Now that the Bank of England has got off its high horse and decided to support
British banks in much the same way that the European Central Bank has been
supporting Spanish and German banks since last August, governments around
the world are finally committed to publicly funded financial workouts. This
is the “Plan B” that I have described here – the inevitable next stage in
the credit crunch, once it became apparent that a market-based solution was
doomed to fail. Now that Plan B has swung fully into action, global credit
conditions should gradually return to normal in the months ahead. The bad
news is that “normal” does not mean anything like the conditions that have
prevailed in the world financial system and the global economy during the
past few years.
Three lasting changes in the world economy are likely to result from the
credit crunch. First, the US economy, which should start to recover this
summer in response to fiscal and monetary stimulus, will no longer be
powered by housing and consumption, but mainly by exports and manufacturing.
Secondly, the British and European economies, which are 12 to 18 months
behind the US in a broadly similar monetary cycle, will only now begin to
experience an economic slowdown and housing slump as serious as the one that
has almost ended in the US. So, while the credit crunch may be in its final
stages globally, its economic impact will probably be far more noticeable
from now on in Britain and Europe than in the United States.
Thirdly, the emerging economies of Asia and other developing regions will no
longer enjoy export-led growth as consumption in America and Europe becomes
structurally weaker. If the developing countries are to continue growing
rapidly – and I believe that they will – they must rely on domestic
consumption, infrastructure investment and their own home-grown property
booms.
These three fundamental shifts in the world economy are by now widely
recognised. There is, however, another apparent consequence of the credit
crunch that is less understood and is causing consternation and anxiety,
especially in China and other developing countries. This is the upsurge in
oil, food and commodity prices, many of which have almost doubled since the
credit crunch began last August, even though the causal linkage between
soaring commodity prices and a collapsing supply of credit remains obscure.
If anything, the credit-induced slowdown in global economic growth and
consumption since last August should have weakened demand for commodities
and therefore pushed down prices. Yet the reality is that commodity prices
have recently leapt higher every time the global banking system was hit by
some new shock.
As a result, China and other emerging countries, which last year were
preparing to boost domestic consumption to compensate for weaker exports to
the US, are now more worried about inflation and are raising interest rates
to try to slow their domestic growth. This is potentially a very dangerous
development for the world economy, which increasingly relies on domestic
demand from Asia, the Middle East and Russia. This unexpected policy
tightening by emerging nations also explains why stock markets fell far
harder in Asia than in America and Europe in the first quarter of this year.
Why, then, has a global collapse in credit created a boom in commodity demand?
The short answer is that nobody knows. A common explanation in the media is
that soaring commodity prices reflect a global panic about inflation, as the
Federal Reserve Board supports the US banking system by printing money and
slashing interest rates.
This explanation does not pass muster for at least three reasons. First,
because US inflationary pressures are already subsiding as a result of the
credit crunch and the associated fall in house prices and employment.
Secondly, because the ECB and the Bank of England show no sign of imitating
the Fed’s expansionary monetary policies, yet commodity prices are soaring
in sterling and euros as well as dollars. Thirdly, because the commodities
rising fastest – such as rice, wheat and pork – cannot be used as long-term
stores of value and so must reflect the balance of supply and demand for
instant use, rather than fears about loose monetary policy and its possible
effects on inflation many years ahead.
What, then, has suddenly boosted demand for agricultural commodities and how
might this be related to the credit crunch? A possible explanation is that
the rise in prices itself has triggered a self-sustaining upward spiral of
demand, in which investors, wholesalers and final consumers want to buy more
of a commodity each time its price rises and this leads to more hoarding and
still higher prices. Such self-sustaining price trends are normally rapidly
reversed because value-oriented investors and commodity producers start to
trade against the trend, selling more each time the price rises. In present
conditions, however, it is harder than usual for speculators to trade
against the rising price trend, because bank lending has dried up. Several
American grain wholesalers, for example, have been pushed towards bankruptcy
because they have sold futures against grain supplies they bought in advance
from US farmers and have then been unable to finance these temporary “short
positions” until the next harvest comes along.
