The "hoarding" and "speculation" in commodities

It is a gross violation of Occam's Razor to attribute the recent very broad-based run-up in dollar commodity prices primarily to the plethora of disparate causes to which they have been attributed: "peak oil", the war in Iraq, ethanol subsidies displacing food, and so on. Rises in industrial demand, increases in the costs of transporting commodities due to high oil prices, and so on explain only a small fraction of the rise in other commodity prices, and do not explain at all why precious metal prices have increased alongside those of other commodities. Occam's Razor points us, as it did to wise investors and economists in the 1970s, to the one kind of commodity all these other commodities have in common: the currencies they are priced in.

In the 1980s, there were just as many of these disparate bullish factors for commodities as in the 1970s and as today. In the 1980s there was increasing industrial demand in Asia and the developing world, and the Iran/Iraq war drove insurance rates for oil tankers in the Persian Gulf into the stratosphere, yet commodity prices in dollars and dollar-linked currencies broadly fell, due to the emphasis of the Federal Reserve on fighting inflation throughout the 1980s.

Commodity prices now reflect more the value of commodities as stores of value and hedges or media of exchange, i.e. their values as money substitutes or hedges, than they reflect demand for their industrial consumption. The trend lines for global industrial demand have not really changed that much -- the increases in Asia are largely offset by slower demand growth in Europe and the U.S., and at today's high prices we will see industrial demand slowly fall in the U.S. and Europe and level off in Asia.

But demand for the oft-dreaded but ill-understood "hoarding" and "speculation", that is storing extra commodities (often off-the-books, or at least not in the officially measured warehouses) and the purchase of extra commodity futures and other commodity derivatives to hedge transactions based on government currencies, will remain strong as long as the Federal Reserve continues to inflate the dollar supply, and as long as many developing countries continue to link their currencies to this dollar. Commodity prices in dollars will level off, and then move back down close to historical trends based largely on just industrial consumption, if or when the Fed stops increasing the supply of dollars faster than the demand for dollars. If the Fed continues trying to inflate its way out of the latest bubble-following slump, commodities will not be the next bubble: instead they will form the basis of the new de facto currencies of high finance. See

The monetary value of liquid commodities

and

Commodity derivatives: the new currencies

Obviously the euro also plays a big role, but it is important to observe that the euro too has inflated, just to a lesser degree than the dollar. The euro has not developed the track record that would make many international investors think euro-denominated debt does not need to be hedged with commodity derivatives. Some wise investors still remember the hyper-inflations and outright defaults of the late 1920s and early 1930s that made many government bonds almost worthless, the destruction in the value of the U.S. debt in the 1970s from inflation, and many similar episodes. In these circumstances commodities are usually safer than government debt denominated in the fiat currencies of the same governments that owe that debt.

That's why the current flight to safety involves commodities as much or more than it involves government debt, and indeed the debts of less robust governments (ranging from municipalities in developed countries to the national debts of less developed countries) are no longer considered safe. It is well known by now that U.S. Treasuries are "safe deposit boxes" that pay negative real rates of interest -- i.e. one must pay for the privilege of storing one's wealth in a form backed by the vast future revenues of the IRS. They are a way losing one's wealth with less rapidity and volatility than with many alternative investments, not a way of actually building wealth. Commodities also store rather than build wealth. By contrast to Treasuries, commodities are more volatile, but are not subject to unknown future amounts of fiat currency inflation. A mix of U.S. Treasuries, European debt, and commodity derivatives now forms the ideal safe "store the cash under your bed" portfolio. Government debt alone is far too risky during periods when central banks are not strongly committed to reigning in money supplies.

[The above is based on comments I made at the Marginal Revolution blog].

Gas stations grant real options

Imagine if the only place you could refill your gas tank was at home, so that you could never choose to drive farther than one tankful of gas would carry you. Furthermore, imagine that it usually required most of a tankful to get from one place you want to go to another -- or to get back home. So you usually could choose to go only one place per trip, and even when you could go more than one place, you had to plan the entire trip well ahead of time and could not deviate from it, no matter how much your needs changed while on the trip.

That is largely the situation with space operations today. You have to plan the entire mission ahead of time. If in mid-mission you discover that you want to change the plane of your orbit, or extend the life of your satellite, or make any other change that requires more propellant than you long ago planned for, you are out of luck. If you want to reserve a wide variety of such decisions instead of committing to the entire plan up-front, it won't happen unless you launch a great deal of extra propellant that you will probably never use.

Refueling capabilities and orbital propellant depots can change that. They provide choices -- what economists call real options.

Like financial options, in an uncertain world real options often have substantial value. The kinds of real options commonly encountered in the business world include input mix options (options to use different inputs to deliver the substantially same output), output mix options (to use the same inputs to deliver different outputs), termination options (to abandon early failing projects or projects that have become unimportant), intensity or scale options (options to increase or decrease output), options to stop and restart, and switching options (the option to abandon one mean or end and change to another). All of these options can have a substantial operational and financial value that is not captured by traditional analysis of fixed plans.

Propellant depots don't provide substantially cheaper propellant: it must all, for the near future, still be launched quite expensively from earth. And propellant depots don't provide an infinite variety of choices. They won't make it affordable for astronauts headed for Mars to return back home when they discover that they forgot to pack their toothbrushes. Orbital mechanics is relentless and an option to take on extra, but still expensive, propellant can only change things so much, and you especially won't be able to afford such an option if you're off the beaten path. But propellant depots and refuelable satellites will allow those operating satellites in common orbits, such as geosynchronous orbit and low polar earth orbit, to change plans during a satellite's lifetime by adding a wide variety of valuable real options, for example:

* Spy satellites have highly uncertain propellant usage, and often end their lifetimes mostly full of propellant or exhaust their propellant long before any other components have degraded. Propellant depots will give spy satellites real options to optimize time over certain targets, to avoid a variety of attacks by changing orbits, and add flexibility to respond to other unpredictable challenges.

