Tuesday, July 15, 2008

Rising commodity prices, excess money and bailouts

World is definitely in perilous situation. Expenses are rising thanks to commodity price increase. Households incomes are falling as businesses fail. Growth is slowing thanks to high cost of debt. Investments are stuck as selling assets at crazy prices is no longer possible. Only thing rising is commodity prices!

Commodity prices - what drives them?
To understand this, we need to go to first principles wherein goods and money are tradable. From here it follows that when the value of money looses its way - goods will be the lodestone, the compass. After all money is used FOR goods! We need to realise that money by itself means nothing. Money is intermediary, a common denominator amongst goods. The best mechanism to protect oneself from arbitrary manifestation of value of money is to have the goods! This has prompted the rush for commodities - the most standardized goods available to international financial community. And naturally, the prices of commodities and goods have lined themselves up in the pecking order of importance to the society. Naturally oil (presumably inelastic demand) pegs itself at the very top.

Cancerous growth of money!
Excess money is one of the root causes of the current situation. The excess money flow was further exaggerated by pegged exchange rates. Initially the increased money supply was cornered effectively by small group, mainly Central banks (reserves) and investors(wealth). The excess liquidity did not reach the masses inflation symptom was masked. The situation seemed like positive spiral. Reserves became trophies and wealth always was one. The ensuing trophy-chase, magnified by leverage, soon trounced one asset class after other. And then we hit the tipping point. Today we are bailing out the first casualties of calamity. The bailout mechanism is infusing more liquidity into the system. Like fighting cancer with cancer or fire with fire. And most likely we will be left with ashes or cancer!

Is capital destruction reasonable solution?
Capital destruction is a painful but sure-fire solution. The least we can do is to stop excess capital creation - that means bailouts will be few and far between. Further on unpegging exchange rates will help destroy some excesses. Write-offs will destroy some more. In worst case only the last person caught holding the bag will be hit. In reasonable circumstances, they will be rehabilitated. In best case - we can rewind and restart where we left off.