30 April 2008

This Makes Sense: Tracking Commodities Response to Bad Monetary Policy

Prices for food and energy commodities have risen in synch with the falling value of the US dollar. Since the recent rapid cuts in interest rates by the US Federal Reserve Bank, the commodities market has gone wild with speculators. Worldwide commodities havoc caused by the weak US dollar is one more indication to politicians who meddle in monetary policy that trying to get something for nothing rarely works out well.
Eight months into the Fed's most recent rate-cutting spree, the evidence is overwhelming that it has been a major policy mistake. Aggressive rate cutting – taking the fed funds rate to 2.25% from 5.25% last September – has had little effect on the banking crisis it was supposed to ease.

...the Fed's decision to open the general monetary spigots has inspired a global commodity boom unlike any since the 1970s. Oil has climbed to nearly $119 a barrel today from $70 in late August, a 70% increase. Farm and other commodities have seen a similar surge, with corresponding increases in food prices leading to shortages and riots in Egypt and other places, and to rice hoarding even in Southern California.

...Like oil, world trading in most commodities is denominated in dollars. When the dollar declines, especially as fast as it has since September, commodity prices surge and speculators gamble on even further declines. As the nearby chart shows, since 2003 the dollar price of oil has climbed far more rapidly than has the euro price – 273% in dollars, compared to 146% in euros. Note in particular the oil spike in dollars since the second half of last year. This reflects the European Central Bank's sounder monetary management. And it means that had the dollar merely retained the same purchasing power as the euro, today's price of oil would be below $70 a barrel.

The practical impact has been to send energy and food prices soaring. This is a direct tax on both the world's poor and America's middle class. Just when the U.S. economy needs a resilient consumer given the fall in housing prices, these price increases have eviscerated consumer pocketbooks. In its attempt to help Wall Street and the financial system, Fed policy is punishing average Americans. The public is frustrated and angry with these price increases, and it has a right to be. Inflation is the thief of the thrifty middle class.

The Fed's weak dollar policy has also done great harm to overall financial confidence, which is essential to any growth revival. A main source of the credit crisis is a lack of trust. Investors stop taking risks, bankers stop lending, and everyone flees to the safety of Treasurys or cash. But how can the Fed expect people to calm down and begin taking risks when it is clearly debasing the currency? Monetary easing itself also becomes less effective, because without confidence more liquidity is merely "pushing on a string," in the famous phrase. __WSJ
The logic makes sense, and economists such as Larry Kudlow have been sounding the warning for some time now.

What would be the short-term cost of letting interest rates rise, and firming up the dollar? If the rates rise too rapidly, a severe recession could occur. A more gradual raising of rates would in the short term depress some economic activity. It is a political risk in the front of the minds of incumbents.

Someone needs to have the courage to take the strong medicine. Otherwise the current slipping into a chaotic commodities environment will sooner or later exact a much higher price.

Of course, commodities could be linked to the Euro instead of the US dollar. The problems with that approach lie with the much weaker long term demographic prospects for Europe as a whole, and the dependency of Europe on the US for its defense. Europe's economy has been largely spared the huge expense of maintaining world trade routes, and all that that implies.

US defense costs in pursuing the anti-jihadist actions in Afghanistan, Iran, the Horn of Africa, and numerous other parts of the globe are a significant expenditure, although not so much when looked at as a proportion of the GDP historically. At this pivotal time in history, the US has no choice but to maintain a large combat readiness to act as a counter-weight to the largely centrifugal forces of tribalism, neo-nationalism, and general third world nihilism so well described by Robert Kaplan.

The developed world is at the brink of a transition from one type of economy and philosophy to one that will be qualitatively different. Only one world power has the ability to provide stability, to allow the transition to take place. If that world power allows its very substance to erode through bad economic policy, it is the entire world that will pay the price.

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Blogger Hell_Is_Like_Newark said...

One day, I would like to see someone running for office (NOT Ron Paul)offer a serious plan to get us back to backing our currency with precious metals (gold, silver, platinum). One proposal I read (years ago) was to issue a new gold backed dollar to be used for foreign purchases, starting with imported oil.

Wednesday, 30 April, 2008  
Blogger Bruce Hall said...

The two major beneficiaries of low interest rates are present debtors with ARMs and manufacturers who export.

Given the banking mess, few people are able to get new mortgages at low rates.

The offset, of course, is inflation.

Wednesday, 30 April, 2008  
Blogger SRliberal said...

Our trade imbalance is the cause of the dollar’s fall. A nation cannot significantly import more than it exports and expect its currency to remain strong.

The solution would be to enact fair trade agreements to replace free trade agreements, especially with China. Also we need to find a way to provide our own energy to help trade imbalance problem. The strong medicine this country needs is a falling dollar until our trade comes back into balance

Oh I forgot to mention the budget deficit is another problem that causes inflation. We have been living on the credit card too long and are now the bill is due. Oh well it was fun ride.

Wednesday, 30 April, 2008  
Blogger al fin said...


Lowering the interest rate to treat US economic problems is like someone with a brain tumour taking increasingly strong pain medicine rather than seeking medical help.

It keeps the person going--until he collapses and dies suddenly.

