Friday, April 23, 2010

Peel Back the Layers of the Marketplace Onion and it Still Stinks

I really don't like American Public Media's public radio show Marketplace. It's rife with bad economics. I once heard a show in which a reporter explained that the Federal Reserve has two tools for influencing the economy: interest rates and money supply. That's like saying there are two ways to drive a nail into a board: you can use a hammer, or you can use a stick with a metal head on it.

Last night while driving I heard the host of the show explain that there is a law against futures trading for onions in the U.S. I was excited because I had actually learned something new from this show that so frequently annoys me. I was delighted when the host pointed out that prices in the onion spot market are more volatile than in other agricultural markets. It turns out that both statements are correct, too.

Then, of course, I was let down, as the host said (and I'm paraphrasing) "It just shows that you never know what to expect from a market". This is an indication of incredible ignorance of economics. Increased volatility is exactly what economics predicts should happen if futures markets are eliminated. Why? Because futures markets allow people to bet on future prices. If I look at weather data and conclude that onions are going to be in short supply in three months, I can sell a promise to deliver onions then (at what will be a high price) and buy a promise from someone else to give me onions (at today's low price). The result is an increase in the demand for onions now, and an increase in the supply onions later. What happens to the price? It goes up now, and down in three months. Prices are smoother over time because speculating in futures markets allows planning for the future. It's intertemporal arbitrage. (This does not mean that speculative bubbles cannot occur; it just means that we should generally expect prices to be smoother over time.)

This is not a surprising result. Econ 101 students should understand this intuitively. It's disappointing that the creators of a much-listened-to radio show do not seem to understand this.

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