Commodities, Crises, and Cycles
by Sean Corrigan
by Sean Corrigan
Though the secular force of globalization and the urbanization of large parts of the world in what some have called a ‘second industrial revolution' seems set fair to continue issuing its increasing call on the basic raw materials needed to build the necessary infrastructure, those calling for a largely uninterrupted rise in raw materials prices are overlooking the fact that our present day financial structure is almost guaranteed to introduce a significant cyclical element into their trajectory.
This instability is fundamentally rooted in the artificial stimulus to growth which originates in credit expansion and which results in that alternation of booms and busts we call the business cycle.
Despite the long passage of time since the pathology of this affliction was first teased out by the great Austrians, the phenomenon is still widely misunderstood, its causes misidentified, and its progression mischaracterised, so another treatise on this virulent, if entirely self-inflicted, the disease is perhaps warranted.
At its most basic, the foundation of all the associated woes were first explained by Richard Cantillon — the father of modern economics and one of history's great traders — nearly three centuries ago when he was making his own, considerable fortune amid the twin manias of the Mississippi and South Sea bubbles.
His exegesis relied, at root, on the insight that the process of money creation can never be ‘neutral' since somebody, somewhere has to have the new money first. In other words, the famous Friedmanite-Bernankean ‘money helicopter' is not some indiscriminate crop-duster, but a Hellfire-spitting Apache with very specific targets in its sights.
Once he has had his bank account credited, the fortunate, early recipient of the new monies can immediately exercise claims upon existing resources far beyond those he has earned through his prior productive contribution — just like the quartermaster of an occupying army can fill his supply train simply by issuing the expropriated locals with requisition chits, rather than having to render them honest payment in exchange.
In this way, a borrower can hope to buy now, on the cheap — before his counterparty realizes the tendered money has just been debauched — while potentially reselling more expensively later, enjoying windfall gains, once the effects of the dilution have begun to manifest themselves.
Whatever the majority of today's policy makers may think, even if output simultaneously rises, or people make after-the-fact savings out of this extra money, so that prices in general remain unchanged, this cannot fail to distort and gradually to weaken the economic structure, while merely transferring — rather than increasing — wealth, in a manner that is both unfair and unsustainable, to boot.
In fact, Albert Hahn once referred to this phenomenon of ‘inflation without inflation' as being the most dangerous type of all, since it was almost guaranteed to lull policy makers and financiers into the most enormous of errors.
But, of course, despite the fundamental lack of equity involved, the masses have been taught to clamour ceaselessly for a regime of easy money, for this gives rise to the illusion of ‘making bread from stones' — as Keynes, the most persuasive modern advocate of this fateful ruse, once put it.
Easy money is popular because it fosters a period of feverish economic activity through lowering the rate of interest well below the level which would serve to match the supply of genuine savings to the demands arising from the most compelling entrepreneurial investment schemes in strict sequence of their merit.
A measure of the seductiveness of this prospect can be seen in the fact that even Hayek, in his early days, once dismissed the idea of halting credit expansion so as not to have to forego a more rapid rate of achieving technological progress. Needless to say, he spent the rest of his long and intellectually prosperous life demonstrating the full extent of this youthful error.
When money is easy, many more undertakings can be launched than are strictly warranted by the resources available.
This gives rise to the intoxication of a boom for so long as we can defer the crucial question of how all this will be funded — that is, supplied with the necessary real resources — as opposed to merely being financed; that is, furnished with the extra, fraudulent credit needed to contend for an unaugmented pool of such scarce resources.
Live now, pay later
A great part of the appeal is that, with no-one having to undergo the rigours of conscious abstinence today in order to provide for a greater plenty tomorrow, inflation is a means of burning the candle at both ends — of living a gloriously indulgent Rake's Progress.
Inevitably, what is consumed in the flames which illuminate the revelry is nothing less than hard-won capital. It is only later, when the taper gutters and goes out, that the true extent of the impoverishment which has paid for such a Bacchanal is fully revealed.
Frustratingly, the date of that day of reckoning cannot ever be predetermined — a fact which makes Cassandras of those of us who tend to fret about its inevitability.
Late in life, Hayek himself regretted that he had tended to underestimate the ability of the great institutional change to universally elastic credit and floating currencies to add greatly to the longevity of the upswing.
However, the fact that we humans cannot predict the date of our own demise makes its arrival no less fore-ordained. Similarly, the discontinuities which accompany such a boom must one day come to threaten its very continuance, even if we cannot say when or even exactly how.
Whenever this juncture does arrive, however, the central banks will finally be forced to face the dilemma inherent in their whole flawed policy, for they will now be confronted by the stark choice that to belatedly jam on the brakes is to instantly derail the runaway train, while to shovel even more paper money into its firebox will only delay the wreck, not avert it.
