financial investors, rather than relying on small groups of potentially collusive firms. Mysterious convergence failures would disappear. Rather than going “WTF?” and convening at the CFTC, we’d observe commodity banks eager but unable to sell simple IOUs for commodities at prices well above their cost because they lack storage or shipping capacity. A phenomenon of high finance would unmask itself as an easy to remedy operational problem, with a clear business case attached. Of course, people in commodity industries already understand the bottlenecks they face, and eventually they’ll find the financing to do whatever needs to be done. But clarity matters. A couple of months ago, farmers and grain elevators faced a “liquidity crisis” — their traditional funding sources, banks, were skittish due to the credit crunch, and other capital sources don’t understand their business well enough to jump in with quick money. With a more transparent informational architecture, capital would cure bottlenecks faster. Time is always of the essence, both from a broad economic perspective, and to farmers who are struggling to meet margin calls on volatile futures contracts when all they want to do is lock-in a price for corn.

This scheme would also render market manipulation more visible, by eliminating complexity at the interface between opaque, dispersed cash markets and liquid, transparent futures markets. If futures prices spike somehow, spot note price would rise, which ought to cause banks to compete for cheap access to the physical commodity. If prices seem “too high”, regulators could focus on spot market conditions (are commodity banks competitive? are producers withholding output? are precautionary inventories rising at banks? is there unusual non-bank-intermediated demand, either by current users or speculators?). Arbitrage relationships hold quite well among predictable, liquid paper assets. With a simple market for spot claims, regulators could focus on the present, and let the future take care of itself.

[1] Exchanges would insist upon these notes being non-fractional claims against actual inventory, as the exchange’s clearinghouse would ultimately guarantee the notes. These would be depreciating, negative carry notes (due to storage costs), so investors without use of the commodity would shed notes quickly, keeping inventories minimal, unless they wish to finance storage for precautionary or speculative purposes (which inventories would be transparent and measurable). Banks would compete both on the price (reflecting their quality of access to the dispersed cash market) and storage fees (reflecting operational efficiencies).

Michael Masters’ testimony regarding the role of speculation in commodity prices has drawn a lot of comment since last week. [See, for example, Cassandra, James Hamilton, Tim Iacono, John Mauldin, Michael Shedlock, Yves Smith.] According to Masters’, portfolio investors’ increasing participation in commodities via futures markets has been driving a speculative price boom, over a period of years.

I have to say, I am very skeptical of Masters’ view. Perhaps I have drunk too deep of the Kool-Aid of orthodox finance, but, as the saying goes, “for every long there’s a short”, and Masters does very little to explain who is taking the other side of what he presents as a one-way bet, a virtual cornering of the commodity markets. We’ll come back to this, because the shorts are the most interesting characters in our story. But before we go much further, we might as well opine a bit on the debate du jour, is “speculation” driving commodity (and especially oil) prices?

This question annoys me, because people rarely define what they mean by “speculation”. Are you concerned about…

1. Traditional speculators, making active predictions about future supply and demand, and determining that commodity are underpriced relative to other goods and services.

2. Nervous hedgers, who respond to recent price volatility by taking larger-than-usual precautionary positions in order to manage operational risk.

3. Portfolio diversifiers, who allocate some fraction of their portfolios to commodities in a price-insensitive way, as it becomes ever more convenient to do so, and the investment profession comes to view commodities as an attractively uncorrelated “asset class”.

4. Momentum investors, chasing recent price rises into a classic speculative bubble.

5. Inflation hedgers and monetary skeptics, who view the purchasing power of financial assets as increasingly volatile, or who expect a decline in the purchasing power of financial assets, but who do not view commodities as undervalued relative to other goods and services.

6. Corporatist governments, who seek to shed market risk by obtaining non-market access to commodities (vertical integration), or whose policies amount to speculation on future market conditions. Examples include countries that restrict food or commodity exports in response to high prices; China, whose state-affiliated firms purchase stakes in suppliers of essential commodities; Saudi Arabia whose purchase of GE Plastics looks to capitalize on preferred access to petrochemicals; oil producers generally, when they produce below capacity; and the United States with its strategic petroleum reserve. All of these practices have the potential to reduce supply to unaffiliated commodity users who rely on public markets.

It takes all kinds to make a market, and I think that we’ve got the whole menagerie. Also, we shouldn’t forget this story, from Jeff Matthews (ht WSJ):

…the fact that a) world oil demand is up 12 million barrels a day since 2000, and non-OPEC oil supply is up only 4 million barrels a day since 2000, and b) America decided to convert food into ethanol at the very moment that c) China’s demand exploded.

See James Hamilton for a fuller exposition of the case that oil price fundamentals are driving prices.

