Monday, June 23, 2008

Hedging inflation - not speculating on commodities

There has been a considerable amount of commentary (mostly by politicians trying to blame the free market and others for their incompetence) about how speculators are contributing to the increases in the prices of many commodities and the resulting effects of inflation. This is largely nonsense. Certainly, speculators play a role in driving up prices just like any other demand factor does. However, there are much larger factors at work:

1. rising end-user demand. The world's economy is still growing and the demand for raw materials will increase with such growth (although not necessarily on a linear basis);

2. market distortion. Many countries heavily subsidise the prices of raw materials and key consumer goods. In some cases this is defensible - in some countries subsidies (or similar) on foods are very necessary to prevent starvation. In some cases subsidies are indefensible on both economic and environmental grounds. Fuel subsidies that prevail in many emerging markets are the worst example. They stimulate demand at a time when the world desperately needs to consume fewer hydrocarbons for both economic and environmental reasons. As much as it goes against my belief in the free market, the case for (higher) user taxes on hydrocarbon products is pretty overwhelming.

As to the calls for speculation in commodities to be regulated in some manner, this is totally unjustified. Not only is it an erosion of free market principles, but any measures which are likely to be introduced will (most likely) prevent consumers from taking one of the few steps available to them to hedge against the impact of rises in commodity prices on their standard of living.

The proposition is simple. Rising prices of essential commodities are an expense which most households cannot avoid paying and can only take limited steps to reduce. Investing in the underlying commodities (e.g. through an ETC or a commodity based ETF) is a simple and effective means of providing a hedge against the impact of rising commodity prices. The gains on the hedge instrument would offset to at least some degree the increased living expenses.

As a side note, there is plenty of academic commentary on the benefits that speculators bring to a market. Attempting to regulate speculators out of the market is likely to be detrimental to the markets as a whole.

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