By draining liquidity in this way from all financial markets, the credit
crunch has exacerbated trend-following behaviour among investors, promoted
stockpiling throughout the global supply chain and encouraged hoarding by
consumers. This financially driven process, rather than a sudden increase in
Chinese and Indian appetites, has probably been the main cause of this
year’s shortfall in global food supplies.
Similar influences may explain other surprising linkages that have suddenly
emerged between financial markets. Since the credit crunch’s start,
commodity prices have developed an uncanny correlation with the euro/dollar
exchange rate (see chart) and this currency trend, in turn, has been
powerfully correlated to two other momentum-driven trends – the collapse in
US Treasury bond yields and the widening of credit spreads.
If all these trends are driven ultimately by lack of liquidity in global
financial markets, they are all likely to turn at about the same time, or in
a fairly tight sequence - and this process may now be starting. The trend in
credit spreads began to reverse in mid-March after the Bear Stearns rescue –
and last week, more or less on cue, the predominant direction of the US bond
market seemed to switch from lower to higher bond yields. If this rise in US
bond yields proves sustainable, the overwhelming currency momentum against
the dollar and in favour of the euro may also start to reverse. If that
reversal occurs, the trend in commodities should soon follow and the panic
about inflation in China and other emerging economies should start to
subside. At that point, we will finally be able to say that the worst of the
global credit crunch is over.
"there are a lot of Chinese and Indians ... set to discover French cheese and German bread makes more sense. No it doesn't. The number is too small. And many for obesity/health reasons eat very little cheese or bread. Te demand is for staples-- rice, wheat and pulses-- and not expensive food.!
acharya, bangalore, India
Good article overall - but a fairly convoluted attempt to explain the credit crunch and rising commodities.
Michael from London has it right. Commodities have been rising for the last two years as the hot money has shied away from US mortgage bonds and gone into the 'next thing' - commodities.
harry e, London,
I am astonished by the optimism of your article which appears to me to be headily optimistic - credit markets recovering in the next few few months? Upon what basis can you make such guesses? This recession will run between four and five years before it turns the corner - that is my guess!
Chris Stuart, Carentan, France
Fact being this whole credit crunch happened because of people always living beyond there means! Sigmund Freud tactics are why we all live beyond our means!
The economy was high because everyone was spending all the money we were borrowing, the bubble was always going to burst.
Bilderberger!
Andrew T, England,
At least "the press" in Europe is more willing to take notice of the credit crunch.
In America everything is always fine...
Peter Vernunft, Berlin, Germany
That is what I call flexibility:
US industry ready for "exports and manufacturing" form mid of april to end of this summer.
Is it that simple after decades of deindustrialization?
It certainly isn't, but let us calculate in - for example - small cars: roughly 3000 billion $ T-bonds outside US have to be served with 3% interests. How many 15.000$ cars is that per month to pay for the interests only?
Well done! It means 500000 (five hundred thousand) cars per month to pay the interests.... only the interests.
What ever comments you read, the facts are cruel.
This illustrates that there is only one exit for gigantic US debts: inflation... ...real inflation...
Peter Vernunft, Berlin, Germany
There are assertions here but more facts and figures would be helpful. Why try to link the credit crunch to commodities inflation? Look at China and India, and look at oil supply constraints to understand commodities inflation.
The economic slowdown and housing slump are almosty over in the US? Phew! Has anyone told them yet?
Stephen, Cambridge,
"The bad news is that “normal†does not mean anything like the conditions that have prevailed in the world financial system and the global economy during the past few years."
So you think "good news" would be conditions that have led to one bedroom flats in London costing half a million pounds and the UK having 1.4 trillion ponds of personal debt? Go figgure...
George, London, UK
And a common cause to lower yields in foods generally could well be a <a href="http://icecap.us">cooler world</a>. People can be fooled into thinking correlation equals causation as regards CO2 and temperatures. Plants can't. Colder = less biomass.
