Milton Friedman Proved Wrong by Aluminum Market
Commodity prices have fluctuated substantially over the past few years. The controversial question is, are financial speculators to blame?
In general, prices are determined by underlying forces of physical supply and demand. But with regard to at least one commodity -- aluminum -- and at least for brief periods of time, new research suggests that financial flows can indeed influence prices significantly.
Over the past decade, commodity prices have risen by an average of 9 percent a year, according to the composite index assembled by the Commodity Research Bureau. Aluminum prices, which have been through some dramatic ups and downs, have gained a bit less rapidly over that time. The average closing price for aluminum on the London Metal Exchange went from less than $1,500 per metric ton in 2001 to almost $2,400 in 2011 -- an increase of about 5 percent a year. (Disclosure: I have clients involved in both the production and use of aluminum.)
The vast bulk of the aluminum price changes can be explained by physical supply-and-demand factors, such as the cost of energy, opening of new supply basins at higher marginal costs and the increase in demand from China. At the same time, however, financial markets have become significantly more interested in aluminum. Over the past five or so years, trading in the material has roughly doubled. Daily volumes on financial markets are now 10 to 20 times the physical consumption of aluminum -- and market participants hold contracts that represent about half of world consumption, a large share even compared with other commodities.
Interest in Aluminum
The rapid “financialization” of this market has been driven partly by the entry of institutional index investors. Index funds, which currently amount to about a quarter of total financial-market holdings of aluminum, allow an array of investors to put money in the commodity without having to worry about physically owning it.
The question is whether expanded financial interest in aluminum has driven up the level and volatility of prices. The dominant academic perspective suggests that market prices will be determined by physical supply and demand, and that financial trading can, if anything, only drive them more rapidly toward balance.
The first prong of this argument applies to speculation in general. As Milton Friedman wrote in 1953 regarding the exchange-rate market, “People who argue that speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when the currency is low in price and buy when it is high.” In other words, trading should drive market prices toward equilibrium because successful traders -- the only ones who will survive -- must “buck the trend” by buying cheap while selling dear.
In the aluminum market, however, a number of the conditions necessary for the Friedman principle to hold appear to be absent.
J. Bradford DeLong, a professor of economics at the University of California, Berkeley, and colleagues have shown, for example, that if other market participants tend to follow “positive feedback” strategies by buying when prices rise and selling when prices fall, financial speculators may destabilize prices even as they turn a good profit.
Daniel P. Ahn, a colleague of mine at Citigroup Inc., says that may be precisely what happens when index funds buy aluminum. Even though the funds typically have no information that is unknown to traders, the anonymity of their trades causes the market to misinterpret an index purchase as coming from someone with superior information. Furthermore, index positions are large and most often long. The result is that the initial investment, which causes the price to rise, generates further increases as other traders jump on the bandwagon.
Supply and Demand
A second prong of the academic argument about speculation applies specifically to physical commodities, such as aluminum. It says that if financial-market participants drive prices above equilibrium levels, consumers will cut back on their demand and suppliers will step up their production -- leading to an observable increase in inventory levels and a decline in prices.
In the case of aluminum, though, things may not work so smoothly -- which is why financial flows can raise prices and volatility for a period of time. For one reason, within certain price ranges, supply and demand are relatively inelastic. On the supply side, that’s because existing smelters are limited in how much additional production they can handle -- and opening new smelters is expensive and takes time. On the demand side, many end users, such as auto manufacturers, are reluctant to switch from aluminum to other materials unless the price increase is extreme. So prices can move a lot without much change in supply or demand.
Inelastic supply and demand also mean that even relatively large price increases generate relatively modest changes in inventory levels. And given how difficult it is to obtain accurate information about inventory in the aluminum business, small changes may be difficult for the market to detect. So trying to use inventory levels to measure how far the market is out of whack may not work that well. As a result, “multiple equilibriums” of plausible market prices can persist over a surprisingly long period before supply-and-demand fundamentals finally exert themselves.
Ahn’s statistical analysis suggests that a surge in index investments in aluminum has tended to precede a gain in prices. For example, the increase in index investment from the beginning of 2006 until July 2008 appears to have raised aluminum prices by 25 percent. At that point, the prices were roughly 30 percent above the level that could be explained by production costs -- and the implication is that the index investments can explain a significant share of the difference.
After the summer of 2008, index funds rapidly left the market, with total index investment falling by about 70 percent from 2008 to 2009. Aluminum prices promptly plunged, from a bit over $3,000 per metric ton in July 2008 to $1,400 in January 2009, before recovering to $2,100 in January 2012.
At the same time as the aluminum price decline, though, a variety of commodity prices plummeted -- so it is difficult to disentangle the broader macroeconomic effects from the index- fund fluctuations. And within the aluminum market, prices continued to be influenced by factors such as the financing of inventories and new projects.
A reasonable conclusion from all of this is that fundamental supply and demand drive aluminum prices most of the time, but that financial flows (including index funds) can, over brief periods, exert a noticeable destabilizing effect -- especially when inflows change rapidly.
The aluminum market thus suggests a broader conclusion, which other evidence indicates also holds for the price of food and other commodities: The Friedman principle of stabilizing speculation is not always right.
(Peter Orszag is vice chairman of global banking at Citigroup Inc. and a former director of the Office of Management and Budget in the Obama administration. The opinions expressed are his own.)
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