Monthly Archives: January 2010

Analysis: Managing price bubbles in crude oil markets

By Munir Quddus
Online Journal Contributing Writer

Jul 21, 2009, 00:13

The Commodities Futures Trading Commission (CFTC) is considering new restrictions on “excessive speculation” in markets for oil, natural gas and other energy products. It is about time they do.

Similar regulations already exist in markets for agricultural products such as wheat, corn and soybeans. The historical record shows that these have been relatively successful in preventing manipulation by a few large players and excessive speculation, without hurting market efficiency in agricultural products.

Predictably, the CFTC moves have some folks riled up. These critics claim that any attempt to regulate speculative trading would be anti-free market. Others have noted that speculation is an essential force that helps the markets move towards equilibrium. Therefore, any attempt to constrain speculation will retard market innovations and reduce benefits such as risk sharing, liquidity and efficiency.

These critics miss the point. Contemporary research by economists and study of business and economic history reveals that speculative trading can be both healthy and unhealthy for market integrity and efficiency. Although without a healthy presence of traders and speculators, markets cannot function efficiently, but excessive speculation can be problematic for market stability and efficiency.

The recent painful collapse of the real estate bubble in the United States which led to a global financial meltdown should, at the minimum, serve as a reminder of the dangers inherent in non-regulated markets that can spin out of control. Economists of all shades agree that markets do not always move towards an equilibrium. A growing group believes the assumption of equilibrium in economic models may have to be jettisoned for more realistic assumptions. It is time to question the conventional wisdom.

Last year, the price of crude oil soared to an all time high of $147 per barrel, more than a 200 percent increase in a relatively short time span. The steep and rapid rise in crude price came as a complete surprise to most experts. Nevertheless, numerous industry experts and professional economists concluded that the price spike was not a temporary aberration caused by a herd reaction of speculators, but was indicative of fundamental changes in market demand and supply. Factors such as high demand in India and China were mentioned. Even top-notch economists like the Nobel Laureate Paul Krugman ruled out the existence of a bubble, given the low inventory levels in crude oil.

The consequences of the sustained rise in crude oil prices were harsh on the global economy. Since crude oil and energy are crucial ingredients in the production of agriculture products, the impact on food prices was predictable and debilitating. Food riots broke out in many developing nations with millions of low income families squeezed in a vicious crisis from the escalating price of rice and other essentials.

Fortunately, most experts were wrong. The spectacular increase in crude oil prices was, in fact, the result of self-fulfilling expectations by traders that led to a speculative price bubble. Fundamentals such as a sustained increase in demand from economic growth in India and China played a relatively minor role. A market bubble is created and sustained by easy money and excessive speculation from an influx of unsophisticated traders. Traders who take long positions in markets infected by a price bubble are not acting irrationally, but the market outcome is highly inefficient. Rational traders can behave with a herd mentality, causing irrational outcomes. A bubble is not sustainable, and when conditions are right it collapses. Once the crude oil price bubble popped in 2008, prices fell rapidly until they were below $35 a barrel, a dizzying collapse of more than $111 dollars per barrel in a few months. Typically, a collapsing bubble overshoots before finding the true equilibrium.

Today, those who oppose the proposed CFTC regulations have presented various arguments. First, some argue that it is a mistake to try to separate the two types of traders, speculators from hedgers, since both add liquidity. Second, some hold that since speculation is a market force, it must be allowed unimpeded. Third, the argument is made that speculation is harmless. Another argument that is often heard is that regulation impedes markets, is anti-capitalistic and, therefore, is always harmful. Finally, some agree that market gyrations can be painful, but believe that attempts to control these fluctuations can be even more harmful.

None of these arguments stand up to close scrutiny. The case for judicious regulations is well established in economics. First, it is relatively easy to separate and regulate trading motivated by a desire to spread the risk, and trading for profit motive only. This is already achieved by appropriate regulations in the US agricultural markets, and in other nations. Second, economists who have studied speculative price bubbles realize that at some point retail investors who are generally unsophisticated wade into the market, creating greater instability. Third, even though normally speculative forces lead to improved market efficiency, these same forces can sometimes cause the markets to spin out of control, if excessive speculative funds come in. According to some estimates, at the peak of the crude oil bubble, demand was several times what could be justified by fundamentals. Contrary to the common view, speculation can be destabilizing eventually creating millions of victims including small businesses and retail traders.

