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With crude oil nearing the highs it reached in the 2007-08 commodity boom, there is the usual spate of editorials blaming speculators for the prices. It never seems to register on the authors that for every buyer there is a seller, so there’s no reason for transactions to push the price systematically up or down. No one thinks that if you bet me $20 the Yankees will win the World Series it makes any difference to the baseball season, and if Yankee manager Joe Girardi blamed his team’s defeat on my bet he would be properly laughed out of baseball. But somehow it’s OK to write that if you bet me $20 that oil prices will go up, you’re responsible for people paying $4 a gallon for gasoline.

I think the misunderstanding begins with the silly fairy tale about futures markets existing so farmers and millers can fix a price for the farmer’s crop ahead of the harvest. No farmers were involved in setting up futures markets, and they have usually been suspicious of them or tried to have them shut down. Farmers have signed agreements with local crop buyers as long as they have sold crops for money, everywhere in the world. Modern futures markets only arose in the 1850s, starting in a few cities on the Mississippi River. A crop buyer agrees to the exact crop the farmer is raising, in whatever quantity the harvest produces, and takes nearby delivery. A futures contract requires standardized terms the farmer’s crop is unlikely to meet, and requires the farmer to guess his harvest yield and deliver to a faraway transportation hub.

Millers do use futures markets, but they sell grain, they don’t buy it. In a standard transaction, a miller goes to a local grain elevator and contracts for the precise type and grade of grain he wants, delivered to him or a convenient location. Then he goes to the futures markets and sells standard contracts for future delivery of the grain. He gets grain today and promises to deliver grain in the future. He has borrowed grain.

Why doesn’t he borrow money instead and use it to buy the grain? He would, if there were plenty of credit and good money available. In the 1850s futures markets were invented because there wasn’t enough gold and silver money in the American West, and government regulations had destroyed the banking system that could have provided credit. From 1900 to 1970, with a currency linked tightly to gold and a sound banking system, futures markets lost their economic prominence. When the US dropped the gold standard and introduced persistent high inflation and complex taxes with high marginal rates in the 1970s, futures exploded in volume and expanded from agricultural products to financial products. Things calmed down a bit from 1983 to 2008, but with a broken banking system, uncontrolled government deficits, and greatly expanded financial repression, futures markets are once again a preferred alternative to money transactions.

The farmer-miller fiction usually goes on to claim the purpose of futures markets is price discovery and hedging. But why did people in 1850 suddenly decide they needed second-by-second price quotes for a few grains, and not things like coal, iron, land, or gold that had far more economic importance, or for that matter, interest rates, foreign exchange, or equity prices? And why did it happen in primitive backwaters instead of London or New York? Why did the futures markets stimulate tremendous economic innovation? Why do traders yell and scream, and get in fistfights, and get rich if all that’s going on is agricultural price discovery? What people needed in 1850 — and this is very clear from reading the history and considering the development of these markets — was financing for commodity-related businesses, not price discovery or hedging.

The miller cannot use grain futures contracts to hedge his risk. His concern is the value of milling services, the spread between the price of flour and the price of grain. If grain prices go up due to an increase in demand, there will be more demand for milling services and his profits should increase. So he could hedge by selling grain. But if grain prices go up due to a decline in supply, there will be excess milling capacity. He would hedge this by buying grain. Not only doesn’t he know which way to hedge, grain prices are actually a small part of his business risk compared to energy, labor, tax, and capital costs, none of which were traded on futures markets at the time (and only energy is traded today). Similar to the farmer, if the miller wants to lock in a price, he goes to a local grain elevator that can supply what he actually needs when he actually needs it, not a futures market for a standardized product he cannot use, with delivery time and place chosen by the counterparty.

Since the miller is going short futures contracts (that is, promising to deliver grain in the future), the speculator going long (that is, promising to accept grain in the future) is actually lending grain. This is the opposite of hoarding. A hoarder stores commodities today with the intention of selling them in the future, reducing currently available supply and increasing future available supply. The futures speculator makes more of a commodity available today and reduces future supply. The illogic of the anti-speculator crowd is demonstrated when they blame both activities for increasing the price of commodities. In fact, the price of commodities is influenced by both current and future supplies, and there is no first-order effect of shifting consumption around in time.

