My favorite recent illustration is the “unholy alliance” that the right and left have formed about “oil speculators.” Darling of Fox News and the right, Bill O’Reilly, has been irate at the “wicked oil speculators” over the past two months. Famously on the left, President Obama recently spoke in the Rose Garden saying, “we can’t afford a situation where some speculators reap millions while millions of American families get the short end of the stick.” Of course, the empirical evidence for this does not exist even if some folks “profit” from speculating.

The main tool allegedly used by speculators in oil is the futures market in oil. Senator Bernie Sanders is right now crafting legislation to allow the government to stop speculation in oil. In a micro class it might be fun to do welfare analysis in the oil market to determine whether the claims of damage are justifiable, but we aim for a simpler task here, which is simply to ask how the futures market works and why it is exists.

The purpose of a futures market is to allow both buyers and sellers of an underlying asset to hedge their risks from the price of that asset changing in an adverse way. In the case of buyers of oil, they are worried that oil prices will rise in the future. In the case of sellers of oil, they are worried that oil prices will fall in the future. As there are millions of consumers of oil (not just drivers, but plastics manufacturers, drug makers, sanitary products, etc.) there too are thousands of producers – each with an interest here. So there are both natural buyers and sellers of oil, and therefore natural buyers and sellers of an instrument to protect themselves.

A seller of a future would be the producer of the underlying commodity. So, for example, Exxon-Mobil would be a seller of a futures contract. Typical buyers would be buyers of the underlying commodity, so gasoline refiners might be a good example, or airlines.

Right now, the current spot price of a commonly traded type of oil is roughly $99 per barrel. The futures price on a 4-year contract (Spring 2016 delivery) is about $89 per barrel.  The spot price indicates that a barrel of oil today sells for $99. That is what Exxon could sell it for, and that is what a refinery could buy it for. The futures price indicates the price of a barrel of oil today, for oil that is to be delivered in 4 years. So, if Wintercow is a refiner and buys the oil future from Exxon, he will send Exxon $89 today. In exchange, Exxon is required to deliver a barrel of oil in Spring 2016. (A typical futures contract in oil is for 1,000 barrels.)

Suppose the price of oil in Spring 2016 turns out to be $109. What would happen when the contract expires in that spring, and what the net gain/loss is to each party to the transaction?

Exxon would have to deliver a barrel of oil to Wintercow in Spring 2016. What typically happens is that Exxon buys back the futures contract at the price that prevails at this time (so that Exxon does not actually have to go deliver the oil). So, Exxon would have been paid $89,000 for the oil in May 2012. It would buy that contract for 1,000 barrels back for $109,000 thereby losing $20,000 on the futures transaction. However, it would then sell its oil at the spot price of $109 for $109,000. Net of these trades, Exxon would end up with $89,000. Of course, it knew this at the time of the initial transaction – that was the point!

Wintercow would have paid $89,000 for the oil today, and then received $109,000 in May 2016 from the futures transaction, for a gain of $20,000. However, he would still need the oil for refining in May 2016, and must buy his 1,000 barrels for $109,000. Thus, he ends up with a guaranteed $89,000. Of course, he knew this at the time of the initial transaction – that was the point!

Suppose the price of oil in Spring 2016 turns out to be $79. What would happen when the contract expires in that spring, and what the net gain/loss is to each party to the transaction? Exxon would have to deliver a barrel of oil to Wintercow in Spring 2016. What typically happens is that Exxon buys back the futures contract at the price that prevails at this time (so that Exxon does not actually have to go deliver the oil). So, Exxon would have been paid $89,000 for the oil in May 2012. It would buy that contract for 1,000 barrels back for $79,000 thereby gaining $10,000 on the futures transaction. However, it would then sell its oil at the spot price of $79 for $79,000. Net of these trades, Exxon would end up with $89,000. Of course, it knew this at the time of the initial transaction – that was the point!

Wintercow would have paid $89,000 for the oil today, and then received $79,000 in May 2016 from the futures transaction, for a loss of $10,000. However, he would still need the oil for refining in May 2016, and could buy his 1,000 barrels for $79,000. Thus, he ends up with a guaranteed expenditure of $89,000. Of course, he knew this at the time of the initial transaction – that was the point!

In what sense are parties to these transactions “harmed?”