Capitalism and free markets were never meant to be free of all rules. Adam Smith the father of modern economic science was well aware of the need for public sector controls of the private economy. After publishing his magnum opus, The Wealth of Nations, he served as a senior customs official. Good regulations play the same role in markets, as good traffic laws play in transportation. They ensure efficiency and safety of all participants. It makes little sense to allow price bubbles to grow unimpeded and wait to clean up the mess after the bubble pops. Good regulations can prevent bubbles from forming, and can pop these before they grow too big.

In case of the recent run up in the crude oil markets, by intelligently using the Strategic Oil Reserves, policy makers could have intervened to prevent the rise and collapse of the 2007-2008 crude oil bubble, saving the economy from much grief. This would have been justified on national security grounds (would have reduced the flow of dollars to unfriendly oil exporting nations), and would have been good for consumers and investors in America.

A market bubble creates and feeds on artificial scarcity — by giving appropriate signals, policy makers can influence unrealistic expectations and puncture a growing bubble. Such aggressive and pro-active management of a bubble may save the economy billions. As a result of cutting edge research, policymakers now have a number of tools in their arsenal to identify and shoot down price bubbles. This includes reducing leverage by raising margin requirements, raising interest rates to reduce excessive liquidity, making fundamentals more transparent, and warning against the dangers of irrational exuberance. 

If only the Federal Reserve and regulators, such as the CFTC, had the necessary tools and the political will, perhaps today the US economy would not be in such serious trouble with over 12 million Americans unemployed. The mismanagement of our economy in recent years has seriously impacted our credibility as the leader of the world’s free market economies.

The CFTC and other regulators, by moving to curb excessive speculation while preserving the ability of traders to conduct their normal business, are finally moving in the right direction. Good regulations strengthen, not weaken, free markets. Excessive speculation leading up to a price bubble can be disastrous to the safety and health of markets and millions of participants. The simplistic choice between judicious regulations and market efficiency is a false choice. It is possible to regulate markets to prevent debilitating booms and busts, and preserve incentives for innovations and efficiency.

To prevent future bubbles, it is crucial that regulators and politicians learn the right lessons from recent debacles, such as the dot.com bubble and the collapse of the housing and financial markets (derivative) bubbles. Further, regulators in the United States must coordinate proposed new regulations with regulators in Europe and Asia for closing loopholes and maximum impact.

Munir Quddus is a Professor of Economics and Dean of the Business School at Prairie View A&M University, Texas. He has a Ph.D. in economics from Vanderbilt University and writes on economic development, entrepreneurship, and history of economic ideas. He can be reached at muquddus@pvamu.edu.

Copyright © 1998-2007 Online Journal
Email Online Journal Editor

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My Half-Baked Bubble by Joshuah Bearman

December 20, 2009

Op-Ed Contributor

My Half-Baked Bubble

By JOSHUAH BEARMAN

Los Angeles

“SARDINES are better than candy,” my father said. “They’re oily, but nutritious!” Easy for him to say. I was 8 and had just moved to a new, fancier school. The socioeconomic shift was most apparent to me in the cafeteria, where there was a wide disparity between my lunch and everyone else’s. Ours was a Spartan household: no chocolate, cookies or extraneous sugar. For us, Rice Krispies cereal was supposed to be some kind of special indulgence.

My childhood happened to coincide with that historic moment in the early ’80s when the full ingenuity of modern science was brought to bear on lunch snacks. Fruit roll-ups had just hit the scene. Capri Sun was like quicksilver-cocooned astronaut juice with a cool dagger straw. Chocolate pudding came in palm-sized cups!

