Friday, June 12, 2009

Is the surge in commodities prices due to improved aggregate demand or counterproductive monetary policies?

I would be inclined to support the view that oil prices will continue to rise this year along with other commodities. The issue is whether this will be driven by aggregate demand in the underlying economy or excess liquidity from present monetary policies. We have seen huge speculative swings in commodities prices with the rise of futures markets, where there has been a decoupling with the underlying goods and services economy. So far export markets remain weak and there is a lot of excess productive capacity. Tanker markets have been terrible with very low rates, indicated little movement of physical product. As the panic in financial markets has passed, money seems to be flowing from treasuries and cash back to higher yielding assets like oil and other commodity speculation.

Since last fall as a policy response to the financial crisis, the US has adopted a 'spend our way out of the crisis' strategy based on a revival of Keynesian economics. US politicians have been massively expanding deficits and public borrowing to support these policies. They perceived the financial crisis last fall as a matter of liquidity rather than solvency. They have been socializing losses and bailing out lame duck industry. They have transferred leverage from private balance sheets to sovereign public balance sheets, trying to re-inflate asset prices rather than de-leverage.

The issue is how effective this revered 1930's economic theory will be in today's open economies and global markets as a policy response to the bursting of an asset bubble financed by high debt leverage.

The politics in the US raises the risk of debt monetization. The rise in commodities prices as well as longer term treasury yields may be driven by growing market perception of this danger. If this scenario pans out, it could lead to a very weak, sluggish recovery, plagued by commodity and asset inflation as well as renewed US dollar weakness.

It will be a very interesting fall this year!

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