Steve Waldman, in a colorful post, “A run on central banks?” contends that the rapid rise of commodities prices isn’t the result of mundane factors like negative real interest rates, but a more fundamental cause: loss of faith in the monetary authorities:
Just as the fear of a bank’s insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much I might criticize it, has not gone on a printing spree…. The Fed’s actions are best described as antideflationary, not inflationary.
But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not… Japan’s central bankers hand out Yen like free acid. China’s guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson’s name to it). Our man Ben is an Amadeus-cum-Macguyver, he’s brilliant, unpredictable, he’ll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB’s Trichet, who at first comes off like a sourpuss, turns out to be alright, when you’ve got some Spanish mortgages to pawn….
So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.
Although commodity prices have been increasing for years, you’ll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB’s refusal to drop interest rates.
This commodities run-up (at least as of 2008) has had the quality of not adding up. The fundamentals are not a sufficient explanation for the velocity of the move. The hype, the desperation, the conviction seem out of proportion to the underlying facts (save in some agricultural commodities). A Journal story today gives indications in the oil market of actions consistent with a price overshoot: inventory accumulation (China and airlines), traders unwinding misplaced bets, leading to further upwards price pressure. Similarly, the predictably contrary Ambrose Evans-Pritchard provides evidence that relief on the supply side is coming sooner than expected. Waldman is right that there is something more at work here.
But is lack of faith in central bankers, as much as it makes for great phrase-making, the best way to frame this? What we are seeing is a large-scale repudiation of financial assets. US stocks have been less badly hit; indeed, the real train wrecks have been in OTC markets.
In a weird way, belief in an inflationary scenario (which is the assumption underlying a commodities run-up, that is, if you accept the speculative hypothesis) reveals a limited degree of trust in central bankers. Investors believe Bernanke will ward off deflation; they see the overhang of debt to GDP and assume inflation is the only way out. Either Bernanke will inflate to diminish the real value of the liabilities, or many of these will effectively be moved over to the Federal government’s balance sheet, and the resulting fiscal deficits will be inflationary.
But consider: narrow money supply growth has been negative, despite the Fed’s aggressive cuts. M3 growth has been very high, due to movement of funds into deposits (that is consistent with general risk aversion and perhaps also deflationary fears). The Fed’s monetary options are severely constrained at this juncture. Even if you use a magic wand and wave away inflation worries, the Fed can cut at most another 1%. It isn’t willing to go into zero nominal interest rate territory. There have been some weak Treasury auctions on the longer end of the yield curve. Even if the Fed were to cut interest rates down the road, any rise in long rates would neutralize its effect via their effects on mortgage markets. Thus the Fed may not be able to provide enough easing to ward off deflation. A re-run of Japan’s experience (with complications due to our lack of savings) is not out of the question.
So many investors are looking into a chasm. It’s not the mind-focusing abyss of mid-March, of possible major meltdown of the financial system (although that danger is still lurking in the background with the credit default swaps market). It’s that they are unmoored. What they know how to do, what they trust, no longer seems to work. Run to commodities? If you think we are going to have stagflation, that’s a simple move in this unsettled environment that makes sense. Run to cash until the smoke clears? That sounds like a good precaution. Buy stocks on dips? Sure, Greenspan provided deep conditioning for that reflex (and hey, even in bad markets, there are always good stocks, right?)
But most investors are in denial about unpleasant truths:
1. Financial assets are far riskier than the press, the textbooks, and conventional methodologies indicate. The models that the pros use are based on assumptions that are fundamentally flawed. The dangers of the erroneous belief that financial assets are safe is now being revealed.
2. The people who control the markets (the intermediaries) have their own, and not the publics’, best interest at heart. Due to the proliferation of OTC markets and the value of assets involved, they cannot be dispensed with. And the regulators lack the skill and will to ride herd on them. As Keynes remarked,
When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
We see ample evidence of that problem, yet seem to lack a way out.
So in a way, these gnawing issues do come around to Waldman’s point. In times of crisis, people look to leaders for guidance. But in our prevailing doctrine of free markets, there are no leaders, just agents interacting in ways purported to produce virtuous outcomes. And the parties who ought to step into the breach fail to understand the need for that role right now. That is why an old fashioned (and very tall) banker like Volcker is so reassuring. He handled a crisis; he’s not afraid to take the reins or say things are bad and changes are needed.
We are at the end of a paradigm: large scale OTC markets, lightly regulated players and instruments, dollar as reserve currency, US as the most important global economic actors. Waldman is good here:
People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan.
But Yeats is better:
Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.