Because We Are Uncertain About The Future, We Speculate

Below is an example of a deceptive article which attempts to pin the blame of surging commodity prices, particularly of onion, on “speculators”.

Wall Street Journal Blog writes,

Shed a tear for the onion. While prices of many agricultural commodities have soared, farmers received just 7.49 cents for a pound of onions in April, down from 29.9 cents a year ago, in part due to a big harvest. Futures trading in onions — unlike other farm goods — is banned, which prevents the pungent bulb from being used as an investment vehicle.

Why is this article misleading?

Because the article tries to demonstrate that falling prices equates to the absence of speculators—a post hoc ergo propter hoc fallacy.

As we always say here, reference point matters.

The chart in that article virtually ignores showing how volatile prices of onions are.

Professor Mark Perry’s charts gives us a much better perspective because his charts deal with the bigger picture.

It is true today that onion prices have been falling whereas oil prices have been moving higher (as shown by above window chart), but prices of onions have been far more volatile than oil over the span of 11 years.

And this can be measured based on the differences of standard deviations of monthly price changes, as shown in the lower window, where price volatility of oil (red line) has been greatly lesser than of onions (blue line) from 2000-2011.

Excessively volatile prices puts farmers or producers at bigger risks because of the uncertainty behind estimates of price trends which guides their production process.

Professor Perry quotes this Fortune article. (bold highlights mine)

Before the U.S. Commodity Futures Trading Commission starts scrutinizing the role that speculators may have played in driving up fuel and food prices, investigators may want to take a look at price swings in a commodity not in today's news: onions.

The bulbous root is the only commodity for which futures trading is banned. Back in 1958, onion growers convinced themselves that futures traders (and not the new farms sprouting up in Wisconsin) were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April.

The volatility has been so extreme that the son of one of the original onion growers who lobbied Congress for the trading ban now thinks the onion market would operate more smoothly if a futures contract were in place.

Speculators provide more liquidity by risking money on buying and selling to arbitrage from uncertainty.

Yet what speculators do isn’t risk free. In other words, speculators are subject to the rigorous discipline of the markets. Because as much as they profit, they lose money too!

By providing liquidity they give markets more pricing efficiency. This leads to better allocation of resources with the option of being backed by hedging tools.

Importantly, because producers don’t know the future, they are speculating too.

The issue here is uncertainty. Because we are uncertain of the future, thus we speculate.

The assumption that markets can exist without speculators fails to consider why markets exist at all.

Where markets that are not liquid, they are, as the Fortune magazine points out, subject to fierce price swings and less reliable of price signals that heightens risks of producers.

As Ludwig von Mises wrote, (bold highlights mine)

In the real world acting man is faced with the fact that there are fellow men acting on their own behalf as he himself acts. The necessity to adjust his actions to other people’s actions makes him a speculator for whom success and failure depend on his greater or lesser ability to understand the future. Every action is speculation. There is in the course of human events no stability and consequently no safety.

Anyone who says they are certain about the future should put their money where their mouth is.