* Commercial satellites: depots will extend the lifetimes of satellites that prove to be important, and allow satellites to be relocated over new locations as markets change. (With a few extra features on a depot tanker, propellant already on board a broken satellite, or a satellite that has proved to be unimportant, might be "siphoned" back into the tanker and used on a working and important spacecraft).

* Upper stages and satellites can be checked out to make sure they are in working order on orbit before being fueled. Immediate systems failure, which is a common failure mode, need no longer result in the waste of expensive propellant.

This short list is probably the tip of the iceberg. Real options are about the unpredictable, and it's hard to make a list of the unpredictable ahead of time. On-orbit refueling and orbital propellant depots are not just a technology, they are part of a new paradigm. They are part of thinking of space activities in terms of real options instead of fixed plans. This paradigm recognizes uncertainties in space missions and businesses that traditonal fixed space planning has neglected. Making good use of propellant depots requires not only technology, but the recognition of these uncertainties, and as a result a recognition of the options that businessmen, militaries, and scientists would like to retain. Those options can then be brought to reality with refuelable satellites and orbital depots, quite possibly in association with other technologies that enhance mission flexibility in other ways. It's not propellant depots and refueling capabilities by themselves that will be beneficial, it will be their use to enable a wide variety of new and valuable real options for spacecraft operators and users. It will be a crucial and lucrative entrepreneurial task to identify these real options and enable them with refuelable satellites, depots, and probably a wide variety of other techniques and services.

Going back to our humble earthbound example, real options explain why most commuters prefer cars (with gas stations available in a wide variety of locations) to mass transist. Mass transist resembles far more the fixed plan -- travel from home to work and back every day, and that's it. Under the fixed-plan assumption, mass transit is far less expensive and far more energy-efficient than automobiles. Cars, and the gas stations that refuel them, provide real options -- to pick up kids from baseball today, to go to a class after work tommorrow, to go shopping at one of a wide variety of stores, to visit your doctor or the emergency room when you get sick, to pick up your friend from the airport after work the next day, and so on. Mass transit and traditional space mission planning both represent the mentality of artificial certainty, the idea that we can simply plot out the future and it will come to fruition just so. At least space mission planners have the excuse of orbital mechanics, which is highly predictable. Human beings are not, nor are the vast variety of our needs and desires known to planners. Economic comparisons between mass transit and automobiles that don't account for the vast number and variety of options made real by the the latter will grossly underestimate the value of automobiles.

Related:

Real options analysis also allows planning for discontinous risk, rather than the artificial assumption that risk is a continuous function that can be modeled simply by adding a risk premium to a risk-free interest rate. More on that, and the implications for space mission evaluation, here.

Here is an introduction to mathematical analysis of real options, and here is a discussion of orbital depots for propellants that turn into vapors at normal temperatures, and are thus hard to store.

Commodity derivatives: the new currencies

Unable to otherwise explain today's high commodity prices, Frank Veneroso and others fear we are in a commodity bubble. Exhibit A is the recent vast increase in the use of commodity derivatives[*]:



Here's how Veneroso observes the unprecedented state of our commodity markets:

Though the six-fold increase in such positions over a few brief years is dramatic , it is the magnitude of these positions that is most alarming...It is hard to know what to make of this data. But it is noteworthy that several years ago, at the then prevailing lower commodity prices, the entire above ground stock of all commodity inventories was only in the hundreds of billions of dollars. Even if only a fraction of the increase in global commodity derivative aggregates in recent years corresponds to a net long position of investors or speculators, implying speculative and investment positions of a “few trillions of dollars,” it would appear that this increased demand for commodity derivative positions has overwhelmed what have been relatively small markets...

No wonder, then, that this cycle’s bull market in commodity prices has gone higher in inflation-adjusted terms [i.e. in terms of the CPI and PPI -- a poor near-term measure of inflation, see below] and for longer than in all prior uninterrupted half-decade cycles in the past.

I agree with Veneroso that the recent commodities boom has a strong causal link to the recent rise in the amount and variety of commodity derivatives. But I couldn't disagree with him more about the role of inflation. Prices, and especially wages, react very slowly to changes in money supply, so that the CPI and PPI are trailing indicators. The leading indicators are increases in money supply in excess to increased demand for money and the associated (if disproportionate) increases in commodity prices.

M3, an estimate of the supply of dollars (including a reconstructed estimate for recent years). M3 is increasing at the highest rate since the 1970s, as are to a lesser extent the supplies of euros and other major currencies, resulting in a commodity boom not seen since the 1970s. Source: nowandfutures.com

The recent vast increase in commodity derivatives, and the resulting commodity boom, is a largely rational response to the vast increase in the supply, relative to demand, for the dollar and to a lesser extent the euro and most other major currencies during most of the last decade. This despite the fact that commodities prices have in the last year risen (at about 40%/year) much faster than the growth of money supply (about 15%/yr). To see why, observe that one of the most useful but least talked about uses of derivatives is their ability to simulate the economic behavior (primarily risk and return) of one kind of asset based on contracts for another kind of asset or performed in another legal environment. The classic example is Eurodollars. But let's take a general scenario:

Alice wants to promise Bob to transfer asset X. But the risks associated with Bob holding asset X on his balance sheet, or Alice holding liability X on her balance sheet, until actual transfer of the asset, are too high, or the transaction costs of actually transfering X from Alice to Bob are too high, or both.

