Volatility

In the week of August 8th to the 12th, the world saw the equity markets swing very wildly from up to down and around again. It was, I am sure, very disconcerting, probably frightening. And people are confused because after a lot of reforms, laws, regulations, planning, stimulation, and quantitative easing, which was suppose to make things better, we are having big, dangerous, damaging swings.

In recent days I have seen several suggestions in the media that volatility would continue, at least for a while, because of the uncertainty as to what direction the stock market would take. These comments have a very narrow focus and fail to recognize wider causes and implications. They do not recognize that it is not just the stock market that has volatility. Currently, well, in fact I am not aware of any international market that isn’t suffering higher levels of volatility. Currency markets, commodity markets, bond markets (except very short term, which are basically pegged by Fed policy), you name it, are all experiencing significant volatility.

The biggest reason is “uncertainty”. What is meant by uncertainty is much more than an understanding that the future is not known. The future is unknowable, but, in many circumstances, it is predictable and can be expected to behave in a comprehensible manner when unexpected changes do occur. If you are a competent investor or businessman, you have confidence in your ability to respond to change. No, this uncertainty goes way beyond the basic unknowable future.

Nor is it just that the international community faces problems. There are always problems, issues that need to be addressed and dealt with. Again, competence leads to confidence.

What is causing the foundation of today’s uncertainty is the lack, one could say the nonexistence, of ideas, solutions, intelligence, willingness, leadership of governments around the world. It is as if there was a contagious disease that has afflicted every ranking member of most of the major governments of the world. They fight, they seek their own political advantage, they evade, they do nearly anything except face the reality of the problems facing them. For months we have been waiting for the leaders of the governments of the eurozone to solve the sovereign debt problem facing several of their members. Several times they have announced triumphantly that they had solved the problem only to see that the market regarded those steps as insufficient. Now a few countries are in extreme recessions. As their economies shrink, their bond problems become worse. No one in Europe (or in most countries) seems to understand how an economy grows, with or without heavy debt. The stimulus steps are not working (as they aren’t in the US, as we shall see shortly). Data released this last week showed that the German economy was not growing as fast as thought. Germany is generally regarded as the backbone, best source, the money source of last resort of the euro system. If it isn’t strong, the eurozone will have much more difficulty in solving the problem of sovereign debt, let alone actually experiencing growth.

It also appears that the US has not grown much at all in the first half of 2011. Nearly everyone was expecting that because of QE2 the economy would be on its way to a normal recovery with growth powering along toward 6%. Now many people are talking about a recession this year. The government policy has failed. People don’t know what to make of that. They are confused, and uncertain.

It is being recognized, slowly, that the Fed has run out of options. In the last couple weeks in announced that it would not raise interest rates above effectively zero for at least two years. Obviously, the charge of uncertainty was heard. But this is recognized as a dumb move. The stock market tried to rally, went up wildly, and then continued downward, just as wildly. There are some at the Fed who understand some of the problems facing banks and businesses in America. For example, read this speech (not saying it is perfect, but he recognizes some important points.)

In addition, and as important, in most of the developed world, laws passed over the last few years have unleashed massive new regulations and restrictions on banks and businesses. Most of these new regulations have yet to be formulated and announced. Bankers and businessmen have little idea as to what to expect, except that it will not be supportive of normal, intelligent, profitable banking and business practices. Everyone is waiting for the shoe to drop – on their heads.

So we have uncertainty hounding us from two angles, the failure of the government policies that were suppose to save us and the impact of new, arbitrary regulatons.

With the Fed’s hands tied from all but the most crazy ideas (The Fed is run by helicopter Ben, after all.) and the Administration and Congress tied up over the astonishingly large deficit already on the books, one wonders what the government could think that it could do if we go into another recession. Will they try to enforce wage and price controls? Will they try to force a command economy? Will they watch in wonder?

Let’s say that they find that they can do nothing. Let’s say that Geither in the Treasury doesn’t go off into nether-nether land as he did in 2007-9 and write lots of checks he can’t pay. Let’s say the economy is on its own (I expect that even the Republicans will try to do something.). Is the economy strong enough and free enough to recover? If it doesn’t, will that give the anti-capitalism crowd more leverage? Is our time to fight shorter than any of us figured?