My dad was a physicist, so I thought he should know the formula for turning our flavorless Rice Krispies into Rice Krispie treats. And yet he packed me the same lunch day after day: one peanut butter and jelly sandwich, one apple, one box of raisins. When I complained, he solved the problem (and taught me a lesson) by giving me sardines instead. As if that was an upgrade.

So I became the weird kid in the corner, opening a tin of sardines, like a hobo — when I managed not to lose the key, that is. “Stick with sardines,” my dad said. “Cheap sweets are empty promises.”

But they didn’t seem so empty to me. Every day at lunchtime the cafeteria turned into an informal marketplace. My classmates laid out their wares on one of the big tables, displaying a panoply of forbidden processed delights. While I was busy trying to open my indestructible sardine can with a sharp rock, a brisk trading economy was under way.

“I am so bored with my Chunky,” a luckier boy would say, considering the options before him. “Maybe I’ll give Mr. E. L. Fudge a try!” And with a quick swap, the deal was done.

I must admit, it was a fairly efficient market. Everyone got what he wanted. Except for me. My sardines had zero value as trading currency. With no way into this economy, I had to watch from the sidelines.

Until one day, out of the depths of my isolation, I developed what you might call a creative business prospectus.

I’m not sure how I came up with this idea, but what I told my classmates was this: my mom is an expert baker, and at the end of the year she always bakes this incredible cake, the best cake ever, for me and my best friends at school. It’s coming, this wonderful cake. Can you picture it in your mind? It will be a great day. But in the meantime, I said, I will let you in on this special opportunity! If you give me, say, your Cheetos now, you can stake a claim on this fantastic pending cake. Like a deposit. One Hostess cupcake equals one share.

Just like that, I became a market maker, peddling delicious cake futures.

And people were buying! First came a round of vanguard investors. Then others followed, figuring they had to get in on the ground floor with this cake deal. From there it went wide. My table in the lunchroom became the hot new trading floor. The bell would ring and my classmates would line up with their items, eager to buy in.

At the beginning, of course, I figured I could really persuade my mom to bake such a cake, and so I’d dutifully record all the trading “transactions” in my Trapper Keeper. Twinkie = one piece of cake. Chunky = half-a-piece. Fruit roll-up = two pieces. Watermelon-flavored Jolly Rancher?! I don’t even want that. Zero pieces! I was setting the terms! It was like a dream come true.

Soon enough, however, the market was spiraling out of control. I started allowing customized cake shares. My Trapper Keeper ledger kept growing, and getting more complicated. The records described a wildly fantastic cake: hundreds of layers, rising to the heavens in all different flavors — chocolate mousse on top of meringue on top of half angel food and half red velvet. I was drunk with power, the creator of a bizarre lunchroom derivatives bubble.

Had anyone thought about it, it would have been clear that my mother, no matter how skilled a baker, could not fulfill my debts. But no one thought about it. We were all in too deep. I had to let the ledger keep growing.

The thing was, we all wanted to believe in this cake. For my investors, it was pragmatic: people were already into this cake for, like, 14 bags of Doritos, and they couldn’t just walk away from the whole idea. So they kept pouring more Doritos in and hoping for the best. Even I sort of believed in it — and I could see the numbers. I too was deluded, imagining the hero’s welcome I would receive when my mom and I eventually wheeled this amalgamated baked colossus into the schoolyard. I couldn’t face the truth.

This was the mutually reinforcing psychology that allowed the cake futures market to continue. Just like the Dutch tulip mania. Or the South Sea Bubble. Or the American housing market. We were trafficking in dreams. Is there anything wrong with that?

The answer, as we all know, is yes — there is something wrong with that. Like all bubbles, mine couldn’t last forever. Eventually, someone was going to blow the whistle.

Spencer. Spencer was both good at math and jealous; he’d always done well by the original cafeteria economy. Since everyone had been lured over to the fancy new derivatives guy, the old trading table had sat empty, and it was Spencer, Mr. Fundamentals, who did a back-of-the-napkin calculation to demonstrate how irrational our exuberance was. If you look at the numbers, he pointed out, my cake would defy the laws of physics.