(1) Solution for risks of holding asset X on books: derivatives. Alice has both assets and liabilities on her books. These have individual and net risks just like an investment portfolio. If Alice has the same amount of assets and liabilities all denominated in the same currency, her portfolio is balanced. But if, for example, she imports from Europe (thus creating liabilities in euros) and sells in the U.S. (creating assets in dollars), her portfolio becomes strongly subject to risk of dollar devaluation against the euro. If a new asset or liability creates such unbalanced risk, it can be hedged with derivatives.

(2) Solution for transaction cost of transferring asset X from Alice to Bob: use derivatives to create a synthetic asset. Construct from derivatives and asset Y a synthetic asset that economically behaves like asset X. These separate derivatives and asset Y that form the synthetic all can be transfered with low transaction costs, thus forming an asset economically equivalent to asset X but that, unlike X, can be transferred from Alice to Bob at low cost.

The reason these uses of derivatives are seldom talked about is that the main cause of problem (1) is the instability of government currencies that it is legally necessary (for a variety of reasons) for contracts to be denominated in. The cause of problem (2) is usually a legal barrier to a particular transaction -- a tax, exchange control, risk caused by regulation, or risk of confiscation in Bob's jurisdiction are four examples. People who route around the law tend to do so quietly, explaining their acts by euphemism, even if as here the new route is perfectly legal and is made necessary by deep flaws in the law or the way the law is executed.

There are often, in other words, huge discrepencies between the contract terms required or incentivized by law and the most economically efficient contract terms. Partly this is due to political stupidity, and partly to the inevitable profound imperfection of any body of rules.

(3) A third function of derivatives is simply as a store of value: a way to diversify or hedge inflation risk in an investment portfolio that otherwise contains either (a) debt denominated in a potentially inflating currency, (b) equity in companies with assets consisting mainly of debts denominated in a potentially inflating currency, or (c) both.

In performing functions (1) and (2), derivatives usually substitute for or augment currencies as a medium of exchange. For (3) they substitute for or augment the monetary function of a store of value. Most derivatives, in other words, perform largely monetary functions. They augment or substitute for a flawed method of payment or a flawed store of value.

Gold prices in dollars (and, not pictured here, the dollar prices of many other commonly traded commodities) roughly follow changes in the global monetary base of dollars. Source: nowandfutures.com

In a climate where one or more commonly used currencies are inflating (and by "inflation" I simply mean rise in money supply without concurrent rise in demand for that currency, not the CPI or any particular and usually trailing measure of inflation), derivatives, if they can be analyzed and traded at low cost, are very much in demand. Furthermore, if all of the currencies practically available for contractual payment terms are inflating, these derivatives will come to be increasingly based, not on currency-denominated debt, but on commodities, especially commodities for which supply and demand are relatively inelastic in the short and medium terms.

Why is it rational, rather than reflecting a bubble, for the recent rise in commodity prices to outpace the recent rise in money supply? The rise in commodity prices reflects the increase not just in supply of dollars per unit of commodity, but greatly increased demand for a commodity as money, i.e. for the monetary functions it serves either directly or indirectly via derivatives, on top of the relatively steady demand for consumption. As I have argued elsewhere, this increase is broad-based: all commodities that can be traded with low transaction costs on modern markets, and that exhibit short- and medium-term inelasticity of supply and consumption demand, are useful for and are being used as reserves for the new derivative currencies. Where computerized analysis lowers mental transaction costs, as with modern derivatives, it pays to diversify one's books, portfolios, and hedges among multiple currencies.

Of course, the traditional use of commodities futures and derivatives by commodity producers and consumers to hedge the assets and liabilities of the commodity sales and purchases inherent in their business continues. But these don't account for the vast majority of commodity derivatives use in recent years.

Before modern computers, networks, and software engineering, the cost of such derivatives was usually prohibitive. In the last period of monetary inflation and the resulting commodity boom, the 1970s, derivatives were available to few and only the very simplest hedges or synthetic assets could be understood, and even then very imperfectly. Today derivatives, and their use in very complex hedges and synthetic assets, are much better understood by most of their users, thanks to computerized game tree analysis, and are available to many. They can be designed, simulated, and traded electronically with very low transaction costs. Computerized derivatives are smart contracts that lower mental transaction costs. So much so, that they've created a vast new world of contractual relationships completely impossible with the brain alone.

Speaking perhaps a bit metaphorically, we are witnessing the rise of new and privately issued fractional reserve currencies. They need not and effectively cannot legally be called "money" by their "issuers", nor can they effectively be used directly in most contracts for payments. But they can be used indirectly to hedge payment terms or investments denominated in flawed, that is in inflating or otherwise unstable, government currencies in which normal contracts and instruments are generally denominated. The results are synthetic "currencies" that, in their economic behavior, may be almost indistinguishable from a tradtional commodity-backed and privately issued fractional reserve currency.

No wonder the Federal Reserve and other central banks are moving hard to usurp jurisdiction over derivatives (per, for example, the recently announced Paulsen plan here in the U.S. to consolidate a variety of financial regulation under the Federal Reserve). To effectively regulate derivatives, for better or worse, the Fed will have to understand them first. But they do not have this knowledge. Indeed no human brain holds this knowledge. The knowledge needed to understand the dizzying variety of derivatives exists mainly in the form of computer simulations.