Many are thinking that foreign currencies and businesses are safe havens from the problems in the US. Actually, these safe havens are more in Asia or the BRICs. But, this is the era of globalism, of international markets and money movement. When the US and Europe are in recession Asia and the BRICs do not have markets to sell to and their economies also decline. Some of the stronger currencies may still be relatively stronger (Japan is a disaster waiting to happen.), but you need to be very careful. If and when recession comes to China, for example, and the real estate market crumbles, it will be interesting to see what the Communist government does, that is unless you live there, they it could be frightening. Remember too, that the government leaders and central bankers all went to the same schools, read the same books, heard the same speakers, and hold the same ideas as those in Washington. There is no country that is a financial and intellectual island. Differences are relative, in degrees, not fundamentals.

So the volatility we see is the result of the confusion and dismay. People see the failure of the promises of the political, economic, and intellectual leaders and do not know what to think. Even the more experienced traders are suffering whiplash by news and promises. People rush from hope to fear, back and forth. They have no foundation for understanding what is happening. The mainstream media is just as ignorant.

The hole that Keynesian policies have dug for us is very deep. The process of fighting over who will be heard and who will lead will cause constant turmoil. The inept attempts at solutions will add to the problems. Lost time in actually solving the problems will result in the problem becoming larger and exerting more strain on the international economy. Volatility will continue, sometimes becoming wilder, sometimes hitting a lull, but as the confusion and fear will not be reduced and the problems will reemerge, the volatility will return, probably in greater, wilder swings.

There will competitors offering answers and solutions. The Christian right, fascists of Christ, will offer answers. There could be an even more extreme, pro-government Democrat emerge who would rival BO in his willingness to use force to achieve the ends of destruction promised by altruism. Competition for the minds of Americans could become fierce.

People are looking for answers. This is an opportunity. Objectivism and capitalism have answers, good ones, ones based on reality. The books and ideas of Ayn Rand need to be spread further. People might be willing to listen.

Truth must be heard.

The Downturn in Commodity Prices

So here is an opportunity for a lesson in observing the economy. In the last few days some commodity prices that have risen significantly in the last couple years, including oil prices, have backed off their highs. I have seen several articles claiming that this price drop proves that the Fed and other inflationary forces are not to blame for the price rises.

Now anyone who has read this blog may remember that I am not convinced that the the Fed's activities  the primary cause of the rise in oil and other commodities’ prices. I see real, actual economic causes at work. But I can not allow my analysis to then infer that recent lowering of those prices proves me right, or proves anything particularly at all. Short-term changes in prices offer little evidence of anything.

Frankly, I think that looking at short-term events is an indication of a lack of thought. It is a knee-jerk reaction. It is a sign that the source has little understanding of actual economic processes and is instead seeking to support his own predetermined ideological position.

Of course, the recent downturn could become something more than short-term, meaning that it is too early to tell if the drop in prices means anything.  If the declines continue, then we have something to consider.

Suppose the drop in prices becomes a trend. We would need to ask why the drop is taking place. The first thing to do is to look at production. If production has increased, then we can regard that as a significant element of the price drop. As government actions, especially money creation, haven’t changed much, changes in production would be the major factor.

If there has been no change in either production or government activity, then we are faced with a weakness in the actual demand for the product. That is, economic activity is lessoning, and we may be seeing the first steps toward a downturn in the world economy.

What changes in commodity prices, prices that are more responsive to market changes than most, means depends upon the details. We should never accept knee-jerk reactions that look solely toward the government.

INFLATION PRIMER

More and more people are getting on the inflation and hyperinflation bandwagons lately. There may be reason to worry about inflation, several, in fact. But, for the most part, the reasons that are being offered for today’s bandwagon do not justify the conclusions that people are making.

My position is this: Real inflation is a major cause of economic disturbance and the destruction of economic value. Inflation needs to be eradicated from our lives and our political system. To remove inflation from our economy would require that we understand it at it’s root and have an accurate history of its influence. Instead, what these people tend to offer is just pointing at some prices that have risen that are special to us or in the news. Even when they mouth reference to the money supply, they do nothing to relate the money supply to the price increases they are seeing. They are just adding confusion. So, I am offering another post about inflation with a slightly different focus.