Clearly what we see is that the futures transactions guarantees a price for oil to both buyers and sellers. In other words, it is a contract that effectively guarantees a sharing of the gains from trade that would have occurred if all purchases occurred on the spot market.  The harm to the parties in the transaction comes from the fact that should luck have worked in their favor, their gains would have been larger. But it is just as correct that each party “unfairly” gains in the event of a movement of prices away from what they would have liked.

Think about this. The existence of a futures market allows a commitment by parties with competing interests to agree to share the gains from trade. Wouldn’t the existence of such a market be grounds for celebration, particularly among the class of people who views the point of civil society as a giant insurance mechanism?  Since neither the seller nor buyer in a futures transaction is certain that the price of a commodity is going to move in a particular direction, they end up sharing the profits they would have had if luck had gone their way. Isn’t this the exact thing that redistribution aims to achieve? To make people whole for events that are beyond their control and to ask the “rich and lucky” to share in their good fortune with everyone else. You’d think that individuals voluntarily engaging in these sorts of transactions would be cause for extra celebration, not excessive scorn.

Based on the  above, who would have to be harmed from activities in the futures markets for O’Reilly’s and Obama’s observations to have any validity? Is such an outcome likely?

It must be the case that parties outside the transactions must be harmed, because no parties to it are harmed (and of course, we may have to make the extra assumption that parties outside the initial transaction have no way of partaking in such transactions, which is a poor assumption to make in the year 2012).

I don’t quite understand the conventional wisdom. So, the thinking goes that if speculators are somehow able to intervene in these markets and make purchases of oil futures, that must be driving the price of oil UP due to their guessing that future oil prices would be higher. Of course, if they guess correctly, then by keeping a barrel of oil off the market today when oil is less scarce and transferring it to the future when it is more scarce, the speculators are actually improving social well-being. If they guess wrong, then they would be hurting future well-being of third parties, but of course would be doing so in an era of lower prices, and competition seems like it would enforce discipline on those who regularly guess wrong.

Notice that right now the futures price of oil is lower than the spot price, meaning that “speculators” (by the logic of Sanders, Obama and O’Reilly) are causing much good right now. That is equally silly. Here’s a question to leave you with. If you are one of those folks who wishes to see “oil kept in the ground” what do you think of the mere existence of a futures market? Should you care of outsiders could participate in it?

The research (and meta-research) of James Hamilton has also demonstrated that oil price shocks can have a significant (and large) negative impact on domestic growth prospects. And we know that wholly aside from the direct impact of higher energy costs on the well-being of the poor, it tends to be the least economically advantaged that are most hurt by downturns in economic activity. Just look at the unemployment rates by education-level during this recession for a glimpse of what I mean.

Let’s keep this short then. Energy price shocks disproportionately hurt the poor in two ways: directly through their pocketbooks and indirectly through the suppression of economic growth. It would seem to me then that as a matter of social justice we would be feverishly pursuing any and all energy policies that would prevent these trends from happening, and this includes accounting for whatever adverse environmental impacts might occur from this pursuit (I suppose this observation depends on exactly who the object of social justice might be). This observation is of course wholly divorced from the possibility that development of fracking and related industries is likely to provide employment for hundreds of thousands of people, many of whom you would think would be the target of “social justice policy” in the first place. But these jobs are costs not benefits. We should want to burn cheap energy and not have to work to do it. Irrespective of what one’s views are on the validity of “social justice” as a doctrine for guiding us in our political affairs, it should at least be in the realm of decent matters to require a consistent approach to the doctrine if it is going to be invoked.

The United States has its own program of course. It is called the Low-Income Energy Assistance Program. The program began in 1981 and was approved by President Reagan (I know, yet another one of those government-choking, poor trampling austerity, deregulatory measures he hammered the Americans with) – and now is about a $5 billion block grant program from the federal government to the states (UPDATE: I am pretty sure he signed on for this as some sort of compromise to cut the budget elsewhere). The states determine eligibility based on family/household income levels, and applicants must present evidence of what their income and utility bills are and I think in many states must show proof that the utility company is going to shut down their service.

Now, think about the intention of that program as it stands against the opposition by folks all over the Northeast and really the Snowbelt states against fracking. The shale-gas boom has already led to a major decrease in the price of natural gas, such that the nominal price is the same today as it was 15 years ago, and in real terms is considerably lower. Signs point to natural gas prices staying low, with the prospect of lowering American heating bills by a considerable degree.