Derivatives, the money of the digital era, perform monetary functions in competition with the Federal Reserve's dollars, an increasingly primitive holdover of the paper era. By regulating derivatives the Federal Reserve regulates its competition. This creates a profound conflict of interest. It's like putting Rust Belt executives in charge of Silicon Valley. Such regulation may cause, not the popping of a commodity bubble, but the destruction of a nascent economic order made necessary by the prediliction of the Federal Reserve and other central banks to inflate their fiat currencies. Whether ignorance or conflict of interest will play the greater role in the destruction of the new currencies, or whether one will cancel the other out leaving the derivatives markets in relative freedom, remains to be seen.

[Obligatory Wikipedia links: Eurodollars, elasticity]

[H/T: I learned of Venero's paper from Byrne Hobart]

[Here's a prior explanation of mine giving a broader overview of why commodity prices reflect demand for their monetary functions as well as for their consumption, but not explaining the role of derivatives].

[*] These numbers are a bit stale -- it would be great to see to what extent this growth has continued. If any reader has data on commodity derivative use through 2007, please let me know.

[UPDATE: here is more straightforward article that gets the basic facts right: production up, inventories up, consumption down, prices up -- inexplicable if consumption is the only major source of demand -- but gets the explanation wrong, replacing the rational and efficient use of commodity derivatives as money that I have described here with the typical speculations about "speculation" resulting in a "bubble"].

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Laches

Laches is the common-law name for the concept more commonly known as "the statute of limitations."[*] The idea is that, if a wrong has been done, or there is otherwise a dispute, we put a limit on the time within which the victim or the victim's estate can file charges or sue for damages. Laches or statutes of limitations apply to practically all kinds of wrongs of any nature. There are three strong reasons for setting time limits on redressing wrongs:

(1) Memories fade, witnesses die, and evidence is degraded or destroyed, rendering the rights and wrongs of the case increasingly uncertain and susceptible to biased propaganda.

(2) Security, confidence in, and stability of legal rights are crucial to a civilized legal system. But if we go back far enough, the "chain of title" for almost every legal right we have (including our political as well as economic rights) can be plausibly argued to be illegitimate due to some kind of unredressed wrong: some commission of force or fraud that was never remedied. Without a time limit, hardly any legal right of almost any kind could be held with legal security.

(3) Having the estate of one person be responsible to the estate of another person for a wrong committed by the ancestor of one to the ancestor of the other gets us too far away from the individual responsibility and the shaping of behavior through incentives that is at the core of law.

Laches should also be a core political principle. Allowing some classes of citizens to extract "reparations" from other classes of citizens for harms done by some or many of the ancestors of members of one class to some or many of the ancestors of another class, without setting any time limits, renders the legal rights of all persons insecure. Evaluations of ancient wrongs are susceptible to very distorted propaganda. Punishments of individuals who did not commit the wrongs do not deter the recurrence of such wrongs in the future, and indeed are themselves wrongs that foster further resentment and breed more future claims for redress. The moral imperative holding the members of one very imperfectly defined class, rather than persons who actually committed the wrongs, for the wrongs committed to some of the members or ancestors of another class, already doubtful, becomes increasingly doubtful as time goes by, as does the power of such laws or other political acts to shape behavior to desirable ends through incentives.

[*] Technically, the term "statute of limitations" applies where a statute expressly sets a time limit, and the doctrine of laches applies where no such statute exists.

How our frog was boiled

Libertarians have long observed with regret the radical expansion of the power of the United States federal government over its original scope under the Constitution of 1789. Lovers of freedom tend to blame two chief culprits for this expansion: President Abraham Lincoln, who instigated our Civil War, and President Franklin Delano Roosevelt with his New Deal. And indeed, these Presidents did instigate some noxious precedents: Abraham Lincoln the draft and income tax, FDR the advocacy of positive substantive rights and the birth of practically unlimited regulatory power of federal government. Some cite villains from the Progressive Era, such as Theodore Roosevelt and Woodrow Wilson.

However, these theories oversimplify U.S. history to the point where the real and fixable sources of our loss of freedom cannot be identified. They make it sound like if we could simply go back in history and remove a handful of powerful villains, or avoid a handful of crises, then we would be living in a much freer society today. That is very far from the reality.

The consequences of even Lincoln and FDR were not unmixed. Lincoln damaged some freedoms, but he also greatly increased freedom by ending slavery. The Civil War Amendments, especially the 14th Amendment, eventually led to a great increase in the enforcement of unenumerated rights (hence the name of this blog!) and the Bill of Rights against the states (and, for reasons I relate here, hence also against the federal government). Among the leading countries in the middle of the evil 20th century, the United States despite FDR was the most free. FDR destroyed the threat of fascism and appointed most of the Justices who ended forced and unequal segregation by race. One can easily argue, especially in the case of FDR, that the curses outweighed the blessings, but one cannot seriously portray even these powerful Presidents as unmixed enemies of freedom. It's great fun, and may be morally imperative, to blaspheme these great gods in the pantheon of government worship, but criticisms of these particular actors don't get us to the core of why, in the face of a Constitution that outline a strictly enumerated set of powers, the adherents of that religion were able burst far beyond those bounds and render them nugatory.