First, of course, rising prices is not inflation. Rising consumer prices may be a consequence of inflation, one of them, but it is only a consequence, not a cause, and it is the cause that we want to understand clearly. It is the cause that is the actual problem. It is the cause we need to eradicate from the economy.

The Austrians (and as further explained and expanded by Ayn Rand) are the ones who identified inflation accurately. Inflation is government manipulation, read expansion, of the money supply. When more money is pushed into the economy, prices, at least some prices, will rise. There are two important points.

First, prices cannot rise without there being more, new, made-up money. Without more money, some higher prices would just mean that fewer of those products could be sold. People would still have only so many dollars to spend. Higher prices for some goods means that the standard decisions people make as to what to buy and not buy must now account for a different price structure than before. Prices are always changing. All prices could not be rising at the same time without there being more money in circulation. Stuff would be left sitting on the shelves. Consequently, if some prices rise, other prices would have to drop, or production would have to be reduced. There are only so many dollars.

Some people try to avoid the basic physics of the issue by talking about the velocity of money, suggesting that if a unit of currency changes hands faster there is the opportunity for prices to rise without more money actually being created. No attempted explanation of inflation using the velocity of money that I have seen actually lays out how that is suppose to work. I can’t figure it out. Try it. The vast majority of people get paid on a regular rotation, i.e., weekly, biweekly, or semi-monthly. How do you fit a higher velocity into that arrangement? You can’t. Higher velocity is out.

Second, the Austrians determined that the entry point for new money makes a difference, meaning that new money does not effect the entire economy the same way, but ripples out from the point of entry. Over the past twenty plus years, the entry points for new money have been limited to just a few parts of the economy. It is easy to identify those connected directly to the Federal Budget because the prices of related items have been going up rapidly and consistently for all of those years. The list connected to Federal Government spending includes medical services and related products and higher education. Recently, Federal employee salaries can be added to that list.

Besides the budget, the other main entry point of new money is by way of the activities of the Federal Reserve System. I have gone into detail how that happens in this blog, so I am not going to restate it. The consequences of the Fed expansion of the money supply normally hit asset prices first. Stock prices and housing prices are pushed by the expansion of the money supply by the Fed – sound familiar? (Constant deficits in our Balance of Payments can also only be explained by the expansion of credit.)

Okay, so that is inflation, i.e., increases in the money supply. Well, take a look. Is the money supply expanding? Ahhhh, no. It isn’t. So where is this inflation?

What the people who are declaring that inflation is upon us are pointing to are certain, specific prices. Right now the major ones are oil, food, and commodities. Certainly, these prices are going up. But, is it inflation?

I would add another sector to the list of higher prices, the U.S. stock market, which has gone up a bunch in the last couple of years. Why has it gone up? The facts about the U.S. economy don’t support that kind of optimism. The actions of the U.S. government continue to make things worse. The market is being pulled along by a ton of money sitting around. It is the same thing that happened in the late-1990’s and mid-2000’s.

So what about the prices of oil, food, and commodities. Okay. Fact one. In any economy (where individuals can make decisions at least to some extent), in any situation, for all kinds of reasons, prices will be on the move. Some prices will go up, some will go down. We do see prices going down all of the time in our world. That is especially true of high tech stuff. Prices change because people’s preferences change. Demand changes. The supply changes because of new technology, new business structure, new sources, governmental action. There are a host of different reasons. You have to look at specific industries to understand the price movements. More than that, if it is inflation that is causing consumer prices to rise, the general trend would affect the entire economy, in a ripple effect. When the price rises are confined to specific sectors of the economy, it is necessary to look closely to determine what is happening. In is not proper to just declare that it is inflation. Looking closely at medical services, oil, and commodities results in very different conclusions for each sector. That is especially true when the best data available on the money supply (admittedly government data, but not sufficiently corrupt) show that the money supply is not expanding to speak of and credit has contracted.

