The Failure of Commodity Market Economics - GROWMARK.com

GROWMARK Research

December 14, 2016

The Failure of Commodity Market Economics How Governments, Academia, and a Global Industry Miss the Major Cause of Price Movements

Executive Summary The currently accepted commodity supply and demand framework does not and cannot explain commodity price movements. Unlike most of the economic world, commodity economics does not even consider the impact of money and spending, and instead measures supply and demand only in terms of the physical amounts created and consumed—even though commodities are priced and exchanged using monetary amounts. Nevertheless, despite the framework’s inadequacy, it is taken as fact and therefore not questioned. However, commodity price movements are correctly and fully explained by the alternative, valid supply and demand model presented here. With respect to the establishment of prices, specifically, demand reflects and must be defined in terms of monetary expenditures, not physical quantities sold. This reality is provable both through logic and mathematics, and is stated both explicitly and implicitly in standard textbooks, if largely ignored by professional commodity analysts. Straightforward market analysis shows that physical supply and physical demand have no relation to prices, but that physical supply and monetary demand explain any price movement of any good in any economy. Thus, in reality, commodity prices are determined no differently than prices of any other good in the economy: by the physical amount supplied to the market and the monetary amount spent to purchase that physical supply. Unlike other economic goods, commodities have experienced a dramatic increase—and subsequent decrease— in spending over the last 15 years, which necessarily dramatically increased (and decreased) their prices. In short, the commodity market experienced a hyperinflation and subsequent deflation that was contained just to that market. In fact, both commodity booms and busts of the last 40 years were solely monetary phenomena, i.e., driven by sudden large changes in the quantity of money spent (i.e., demand). The surge and contraction of monetary expenditures were driven by Wall Street investors making asset allocation shifts to and from commodities. This factor alone explains both the movements of commodity prices and also why most commodity prices move in tandem over the long run, regardless of their differing individual fundamentals.

© 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

Page 1

Even if it were not Wall Street doing the additional spending, someone was, because the only way prices can rise while supply expands is by more money being spent. This is an inescapable law of economics. All instances of rising prices coinciding with expanding supply are instances of additional spending causing price inflation. Commodities experience price inflation in the same way as other goods—just more sporadically. While the supply of individual commodities is an important factor, it is one that usually changes little year by year, and especially decade by decade. But demand—the amount of money being spent on the supply—can change dramatically. Most analysts ignore this elephant in the room, focusing instead mostly on supply, along with other factors of minimal relevance. Any factor affecting the price of a commodity has to be transmitted through either supply or demand. But most popular explanations of prices focus on factors fundamentally extrinsic to either physical supply or physical demand, and therefore must be seen as hypothetical third factors. With the proposed comprehensive understanding of demand as spending, however, all explanations of commodity price movements are revealed as being aspects of either (physical) supply or (monetary) demand.

This research paper should not be considered as representing the views of GROWMARK as a whole. The ideas expressed in this report are those of the author(s) and do not necessarily represent the opinions of GROWMARK management or other GROWMARK analysts.


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Introduction

The explosion and subsequent collapse of commodity prices both in the 1970s and the 2000s surprised analysts of commodity economics. They offered numerous hypotheses, including the Russian wheat deal, OPEC oil price manipulations, supply reductions, global economic growth, Chinese demand, world food shortages, the rise of biofuels, the influence of “marginal” buyers, changes in stocks/inventories and financial speculation. As this paper will show, only the last hypothesis has any plausibility. These faulty explanations, which are “third” factors outside of the traditional supply and demand framework, are proposed—seemingly—because the traditional supply and demand analysis does not explain sudden and dramatic yet sustained movements in commodity prices. The traditional framework correctly calls supply the amount of physical units available, but it incorrectly calls demand the amount of physical units bought/consumed/used. To provide evidence that analysts focus solely on physical quantities, consider Figures 1 and 2. Figure 1 shows USDA’s May 2016 wheat forecast1, consisting of wheat’s supply and demand balance and its individual components. Notice that total supply consists of beginning stocks plus production plus imports. Total demand—called total use here—consists of wheat used for food plus wheat used for seed plus wheat used for feed minus exports. Further, notice that all of these items are referring to

Figure 1: USDA’s May 2016 Wheat supply and demand forecast, showing supply and demand in physical quantities.

Source: USDA World Agricultural Supply and Demand Estimates Report, PDF page 11.

1

http://www.usda.gov/oce/commodity/wasde/latest.pdf © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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physical bushels of wheat, as noted in the table. Figure 2 shows the U.S. Energy Information Administration’s (EIA) forecast and supply/demand balance of crude oil2 in graphical form. Both supply and demand (called consumption here) are in units of million barrels per day. These supply and demand magnitudes are the entirety of the supply and demand framework for these agricultural and energy commodities. These quantities are presumed to explain all price movements the commodities experience, even though no analysis of money exists. There is no consideration whatever of how much money will be spent on these commodities and whether the spending will influence prices. When confronted with the notion of money affecting prices, most commodity economists either reject the idea out of hand, or claim that additional money and spending does not necessarily have an influence. The analysis in Part 1 will prove that spending necessarily does affect prices, and is actually the dominant effect on prices over time. Figure 2: EIA’s May 2016 crude oil supply and demand forecast, showing supply and demand in physical quantities.

Why the traditional supply and demand framework does not seem to explain price movements and why third factors or theories outside the supply and demand framework are needed is not discussed. On the contrary, traditional commodity analysts implicitly and abstractly attach the new theory(s) onto the traditional supply and demand framework.

2

https://www.eia.gov/forecasts/steo/report/global_oil.cfm © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

Page 4

They tend to assume that whatever prices do, their movement reflects the natural market response to the workings of physical supply and demand, as theorized by mainstream economists. This is the case even though the physical supply and demand data do not actually fit with the popular theory at the time. For example, the hypothesis that demand from China drove up commodity prices during the 2000s is not supported by an actual increase in the formal commodity demand numbers, as most commodities did not experience increased purchases by China. Even if one or two commodities saw a large increase in consumption by China, the increase in consumption was still not enough to explain the dramatically greater increase in price the commodity experienced. Likewise, it would not explain how the prices of other, different commodities also rose to the same extent when their demand from China was unchanged. None-the-less, the commodity boom is commonly attributed to both “demand from China” and the interaction of physical supply and demand (see our paper on China, which has a link at end of this document). This report will analyze, in detail, the logic, functionality and “fit” of the current supply and demand model as widely understood in commodity economics today, explaining why the model is an impossible candidate for the explanation of commodity price movements. In short, it will prove that the current framework is faulty. Part 1 of the paper presents an alternative supply and demand (S/D) model that is able to perfectly explain every single price movement, along with the reason for why this correct model works. Part 2 will present empirical data serving as evidence of the correctness of this alternative model.


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1. What Is Demand? The crux of the problem with the popular S/D model is primarily with the demand component, and the focus of this paper is the question of exactly what constitutes demand. Thus, Part 1 will analyze and correct the current definition of demand. The other half of the S/D model, supply, along with other factors commonly seen as part of the fundamentals, such as stocks and global events, are addressed at the end of Part 1.

