Boom-bust cycle and commodities

In one of the comments of the previous blog entry qadi referred to a famous quote running within investment circles at the beggining of the Asian Tigers Crisis and was attributed by some to Jacque Fresco, with his Resource Based Economic Model, by others to Albert Barlett, and by a few even to Lionel Robbins. This quote has been circulated in several forms and qadi got it as:

"monetary doesn't matter, since the world has reached the point of infinite production capacity... the only constraint, of course, being natural resources!"

I know a different version which states:

"the monetary angle becomes irrelevant as the world reaches the point of infinite rate of production capacity expansion, which is constrained only by the availability of natural resources"

While everybody gets hysterical about the Debt Ceiling Show, I believe it would be interesting to discuss this issue. The best illustration is to use an example from nature described by the Lotka-Volterra equation because it is simpler and more intuitive than a control-Lyapunov model, which would better fit this situation.

I am not going to talk about eigenvalues and I will not post sets of equations. The whole thing is very simple: we have the natural variation of prey-predator populations in a stable ecosystem, and the preferred example is foxes and rabbits. Basically rabbits are prey and they have an inexhaustible supply of food (grass), as a natural resource, while the foxes are the predators and they feed on rabbits.

An increase of the population of rabbits creates a larger food supply for foxes until the population of foxes increases relative to the number of rabbits to unsustainable levels. The rate of prey consumption increases past the reproduction rate of rabbits and as a result the number of foxes decreases too until again the rabbits have a chance to breed which triggers another increase in the number of foxes. The system reaches a dynamic equilibrium defining on a long term the average population of rabbits and foxes for a given ecosystem.

The chart is fairly simple:



Now let''s assume we have the grass as the natural resources available to an economy, the rabbits (prey) are the industrial/production capital, while the foxes are the financial capital.

The model requires a few improvements to keep it closer to the natural example. First the natural resources available to the herbivore population is limited at least with respect to density. Even in nature there are only so many tons of grass which can be harvested daily from a square acre of a meadow (we are talking here about the happy case of renewables).

In the economic sector the predation/competitive action is governed by the rate of profitability. Both financial (money rent extraction) and production capital are actually competing. Investors will crowd towards the higher yield. Like in nature there is intraspecie competition for both sectors (capital will flow from the most productive/profitable corporation within each sector).

However, there is a very interesting aspect which governs the financial predation which doesn't have a clear equivalent in nature. That is given by the profitability threshold imposed by the financial sector on the productive sector by three means:
a) Competition. If there is a great market for a certain type of mouse traps, and a company manufacturing that type of mouse trap obtains high profits then financial capital will flow into creating other companies competing for that market sector as long as the specific profitability is higher than the general profitability of financial capital.
b) Credit for expansion. At similar levels of productivity the manufacturing/production entities will be force to compete by expansion to benefit from the economy of size. Therefore they will have to raise capital (from the market, by issuing corporate bonds, etc.) As a result of this limitation the direct profitability of the industrial/manufacturing capital is eroded by the rent on the borrowed money from the financial capital. In the limit case the final expansion level is reached when the real profitability of an industrial or manufacturing entity tends to 0. Basically all big corporations have no profits, to insure endogenous growth. They exist only to pay interest on the credit taken from the financial sector. The market is full of industrial and production behemoths who are profitability zombies, being only a proxy for financial rent extraction, while small and medium productive enterprises and small family businesses can provide a real profitability above after all credit obligations have been paid.
c) Monetary expansion and inflation. This a little but tricky to present it intuitively. The financial capital has the same intraspecie competition of grow or die, and self predation. However, the profitability of financial capital is proportional with leverage. In order to attract more investors financial capital entities are forced to leverage to the maximum extent allowed by regulators and risk perception thresholds. Naturally this creates a growth in the monetary aggregate resulting in inflation. This will affect industrial manufacturing capital by increasing competition (credit availability) eroding it's real profitability threshold by decreasing the real value of its profits and by increasing the price of commodities and raw materials. It becomes obvious that the price of any commodity depends theses days not on the rate of demand/scarcity but by the specific level of sectoral inflation. If financial instruments of investment in commodities will crowd a certain market (oil for example) the price of that commodity will increase or decrease regardless the actual values of demand.

