Oil prices and irrational exuberance

Alan Greenspan’s great phrase about irrational exuberance gains greater resonance by the day, as one looks at the way markets behave in our modern deregulated world.

Take oil.

Everybody knows that oil prices are soaring. This is often attributed to increasing demand, especially from China. But there’s increasing comment in the media that the recent increase is much more likely to be due to speculation, and that the fundamentals underlying the market haven’t really changed – for example this one from Anatole Kaletsky in The Times. Kaletsky is scathing about how prices become detached from the economic fundamentals – and argues that OPEC countries are storing massive surpluses. So much for the laws of supply and demand. He writes:

“The resulting misconceptions drive market prices to a “far from equilibrium position” that bears almost no relation to the balance of underlying supply and demand. The people who tell you that commodity prices today are driven by “economic fundamentals” are the same ones who said that house prices in Britain were rising because of land shortages. The amazing thing is that just months after losing hundreds of billions in the housing and mortgage bubbles, investors and governments around the world have reverted to the discredited fallacy that financial markets always reflect economic reality …”

Now I’m not going to argue that in the long term oil prices don’t have to rise. On the contrary, I think there’s a lot of evidence that we are facing the exhaustion of oil supplies and a painful and difficult period of re-adjustment. But how should this transition be managed? By concerted political initiatives based on international institutions? Or by leaving the market to the ravages of speculators?

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