Opinion

Promoting inflation for building prosperity!

S. GURUMURTHY | Updated on March 12, 2018

Welcome to the commodity casino.

During 1976-2012, the US equity prices rose 8.4 per cent and commodity prices 28.3 per cent. But producers suffered. Theories that legitimise credit-induced asset ...

When US rice prices skyrocketed by 70 per cent between January and April 2008, President George Bush blamed the Indian middle class for the food shortage and high food prices in that country. But the California Rice Commission and the USA Rice Federation contradicted him and said: “Bottom line, no rice shortage in US. We have supplies.” It soon became evident that the rice prices had shot up not due to food shortage but because financial funds had turned traders in grains and hoarded them to profiteer.

In the 1990s, generally stocks and real estate constituted the investment asset class. But a major shift occurred in the early 2000s when investment funds turned to commodities like rice and wheat, oil and metals to invest. Investment funds found equity and real estate investment opportunities inadequate for the huge phoney money tsunami. Commodity prices forced up by the rush of new money yielded high returns to commodity investors. A new branch of financial economics emerged.

That the US created cheap credit-driven fake rise in prices of real estate and stocks and accounted the artificial effect of it as GDP is, by now, well known. Between 2000 and 2007, the US home value index rose by 85 per cent, the US stock market cap by 110 per cent, but the US GDP by just 14 per cent.

Look at the telling equation between home prices and GDP in the UK. UK’s GDP in 1952 (£166 billion) could buy 8.5 million homes at the prevailing prices. But its GDP in 2012 (£1,508 billion) would yield just 9.3 million homes at current values. In 60 years, the UK just managed to add prosperity equal to 800k more homes! That is all the real growth.

Home or stock price rise could be regarded as wealth had the genuine savings of people funded their acquisition, but not when their acquisitions were designed by financial steroids. The wealth effect of artificial asset inflation — celebrated as home equity — is illusory.

Yet modern economists enticed unwary people to borrow against artificial wealth and spend. And the US GDP statistically grew on this illusory spending. This asset inflation-fed growth met with a near-fatal end in 2008 when the US stock market cap plunged to its 2001 levels. US home prices fell in 2009 to where they were in 2002.

This distorted economics which fed on, and also was fed by, the lifestyle actively promoted in the US, globalised the crisis. Yet two economies — Germany and Japan — did not heed the advice of modern financial economists and avoided the US-type crisis. Even as home prices driven by credit steroids almost doubled in the US and trebled in the UK between 2002 and 2007, in Germany home prices remained stable and declined in Japan by 26 per cent ( The Economist May 16, 2013).

Stock and real estate wealth effect is an old story. The financialisation of commodities is their latest edition.

Corn to casino

When the US food prices hit the roof in 2008 despite the US food silos being full, the US farmers alleged that large mutual funds, pension funds and index funds had turned the corn trade into a casino ( Business Standard April 4, 2008). The corn casino opened in the early 2000s when modern financial economists advocated expanding the investible class of assets to cover commodities — such as crude oil, metals, cereals — rationalising the consequent rise in their prices as wealth and prosperity.

The Wall Street Journal (September 9, 1994) announced the emergence of commodities as investment assets. Even earlier, commodity exchanges had opened and exchange traded commodities (ETCs) had emerged in which commodity funds — exchanged traded funds (ETFs) — invested, like mutual funds invest in pools of stocks.

With commodities such as oil, steel, copper, gold and foodgrains graduating as asset class for investment, their prices skyrocketed, which attracted more funds into ETFs. Investment in commodities ($10 billion) in 2001 rose 40 times to $400 billion in 2011. Soon, derivatives populated commodity markets like a tsunami.

The annual physical sale of ETC commodities is now $6.4 trillion. But their derivative turnover exceeds $128 trillion, making the turnover of derivatives to actual trade 20:1. Consequently, the global commodity index jumped from 100 in 2000 to 290 in 2010 — up by 190 per cent. Investment in gold ETFs, which started in 2003, shot up to $700 billion in 2007.

