Two weeks ago I regretted, with some relief actually, that my earlier predictions about a bubble in commodities derivatives seemed to have been inaccurate. More to the point, the oil price collapse triggered by the Saudis had not led to a broader avalanche in other commodity prices or the failure of any big hedge funds.
I may have jumped the gun.
Collapsing oil prices may be starting to kick off just the kind of broader financial crisis that I had worried about. The first evidence is beginning to show up in prices of food, aluminum, copper and other goods. This could get ugly, but it might yet fizzle out.
The problem has been evident for a long time. Commodities prices have been on a steady upward swing since we expanded speculators’ access to the market fifteen years ago. This inflation has happened in spite of steadily rising surpluses and modest demand in almost all of these commodity categories. As I wrote three and half years ago:
We aren’t talking about our supply problem because our economic reasoning says that it must not exist. But we have an oil glut, just like we did the last time prices spiked in 2008. So if the world has more oil than it can burn, why are prices so high? You could have asked that same question in 2008, and you could ask it about any number of commodities that were bubbling then from iron to houses. The answer then is the answer now.
The gist of the original argument was that efforts to open up commodities markets to broader participation by speculators had created some perverse effects. Basically, it had tamped down the notorious beta of those markets (the vast, rapid value swings), but in the process had created extraordinary risk.
Sloppy efforts at deregulation in 2000, and again across the Bush years, had made the markets more accessible to institutional traders and derivatives speculation. This had, as predicted, flattened out some of the previously troublesome unpredictability of those markets.
The problem was that the new structure of those markets created an inflationary bias. Big institutional traders don’t have the freedom to take heavy short-bets. They had a bias toward long trades that prop up asset prices long past the point when the market fundamentals have shifted away from them.
My argument, basically, was that 20th century regulators were right. Commodities markets are too inherently volatile to be opened up to speculation by day traders, pensions, banks, and sovereign wealth funds. If they are going to participate, they should not be publically insured and they should have no access to derivatives.
When combined with the rise of derivatives, CDO’s, CDS’s and other largely unregulated forms of investment insurance, commodities deregulation created three conditions:
1) A market that can’t react quickly to changes in supply and demand, which means prices tend to balloon long after real value has disappeared.
2) Forms of leverage that create no economic value while exponentially magnifying the cost of a bad trade.
3) Publicly insured institutions participating both in inflated commodities markets and hyper-dangerous derivatives trades based on those markets.
Once again, just like the last decade, we’re left with financial institutions critical to the survival of global capitalism risking their solvency on trades they don’t understand based on commodities they don’t intend to use. At least this time the exposure is slightly smaller. Nearly every American family was affected by home prices and the mortgage market. This crisis is modestly more limited in scope.
If my predictions were right then the collapse of one broadly owned commodity should create losses that force investors to sell off others as well, without any connection to a broader economic change. That’s pretty clearly happening as every commodity, even food, has started a decline.
The next step should be a collection of moderate to large hedge funds collapsing under their investment losses. That hasn’t happened yet. If we don’t see some headline-grabbing fund failures by about the end of February then this whole mess may prove to be relatively localized and I may be wrong.
Even if broader institutional failures materialize, a few firewalls might hold. For the theory to hold, then the failure of a few hedge funds should be followed by the failure of one or two major financial institutions. Their collapse should be due to the size of their CDO obligations against failed commodities bets. Again, if these institutions have figured out how to manage and regulate their derivatives trading better than they did in the last decade then I was wrong and this might not materialize. Maybe they will just experience a couple of bad quarters before stabilizing.
If commodities derivatives create yet another economic crisis, then we deserve it. We had every opportunity to shut down the perfectly pointless though lucrative speculation that created the last crash. Blame Wall Street all you want, but they don’t make the laws. Merrill Lynch doesn’t cast a single vote.
By the way, the budget bill passed by Congress last week contained a minor provision, pointed out by Senator Warren, which strips the Dodd-Frank financial regulations of just about the only meaningful provision it contained. Once the law takes effect then publicly insured banks can resume derivatives trading on their own books. America, you’re welcome.