Assume martians are really poor

... and they buy nothing. In that case, the economy of the earth is a completely closed system. I realize that this sounds silly, but I feel that one of the fundamental mistakes people make when thinking about economics is to forget this. Marx, for example, went astray in part because he forgot this (though also, as Kolakowski makes clear, because his economic theory was always at the service of his philosophy) even though with Marx it was perhaps excusable because "the world economy" when he was writing, only meant Europe, which was in fact able to rely on a sort of alien colonialism. But that age is pretty much over now. Unfortunately, our ability to think about whole inter-connected systems hasn't actually progressed much since Marx, and we still regularly imagine a functional role for the martians.

This is a long-winded prelude to the question of inflation, one of the hot financial topics recently, and one of the topics where the debate seems to suffer especially from this type of fuzzy thinking.

William Buiter has a post today that clarifies who or what causes inflation.

This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always can be offset by the central bank, given enough time, freedom to act and courage.

So, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices - in the real prices of oil, of food, of oil and of labour for instance - if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.

There you have it. As far as I understand the terminology, Buiter would be considered a "monetarist" (a la *gasp* Milton Friedman -- who, by the way, when you actually sit down and read him, turns out to be remarkably similar to Lessig and Chomsky on a number of points. Intellectual life is so much more confusing when you actually read the original books, isn't it?). I'm hardly an expert, but up till now I have still found no coherent description of inflation that would be anything other than "monetarist". People tend to blame inflation on oil prices, or labor unions, or greedy corporations, but in a closed system, I don't see how this can constitute an explanation. If I pay more to put gas in my car, I have less to spend getting a hair cut. That's not inflation, that's just a transfer of wealth from people without oil to people with oil. No one is saying that the recent increases in commodity prices don't have importance for a lot of poor people who are paying more for food. It's just that it isn't inflation. For it to be inflation, those price increases would have to continue for the indefinite future -- that is, the price of food would have to continue to increase not simply to stay at a permanently high new level. And the only way those prices could continually increase would be to pay more to the people who are buying these things. This is the wage-price spiral one hears so much about, and it can only be facilitated by someone, somewhere printing more money.

Or by many someones, somewheres, each of whom can blame the others for its profligacy, which is what seems to be happening now. The US prints money buy holding real interest rates negative for years, and exports this inflation to the rest of the world via their willingness to support the dollar, which they do by using their own printing presses to maintain "competitive" exchange rates. Both sides blame the other, and we all suffer, with perhaps a bigger lag than in the past, from the resulting inflation.

CDS Exchange

The more I read and think about it, the more obvious it becomes that we need a CDS exchange to contain these financial weapons of mass destruction. The whole point of an exchange is that it pre-regulates leverage in a transparent way and so prevents any crisis of confidence leading to a bank run. Also, you'd think this would be a major opportunity for any of the big exchanges. Jim Hamilton has some clear thinking up on this question.

Specifically, any institution that is in this position of borrowing short and lending long needs to ensure that a certain fraction of the funds it is lending came not from borrowers but instead from the owners of the institution itself, in the form of net equity. The goal is for the size of this net equity to be larger than the losses the institution would incur from selling its less-liquid assets at steep discounts. As long as it is, no creditors ever have reason to demand cash, and there would be no need for the central bank to step in to prevent a self-fulfilling breakdown.

And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion. Much of these were credit-default swaps, in which the seller receives a fee in exchange for promising to pay any losses incurred by the buyer on some specified asset and time interval. If every such asset lost 100% of its value over the period, then maybe Bear is supposed to pay or receive $13.4 trillion. In practice, the actual price moves and net sum owed would be a small fraction of that notional total.

Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You're doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.

Actually, I think if you follow this reason to its logical conclusion, you can start to wonder why we have banks at all -- that is, why we don't just directly allocate all capital through an exchange mechanism like the market? Why don't we just have a bond market and a stock market and dis-intermediate banks entirely? These markets could then have net margin requirements just like the futures market.