There is the particular case of gold which is still used as a minor component of the power money of the global liquidity pyramid (the overwhelming share being represented by by the US Treasury paper hoarded by central banks). It is not a simple coincidence that there is a pretty good correlation between the T paper held by central banks and the price of gold referrenced in USD.

So where does this lives us? Actually the Lotka-Volterra model is simplified because even in nature the interaction between predator and prey are far more complex. We are talking here about a dynamic equilibrium system, for the discovery of the optimum ratio between the populations of predators and prey in a stable system. One may say that the herbivore prey, in a stable system benefits from the existence of predators. Rabbits have evolved in time, by natural selection, to be able to dig deeper burrows, to have longer legs (allowing them to run faster), longer ears and better eyes (to warn them of the approach of predators) and even they developed better digestive system to allow them to extract more nutrients from the same amount of digested grass.

After thousands of years of adaptation as a herbivore, when rabbits were brought to Australia as an invasive specie, the local predators were simply no match for them. Also the local herbivores were no match for rabbits. Rabbits were able to deplete the local vegetation, by unchecked population growth, which created a food scarcity for the native herbivores reducing their numbers. Conversely in the absence of the financial predator in an economic system, we are witnessing a dramatic increase in the size of the industrial capital, resulting in the exhaustion of resources and in the transformation of the local territory into a waste land. I believe that when the monetary angle becomes irrelevant, we are moving towards the so called Resource Based Economy, where the only limmitting factor for growth is the scarcity of natural resources.

Example of this unchecked growth of industrial/production capital (similar to the multiplication of rabbits in Australia) are numerous in history. One would be the industrial development in US before the Great Depression when by the mercantilist policies adopted by the government (US was doing at that time to Europe, what China is doing now to US) and due to the absence of an antitrust legislation, there was no financial predation on industrial/productive capital.

Another example is the state of the Eastern Block economies when the Communism fell. In communism there was no financial predator since the central banks of Communist states were just the monetary division of the local Communist parties. A profitable communist bank is an oxymoron.

The most recent example is of course China, but in this case there is a twist because the Chinese banking system is allowed to hide enormous losses on its balance sheet. However the great and unchecked industrial development brought in China by globalization and free trade, has produced the result of a sick ecosystem. There is an overpopulation of industrial/manufacturing capital whose inefficiencies are for time being hidden by subsidies and and erasing of losses (especially for SOEs) the pollution is a major problem and China's resources are depleted at an incredible and unsustainable rate.

Who benefits from this massive expansion? The answer is simple: the Western predatory financial capital which in the global system has grown to never seen before levels. The Western (or better said the North American) financial predator has been able to escape the constraints of the Lotka-Voltera equation quite a few times after the Great Depression which was the last recorded instance of US financial capital collapse (major deflationary event).

Actually even from the Great Depression they escaped with little damage, by inflation, when FDR devalued the dollar (partial default) and confiscated the gold held by US citizens.

In 1937 when the economy was going towards another depression and deflationary moment, there was the inflation produced by WW II when US became the Arsenal of Democracy, entering an economic military production boom, fuelled at the expenses of the initial belligerents. The trade was so profitable that US was selling oil and industrial equipment even to the Nazy Germany until right before the Pearl Harbour attack.

After the war there was the Marshall Plan, the Bretton Woods Agreement and the Cold War. If examined in detail it is hard to believe how profitable was the Cold War for the US finacial predator and one may wonder if US wasn't actually interested in maintaning the Soviet Empire which could be leeched so well, the socialist states being the perfect victim for the international trade providing cheap resources. One of my friends was saying during that time that if US wants to defeat the Soviet Union, we shouldn't build more nukes, but to stop the grain exports and starve them to death.

The natural cycle of decrease in population was avoided again by the North American financial predator, by another partial default during the Nixon Shock when the dollar was taken off the gold standard (the huge government debt produced by the Vietnam War was essential for pulling out that default without a flaw and impose treasury paper as an international reserve currency)

Then it was the Plazza Agreement when Japan was forced to revalue it's currency, and the decrease in the financial predator population was again avoided by placing the losses on the domestic balance sheet of Japan's central bank.