An economy that is mismanaged by an inept congress and administration will never find the will to reform its bad budgetary policies and trade imbalances as long as it is being enabled by monetary shenanigans like progressively lowered interest rates.

Thursday, 01 May, 2008  
Blogger IConrad said...

srliberal wrote: "Our trade imbalance is the cause of the dollar’s fall. A nation cannot significantly import more than it exports and expect its currency to remain strong.

The solution would be to enact fair trade agreements to replace free trade agreements, especially with China.

With all due respect, sir, you have no clue what you're talking about. We do export far more manufactured goods than we import. Furthermore, historically speaking the trade imbalance and the nation's economic strength have been directly correlated; as one increases so does the other.

The reason for that is simple; the 'trade balance reports' you read include capital investments. The reason why our trade imbalance is so great is because other nations -- especially China -- are investing their money into our country, in the form primarily of business start-ups and venture capital.

What all this boils down to is the fact that what you are asking for is the recipe for an economic depression (note I did //NOT// say 'recession').

Thursday, 01 May, 2008  
Blogger Will Brown said...

iconrad nails it. The lower cost of dollars vs other currencies makes investment of those dollars into the US economy a greater value then investing them outside the US (or just holding them as an investment in their own right or as a hedge strategy). Part of the process of a globalized market is the mechanism of fluctuating currency values driving capital investment. We Americans want China and all the rest to spend their dollars within the US marketplace (capital investment) rather then simply trade them between themselves, leaving us to fend for ourselves economically. Those of us who remember the '80's (fairly clearly, at least:)) will recall this same general crisis mongering being directed at the Japanese for "buying up America". Same fish, different school; other than a heightened awareness of the sushi/sashimi restaurant business, did the US suffer any great damage from that episode?

Thursday, 01 May, 2008  
Blogger SRliberal said...

Well I am not surprised by the response I got here, but I do business worldwide and have a better understanding of the currency issue than I am given credit for by those here.

And doesn't "all due repect" really mean "I have no respect for your opinion"?

Anyway I enjoy reading this blog and I think Al Fin makes alot of interesting posts that gives me food for thought; just not on the trade issues.

Thursday, 01 May, 2008  
Blogger SRliberal said...

Here are some people who agree with me:

June 2005, Former Fed Chairman Paul Volcker said "he doesn't see how the U.S. can keep borrowing and consuming while letting foreign countries do all the producing. It's a recipe for American economic disaster - - a crisis is likely."

Federal Reserve Chairman Alan Greenspan said, "We cannot depend on imported capital, that is, a current account deficit, to offset low domestic savings indefinitely."

In its August 2001 annual assessment of the world's largest economy, the International Monetary Fund (IMF) said "the yawning current account deficit raised the risk of a sharp depreciation in the U.S. currency."

On July 2001 former Federal Reserve Chairman Paul Volcker told the Senate Banking Committee hearing on risks of growing balance of payment deficit, "We are a debtor nation with nil personal savings and are absorbing a significant portion of other countries savings. These huge and growing external deficits are symptoms of imbalances in the national economy and the world economy that cannot be sustained."

On 30 April 2001 White House Economic Advisor Dr. Lawrence Lindsey said, "We are in uncharted territory - - it's unprecedented - - it cannot go on - - something has to give."

MIT professor Dr. Lester Thurow said, "No country can run a large trade deficit forever."
The U.S. Trade Deficit Commission, December 2000, said, "Not only is the trade deficit not sustainable but it carries a great deal of danger to the nation and living standards.

WASHINGTON, April 16, 2005 (Reuters) - Global economic risks from large U.S. deficits and uneven growth and saving rates are clearly increasing and require urgent action, International Monetary Fund chief Rodrigo Rato said.
"Growing domestic and international debt has created the conditions for global economic and financial crises.” Bank for International Settlements, June 2005.

On 16 June 2005 Federal Reserve Chairman Ben Bernanke told the Economic Club of Chicago "the towering U.S. current account deficit must be addressed, because currently we have a net obligation to foreigners of about $3 trillion. At some point, foreigners wouldn't want to continue to lend to us, and would want to get paid back."

Warren Buffett (2003 article in Fortune) tells the story of two fictional islands, Thriftville and Squanderville. In Squanderville, the residents live beyond their means by importing from Thriftville in return for IOUs. Eventually, Thriftville converts this debt into Squanderville assets until Thriftville owns all of Squanderville. America, Buffett warned, was facing the same fate as Squanderville. "Our trade deficit has greatly worsened, to the point that our country's 'net worth,' so to speak, is now being transferred abroad at an alarming rate."

So maybe just maybe I have a clue.

Thursday, 01 May, 2008  
Blogger al fin said...

SRL: I do not disagree about the problems with the budget deficit or the problems with running indefinite trade deficits.

I only suspect that a falling dollar will not be able to solve the problem. It may palliate the problem to a point, like pain medicine. The only solution is to correct the deficits. The only way to do that is through radical surgery, not palliation.

Manipulation by the Fed could never have been the corrective action needed.

Thursday, 01 May, 2008  

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“During times of universal deceit, telling the truth becomes a revolutionary act” _George Orwell

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