The expansion of power of the U.S. federal government was not primarily due to villians, crises, or revolutions, but far more resembled the proverbial boiling frog: it mostly happened by small and obscure steps that were not widely noted by lovers of freedom at the time, and have seldom been noted by us since. The slow rot of Constitutional protections against federal power stemmed from subtle but endemic flaws in the original frame of our federal government, the rise of an economy where large numbers of people earned income from auditable corporations (making the income tax, the most lucrative tax in history, practical), and the disappearance of frontiers of free land to which the overtaxed or overregulated could flee. This article focuses primarily on the first, the clearest and most fixable cause, the procedural flaws in our Constitution.

The U.S. Constitution lists a number of enumerated powers, beyond which Congress was granted no power to legislate. In other words, the U.S. Congress was supposed to have a small, close-ended list of powers, and this is still recognized by the Supreme Court as theoretically true today. If this had remained true in practice, as well as legal theory, the U.S. federal government would be a radically libertarian entity today. That it is no longer practically true, is, more than any other factor, due to the long series of usurpations of power by Congress under the Commerce Clause, which in its words gives the Congress the power to regulate “commerce among the States.” At the time, this power was thought to be limited to power to regulate the transport of goods and persons across State boundaries, and indeed in the first century of the Constitution it was largely in practical fact so limited. (There are a number of other causes, such as the 16th Amendment of 1913 legalizing the income tax, but the Commerce Clause is the way in which Congress has most expanded its power to regulated, and an extremely vast expansion it has been).

It’s fairly obvious why Congress, by itself, has not and would not seriously let any kind of Constitutional text limit its own power. Less obvious is why the Supreme Court, which has the final word on interpreting Congressional power to legislate under the Constitution, would allow Congress to so greatly expand its powers. But that is just what it did, by many slow and incremental steps.

Under Chief Justice Marshall, there were a number of cases restricting the power of States to regulate what Marshall argued was interstate commerce, and thus under federal jurisdiction. In immediate effect these were libertarian decisions, since they overturned often burdensome State laws. The Marshall Court, and the Story Court that followed it, refused to find, even once, any limits on the federal Commerce Clause power. Although it was generally agreed that “commerce among the States” was limited to the transport of goods and persons across state lines, Marshall refused to define it in this manner, or indeed define any clear outer limited to the Commerce power. Indeed, in dicta (sentences in a legal opinion that are not legally binding, because they are not logically necessary for reaching the verdict), Marshall suggested that any activity that “effects” such transport might be regulated. Although Marshall’s nationalist ideology set the tone, overturning state laws and ignoring federal laws, this pattern of limiting state usurpations but ignoring federal usurpations was largely continued by future courts, for reasons of bias or conflicts of interest caused by court selection and structure which I describe here.

Although there were a handful of cases limiting the Commerce Clause in very narrow and specific ways at the end of the 19th century, the Swift v. U.S. case in 1905 greatly expanded the Clause’s scope to cover manufacturing, not just the transport of goods or persons across State borders, on the theory that the manufactured goods would end up in interstate commerce. This was part of the so-called “Progressive” movement, the rise of the modern religion of "the government", an omnipotent deity called upon by the national press to solve any major problem deemed to be national in scope. This era saw the greatest expansions of federal power in U.S. history, including its basic tools of financial power, the Federal Reserve system and the 16th Amendment in 1913 legalizing the income tax. During this era, in which states also greatly expanded their powers, the Supreme Court was again far more active at limiting the states than limiting federal power. The “Progressive Era” was a very broad and general ideological movement, and most of it cannot be pinned on any particular politician. Drivers of the movement included the steam press and news wire agencies, which promulgated a national view (that vague godlike phrase, “the government”, came to refer to the federal rather than state government during this era). Under this new media system information transfer became dominated by the press releases of powerful governments and corporations. The spread of government-mandated education, again inculcating a very nationalist view, in the latter half of the 19th century also played a large role. The end of free arable land on the Western frontier and the rise of the auditable corporation also played crucial roles in facilitating much greater levels of taxation. During this era, except for a handful of minor victories, the federal courts did not prevent Congress and the President under the impetus of this movement from usurping vast powers not granted them under the original meaning of the Constitution.

After this, the New Deal simply delivered the coup de grace. In Wickard v. Fillburn, the Court proved it had no desire to limit the federal government in any serious way, using Marshall’s “effects” dicta to justify its holding that growing wheat on your own small farm for your own consumption is “commerce among the States." Quite recently, the Supreme Court reconfirmed this absurdity: growing marijuana in your house is also “commerce among the States.” And thus the frog has been boiled. To this day our amphibian does not realize that it has already been cooked. The idea that the U.S. Supreme Court, given this long history of precedents, and the same kinds of selectional and operational biases it has always operated under, will ever seriously limit federal power again, just because that is what the Constitution says it must do, is far-fetched. Our courts as currently structured will only protect certain narrow rights of persons under the Bill of Rights from otherwise omnipotent governments. The idea that “We the People” will somehow elect a Congress or President that will voluntarily waive their own powers is even more absurd. Libertarians are playing a game with a very stacked deck, and that deck is stacked by the Constitution itself, the very same Constitution that in its original meaning was, substantively, radically libertarian, but that included procedural incentives for Congress and the Courts to slowly aggrandize federal powers.

The monetary value of liquid commodities

In modern commodity markets one can exchange money for commodities at almost zero transaction costs. These markets thus reflect not just the supply and demand of the commodity, but also the supply and demand of the currency they are priced in.

