May 5, 2008

Commodity Inflation and the Missing Wage/Price Spiral

Why are commodity prices rising worldwide? What does that do to western inflation pressures?

Permanent inflation is not possible without a wage/price spiral (the more usual term wage/price spiral has the cause and the effect backwards). There might be such a thing in China, but not in the strength that some foodstuffs have risen lately. In the US there seems to be no such thing, except for an insignificant 1 percent of the population. This fraction might be significant enough for gold, maybe, but not for other commodities.

So clearly this price growth is at least partly a financial phenomenon. I would say that it has been probably started by a spurt of speculative growth, based on a limited underlying fundamental scarcity, a surge of short term credit from central banks and a dearth of better speculative prospects. After all, one can't do much other than speculate on short term capital.

But this speculative start was most probably amplified by sudden hoarding by actual consumers, who were frightened by the initially speculative price surge. This hoarding has generated an actual (but temporary) shortage in some basic foodstuffs, like rice and wheat.

Some people, like Paul Krugman, have proposed that inventory levels do not support the speculative hypothesis. I think he is pretty much right when it comes to the gradual price development of oil and metals. But I think that the unofficial inventories created by simple consumer hoarding, which is just as speculative as anything, is quite enough to explain the extreme price movements of basic foodstuffs.

Let's study another example: Was there a big inventory of houses as a sign of the growing speculative bubble? No, there was a perceived shortage of houses, caused by consumer hoarding, ie. the inventory was held by the house flippers. The same goes with foodstuffs, and might go on with metals as well. End users are always hoarding somewhat when there is an expectation of price increases.

Such hoarding can create a false signal of shortage, which can then be met by a surge of overproduction and a price collapse, when consumers have filled their cupboards and return to normal consumption. When prices stabilize, they start to unwind their inventories, which results in a fall in demand to even lower levels than the actual consumption. This gives the consumers incentive to draw down their inventories as low as possible in expectation of further price reduction.

So what will happen in the western world where any evidence of a wage/price spiral just isn't there. An equation of rising cost of living with stagnant wages is not sustainable in the long term. In the Western world, there are, of course, significant "buffers" until people start to go hungry. What if we add ever extending credit into this equation? Growing debt repayment makes this equation even more unsustainable, as in prone to a violent snap-back effect. Credit is no substitute for income.

As wages are not going to grow, either prices or consumption must (eventually) come down. Debt will be simply defaulted on. People haven't understood that "free money" only refers to the interest, not the principal. One can not consume something today without giving up something tomorrow. If nothing else, then your credit score.

Unless wages are going to follow prices, there is going to be an eventual price deflation, no matter how much baseless credit is extended. US monetary base has been stagnant for two years. The Chinese have probably prevented massive printing with the nuclear option of massive Treasury liquidations.

An ounce of gold is always going to be worth an ounce of gold. There is no reason why its value should change (or not change) very much against other durable if nonproductive assets, including little green pieces of paper that can be used for paying taxes. But there are precious few (0.8 trn) pieces of green paper, compared to the mass of promises to deliver those pieces of paper on a later date (25 trn).

In these circumstances, the value of those few little green papers might actually rise significantly. But wouldn't that be an intolerable atrocity, because those little green papers are just little green papers, right? They can't be used to produce anything, except that special something, which until recently used to be called "AAA". But nowadays everybody knows what those three vowels really stand for, and that ain't much. So isn't it just appropriate that those little green papers should lose their value along with the worst of IOUs written on a paper napkin with lipstick?

Don't let yourself be fooled. Good credit still exists, even though "AAA" has lost its significance. Looking at how US stores have become a bargain basement for foreigners, it seems that the US dollar does have some value after all. Dollar has been getting a lot cheaper, but has it really lost value? That of course depends entirely on what you are going to buy. ("Price is what you pay. Value is what you get.")

BTW, since GDP is a measure of added value, shouldn't US GDP statistics for the last ten years be revised downwards for the "value" that is now melting away from housing? That value was never actually created, after all. It was just a pricing mistake. Think about that.

Since the instruments of exchange (promissory notes, not to be confused with cash) that were used to create those imaginary valuations are still in circulation, they will find a home somewhere else, like basic commodities. But those are still just promissory notes. They are not little pieces of green paper. I guess the Federal Reserve could convert all kinds of promissory notes to little green pieces of paper, but that wouldn't do the US external credit very much good at all.

So first the US economy was producing value in dotcoms, then in housing, then in commodities. Then what? How much of all that added value still exists? Maybe a little more than the value of a pair of collapsed Bear Stearns hedge funds. But all is fine as long as the fund managers get their 2 and 20 from each successive bubble.

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