Masters fingers as the villain “index speculators”, a Frankenstein combination of Types 3 and 4 above. There outta be a law agin’ them, he suggests to Congress. Pension funds should be barred from commodity investing, loopholes that have undermined speculator position limits should be closed, and the increasingly meaningless distinction between commercial and noncommercial traders should be resurrected in CFTC reports. Okay.

But what if the price-setting speculators are not momentum-driven index funds, but “traditional speculators”, correctly predicting that prices are below long-term fundamentals? Then limiting commodity speculation would prolong the mispricing, and cause us to waste resources that are kept artificially cheap. Alternatively, what if (as I suggested in the previous post) commodity prices are being driven by monetary fears? Then banning pension funds from commodities would amount to barring the exits, forcing workers to watch helplessly as their retirements are devalued away. If “fundamentals” are driving prices, or a flight by official actors from market to non-market means of resource allocation, limiting speculation would do no good, but would obscure the news by interfering with price transparency. The only circumstance under which limiting “speculation” might be a good idea is if the dominant tale is a momentum-driven speculative bubble. Which could, of course, be the case. Or not.

Which brings us back to the shorts. “Irrational exuberance” isn’t enough to cause a speculative bubble. There needs to be something else that discourages rational traders from taking irrational traders’ money when they buy overpriced assets, “limits to arbitrage” in the lingo.

Now, this is an old conversation in academic finance, especially with respect to the stock market. Heck, go chat with Brad DeLong and Robert Waldmann about noise traders, they’re right here in the blogosphere. We’ll dispense with the details here, and recite the pithy Keynes quote…

The market can stay irrational longer than you can stay solvent.

If a stock is overvalued, to correct the mispricing, you must sell it short. Even if you are right that it is overpriced, if the speculative mania continues, red ink on your short position might drive you out of the market and into poverty long before your foresight is vindicated. On the stock market, unleveraged “longs” can safely buy and hold, but “shorts” are forever at the mercy of the lunatics, hoping and praying that starry-eyed optimists don’t go even more batshit insane. Sane people sit on the sidelines, allowing enthusiasm to run unchecked, for a while.

But there’s a problem with applying this story to commodities. At least in theory, shorts in commodity futures needn’t face the same risks as stock short-sellers. Commodity futures are time-bound and perfectly hedgeable. If you are a commodity producer, and know that futures prices are way too high, you can sell your own product forward into the market. If prices move irrationally against you, your only cost is the foregone opportunity of a speculative gain. If cash prices are out of sync with inflated futures markets, then anyone (in theory) should be able to get into the act, purchasing physical commodities and storing them for future delivery, thereby locking in a certain gain, a perfect arbitrage. If you think that the commodity boom is a speculative bubble, then you have to explain not only who is buying, but why all that speculative interest doesn’t attract knowledgeable sellers who hold the price to “fundamentals”.

A while back, Yves Smith pointed out the possibility that…

the volume of futures contracts is so large relative to the actual deliverable commodity that arbitrage (via taking physical delivery) won’t force convergence of futures prices to cash prices at contract maturity.

In other words, in this messy real world, speculative interest could overwhelm the arbitrage mechanism designed to tether futures prices to fundamentals, for a while. But that begs another question. If you buy Masters’ story, then we are in the midst of a speculative bubble that has been building over a period of years, not a sudden spike. So why haven’t arbitrageurs increased their capacity to store and deliver goods, as speculative demand has slowly ramped up? The opportunity to profit is tremendous, especially if there are hordes of paper speculators who have no choice but to liquidate or roll their positions every few months. People with access to the physical commodity could profit from more than the ordinary arbitrage. At every roll, they have the entire community of “index speculators” over a barrel. Shorts are under no obligation to let speculators close out their positions at inflated “market prices”, or even estimated “fundamental values”. They can force longs to accept prices that overshoot downward, exacting a price for release from obligations that paper speculators are incapable of fulfilling, the obligation to accept delivery. If you think Masters is right, you have to explain why, year after year, those taking the short side have been willing close their positions at a loss rather than forcing more deliveries. Why haven’t shorts entered the market who are capable of calling index speculators’ bluff?

Hmm. Let’s turn once again to Smith:

Remember, you can arbitrage futures to physical only if you are permitted to do so (only certain traders, known to have access to the storage and transport, are allowed to take or make physical delivery) and can actually obtain the relevant commodity.