I have already discussed the constant rise in the prices of medical services, which is a direct consequence of government spending. Let’s try oil. The price of oil is an international price. For its price rises to be a consequence of inflation, it would be necessary for there to be inflation of significant amounts in many countries. But, there are more obvious and immediate explanations as to why the price of oil has gone up, and may continue to rise. Two explanations, actually. First, as a result of the anti-industrial movement (which includes the ecology movement), the production of oil has been forcefully reduced nearly worldwide. In a few countries, the production is kept lower than those countries are capable of for the reason of attempting to influence the price (OPEC, of course). We all know that the supply of oil is less than a free market is capable of providing. Second, we have a couple large countries, very large countries, that have finally begun to open their economies up sufficiently that they have produced a modicum of wealth. These countries are now also buying oil in larger quantities than they have in the past. Just a little increase from these very large countries has a significant impact on the price of oil. So, we have a supply that is less than possible and a significant increase in demand, and, surprise, oil prices rise. Standard stuff. Inflation is not necessary to explain the price of oil. To the extent that there is inflation, the increase in the price of oil will be worse. If a specific country has inflation, its currency will tend to buy less internationally over time, and the price of oil in that country will rise faster.

The second half of the analysis of the oil price applies to commodities, including food. There is more international demand. Higher demand means higher prices for basic, auction-derived prices such as commodities. China and India are buying more than they did a few years ago. If there is the possibility of greater production, the higher prices will attract more supply and the price may go down, but that does not happen overnight.

Food prices, especially within a large country like the U.S., is more dependent on local factors. I have not seen sufficient reports to make a well-founded conclusion as to why prices have begun to move upward. International grain prices have moved upward, but really have only a minor impact on the prices of consumer goods in the U.S. The cost of wheat in a loaf of bread in the U.S. is only a small fraction of the price at the store. Transportation, i.e., oil prices might be more important. Weather is important. The important point is that the factors causing our food prices to rise are not an increase in the money supply and are somewhat different that the reasons why oil and other prices are rising.

Then there is the issue of inflation here vs. inflation there, in the present day case: inflation the US vs. inflation in China. China is experiencing inflation, both asset and consumer price inflation. It is also experiencing sufficient growth that allows people and businesses to buy basic materials on the world market that they couldn’t before. Both of these factors make up the fact that China is a major reason why international prices are increasing. To fully understand what the impact of China’s rise (as well as India’s) means, it is necessary, as always, to gain perspective. Don’t just focus on selected markets that fit with a particular expectation or world-view. Look at the big picture.

What is my suggested perspective maker? French wine! The prices of good French wine have gone through the roof, up maybe as much as 3 or 4 times what they were a couple years ago. The reason is that a very small percentage of China’s 2,000,000,000 people have discovered the good stuff and have the money to start buying. They have bid up the prices. The Chinese are bidding up the prices of many things right now. The world has been rolling along with a few industrial countries and a lot of undeveloped ones as the status quo. Imagine the situation if many countries were to open up their economies to individual efforts and wealth. The demand for basic commodities would skyrocket! The old, restricted level of production would not be able to respond, shortages would ensue, and prices would rise. That scenario is pretty much what we are seeing. Newly freed countries would mean periods of economic adjustment as changes in distribution patterns developed. Ultimately, either we would see greater production, and thus higher standards of living all around, or we would see massive shortages and breakdowns in the world economy. In this respect, the emergence of China and India as economic powers will be good for all of us. Countries that refuse to deregulate, like the Europeans are blindly doing, will be faced with falling standards of living and fiscal nightmares, as is happening. For those who have tied their thinking to the dominance of the U.S. in the world economy, there will be confusion. In a world that is free and prosperous, the U.S. would be a great competitor, but not the richest nation. It is not the biggest country. But it would be incomparably richer than it is now. Higher productivity and creativity worldwide would mean greater wealth for all, and we would benefit.

But, back to the point of this post, greater demand for commodities, or anything, and subsequent rises in prices is not inflation. Only increases in the money supply by government action is inflation. Keep your causes straight.

Inflation and the International Wheat Market

One site that I monitor that discusses inflation is loudly trumpeting the recent rise in wheat prices as proof of their longstanding belief that we will be seeing lots of inflation, and future hyperinflation. They have forgotten or did not know that inflation is a domestic issue, revolving around a nation’s currency, that price inflation is a rising of the general price level, and that many different things can cause a specific product’s price to change, even without regard to any government activities. They also do not seem to understand the importance of looking at the context of the facts of reality, in this case the international wheat market.



