HRA Journal - June 2008
Role Reversals

David and Eric Coffin's
Hard Rock Analyst Journal
Jun 30, 2008

In the 1970s, Baby Boomers were swelling job ranks and women were moving out of the home and into the paid workforce in most of the industrialized world. At the same time OPEC pushed crude oil prices through the roof to overturn what it viewed as a predatory system of resource transfer set up by colonial powers.

The expanded wage earner base in the industrialized economies was able to absorb the imposed cost gains well enough to create an upward spiral of inflation that had to be choked off by heavy handed interest rate jumps in the late 1970's. Even though this meant an economic hang-over in the early 80s, inflation also created permanent price gains for big ticket items like housing and cars in wealthy economies, and the former became a mainstay of increased wealth in the Industrialized World.

That hangover, ironically, was most heavily felt in resource exporting economies that crashed because the excess pricing had in turn generated excess funding and created an oversupply of most mineral resources.

The downside of this included a banking crisis from first South America in the late '80s and then Mexico in the early '90s. Both resulted from over lending in dollars that could not be repaid because mining venture profits had been reduced to zero and producer currencies had dropped like stones in dollar terms. OPEC members had their own problems, but oil extraction costs in many of them were so low they did avoid bankruptcy by undercapitalizing their sector.

The upside from this was political, with Latin America, the Soviet system and parts of Africa tossing off dictatorial rule that had lost its hard currency funding base. India and China were both reforming in largely closed economies outside of the direct impacts of the hangover, until recently.

In the 2000s Baby Boomers are leaving the wage earning economy and women, more or less, are a fully integrated part of the Industrialized economy other than in Japan. Wealth has become large enough in industrialized economies that people are having fewer children, to the point of creating what is in essence a domestic undersupply of people.

This is made up by immigration or guest worker programs in most places, but this has none the less generated an upward spiral of percapita wealth creation. In China a forced "one child" policy has been a large aid in creating the economic miracle there, especially in urban areas where the one child rules were harder to dodge.

Low inflation rates resulting from a shift towards a more ephemeral industrialized world service economy and goods export from low wage economies became the norm. This allowed long term decreases in the cost of capital which, among other things, has driven the price and in many areas the supply, of housing to unrealistic levels.

Large population economies finally hitting their stride in terms of accelerating per capita income and 20 years of under investment have driven the commodity boom that is familiar to all by now. This is leading to a role reversal in terms of money flows and wealth generation. Its still unclear how all this will settle in the long term but its making for some serious economic strains in the short run.

When OPEC had its way in the 1970's it helped create some structural changes that were, in retrospect at least, good for all. There was a drive to greater energy efficiency in the industrialized nations that held until a low oil price in the 1990's brought back the SUV. Even after the return of mega-cars energy consumption is a much smaller proportion of the G8 economies than it was 40 years ago. That is one reason why oil prices could and did move though $100 a barrel without western economies wilting, though they are looking frayed at $135.

These increases in energy efficiency were not mirrored in the developing world for the simple reason that they were very low per capita energy users to begin with. The last energy price run did not affect them as much.

During the OPEC price surges it was easier for developing nation governments to install energy price subsidies. They became commonplace in Asia and in developing countries that had a domestic oil producing sector. A lot of the world's population has been sheltered from energy price gains until very recently. That was manageable with $30 a barrel oil but at $130 it just doesn't make any sense.

There is much talk about high oil prices leading to demand destruction. That will only happen where the price signals are transmitted to the marketplace. In many of the world's most populous countries consumers are paying a fraction of the real cost of energy.

In the past few days several Asian countries have cut subsidies, but there hasn't been a move yet from China. Cheap energy is considered a right in many of these countries. Its political suicide to allow more than token increases. That is one reason why energy consumption is rising so rapidly in the BRIC nations even as it stalled out in Europe and North America.

Energy aside, many developing countries have been on the right side of the commodity boom and generating surpluses from trade in general. Their better financial condition has allowed them to retain subsidies on oil and other staples. These have helped keep inflation imported from the US thanks to pegged currencies, at manageable levels. The US alone appears to have inflation under control but that is a fiction based on false statistics and the export of loose money.

The combination of exported inflation, false price signals on many "soft" commodities thanks to pegged currencies and subsidies and stupidities like grain based ethanol production is now coming to a head. Economies are reaping what they sowed. With food staples, like energy, meddling in the marketplace has ultimately made things worse.

