A reader asked me a while back what I thought of this little article by my former Fortune colleague Jon Birger about onions:
The bulbous root is the only commodity for which futures trading is banned. Back in 1958, onion growers convinced themselves that futures traders (and not the new farms sprouting up in Wisconsin) were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.
And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics’ belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April. …
It’s an interesting tale, but I’m afraid I know too much about this little onion story to entirely accept the argument that futures markets reduce price volatility. I mean, I’m all for futures markets, simply because they provide a way for producers and consumers to lock in prices if they want to. But the most important of the academics who have argued that futures trading diminishes extreme price swings, Holbrook Working, devised an onion-based test for his hypothesis–what others were later to dub the efficient market hypothesis–that ended up delivering less than conclusive results. After the break, the full story, adapted from some book that somebody’s planning to publish next year:
The Chicago Mercantile Exchange, which had started out as the Chicago Butter and Egg Board, lost its butter futures business in the 1930s with the advent of federal dairy subsidies. Onion futures, launched in the late 1940s, were an attempt to replace that lost income. But the struggling Merc remained dominated by a handful of traders. In 1957 a couple of them cornered the market in onion futures, and prices skyrocketed. Onion farmers who should have sold at the high prices and pocketed the money instead got swept up in the excitement and bought futures.
“Onions ended up selling for less than the price of the burlap bags in which they were delivered,” recalled Leo Melamed, a trader then who later went on to run the exchange. “The onion farmers of America were outraged. They had lost money on their crops as well as their futures contracts.” The angry farmers lobbied their representatives in Washington to rid them of the plague that was onion futures trading, and got their way in 1958 with a federal ban that remains on the books today.1
For the Merc, this debacle was the impetus for a big cleanup, then a spectacular burst of innovation and reinvention led by Melamed that began with the creation of pork belly futures contracts in 1961 and continued through the introduction of financial futures based on currencies, interest rates and stock market indices in the 1970s. For Working, the ban was a prime opportunity to test the efficiency of futures markets. He figured that by comparing the volatility of onion prices in the presence and in the absence of futures trading, he could get a sense of whether futures markets steered prices toward their correct levels or simply added volatility.
Working initially looked at the behavior of onion prices before and after onion futures trading began in the 1940s and found that prices had been less volatile during the futures trading years.2 This was an encouraging result, but it was the post-ban studies, undertaken by other agricultural economists along the lines set out by Working, that could offer more compelling evidence. The first, in 1963, showed more price volatility after the ban than before—supporting the thesis that futures markets made pricing more calmly rational.3 But in 1973, yet another study found that onion prices over the entire course of the 1960s, a decade entirely bereft of onion futures trading, were the least volatile on record. There may have been other factors at work: Better transportation, better weather, better onions. But there was certainly no clear evidence from the onion fields to support the presumption that speculative markets got prices right.4
1. Leo Melamed, with Bob Tamarkin, Escape to the Futures, New York, John Wiley & Sons, Inc., 1996, p. 99.
2. Holbrook Working, “Price Effects of Futures Trading,” (reprinted from Food Research Institute Studies, Vol. 1, No. 1, Feb. 1960), in Selected Writings of Holbrook Working, Anne E. Peck, ed., Chicago Board of Trade, 1977. pp. 45-71.
3. Roger W. Gray, “Onions Revisited,” (reprinted from the Journal of Farm Economics, Vol. 45, No. 2, May 1963), in Anne E. Peck, ed., Selected Writings on Futures Markets, Vol. II, Chicago Board of Trade, 1977, pp. 325-328.
4. Aaron C. Johnson, “Effects of Futures Trading on Price Performance in the Cash Onion Market, 1930-1968,” (excerpted from USDA, ERS, Technical Bulletin No. 1470, Feb. 1973), in Peck (1977a), pp. 329-336.
Update: Jon points me to a couple of pieces that followed his (but did not credit him): an WSJ editorial that cites the “classic 1963 paper” by Roger Gray but ignores the 1973 Aaron Johnson paper and an FT editorial that claims, “When economists studied the market, they discovered that volatility and prices were higher in the period after the ban than they were before.” Do these people never read the USDA ERS Technical Bulletin?!?!
I actually generally agree with the arguments that a) futures markets serve a useful purpose and b) aren’t the main reason why oil prices are high. But I do find it interesting that these people go around citing overwhelming academic evidence when in fact the evidence is mixed.