Commodities Crash: A Market Economist’s Nightmare

Do you remember the first great internet investment bubble of the late 1990s?

Hundreds of millions of dollars were invested in astonishingly flimsy firms like Pets.com and drkoop.com. The NASDAQ market, host to many of the Initial Public Offerings (IPOs) that attracted funds to these companies, witnessed its composite index quintuple in value in just six brief years between 1995 (when it surpassed 1,000 for the first time) and 2001. But then, like all bubbles, the index valuation crashed, collapsing back to a value slightly above 1,100 by late 2002.

At the time of the crash, many American investors swore that they would never again be beguiled by future bubble markets, promising to restrict their funding decisions to more stable industry sectors. And yet, just a few years later, rock-bottom mortgage interest rates created a mammoth real estate bubble, supported by the irrational proposition that home investment valuations in the United States could never decline in absolute terms. Nevertheless, when that bubble burst in late 2008, it nearly brought the entire global economy down with it.

Have global investors learned their lessons about avoiding manic bubbles? Apparently not! In fact, yet another investment sector appeared to gyrate towards a crash last week, one so universally significant that it is giving market economists nightmares.

Silver and Gold and Oil, Oh My!

The sound of the largest crash last week came from the silver market. The value of silver, having soared by 57% during the first four months of 2011, suddenly reversed direction and fell more than 25% during the first five trading days of May.

And yet gold, too, went into a tailspin. After having jumped from $1,000 to $1,541 between September 2009 and April 2011, it suddenly slumped by close to 5% during the most recent four trading days. And oil, having soared from $33 per barrel in January 2009 to levels beyond $100 per barrel in February 2011, fell by almost 15% last week.

Pundits blamed these sudden lurches in commodity values on investment speculators who buy and sell vast quantities of these materials on the global markets. Unfortunately, though, firms that use these commodities for industrial and consumer applications must purchase them on the same global markets. Inevitably, when prices fluctuate so dramatically, corporate planning activities for the future — as well as their operations activities in the present — become unmanageable.

Ripple Effects

Gold, for instance, is more than just a glittering metal that is shaped into rings and necklaces. It is also an excellent conductor of electricity, and is therefore employed as an industrial component in many types of electronics equipment. Manufacturers of computers and cell phones thus feel their profits pinched whenever speculators drive up the cost of the precious commodity.

Silver, as well, is a strong conductor of electricity and heat, and is able to withstand extreme variations in temperature. Manufacturers of conventional batteries and solar energy panels rely heavily on it, and likewise see their profits vanish whenever the cost of silver increases. And in the nascent alternative energy industry, where losses are common even under the best of conditions, such cost bubbles can drive development projects (and entire firms) into bankruptcy.

Sharp increases in the cost of crude oil can, likewise, ripple through the entire global economy. Airlines simply retreat from markets that become impossible to serve profitably, cutting off tourist areas and business markets from their constituents. And, on a personal level, economically strapped families in cold weather states like Massachusetts and Michigan are forced to wonder how they’ll find the funds to heat their homes through frigid northern winters.

The Cost of Uncertainty

As market economists know, the true costs of such massive fluctuations in commodity values extend far beyond the expenditures that are required to procure the materials themselves. Indeed, the greatest costs of all may emanate from the uncertainty that is generated by such fluctuations, an effect that paralyzes commercial activity and drives up the cost of capital.

When the Chief Financial Officers of alternative energy firms witness the cost of traditional crude oil more than triple within two years, and then drop by almost 15% in a single week, they cannot help but wonder whether that cost might continue plummeting in the near future. If such declines actually continue, the cost of oil-based energy would likely fall so low as to make the cost of alternative energy unattractive by comparison.

Furthermore, banks and investors would perceive such alternative producers in a far more risky light, and would raise their interest and dividend demands accordingly. In other words, the cost of obtaining investment capital at alternative energy firms would soar at the very moment that their competitors’ operating costs would fall.

The result would be paralysis in the alternative energy sector, thereby locking our economy into the perpetual boom-and-bust price cycles of the traditional commodities sector. Can we afford to continue living with such outcomes? Perhaps not, because without stability in the price levels of commodities and other raw materials, no business can feel comfortable investing in growth plans for the future.

Four More Years: Bernanke Returns!

For a brief moment this past week, the American public glanced away from the economy’s unprecedented run of volatility and took pleasure from the insight that the biggest news story actually involved continuity.