The Concept of “Demand” While the word demand is tossed around daily, consideration is rarely given to what demand actually means, or should mean—or even what text books say it means. Real demand is a function of what is produced. One can demand something—purchase something—only with what he has to exchange in return. What he exchanges must be something he has already produced: products are ultimately paid for with products. The baker exchanges bread he baked for shoes the shoemaker made. The shoes pay for the bread, and the bread pays for the shoes. The more one produces, or supplies, the more he can exchange for other products or services produced by other people. The more one produces, the greater is his demand. Thus, supply creates demand. A price is merely a ratio. For example, suppose in a given year the baker exchanges one loaf of bread for one pair of shoes. The pair of shoes is obtained by the baker in exchange for a loaf of bread. So the price of the pair of shoes is one loaf of bread. In other words, the ratio is 1/1. But consider what happens the next year when it takes two loaves of bread to buy one pair of shoes. In this case, the ratio of bread to shoes is 2/1. The two different exchanges are summarized in Figure 3. Figure 3: A summary of two different exchanges between a baker and shoe maker.

Clearly, the price of the shoes is the ratio of bread to shoes. The price is the ratio of what is spent to what is bought, or what is demanded to what is supplied3. The bread is the demand and the shoes are the supply. This is no different from how currencies are priced against one another on foreign exchange markets: their price is the ratio of how much of one currency is spent, or exchanges, for another. It is also how goods are priced on a store shelf: so many dollars exchange for so many units of goods.

3

The term demanded in this case refers to how much one turns over in an exchange. They are demanding (buying) with their own supply. This is not to be confused with the concept of quantity demanded, which refers to physical supply of the seller that is purchased with the supply of the buyer. © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

Page 6

Contrast this understanding with the traditional S/D model. While it correctly calls “supply” the number of units produced or available for sale, it calls “demand” the number of units bought; it conceives of both supply and demand in terms of physical quantities. In the preceding analysis where the price becomes $2, the traditional S/D model would say that in year one, the demand is one pair of shoes, while the supply is also one pair of shoes. More importantly, it would also say that demand and supply are both still one pair of shoes in year two as well (Figure 4). Thus, traditional S/D economics would say demand and supply remained unchanged even though the price doubled! That is why the traditional model has to look to third explanations to explain price movements. Figure 4: The two different exchanges from Figure 1 using the traditional S/D framework.

The problem is solved by fully grasping that demand is actually the amount spent, not units purchased. No matter how common it is to call demand the taking possession of the physical product, the taking of the product is meaningless for price-setting without knowing how much is spent for the physical product. Products are bought by exchanging a certain sum for them, not by just physically acquiring them. Demand (as it relates to price determination) is, therefore, always represented by actual spending, not by the mere want or desire for something. Demand is the will plus the ability to purchase. Someone might have a “demand” for a good or service, but unless he can hand over a certain amount of spending, his demand is meaningless. Therefore, theoretical demand, or mere longing, is infinite. True demand is defined only by actual spending.

Demand and Prices In today’s world, tangible goods are not usually traded directly for other goods though bartering. Instead, currencies (i.e., money) are used to represent the relative exchange values of the goods being traded. Thus, it is the expenditure of money that is the specific type of demand which sets the price for a product, as goods are priced in money, not in physical units such as bread or shoes. Prices are defined as the ratio of money for goods: a certain amount of money trades for a certain amount of goods. Thus, the updated price formula is:


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For example, in 2008, $49.1 billion was spent to purchase 12.1 billion bushels of corn in the U.S., resulting in an average 2008 corn price of $4.06. But in 2011, $76.9 billion was spent to purchase 12.4 bushels, resulting in an average 2011 price of $6.22 (Figure 5). Since the supply between the two years remained about the same, the only factor driving prices higher was the 57% increase in spending for the same amount of supply. Figure 5: The derivation of the average annual corn farm price in two different years, showing that the only difference was the increased amount of spending.

The price of any good in any given period of time is the demand divided by the supply, i.e., the quotient of the amount of money spent and the number of units sold. Figure 6 provides an example in the form of the derivation of the average farm price of corn for each year since 1994. Figure 6: The mathematical derivation of the average annual corn price since 1994.

$7.00

Corn Price Trend

$6.00

Demand Amount Spent = Price = Supply Units Sold

$

$5.00

$ $

$4.00

,

,

,

,

$3.27

$1.00

$

,

,

$ $

$2.43

1994

$1.94 ,

,

,

,

,

,

,

,

,

,

,

$1.81

,

,

,

,

,

,

=$ .

=$ .

$2.33

2000

$2.06

$1.99 $

=$ .

1998

$3.05

=$ .

$2.43

=$ .

$1.87

1996

,

=$ .

$6.89

$6.22

$5.35

$4.19

$4.48

$4.06

$2.72

$2.00

,

,

,

=$ .

$3.00

$2.28

,

$

2002

,

,

,

,

2004

$3.68 $3.57

$

,

,

,

,

=$ .

$

,

,

,

,

=$ .

$2.00 =$ .

2006

2008

2010

2012

2014

Source: USDA Agricultural Marketing Service, author’s calculations


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In this example, the average corn price in any given year is the quotient of the numerator and denominator—the spending and the number of units sold. That is how a price becomes a price. There is no other way it could be established. To simplify the point even more, consider a t-shirt that sells for $10. The selling price is $10 because $10 was handed over. $10 for one t-shirt equals a price of $10. If the selling price becomes $20, it is because $20 was handed over for the t-shirt. The price is the amount of money spent.4 The spending is the price. Prices are obviously a monetary value. But when both supply and demand are expressed in physical units, there is nothing in the equation that yields a monetary figure. Merely counting how many units were purchased says nothing about the price paid, nor does it explain the price paid.

Demand, Inflation and Commodity Prices In Figure 6, the price of corn rose when spending, or demand, increased at a faster pace than did supply. This is how all prices rise, whether it is the price of t-shirts, soybeans, automobiles, movie theatre tickets or housing. Prices rise when the growth of money in a market—be it a single market or entire economy—outpaces the growth of goods and services. When the supply of money in a market grows, the new and additional money is spent on things. Those things then rise in price. Some things like computers fall in price. This is because the growth in the supply of computers outpaces the spending for computers. Is the argument here that rising commodity prices are simply price inflation, as is the case with rising consumer prices? Yes, it is. Both consumer prices and commodity prices rise because demand, or spending, increases faster than the supply of the things on which the money is being spent. People commonly accept that consumer prices rise because of an increase in the quantity of money being created and spent. But they do not commonly consider that an increase in money would necessarily raise all types of prices—both consumer prices and the prices of financial assets such as stocks, bonds, houses and commodities. They do not consider that asset price inflation is inflation no less than consumer price inflation. Though the timing and means by which new money makes its way into financial/commodity markets might be much different than consumer prices, it does make its way there and necessarily raises prices in those markets. Conversely, prices in those markets simply could not rise in absence of an increase in money and spending (given that supply is not falling).5

4

Indeed, the $10 and $20 was handed over because the seller asked for that much. But a seller prices products at the most he thinks a market will bear. If he asked $100, he would not get many people to hand money over. In the commodity markets too, sellers price products at levels they think buyers will pay. As they see buyers willing to spend more and more money, they ask higher and higher prices because they know they will get takers. The formal selling price is established once buyers actually hand the money over. 5 Though most economists agree that rising consumer prices are due to increases in the money supply, many economists also believe, and textbooks even state, that prices can increase as a result of economic growth. But this is demonstrably wrong. Economic growth refers to an increasing quantity of goods and services in a country (an increase in supply), which lowers prices, because it results in the same amount of money purchasing an increased amount of goods. The businesses and individuals who produce these products and services do not produce money. Only the central bank can produce (i.e., print) money. Rising prices are a result solely of the central bank adding additional money to the economy; they are completely unrelated to economic actors producing goods and services. The central bank creates money concurrently while producers produce non-monetary items. As the price formula on page © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

Page 9

Ultimately, calling demand the physical product obtained leads to supply and demand in the commodities world being essentially the same thing. This is because what is consumed is what has previously been produced. Most of the commodities produced in any given year are sold that year. Some that are held over in stocks/inventories might sell the following year, but a comparable amount is held over each year. So the annual production amount ends up being about the same as the annual amount consumed. Thus over time, demand cannot differ much from supply. An example is Figure 7, where corn production is volatile some years, but averages out to be about the same as consumption/usage. Through time, the two values are roughly equal. Consumption/usage is just the recent quantities produced being consumed. What dictates the level of consumption in general—especially over, say, a several-year period—is simply what has been created. What is created will soon be consumed. Thus, physical supply and physical demand are really the same thing. They are two sides of the same coin.