Moving From Farm to Finance

Up to this point, I expect no disagreement from anyone who has thought about this for more than a minute. But there is an objection that takes a little more subtlety to answer. It seems as if the speculator going long grain is not lending anything, not making anything more available today; he’s just betting on price movements. He’s not doing anything in the future either, because he will roll his contract when it comes due (replace it with a contract farther in the future) or settle for cash, not accept grain.

The best way to understand that he is nevertheless lending is to consider the obvious alternative way to lend. Suppose community leaders had set up a banking system in 1848 Chicago instead of starting the Chicago Board of Trade. These banks would have lent money to millers to buy grain. But they wouldn’t have anything to do with grain, and they wouldn’t give anything of value. They would lend banknotes they printed up, or simply credit account balances. When people did withdraw cash from one bank, they would deposit it in other banks; the system as a whole would not give out net cash except in a panic (in which case the banks would collapse, because they would not have the cash to repay all deposits).

These banknotes would be used to buy grain, the farmer who received them would use them to make payments on his loan. When the miller sold flour, the banknotes he received (borrowed from the same or some other bank) would be used to service his loan. The banks would never provide any real goods to anyone, but everyone knows they would stimulate tremendously increased economic activity, more grain, more milling, more flour. Just as with rolling futures contracts, the miller will never repay his loan unless he wants to liquidate his business. When each loan comes due, he’ll borrow again for repayment.

The key role of the bank — the reason we all agree it is engaged in lending instead of paper shuffling or speculation — is to affect how losses get allocated when there is a problem. If business is bad, people will default on loans and collateral values will shrink. The banking system will absorb losses up to the amount of its capital. Any remaining losses will be borne by bank depositors in proportion to their deposits, rather than by the economic agents that incurred the losses. This first-loss buffer and shifting of risk from entrepreneurs to depositors creates an environment much more conducive to economic growth than one without lenders, or one in which lenders must provide valuable assets instead of pieces of paper.

Now consider an institutional investor that decides to go long commodity futures with a notional value equal to 5% of the investor’s assets. It is one of the famous speculators. On the other side of these futures trades are people who want to borrow the commodity. They will be listed as hedgers officially, but anyone who looks closely will notice that they’re selling the things they need to buy for their businesses, which seems to be anti-hedging. No commodities have been produced by this process; all that’s changed is how losses will be allocated if the economy tanks, or at least if the price of commodities falls. Just as with the bank, the institutional investor’s willingness to absorb bad state losses creates an environment in which we will have more real activity: more commodities, more processing, more jobs, more growth.

The investor makes this investment because it has lost faith in the value of money. In that case, real assets seem safer than nominal ones (like bonds, that pay off in fixed dollar amounts; securities like inflation-protected Treasuries and stocks are intermediate with some nominal and some real components). The processor uses the futures markets to borrow commodities either because credit is expensive (or unavailable) or it does not want to take the risk of deflation. Direct borrowing and lending of commodities takes the money risk away from both sides.

Given all this, what is the effect on commodity prices? The full answer to that is far too complicated to discuss here. We would have to consider the effect of the stocks and bonds the investor sold in order to enter into commodity futures. The investor’s precise strategy, what commodities he buys and when, matters. We would have to model the price for the commodity based on current stocks, production levels, and anticipated future demand, as well as the feedback loop of price on these parameters. And it’s not a single price; in futures markets you have prices for multiple future delivery dates.

We can, however, give a first-order answer. When banks lend money to people to buy houses, it decreases the value of money (because there’s more of it around and no more goods) and increases the value of homes (because it is easier and cheaper to buy them). Of course, that’s just the immediate effect; when the loan ripples through the economy, lots of complicated forces are set into motion than can affect or even reverse these changes. Still, it’s fair to say in general as a first assumption, the thing that is lent (money) goes down in price and the thing that is bought (houses) goes up in price. More banks, lower interest rates, and easier loan terms all tend to push home prices up but if carried to extremes can cause inflation or asset price bubbles.

When an institutional investor loans oil to a refiner, that logic suggests the thing that is lent (oil today) goes down in price while the thing it is used for (oil in the future) goes up in price. I don’t have much faith in that conclusion, because of all the follow-on effects. But at least if someone blamed institutional commodity investment for overly steep futures curves there would be some tenuous logical case.

I don’t have any opinion on what the price of oil would be if we restricted trading in oil futures more than we already do. I’m pretty sure nobody else knows either. I do think it’s a bad idea, especially now, to restrict credit. But most of all, I hate to read the illogical nonsense that spills out every time a price moves in a direction someone doesn’t like or can’t understand. Prices change. Get used to it.