As an even more radical thought experiment, imagine what would happen if you made charging interest illegal. Instead, require all capital to be equity capital, that is, all investments are explicitly required to be a non-zero sum game before anybody gets anything. Now some people aren't going to want to take lots of risk with their capital, and they're not going to know enough to want to directly buy stock in a business, and especially not on margin. I imagine banks would re-emerge as aggregators of equity capital that then put this to work in the form of further equity, much like a mutual fund does. Their leverage would in this case be regulated by the margin requirements of the exchange, eliminating any need for futher, and as we have seen largely non-transparent, capital requirements. This is probably a delirious idea, and I'm not even sure it's coherent at the level of the entire economy, but I find it kinda interesting.

Demography is Destiny

This post from the Telegraph may be a bit gloomy overall, but I have to admit that I too wonder whether the prospects for China are quite as bright as everyone thinks.

China's workforce will peak in seven years (the delayed fruit of the one-child policy) and then go into the steepest downward spiral ever seen by a large nation in peacetime. It will, and do so long before it is rich. This demographic implosion cannot be reversed quickly.

In addition, China is hitting some major infrastructure hurdles and higher commodity prices just as demand for their products in the rest of the world slumps. Of course, I still believe that over the long-term, the BRIC economies and other emerging markets will out-pace the US, and if they doesn't, that won't be a positive for the US either. This is also why I can imagine that some of the rises in commodity prices are sustainable over the medium term. In the short-term however, I find it very difficult not to be a bear, and not to essentially agree with the idea of a spreading slowdown that gradually engulfs everything -- the world is too linked and, more importantly, too unbalanced to avoid this right now.

Oil Nonbubble

Paul Krugman dives straight in today with an accessible post about how oil prices cannot be a bubble because there's no inventory. I think his reasoning makes perfect sense -- if the current increase in prices were due purely to financial players operating through the futures market, the prooposed speculative mechanism would involve an increase in inventories, which we are simply not seeing anywhere, as commodity inventories are at multi-decade lows for almost everything. Note that the best candidate for 'speculator' here is, paradoxically, the big ETF's and futures programs of pension funds that are getting into this market as a long-term asset class investment, so the role of speculation here should be read without the usual whiff of moral stigma people give it.

One answer to this has already been proposed -- that there are inventories, but because they are not being counted correctly because of the growth of all kinds of wacky OTC derivatives and other deals that the commodities markets have never seen before. There is an interesting commentary to this effect by a veteran commodities trader here. Of course, it's very hard to validate this line of thinking, which amounts to a sort of dark matter of the inventory world, because by hypothesis, you can't count these inventories. While arousing suspicion though, that fact alone does not mean that the theory is incorrect; the paranoid also have enemies. A related idea would suggest that instead of piling up as inventories, the boom in prices has actually caused a reduction in supply to the market, as we can easily read about grain elevators not accepting more corn simply because they are now unable to hedge against the price volatility. The basic idea remains plausible -- that the unprecedented wave of purely financial money at work in commodities is having an effect on prices -- even if the mechanisms are hard to pin down.

But so then where does this leave us with respect to a price prediction? Is oil going to $200 a barrel like Goldman Sachs says? My own feeling is that there is somewhat of a bubble in commodity prices, even though, like all good bubbles, it got started for fundamental reasons, some of which are still valid over the medium-term. In other words, we are seeing exactly the combination of real and fictitious price increases that makes every bubble so psychologically difficult to identify. If this idea is correct, we could see a major pullback in prices on the basis of speculation drying up, coupled with an almost assured global demand slowdown over the next year or so. A few things complicate this picture. First, as I mentioned, speculation here is less the famous hot money (surely along for the ride though?) than these giant pension fund and endowment ships. That is, financially, the bubble may still be in the inflation phase. Second, the effect of a global slowdown may be offset by negative real interest rates, which naturally makes commodities more attractive as a store of value and an inflation hedge. Finally, commodity prices may not being going back to their 2000 levels. We really do have several billion new and highly inefficient new entrants to the global economy via the industrialization of China and India. Demography is denstiny. In addition, this is happening right at the moment when the externalities associated with commodities are (potentially) going to be internalized in the price.