Millions

Figure 7: Corn supply and demand since 1960, showing that the two variables move in synch over time, because they are two sides of the same coin.

12

Production + Imports

Usage

10 8 6 4 2 1960 1966 1972 1978 1984 1990 1996 2002 2008 2014 Source: USDA Agricultural Marketing Service

This fact becomes more apparent when looking at commodities whose level of stocks/inventories is relatively stable. Crude oil stocks, for example, oscillate in a range which averages out to about the same volume over time, which keeps the stocks level rather flat. So in any given year, supply is virtually exactly the same as demand. (The formal supply and demand numbers do not quite show the full extent of this correlation, as crude oil supply and demand data are not strictly comparable because they are based on different sources and on estimates.) Figure 8 shows crude oil supply and demand. The widest gap on the chart between supply and demand is just a 2.2% difference; the two lines are almost identical throughout the entire chart (the margin of error is >2%, and

4 shows, without new and additional quantities of money, prices would fall as the supply of goods and services increased (as they used to before the advent of central banking). This is because the same quantity of money would have to be spent on increasing amounts of things in the economy, causing the per-unit price to fall. Rising prices economy-wide have nothing to do with economic activity. They have solely to do with money-printing by the central bank.


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EIA periodic updates result in changes to these figures by more than 1%). Figure 9 has the price of crude oil added to the chart. It should be immediately obvious in Figure 9 that the price line is much more volatile than the supply and demand lines, which by contrast look straight and unchanging, and indistinguishable (there are two lines there still, it is just difficult to see both). It should also be obvious that analysts attribute relatively unchanged supply and demand as a cause of wildly erratic prices. Figures 8 and 9: Crude oil supply and demand (left chart) and supply and demand with price added (right chart). Figure 8 100 95 90

Figure 9 500

Supply Demand

450

(Million Barrels Per Day)

400 350

Supply Demand Price (Indexed)

300

85

250 200

80

150

75

100 50

70

2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: Energy Information Agency (EIA).

2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: Energy Information Agency (EIA).

Conventional commodity analysis holds that the wild, erratic black line (price) in Figure 9 is determined by the very subtle changes of the two blue lines (supply and demand). It should be immediately obvious that such a relationship is impossible. The price is obviously moving for other reasons besides the virtually identical movements of the physical supply and demand levels. Conventional economics does not offer an explanation for how a 2% change between supply and demand can cause a 50% change in price. Much less could it explain how the same 2% positive change in supply and demand could cause a price increase in one year, but a price decrease or lack of change in price in the next year. This is precisely what occurs. Analysts typically exclaim “well that is how the market reacted to that information” (i.e., to that supply/demand change). In actuality, the “market reacts” by way of individuals spending money or taking money away, and by offering or taking away supply. It is mathematically impossible for such slight changes in supply and demand to cause extreme movements in price. Consider 2009, where crude oil demand was just about unchanged from 2008, while supply fell 1.5%. Prices rose 61% over that year. The 1.5% reduction in supply could not be responsible for a 61% rise in prices. To prove this, consider the price formula on page 4. If the same $1.528 trillion that was spent in the oil market in 2008 was spent in 2009 (if money is not the determining factor, it remains unchanged), then the price of crude oil could have risen only 1.48%, to 49.50, as shown in Figure 10.


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Figure 10: The mathematical derivation of crude oil prices in 2008 and hypothetically in 2009, keeping the 2008 spending level constant. Crude oil price

2008:

$1.528 trillion 85.75 mln bl./day

=

$48.82

2009:

$1.528 trillion 84.5 mln bl./day

=

$49.50

What drove the price higher was not the small reduction in supply; rather it was the very large increase in spending, or demand, in the crude oil market. But why would the market spend so much more or less money over such minor S/D changes? Most often, the large demand changes are caused by a desire to invest in commodities as an asset class. That event is unrelated to the economic fundamentals of commodities, as will be explained below. The same math above reveals that it is impossible for prices to rise to new heights without a greater quantity of money entering the market. The math also proves that new money entering the market must necessarily raise prices. For new money to enter a market, it has to actually purchase a commodity in order to be in a commodity market. If it buys the commodity, the new and additional money must raise the price. A payment of $20 cannot buy a formerly-$10-t-shirt without the price of the t-shirt becoming $20 instead of $10. This is an important fact, especially given that many observers claim that additional money merely adds so-called liquidity to markets without affecting the price.6 This argument shows that money is not only unrelated to the production and supply of commodities, but it is an independent causal force that has a life of its own. A doubling of the quantity of money spent on a commodity will—all else being equal—double the price of the commodity. In this way, the quantity of money is most definitely part of the “fundamentals” of the commodity markets. In fact, since it constitutes demand, it is half of the fundamentals. This means that mainstream economists ignore half of all commodity market fundamentals. Figures 11 and 12 bring monetary demand into the chart from Figure 9 to better show that the dominant force affecting oil prices is not the very small changes in physical supply or demand, but instead very large changes in spending. The first chart is in nominal values while the second is in terms of the annual rate of change. The gap between monetary demand and price in the charts, between the red line and the black line, is caused by the change in supply each year (think of the price formula above). Clearly, since the volume of supply in the crude oil market changes much less than the volume of spending, crude oil prices are driven a little by supply changes, but mostly by changes in monetary demand (spending). But they are not driven at all by changes in physical demand, i.e., consumption or usage. The same applies to all exchange-traded commodities.

6

The observers confuse the spending of additional money in a market with the velocity with which the already existing money in a market is re-spent (how often trades are made), along with the volume changes of securities traded in the market. © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

Page 12

Figures 11 and 12: Crude oil price, supply and demand, with monetary demand added. Figure 11 is in nominal terms while Figure 12 is in terms of annual percentage change. Figure 11 550 500 450 400 350 300 250 200 150 100 50

Monetary Demand Price Supply Demand

Figure 12

70% 50% 30% 10%

(Indexed)

-10% -30% -50%

(Indexed)

2000 2002 2004 2006 2008 2010 2012 2014 2016 2000 2002 2004 2006 2008 2010 2012 2014 2016

Source: Energy Information Agency (EIA), author’s calculations.

Supply

Demand

Price

Monetary Demand

Source: Energy Information Agency (EIA), author’s calculations.

