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How to Get Rich Investing in Stocks by Riding the Electron Wave

US Economy, Commodity Prices and the Trade Cycle

Economics / US Economy Apr 07, 2008 - 08:43 AM GMT

By: Gerard_Jackson

Economics The current economic situation brings to mind 1999 when worries about the state of the US economy were piling up faster than rationalisations about the country's alleged growth rate. There was less talk of a "new era" economy and more about a "correction". What was it that brought about a more subdued assessment in so many quarters? Commodity prices are the answer.

The problem with commodity prices is not their price falls but the squeezing of their price margins, the difference between costs and prices. This is an important signal to look for yet, like the Titanic's SOS, no one seemed to have been listening. It's the same old problem of not seeing the trees because of the wood. And in this instance, price margins were the trees.

We witnessed mood swings from overvalued stock to falling commodity prices and back again. First, so we were told, the former could burst and send the economy into recession; on the other hand, a continuing fall in commodity prices would tip the world into a global recession. Well, which one was it? Neither, is the answer. Falling commodity prices can no more cause a recession than falling share prices can. And yet the two are closely linked just as some clusters of mergers are. In economics, everything is connected to everything else and prices are the means by which this is accomplished.

Distort prices and you discoordinate the whole economic process. This, unfortunately, is precisely what the Fed did, and still is doing. What is equally unfortunate is that the vast majority of economic and financial commentators are totally oblivious to this fact. Loose monetary policy fuelled Clinton's stock market boom and fuelled corporate mergers while having a malign influence on commodity price margins. Commodities are inputs. As I explained in previous articles, artificially lowering the rate of interest causes over-expansion in higher stages of production.

Commodities are part and parcel of those stages, meaning that lower interest rates also raise the demand for commodities, even though their secular price trend is downward. Once the higher stages find themselves in a profits squeeze as rising costs and falling demand puts them in a financial vice, this will feed back into a reduced demand for these products which in turn reduces their price margins. This is why commodity price margins rather than commodity price trends should be followed more closely*.

But where do mergers enter the field? Two periods in American economic history throw considerable light, at least in my opinion, on "corporate mega-mergers". Readers will recall that I have referred several times to the 1920s economic "new era". But the boom of 1896 to 1903 was also very much a "new era" phenomenon. Now 1924 to1929 was characterised by considerable take-over activity, just as the 1899-1902 period was.

These "new eras" were marked by 'cheap credit' and feverish stock market activity. With ample credit available and stocks rapidly rising it becomes easier to issue abundant securities, which made it easier to buy out other companies and consolidate holdings. Once again, it is what fuels the action that counts rather than the action itself. Each era of considerable merger activity was fuelled by credit expansion.

Like the rest of the world, America is going through not a business cycle but a cycle of ignorance. The belief that the so-called business cycle is a natural and unfortunate feature of market economies is so ingrained that it is rarely questioned. For nearly 2000 years Aristotle's assertion that heavier objects fall faster than lighter objects held sway over the European mind. Then one day Galileo completely demolished Aristotle by simultaneously dropping from the top of the Tower of Pizza objects of different weights.

Regrettably it is not as easy to refute the fundamental belief that the trade cycle is a sad by-product of capitalism, especially since the birth of Keynesianism. But until we do our economies will continue to undergo periodic booms and depressions. Even though the Austrian School of economics has provided an analytical refutation of Keynesianism it has yet to receive the recognition it deserves. This means that we shall continue to suffer the consequences of the public's economic ignorance.

*This does not mean that commodity prices always rise during a boom. After WW I commodity prices were depressed despite the post-war booms The reason is that the war had created an excess supply that that took years to balance out. On the other hand, current booms in China, the US, India have driven up commodity prices.

One must also consider a situation in which improved technology could keep commodity prices stable even as demand increased significantly. In the absence of a rise in demand commodity prices would have risen. We can therefore say that the difference between the boom price and the price that would have otherwise prevailed amounts to an increased prices for commodities.

By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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