Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

17 May 2011

Commodities Today: How to Make a Bad Situation Much, Much Worse


The Real and The Symbolic
All that Matters is not Gold
Why Prices Are Rising
How Financial Markets Can Make a Bad Problem Worse
Possible Solutions
Conclusions

Markets today are all agog about commodities. Some say the stock market is falling because commodities’ prices are rising, stressing the consumer and killing her buying power. Recently commodities prices crashed a bit. That, they say, reflected a coming slowdown in the general economy, which the stock market is supposed to predict, cutting demand for commodities. The stock fallback might also reflect the markets’ response to the GOP threat to throw the United States into default to get its way.

Who’s up? Who’s down? Who’s on first? Our financial markets, which we suppose to be our national, capitalistic pride and joy, are acting like comedians in a 1920s slapstick routine. Maybe 1929 specifically.

To get your mind around commodities, you need to know a few things. But most of them follow from two basic principles.

The Real and the Symbolic

That most important principle is simple but profound. Commodities today are the only real thing in our entire cockamamie financial system.

I don’t mean futures and other so-called “derivatives.” I mean the commodities themselves: things like a barrel of oil, a pound of copper, or a bushel of wheat stored right now in a clean, dry granary somewhere.

Let me explain that. The long-form explanation is in a post I wrote some time ago, entitled “Conservation of Money, or Why the Fed Should Manage Derivatives.” But for those who don’ t have the time or interest to read it, I can summarize its basic message.

Money is a symbolic or imaginary commodity. It used to be as disposable as paper, but now it’s even more evanescent than that. It’s just electronic records in a computer somewhere or, if you like, magnetic domains on a hard drive.

The only reason these intangible symbols have any value at all is agreement. Governments that issue them and the people who use them agree on what their value is. And as long as they continue to use the symbols for trading, they have the agreed value. (Foreigners help keep us honest by saying what our money is worth in their money, for which we can buy things and services they produce.)

Commodities are different, or at least some of them are. They have intrinsic value, not just exchange or symbolic value. If you want to run your car, nothing but oil and its refining product, gasoline, will do. If you want to wire your house, you’ll have to have copper. You can try aluminum, which also will work, but it won’t work as well and is incompatible with copper.

The second important principle is that commodities are not all alike. Some have symbolic as well as real value, and the ratio of symbolic to real value varies depending on the commodity.

Take gold and silver, for example. Most of their extraordinary value today comes from what they used to be, not what they are today.

As explained in detail in my earlier post, they used to serve as money. Once sovereigns used them as money because they are scarce and hard to duplicate, as well as heavy and hard to steal. As the world switched to paper money for greater liquidity and convenience, we tried to “back” our paper with sold and silver, first dollar for dollar and later by an increasingly small percentage (sort of like our banking reserve requirements today).

But today the gold standard is gone. So is whatever silver standard may have existed at one time. Today, gold and silver are just like paper or those magnetic domains. They are worth only what governmental authorities say they are worth, and then only when markets go along.

If we ever have another real depression, in which food, transportation and shelter become scarce or unavailable, you will see how quickly the “value” of gold and silver evaporate. What starving person wouldn’t hock a gold earring, for example, for a week of solid meals, or even a single good meal, although the earring once may have been “worth” a small fortune?

Maybe that’s what happened recently with the mini-crash in silver. People are beginning to realize that its price had and has no more rational means of support than does the price of dollars themselves. And if that could happen in silver, could gold be far behind?

All that Matters is Not Gold

The reason gold and silver are different is that many of us never got over their use as a medium of financial exchange quite divorced from their intrinsic value. But today they have little intrinsic value. They can be used to make jewelry. People value that jewelry a bit more than, say, similar items made of jade or onyx, for the same reason: they think they can hock it for more if times get tough.

But that whole concept of “value” stands on a house of cards. Everyone is betting, in effect, that some day gold will become a medium exchange again, maybe the medium of exchange.

Don’t hold your breath. We got rid of gold and silver as media of exchange because they were too inflexible for a modern, diverse and dynamic capitalistic economy. That was the gist of William Jennings Bryan’s famous “Cross of Gold” speech, which dates back to the nineteenth century. If gold and silver were too limited and inflexible for a nascent nineteenth-century America, they’re surely too small for the dynamic global economy we have today. We’ve been there and done that, and we ain’t goin’ back.

