In these days of $135 barrels of oil and $4 gallons of gasoline, a particular siren song is being heard repeatedly from people of all political stripes: “It’s the speculators!”

There is just enough of a kernel of truth in the claims to give dangerous and economically nonsensical policy suggestions some momentum. However, as Bastiat explained, economic plans through which the government provides publicly desirable outcomes in the short term are almost always ruinous in the long term.

From most Democrats, such as Jim Webb, to the occasional Republican such as David Vitter, to the Italian Economy Minister to the dominant liberal media to a hedge fund manager who testified before the Senate (but appears to own a stock portfolio which is getting hurt by high oil prices), you can hardly swing an empty 5-gallon gas can without hitting someone trying to make political points or a few bucks by bashing those evil speculators.

The basic case against speculators goes like this: Commodity index funds, essentially like stock index funds except that they buy groups of commodities instead of groups of stocks, are pouring so much money into these markets that they are “artificially” forcing the price up. And, unless investors in the funds start taking money out, the funds never sell.

In an excellent article discussing the hedge fund manager’s testimony, John Mauldin includes this interesting chart which shows a correlation between the prices of commodities and the amount of money in commodity index funds:

Looking at this chart, it would be easy to assume that index investment flows are the cause of higher commodity prices. And while there is little doubt that index investors have had some impact on prices, several key points must be made:

Over the long term, the balance between fundamental supply and demand is a more important factor in a commodity’s price than index fund investment flows are. America’s ongoing reduction in oil use, combined with new supply such as from developing economically feasible ways to develop oil shale or (less likely with Democrats in charge) from drilling off our own shores or in ANWR, will reduce the price of oil directly.

Another factor behind the rise in oil is the weakness of the US Dollar, for which both the federal government and the Federal Reserve bear some responsibility. However, even the relationship between oil and the dollar is not as simple as it seems, as shown in this article by an energy economist and this academic blog posting, both of which remind us how financial markets are much too complicated for the average person to understand in any depth, and far too complicated for the average politician to be trusted to regulate.

There are legitimate investment reasons for people to want to have their money in commodity index funds, particularly to try to keep up with inflation. But there is also a momentum component to flows into those funds. In other words, as the prices of commodities rise, many investors chase those investments, just as they did with internet stocks in the late 1990s or with residential real estate in the middle of this decade. A reasonable argument can be made that increasing commodity prices caused money to go into commodity investment funds, as much as the other way around. This makes sense if you remember how many of your friends saying there were going to invest in anything dot-com or in housing near the ends of those bubbles because they were so tired of hearing others say how much money was being made and feeling like they were missing the boat.

And just as with those bubbles, when prices begin to come down (as they will if supply and demand change as I expect) investors will run for the exits; as we learned in those other bubbles, prices can fall rapidly and for a prolonged time. (Of course, when that happens nobody will thank the “speculators” when they’re keeping prices “artificially low”.)

Speculators perform valuable functions in the marketplace, providing liquidity (no pun intended, for those worried about oil) where there is a void in natural supply or demand. They take real financial risk for the chance at profits, just as we all do when we make any investment. Those who “speculate”, i.e. invest in, commodities are not evil. Their trades do not deserve to have a moral judgment attached to them any more than my decision to buy shares in a stock or buy government bonds should be judged. We’re all simply doing what we think is best in order to maximize returns.

And while many people equate both speculation and futures markets with gambling, the facts are that futures markets provide a critical social function, allowing suppliers and consumers of commodities to plan ahead by ensuring future purchasers or suppliers of wheat, oil, orange juice, coffee, or dozens of other products we use daily. Yes, some speculators may truly be gambling, but those people are not really whom the politicians are targeting. A large fraction of the money in commodity index funds comes from pension funds. In other words, these investments are being made by professional managers who are doing what they think is best to diversify their clients’ investments and to try to ensure that those clients don’t live a life of poverty after retirement.

Unless someone is breaking one of the few laws which may be legitimately applied to markets, such as to prevent “cornering a market”, his trade is no less or more honorable than anyone else’s trade. Markets are and must remain amoral in that sense: as long as participants are not behaving fraudulently or with the intention to manipulate the market, there should be no such thing as an objectionable or impermissible trade.

Although we’ll continue to see our politicians foam at the mouth about in the name of “doing something”, there are several problems with trying to regulate “speculation”. The main one is, as always with the intersection of politics and economics, negative unintended consequences. Speculators are truly critical to market function. While we focus on the possibility that they are increasing prices in the short term, we must remember that they will become a source of supply (either of futures or of the commodities themselves) later.

Would the politicians want to rein in all “speculators”, including those whose intention is really investment, in addition to those who might be “just gambling”? If only the latter, how do you tell the difference? And why not then curb “speculation” in other markets or in real estate? (Of course, we know the answer: People like stocks and homes going up in price, but not oil. But do you really want a politician drawing that line?)

In general, Republicans seem to understand that the main issue with oil now is supply, not speculation. On Fox News Sunday, Senator Kay Bailey Hutchison (R-TX) basically got it right in response to a question about her support for “legislation on oil speculation”: “If you're talking about people going into the market of their own free will, not controlling anything, then it is a market issue. And I think transparency would be a good add….I think we need to look at the whole issue and understand it. But if we bring up supply, we will bring down the price.”

Interestingly, neither of the two major presidential candidates seems fully on board with regulating speculation. John McCain has been very inconsistent with his oil-related rhetoric, including the socialist suggestion that oil companies should “be more participatory…in sharing their profits” and has suggested a “thorough and complete investigation of speculation”, but he hasn’t said he supports regulation at this time. Barack Obama has actually said that he supports high oil and gasoline prices (he just wishes they went up over a longer period of time). He is much more interested in attacking oil companies than speculators.

Although it is not possible to curb “speculation” without long-term damage to our markets, our economy, our liberty, and our nation, I would expect either of our populist candidates to sign some sort of anti-speculation legislation if it were to get to the next president’s desk. Bastiat warns us still…