RE: Bank Bailouts & Commodity Devaluations

Below is a comment that I posted in response to LibertyBaby's thread titled, Can someone explain why bank bailouts devalue commodities?. It's a little long so I figured I'd just post it as a thread of its own also. Caveat emptor - no one has a crystal ball, and this only my opinion.

- - - - - - - - -

The relationship between the recent government bailouts and the fall in commodities is not a cause/effect relationship. What we are witnessing now - in my opinion - is a generalized deflation. Valuations are falling across the board - paper assets as well as commodities - but the government is choosing to save the paper assets with bailouts while letting the rest fall.

Since America left the gold standard in 1971, prices have been rising steadily, inflated by cheap credit supplied by the Federal Reserve. As I like to say, everything from a cup of coffee at Starbucks to the house down the street is overvalued due to the availability of cheap credit. Half of Americans are technically broke - no savings and net credit card debt. But they can still get a latte at Starbucks! Just put it on the credit card, if there is room. The result of the Fed's cheap credit policy is that it flowed throughout the global economy, causing higher and higher prices for some things, but paradoxically, lower prices for others.

An example of higher prices was the housing boom: People were only getting 1% in their bank savings accounts, so they thought, "Hey - maybe I should go out and try to flip a house. I'll get a liar's loan, buy a house and fix it up. Instead of 1%, I'll make 20, 50 maybe even 100%! And instead of just doing one, maybe I'll do 10, or build a tract of houses." And that worked for a while - it really did. Housing prices went way up from 2001 - 2005. That was the housing boom, but as we are now painfully aware it was only an illusion.

Meanwhile, cheap credit also flowed into industries like the domestic auto and airline industries, and overseas to countries like China. China had all kinds of money to build factories for the kinds of things Americans liked to buy to furnish their new homes: DVD players, flat screen TVs, and and cheap and flimsy furniture. Just like America got overbuilt with houses, China got overbuilt with factories. Likewise, the airline industry got over extended with excess capacity, and the auto industry went crazy with 0% financing allowing them to keep their factories humming. And why not? Credit was so cheap!

As a result, excess industrial capacity - in autos, airlines, factories in China, and yes, even Starbucks, - pushed prices down for consumer goods. It looked like the best of all worlds - assets were rising in price while stuff was getting cheaper. This is part of mechanism by which inflation (increases in money supply) was hidden. You could fly across the country and back for a few hundred bucks, and get a portable little DVD player at the drugstore to watch movies as you flew for $20. No inflation there, right? And while you're at it, charge yourself a $4 latte while you wait at the airport. (Yeah, $4 is a lot for coffee, but what is $4 more on a credit card balance of $10,000? People need their "little luxuries" in these hectic days, right? )

Prices may have looked fine at the time - including $350,000 for a converted half-a-duplex condo, and $4 cups of coffee - but G.I.G.O. as they say: Garbage in, garbage out. Economists (at least good ones) understand that price is information, and if that information is wrong, economic actors will make wrongheaded decisions.

Well guess what? The Fed mispriced the money. They marked it down in an artificial clearance sale. The problem is that money is the measure of all transactions in the economy. Misprice the money and you distort every transaction made in the economy. People made bad decisions because they got bad information. Yesterday the Fed sowed the wind, today we all reap the whirlwind. Too many houses were built, too many cars were made, too much airline capacity was created, and too many factories in China. And too many long-ago-consumed $4 lattes remain on the balances of consumers across this country, their prices increasing with the credit card's APR, day by day.

Eventually, the housing boom played itself out. Prices became so disconnected from reality that people actually noticed. The spell was broken once people realized en masse that they couldn't pay for their houses, and that flippers couldn't unload them.

Today's problem is not difficult to understand. We simply have too many houses, many of them empty. As a result, the paper assets (mortgages) backing these physical assets (houses) has collapsed. This caused a huge DEFLATION, because those pieces of paper were the underlying assets for mortgage companies (Countrywide Credit) commercial banks/thrifts (Washington Mutual), hedge funds (Bear Stearns subsidiaries), and other financial service firms (Fannie Mae & Freddie Mac.) This is the fundamental reason why so many financial firms are now facing survival issues. Many of the assets that they thought were good are now worthless. And many of the firms borrowed to the hilt to buy as many of these assets as they possibly could.

The collapse in paper assets caused fear that morphed into near panic. Investors abandoned paper assets, including the dollar, for real goods. The dollar went down and physical commodities - gold, oil, and other commodities - went up. Adding to the stampede into these commodities was the belief that emerging economies (China, India, Russia, etc.) were going to gobble up all the resources forever! Just as people believed in 2005 that housing prices couldn't go down , in 2008, until just a few weeks ago, people believed that commodity prices couldn't go down.

Wrong on both counts.

Much of China's tremendous economic growth comes from exports to the US. With the US in recession, possibly heading for depression, it means less demand for China's goods. This means China will have less demand for physical commodities, ergo, commodity prices begin to fall. Plus, stuff is just so expensive that people don't buy it anymore. Whatever the traders say, speculation was a major contributor to the commodities boom, and when hedge funds turn tail and run, unwinding their positions, we'll see dramatic declines in commodity prices, just like we saw in internet stocks in 2000, and housing prices in 2005 .

I hope now it is clear that the fact that commodities are going down as the government is doing bailouts is not a cause/effect relationship. What we are seeing is an across the board deflation. Everything is falling in value, from houses, to the value of financial assets, to the value of commodities, to the price of a cup of coffee at Starbucks. Starbucks is now testing $1 coffee with free refills.

It just so happens that the government wants to bail out certain entities because it is their goal to save the current financial system. They have no interest in bailing out the little guy (homeowners) though they pretend to for political reasons. They have no interest in supporting the price of gold, oil or corn, nor do they care much about the price of coffee. But they must save the dollar! The Fed may be dumb, but they are not stupid, in my opinion. They have pushed inflation as far as they could, and now there engineering a managed deflation, in my opinion.

Inflation and deflation are processes, not static events. We have already seen tremendous inflation. It is now time for a little deflation to even things out. Just as inflation took years to work its way through the economy, deflation will take its sweet time as well.

In response to one of my previous articles on deflation,, a random poster wrote one of the most insightful comments I have ever read:

I am fascinated by the common perception that the Federal Reserve is a proven non-stop inflation machine. Inherently, the Federal Reserve uses inflation and deflation to whipsaw the average bystander out of their savings. I don't see how one economic machination is more favored over the other when the goal is to ensure that the public's savings ends up in the accounts of the shareholders of the Federal Reserve System.

Let's just look at what has happened just since 1995, when I first began following financial markets closely: First we had the great inflationary stock bull market, culminating in the tech blowoff of 2000. Then we had the great deflationary stock market collapse until 2003 in which the Nasdaq lost 80% of its value, and the S&P 500 was cut in half. Meanwhile, the housing boom was building to an inflationary crescendo from 2001 - 2005, and since 2005 it has gone nowhere but down. Some properties have lost 95% of their value (in Detroit), and more will.

Feeling whipsawed? Most people are.