At first no one wanted to believe him. If Spencer wants to be left out of the glorious new cake era, everyone thought, then, hey, fine by us. But then Spencer won a few people over with his sober analysis. And then a few more. And just as quickly as confidence in the cake was built, it eroded. We crossed the crash threshold and, overnight, belief in the cake evaporated. My classmates knew that the ledger was a sham, and they were not getting their investments back. The Fritos, Nutter Butters, Hostess pies — they were all gone, good snacks after bad.

The bigger the bubble, the harder the fall. I was an outsider before, but now I was a pariah. The old snack economy quietly rebuilt itself, and I was back to knocking my sardine can against the monkey bars out in the playground.

When my dad found out about my mischief, I got a lecture. It was one big “I told you so,” because, well, he had told me so. “Stick with the sardines,” he’d said. “Cheap sweets are empty promises.”

Joshuah Bearman is a writer.

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Social Entrepreneurship

Bill Drayton

http://dotsub.com/view/6af887c8-3834-4194-94ff-2541ae1200d5

Muhammad Yunus on povery 

http://dotsub.com/view/d54adaa6-dddc-4d6b-8007-a240ed970c0a

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Analysis: Managing price bubbles in crude oil markets

The Commodities Futures Trading Commission (CFTC) is considering new restrictions on “excessive speculation” in markets for oil, natural gas and other energy products. It is about time they do.

Similar regulations already exist in markets for agricultural products such as wheat, corn and soybeans. The historical record shows that these have been relatively successful in preventing manipulation by a few large players and excessive speculation, without hurting market efficiency in agricultural products.

Predictably, the CFTC moves have some folks riled up. These critics claim that any attempt to regulate speculative trading would be anti-free market. Others have noted that speculation is an essential force that helps the markets move towards equilibrium. Therefore, any attempt to constrain speculation will retard market innovations and reduce benefits such as risk sharing, liquidity and efficiency.

These critics miss the point. Contemporary research by economists and study of business and economic history reveals that speculative trading can be both healthy and unhealthy for market integrity and efficiency. Although without a healthy presence of traders and speculators, markets cannot function efficiently, but excessive speculation can be problematic for market stability and efficiency.

The recent painful collapse of the real estate bubble in the United States which led to a global financial meltdown should, at the minimum, serve as a reminder of the dangers inherent in non-regulated markets that can spin out of control. Economists of all shades agree that markets do not always move towards an equilibrium. A growing group believes the assumption of equilibrium in economic models may have to be jettisoned for more realistic assumptions. It is time to question the conventional wisdom.

Last year, the price of crude oil soared to an all time high of $147 per barrel, more than a 200 percent increase in a relatively short time span. The steep and rapid rise in crude price came as a complete surprise to most experts. Nevertheless, numerous industry experts and professional economists concluded that the price spike was not a temporary aberration caused by a herd reaction of speculators, but was indicative of fundamental changes in market demand and supply. Factors such as high demand in India and China were mentioned. Even top-notch economists like the Nobel Laureate Paul Krugman ruled out the existence of a bubble, given the low inventory levels in crude oil.

The consequences of the sustained rise in crude oil prices were harsh on the global economy. Since crude oil and energy are crucial ingredients in the production of agriculture products, the impact on food prices was predictable and debilitating. Food riots broke out in many developing nations with millions of low income families squeezed in a vicious crisis from the escalating price of rice and other essentials.

Fortunately, most experts were wrong. The spectacular increase in crude oil prices was, in fact, the result of self-fulfilling expectations by traders that led to a speculative price bubble. Fundamentals such as a sustained increase in demand from economic growth in India and China played a relatively minor role. A market bubble is created and sustained by easy money and excessive speculation from an influx of unsophisticated traders. Traders who take long positions in markets infected by a price bubble are not acting irrationally, but the market outcome is highly inefficient. Rational traders can behave with a herd mentality, causing irrational outcomes. A bubble is not sustainable, and when conditions are right it collapses. Once the crude oil price bubble popped in 2008, prices fell rapidly until they were below $35 a barrel, a dizzying collapse of more than $111 dollars per barrel in a few months. Typically, a collapsing bubble overshoots before finding the true equilibrium.

