Ask most Americans what futures traders do, and they’ll tell you that futures traders are adult men and women who make vast fortunes by standing in a circle, gesticulating wildly, and shouting at each other. In the minds of many Americans, futures traders resemble frenzied gamblers on a casino floor or participants in a contact sport whose rules are particularly demented. Should such people, many Americans wonder, be allowed to play a role in the shaping of the American economy? Indeed, should such people be allowed to roam the streets freely?
Even among those who are not swayed by this image of futures traders, there has been considerable antipathy towards futures markets. This antipathy is founded on the belief, common among many intellectuals, that futures markets play no significant economic role and have no socially redeeming value; instead, they exist simply so that greedy people can make fortunes at the expense of farmers, small investors, consumers, and other “little people.”
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Should we, then, “do something” about American futures markets? Would greater government regulation be advisable? Indeed, should futures trading be banned altogether? In what follows, I would like to defend futures markets as an economic institution and inquire into the proper role that the government should play with respect to these markets. There is, I think, a role for the government in futures markets, but I think this role stops far short of the kind of heavy-handed regulation that many have called for.
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To begin with, a futures contract, as its name implies, is a contract between individuals. Whereas many contracts (e.g., a bill of sale for a car) specify an immediate exchange of goods, a futures contract specifies an exchange of goods at some future date.
Although individuals can draw up “custom made” futures contracts between themselves, there are advantages to using the standardized contracts traded on futures exchanges like the Chicago Board of Trade or the Comex in New York. For one thing, at organized exchanges it is much easier to find someone with whom to enter into a contract; and if one later decides to “back out of’ the contract, it is much easier to find someone willing to assume the contract in question.
By buying a futures contract, one becomes obligated to take delivery of a certain amount of a certain commodity for a certain price on a certain date. The commodity in question can be something mundane like orange juice or pork bellies (from which bacon is made), or it can be something exotic like palladium, or something intangible like a “basket” of common stocks. In parallel fashion, by selling a futures contract, one becomes obligated to deliver a certain amount of a Certain commodity for a certain price on a certain date.
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Futures contracts, then, can be seen as a form of insurance, but instead of insuring people against loss of or damage to a physical asset like a house or a car or a crop of wheat, futures contracts “insure” producers and consumers of a certain commodity against price changes in the commodity in question. In other words, futures contracts function to shift the risk of price changes from the producers and consumers of a commodity to speculators, who are willing to assume the risk in question in return for the chance to profit from doing so.
[I fixed a couple odd typos in the last paragraph - hope nobody minds. If anybody can figure out how the meaning might have changed... well, let me know.]
You'll have to go to his article to read about the types of "sober people" who buy futures contracts - it's important evidence for the defense of futures in general, but I want to get to the hard cases.
It is true that the parties to a contract may be mistaken about what is in their best interests. However, a case can be made that people generally have a far better idea of what is in their own interests than politicians do. Indeed, someone sophisticated and affluent enough to trade futures is generally someone who has demonstrated his competence in handling practical affairs; not every politician or government regulator can say as much. This suggests that we should leave it:to people to decide what contracts they should enter into—and this in turn means leaving it to the futures exchanges to set the rules for trading contracts and to determine the standardized form contracts should take.
What if people don’t like the contracts or trading rules offered by a futures exchange? What if they think the rules or contracts are unfair? Then they won’t trade on the exchange in question; they will instead trade on other exchanges (whose rules or contracts they like better) or they won’t trade at all. Notice, however, that it is in the interests of futures exchanges to offer the public the contracts and trading rules that they desire; for the only way that members of an exchange can make a living is if people are willing to do business at their exchange. When thinking about this issue, we should also keep in mind that in America there exist several different futures exchanges competing for the business of futures traders.
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Most people agree that one proper role of government is to act as the enforcer of contracts into which individuals have entered. If you make a contract with someone and he fails to live up to his end of the deal, you can seek compensation in a court of law. Thus, if a futures exchange does not live up to its own rules—and fails to compensate those who are thereby harmed—the courts should enter the picture.
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Some will complain that in making the above remarks I ignore the fact that events on futures exchanges can harm the economy in general (say, by causing stock-market crashes) and thus can affect Americans everywhere. Since the events that take place on exchanges can harm “innocent bystanders,” they will maintain that the government is playing an appropriate role when it tells exchanges how to conduct their business.
In reply to this criticism, two comments are in order. First, it is far from clear that events on futures exchanges can cause stock market crashes. This, at any rate, is an issue on which economists are divided. Second, even if events on futures exchanges could cause stock market crashes, it is far from obvious that stock market crashes harm the economy in general.
Along these lines, Nobel laureate Milton Friedman has argued that stock market crashes need not destabilize the economy. Those who are skeptical of this claim should recall the events of 1987: America witnessed a particularly severe stock market crash, but it had little effect on the economy. Not only didn’t we have a depression, we didn’t even have a recession.
Other economists have argued that financial crashes, although painful in the short term, can be beneficial to an economy in the long term. After all, these crashes, by wiping out marginal (and presumably inefficient) enterprises, keep the economy in fighting trim. By way of analogy, a herd of reindeer will, in the long run, be far healthier if there exist packs of wolves who pick off diseased and deformed reindeer, whose presence would otherwise jeopardize the overall health of the herd. It is true that stock market crashes have their victims, but a case can be made that society as a whole (and in the long run) is better off with these victims than it would be if it tried to create an economy in which marginal businesses were protected from destructive economic forces.
So it's not dog-eat-dog at all, but wolf-eat-sick-caribou. "Reindeer," excuse me. Not an unnatural, but rather a natural situation.
Ah, crud! He doesn't tackle the hard question. Well, that's what I get for trusting a philosopher to deal with economics.
Come on, man! The question is, don't speculators artificially bid up prices - gas prices, in particular these days - to slake their own greed?
Looks like I'm going to have to turn to my buddy Walter Block. [All right, I never met the guy.] After eat my lunch.
OK, I'm back. Block actually talks, in his chapter on speculators, about food hoarders, but they're closely parallel. His last two paragraphs:
The effect of the speculator on food prices is to level them off. In times of plenty, when food prices are low, the speculator by buying up and storing food causes them to rise. In times of famine, when food prices are high, the speculator sells off and causes prices to fall. The effect on him is to earn profits. This is not villainous; on the contrary, the speculator performs a valuable service.
Yet instead of honoring the speculator, demagogues and their followers revile him. But prohibiting speculation has the same effect on society as preventing squirrels from storing up nuts for winter--it leads to starvation.
OK, you have to admit that no futures speculator actually wants to take delivery of the product. He hopes to sell at a profit before the trucks arrive at his door. Unless he's actually a gas station owner, in the case of fuel, it can be rather costly for him to move the stuff from his place to the place where it will be used. Of course, what would really happen is that, if he couldn't find a buyer at a profitable price, he'd have to sell at a loss. Either the contract, or the actual product. At which point, he'd be looking for a new line of work.
What happens if we ban speculators? Prices are lower now because there's less competition, more gas is wasted and the crunch hits more suddenly and more severely.
What's the denouement?
Wait, I should put a link to Savages article up there. Have another. A guy (one guy) there makes the same points I'm making.
Actually, this artical in Der Spiegel (don't worry, it's in English) addresses my point more directly, from the opposite viewpoint.
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