So what are gold and silver “really” worth today? Who knows? Gold sure as hell isn’t worth $1,500 per ounce, which is what gold futures got close to recently. The only thing we know gold and silver are worth is their value in their very few real uses, in jewelry (itself largely of symbolic value), corrosion-free but expensive electrical contacts, and a few rarer, more exotic industrial uses. If gold’s price ever falls to that level, most commodity enthusiasts will long since have declared bankruptcy.

The truth is that history and our linguistic metaphors got it all wrong. Oil is not “black gold.” Rather, gold is “brassy oil.” There is no question today which has greater real worth and which commodity’s trajectory is surely and unequivocally up.

Not all commodities are like silver and gold. Some have a value that is directly tied to industrial and commercial reality. Oil is like that, probably more so than any other commodity. Even food has some slop in it, at least here in the US. Demand for food is elastic because it comes in so many varieties, and because so many of us are obese. Its supply is elastic because there is always more land we could convert to agriculture.

But oil is running out, and when it’s gone you can’t run your car. If you have a Hummer you can gain a little elasticity by buying a Prius. But when mosts of us have done that, as we’re (belatedly) in the process of doing, we’ll meet another stone wall.

As Will Rogers said of land, “They ain’t makin’ any more oil.” So as it runs out, it will get more and more expensive and we will have to find substitutes to survive, both financially and industrially. And from now on it’s going to run out quicker and quicker as the rest of the world embarks on faster and faster development, which depends heavily on oil.

So what’s important is not what’s happening, or may soon happen, to the prices of gold and silver. It’s what’s happening to the prices of oil, copper, iron, uranium and lithium for the good batteries that will run our electrical economy.

Why Prices are Rising

When you think about commodities whose value is real, not symbolic, their future prices are not hard to see. Again, Will Rogers is the guru. Just take his famous bon mot, “They ain’t makin’ any more land,” and substitute the name of your favorite real commodity for “land.” It’s still true.

Food is a bit different, but only a bit, because you can often eat less or grow more. But the amount of oil and minerals in the Earth’s crust where we can reach them was fixed a long time before we humans evolved. Absent a global catastrophe like the one that extinguished the dinosaurs, it won’t change for millions of years.

So when we run down, we run down. And when we finally run out, we run out. And as we get down toward the bottom of the figurative barrel, when every unit takes more and more effort, wastes more and more energy, and creates more and more pollution to extract, the costs may exceed the benefits.

Of course we aren’t there yet. The extractive industries are still booming, including the oil industry.

But think about the last time you heard of a really big “strike,” a huge discovery of oil or any other intrinsically valuable commodity. No, I don’t mean the discoveries of minuscule reserves that oil companies and their shills in Congress constantly rehash to justify offshore drilling. I mean the discovery of a single field that, all by itself, increases global reserves by 5% or more.

If you think about it and do a bit of research, you’ll find out that that sort of “strike” happens only a few times a decade, and for all intrinsically valuable commodities together.

What does this mean? Put bluntly, it means that we are approaching, if we haven’t already passed, Peak Copper, Peak Uranium and Peak Lithium, just as we already have passed Peak Oil.

Now the law of supply and demand is no fiction. It’s about as good and reliable a principle as exists in any science, let alone economics. When supply is strictly limited and maybe declining, and demand is increasing as the 90% of humans who don’t live in the US, Europe or Japan go through a process of rapid economic development (incredibly rapid, in the case of China and India), prices do one thing only. They go up.

Nothing can stop this secular rise except a catastrophic decline in human population. But nuclear war is a far more drastic solution than using less and finding substitutes. So that’s what we humans have to do, or go without. And prices will rise continually as we do so.

How Financial Markets Can Make a Bad Problem Worse

Now we are in a position to understand why the gamblers and swindlers in our financial sector are doing exactly the wrong thing, not just for finance, but for all of us.

When some financial genius invented futures, we were far from our current commodities regime of decreasing supply and rapidly increasing demand for the foreseeable future. In those halcyon days, we had plenty of untapped resources right here in our own country, including oil, copper and other minerals.

So we didn’t invent futures to deal with some real, ineluctable shortage of commodities with high intrinsic value. We invented them to deal with cruel fate and human folly.

Specifically, we invented them to save farmers from the depredations of weather and financial speculators in New York City and Chicago. The gamblers and swindlers were having a field day with agricultural commodities like wheat, corn, and pork bellies. Some tried to drive prices up by cornering the market, then sold out fast. Others drove prices up by speculation, leaving farmers to the mercy of the inevitable crash.