Today, those who oppose the proposed CFTC regulations have presented various arguments. First, some argue that it is a mistake to try to separate the two types of traders, speculators from hedgers, since both add liquidity. Second, some hold that since speculation is a market force, it must be allowed unimpeded. Third, the argument is made that speculation is harmless. Another argument that is often heard is that regulation impedes markets, is anti-capitalistic and, therefore, is always harmful. Finally, some agree that market gyrations can be painful, but believe that attempts to control these fluctuations can be even more harmful.

None of these arguments stand up to close scrutiny. The case for judicious regulations is well established in economics. First, it is relatively easy to separate and regulate trading motivated by a desire to spread the risk, and trading for profit motive only. This is already achieved by appropriate regulations in the US agricultural markets, and in other nations. Second, economists who have studied speculative price bubbles realize that at some point retail investors who are generally unsophisticated wade into the market, creating greater instability. Third, even though normally speculative forces lead to improved market efficiency, these same forces can sometimes cause the markets to spin out of control, if excessive speculative funds come in. According to some estimates, at the peak of the crude oil bubble, demand was several times what could be justified by fundamentals. Contrary to the common view, speculation can be destabilizing eventually creating millions of victims including small businesses and retail traders.

Capitalism and free markets were never meant to be free of all rules. Adam Smith the father of modern economic science was well aware of the need for public sector controls of the private economy. After publishing his magnum opus, The Wealth of Nations, he served as a senior customs official. Good regulations play the same role in markets, as good traffic laws play in transportation. They ensure efficiency and safety of all participants. It makes little sense to allow price bubbles to grow unimpeded and wait to clean up the mess after the bubble pops. Good regulations can prevent bubbles from forming, and can pop these before they grow too big.

In case of the recent run up in the crude oil markets, by intelligently using the Strategic Oil Reserves, policy makers could have intervened to prevent the rise and collapse of the 2007-2008 crude oil bubble, saving the economy from much grief. This would have been justified on national security grounds (would have reduced the flow of dollars to unfriendly oil exporting nations), and would have been good for consumers and investors in America.

A market bubble creates and feeds on artificial scarcity — by giving appropriate signals, policy makers can influence unrealistic expectations and puncture a growing bubble. Such aggressive and pro-active management of a bubble may save the economy billions. As a result of cutting edge research, policymakers now have a number of tools in their arsenal to identify and shoot down price bubbles. This includes reducing leverage by raising margin requirements, raising interest rates to reduce excessive liquidity, making fundamentals more transparent, and warning against the dangers of irrational exuberance. 

If only the Federal Reserve and regulators, such as the CFTC, had the necessary tools and the political will, perhaps today the US economy would not be in such serious trouble with over 12 million Americans unemployed. The mismanagement of our economy in recent years has seriously impacted our credibility as the leader of the world’s free market economies.

The CFTC and other regulators, by moving to curb excessive speculation while preserving the ability of traders to conduct their normal business, are finally moving in the right direction. Good regulations strengthen, not weaken, free markets. Excessive speculation leading up to a price bubble can be disastrous to the safety and health of markets and millions of participants. The simplistic choice between judicious regulations and market efficiency is a false choice. It is possible to regulate markets to prevent debilitating booms and busts, and preserve incentives for innovations and efficiency.

To prevent future bubbles, it is crucial that regulators and politicians learn the right lessons from recent debacles, such as the dot.com bubble and the collapse of the housing and financial markets (derivative) bubbles. Further, regulators in the United States must coordinate proposed new regulations with regulators in Europe and Asia for closing loopholes and maximum impact.

Munir Quddus is a Professor of Economics and Dean of the Business School at Prairie View A&M University, Texas. He has a Ph.D. in economics from Vanderbilt University and writes on economic development, entrepreneurship, and history of economic ideas. He can be reached at muquddus@pvamu.edu.

