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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.
Blackhawk down!
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.
Inverted logic
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.
Sean Corrigan
Sean Corrigan is Chief
Investment Strategist at Diapason Commodities Management (Lausanne and
London)
Copyright © 2006 -
Copyright © Diapason Commodities Management - Sean Corrigan
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