Economists use physical units for both supply and demand because they want to think in terms of having comparable things to match up to assess whether supply and demand are in balance. We propose that they are looking at things the wrong way. In the sense of establishing a price, supply and demand are always in balance; otherwise no exchange of money for commodities would take place. They are in balance because when some amount of money is spent for some amount of physical supply, the exchange results in some price being established. The exchange creates the balance. From a physical perspective, it is wrong to think that price movements reveal something about how many units people want to buy versus how many units are available when the price moves drastically while the physical units supplied and sold change very little. Indeed, a large physical mismatch can cause people to spend a lot more or a lot less money, but the physical imbalance is only one of many factors that can cause spending levels to change. Another factor is economy-wide or localized inflation, as has been shown with the crude oil example. With trillions of dollars being created each year by the central bank and flowing from banks to Wall Street, and with commodity markets so very small relative to other financial markets, the amount of money being spent in the commodity markets changes very rapidly and in large proportions—separate from the underlying desire to buy or sell the physical commodity. What counts for establishing a price is not how many units were purchased, but how much money was spent to make that purchase. Commodity economics completely (or mostly) ignores the quantity of money brought into and spent in a market and implicitly pretends that the price had nothing to do with these changes in the money flow (i.e., money flowing from one asset market to another). Rather, it focuses only on the physical actions of producing and buying products.


Page 13

Economic Textbooks Say Demand Is Spending While mainstream economic textbooks state that demand is “the amount of goods or services consumers are willing and able to purchase at each price7,” they implicitly (microeconomics) and explicitly (macroeconomics) show that changes in demand (a shift in the demand curve) are based upon changes in the quantity of money spent. Below is the list of factors that these textbooks say cause a shift in the demand curve (with a focus on increases in demand), along with the author’s commentary, showing how each factor is a monetary factor. In Microeconomics:     

Changes in incomes Changes in wealth Changes in prices of alternative products Changes in tastes and preferences Expectations about future income, wealth and prices

Changes in incomes: Average or aggregate incomes can increase only when additional quantities of money are added to the economy. Incomes do not increase from workers creating more goods; they increase due to increasing volumes of money pushing up the prices of workers (along with the prices of consumer goods). Money creation is not part of the economic process of creating goods and services. It is a separate and unrelated act of a country’s central bank literally creating it out of thin air. Changes in wealth: Similar to incomes, average or aggregate wealth can increase only when there is an additional quantity of money in the economy that allows an increased quantity of goods to each sell for higher prices. Changes in prices of alternative products: If an alternate product price rose, people would spend less for that product and more on a competing product. Therefore, money would “flow” from one product market to another, lowering the price of the product where the money left, and raising the price of the product to which the spending was redirected. Changes in tastes and preferences: The effect is the same as that of changes in prices of alternative products: more or less money would be spent in a particular market when buyers choose or do not choose competing purchases. Expectations about future income, wealth and prices: If buyers think the price will rise in the future—which could not happen in actuality without either a reduction in supply or an increase in the quantity of money available—they will spend sooner/more often in the present. The increased amount of money spent currently, by way of an increase in the speed of making transactions or the “velocity of circulation,” as opposed to later, will raise prices higher than they would have been without expectations of future price increases.

7

As shown in this online macroeconomics textbook provided by Rice University: http://openstaxcollege.org/files/textbook_version/hi_res_pdf/27/col11626-op.pdf © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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In Macroeconomics:   

Changes in the money supply Changes in tax rates/receipts Changes in government spending

Changes in the money supply: This is self-evident as a monetary factor: an increase in the supply of money will raise prices—assuming supply does not increase to the same extent. Tax cuts: With more money in the hands of consumers due to fewer taxes paid to the government, consumers have more money to spend on goods and services. In reality the total economy-wide spending would be unchanged, because increased spending by consumers comes from reduced spending by the government. Increase in government spending: If government spending increases, more money is spent in the economy. The government can spend more only by: 1) taking spending away from citizens or bond investors, or 2) printing more money at its central bank. In the first scenario, total spending in the economy is largely unchanged. In the second scenario, there is a greater quantity of money being spent. It is the same scenario as the first macroeconomic bullet point “Increases in the Money Supply.” Whether in microeconomics or macroeconomics, every explanation textbooks give for causes of changes in the demand curve consists of changes in spending. Thus, changes in spending—changes in the quantity of money in particular markets at particular times—is the sole driver of changes in demand. To quickly mentally concretize this notion, consider that the discussion thus far has entailed smaller changes in commodity market spending. Now broadly expand the scope and consider instead how commodity prices in countries with hyperinflation, for example, can increase by a million percent per year or more—all for reasons unrelated to the commodity. The only big change in this scenario is a large economy-wide increase in the quantity of money. Now zoom back in and think about that commodity prices in some countries can incur large inflows of money not from an economy-wide increase in inflation, but instead a narrow increase in money coming from other asset markets in the same country (i.e., money flows). Demand changes are necessarily monetary-oriented changes, not quantity-oriented changes. Therefore, demand, as far as price determination goes, should always be in the form of monetary amounts, not physical quantities. What About the Fundamentals? If spending is such a significant driver of commodity prices, what importance do the “fundamentals,” such as weather, yield, production, stocks/inventories, economic growth and inflation have? It should first be understood that the bottom-line fundamentals consist only of supply and demand. Nothing except supply and demand moves prices, as the price formula has shown. Therefore, every factor that affects commodity prices rolls up into, and is transmitted via, either supply or demand. Similarly, any other “story” or “theme” held to affect commodity prices such as China, growing economies, a hungry world needing food, or


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OPEC manipulation, can influence prices only by changing supply or demand. They will affect either the quantity of physical product sold on the market, or the quantity of money spent on that physical product. Factors such as weather, yield, soil moisture, production and OPEC manipulations affect how much of a commodity is supplied. They do not change the quantity spent (demand) for the commodity. Indeed, concern about these changing factors could cause market participants to spend more or less. Yet the fact is that during periods where large amounts of money are not entering the commodity market from external sources, spending does not actually change when these supply-oriented factors change, apart from small, fleeting spending changes initiated by day traders. Spending/demand changes in the commodity market come from two primary sources. The first is normal economy-wide price inflation, where new and additional money entering the economy from the central bank flows into the commodity industry(s) as it does every other part of the economy. The second source is that of monies being redirected from other financial asset markets into commodities as part of asset allocation plays by Wall Street, as discussed in Part 2 below. This large, sudden increase in money can be considered hyperinflation. Stocks/inventories, while commonly viewed as a major component of supply, are actually not part of supply and have no effect on either supply or demand—except through spending changes based on the false perception that they do. Stocks are kept off of the market, and are not actively offered for sale. Since they are not part of the supply actually on the market, they cannot contribute towards affecting supply or prices (think of the price formula). Consider, for example, a classic 1957 Chevy automobile. The market price of the Chevy this year is based on prices the cars have actually sold for this year, and/or the price at which they were offered for sale this year. The Chevys that are sitting in barns or car museums and not offered for sale (i.e., stocks of Chevys), did not play a role in setting this year’s price—except to the extent the knowledge that these cars exist and might soon be available for sale affected the decision of buyers to spend this year, or of suppliers to sell this year (but since the number of Chevys coming to market each year should be comparable, there is no reason this knowledge should change significantly each year). But, had the owners of all the Chevys in barns or museums suddenly also offered their cars for sale in the current year, the price being paid for 1957 Chevys would, in turn, suddenly fall significantly since the supply would suddenly greatly increase. Until they were part of the active supply on the market, they were not part of the active supply on the market. For much more information and analyses on stocks, please see our “Stocks” paper link on the last page of this document. Also contrary to conventional wisdom of the industry, economic growth does not lift commodity prices. It lowers them. Economic growth consists of an increase in production and supply of goods and services, including the production and supply of commodities. An increase in supply lowers prices, as the price formula has shown (see page 4 of our “China” paper for a detailed explanation). An increased supply of goods is the only means by which standards of living rise, i.e., that economies grow. They rise from prices falling, not from workers being paid higher money wages. Commodity analysts theorize that as economies grow, countries need more materials, such as metals and energy, with which to build things, and that economic agents therefore lift prices with their increased “demand.” But since economic growth consists of producing more goods like commodities, economic agents are thus merely enabled to build still more things, because of the existence of more materials. They will use as much material as is