So, there are potentially barriers to entry for bluff-callers. Who are these “certain traders” permitted to make delivery? I don’t know, but one would imagine that commodity producers would be prominent among them. So, for the conspiracy-minded among you, here’s a theory: Producers’ core asset is not the stock of goods they have for sale today, but their potential to produce and sell a stream of commodity out into the indefinite future. It might be worth it for producers to bear an opportunity cost by not exploiting futures trades aggressively — that is by letting specs close positions at artificially bid-up prices — in order to inflate the apparent value of their enterprises, especially when producers intend to borrow funds, sell equity, or make stock-based acquisitions. Managers whose compensation is equity-linked might be particularly enthusiastic. Depending on how numerous and competitive the community of enterprises capable of physical delivery on prominent contracts, there might be a tacit cartel on the producer side, accommodating speculative futures prices, while managing spot supply so that cash market prices (which are less consistent and transparent than futures prices) are not outrageously out of line with futures market benchmarks.

Is this really going on? I have no idea. As I said initially, I can see all kinds of reasons why commodity prices might be rising, besides “irrational speculative bubble”. But I do know this. If it is the “index speculators”, if it is a speculative bubble, then those who blame workaday money managers asset-allocating into commodities are buying the con and blaming the patsies. If there’s a speculative bubble, the mystery — and the target of any reasonable policy interventions — lies on the short side. Sooner or later, the lemmings going long will take care of themselves.

When I see what commodity prices are doing, I don’t think “low interest rates” or “skyrocketing demand”. I think about a loss of confidence.

There is that old saw about gold, that it is the only money that is no one’s liability. Wheat is no one’s liability, and neither is corn. Oil is no one’s liability.

It is common to invest in commodities as an “inflation hedge”. If the central bank prints too much money, you need wheelbarrows to buy bread. If you have a sack of wheat, you will have your bread whatever the central bank does. But if everyone buys wheat, the price of grains will rise, even if the central bank does nothing at all.

Just as the fear of a bank’s insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much I might criticize it, has not gone on a printing spree. It has lowered interest rates, and altered the composition of bank assets by replacing less liquid with more liquid securities. But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid. The Fed’s actions are best described as antideflationary, not inflationary.

But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not. Rather than “taking away the punchbowl“, central bankers have become the life of the party. Japan’s central bankers hand out Yen like free acid. China’s guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson’s name to it). Our man Ben is an Amadeus-cum-Macguyver, he’s brilliant, unpredictable, he’ll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB’s Trichet, who at first comes off like a sourpuss, turns out to be alright, when you’ve got some Spanish mortgages to pawn.

Some of us think that something’s wrong, and these guys we’re drinking with aren’t serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don’t know who’s ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about “imbalance” and “adjustment”, but we’ve yet to see a serious plan, other than let’s-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.

Although commodity prices have been increasing for years, you’ll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB’s refusal to drop interest rates.

I can’t tell you where the inventories are, except to wonder why anyone would put them where they would be counted. Hoarders tend to get nervous, and not advertise their hoards. (But this is pretty obvious.) Perhaps producers of storable commodities who lose faith in paper quietly hold back production. Interestingly, people who no longer trust the very core of the financial system remain comfortable with collateralized, centrally-cleared futures exchanges. These are well designed to manage credit risk, but they can default, have defaulted, and will default in extremis. I heartily endorse Cassandra’s suggestion that they step up their margin requirements, ASAP.

None of this is any good at all. Capital devoted to precautionary storage would be better employed building new enterprises, laying a foundation for tomorrow’s prosperity. But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban “hoarding, profiteering, and price-gouging”. People will hoard anyway if they don’t believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won’t suffice. Nor will yet another drink from the punch bowl.

Mark Thoma offers a very thoughtful rejoinder to my post on whether the Fed should be given authority to pay interest on deposits. Mark’s comments range from specific, technical points to broad questions about governance. What follows is a quick response to some of the issues he raises. Do read his piece, The Fed Already Has a Blank Check.

My bottom line remains the same. Although the central bank does have the capability to unilaterally expand its balance sheet, it is subject to a variety of constraints that restrain it in practice. I am opposed to relieving the Fed of those constraints unless hard limits are placed upon the scale of its direct investment in the financial system, both to protect taxpayers from absorbing losses, and to support the long-term ability of financial markets to allocate real economic capital well.

I address some of Mark’s points specifically below.

• Mark suggests that “the Fed already has a blank check”, because it could increase reserve requirements, rather than borrow funds, to sterilize the inflationary effect of printing cash. This is true in theory, but I think it would be very difficult in practice for the US central bank. The Fed has not used reserve requirements as an active instrument of monetary policy for a long time, and has allowed (encouraged) them to atrophy, with an eye towards eliminating them entirely. (See here and here.) Reserve requirements could be reinvigorated, of course, but not easily or quickly. They would have to be restored over time and in careful consultation with banks, whose enthusiasm for the project would be less than overwhelming.