If they do choose the first course — never smart, politically, since it is one option for which the blame can hardly be deflected — it will primarily hit those businesses whose false profitability has come to depend only on the continuation of inflation (and perhaps on its intensification, if the process comes to be better and better anticipated by buyers and sellers).
Those disrupted in this manner will find their margins suffer horribly at the moment the credit expansion begins to decelerate. Then, as their own income falls, their suppliers (especially those of deferrable investment goods), creditors, shareholders, and workers will, in turn, have the squeeze transmitted to them.
Additionally, the economic frictions inherent in the struggle for scarce resources will become progressively unresponsive to the lubrication of inflation. So-called ‘bottlenecks' will appear in many areas, severely limiting the smooth flow of goods and services wherever they do and thus occasioning losses to those consequently unable to meet deadlines or to deliver on budget.
Moreover, though those urgently-needed workers and owners fortunate enough to be the subject of a bidding war will enjoy a sizeable (if temporary) windfall, this will not do much to mitigate the wider pain if their — or their would-be competitors' — efforts to increase supply are either protracted, or even precluded absolutely.
Once a fire breaks out in a crowded tenement, the man who has a hose to rent may be paid far more than he could ever have foreseen for its use, but, if the conflagration spreads too rapidly and attacks too many different points at once, this will not spare either his customers, or even him, personally, from suffering the resulting agonies.
In passing, it is this combination of a scramble for the necessary co-factors to one's own output (many of which may lie well downstream) and the associated dwindling of cash flow which tends to push up real short-term interest rates at the same time that the strident disharmonies in the structure discourage or disable longer-term investments and so lessen the relative pressure on long rates.
This is why an inverted yield often presages a crisis, since the exigent demand for money which twists time rates in this fashion is, in effect, a signal of a generalized scarcity of present goods: to borrow a term from commodity markets, it is akin to a widespread ‘backwardation' of circulating capital, of a dire lack of the needed complements to all too many misconceived productive plans.
Thus, contrary to the many who rely, not upon a theory as to why this should be so, but only upon a happenstance of the statistical record, it is also why such an occurrence should be disregarded when, as today, it is not accompanied by elevated real short rates, falling profits, rising risk premia, and direct evidence of credit restriction.
No, sir, today's inverted curve can in no way be construed as a characteristic sign that extraordinary numbers of producers are forlornly trying to salvage something from the wreckage of their plans even as the financial system has finally become more wary of accommodating them in the attempt.
Rather, the present inversion is only an artefact of three, highly idiosyncratic influences, namely, those of:
- the prodigious, leveraged purchases of longer-dated securities which are being conducted by the speculative horde — conducted, moreover and in good part, by using the lowest cost global currency to the purpose in a manner which begs the entire question of whether the ‘global' yield curve (if we can allow ourselves such a loose description) is effectively negative at all;
- the vast, concerted, governmental programme of foreign exchange intervention, enacted through the same medium of the bond market, but in a largely price-insensitive fashion;
- the post-Tech Bubble shift in the regulatory environment for pension funds, et al, which has conveniently given these supposed stewards of the small man's savings a perverse incentive to devote an increasing share of them, not to viable long-term wealth creation, but to finance the present squanderings of the welfare-warfare state by buying its longest dated bonds, regardless of the vanishingly small real yields which they offer.
To sum up, as Hayek again put it, the truly ominous aspect of a negative yield curve is that which arises in a situation where ‘investment raises the demand for capital' and not when inflation itself — properly defined — is boosting the price of riskier financial assets and thus suppressing long bond yields in a highly artificial manner.
E&P or M&A?
To return to our theme, despite all the inescapably malign side-effects of credit expansion we have detailed above, it is nevertheless true that, while the Pan pipes still play, all manner of businesses can appear to thrive. The rising incomes of those who work for, or speculate in, such concerns will therefore tend to boost all manner of spurious economic activity until the music finally stops.
The political attractions of all this are not to be underestimated, especially since there are, these days, no dynasties to be preserved through the ages, only the briefest of incumbencies to be exploited as shamelessly as possible by each succeeding crop of elected dictators.
In the boom, not only is tallow burned to light the merry makers' wild carousing, but concrete is poured, copper is wound, chrome is plated, and thrifty sub-compacts are traded in, en masse, for thirsty SUVs.
As this happens, it is of little immediate consequence to the producer of the commodity being more rapidly used up than it otherwise might whether it is contributing to a self-regulating, mutually consistent upswing — one built on the careful deployment of voluntary savings — or whether it is helping construct yet another grand architectural folly; a monument to those recurrent episodes of human credulity which are all too readily financed with paper money and lax lending.