In summary, while there are good reasons to suspect a correction in prices from current levels, though it may not happen as quickly or dramatically as some think. Commodities may be going through a period of overshoot before reaching a new higher stable price regime.

Unfortunately, as we all know, economics is not a science because ...

THERE ARE NO NUMBERS

Depression though experiments

Jim Hamilton has written one of the simplest and most direct explanations of what happened with the depression in the form of a thought experiment asking what would have happened if the US went back on the gold standard in 2006. The crucial point, I think, is that financial crises are inherently deflationary because you have sudden increase in the demand for money relative to the demand for other things, particularly financial assets. Money comes to be worth more in relative terms, which is the very definition of deflation.

Naturally, given that Ben Bernanke's entire academic career was founded on studying this phenomenon, the Fed is aware of this problem, and is increasing the money supply enormously, even though this means that the price of gold (which we could replace in Hamilton's story with the price of commodities generally) goes through the roof. The trick I suppose is to just balance the deflationary effects of a financial panic with the inflation of the money supply.

SWF Mania

We have all heard this story various times already, but somehow this graph made it strike home visually (I guess I secretly continue to follow Wolfram in thinking that the eye is a pretty good general purpose pattern detector). It makes me wonder as well about the history of the collapse of the British empire -- when did the US start financing the queen, and wasn't that the end for her?

What's still not clear to me is how all of this plays out. Given that these reserves are in dollars, and that these exchange reserves are in the same ballpark as the $1B IMF estimates of US credit losses (coincidence?), I find the final comment of Brad Sester's post compelling:

Felix claimed not so long ago that the US was too big to fail. Certainly many emerging markets are doing their best to finance the US through its current troubles, and thus keep up demand for their oil and goods. But a part of me wonders if the rise in inflation in the Gulf and China and the difficulties both are facing trying to sterilize the rapid growth in the foreign assets is an indicator that there is a small risk that the US also might end up being a bit too large for the emerging world to save.

The US does indeed seem too big to fail at this point. But is China going to, effectively, repossess us? These of course were Buffett's comments several years ago, even though most everyone only paid them lip service. Does this mean that we're going to see a further collapse in the dollar and even higher world-wide commodity prices and inflation? Can the Chinese really frog march themselves to prosperity by financing America's consumerism? They seem to have the cash to re-capitalize the entire credit mess, and we could go on just like before. Somehow though, I just don't see politicians being smart enough to work themselves out of this mess, and that is what is required to correct the market imbalances. In this case, the market cannot re-equilibrate itself without a political solution, which is perhaps the scariest line of thinking of all.

Long-term commodities prices

Having mentioned elsewhere what seem to me the two possible takes on long-term commodity prices:

• Prices go down because the increasing efficiency of production and consumption of basic materials outweighs the population and per capita GDP increases. This is the overall historical trend, even though it doesn't help to tell you how long the current increases can go on.
• Prices going up for Malthusian reasons, or population and consumption overwhelming production.

... I would like to add a third option that has occurred to me that I don't yet know how to evaluate, namely:

• Prices going up because the cost of commodities begins to reflect the social and environmental externalities that we have previously not included in their costs. So far, we have essentially taken out a giant loan from future generations to be able to ignore these costs. Someday it will cost real money to take better care of the planet, and that cost may be reflected directly in commodity prices. either via taxes or continuing supply constraints.

An editorial from Kenneth Rogoff speaks to this point:

... the price mechanism is a much better way to allocate natural resources than fighting wars, as the Western powers did in the last century.

The United States’ ill-considered, biofuels, subsidy programme, demonstrates how not to react.

Rather than acknowledge that high fuel prices are the best way to inspire energy conservation and innovation, the Bush administration has instituted huge subsidies to American farmers to grow grains for biofuel production. Never mind that this is inefficient in terms of water and land use.

Basically, I think that there is a possibility that we may stop letting the government subsidize these markets, and this could cause price increases.