Because they combine liquidity with short- and medium-term supply inelasticity, mineral commodities are a good way to hedge a falling currency. When the supply of money increases or is expected to increase, whether because of lower nominal or real interest rates, because the bank that issues the currency is buying government treasury bonds or (like John Law of Mississippi Bubble infamy) mortgage-backed securities[*], or for any other reason, a disproportionate amount of the expected or surprise increase in money supply is soaked up by commodities. Indeed the commodities with the most liquid markets and inelastic supply, such as oil and gold, tend to move in lock-step with each other. Such price movement is strong evidence for the movement being primarily a phenomenon of changing money supply or demand rather than of changing supply or demand for particular commodities. If oil prices were rising primarily due to rising industrial demand for oil, or primarily because oil was getting more expensive technologically to produce (e.g. "peak oil" theory), we'd expect them to move quite differently than gold, which is demanded for primarily non-industrial reasons and has a vastly greater inventory/production ratio on the supply side than oil. That's not what we see -- we see oil and gold moving together, and indeed the price of oil in terms of gold and silver has been practically flat in the recent commodity boom. This is almost entirely due to expected or actual increases in the supplies of the currencies they are traded in (and especially recently in the weak dollar) rather than to "real" factors.

This inflation only slowly percolates into price rises in other goods and services, which tend to be far more rigid than commodities. Wages are particularly rigid. Because the U.S. Federal Reserve and most other central banks regulate their money supplies based on trailing indicators of inflation(e.g. consumer price indices) rather than leading indicators (commodity prices), it is no surprise that their decisions tend to produce boom-and-bust cycles in commodities, and that to a lesser and more delayed extent they cause both general inflation and recessions. No uncommon demand from China or the like is needed to explain the recent commodity boom, just as no such rise in demand or long-term fall in supply was needed to explain the very similar commodity boom in the 1970s. But since most people judge supply and demand of a commodity by nominal price, both in the 1970s and now we get a lot of irrational hysteria about "running out", "peak oil", how our energy industries and consumption are "unsustainable", etc. I'll believe that when oil per barrel doubles or more with respect to gold and silver. When they move together, we're just being fooled by monetary instability, and most of the current disproportionate increase in investment in energy supplies and conservation, whether traditional or renewable, is malinvestment in response to highly distorted nominal price signals, as is the accompanying political bubble of "energy security", conservation enforced through idiotic micro-regulations (e.g. banning traditional light bulbs), and so on.

Another way of putting this is that, when currencies become unreliable as a store of value, commodities take on part of that monetary role. Both oil and gold increase in value by performing this monetary function better than the currency against which they are being traded, better than credit instruments denominated in that currency, and even better, in the short term, than stocks of companies that do business primarily in that currency. The joint movements in oil and gold reflect their value, relative to the currency they are priced in, performing the monetary function of a store of value. Global supplies and industrial demands for minerals are far less volatile than the change in their value in this monetary role. It's the logical emergence of money from barter, but this emergence goes on every day that liquid commodities act as a better store of value than the currency in which they are priced. Contrariwise, as the currency becomes a better store of value than the commodity, these commodities move back down towards just being commodities valued only for their consumption. Thus their exaggerated moves, both upward and downward, in reaction to changing expectations of future increases or decreases in money supply.

Due to their exaggerated moves and the relative rigidity of most non-commodity prices, commodities themselves are an imperfect store of value. They react far more than the general level of prices to both increases and decreases in money supply, or changing expectations of same. If the Fed stops playing John Law and desists from buying bad mortgages, if others besides the Fed soak up all the new Treasuries produced by large federal budget deficits, ifcounterparty risk in credit markets subsides, the Fed can raise rates, sell securities and retire the money, and otherwise take steps to lower the money supply and stanch inflation. In such a case, commodities will react disproportionately on the downside, as they did in the 1980s. If the Federal Reserve can't do these things, dollars and dollar-denominated securities will continue to decline and people will increasingly turn to commodities to protect their nest eggs. All the ads I see and hear for gold these days suggests the peak of a commodity bubble is near, but on the other hand credit markets may worsen due to the continued crashing of the previous bubble (the housing/mortgage bubble), federal deficits may continue to increase, and the Fed may thus buy even more securities, making commodities even more attractive. I'm thus afraid that I have no buy or sell recommendations for you, dear readers. :-)

[This comment is based on a comment I recently made at the Marginal Revolution blog].

* [Obligatory Wikipedia links: John Law, Mississippi Bubble, BearStearns bailout]

[UPDATE: reader Byrne Hobarth has linked to this excellent analysis of the commodities market. This study debunks the theories that trends in supply or consumption demand, very steady over the last century, have greatly changed over the last decade. In particular, increased demand for many commodities such as copper in China has been offset by slows in growth or declines in demand in Europe and the U.S.

The studies' thesis is that the commodity runup is largely just a bubble. The study shows the spectacular rise in commodity derivatives. These represent far more contractual liability or asset than the underlying commodities. Treating commodities as money, this to me looks like a new emergent form of fractional reserve banking, but reconstructed in the investment rather than the banking sector. These derivatives, on this view, act essentially as private fractional reserve currencies, backed by a variety of commodities. The report views all this as evidence of a bubble. It points out we haven't yet seen the consumer inflation of the previous commodity bull. I emphasize yet. Consumer prices are a trailing indicator, and I believe the commodity markets are more rational in anticipating and reacting to money supply increases than they were in the 1970s thanks to the dominance of derivatives. The development of these new kinds of currencies, though prone to the risks and errors of novelty, are largely rational.]