Copyright © 1998-2007 Online Journal
Email Online Journal Editor

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Interesting articles on success in the Business World

May 19, 2009

Op-Ed Columnist

In Praise of Dullness

By DAVID BROOKS

Should C.E.O.’s read novels?

The question seems to answer itself. After all, C.E.O.’s work with people all day. Novel-reading should give them greater psychological insight, a feel for human relationships, a greater sensitivity toward their own emotional chords.

Sadly, though, most of the recent research suggests that these are not the most important talents for a person who is trying to run a company. Steven Kaplan, Mark Klebanov and Morten Sorensen recently completed a study called “Which C.E.O. Characteristics and Abilities Matter?”

They relied on detailed personality assessments of 316 C.E.O.’s and measured their companies’ performances. They found that strong people skills correlate loosely or not at all with being a good C.E.O. Traits like being a good listener, a good team builder, an enthusiastic colleague, a great communicator do not seem to be very important when it comes to leading successful companies.

What mattered, it turned out, were execution and organizational skills. The traits that correlated most powerfully with success were attention to detail, persistence, efficiency, analytic thoroughness and the ability to work long hours.

In other words, warm, flexible, team-oriented and empathetic people are less likely to thrive as C.E.O.’s. Organized, dogged, anal-retentive and slightly boring people are more likely to thrive.

These results are consistent with a lot of work that’s been done over the past few decades. In 2001, Jim Collins published a best-selling study called “Good to Great.” He found that the best C.E.O.’s were not the flamboyant visionaries. They were humble, self-effacing, diligent and resolute souls who found one thing they were really good at and did it over and over again.

That same year Murray Barrick, Michael Mount and Timothy Judge surveyed a century’s worth of research into business leadership. They, too, found that extroversion, agreeableness and openness to new experience did not correlate well with C.E.O. success. Instead, what mattered was emotional stability and, most of all, conscientiousness — which means being dependable, making plans and following through on them.

All this work is a reminder that, while it’s important to be a sensitive, well-rounded person for the sake of your inner fulfillment, the market doesn’t really care. The market wants you to fill an organizational role.

The market seems to want C.E.O.’s to offer a clear direction for their companies. There’s a tension between being resolute and being flexible. The research suggests it’s more important to be resolute, even at the cost of some flexibility.

The second thing the market seems to want from leaders is a relentless and somewhat mind-numbing commitment to incremental efficiency gains. Charismatic C.E.O.’s and politicians always want the exciting new breakthrough — whether it is the S.U.V. or a revolutionary new car. The methodical executives at successful companies just make the same old four-door sedan, but they make it better and better.

These sorts of dogged but diffident traits do not correlate well with education levels. C.E.O.’s with law or M.B.A. degrees do not perform better than C.E.O.’s with college degrees. These traits do not correlate with salary or compensation packages. Nor do they correlate with fame and recognition. On the contrary, a study by Ulrike Malmendier and Geoffrey Tate found that C.E.O.’s get less effective as they become more famous and receive more awards.

What these traits do add up to is a certain ideal personality type. The C.E.O.’s that are most likely to succeed are humble, diffident, relentless and a bit unidimensional. They are often not the most exciting people to be around.

For this reason, people in the literary, academic and media worlds rarely understand business. It is nearly impossible to think of a novel that accurately portrays business success. That’s because the virtues that writers tend to admire — those involving self-expression and self-exploration — are not the ones that lead to corporate excellence.

For the same reason, business and politics do not blend well. Business leaders tend to perform poorly in Washington, while political leaders possess precisely those talents — charisma, charm, personal skills — that are of such limited value when it comes to corporate execution.

Fortunately, America is a big place. Literary culture has thrived in Boston, New York and on campuses. Political culture has thrived in Washington. Until recently, corporate culture has been free to thrive in such unlikely places as Bentonville, Omaha and Redmond.

Of course, that’s changing. We now have an administration freely interposing itself in the management culture of industry after industry. It won’t be the regulations that will be costly, but the revolution in values. When Washington is a profit center, C.E.O.’s are forced to adopt the traits of politicians. That is the insidious way that other nations have lost their competitive edge.

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