The war against retirees

I am quite chagrined that a number of influential folks have almost reached the same conclusion as I, namely they've concluded that "speculation" not fundamentals are driving most of the recent commodities rise, yet they reach a policy conclusion that is utterly insane: restrict or ban much of this "speculation". They stop at the word "speculation", repelled in horror by the idea, and don't take it a step farther -- ask why this "speculation" is going on. A good clue comes from those responsible for the biggest piece of it -- retirement funds. Retirement funds have long been heavy, relative to other kinds of funds, on less volatile (over <15 year periods) investments like bonds. But bonds are mostly denominated in dollars. With the threat of dollar inflation (apparent from the recent drop in the dollar, from recent Fed activity, and from the history of the floating dollar in the 1970s) they have a fiduciary responsibility to protect their investors' retirement nest eggs by hedging bond positions with commodities baskets. And that is just what they have been doing. Besides providing an inflation hedge and a performance comparable to bonds since the dawn of the floating dollar era in 1970, commodities are also "anti-correlative", i.e. they tend to move in the opposite direction of stocks and bonds, substantially reducing the risk of the overall portfolio. To suggest that commodities are not proper vehicles for investment in this era of the floating dollar is stunningly pathological, but that hasn't stopped a number of people who should know better from suggesting this.

(I suspect a similar explanation is behind much of the high Chinese demand -- but that rather than buying futures they are actually stockpiling commodities, including cutting back on production of the mineral reserves that they own, to hedge their peg to the U.S. dollar, their massive dollar earnings from exports, and their heavy investments in U.S. Treasuries, all of which are vulnerable to dollar drop or inflation -- but I don't know where data on such stockpiling activity might be readily available).

Many of these retirement funds can be politically influential. I wish, for the sake of the retirees they have a duty to protect, they would defend themselves politically against the insane proposals to restrict or ban commodity index funds. Those seeking to save for retirement have perfectly good and strong reasons for investing in commodity indices: they don't want to see their retirement funds eroded away by inflation, as happened to millions of seniors in the 1970s. More generally, people have a right to be free from ignorant government interference and federal spite when they choose to hold their savings in forms protected from the erosion of the dollar.

Commodity index exchange traded funds (ETFs) have allowed people to construct, without many of the costs, risks, and complexities of direct purchases of commodity futures, retirement portfolios hedged against inflation. Portfolios protected against inflation are an exceedingly valuable asset both for the retirees and for the society on which said retirees will be less dependent. They are also quite valuable for many other kinds of investors, such as college endowments that lower the cost of tuition for future students and fund research that benefits the future of us all. Instead of attacking the fever by shutting down the immune system, i.e. instead of attacking the commodities indices needed to hedge against inflation, it is the prior main cause of the problem, Federal Reserve monetary policy, that needs to be addressed. The Fed needs to put a higher priority on preserving the value of the dollar and fighting inflation, and it needs to use leading indicators (e.g. commodity and foreign exchange prices) far more than trailing indicators (e.g. CPI, PPI) in this task. (I understand of course that the recent credit crunch has probably been a very good reason for the Fed to "print dollars." That doesn't change the fact that the Fed is smack dab in the middle of the causal chain that has led to the commodities boom, and that savers have a right, and investment funds a fiduciary duty, to protect their savings against the inflationary effects of Fed policy).

It's certainly possible that some of the commodities boom is a bubble. It is often the case that economically efficient bull markets become overextended into wasteful bubbles, it being very hard to tell just how large of a price increase is actually warranted, and we may be seeing some of that now. (These bubbles are allowed to occur by a lack of available instruments for speculation, especially the transaction costs involved in holding long-term short positions against markets that may rise substantially further before they fall. The worst way to combat a bubble is to ban the last modicum of imperfect speculative mechanisms such as short sales that currently prevent bubbles from getting worse). There is no easy way to gauge just how much retirement funds and others seeking to hedge inflation need to allocate to commodities baskets in order to optimize their portfolios, because it depends greatly on future Fed behavior. On the one hand we know that hyperinflation has sometimes occurred historically with floating currencies, so that dramatic further increases in commodity prices are possible; on the other hand the farther commodity prices go up (and they have gone up very far indeed) without corresponding inflation in other goods and services, the more downside price risk there is in commodities. Oil next year might be $40 per barrel, or $300 per barrel, or anything in between. It's certainly true that commodities have become a far riskier, i.e. more volatile, investment than they were three years ago, and that puts a severe limit on the proportion of an investment portfolio it makes sense to devote to commodities. But that proportion is certainly nowhere near zero as the lunatic anti-"speculation" activists would have it.

(This post is based on a comment I made on a previous post. Here,, h/t to reader "munin", is a hedge fund guy who reaches almost the right theory, but the abominable policy conclusion, and is the source of the graph above. Here is some of my previous writing on this subject: The Monetary Value of Liquid Commodities and Commodity Derivatives: The New Currencies).

[Update: at least we don't have war hysteria (or click to enlarge the facsimile at left). Note that Herber Hoover, who many history books still proclaim with preposterous prevarication to have been a free market guy, and who later presided over the start of the Great Depression, was at this time (1917) the head of President Wilson's Food Administration, which came up with this plan for "Control of Food By Government". Hoover's food plan, like the crazy plans to "fix" the commodities markets today, was designed by and for the ignorant and the paranoid, targetting "Evils" of "Unreasonable Profits, Speculation, and Hoarding", i.e. the "evils" of people stocking up to ensure own and their customers' future food supply instead of letting the benevolent Herbert Hoover control it for them. Today it is apparently evil to protect your retirement nest egg instead of letting it fall with the dollar].