Representation distance

An agent (or representative) is a person authorized by his principal (or constituent) to act on behalf of that principal. The task of the agent, ideally, is to implement the will, interests, or preferences of that principal. The degree of communication and control of the principal over the agent varies greatly. Examples of principal/agent relationships include employer/employee, shareholder/management, and voter/representative. Agency law and principles can be applied, metaphorically or actually, to all such relationships. Economists study the “agency problems” that occur when the agent’s behavior is influenced by other interests, especially his own. A contract in which, when rules are not specified, one person is legally or morally expected to learn and implement the preferences of the other, or at least to maximize an abstract measure representing the preferences of another, is an agency contract.

Agency contrasts sharply with a grant of property rights. The grantee, the person to whom property is granted, is bound by the rules of the grant, not by the will of the grantor. A grantor can cause his interests to be represented only through specifying, before the grant is made, the conditional rules under which the grant is made. Within the grant condition and boundary rules, the owner of property is legally expected to act solely in his own interests. With political property rights, the “boundaries” are rules of legal procedure which the owner may not breach. A similar but temporary effect can sometimes be achieved with a contract that details all of the rules of the relationship, with the legal and moral understanding that all else about the relationship is simply a matter of personal preference rather than of one party learning and implementing the preferences of the other.

Representation distance estimates the degree of loss of information, control, or both in a principal/agent relationship. In other words, it estimates the degree to which the agent fails to know or implement the true preferences of the principal(s). In a representative democracy or republic, representation distance estimates the degree to which the representative actually represents the interests (basically equivalent to economic preferences, but in politics they might also include preferences to coerce others) of his constituents rather than others.

Representation distance generally grows with the size of group represented. Since even any two people communicate imperfectly, and have conflicts of interest between them, it's not even possible for one person to perfectly represent another, albeit such representation can far more accurately represent any interests than representing a group. One can think of this distance as being minimal, call it 1, when a person is acting for himself. When one principal delegates duties to one carefully chosen and monitored agent (a.k.a. representative), the distance is some greater value, perhaps 2. Representation distance is further compromised by majority vote, which leads to two losses: (1) the interests become increasingly general and vague, rather than the specific and concrete interests the voters actually have, as the number of voters increase and (2) the interests of minorities tend to be neglected. These numbers are purely illustrative (perhaps we should start at zero), and the function whereby representation distance increases with the size of the group represented is unknown.

A similar effect occurs in shareholder/management relationships. Shareholder interests vary greatly. Their time preferences for dividends or capital gains vary greatly. They sometimes have non-monetary interests, as in "socially conscious" investing. But the duty of management to shareholders usually gets stripped down to a very simple one, a fiduciary duty to maximize profit.

There may also be efficiency measures proportional to representation distance. For example, the efficiency of investment in public goods (where the "public" is just the population of voters) may be some function of the number of voters. On the other hand, larger representation distance may have a good effect in decreasing the ability of some voters to coerce or oppress other voters via the representative.

Vast amounts of money are put into K Street lobbying, primarily by corporations and government employee labor unions. This is readily explained by representation distance: the relationships between lobbyists and Congressmen, and even more between lobbyists and unelected but influential bureaucrats, often have a much shorter representation distance than those between voter and Representative. (The much shorter physical distance, which greatly facilitates face-to-face relationships, greatly helps to shorten the representation distance, but these are otherwise independent ideas). We can thus expect persons with sufficient resources at stake, such as corporations and government employee unions, to put far more effort into lobbying than they or others do into mere voting.

Since a political representative represents not the only normal economic preferences of voters, but also preferences to coerce others, large representation distance is not necessarily a bad thing. An effectively infinite representation distance is effective independence, which is often a good thing. (We can’t achieve perfectly infinite representation distance, of course). We want the legislative, executive, and judicial branches to operate independently, for example, not for one to represent the other. However political property rights, or contracts where when the rules are unspecified on party is not expected to learn or implement the preferences of the other, are usually a far better way than pseudo-representation to achieve independence or infinite representation distance. Political property rights turn at least putatively will-based (a representative is supposed to represent the will of his principal(s)) system into a rule-based system (the owner must operate within the procedural bounds of his property right, and is expected within those rules to learn and follow only his own preferences). Pseudo-representation -- the use of the language of agency depsite a very large representation distance -- may, however, provide an illusion of participation sufficient to satisfy the naive that their interests are actually being represented.

To summarize, no group is truly homogenous, so it's not possible to perfectly represent any group. Since even any two people communicate imperfectly, and have conflicts of interest between them, it's not even possible for one person to perfectly represent another, albeit such representation can far more accurately represent any interests than representing a group. Thus representation distance grows with the size of group represented. Much politics can be explained by problems caused by representation distances that are too long or too short, or by poor estimates of representation distance made by naive participants.

[These comments are based on my comments on a previous post, and thanks to "anonymous" for reminding me about my old idea of representation distance, and for the idea that bribery of a representative by a third party increases representation distance from the principal].

Here are some links to learn about agency law, the principal/agent problem, and political property rights.

Unpredictable elections

Elections create a big public choice problem. People contribute money or other favors to candidates in exchange for political favors. This is economically indistinguishable from bribery. The problem with bribery is not that people can buy votes -- one can buy votes in corporations, and there's nothing corrupt about it -- but that there is a wasteful lobbying, a spending of both money and time, to purchase not votes but particular political outcomes. Arthur contributes to Bob's election, or flies Bob around in his corporate jet, or runs some "independent" ads or news stories favorable to Bob, and Bob sends some special pork barrel goodies Arthur's way, or gives him a special dispensation from a regulation that will hurt his competitors, or gets him a government job. Some of the more overt forms of this election-phase bribery can be banned or minimized by law, but for every overt form there are a dozen or more subtle or novel forms that cannot effectively be regulated.