• You’ll hear no argument from me when Mark suggests that the Fed already has the power to do great harm. Poor monetary policy can lead to unnecessary recessions, or to credit and mis-investment booms that leave the economy structurally crippled. That an institution already has great and terrible power is no argument for handing it yet another means of mischief-making.

• While central banking has always entailed risk, customary and statutory constraints usually reduce the likelihood of harm. Any asset can lose value, but restricting Fed purchases to short maturity Treasury securities limits the risk of capital losses, and importantly, distributes gains from seignorage to all taxpayers. Purchasing or lending against more speculative assets provides a subsidy to particular sectors and institutions (undermining legitimacy), puts taxpayer funds at risk, and privatizes the gains of seignorage in the event of nonperformance. (Central bank cash that otherwise would have retired public debt are instead distributed to private parties and never returned.) Fair allocation of seignorage gains is one of the prime virtues of fiat money central banking. Lending against questionable collateral imperils that advance.

• Mark correctly points out that the potential upside of the Fed’s bank investments is not merely, as I suggested, “about what [taxpayers] would have earned investing in safe government bonds”. The purpose of the central bank’s activism is to prevent harms to the public that might result from turmoil in the financial sector, and these foregone harms should be included in our calculus. But if we include nonfinancial benefits, we must also consider nonfinacial costs, such as the long-term effects of the “moral hazard”, a loss of information in asset prices (assets must be valued as complex bundles of economic claims and options on potential government support), and impaired political legitimacy of the central bank and the financial system as a whole. We must weigh these costs and benefits against alternative policies, not only a straw-man scenario under which all government agencies stand completely aside and watch helplessly as the world falls apart. Of course, in “real time”, the Fed did not have the luxury of reflection. But we do have it now. Mark and I would come to very different judgments about the nonfinancial costs and benefits of Fed policies. I assure you that, in general, Mark’s judgment is much better than mine. Nevertheless, cranks like me will aver that the long-term costs due to moral-hazard and information loss are inestimably large, that questions of legitimacy and favoritism will haunt financial capitalism for a generation, and that it would be possible (even now!) to adopt uniform procedures for managing the collapse and reorganization of institutions that could not survive without life support from the Fed. Who should be empowered to decide these issues? Ben Bernanke? Hank Paulson? I vote for the people that I voted for, warts and all.

I want to make clear that I don’t actually disagree with Mark on the technical question of whether an interest rate corridor is a good idea. So long as the Fed restricts itself to traditional monetary policy — that is, so long as it buys only Treasury debt with borrowed funds — I would support this change (mostly because an interest rate corridor is easier for non-experts to understand than open market operations).

Unfortunately, not only has the Fed resorted to unorthodox tools during an acute emergency, but all indications are that the central bank plans to expand its innovative practices and continue them indefinitely. The “unusual and exigent circumstances” under which the Fed’s extraordinary actions have been justified specifies duration about as precisely as the “global war on terror”. Mark has great confidence in the Federal Reserve, and sees little hazard in granting it more freedom to maneuver. I view the central bank as prone to catastrophic error, and wish to see its capabilities clipped, not enlarged. I think the consequences of centralizing private sector risk on public sector balance sheets will turn out be grave, and must oppose any tool that would make it easier for the Fed to continue to do so.

Finally, Mark writes regarding the occasional need for fast action in a crisis:

This is an old problem — how much authority should be centralized thereby allowing quick and immediate response during a crisis, and how much should be retained in slower, deliberative bodies like the House and Senate? The War Powers Act reflects this compromise — we want the ability to respond quickly to an attack or other military developments, but we worry about the concentration of power in the hands of a single individual. Centralization has the benefit of allowing a quick response to a crisis, but it risks being out of step with the democratic process. In the case of financial market emergencies, however, I have more faith in the Fed than in congress to act quickly and correctly. That’s partly because I have little faith in the ability of congress to quickly comprehend what the problem is and attack it directly and effectively — many of them admit to not having a clue about economics, and more worrisome are the ones who think they have a clue but don’t — but congress should not give up its oversight role.

I have little faith in Congress, and even less faith in the Fed. (That’s not, by the way, a reflection of the individuals running the place. Ben Bernanke is quite brilliant. But culture and ideology saddle the Fed with both blind spots and hubris.) I like Mark’s idea, though. I’d support a financial “War Powers Act” that would authorize emergency extensions of secured credit by the Fed to private actors deemed systemically important. But here’s my deal-breaker: That support would have to be withdrawn within 180 days, and would not be renewable. Six months is long enough for solvent institutions to counter a “liquidity panic” with full disclosure, for modestly troubled institutions to secure new capital, and for regulators to arrange an orderly unwinding of firms that cannot be made solvent and liquid within the statutory timeframe. Whaddaya say?

By the way, we’ll have our six-month anniversary of the first $40B in TAF financing in June.