In other words, a lack of change was the big story this week. But what exactly was this story? Were the New York Yankees winning yet again? Or was there yet another ghastly rumor in the Michael Jackson case?

Well, yes … and yes. The Yankees and the Jackson case just keep chugging along. But those stories of continuity don’t impact our economy, at least not in any dramatic manner. The reappointment of Ben Bernanke as Chairman of the Federal Reserve Bank of the United States, though, created quite a stir.

American Socialism

In retrospect, the buzz surrounding Ben’s reappointment should not have surprised any one; after all, the existence of an American national bank has itself been a controversial news story for decades, even centuries. Initially proposed by Alexander Hamilton to pay off the fledgling nation’s Revolutionary War debt, the short lived First Bank of the United States was dissolved soon after achieving this goal in 1811.

Just one year later, though, America entered the War of 1812 and began incurring a brand new pile of war debt. The Second Bank of the United States was then established to pay it off yet again; then, after achieving this goal, President Andrew Jackson dissolved the Second Bank during the 1830s. And after banking titan J.P. Morgan played a huge role in stabilizing the American financial system during the Great Panic of 1907, Congress decided to (finally!) create a permanent Federal Reserve Bank in 1913.

We’ve lived with this modern “Fed” ever since 1913. Nevertheless, why have Americans historically felt such ambivalence about creating a permanent national bank? Apparently, certain conservative politicians and citizens have always regarded national banks as socialist threats to capitalism and liberty. In fact, many of the arguments being made today against national health care echo the arguments made throughout history against national banks.

A Long Shot

At one time, the continued existence of any national bank seemed like a long shot; similarly, Bernanke’s reappointment at the Fed recently seemed like a long shot as well. Ben was, after all, first appointed by President Bush; President Obama was strongly rumored to favor chief economic advisor Larry Summers instead.

But Bernanke aggressively flooded the American economy with capital and slashed interest rates during the economic meltdown of 2008, decisions that pleased the Obama administration. His explanation? According to Bernanke, “I was not going to be the Federal Reserve chairman who presided over the second Great Depression.”

A laudable sentiment, without doubt. But there are actually two distinct approaches to avoid presiding over a depression: one is to prevent its occurrence entirely, and the other is to delay it until someone else assumes command. Perhaps Obama reappointed Bernanke in order to eliminate any possibility that Ben was selecting the latter option!

Remember Greenspan?

Bernanke, of course, is not the first Federal Reserve Chair to resort to boosting liquidity during times of economic crisis. His predecessor, Alan Greenspan, did so time and time again in response to market declines, a currency crisis, a terrorist attack, and various other incidents during his long tenure. In fact, Greenspan’s actions appeared to preserve the longest run of economic prosperity in modern American history. So who could argue with his track record?

Well, Alan himself could … and in fact has done so. He went on the record to acknowledge that his actions might have contributed to the inflation of economic bubbles that “popped” after he retired from office, though he has also defended himself against his harshest critics. By flooding markets with investment capital, Greenspan asserts that he ensured the continued flow of healthy economic activity during his tenure. Nevertheless, he also agrees that he may have enabled the stock market, real estate, and other dysfunctional bubbles to flourish as well.

Time will tell whether Bernanke’s strategy will lead to a similar fate. There is, sadly, a distinct possibility that today’s tentative “green shoots” of economic recovery are actually only temporary bubbles that may eventually collapse into the throes of a “double dip” recession.

The Nature of Risk

A double dip recession is a depressing prediction, isn’t it? But it isn’t an inevitable one; after all, many different unique factors contributed to the collapse of the world’s markets in 2008. For instance, oil soared to $147 per barrel. The Afghani and Iraqi wars drained America’s wealth. And global warming appeared to reach a tipping point, sparking hurricanes, tsunamis, droughts, and other catastrophically costly natural events.

Greenspan and Bernanke argue that the likelihood of a second Great Depression would have been much higher if not for their actions. But if they only succeeded in delaying (as opposed to preventing) future economic collapses, then the costs of their decisions may prove to have exceeded their benefits. In other words, all of their efforts may have gone (or may yet go) for naught.

The nature of risk is a function of balancing the possibility that crises may occur against their potential effects if they cannot be avoided. With this in mind, only time will tell whether Bernanke and Greenspan truly eliminated the possibility of a Second Great Depression, or instead simply delayed it. Given Obama’s reappointment decision, though, we may still have Ben around to thank – or blame – when we learn the answer to that fateful question.