Indeed, to the extent that the producer suspects that things are running just a little too well — and so resists taking a full participation in the boom — such a period of heightened appetite may well not elicit much at all in the way of a supply response.
Instead, he may forego the hard slog of finding and developing his own reserves in favour of using his newly-buoyant share price and his lately-enhanced creditworthiness to try to gain control over those of his peers.
The flipside of this is that, in order to lessen the chances that he will himself become the target of an unwanted bid, he will be tempted to apportion a sizeable proportion of his swollen income stream not to delivering more material to the market, but to putting more cash in his shareholders' pockets — cash which may well, of course, serve only to further excite the demand for his product when it is finally spent.
Even if he does finally succumb to the urge to expand, he may well find that most of his peers have reached the same decision along with him, meaning our man will soon be confronted by the very same forces of overstretch on which his own forecasts are based — forces which we have highlighted as a major feature of every boom.
If so, he will find that such matters as a shortage of truck tyres; a lack of specialist steels; waiting lists for capital equipment; rising energy costs; the income retardant of a differential strengthening of the ‘commodity currency' in which he pays his bills; an ageing workforce lacking replacement cadres with suitable skill and experience — and many more such operational difficulties — may greatly limit his own ability to react.
Far from being an academic construct, these very phases of caution giving way to cupidity should be familiar to anyone who has been following the boardroom manoeuvrings of the miners and drillers through the course of this cycle. Each of them has, in its different way, served only to intensify the impact of the secular upswing on the prices of the resources involved.
A promenade down rue Quincampoix
Meanwhile, it must always be borne in mind that the creation of extra purchasing power — in the form of unsaved credit — is a business which involves essentially no cost of production.
Patently, the same cannot be said for the real resources on which those funds may be spent, meaning they are always likely to boast a rising scarcity premium amid a sea of financial super-abundance.
Put at its briefest, this excess of easy money can give the post-hoc appearance of too many savings chasing too few outlets — a ‘global savings glut', as our esteemed Fed Chairman fatuously termed it, early last year.
Risk premia fall; multiples expand; a ‘search for yield' begins; leverage rises; a credit-collateral vortex starts to form, and analysts go back to the old Amazon/Google game of making headlines, not through any dispassionate reckoning, but by competing to be the most raucous cheer leader of the boom and issuing ludicrously ascending ‘targets', like roosters bragging on a dunghill.
In such a phase — like the one witnessed as recently as this spring — it almost doesn't matter which asset you borrow money to buy, it's almost guaranteed to go up — pro tem — and the greater the relative weight of money pouring into any individual market, clearly, the more dramatic the results to be expected from the influx.
Conversely, of course, the greater the superstructure of unstable positions which have been built up, the more violent the downdraft when the margin calls can no longer be met, as anyone familiar with this year's debacle in the natural gas market can attest.
Taken together, all of these malign monetary influences mean that one must always temper one's enthusiasm for the so-called ‘fundamental' reasons why commodity prices should tend to rise for some time yet. To recap, these are the ones we adduced above: viz., that producers — themselves victims of an earlier entrepreneurial error of underinvestment — are struggling to catch up to the largely unforeseen and immensely magnified demands of an industrializing world.
However, ‘fundamentals' alone are never sufficient in an investment process, for this is another realm where subjectivity reigns. We must realize that, just as the humble shopper, in expressing her preferences down at the mall, casts a vote with every lowly dollar she spends which helps determine the fate of commercial empires, vast beyond her ken, so consumer sovereignty is no less absolute in financial markets and that here it is the investor himself, in all his folie d'amour, who comprises the consumer who matters.
Thus, however solidly-grounded we may believe the secular trend to be (‘More' will almost certainly be required: that same ‘More' may not easily be forthcoming), the more transient manifestation of periods of significant decline can never be ruled out, particularly when a previous outbreak of financial market euphoria evaporates, or when a cyclical overextension in the real economy intrudes and a period of recuperation and rebalancing has to ensue.
It is hardly a novel concept that, amid such turmoil, the canny investor's task is to try to identify and thence to exploit such oscillations — and not to act so as to magnify their amplitude by blindly following a peer group often bereft of any real intellectual understanding of the forces at work in the market, but whose every member implicitly trusts in his individual ability to jump off his log raft just before the stream's momentum carries him over the cataract with all the others.
What may be a less commonplace observation is one which rests on the propositions we have tried to advance in the course of this article; namely, that the speculator who wants to stand out from the Herd will be greatly assisted in his quest if he conducts his own, entrepreneurial-style assessment of the opportunities and uncertainties which face him resolutely and exclusively from within the correct — and uniquely Austrian — framework.
November 24, 2006
Sean Corrigan [send him mail] writes from Switzerland.
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