THE BEAR'S LAIR When money is worthless
By Martin Hutchinson
The Financial Times on October 6 noted a disturbing new trend - hedge fund and
other investors are increasingly seeking to invest in physical commodities
themselves, rather than in futures. Given the excess of global liquidity, this
is not entirely surprising. It does, however, raise an ominous possibility of a
supply shortage in one or more commodities, caused by investor demand that
exceeds available mine output and inventory. That could potentially produce a
collapse in economic activity similar to that from the 1837-41 and 1929-33
liquidity busts, but with the opposite cause.
The problem arises because of the size of the world's capital pools in relation
to its volume of trade. The total assets of US hedge funds in September 2009
were US$1.95 trillion (down from almost $3 trillion a year earlier). That
compares with total US
imports of goods and services in 2008 of $2.1 trillion.
However, in addition to the hedge funds, there are other huge pools of money
available for deployment in commodities markets. For example, China and Japan
each have around $2 trillion of foreign exchange reserves, while Saudi Arabia
and the Gulf states have comparable-sized pools of liquid assets available for
investment. Since the available inventory of commodities is a fraction of their
annual production, we could potentially end up with an extreme case of too much
money chasing too few goods.
This would not matter much if investment were concentrated in futures markets.
The open interest in such markets is controlled by the traders, who arbitrage
to close positions as the settlement date nears. Thus when huge speculative
money flows pour into futures markets, they drive up the price of the commodity
concerned, but do not significantly interfere with the production of that
commodity, nor with the flow of the commodity from producer to consumer.
Normally, commodity investment is confined to futures markets because it is
much more convenient. The cost to a hedge fund or other financial investor of
holding stocks of a commodity is quite high, normally sufficient to deter
investors from attempting to buy commodities directly. They will only buy
commodities directly if they are afraid that the normal arbitrage mechanisms
between the futures markets and the commodity markets will be overwhelmed by
the volume of demand, so that investment in futures will prove less profitable
than it "should".
When investment moves to physical commodities, as it may now be doing, it
potentially disrupts trade flows. A ship laden with copper ore that would
normally have sailed from Chile to a smelter on the US West Coast is instead
parked in a holding area in order that investors can profit from the rise in
value of that copper. That reduces the amount of ore available to smelters.
Since the balance between supply and demand of most commodities is quite
delicate, and supply cannot be ramped up by more than a modest percentage at
short notice, that could result in a physical shortage of the commodity at the
smelter, shutting down the smelter for a period and depriving its customers of
the copper products they need for their own operations.
Disruptions of commodity flows of this kind can potentially cause both
hyperinflation and a major recession. The value of copper to the smelter and
its customers is much higher in a shortage than if it is available normally
because the cost of closing their own operations is large - hence the price of
any spare copper that might be available locally zooms upwards. Equally, the
economic cost of shutting down the smelter and its customers far exceeds the
value of the copper ore shipment. Products containing copper are suddenly in
short supply, while workers lose their paychecks and so are forced to stop
consuming at the same level.
The effect of a gross liquidity surplus is thus quite similar to that of a
sudden shortage. In the shortage case, as in 1837-41 and 1929-33, prices
decline sharply - in those two cases by as much as 20-25% - economic activity
is hugely reduced as businesses are unable to obtain financing and workers are
laid off. The resultant decrease in demand causes producers to lose money,
eventually closing their doors, as well as bankrupting the financial system.
In a gross liquidity surplus, in which investment capital disrupts commodity
trade flows, inflation rather than deflation results, probably very rapid
inflation rather than the moderate 5% to 10% inflation we became used to in the
1970s. That inflation still further increases demand for commodities, worsening
the problem. Businesses unable to obtain raw materials close their doors,
workers' real incomes decline sharply (even when they keep their jobs) and
gross domestic product declines similarly to the deflationary case.
