I thought Greenspan's take in the FT on the oil market deserved comment.

Greenspan says 'good speculation' will cut the top off market peak

The recent fall in the price of oil is primarily the result of investors unwinding speculative positions that helped drive up oil prices earlier this year, Alan Greenspan has told the Financial Times.

The former Federal Reserve chairman said speculation was "importantly responsible" for the rapid move up in oil prices in late 2007 and early 2008.

But he said this was "good speculation" of the kind that ultimately moderates a change in prices, and not "bad speculation" of the bubble-creating kind.

Let's first have a look at "speculation" and "bubbles".

I see speculation as a transaction-based phenomenon, when investors buy and sell (not necessarily in that order) in pursuit of a profit, and risk a loss.  Investment, on the other hand, to me involves the purchase and sale of productive assets.

Speculation involves risk transfer, and I have never had any problem with the role of speculators as "risk taking" liquidity providers eg market-makers.

We must simply be careful not to let these middlemen own and run the markets for their own benefit.

The problem comes when "speculation" is reinforced by "gearing", through the use of deficit finance. This may be through margined futures  contracts; other derivatives, the use of borrowed money to buy the relevant assets, or a combination.

There is qualitatively no difference between the role of a central counterparty operating a "margining" system in futures contracts, and the role of of banks in "fractional reserve" banking.  Our Money - which is credit created by credit institutions and backed by their Capital - essentially is a futures contract.

I digress.

 Mr Greenspan said that while the long-term rise in oil prices was "wholly a physical phenomenon", financial speculation influenced the "timing and profile" of price increases.

I think that this is essentially a truism.

"Financial speculation did play a significant part in the rapid increase in oil prices," Mr Greenspan said. From 2004 onwards financial investors identified a one-time opportunity to profit from the expected increase in the price of oil caused by pressure of mounting demand on constrained supply.

"It was classic stabilising speculation," he said. "It brought forward the price increase that would have otherwise taken place over a much longer period of time, reducing demand sooner and ultimately cutting the top off the intermediate peak price."

I think he has it entirely wrong. I think that the role of a market maker as a liquidity provider could be used as an example of "stabilising" speculation.

But that is not the case here. I think that we have seen a classic case of destabilising speculation in the form of a "bubble" itself generated - as are all "bubbles" - by the phenomenon of "gearing".

In other words, the market price ran up far higher, and far quicker, than it should have, generating profits and losses for speculators, and huge profits for the financial service providers through prime brokerage and proprietary trading based upon privileged information.

But it is no surprise that the person responsible for the "Mother of All Bubbles" - currently deflating and taking the US financial system with it - should have a blind spot about the nature of speculation.

Indeed, IMHO this MegaBubble he fostered will have had the beneficial effect of bringing forward the end of an unsustainable monetary system, in an analogy to the role he claims of "good speculation" in the oil market.

Many experts reject the idea that financial speculation played a significant role in driving up oil prices, arguing that it did not affect the underlying balance of supply and demand for oil.

This is the key issue, and it comes down to discussion of what the oil price actually is and the nature of the sale contracts which are habitually in use.

Mr Greenspan disagrees. He said the data suggested that financial investors from 2004 onwards built up a large net long position in crude oil futures.

The counterparties to their net long positions were owners of oil inventories, who in effect sold forward some of their existing stock of oil.

In order to compensate, the owners of oil inventories stepped up their acquisition of new oil. "This showed up as a significant rise in the stock of usable crude - that is, oil inventories over and above that needed to keep the pipelines, tankers and refineries operating."

Over the past year, he said, owners of inventories continued to bid for oil, but their attempts to replenish their owned stocks were largely thwarted by increases in demand from China and other emerging economies.

Never having been a trader, and not being embedded in the market as I used to be when I was a market regulator, I would be interested in the opinion of other market professionals in relation to Greenspan's analysis.

Mr Greenspan said financial investors began to unwind their net long positions in July to realise capital gains amid indications of slowing global growth, removing the upward pressure on oil.

This reinforced the "demand destruction" caused by high prices sustained for long enough to allow consumers and businesses to change their behaviour.

However, Mr Greenspan said the underlying supply/demand balance suggested "we will not go back to $80 or lower". Once the current economic downturn was over, "oil could go back to $150 or higher" unless oil producers significantly increased their capacity.

But he said: "Future price increases will probably be stretched out over a longer period of time than the increases from mid-2007 to mid-2008."

My take is that speculative money has indeed been instrumental in recent market gyrations, but it is not clear to me - or indeed, to anyone else due to the current global absence of transparency - that it has been the futures markets which have been the primary mechanism, as opposed to massive "off exchange" positions.

Unlike Greenspan, I do not see a smooth increase over time in obeisance to the Gods of market forces. I see greater waves of speculative money washing in and out of the market until there is - and IMHO it is inevitable - a "market meltdown" analogous to the Tin Crisis in 1985.

ie a "market discontinuity" which will wipe out the single points of failure known as Clearing Houses, which are pretty much as undercapitalised for the risks they run as Fannie Mae and Freddie Mac are in the mortgage market.

...and of course the taxpayer will pick up the pieces.