Wayne, Christchurch, New Zealand
There has been a large increase in derivatives to enable easy trading in commodities and much of the loose money has gone into these. Should a good harvest or a marked downturn in demand in hard commodity products occur there will be enormous losses for the speculators in these instruments. These positions are being financed by banks and it is more than likely positions are in futures rather than physical goods. Should banks be told to reduce their financing of Hedge Funds or at a higher cost that might precipitate a sooner collapse in prices.
Damian, Brighton, UK
Stability is the key, not just economic but social stability and the Bank of England should be commended for taking bold measures to ensure it.
The UK is burdened with an army of surplus non-EU labour in a post boom economy living on low wages and benefits, who are suffering disproportianately from higher taxes, food prices and living costs.
The collapse in the housing market that some predict and even seem to be willing would drag down the rest of the economy and the whole of the service based economy that the
UK is today.
As for the mystery of rising food and fuel prices look no further than the beggar thy neighbour collapsing dollar, in which commodities and fuel are priced and the activity of hedge funds. Speculative activity in these ingredients of life should be strictly regulated to avoid the social consequences of a rampant and immoral capitalism.
John Collins, Bromley, Kent
"The bad news is that “normal†does not mean anything like the conditions that have prevailed in the world financial system and the global economy during the past few years."
This is in fact good news: the credit conditions of the past few years in the global economy have been in no ways normal or productive. Easy credit and reckless lending have simply encouraged speculative excess and over-leveraging of funds. If this credit crisis can achieve anything, we should all hope that its main benefit is in bringing some level of reality and prudence back into banking.
MB, Edinburgh,
The enourmous increases in commodities (petro, metals and agri commodities) are being driven along hard by a substantial rise in investment by parties with no end use. In that oil prices both in terms of the cash price and the oil volatility price are traded by hedge funds, asset managers etc who will never ever take delivery of a barrel of oil. Nor wheat, orange juice, copper, iron ore, gold etc etc. these trades are on pretty much every leveraged investors trade sheet now and for the last 2 years. There may be an argument for the provision of end user licences in order to be able to participate in these markets in sizeable numbers, this would reduce their price overnight. However, you would then remove the safety net the speculators provide when an asset mkt price collapses and no one else will buy except the same speculators. On a different note does the Euro really belong at this level, or the autralian dollar, New Zealand dollar, brazilain dollar. Dont count the USD out yet.
Michael, London,
it will be interesting to see if Anatole's prediction about th USA will come to pass. Quite how a nation that runs on consumption and house price inflation can suddenly in the space of a few months turn to exports and manufacturing, is itself a bold prediction. Particularly as for years US manufacturing has lost ground and exports have barely increased. In general the USA has no need of an export market in the same way Germany for example does, because its own internal market is so huge. Manufacturing will suddenly have to discover efficiency, innovation and technical excellence that it doesn't bother to much with at present. This kind of wholesale re-alignment takes years to achieve. This notion that all will be well before Christmas is about as realistic as the fond assumption at the start of a war that it will by Christmas. We should learn the lesson to beware false dawns, from Bush's 'victory' speech to the current belief that at a stroke we can solve the credit crisis.
John Walter, Bonn, Germany
Interesting theoretical arguement which may well turn out to be true.
I would add an additional, perhaps more significant, factor explaining the rise in commodity prices.
It has become clear that western governments in general, over-indebted as they are, have been reduced to a single, last, meaningful intervention to stave off economic recession; print money in all its forms, in so doing eroding debt in real terms (along with savings of responsible taxpayers).
Every investor worth his or her salt knows that the eventual outcome of this, 2-3 years down the line, is higher nominal prices for just about everything.
We've witnessed a micro version of this over the past 7 years. Traders know this too.
What's the best way to protect your portfolio against this hyperinflation ? Hard assets (commodities).
Shift a small percentage of your devaluing dollar assets (bonds, US equities, etc.) into the relatively small commodities markets and, hey presto, surging commodity prices.
Derek, Cape Town, South Africa
You think developing countries should rely on a home grown property boom for growth? Seriously?
Malcolm, Wirral, UK
Three observations : (A) There is no such thing as "Global Financial Market". (B) The Eurozoe is booming. (C) The laggards are the USA, Japan, and the UK.