We have never experienced a global hyperinflation, in which money is unable to
purchase goods, so it becomes worthless. In particular countries, wars have
produced this effect, notably in the revolutionary wars in both the United
States and France, when the "continentals" and "assignats" became of no value.
Similar effects have been produced by excess money printing in Latin America;
in hyperinflationary periods citizens of Argentina have starved, even though
the country is one of the world's greatest food producers. However, globally we
have experienced nothing worse than the moderate worldwide inflation of the
1970s, in which trade flows were disrupted and incomes and assets affected, but
commodities generally remained available in the market and output weakened but
did not decline sharply.
The fascination of adding another chapter to economic historians' textbooks is
not sufficient to make global hyperinflation anything other than an event to be
avoided at all costs. It might help the Ben Bernanke of 2080 to make better
monetary policy decisions than the present Federal Reserve chairman, since he
would have the chance to be the world's greatest expert on the
hyperinflationary crash of 2011. However, as far as this column is concerned,
future generations can take their chances - we need to avoid hyperinflation
happening to this generation.
The cost of avoiding this disaster appears to be steadily increasing. Once
articles start appearing in the Financial Times about investors choosing to buy
physical commodities rather than futures, many more such investors will be
drawn into this activity. A moderate tightening of monetary policy that might
well have deflected the forces of hyperinflation if it had been instituted
several months ago may well prove ineffectual at this stage.
In determining the necessary monetary policy, the gold price provides a very
useful signaling device (and its definitive breakout through previous highs
last week provides a stern warning). It does not matter one whit whether
investors demand physical gold rather than futures because gold has only
insignificant industrial uses and the stocks of gold available in "inventories"
such as Fort Knox are far more than sufficient to supply those uses for a
decade if necessary.
However, the commodity investment impulse is closely tied to the gold
investment impulse; both reflect a well-warranted distrust of fiat money and a
desire to hold items of secure long-term value. Hence the gold price is
available to show policymakers whether their monetary policy is appropriate.
If, following the recent breakthrough, the gold price continues to increase,
heading for $2,400 per ounce, the equivalent in today's money of the 1980 high,
that will be an excellent signal that monetary policy urgently needs
tightening.
If, after a first monetary tightening, the gold price retreats for a few weeks
and then breaks through its recent highs, that development will be a signal
that monetary policy must be tightened further, as the flight to commodities
has not halted.
Only when the gold price breaks definitively downwards, dropping 25% or more
from its high, will policymakers know that they have succeeded in breaking the
commodity investment mania. Such a development is however likely to occur only
after a definitive crack in government bond markets, forcing policymakers to
address their gigantic budget deficits as a matter of urgency.
Given the predilections of today's policymakers, it is unfortunately unlikely
that they will tighten monetary policy sufficiently to break the commodity
flight, whatever the gold price does. Instead, led by the determined Keynesians
of the International Monetary Fund, they are much more likely to attempt to
control the gold price itself, either surreptitiously by selling off massive
quantities of the world's gold reserves, or openly by imposing limits on gold
futures trading and possibly, like Franklin Roosevelt in 1933, making it
illegal for ordinary individuals to own gold or to buy gold futures.
That will of course only make matters worse; it would be equivalent to trying
to avoid a speeding ticket by smashing the car's speedometer. Manipulating the
gold price to pretend that liquidity is not excessive does not stop liquidity
from being excessive. Nor does it lead any but the stupidest institutional
investor to believe that his urge to invest in physical commodities is
misguided.
Rather, it will cause commodities investment to be carried out through shell
companies in tax havens, away from regulators' radar screens. The effect on
global supply chains will be equally damaging, but policymakers will no longer
have a straightforward way of determining how to avoid the resulting economic
depression.
I wrote last week that tightening liquidity directly by entering into a central
bank "exit strategy" is dangerous. However, the Financial Time's story itself
and the gold price breakthrough have significantly increased the size of the
hike in interest rates necessary to halt the flight to commodities.
Time is short, and the probability of disaster is rising.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)
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