Soon after the end of the First World War, psychologist Hermann Rorschach invented a psychological test based on the idea that people will project their unconscious drives onto an inkblot.
Ongoing debates over speculation, especially in the commodity markets, have much the same character. Such facts as are known present no unambiguous picture. Instead, they allow for a lot of projection.
On September 22 the Futures Industry Association, in a statement, congratulated the International Monetary Fund on its finding that speculators cannot be blamed for volatility in the commodity markets. Though the IMF did say much that can be so interpreted, its discussion of the issue in its latest “World Economic Outlook” is chiefly notable for its refusal to draw any conclusion more definite than that “research does not provide strong evidence that commodity market financialization has had obvious destabilizing effects.” (Italics added.)
The report makes for a thick 241-page pdf, and among the unfortunate trends it relates is the increase in the prices of food, along with other commodities, in emerging and developing economies. These price increases, the IMF notes in a somewhat gingerly expression, have “exacerbated social problems.”
So: what has caused higher prices? There are the obvious factors: bad harvests, high fertilizer costs, the use of some foods for the production of fuels, and so forth. But one factor the report considers at some length, in “Box 1.4” is the “financialization of commodity markets – that is, the greater role of noncommercial participants … in commodity derivative markets” with a resulting increase in trading volume both of the physical commodities and on the derivatives.
It is certainly true that there has been an increase in speculative (or “noncommercial”) futures market positions, in the U.S. markets especially.
But why should financialization produce price increases? The IMF cites two possible mechanisms. First, long-only investors may have crowded into derivative markets, putting upward pressure on futures prices, which pressure in turn (through arbitrage opportunities) has translated into upward pressure on the prices of the physical commodities. Second, indexing-based investment strategies might have led to a lot of noise trading, increasing demand for the whole set of futures encompassed by a particular index, with the same consequences.
Is there actual evidence that either of these mechanisms is at work? If noise trading had become more important over time, one would expect an increase in volatility. Yet the IMF staff writes, “There is no general evidence of increased commodity price volatility since the onset of financialization in the early 2000.” It offers a chart to make this clear, sourced to Bloomberg Financial, as well as to the IMF staff’s own calculations. The chart shows that commodity price volatility has remained roughly flat since 1900, in foods, metals, and crude oil, as well as in a broad energy price index.
The report takes note of the argument that financialization might be a good thing, because it increases liquidity in these markets and that should improve price discovery and lower volatility. But its authors can’t find any solid empirical evidence to support that hypothesis either. If that were happening, they note, there should have been a reduction in price volatility over time. Just as there has been no increase, so there has been no reduction. Financialization may simply have been a wash.
Another way to test the theory that financialization has led to higher commodity and food prices is to look to the predictive power of futures. Whether because futures traders accurately predict underlying price moves, or because futures prices cause changes in the underlying price, or for some combination of both reasons, the one does tend to predict the other. But how reliable is this? The IMF staff postulates that if bull markets involve “price overshooting driven by the herd behavior of uninformed long-only investors,” the predictive value of futures prices would work best during downward moves, and deteriorate during the upward phase of the cycle. Yet in fact this predictive power does not vary as between up and down moves.
The bottom line is that there is no bottom line. “[R]ecent research does not rule out spot price effects of commodity market financialization,” the IMF said, but it has uncovered no “smoking gun for obvious price misalignments or destabilizing effects due to financial speculation.”