So our political geniuses decided to fight fire with fire. They forced the speculators to trade on an open, regulated market, on which farmers and their cooperative associations could trade, too. If the gamblers drove the price of wheat futures up without reason, for example, the farmer could withhold his wheat from the current market, store it, and sell it for future delivery at the higher price.

This futures regime did two things. First, it prevented speculators from swindling farmers as a group by driving current prices up or down, regardless of fundamentals, by betting on future prices. Second, it gave farmers a way to protect themselves against natural vicissitudes of drought, inclement weather, heat waves and the like by “hedging” in the futures market. The nascent futures market probably gave farmers as a group the upper hand, at least for a while, as they, not bankers in New York, were the experts on crops, weather, and local growing conditions. (Now that slight advantage may have disappeared due to the Internet and financial specialization.)

Similar reasons for having futures markets applied to oil and mineral commodities. Just as futures soften the blows of fickle weather and pests on farming, so they reduced the impact of fortuitous oil and mineral exploration on drillers and miners. Why bankrupt a business that invests soundly in a perfectly good and productive mine simply because miners of the same mineral in Chile hit a bonanza? In both cases―farming and mining―futures serve to protect competent, reliable and prudent businesses from the unpredictable twists of fate. Second, by putting financial speculation in the open, under regulation and on recognized public exchanges, they attempt to quell market manipulation and speculative booms and busts, although of course they don’t aways succeed.

But now we have a new problem that falls in the “none of the above” category. We humans are reaching the Malthusian limitations of our single environment, our Planet Earth. Those physical limitations, coupled with ever-increasing economic development and population, create an unavoidable, secular trend of ever-increasing prices for commodities whose real value predominates over their symbolic value.

What good are futures in this new, threatening economic regime? They can’t stop increases in human population or economic development, except perhaps indirectly and sporadically, by creating destructive booms and busts. And they won’t quell gambling and swindling by increasing it or its frequency.

And while on this subject, let’s spend a few lines on the ever-increasing volume and frequency of our speculation. The last decade or so has seen the rise of the day trader and the computer as programmed trader, not only in the stock market, but also in commodities markets. Yet real changes in the “hard” commodities markets, such as new mineral finds or new engineering means of conservation and efficiency, hardly occur in a single day, let alone a microsecond.

So this new capability of trading by the day or microsecond does nothing for the original purposes of futures. It just increases the frequency and risks of gambling and swindling which, on the stock market, led to the Flash Crash of May 2010.

In essence, then, we have a very simple but profoundly important problem. We have too many people seeking too rapid economic growth for the limited supplies of “hard” commodities like oil and minerals to comfortably support. According to well understood and widely accepted laws of basic economics, these circumstances promise steadily increasing commodity prices, without limit (with perhaps some deviations due to irrational exuberance and bubbles popping).

Nothing in the theory or purpose of futures addresses such a solid, reliable and fully predictable secular trend. There is no fickleness or uncertainty about it, no vagary of fortune to avoid. Trying to solve a real and fundamental physical problem like this with financial manipulation is about like going out to gamble because a tornado destroyed your house. The “solution” not only won’t work; it’s almost sure to be counterproductive.

But that’s what our nation is apparently trying to do, with its ruling class of business people in the lead. The notion is that gambling and swindling on an appropriately configured market for futures or other, more exotic derivatives can make the real and ineluctable problem of scarcity go away. It can’t and it won’t.

Possible Solutions

So how do we prevent more widespread gambling and swindling from making a bad situation much worse? Aye, there’s the rub! There are some things we can do, but there’s no silver bullet.

Why not make money by buying a life insurance policy on the old, sick, irascible widower in your neighborhood, whom everybody hates? He’s going to go sooner or later anyway, and most of your neighbors think sooner would better. Meanwhile, he’s just helping raise the price of health care for everyone by overusing medical resources in an ultimately vain attempt to prolong his life.

The short answer is the law won’t let you. We regulate insurance at the state level, but every state has a so-called “insurable interest” requirement. You can’t buy insurance on the life of that irascible old coot―unless he happens to be your spouse or father―because the law doesn’t want speculators betting on the life and death of strangers. Financial pressures could motivate them to step over the line and speed the inevitable demise along.