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available, since there are always more goods needed by consumers. As explained earlier, how much of a commodity is used is a function of how much is produced.8 Economic agents do not “demand” more commodities by using the increased amount produced each year over the prior year, as using what is created is not “demand.” Demand is expressed by spending money. To “demand” more commodities, more money has to be spent. But where does the additional money come from? A growing economy does not produce more money, it produces goods. Only the central bank produces money, but money printing neither causes economic growth, nor is caused by it. So if economic agents have more money with which to “demand” more commodities, that is merely the result of central bank money-printing (or money flows from other markets), not a result of economic growth. If no more money was ever printed, and/or if no more money ever flowed into the commodity market, there would be the same quantity of money spent there every year while the supply increased. With the same quantity of money being spent on a larger quantity of goods, per unit prices would then fall every year, even while consumption/use increased every year. Consider, for example, that the nominal price of crude oil fell or stayed the same between its creation in the mid-1800s and 1970, while both U.S and world economic growth grew dramatically. This is because the crude oil market did not experience large increases of money inflows (demand) over that time. Inflation is not something that affects commodity prices per-se, it is the manifestation of commodity prices going higher. Rising commodity prices is inflation. Sometimes, it is a normal, slow price inflation, and sometimes there is a hyperinflation that takes place in the commodity markets. During non-money flow periods where large amounts of external money are not flowing into the commodity markets, the amount of commodities supplied to the market (i.e., supply) changes much more rapidly each year than the amount spent on commodities (i.e., demand)—though over time normal price inflation (which is also demand) grows at about the same pace as supply, thus keeping commodity prices from falling as they otherwise would as supply increases. But during money flow periods (1971-1980 and 2001-2013, most recently) demand/spending changes much more rapidly than does supply. During these periods, if supply increases about 2% on average, prices would theoretically fall about 2%. But since the volume of money flows (demand) are increasing at, say 20% per year, then prices rise 18%. During money flow periods it is naive to think that supply changes of less than 5% or so are significantly affecting prices, because they are vastly overwhelmed by spending/demand changes.9 Similarly, since there is both normal price inflation and money flows (which do ultimately reverse to a large degree) occurring over time, and since these outpace supply changes over time—preventing prices from falling— demand/spending changes are by far the dominant factor affecting commodity prices over time.

8

This does not mean that there is always a need for every commodity. But as long as a commodity has a use in an economy, all that is produced of that commodity will be used. 9 The supply changes during these periods occur while the spending changes—which would take place regardless of supply changes—are occurring. Observers are fooled into thinking that the large price moves are due to the supply changes, when in fact they are not. Traders directing the money flows simply make trades in response to supply changes (and traders themselves believe the supply changes are moving prices), alongside other longer-term trades they are making. Thus, supply changes have a price reaction for the very same supply event (same magnitude) that is four times greater during money flow periods than non-money flow periods. The money is driving the price, but everyone involved believes it’s the supply. © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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2. Empirical Evidence that Money Drives Commodity Prices Though Part 1 presented mathematical proof that monetary demand is the dominant force exerted on prices, the goal of presenting the circumstantial evidence in this part is to reinforce that idea. The material below is an amalgam of different macroeconomic and commodity market prices, which as a diverse collection, should give a convincing picture of the commanding influence of money on prices. As most of the charts presented below are different subject matter, there is no constant theme running from one to the next. Instead, they are individual examples supporting the overall argument that monetary changes drive prices as much or more than do supply changes. Correlated Commodity Prices Simply looking at the evolution of commodity prices and how they tend to move together over time should reveal that there is some other force that prices seem to respond to more than the traditional fundamentals—especially since different commodities have different patterns of supply, physical demand and other “fundamental” attributes such as inventories/stocks that are considered fundamentals. Figure 13a and Figure 13b show how four particular agricultural commodities have very different production and stock patterns. Yet Figure 13c illustrates how much the prices of these four disparate crops move almost in tandem with each other over the long run. Regardless of their different production or inventory (stock) levels at different points in time, the prices of the individual commodities each move to new highs, fall from new highs, or flat-line at nearly the very same time. As further evidence that monetary demand is the dominant force driving the shared price pattern of the crops, consider that the same price pattern applies to most other commodities. Figure 13d and Figure 13E show that familiar price pattern shared by the entire grain complex, the entire agriculture complex, and all commodities in general. What all of these commodities share are a broad commodity price inflation resulting from new and additional money spent in the commodity market, where the spending is spread across all commodities in similar fashion. Another example of money affecting all commodity prices similarly is the 2008 financial crisis, which is discussed more below. The fact that commodities across the board collapsed more than 50% all at once shows that there had to be a single, driving force moving those prices. Since supply across all those commodities was unchanged during that short time period, the driving force had to be the change in demand. Further, that reduced demand must have come from the largest buyer of commodities—Wall Street.


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Figure 13 The evolution of production, stocks and (farm) prices of four crops, as well as prices of grains, all agriculture and all commodities (Figure 13D), showing the uniformity of (futures) price movement of different commodities. All data is indexed. Figure 13A: Production

Figure 13B: Stocks

3

2

2 1 1 0

0 1960

1970

1980

Corn

1990

Wheat

2000 Barley

1960

2010 Oats

1970

1980

Corn

1990

Wheat

Figure 13C: Prices

2000 Barley

2010 Oats

Figure 13D: Prices

7

7

5

5

3

3 1

1 1960

1970

1980

Corn

1990

Wheat

2000 Barley

1960

2010

1970

1980

Agriculture

Oats

1990

2000

Grains

2010

All Commodities

Source for charts 11A-11C: USDA Agricultural Marketing Service; Source for 11D: Quandl.com

Figure 13E: Prices 4.5 3.5 2.5 1.5 0.5 -0.5 -1.5 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Coal Rubber Copper Cash

Heating Oil Lead Iron Ore

Uranium Aluminum Gold

Barley Nickel Silver

Sorghum Tin Platinum

Wheat Zinc


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The Wall Street Effect The specific inflation, or money flows, affecting U.S. dollar-based commodity prices in recent years are those instigated predominately by Wall Street investors, i.e., banks, investment firms, hedge firms, broker-dealers and the like, who, cumulatively, far outspend other buyers. Though Wall Street money has always been in the commodity futures markets to a smaller degree, unprecedented quantities of money flowed into the market between 2002 and 2006 (1998 for the energy markets), as investors sought “new” markets that were less correlated with other asset classes.10 The apparent inspiration for this change was a series of academic papers in the late 1990s and early 2000s showing an inverse correlation between commodities and other asset classes. In the early to mid-2000s the volume of spending in the futures markets increased by a factor of four to six times its prior level (Figure 14). In this case the new money did not come directly from the central bank; it came from other asset markets. Wall St. fund managers diversified into commodities by redirecting just a small amount of funds from stock and bond investments. The U.S. stock and bond market together are worth about $65 trillion as compared to a mere $1 trillion valuation of the commodity markets. Thus, re-allocating just 2% of funds from the stock and bond markets would more than double prices in the commodity markets. This is what happened. Wall Street money flows cause the prices of most individual commodities to move more or less in sync with each other, as investors tend to buy across all commodities when they invest, and sell across all commodities when they exit commodities, or just quickly deleverage. Perceived—and real—increased financial risk in 2008 caused investors to suddenly shed commodities, sending prices across the board 40-60% lower, along with all other financial asset prices. Although these financial investors/speculators have nothing to do with the various industries that produce or use commodities, they nonetheless are buyers of commodities and they compete against traditional buyers (i.e., users of commodities) with their investment dollars. They outbid the traditional commodity buyers. In fact, in recent years financial/speculator purchasing has represented the vast majority of spending in the futures market. For example, between 2006 and 2013, over 65% of transactions in the corn futures market consisted of investor money, and 40% of those transactions came from index investors specifically. Similarly, 82% of spending in the wheat market was done by Wall Street, as was 87% in the oil futures market. Additionally, 80% of trades on the futures market consisted of day trading, not long-term purchases. Clearly, Wall Street has dominated the commodity markets.

