When currencies do not serve as a long-term store of value, economic actors search for ways to preserve future purchasing power, which often mean purchasing commodities. But most commodities are not cheaply storable over long periods, so actors get forced into the few that do: gold, silver, etc. There is a problem here, stemming from dumb money. When dumb money shows up for purchase of generic “commodities” distortions follow: backwardation, large storage demand, and warped market incentives.
Eventually overproduction catches up, but the volatility when it breaks can be huge and self-reinforcing, with c0unterparties raising margin to protect themselves. Extreme volatility causes exchanges to raise margin requirements substantially, which reveals which side of the trade is inadequately financed, which typically is the side that was winning, which leads to a reversal in price action. The dumb money is revealed.
Now after a washout, the dumb money often assumes that powerful entrenched interests colluded against them to deny them their long-deserved free ride to prosperity through speculation. The exchanges are in cahoots with the other side. Well, no, the exchanges have two interests, which are solvency and transaction volume, which drives their profits. Solvency is a more primary goal for an exchange, because the second goal can’t exist without it, and exchanges are not thickly capitalized.
Many different types of financial systems are subject to these risks. Think of AIG: they were rendered insolvent by rising margin requirements as their creditworthiness was downgraded, largely because the rating agencies concluded they were going to lose a lot of money off of their many bets on subprime residential credit. Think of all of the mortgage REITs that got killed as repo haircuts rose on all manner of mortgage-backed securities at the time that values for the securities were depressed. Alternatively, think of Buffett, who entered into derivative trades where he received money and bore the risk, but his agreements limited the margin that he would have to post.
Commodity-linked exchange traded products serve four functions:
- Allow sponsoring financial institutions to get cheap financing through exchange traded notes.
- Allow sponsoring financial institutions to inexpensively hedge their commodity risks.
- Allow commodity producers to have cheap financing of their inventories via backwardation. (And indirectly allow more clever speculators to earn extra profits from gaming the rolling of futures contracts.)
- Allow retail speculators who cannot access the futures market to make or lose money. Scratch that, that should probably read “lose money in aggregate.”
Wall Street does not exist to do small investors/speculators a favor. It exists to make money off of the issuance of securities, and their trading in secondary markets.
As Buffett put it, “What the wise man does in the beginning, the fool does in the end.” Yes, there is monetary debasement going on. We should expect gold, crude oil, and other commodity prices to rise to reflect that. But rises can overshoot, particularly in smaller markets like gasoline and silver.
So in answer to the question, “Which came first – the margin call or the commodities mayhem?” my answer is simple: The cause of the bust is found in the boom, not in the bust. The boom happened because of loose monetary policy, which led many people to adjust their risk posture up, whether in commodity speculation, or in high yield debts. (Oh wait, there are ETFs for that now too.) Eventually self-reinforcing booms have self-reinforcing busts. The elites think they can tame this, but they can’t, because you can’t change human nature, which means you can’t change the boom-bust cycle.
James Grant, at a recent meeting of the Baltimore CFA Society said that we had exchanged a “gold standard” for “Ph. D. economist standard.” And indeed, the value of our currency is manipulated by that intellectual monoculture at the Fed, who pass Einstein’s test of insanity: doing the same thing over and over again and expecting different results. I say that because the Fed thinks that it can produce prosperity by reducing interest rates. All that their policy does is produce an asset bubble, or price inflation in goods and services.
The Fed drove us into this liquidity trap through increasing application of an easy money policy. It will take different ideas and different people, and a lot of pain to get us out, because the Fed is blinded by their bankrupt theories.