The next deflationary cycle (and a decrease of the US predatory financial capital) was avoided through globalization and the proliferation of a regime of global trade/capital flow imbalances. One may think as an expansion of the trick used with Japan's development. China and other EM are used for the same stunt but on a scale a few orders of magnitude higher.

The problem is that unlike the ideal case of our example with foxes and rabbits, the surface of the Earth is finite. Therefore there is an upper limit of the population of prey (industrial and manufacturing capital). In nature, foxes don't feed only on rabbits. They also feed on many other small rodents, birds, lizards, fish and insects.

When food is scarce foxes eat berries and grasses. In situation of famine, the fox which is a solitary predator will become canibal and will attack and eat other foxes (bank eat bank).

We are now in the situation in which the US predatory financial capital does not have any more enough prey to feed it to insure it's profit margin. The globalization has progressed to the point in which we are witnessing a boundary constraint.

Analitcally there are only four outcomes possible. We return back to the cycle of inflation deflation which would result in the decrease in the size of the US financial capital.

The second outcome is granularization by intraspecie competition of the financial capital. This will amount to a process of deglobalization. Countries and multistate regions will decouple from the central harmonic of boom-bust generated by Treasury paper as international reserve currency and we return to pre-WTO paradigm. US government will declare a partial/stealth default. For USA the elimination of the unfair competition would result in an unprecedented industrial/manufacturing boom. Warren Buffet is buying rail roads in US... I believe his bet is clear, but I don't think that even Buffet believes that this outcome will happen very soon, rather he is positioning himself at the basis of the new industrial infrastructure.

The third possible outcome is the destruction of the system: global revolution or WW III. Again as the only remaining superpower USA is pretty well positioned to win in such eventuality.

The fourth possible outcome is the removal of the boundaries which limit the size of the system. That means the expansion of the human race in space which will probably be from an economic point of view to the discovery of America. While this sounds a little bit SF and definitely not bound to happen soon, eventually this is the only solution for breaking out of a static system in which the evolution has basically stopped. I don't expect to become in my life time a colonist on a Goldman Sacks space ship, but well,... in the future I would not be surprised to see the Vampire Squid selling derivative shit to aliens and then foreclosing them from their habitats while the just to get a fat bailout from the Galactic Treasury... :)

So where does this lives us with the price of commodities? The answer should be obvious... It depends on the evolution on the monetary front.

If the artificial manufacturing/industrial development in the emerging markets, collapses and we see a deglobalization, the USD price of most of industrial raw materials and commodities will decrease. N0t only that the artificial demand will be slashed, but the industrial commodity and raw material producers will be in a disastrous economic state, which would force them to sell at very low prices.

If the show goes on and the Fed continues to pump US gov debt in the global financial system as the backbone of the international currency reserve system, the commodities will enjoy a bull market.

If things get out of control and the Treasury experiences a crash default, it makes no sense to talk about the price of commodity in dollars since we will probably return to a domestic currency anchored in a basket of commodities or to some form of demand note as the original greenback. The Federal Reserve Note will be gone.

The only thing now left to discuss would be if the monetary angle becomes irrelevant since the world production capacity has reached infinity and the only remaining constraint being of course the (scarcity/availability of natural resources).

If there is a global war or revolution, then the price of commodities can be all over the chart. It would be impossible to predict without a clear view of the future political and strategic evolutions.

Obviously I believe the paradigm of the quote is misconstrued. In a system in which the monetary angle becomes ireelevant (there is no financial capital predation) the production capacity can reach infinity (as a figure of speech, but more correctly can reach unsustainable levels due to the absence of the productivity threshold) and the only remaining constraint will be the natural resources. This would be a resource based economy in a post-scarcity type society...

I am not sure I would like to live in such a society. I am also not very happy to live in a world in which the growth of the financial predator has been left unchecked, and millions of people see themselves transformed into debt slaves after all their wealth has been stolen by the crooks who control corrupt governments.

What am I saying is that I want to see a return of the economy to a state of normal and healthy equllibrium, where markets are transparent, fair and free, even if that means that the optimal capital and resource allocation levels are permanently discovered in a dynamic boom and bust cycle. That is the nature of things and part of the beauty of life,...