10

Some argue that the futures markets are a zero-sum game not affected by money. But two things must be remembered. First, futures contracts have a price people pay (even if they pay only the initial margin). Buyers are handing over a certain sum of money. One has to ask how much they are handing over and why, and whether new money or participants entered that market. Second, not all futures contracts are zero-sum. For some contracts there is physical delivery of physical commodities—the thing which all other market participants are pricing. For these, actual money is being handed over for a commodity.)


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Figure 14: Total futures market spending since 1986 on the commodities listed in the chart.

Source: CFTC, authors’ calculations

The charts in Figure 15 give a visual depiction of the vast volumes of Wall Street spending by showing the money flow of both commercial-oriented traders and of Wall Street in the corn, live cattle, cotton and crude oil markets.11 The information is based on CFTC Commitment of Traders (COT) data. The first chart uses the old CFTC reports while the other charts use the newer, more accurate and detailed data. Whereas commercial spending used to be between 75-90% of the spending in these markets in the old corn data, as of 2013 it averaged 20-30%—even as its nominal volume has increased, not decreased. It is monetary factors unrelated to the production and supply of commodities that are most affecting commodity prices.

11

Money flow is equal to price times open interest, since price times quantity equals total revenues/total spending. The difference between total spending and price, i.e., the extent to which the two do not move perfectly in alignment, is due to changes in supply, which in this case is changes in the number of contracts. © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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Figure 15: Futures market spending divided between Wall Street and non-Wall Street players for different commodities (left-hand side is price; right-hand side is billions of dollars in spending)12. 11A: Corn (Old Data)

$9

$60

Financial Money Flow Wall St. Money Flow Commercial Money Flow

$8

$50

Corn Pricel

$7

$40

$6

$30

$5

$10

$3 $2

$0 1999

2001

2003

2005

2007

2009

2011

2013

2015

Billions

$20

$4

Source for all charts: U.S. Commodity Futures Trading Commission, authors’ calculations.

11B: Corn (New Data)

$8 $7

Financial MoneyFlow Flow Wall St. Money Nonclassified Purchasers Commercial Money Flow Corn Price $/Bushel

$6

$50 $40 $30

$5

$20

$4

$10

$3 $2

$2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

12

$60

Billions

$9

Cotton and live cattle charts contain futures prices, while corn contains cash price. Detailed data was not kept prior to 2006. © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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11C: Live Cattle Wall Financial/Speculator St. Money Flow Money Flow

$165

Nonclassified Purchasers

$145

$20

Commercial Money Flow Live Cattle Price (cents/CWT)

$125 $105

$15 $10

$85

$45

Billions

$5

$65

$2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 11D: Cotton Wall St. Money FlowMoney Flow Financial/Speculator

$195 $175 $155 $135 $115 $95 $75 $55 $35 $15

Nonclassified Purchasers Commercial Money Flow

Billions

Cotton Price (cents/lb.)

$18 $16 $14 $12 $10 $8 $6 $4 $2 $-

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 11E: Crude Oil

$130 $110

Wall St. Money Flow Financial Money Flow Nonclassified Purchasers Commercial Money Flow Crude Oil Price $/Barrel

$200 $150

$90 $70

$100

$50

$50

$30 $10

$250

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

$0

Billions

$150


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The Big Picture of Inflation Commodity prices worldwide used to fall over time—while economic growth was very strong (Figure 16). This is because the supply of products and services, including agricultural products, increased at a faster pace than did the supply of money in the economy. Prices were still very volatile due to constant expansions and contractions of credit by banks, but because the world was on a gold standard, the overall money supply could grow only as fast as the world could dig gold out of the ground. Thus, for the 100 year period prior to the end of the 18th century gold standard, agricultural prices were more than 50% lower at the end of the period than the beginning. But once the gold standard ended, world central banks—including the one created in the United States in 1913— were free to create money at unprecedented rates. And they did. With high rates of money-printing, the money supply (M2) in the U.S. began growing exponentially, as shown in Figure 17. Just to confirm that the steep rise is not a matter of false perception due to the scale, Figure 18 presents the same data on a logarithmic scale where each incremental increase in the index level is proportional, reflecting the true percentage growth rate.

Figure 16: 100 years of falling agricultural prices (indexed). 200 170 140 110 80 50 1812

1832

1852

1872

1892

1912

Source: Gregory Clark, University of California, Davis

The largest increase in the world money supply came once the Bretton Woods gold standard of 1946-1971 collapsed. With this, the global money supply exploded (Figure 19). Before the 20th century—when the world shed money backed by precious metals and turned to central banks that literally created money out of thin air—people were not used to rising prices, especially not to high rates of inflation. Figure 20 shows historical consumer prices in the UK since the year 1550.


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Figure 17: Growth of the U.S. money supply (M2) between 1867 and 2012 (billions). 18,000 15,000 12,000 9,000 6,000 3,000 0 1867 1905 1888 1907 1909 1927 1930 1946 1951 1965 1972 1984 1993 2003 2012 1867 Source: Federal Reserve Bank of New York, Milton Friedman, Anna Schwartz, Robert Raschle

Figure 18: The data in Figure 17 put on a logarithmic scale to show the U.S. money supply in proportion with time.

5,000

500 1867 1867 1905 1888 1907 1909 1927 1930 1946 1951 1965 1972 1984 1933 2003 2012 Source: Federal Reserve Bank of New York, Milton Friedman, Anna Schwartz, Robert Raschle

Figure 19: The growth in global money supply (in trillions), 1971-2011.

150 120 90 60 30 1971 1976 1981 1986 1991 1996 2001 2006 2011 Source: DollarDaze.org; Federal Reserve FRED Database


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Figure 20: UK consumer price index, 1550-2001 (index). 1000 800 600 400 200 0 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000 Source: Global Financial Data

The collapse of the gold standard and resulting high rates of money creation brought mass inflation to other exchange-traded assets as well. Figure 21 shows the evolution of stock prices in two select countries, the United States and Sweden, since 1870. American stock prices were mostly flat until unrestrained money printing began to fuel stock purchases in the early 1900s. Stocks took off on a permanent rise within the decade after the Federal Reserve was created in 1913, and after the final dismantling of the gold standard in 1973. Figure 21: U.S. stock prices, 1871-2015; Swedish stock prices, 1870-2012 (Index). 2000 U.S. Stock Market

1500

300

Swedish Stock Market

250 200

1000

150 100

500

50 2010

2000

1990

1980

1970

1960

1950

1940

1930

1920

1910

1900

1890

1880

1871 1879 1887 1896 1904 1912 1921 1929 1937 1946 1954 1962 1971 1979 1987 1996 2004 2012 Source: Global Financial Data

1870

0

0

Source: Swedish Riksbank.

