Speculative Demand and Hoarding Drive Real Prices Higher   (December 14, 2009)

The combination of cheap money/limitless liquidity and speculative demand are driving real prices higher even as "real world" demand and income both falter.

Whenever I announce a topic as "critically important" then readership plummets. I'm not sure if it's karma for sounding self-important or a jinx generated by readers' fear of IBB material ("important but boring"), but I'm going to risk the curse and declare today's topic of critical importance in understanding how real-world demand can fall yet prices can continue rising.

Why is this important? In classic economics, falling demand (assuming supply remains constant, or that it falls at a slower pace than demand) leads to falling prices as suppliers cut prices to move product, take market share from rivals and hopefully stimulate demand.

But if prices rise due to speculative demand and hoarding even as wages, home equity and income stagnate, then we enter the dreaded vise of stagflation: prices for finished goods rise even as income stagnates or declines.

Frequent contributor B.C. outlines the dynamic very succinctly:

Since '05-'07, gold and other commodities have increasingly become an "asset class" into which hedge funds, pensions, and individuals have shifted money, i.e. "monetizing" use goods as opposed to paper assets or real estate, in an attempt to hedge against central bank credit-money printing and perceptions of the risk of hyperinflation at some point.

But rarely does one read or hear discussed the "hoarding effect" resulting from money flowing to gold and other commodities, creating artificial demand which pushes up the price of use goods required by firms and households. CHS: emphasis added

Two important aspects of the hoarding effect (1) increasing cost of production with slack capacity, reducing profits and incentives for further investment in production, and the past-through costs to households, which squeeze spending; and (2) the continuing downward pressure on money velocity as a larger incremental share of increasing credit-money supply goes to hoarding or speculating in commodities, with less money circulating in the larger economy.

As commodities speculators pile on with leverage, capturing a larger share of future surplus gains to existing and future commodities production, producers and intermediaries are required to go further out into the future to hedge or lock in prices, requiring many to become de facto commodities speculators themselves.

However, at some point, the speculative demand causes constraints on the real economy at which point the speculative alpha disappears, and buyers become sellers en masse to lock in outsized gains or to liquidate derivatives positions to avoid physical delivery, which was never the speculators' intention.

This is a profound dynamic that has received essentially zero coverage.

This slices through the cul-de-sac blather about deflation-inflation like a samurai sword through an over-ripe watermelon. Cheap abundant money drives speculative demand, fear of future inflation drives speculative hoarding, both divert funds and money velocity from the real world, which reduces real demand even as real prices rise.

The mismatch between speculative commodity derivative positions and physical delivery eventually drives a self-rienforcing liquidation of positions and leverage alike, crashing both prices and financial markets as the unwinding kicks off stops and reduces many positions to zero.

Couple this decreasing money velocity in the real world with income withdrawn from circulation to pay down debt (deleveraging, paying down credit cards, etc.) and you get a double-whammy on both velocity and disposable income: money is diverted to reduce crushing debt loads and pay rising prices. Consumers are crunched in the vise and Main Street investors can only watch from the sidelines, as they have no access to the credit or leverage enjoyed by large speculators and commercial traders.

Thus the "average investor" has few ways to gain from the speculative ramp-up in commodity and end-use prices, but ample opportunity to lose big when the cycle implodes, bringing down credit and equity markets as in Fall 2008.

Frequent contributor Harun I. offered this description of how easy credit fuels speculative gains and eventually, the destruction of consumer purchasing power:

Every government that has fired up the "printing presses" to monetize debt have created a boon for speculators. Those with first access to counterfeited money go out and purchase real assets at no real cost. However, their purchasing drives the prices of those assets up. By the time the money reaches the ordinary citizen, their purchasing power has been destroyed and they are effectively priced out of the market.

As long as the printing presses are running full steam, those with first access to the money, banks, are going to purchase real assets with that money just as they did in Weimar, Argentina, Zimbabwe, etc., and prices will rise.

Perhaps what we should be re-examining is our assumptions and definitions of inflation and deflation, exploring whether they can occur simultaneously.

Thank you, B.C. and Harun, for your insights. Many have attempted to build a case for deflation or hyperinflation. But without understanding the speculative dynamics outlined above, the picture is incomplete.

With the above dynamics in hand, it is possible to foresee consumers facing deflation in their primary asset--their house--effectively reducing their net worth, and deflating prices of finished goods which are mostly detached from speculative demand (for instance iPod-like devices, which contain little but mass-produced electronics and software) even as commodities with huge impacts on the costs of non-discretionary goods and consumer purchasing power such as oil and grains rise in a speculative-demand/hoarding spiral.

Indeed, we have already seen how speculative demand/hoarding of oil has created a situation in which the world is swimming in oil as consumer demand has plummeted--every storage facility is filled to capacity--yet prices rose to $80/barrel, only recently dropping to $71/barrel.

Without speculative demand/hoarding, how low would oil fall? That is unknown, but many expect the final Global Depression collapse in oil prices to reach $20 or even $10/barrel. (This is what I have termed the final "head-fake" in which oil falls one last time before shrinking supply drives it to $300/barrel.)

This overall dynamic is how you get falling net worth, declining prices for discretionary goods and rising prices for essential/non-discretionary goods such as oil.

This complex mix of inflation/deflation and falling purchasing power/asset base has long been my position on the simplistic (and thus misleading) "deflation/inflation" debate. What is new to me is the speculative dynamic which fuels just such a volatile mix of declining purchasing power and rising real costs.

I am indebted to David Hackett Fischer's detailed explanation of how rising prices run in long cycles--The Great Wave: Price Revolutions and the Rhythm of History--and to contributor Cheryl A. for sending me his work.

These inexorable cycles of rising prices are a key part of the Survival+ analysis and forecast.

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