An Inconvenient Truth: the Onion

Politicians and markets don’t always get along.  When market prices behave in a way that is politically inconvenient, politicians tend to step in—usually with little understanding of the consequences.  (Note: it doesn’t matter whether prices are plummeting or rocketing, it’s the politics that count.)  When housing prices were rising, everyone was happy.  When housing prices fell, politicians of all stripes felt a need to blame someone for the price collapse and to prop up the market.  When gasoline prices are rising, politicians often feel the need to demonize someone.

One day soon, evil speculators will be blamed for some price misbehavior that is politically inconvenient.  Don’t believe it.  In fact, as Jonathan Hoenig points out in a Smart Money article:

…the fact is that speculative futures markets don’t create volatility, they reduce it.

For proof, let’s go back to the 1950s when farmers began to complain about the price of onions, which were falling.  They appealed to their elected representatives to do something about the evil speculators who were obviously impacting their livelihoods.  The biggest onion producing state at the time was Michigan, so Michigan congressman Gerald Ford pushed through the Onion Futures Act, which banned trading in onion futures.  No more evil speculators.  (According to the Smart Money article, it is still the only commodity-specific futures ban.)

I realize this must sound comical, but yes, Congress actually prevented speculation in onions!

Professor Mark Perry (of the University of Michigan!) recently posted a chart of onion price volatility, showing it in comparison to oil which still has a futures market despite recent calls to exorcise the evil energy speculators.  Oil is much less volatile than the onion market:


Lest you think that energy prices are just inherently less volatile than onions, even CFTC commissioner Joseph Dial in a 1997 speech pointed out:

…economists “found more cash market volatility in onion prices before and after the period of futures trading than there was while the onion futures market was operating. In other words, futures markets don’t cause volatility — they respond to and decrease volatility.”

Politicians can pass laws to hinder markets from operating efficiently, but they cannot repeal the law of supply and demand.  That’s why price is all-powerful in the end.  Auction markets are critical in determining the proper clearing price so that producers and consumers can make intelligent decisions in the future.  Trying to curb “speculation” just causes poor capital allocation for society.

Postscript: for a complete academic treatment on futures markets and volatility reduction, this paper by David Jacks of Simon Fraser University is fantastic.

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