The gold derivative turnover rose from $1.5 trillion in 2001 to $8.5 trillion in 2010, against which all the gold estimated to have been mined so far is worth just $7.6 trillion. With the entry of ETCs and derivatives, the gold prices pole-vaulted six times — from $271 per ounce in 2001 to $1693 by 2012. This artificial inflation of gold value was celebrated as “return on investments”. Now, return to foodgrains.

Skyrocketing prices

Investment funds accounted for 40 per cent of the US wheat trade in January 2008. It jumped to 60 per cent by April. Food prices hit the roof — rice 217 per cent, wheat 136 per cent, corn 125 per cent and soya bean 167 per cent ( Business Week April 29, 2008). This hurt the farmers most. But their appeal to US Federal officials fell on deaf ears ( The Washington Post April 23, 2008). “Wall Street Grain Hoarding Brings Farmers to Near Ruin” headlined Bloomberg (April 28, 2008) saying that commodity index funds held more than half of the US grains. UN officials blamed investment funds for higher prices and shortage ( April 10, 2008).

International Herald Tribune characterised investment and profiteering in foodgrains as “parasitical” and accused the IMF and World Bank, which had met to discuss the food price issue, of turning a blind eye to speculation (April 16, 2008). Investors such as George Soros and Jim Rogers declared “crops and raw materials have become investment class assets”. Dow Jones Online Financial News (April 21, 2008) spoke of “the $12 trillion oil derivatives” which lifted the oil prices to $115 per barrel — when the global oil demand had inched from 86 million barrels per day in 2007 to just 87 million in 2008 ( Business Line May 16, 2008). The artificial commodity price rise — sheer inflation — hurt the people but shored up hedge, investment and pension funds and even the endowment funds of Harvard University!

Private wealth

Financial economists commended ETCs and ETFs as price discovery mechanisms and rationalised the rise in prices of commodities as risk return on investment. They confessed their inability to distinguish speculation from investment, ignoring the ultimate truth that the investment itself is for speculation. Making private wealth for the top few out of the evil of inflation that hurts all is now integral to financial economics.

A paper (‘DWS enhanced commodity strategy fund’, May 2013) by Deutsche Asset and Wealth Management (DWS) partnered by the mighty Deutsche Bank said that against the US inflation of 4.3 per cent during 1976-2012, the US equity prices appreciated 8.4 per cent, bond prices 6.3 per cent, but rise in commodity prices was 28.3 per cent — pointing to the high returns in commodities.

DWS emphasised that the US, which has printed $2 trillion to save its economy, has exposed the world to hyper inflation. DWS saw in the emerging inflation high returns to commodity investors. The theory that phoney dollar-induced inflation that robs the people is a source of wealth for the wealthy did work for the US.

Between 2002 and 2008, the US producers’ price index rose by 50 per cent, but the US inflation index grew by just 20 per cent. How come the US producers charged 50 per cent more but the US consumers paid only 20 per cent more? How come the US commodities rose by over six times the US inflation as mentioned in the DWS paper?

In their study, ‘Global inflation dynamics: regularities and forecasts’ (2012), A. Akaev, A. Korotayev and A. Fomin, scholars attached to the Russian Academy of Sciences, examined this dichotomy and established that by importing cheap Chinese goods, the US had cut consumer prices.

From 2001 to 2012, US imports rose by 50 per cent but imports from China by 250 per cent, with like increase — five times — in its current account hole with China. The burgeoning US current account deficit was financed either by the US Fed printing dollars or by borrowing.

The US gained in the game of inflating the commodity markets through ETFs, ETCs and derivatives and yet avoided inflation because of its capacity to run trade deficits with impunity. Financialisation of commodities through ETCs, ETFs and derivatives uniquely suited the US, and only the US. And yet Indian policymakers love to copy Wall Street economics for India.

Even as the farmers in US were blaming ETCs, ETFs and derivatives for the high food prices, Montek Singh Ahluwalia opposed a ban on commodity derivatives in India saying that Indian food prices were high not because of derivatives but because global prices were high ( Economic Times April 30, 2008) — when the cause of high global prices itself was financialisation and derivatives.

QED: Financial economic theories that legitimise credit-induced asset and commodity price rise — read inflation — as prosperity need close scrutiny.

(The author is a commentator on political and economic affairs, and a corporate advisor.)

(This article has been corrected for error.)

Published on August 08, 2013

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