12 May, 2008

Krugman to the Rescue

In my earlier post, we had an argument about whether speculation was the cause of high oil prices. Paul Krugman's column today sheds some light on this issue:

Now, speculators do sometimes push commodity prices far above the level justified by fundamentals. But when that happens, there are telltale signs that just aren’t there in today’s oil market.

Imagine what would happen if the oil market were humming along, with supply and demand balanced at a price of $25 a barrel, and a bunch of speculators came in and drove the price up to $100.

Even if this were purely a financial play on the part of the speculators, it would have major consequences in the material world. Faced with higher prices, drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production.

As a result, the initial balance between supply and demand would be broken, replaced with a situation in which supply exceeded demand. This excess supply would, in turn, drive prices back down again — unless someone were willing to buy up the excess and take it off the market.
This is the shortest relevant clipping I could make, but I recommend reading the whole column as it is all pertinent.

UPDATE: Here is more from Krugman.

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