Before looking at the wheat market, I want to emphasize that there is no free market in the world. All markets, including international markets, are affected by individual nation’s attempts to manipulate their own domestic currencies and product markets. Nearly all nations today are manipulating domestic markets directly or indirectly with little restraint. International markets are the total sum of the actions of each nation, plus the actions of individuals and associations of individuals (companies) both to meet normal business objectives and to avoid government restrictions. Whenever international markets are discussed today, these basics must be remembered. If someone talks as if markets were free of interference, we know that they are missing, ignoring, or evading current conditions. It is true that international markets do act independently of any one nation and that the controllers of a nation’s economy are often unhappy with what happens in different world markets. But the markets themselves are fundamentally affected by the actions of different governments, which often overcome real, purely economic or business factors.


Occasionally, and maybe surprisingly within today's context, a market will move as a result of events, real events, not government activity. That is what has happened in the world wheat market. Interestingly, the Russian economy after communism (notice I didn’t call it “capitalistic”) has turned its production of wheat into an export crop. Before, under the communists, Russia had to import wheat, in spite of its very fertile agricultural regions. Russia, as a mixed economy has managed to become a major exporter of wheat. Even so, Russia is not an advanced economy, not even where agriculture is concerned, so that it is more vulnerable to “mother nature”. Russia is suffering from a major draught (see news stories about fires around Moscow, too). Its wheat production has fallen dramatically (the Russian government has now banned wheat exports), and the world price for wheat has risen as supply has fallen, as you would expect.


A rise in a commodity’s price due to a shortage is not inflation. Certainly, if there is inflation, the situation would be worse, which is true today in nearly every country, but they are still two different things. Someone who doesn’t notice the difference does not understand the issues or the economy.


The price of oil is similar to that of wheat, with some additional provisos. The effects upon the international oil market of the actions of individual governments are more obvious, to anyone who looks, that is. The most important result of government action on the oil market is that of reducing the supply of oil, enforced shortage. Governments in many nations have restricted the search for and the recovery of oil. Further, many oil rich nations do not allow private companies to operate in their country, so their search for oil and its production is generally less competent and less successful.


If you have read my earlier posts you will have seen that I have been expecting oil prices to rise to close or above the prices from earlier this decade. The basis of my expectations were that the reasons why the prices was above $100 a barrel would exist again, i.e., increasing demand from the two largest populated countries in the world, India and China. Chinese demand for oil has resumed. India doesn’t seem to be as strong as it was, however. What we have seen is a price that has gone up, but still is significantly lower than it was earlier this decade. I think that the lower price is due to lower demand in the U.S., and probably Europe as well, due to the fact that neither area has recovered from the 2008 recession. Neither area is poised to actually recover, so for the immediate future, we can expect world oil prices to remain lower than the earlier highs. This may be true even though U.S. production of oil is bound to be further constrained by the backlash from the Gulf of Mexico oil spill.


To further my point in this post, oil price increases are not necessarily the result of inflation, either. International oil prices are going to be generally impacted more by direct manipulation by each countries domestic controls. There are so many examples besides the obvious restrictions on drilling and refining, which predominate in the U.S. Most of Europe has taxes on gasoline that make it very expensive, thus cutting demand. Some countries subsidize gasoline sales to consumers, increasing demand. Many of the oil rich countries have nationalized oil ownership and production. It would be interesting to research Indian and Chinese government policies regarding the discovery of oil reserves, production of petroleum products, and the importation and distribution of oil and gasoline. Regardless of those policies, both countries currently require significant importation of oil to support their growing economies, and their increasing requirements will tend to push international prices up. Which is not inflation. An investor, in a fairly rational context, would look upon the emergence of large economies that were actually developing as opportunities for enormous profit.


To that let me add a note regarding commodities in general. I want to talk about the basic stuff of production, i.e., metals, not foodstuffs. Consider a world in which all economies, all countries, were becoming capitalists. The initial supply of the basic materials of production would be stressed to meet the demand of newly productive economies. New mines and processing facilities would be competing for investment funds. Initially, prices for these materials would increase and products worldwide would become more expensive. This would continue for a while because the new mines would be producing material that was harder to extract and more expensive to mine or process. Over time, new mining and processing technology would be discovered which would tend to reduce the cost. Some of the upward pressure on commodity prices is happening now with the emergence of more productive economies. There are opportunities both in the short-run and longer term for investment, profit, and creativity.