Why does everything cost more? Blame Congress

As long as pension funds are continually allocating ever more money into commodities, they will drive the price up. It's a self-fulfilling prophecy.

By Benzinga Oct 5, 2011 4:22PM
By John Thorpe, Benzinga Staff Writer

If there were ever an official league for screw-ups, Wall Street and Congress would earn perfect attendance awards nearly every year. It seems like everything they do to "fix" some flaw in the system only serves to create two new problems down the road. (Guess who pays the bill each and every time?)


This cycle of inept intervention is described in greater detail by Dr. Randy Wray, a respected economist at the University of Missouri, Kansas City, as he describes the across-the-board increase in commodity prices in recent years.


"There are 33 basic commodities, indexes that include the 25 most important ones, and if you look across the whole spectrum of commodities, what is unusual is that they are all just exploding together.


"On the surface of it, that makes it appear to be pretty unlikely. Why would we have supply shortages across the full range of commodities and exploding demand across the full range of commodities? It causes you to look a little more closely and compare the increases of individual commodities' prices with, say, the past century's experience in each one of those. What you find is that individually, the price increases are extremely improbable. In the case of iron ore, it's a once-in-a-two-million-year event.


"Then, when you take the whole basket of commodities, and you think about how likely each one of these is, and multiply all of that together -- what has happened just is impossible," Wray told Benzinga Radio.


What caused that? Congress, of course. They saw an opportunity to do something monumentally stupid (and pay off some campaign contributors, no doubt) and rewrote the law. They deregulated the market and, the rest is, well, history.


"Congress, in its infinite wisdom, deregulated pension funds. They actually wrote the law in a way that pretty much forced [pension fund managers] to diversify into commodities. So, the pension funds started flowing in the early 2000s into commodities," Wray said.


"This sort of caught my attention in the mid 2000s. I started looking at it, and you started having the strange thing that financial market participants were buying up, or renting, grain silos to store the wheat they had been buying. They actually were diversifying into the physicals. The problem with that is that it costs money to store the physical commodities. Storage costs hit an all-time peak, so they looked around. How could they buy commodities without storing them? Well, you do it in the futures markets.


"So what pension funds did is they decided, "We're going to diversify, just like we're supposed to, into commodities. We're going to buy pieces of paper rather than the commodities. What we'll do is allocate, let's say, 5 percent of our total assets into commodities." Now, that all sounds good, but you have to remember that pension funds are huge. Pension funds have assets equivalent to 75% of GDP. So even if it's only 5% of total pension fund assets, it's huge amounts of money, and you can easily get five times as many dollar bets as there actually is of a physical commodity. As long as pension funds are continually allocating ever more money into commodities, they will drive the price up. It's a self-fulfilling prophecy because the financial flows will drive the prices up."


On the surface, this seems like a problem with one dimension. More investment in the commodities futures market drives up the price of commodities. That makes everything more expensive, which is not a good thing. But there are more problems along with this as well.


Wray explains, "Let's say a pension fund has 5% of their assets in commodities. Let's say commodities fall in price by half. They are hurt a little bit, but it's not a catastrophe. How can this possibly lead to a financial collapse? Furthermore, consumers are going to be better off as commodity prices come down. We are finally going to get some relief at the gas pump, and so on. So won't it be a good thing?


"Here's the problem. There are many ways that this can affect the economy. First, yes, the pension funds take a hit. Second, other kinds of financial institutions that are into commodities markets to the extent that it hits banks -- well, banks have already been hit by all sorts of whammies. All across the asset spectrum, they're in trouble. They're probably insolvent. This will only make those problems worse. Third, it hurts the producers. In 2008, when commodities prices collapsed, that really hurt U.S. farmers. U.S. farmers are already suffering. So they get into trouble. They can't repay their debts. That brings down their banks, and so on.


"Fourth, we know that there is high leverage and layering throughout the financial sector so that one financial institution owes another financial institution. If you go way back to the early 1980s, some will remember that the Hunt brothers had cornered the silver market. They thought they were really brilliant. They were borrowing money, buying silver, and they figured that once they cornered the market, they would have complete control over silver, and they could set any price they wanted.


"They got collateral calls that they had to meet. They needed to sell some assets. They sold silver, but they also sold their other assets. It turns out that the Hunt brothers were cattlemen. They started selling cattle. The price of cattle collapsed. Now, no one would have thought that silver and cattle are highly correlated commodities, but it turns out they were. The same thing will happen. Anyone holding commodities is going to sell commodities, and when that doesn't cover their loans, they're going to have to start selling other stuff. So, because of the linkages, we get very strange correlations. Other markets are going to get hurt too as commodity prices fall, and people have to sell commodities and then sell other assets too."


So, to recap: Congress and Wall Street teamed up and deregulated the commodities market. This drove the price of everything (from gas to food) up, and now, whether the price stays high or sinks low, we're all screwed.


Is it any wonder people are protesting in the streets and preparing for revolution?


You can reach the author by email john@benzinga.com or on twitter @johndthorpe.

 

Tags: Benzinga
8Comments
Oct 5, 2011 6:35PM
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If only congress would just go home for a couple of years and  let everything work itself out on its own, without their "help" we would be so much better off.
Oct 5, 2011 9:04PM
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We need to start with putting severe restrictions on lobbyists. No private meetings.  No gifts..... including breakfasts, lunches or dinners, trips (aka meetings, junkets, fact-finding tours), parties or fund-raisers. These rules should include all private citizens and businesses. 

Legislators all say that they need lobbyists because they provide crucial information.  Yeah.... they also provide a LOT of money.  Let them provide their "information" at public meetings.  They can state their case in public.... period. 

Private money has been sliming up the halls of Congress far too long.  Legislators need to work for the people rather than those with the most money. 

Oct 5, 2011 8:46PM
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there is nothing unusual at all.  Commodities are priced in dollars, the dollar is weak, therefore cost in dollars go up.  Try trading futures in strong currencies and look what happens, price goes down. If the Fed would stop buying debt, and the treasury stop printing money we would not have this problem.  We have high and rising prices with weak demand, when have we ever seen that before, so its a monetary problem, not a supply problem, and who sets monetary policy?  its not the people running the retirement accounts.  The hedge funds are in commodities so much since they cannot go into treasuries since the yield is below what they have to make to pay the pensioners.  MSN you should hire bankers to write this rather than kids just out of school.
Oct 6, 2011 7:48AM
Oct 6, 2011 1:02AM
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The CEO of the country is the blame.
Oct 5, 2011 10:16PM
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I need more info than the simpleton statement: "congress is to blame".  For all I know, YOU are to blame and you are an Obama mouthpiece.
Oct 5, 2011 7:52PM
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Lenny ...better yet, threaten to dust off and oil up the Guillotine !!!
Oct 6, 2011 11:30AM
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This is such an adolescent attempt at an analysis. To talk about the phenomenon of high commodity prices without talking about the US Dollar, is ridiculous. When the USD is weak and congress runs huge deficits and we borrow and print the difference, more US dollars are in circulation. When more dollars are in circulation, things that are priced in dollars reflect there being more dollars in circulation. Your logic seems to follow that when Congress deregulates something, prices go up? Let me give you examples of congress getting involved in industries: education and healthcare. Prices have soared. Do you really believe that congress getting involved increases productivity and lowers prices?

When currencies are losing there value, people prefer to hold physical assets rather than paper assets which will lose value from this inflation.

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