So, what’s it gonna be? Cheap fuel for the poor? Or expensive fuel for the poor? You cannot have both of course. Just because we don’t vote directly for one against another does not mean that this tradeoff is not real. It is no less real than the fact that when I am sitting here charging up my laptop right now, and not allowing that energy to be used by someone else, and not donating the money I am using to charge my laptop to a poor person, means that I am letting some poor person be a little bit colder today than they otherwise could be. Just because I don’t like thinking about that reality does not make it any less real.

What is the Precautionary Principle? It’s a doctrine that turns the tables on where the burden of proof in a policy ought to fall (it’s not just an argument, it’s a policy response). I’d suggest that in “typical” discourse and policy, the burden of proof falls on folks that are intending to take some particular action. Implicit in this argument is that the there is some underlying value that we agree upon. For example, if it is to be agreed that autonomy is a value unto itself, then our default political position on taxation seems to be “no taxes, unless you can demonstrate the value of doing so.” Or something to that effect.

When it comes to the Precautionary Principle, this is turned on its head. In this case, the burden of proof rests with the “do nothing” crowd. Take the case of Global Warming. If this is something that is going to cause great harm to many people then the burden of proof stands with folks who claim that it is not harmful (notice what this leaves out … the possibility that it is “harmful” but that folks can deal with it …). Only if it can be overwhelmingly demonstrated that there is little (what does this mean?) risk can we really relax the precautions we were going to take.

Let’s not argue with this idea — if we were to argue we’d appeal to the fact that such a principle implies that we are committed to doing something in all cases because we can never provide the counterfactuals in any of these cases. Let’s ignore for the time being that there can be infinitely many things that might be catastrophically bad for people and that the principle would proscribe doing something about everything.

I assert that the precautionary principle is popular because it gives proponents a tool to not have to rely on the science to make assessments to support their favored outcomes. What, exactly, does “do something” mean? If a global warming alarmist tells you that “reduce CO2 emissions by 80% by 2050 over 1990 levels” is required by the precautionary principle and you ask, “why?” they will have to rely on science to answer the question. But once we walk down that path, then it is hard to avoid dealing with the questions, “is reducing CO2 emissions by 80% by 2050 a good way to do this?”

Why do I bring this up? Because the Precautionary Principle has been invoked when it comes to Fracking. There has been a moratorium on new leases for fracking in New York since 2008, and it has to this day not been ended. For four years the common claim is that we cannot allow gas drilling in New York until more scientific studies are done on the impact of fracking on drinking water safety and other related environmental issues. We’ll delve into the details of those as the summer progresses, but for now, it suffices to say that this is indeed a direct application of the Precautionary Principle. Since fracking carries some risk to people, the “smart” course is to prevent the action from happening unless a consensus decides that fracking is safe. Of course, there is no objective measure as to what “safe” is, so there is no way to predict whether this moratorium will ever (or should ever) cease.

But doesn’t this put the Precautionary Principle folks in two pickles? First, if Global Warming is presenting us with risks that are unconscionable, and we are supposed to take every precaution to prevent the planet from heating up, then shouldn’t all marginally better programs be approved? Isn’t it pretty clear that natural gas is a much better energy source than what it is replacing (including all life-cycle effects)? After all, research has already shown that natural gas expansion in the last decade has reduced carbon emissions by up to 1 billion tons. Here is where some of those gains have come from.

So, by following the precautionary principle at the local level suggests that we ban fracking and continue to get our energy from coal and the rest of the grid makeup because fracking may cause harm to groundwater. But following the precautionary principle at the macro level suggests that we voraciously pursue fracking and in fact perhaps mandate more fracking and with each BTU of energy found from fracked gas we close down an equal amount of coal production.

So what does the Precautionary Principle tell us to do? We should both frack and not frack? Sounds like a bad old campaign problem.  The related discomfort this poses is that perhaps to answer the conundrum someone is going to have to appeal to the science again, but that was precisely what the precautionary principle aims to avoid having to do. What kind of a consensus must be reached here and who makes the decisions?

We’ll continue our exploration (sorry for the pun) of fracking questions tomorrow by pointing out another uncomfortable inconsistency.