Dan Berlinski, Geneva, Switzerland
Fascinating article but wrong in my view. It is cheap money that has caused all this - there is a huge amount of wealth around - what on earth is it to invest in - dollars, no way, money deposits in a time of falling interest rates, no way hedge funds and commodity funds and ETFs - yes - oh, and the first two are often highly geared - yes, banks are happy to lend veyr cheaply to their mates in these but not to people they don't know like house owners - it is this loose liquidity that is causing this inflation - it is a self per perpetuating cycle - as in all bubbles this one will eventually burst but when........it is why omentary policy and interst rates desperately need to be controlled not cut even further slack before enromous damage to the world economy is done - it is why Bernanke and King are wrong to cut interest rates and the ECB (yes even them) and the Chinese are doing right holding or increasing interest rates - nevertheless, the cheap dollar is still king in this.
Richard, Newton Abbot,
At last a reasoned explanation. I couldn't find the link,but the lack of financing for short positioning in commodity markets does go along way to pull all the pieces together.
TC, Cheltenham,
Correct me if I'm wrong but wasn't the bear market in stocks of the mid to late seventies accompanied by a run up in commodity prices? Is it possible that all the loose money sloshing around the markets is coming out of a depressed property market and is skirting a stock market where each rally appears weaker and prompted by ever dimmer glimmers of good news and is going somewhere else? Some analysts have been singing comodities praises for a couple of years or more now - and as you say it's not just minerals it's animals and vegetables too.
I take your point that some commodities have a finite shelf life but the arguement that there are a lot of Chinese and Indians moving into the middle classes set to discover French cheese and German bread makes more sense than most of the recet and rather athetic stocks rallies....
After all McKinsey released a report last year predicting a rise in Indias middle class from 50 to 550 M by 2025. It's intoxicating stuff.
Jonathan, London,
Is Britain (UK) moving to the Euro with devaluing of individuals investiments, property, and the low euro value against the pound.
The final path to the European State was the establishment of the Northern Ireland Assembly.
The Council of Isles can now be established with the Eire TD's being able to set in Westminster.
Yes the public are being bluffed by the government and banks.
JFC Belfast
John F Caddell, Belfast, Northern Ireland
The credit boom created inflation.
Inflation created the credit crunch and high rice prices.
Dominic, Manchester, UK
So, Darling is going to meddle in the markets. Most, informed people know that the markets regulate themselves - always. Remember all the currency crisis's - don't meddle. They tax the poor to pay the rich - what a load of uselessness they are.
Frederick, London, UK
In brief, every time there is a hiccup in the banking system the relevant govenment prints more money.
More money with supply remaining (relatively) constant = higher prices (= higher commodity price expectation on the part of traders). Economics 101.
A return to monetarism is on the cards. Savers are being robbed by thieving politicians and bankers, assited by kow-towing Keynesian economists.
The 18-year old paradigm of inflation-targeting has been abused by politicians and will eventually come to an end when the full extent of the lie is exposed.
Economists should look behind the statistics and theory for a broader view outside of the fish bowl in order to get closer to a real-world truth.
After all
'beauty is thruth, truth beauty,
that is all ye know on earth and all ye need to know'.
John Maynard Keates
Derek, Cape Town, South Africa
"What, then, has suddenly boosted demand for agricultural commodities and how might this be related to the credit crunch?"
You could try bad harvests caused by lack of rain. That is the reason that China, Australia and to a certain extent Thailand (the rice basket of Asia) have seen prices increase. Plus of course grain speculators and the rapidly increasing cost of transport (speculators again! OPEC have repeatedly told us there is no shortage of oil). If OPEC did the sensible thing and switched Oil pricing to Euros (which is what Saddam was going to do which was the REAL reason for the US invasion) then we might see some sanity restored to that market.
You need to get out of the office more and you'll see that most of the problems are caused by good old fashioned greed and US imperialism.
Incidentally the latest rice crop is coming in about 2 months and again its not going to be good because of weather conditions in Asia. It'll be interesting to see what happens then.
Kevin, Workington, UK