Similar to the evolution of stocks above, Figure 22 shows gold prices mostly flat from 1791 until the end of the classical gold standard in 1913. Remember, gold is measured in terms of other currencies, most commonly dollars. So when the other currencies are inflated, prices of all things rise. In this case the price of gold began rising once the quantity of dollars was expanded. While gold was priced between $19 and $21 for almost 100 years, it eventually shot up to $1,900 intra-year in 2011. This is simply because more dollars than ever before were existing and spent on purchasing gold (which itself is an alternative currency).


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Figure 22: Gold prices, 1833-2014 (dollars per ounce). 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 1791 1811 1831 1851 1871 1891 1911 1931 1951 1971 1991 2011 Source: Lawrence H. Officer and Samuel H. Williamson, "Measures of Worth," MeasuringWorth.com.

Crude oil has a price evolution similar to gold (Figure 23). After crude oil production began exploding in the late 1800s at a faster pace than did the money supply and spending on crude oil, its price fell for decades. Through most of the 20th century, crude oil prices remained flat, even while economic growth, incomes, and physical demand for oil around the world all grew strongly. Figure 23: Crude oil prices, 1861-2010 (dollars per barrel). $100 $90 $80 $70 $60 $50 $40 $30 $20 $10

Israeli Six-Day War OPEC Created / members nationalize oil resources Various internal Iranian conflicts Suez Canal conflict Israel War of Independence WW II

1861 1867 1873 1879 1885 1891 1897 1903 1909 1915 1921 1927 1933 1939 1945 1951 1957 1963 1969 1975 1981 1987 1993 1999 2005

$0

Source: Quandl.com; Author’s historical research

It was not until the collapse of the Bretton Woods gold standard that crude oil prices exploded. Today, observers believe that any supposed threat to production due to Middle East conflicts can cause crude oil prices to spike. But while on the gold standard, when money was not sloshing around the financial system as it does today, crude © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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oil prices did not react to news as they do today. During WWII, the Suez Canal conflict (where 65% of all crude oil transportation went through the canal), Israeli wars and even the very creation of OPEC and the nationalization of foreign-owned crude oil assets, the price of crude oil never spiked. This is because Wall St. traders were not throwing around large sums of money in the oil market. The money supply was growing rapidly, but crude oil was not a financial asset trading on financial exchanges. In 1973, analysts, unaware of the effects of money, attributed the small 5% reduction in crude oil production initiated by OPEC to the reason oil prices jumped 850% over the next seven years—which is mathematically impossible. Production returned to its prior level a year later, but prices did not fall back to their prior level as they should have if supply changes were the cause of the price spike. Then, seven years later, production was reduced a whopping 15% while prices, that time, fell 50%! Analysts did not consider how much money was spent on oil, and therefore came to incorrect conclusions. In reality, the collapse of the gold standard caused dollars from central banks around the world to flow back in to the U.S., causing massive commodity inflation—along with consumer price inflation. The Currency Effect The term “inflation,” is commonly used to refer to rising prices. However, what is really being inflated is the currency the prices are measured in. To inflate the currency is to expand the amount of currency existing; to create new money. Rising prices are merely a symptom of the inflation. The rate of price inflation in different currencies depends on the rate of money creation.13 Currencies that are inflated more will have higher price inflation rates, and currencies inflated less will have lower price inflation rates. It should follow then, that the currency used to measure a price is an important factor in understanding price movements. For example, consider Figure 24, which shows the price of corn as measured in different currencies. All the various corn prices are moving in different directions, and at different rates. The black line is the price measured in U.S. dollars (the most commonly referenced price). Obviously, if one wants to understand what the price of corn is doing, it depends on the currency in which the corn is priced. Corn prices typically rise more in countries which inflate their currencies more.14 Consider the evolution of the U.S. dollar price of corn from another angle. If corn is priced in its historical unit of measurement of gold instead of in dollars, corn prices have actually fallen. Figure 25 presents the price of corn since 1968 in both dollars and gold. Priced in dollars, gold has risen from $117.70 to as high as $800, before falling to its current price of $347.75. By contrast, priced in gold, corn prices have fallen to $11.56.

13

It also depends on the rate of increase of the supply of goods available in the area where the currency is used. However, since changes in the supply of goods are usually quite small relative to changes in the quantity of money, supply changes are ignored here. 14 Unlike the U.S. and Europe, most countries do not have a sophisticated financial system where money flows disproportionately and specifically into asset prices; most countries’ commodity prices move somewhat in parallel with consumer prices. © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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Figure 24: The price of corn in different currencies, reflecting the different growth rates of the money supply of those different currencies (indexed). 3.8 3.3 2.8 2.3 1.8 1.3 0.8 0.3 2008

2008

2009

2009

2010

Colombia (Colombian peso) Brazil (Real) Ecuador (USD) Mexo (Mexican peso) Nicaragua (Cordoba Oro) Peru (Nuevo Sol) South Africa (rand) Ukraine (Hyrvnia)

2010

2011

2011

2012

2012

Argentina (Peso) Chile (Peso) El Salvador (USD) Mozambique (metical) Nigeria (Naira) Philippines (Philippine peso) Thailand (baht) United States (USD)

2013

2013

2014

Bolivia (Boliviano) Dominican Republic (Dominican peso) Ethiopia (Ethiopian birr) Ghana (Ghana cedi) Panama (balboa) Russian Federation (Russian ruble) Uganda (USD)

Source: Food and Agriculture Organization of the United Nations

This is because over time the quantity of gold has increased at a much slower rate than the quantity of dollars. There have been more dollars flowing into the commodity markets bidding up the price of gold. Gold is costly and difficult to dig out of the ground. Dollars are created with computer keystrokes. This is why governments insist on citizens using the monopoly government currency which they can print on demand instead of allowing the money supply to consist of commodity-based money (or private money) as it used to. Figure 25: Corn priced in both U.S dollars and in gold. 800

Corn Priced in Dollars

700

Corn Priced in Gold

600 500 400 300 200 100

2016

2013

2010

2007

2004

2001

1998

1995

1992

1989

1986

1983

1980

1977

1974

1971

1968

0

Source: Quandl.com


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Commodity prices were volatile before and after the 1946-1973 Bretton Woods gold standard period, but extremely stable during the period15, as can be seen in the first portion of the chart in Figure 26. During the Bretton Woods period, money creation was very limited and uniform throughout the world—no country expanded its money supply much faster than another. With stable monetary conditions commodity prices were extremely stable too, likely the most they have ever been. These 25 years of relatively flat-lined commodity prices provide good circumstantial evidence of that money is the primary driver of commodity price volatility. Figure 26: The Reuters/Jeffries CRB commodity index, 1946-2015. 265

215

165

115

65

15 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 Source: Reuters/Jeffries

In contrast to stable commodity prices resulting from stable money supply growth, consider the opposite scenario in Figure 27. Here, corn prices in Argentina over the last century climbed an unimaginable one quadrillion percent. Why? Because Argentina experienced hyperinflation during the middle and latter periods of the 20th century. The Argentine government was printing trillions of pesos each month. As a result, all prices in Argentina rose that much since there was that much more money in people’s hands being spent on goods. Notice the scale of the chart: for the chart to really present the data in correct proportions, it would have to be stretched all the way up the side of a skyscraper. This is another example of price changes resulting from changes in the currency in which they are measured. The more spending there is the more prices will rise—no matter the supply. Certainly, mainstream commodity economics could not explain the rising Argentine corn prices through its current supply and demand framework. Mainstream economists might (abstractly) say that there was a “lot of demand for Argentine corn.” That is not a reasonable or correct explanation.16