In her talk, Hosterman said [paraphrasing] “water problems have big impacts… one California town has 40% unemployment; water shortages have led to thousands of job losses.”

Knowing that these numbers are somewhere between disputed and wrong, I went up after her talk and said:

• The 40 percent unemployment figure in Mendota, CA is persistent; it does not go up or down according to water supplies.
• The headline figure of 80,000 job losses has been disowned by Richard Howitt. He and Jeffrey Michaelcollaborated on calculations to arrive at a figure of 5,000-7,000 job losses.*

Her basic response was “so what?”

I clarified: “No, you don’t understand — the researcher, Howitt, who made the estimates denounced them.”

She said, “I don’t care, I will use those numbers.”

Read the rest.

The “government budget identity” is simply a way to think about how a government can finance its expenditures. Suppose a government is required to help us build bridges and defend our borders – it requires funds to do this. A typical sovereign government can secure funds from three “legitimate” places.*What are these sources?

1. Taxes today.
2. Taxes tomorrow. In other words we can borrow money today in order to build our bridge and then use future tax revenues to pay for the debt tomorrow. By the way, if the government is in the business of actually producing valuable “public goods” then you can easily think of this as value enhancing.
3. Printing money. It’s not generally done this way, but in effect the monetary authorities can monetize the borrowing of a sovereign entity (how they do it is beyond the scope of this post). For simplicity, imagine instead that a central bank prints new bank notes from scratch, hands them to the Treasury, and then the Treasury spends them on goods and services. This is just another form of a tax, again beyond the scope of this post.

So, this is what the government budget identity looks like for “normal” countries:

G = T + the change in debt + the change in base money

But what’s the deal with Greece? Ignore what it has been spending money on, and just suppose that it “needs” to continue to spend G. Greece (and the other PIIGS) faces two problems that the US does not. First, Greece is part of the European Monetary Union. This means that it “outsources” its central banking to the Euro zone. In other words, there is no independent Greek central bank that can print its own currency and spend it into circulation. Greece is to the Euro as Mississippi is to the dollar. There is no Mississippi central bank, so if the state of Mississippi wishes to spend resources, it can either tax the people of Mississippi or it can borrow (states have limited borrowing power). Mississippi also receives transfers from the federal government, and this is what some folks hope happens in Greece. So, Greece cannot print money to pay for its spending (which includes interest payments on previously issued debt).

So Greece’s government budget identity really is:

G = T + the change in debt

However, although Greece has an independent fiscal authority (it IS a sovereign nation) the last item is a problem for Greece. How does Greece borrow money? It must attract investors to lend it money and part of that requires a promise to pay back lenders in full. These lenders have typically come from outside of Greece. Now, given Greece’s historical fiscal record and current budget problems, folks are very skeptical that they would be paid back if they loaned the government of Greece money. In order to persuade folks to lend to them, the Greeks would have to offer a very attractive rate of interest. In fact, some recent Greek bond auctions have seen interest rates in the 20% range.

To put that in perspective, if the US had to fund its entire $15 trillion of debt at 20% interest, it would face an annual interest payment on the debt of $3 trillion. The total amount of federal tax revenues last year was … $2.3 trillion. Ding-dong, the witch is dead!

So, in effect the Greeks cannot afford to pay 20% interest even on newly rolled over debt. In other words, in addition to not being able to print money, the Greeks cannot borrow money. So their government budget identity looks pretty much like what a little kid’s does:

G = T.

The Greeks can only spend what it raises in taxes. I think you can see why this is a problem, particularly in an economy that is shrinking by something like 5% per year and in a country that is not exactly famous for having well-behaved taxpayers. This is why the game is up, Either the Greeks have to raise taxes, reduce spending or somehow persuade someone else to intervene in the place of borrowing and printing money.

I have no intention of posting on the political economy of all of this, but several students asked me for a “back of the envelope” illustration of the problem in Greece. I hope this helps. And note that I said nothing about how we got to the point where their spending was unsustainable. Perhaps for another day. Enjoy your weekend, I’ll keep grading.

* There is a 4th way to secure funds that the Charles Taylors of the world like to indulge in. That is to expropriate the assets and property of private citizens for public purposes. Of course that process is not “sustainable” for very long periods of time unless we think that private citizens obtain massive amounts of utility from contributing to a kleptocrat.