In recent weeks, many U.S. lawmakers have blamed soaring oil prices on the “speculators” who have invested in energy futures markets. But can a small number of investors really harm an economy as big as ours? More specifically, do flows of investment capital cause market fundamentals to change, or are they more often the result of perceived changes in those fundamentals?

Throughout the Western world, politicians have a long history of scapegoating capital markets. For example, after George Soros made $1 billion in 1992 by shorting the British pound, British government officials blamed currency speculators for causing the UK’s economic problems. Similarly, at the end of the great German hyperinflation in 1923, prices stood at 1.38 trillion times their 1914 levels and unemployment approached 30 percent. But Reichsbank president Hjalmar Schacht railed against speculators who had shorted the Reichsmark against the dollar. 

Today, in response to voter anger over high gasoline prices, committees in both the U.S. House and Senate are holding hearings on commodity speculation. Oil market speculation has “become a growth industry, and it is time for the government to intervene,” Michigan Democrat John Dingell, chairman of the House Energy and Commerce Committee, said recently. “We need to consider a full range of options to counter this rapacious speculation.”

The anti-speculation fever transcends party lines; both Barack Obama and John McCain have called for an investigation of commodity markets. Several bills are being considered in Congress, and their general theme is captured in the title of H.R. 6330, the “Prevent Unfair Manipulation of Prices (PUMP) Act of 2008,” introduced by Michigan Democrat Bart Stupak.

The political class blames the run-up in oil prices on institutional investors such as pension funds, which are buying commodity index futures and supposedly “manipulating” the price of oil by their very presence in this market. Critics distinguish between these “financial” buyers and those who are involved in the actual consumption of the physical commodity—the implication being that speculation might be okay for, say, an oil jobber or refiner, but not for an investor. In short, the critics apparently believe that capital investment is tantamount to buying and hoarding a physical asset to ensure that prices rise.

Potential remedies for this alleged problem include outright prohibition of institutional investor participation in commodity index futures, greater federal oversight (by the Commodity Futures Trading Commission or Federal Energy Regulatory Commission), and strict limits on the positions taken by any investor across futures markets. But, as is often the case in Washington, these measures aim to “solve” a problem that does not exist and display ignorance of basic economics. Worse, increased political meddling in the futures markets will dampen economic efficiency.

Far from being a villain, commodity index futures are conveying a useful message: more inflation is expected, and U.S. energy production needs to be unshackled.

To optimize policy, it is crucial to understand how important speculators are in markets such as commodity futures. As Columbia Business School economist Glenn Hubbard explains, institutional agents in efficient financial systems offer three types of services: risk mitigation, liquidity, and better market information. In the case of index futures, producers, buyers, and investors can hedge against price movements, including government-induced inflation. Speculative capital in a futures market also enhances overall market liquidity, which is unambiguously helpful for buyers and sellers of all stripes. Institutional investors often participate in markets because they have knowledge (or strong opinions) about the future course of market values. All of this contributes to asset prices that more exactly reflect economic reality.

According to various estimates, institutional investment in commodity index futures has increased by between $140 billion and $250 billion over the last five years. While it is hard to see how this can materially impact a crude oil market now doing over $4 trillion in annual business, some politicians claim that if these “financial” speculators were sidelined, the price of crude oil could fall dramatically. That is flatly untrue. Some futures speculation would merely move to offshore, unregulated, and less transparent markets. Don’t forget, moreover, that many speculators have actually shorted commodity markets; their positions have canceled out the long positions in terms of price movements.

On a fundamental level, any time liquidity and informed financial intermediaries are withdrawn from a specific market, both the market and the economy as a whole suffer.  Look at the current U.S. housing market. More liquidity from well-informed investors would clear markets and lower prices—the exact opposite of speculators’ alleged effect on oil markets. Enhanced liquidity and better information also lead to superior allocation of resources, which improves investment returns and creates more wealth. And in cases where institutional speculators are acting on behalf of commercial or investor principals (i.e., Morgan Stanley acting on behalf of, say, United Airlines), the loss of a vehicle for hedging against inflation, or for diversifying a portfolio containing uncorrelated assets, harms the economy-wide deployment of capital for wealth and job creation.

Politicians’ disparagement of speculation has its antecedent in Marx and Keynes. Both excoriated speculation as emblematic of capitalist instability. The Marxian distinction between “money capital” and “actual capital” is a direct precursor of the modern-day distinction between “financial speculators” and industrial players. Meanwhile, in Chapter 12 of The General Theory, Keynes attacked speculators who were not long-term investors, decrying the availability of liquidity for in-and-out trading and likening modern financial markets to gambling casinos. He even mused about the efficacy of a transfer tax on stock sales to encourage long-term holdings, and foresaw eventual government control of investment.

Such criticism misunderstands the nature of speculative investment, which is essentially an act of knowledge-extending entrepreneurship that deepens our liquid and flexible capital markets. The envy of the world, these vibrant and dynamic markets are critical drivers of our advanced economic welfare.

The truth is that increased speculation in oil futures is not a cause of rising oil prices, but rather an effect of those prices, which have skyrocketed due to growth in global demand, geopolitical instability, and constricted supply in several producing countries. The U.S. government also deserves a share of the blame for its disastrous interference in the domestic production of energy and for its inflationary monetary policy. Indeed, had the dollar merely tracked the euro during the Bush presidency, we would have $80-a-barrel oil, less commodity inflation, a better economy—and less speculation. Today’s sky-high oil prices reflect, in part, the failings of U.S. monetary and regulatory policy.

Senator Obama says that we cannot drill our way out of this problem; but neither can we demagogue our way out of it. Far from being a villain, commodity index futures are conveying a useful message: more inflation is expected, and U.S. energy production needs to be unshackled. Rather than demonize the speculators, lawmakers should take that message to heart.

John L. Chapman is a researcher at the American Enterprise Institute.

Image by The Bergman Group/ Darren Wamboldt.