Just so, we might help keep speculators from destroying our commodities markets with unnecessary boom-and-bust volatility by imposing a restriction on trading in commodities. We might require some sort of legitimate business interest in speculation as a condition for engaging in it. For example, we might limit speculation in grain futures to farmers and makers of farm equipment, or speculation in oil futures to drillers, refiners and heavy users like airlines.

That’s probably a good idea, but it’s no panacea. Take airlines, for instance. They should know by now that their fuel prices, over the medium and long term, are going nowhere but up. They should know also that there’s no way to “hedge” against that secular and inevitable price rise. It’s not itself a product of speculation. Nor does it arise out of vagaries of weather or fortuitous oil “strikes.” Rather, it arises from economic fundamentals, namely, limited and declining supplies of oil and ever-increasing global demand.

So the right ways for airlines to “hedge” against the secular increase in oil prices are: (1) to buy more efficient and less wasteful aircraft like Boeing’s Dreamliner and (2) to raise their fares periodically to compensate for the increasing real cost of air travel, thereby encouraging flyers to conserve and seek substitutes for travel less wasteful of fossil fuels. The wrong way is to delude themselves into thinking that financial legerdemain can solve the real and growing problem of scarcity of a key commodity.

But think a bit about restricting airlines’ hedging. How would you do it? Airlines have a legitimate need to hedge against fortuitous rises and falls in the price of oil, such as those caused by the civil war in Libya. They also have a need to protect themselves against others’ speculation. How can the law let them to do that without throwing the baby out with the bath water? It’s a bit like trying to parse the “insurable interest” of a spouse or child, who may, for very personal reasons, want the insured dead.

The law is a blunt instrument incapable of making such fine distinctions in motivation. So just as we let husbands and children take out life-insurance policies on their wives or fathers, respectively, even though they may have murder in their souls, we can’t keep airlines from speculating in oil vainly or for the wrong reasons. The law can stop people from doing really bad or really stupid things, but it can’t make them moral or sensible.

In the end, probably the most we can do is educate managers about economics and curtail an avalanche of speculation by refusing to permit ever-more-powerful instruments of speculation and ever-more-rapid trading in them. That’s why we need strong financial regulation, especially in “derivatives” beyond simple futures contracts. We should make sure that financial “innovation” doesn’t explode out of control, as it did in the mortgage market in 2008, and subvert the whole system. For that we need constant, expert and attentive regulatory guidance and control.

Conclusions

We don’t need more futures and ever more risky and exotic derivatives. People like me, with no legitimate business interest, who want to gamble on the inevitable Malthusian trend can do so by buying ordinary shares in producers of hard commodities likely to be or become in short supply. If we want leverage, we can purchase naked call options on those shares. There is absolutely no need to let such speculators muck up the futures markets, let alone the markets for the commodities themselves, for example, by hoarding. Allowing them to do so will only make things worse, much worse.

And there’s another reason not to let gambling and swindling control the prices of commodities. According to classical economics, markets are very good (but not omnipotent!) at rationalizing the use of scarce commodities for maximum efficiency. As a commodity gets scarcer and more in demand, its price goes up, forcing people who can to pay more or find substitutes, and people who can’t to do without. In this sense, markets are partially self-correcting, although they can never entirely compensate for the increasing scarcity of a vital commodity like oil.

That’s the widely accepted and generally understood function of pricing in free markets. Among many other things, it motivates a lot of research and development in conservation, efficiency, and (for scarce metals) recycling. By disturbing that all-important pricing mechanism in a quixotic quest to make a real problem go away, financial manipulation destroys the very value of free markets in commodities, in theory as in practice. It converts what should be an economic “governor” on volatility into a runaway throttle.

There will always be people who see the inevitable and try to profit from it, even if their speculation causes others misfortune. And there are always ways for them to do so, like the purchase of stock in commodities producers and options on that stock. There is no need for yet more exotic options for gambling and swindling, which inevitably depend on secret, insiders’ knowledge for profit.

If we continue to run down the road of ever more complex and obscure financial instruments, traded ever more frequently by ever greedier gamblers and swindlers, we will not only distort and debase our free-market economy. We will undermine its moral and psychological underpinning by making it easier and more profitable to gamble and swindle using financial abstractions than to run businesses that use real commodities to make real things. That’s what happened in the mortgage market in 2008; we ought to make every effort to insure it doesn’t happen again, especially not in the market for a vital commodity like oil.


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