The sordid magic of levitating commodity prices

This is the fourth month in a row that we talk about prices. But as we had said all those months back, 2008 is going to be about inflation management and policy credibility. It will also be about further discredit earned by multilaterals, as also by those who had till recently sported Delphic stature, divining in mysterious ways, the clear course that the ship of the global economy must take.

In fact, this is what increasingly seems to be the final chapter in the great quest for development. It is no longer about the chasm of hunger versus plenty, capital versus the lack of it, technology versus the lack of it. But it is about the complex art of managing the world of finance, expectations and price stability.

Not by the futile short-cut of the Bolshevik way: Of abolishing the market and sending the bourgeoisie, the kulaks and all others suspect of independent thought to die in Siberia. But the refined method of leading the market onto the path of price stability, while operating in a world characterised by increasing, not diminishing volatility. Volatility is short-term and often more indicative of the ability of information to flow through the system faster. Something akin to how a modern high-speed loom not only weaves cloth much faster, but it also produces one of much closer and finer weave.

But it is here that the most powerful leaders of the global word of finance and macro-economic policy coherence lost the plot. The turning point was the full scale outbreak of the sub-prime banking crisis in the US. In fact the irony was not that there was a bubble in sub-prime assets, per se. That kind of thing has happened in the past and will happen again. The disaster was first, in the regulatory failure in dealing with the mess as it matured, certainly since 2005. The even bigger disaster was the regulatory response to the crisis after it broke in August 2007. The major problem with the outbreak of any crisis is the contagion. It is imperative to contain and isolate the affected aspects and portions from the rest of the system.

The immediate problem was the loss of liquidity of banking assets and the obvious remedy was to ease that through refinancing. It took the US Federal Reserve six long months to figure out how. What was its instrument of choice? Cut interest rates to the bone – push the system into some kind of a time machine, back to 2003 and 2004. How about providing refinance to distressed homeowners? Many big speeches and the launch of several schemes later: zilch. No smaller mouse ever came out of such a big mountain of hot air.

In the interim there was the most amazing spectacle of a central bank and finance market players seemingly trying their best to push the economy into a recession. Perhaps hoping that outcome would best serve to justify their dramatic interest rate cuts and maybe in the process cool off inflation too. Bad policy however always produces disastrous harvests. Providence does not bail out inconsistent actions, however fervent may have been the prayers.

In the era of technology, quantitative techniques and bosses who are many times removed from the ground far below, leaving common sense and awareness of history behind is the work hazard of the Olympian heights. In the surreal world of high technology and echo chambers, the adult decision maker can as easily depart good sense, as the adolescent playing computer war games. Thus, the US Federal Reserve chose to forget its own history – the great inflation, the stagflation and painful recovery of the seventies and eighties.

George Santayana, the Spanish born Harvard philosopher coined the oft-quoted (and more often misquoted) phrase: “Those who cannot remember the past are condemned to repeat it.” I have heard the faithful attributing this to Marx – after all what is the point in faith otherwise? But Marx had a couple of good lines that could well apply to the present imbroglio of the US Fed. Writing of the December 1851 coup d’état by Napoleon’s nephew, then the elected President of the Second Republic who a year later crowned himself Emperor, Marx penned: “Hegel remarks somewhere that all great, world-historical facts and personages occur, as it were, twice. He has forgotten to add: the first time as tragedy, the second as farce.”

It is easier to understand this surreal period, which may well come to be known in later years as the “Great Inflation of 2008”, as an exercise in high farce. Mighty personages – from the US President, his Secretary of State and the No. 2 at the IMF – have ventured profundities on how high prices – of food and crude oil – were because of rising incomes in India and China. Many in India, especially vegetarians, have taken umbrage – and rightly so. The absurdities of the argument aside, it is indeed revealing of how much the tectonic plates of the global economy have shifted, that the mighty could look for excuses along these lines.

In March 2007, wheat was 17% higher than a year back and by July it gained another 17–19% for various grades. Thereafter it rose by 97–115% to March 2008. Likewise, corn prices rose by over 100% between July 2007 and March 2008. Maybe those pesky Indians and Chinese had eaten their way right through the harvest and stocks in these seven short months.

Crude oil was $75/bbl in early September 2007 and rose to over $90/bbl in late October on the fears that the US may bomb Iran’s nuclear facilities. Today oil is at $133/bbl and the Iranian crisis has long blown over.

What has happened between August 2007 and now? Financial investments have moved from other assets, including the sub-prime based CDO market, to the commodities space. The US Treasury Secretary has himself said that investors were making much greater allocations to commodities. The interest rate cuts and flooding of liquidity by the US Fed (and ECB) has fuelled this boom in commodities prices. Food riots have broken out in many poor countries that have to import food. Fuel price increases is pulling everybody down. Pointing a finger at India and China is the greatest admission of incompetence and impotence possible. It is the time for us to learn from the errors of others and take a step forward in the final chapter of the great quest for development.

(The author is Economic Advisor, ICRA)

Number of words: 1,073

Published in The Economic Times, Friday, 23 May 2008