15

Though the gold standard began in 1946, money that was created before it started was still sloshing around the banking system and economy. Thus, it took a few years for commodity prices to become calm. 16 Technically, it is correct, because the increased money printed and spent is actually increased demand. However, it is increased monetary demand; mainstream economists recognize increased demand only as quantities, not as merely spending more money. © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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Figure 27: Argentine corn prices (in pesos, on a logarithmic scale), 1910-2011. 1,000,000,000,000,000 100,000,000,000,000 10,000,000,000,000 1,000,000,000,000 100,000,000,000 10,000,000,000 1,000,000,000 100,000,000 10,000,000 1,000,000 100,000 10,000 1,000 100 10

2010

2000

1990

1980

1970

1960

1950

1940

1930

1920

1910

1

Source: Rosario Futures Exchange, Argentina


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In recent years, corn prices in dollars and Argentine pesos were mostly moving in line with each other until 2012 (Figure 28). That is when the primary source of spending in dollar-based corn markets (Wall Street) exited the market and took money out. By contrast, Argentina’s economy-wide money supply was increasing ever more rapidly. It increased 864% in the ten years from January 2006 to January 2016 (compared to 88% in the U.S.), resulting in more than a 30% annual increase in consumer prices and an 80% decline of the value of the Argentine peso (Figure 29). Thus, while the dollar price of corn fell, Argentine corn prices continued higher. This is inflation pure and simple. But in the U.S., observers believe that the traditional “fundamentals” are driving these individual prices when in fact they are driven mostly by changes in spending.

Figure 28: Corn priced in both Argentine pesos and U.S. dollars (indexed).

2100

U.S. Corn Prices (dollars) Argentine Corn Prices (pesos)

1600

1100

600

100 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Rosario Futures Exchange, Argentina, Quandl.com

Figure 29: The Argentine peso falls as and because the Argentine money supply increases rapidly (logarithmic scale). 0.35 1,900 1,700

0.29

1,500 .235

Argentine Peso Exchange Rate vs. US. Dollar Argentina Money Supply (In Billions)

0.17

1,300 1,100 900 700 500 300

0.065

100 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Oanda.com; Federal Reserve Bank of St. Louis FRED database.


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It should be pointed out that the traditional fundamentals could not possibly have been the cause of this price increase. Argentine corn production stayed steady at an all-time high for the last two years while corn prices skyrocketed 135%. All-time high supply should send prices lower, not higher. Exports as a percent of production actually decreased in the last few years, so this change cannot be the supposed China effect. Similarly, ending stocks were flat as prices rose, and in 2015 and 2016 were at a lower level than 5 years prior when prices were much lower. So it is not the supposed stocks effect. Once again, it is just price inflation. In fact, the amount of money spent to purchase Argentine corn in 2000 was more than existed in the entire Argentine economy several decades prior. It would have been impossible for prices to rise without the additional money. One last example of the currency effect and spending driving market prices comes from Zimbabwe. In 2007 Zimbabwe had the best performing stock market in the world, up over 50,000% from two years prior (Figure 30). Like Argentina, Zimbabwe was simply experiencing hyperinflation. It was reported in November 2008 that Zimbabwe's annual inflation rate was 89.7 Sextillion (10 ) percent, which equaled a daily rate of 98 percent, with prices doubling every 24.7 hours.17 With citizens getting millions of new Zimbabwean dollars each month, they had to spend it on something, and put it somewhere that might keep its value. They chose the stock market as a key destination. Most stock market observers think stock markets reflect future values of companies. In reality, it is that both the future value of companies (in aggregate) as well as the current value of the stock market simply reflects inflation. People also think the stock market reflects economic conditions. But Zimbabweans had 60% unemployment and empty grocery store shelves, while their stock market was booming. Again, it is just inflation. When measuring the Zimbabwean stock market performance in U.S. dollar terms, which adjusts for currency devaluation through the foreign exchange market, the Zimbabwean stock market was flat. The stock market ultimately closed in late 2008. When it re-opened, Zimbabwe dollars had been shed, as trading was permitted only in U.S. dollars. With that, unless the U.S dollar becomes hyper-inflated, it would be impossible for the Zimbabwean stock market to rise at the rate it had previously. And unless Zimbabwe attracts additional U.S. dollars into its economy and stock market, the stock market cannot rise at all, unless the number of shares outstanding falls. The myriad examples in Part 2 should ideally serve to prove that (as long as supply is steady or rising) additional amounts of money are the only thing that makes commodity prices go higher on a sustained basis. No matter the supposed “economics” or “fundamentals,” prices cannot rise without additional quantities of money being spent.

17

Doug French, Mises.org. 2010. https://mises.org/library/welcome-zimbabwe. © 2016 GROWMARK, Inc. All rights to the material or compilations contained herein are hereby expressly reserved. No part of this publication may be reproduced in any form or format without written permission granted by GROWMARK, Inc. Any distribution or reproduction of this material is prohibited and may be in violation of copyright laws, conventions or agreements of confidentiality. All such violations will be prosecuted. All trademarks contained herein are the intellectual property of their respective owners.

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Figure 30: The Zimbabwean stock market performance, 2005-2007 (index). 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 2005

2006

2007

Source: Zimbabwe Stock Exchange

Conclusion The influence of money is almost universally left out of commodity price analysis. This is a catastrophic mistake, as money represents one-half of the supply/demand equation, just as economics textbooks indicate. Commodity analysts have somehow lost a grasp of what truly constitutes (price-determining) demand, believing that demand is measured in physical quantities instead of money. In reality, physical quantities purchased are merely the flip side of supply, or quantities created, since what is created is—ultimately—what is purchased. This misunderstanding has caused analysts to witness commodity booms and busts over the last 100 years without understanding the cause. They incorrectly attribute all kinds of factors as causes of price changes—many of which have nothing to do with supply or even their own concept of demand—which could never possibly be the real driving force. Thus, to understand commodity price movements, it is critical to view supply as the amount of goods offered for sale on the market, and demand as the amount of money spent for those goods. This supply/demand framework will always explain commodity price changes, even if the explanation of why changes in spending occurred remain unknown.


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This paper is the last in a series of six: “4 Reasons Why Ethanol Doesn’t Drive Corn Prices,” January 2013 “Demand from China: Fact or Fiction?,” August 2013 “Food, Hunger and Commodity Prices,” December 2013 “The Stocks-to-Use Ratio: Is it Meaningful for Price Determination?” June 2014 “News, Money, and Prices,” June 2014 “The Failure of Commodity Market Economics: How Governments, Academia, and a Global Industry Miss the Major Cause of Price Movements,” December 2016

Katherine Scott Hornblower Daugherty is an is analyst a Sr. Market with GROWMARK, Research Analyst focusing with GROWMARK. on the financial Contact systemher: and commodity prices. Contact him: [email protected] [email protected]

Kel Kelly is in head charge of GROWMARK’s of GROWMARK’s Economic Economic and and Market Market Research. Research. Contact Contact him:him: [email protected]

About GROWMARK GROWMARK is a $9 $10billion billionregional regionalagricultural agriculturalcooperative cooperativebased basedininBloomington, Bloomington,Ill.Ill.GROWMARK GROWMARKisis owned by local member cooperatives and provides those cooperatives and other customers with fuels, lubricants, plant nutrients, crop protection products, seed, structures, equipment, and grain marketing assistance. In addition, GROWMARK provides a host of services from warehousing and logistics to training and marketing support. The GROWMARK System serves customers in more than 40 states and Ontario, Canada.


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