With oil hitting records, the meddling will continue. Politicians are looking for someone (else) to blame. The current villain of choice is commodity markets and "speculators". (For the record, speculators are people who drive up the price of things you want to buy. Investors are people who drive up the price of things you already own). Politicians are likely to discover what most of you already know; prices of "stuff" are rising because more people what to buy them than sell them right now. There are definitely funds and other larger investors taking larger positions in just about everything commodity than every before. In that sense the politicians are right. Where they are wrong is viewing it as "mere" speculation.

Investors view many commodities, and especially oil, as "anti dollars". It's no coincidence that some of the biggest climbs in prices for energy metals and soft commodities came in the midst of US financial crisis. Commodities are getting viewed as both portfolio stabilizers and plays against the dollar. This has created a market backdrop where energy prices are becoming a major drag on consumers in the G8 while foodstuff prices are in danger of having similar effects in the developing countries.

Is there a happy medium here? In one sense, no, because not all of the prices increases are mere market moves. A lot of the demand surge is real. Enforcement of some commodity market rules, like position limits for "non commercial" traders will help but higher prices for most commodities are a fact of life for the foreseeable future.

At the end of the day, to even be partially successful, price signals will have to be allowed to function. The best way to start that will be for developing countries to start loosening up their currencies No one expects that to be a painless manoeuvre but it will benefit those economies by cushioning increases in $US dollar priced goods like commodities. It will also help developing economies start to get inflation under some control before it gets completely out of hand.

This partial solution would have some very direct benefits for the US, though they might not be appreciated. As a debtor nation, the US would benefit by having cheaper dollars to pay off debts. This is a time honoured method used by banana republics everywhere to get rid of foreign debt.

Developing countries would see increases in purchasing power, though that would be weighed against higher export prices due to stronger currencies. Energy and other dollar priced commodities would become cheaper. This could ease some of the strain due to subsidies and allow some of them to be decreased or phased out.

Properly handled, increased currency values and lower input prices should enable fast growing countries to keep productivity gains coming while rewarding workers with greater purchasing power. It would also help ease inflation that is ramping up dangerously in many countries. One good example of the impact of a floating currency is Brazil. For decades, Brazil was a basket case when it came to inflation. It now has the lowest inflation among developing nations. The reason for this is a floating currency. A rising Real has created some other problems to be sure but it has kept inflation in check.

This would help the US as a debtor nation but it's less clear that it would help individual Americans in the short run. US exports would become more competitive still. Exports are already one bright spot in a weak economy. Rising foreign currencies would make US goods that much easier to sell.

The US would obviously not escape the trap of rising energy and commodity costs in dollar terms. The only way that will happen is if the world finally moves away from dollar pricing and if real price signals in other economies generate enough fall off in demand.

Many in the US administration are aware of the fact that some commodities, notably oil, may move away from dollar pricing. There were a couple of bounces for the dollar thanks to (marginally) better economic news and saber rattling by Fed chief Bernanke. Many observers suddenly got bearish again on metals, gold and oil. They pointed out that "you can't fight the Fed" so you'd better lose those long commodity positions.

While we think oil is overbought and due for a pull back we think this is a case where nothing could be simpler then "fighting the Fed" After all, just what could the Fed do to enforce its wishes?

With horrible housing numbers and falling employment the odds of an interest rate increase look close to zero right now. With investment banks set to release yet another set of lousy quarterly numbers and banks choking off credit, changes in things like reserve requirements are a non starter and unlikely to have any effect anyway. Bernanke's bluster seems an empty threat and the market is quickly discounting it.

In the longer term, the answer for foodstuffs is more production and less protection. Barring weather disasters this is the commodity segment that can respond most quickly. Sustained higher prices are manageable in many high growth economies. Indeed, higher food prices should inordinately benefit the countryside. That sort of income leveling is exactly what many of these countries have been looking for to keep farmers from streaming into the cities.

Higher energy and metals prices are less fixable. They should be viewed as a fact of life we will all have to deal with. Especially if one thinks in dollars. The trick will be managing this historic wealth transfer to minimize the pain in the G8 while maximizing the gain for all concerned.

David Coffin & Eric Coffin
Editors HRA Journal
email: hra@publishers-mgmt.com

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