Here in the U.S. the notorious McCain-Feingold law is an attempt to curb this problem. It is notorious because it does so by restricting free speech. In particular, it restricts who can spend how much on what kinds of speech running up to an election. Inevitably, it and similar laws are both full of loopholes and contrary to the spirit, if not the letter, of our First Amendment.

There is a far better solution that does not have significant loopholes and does not regulate any speech: make elections unpredictable. If would-be purchasers of political favors cannot predict who will win, or even who might win with substantial probability, they cannot purchase any favors prior to an election. A perfectly unpredictable election would be bribe-free.

The Grand Council Chamber in Venice

We can't make elections perfectly unpredictable, but we can get pretty close. There are historical and even contemporary precedents. For example, we choose jurors by lot from a pool much larger than the twelve jurors selected. This prevents wealthy plaintiffs, defendants, or governments from buying jurors through the selection process. (After selection, there are a number of legal and physical sequestering mechanisms that can be used to isolate a jury from contact with favor purchasers. As for political office, this article deals only with bribery during the selection process).

In ancient Athens, not only juries but many office-holders were selected by lot. But the most intriguing unpredictable election process was probably that of the medieval Venetian Republic. This republic helped turn a secure island into Europe's wealthiest trading empire. In Venice, many political offices were selected by a repeated cycle of lottery, vote, .... lottery, vote. The final lottery and vote, at least, were held one after the other in the same room, giving favor purchasers no time or privacy to do their business. The leading office in Venice, the Doge, was selected by a Great Council of about 2,000 members from those members, through a process that can be diagrammed as follows:

2,000 --> L30 --> L9 --> E40 --> L12 --> E25 --> L9 --> E45 --> 11L --> E41 --> ED

Scott Gordon describes this process as follows:

L refers here to selection by lot; E to selection by election [voting]. In the Great Council, by the drawing of balls from an urn, 30 members of the Council were selected; a further drawing reduced these to 9 who met to elect 40 men. This 40 was reduced by lot to 12 who proceeded to elect 25, and so on until the final election selected 41 nominators, who submitted their choice to the Great Council [i.e. made the final vote for Doge].

The process is loosely similar to the confusion/defusion cycles of encryption or the repeated mixing phases used for securely anonymous Internet communications. The Venetians alternated a randomizing step with a debate-and-voting step. It's not clear what, if any, function was served by the particular number choices or some of the other detailed structure. Each elector presumably had a substantial but fixed number of votes, so that there would exist a top 40, 25, 45, or 41 of vote getters despite being only 9, 12, 9, or 11 electors respectively.

I suggest the following leaner structure. A modern congressional election, for example, might look like this:

600,000 voters / 100 candidates --> E23 --> L7 --> E19 --> L11 --> E17 --> L7 --> E19 --> EM

Thus the top 23 vote-getters (by the 600,000 voters) are selected, from whom 7 are chosen by lot. These lucky candidates, who now serve as electors, then elect from among all the candidates except themselves 19 electors, who are whittled down by lot to 11. These elect 17 electors from the candidates except themselves, who are whittled down by lot to 7. These final seven then elect 19 final electors except themselves, who proceed to elect the Representative from among all the candidates except themselves.

This should probably be done online at a scheduled time, if an online election can be made secure, rather than trying to get all the elector/candidates to meet physically at one or more scheduled times. The last two steps at least need to proceed quickly enough that no deals can be done between or during them. With reliable connections and good user interface design it should go quite fast. The preceeding election steps should usually include time and communications channels for debate and research, but not enough time to forge the social relationships often necessary for reliable favor purchase.

I've used prime numbers based on a possibly superstitious analogy to the use of prime numbers in cryptography or by cicadas, i.e. on the hunch that prime numbers will make each step less predictable than with factorable numbers. The process of signing up to be a candidate must be very easy, so that we can get large numbers of people signing up to run in even small elections. The fact that they double as both electors and candidates who might get elected to office increases the motivation to become an elector/candidate. A further benefit is that electors, themselves elected, can prevent a demagogue from being chosen, while the election cycles make it less likely than in a pure lottery for a whacko or incompetent to be chosen.

Comments on the United States Constitution (iii)

Our Constitution, while admirable in many respects, has some deep flaws, especially the federal court structure. But given the flawed court structure, it has developed one very redeeming feature: the Incorporation Doctrine. Under this doctrine, said by the Supreme Court to be implied from the 14th Amendment clause requiring States to respect due process, the federal Bill of Rights is applied as a limitation on States. This doctrine has allowed federal courts to enforce many individual rights against state governments, which state courts have far less incentive to do, even though similar or the same rights are written into most state constitutions. Combined with the doctrine that the Bill of Rights means the same thing when applied to States as they do when applied against the federal government, (the Same-Scope Doctrine -- an assumption that on original meaning grounds is perhaps flawed), it has also given the federal courts far more incentive to enforce the Bill of Rights against the federal government itself.

A brief further explanation of the basic flaws in both federal and state courts are in order. These courts are selected by the legislatures and executive whose power they interpret. This gives a strong selection bias (similar to adverse selection in economics, but involving the choices of third parties). When on the bench, operational bias (analogous to moral hazard in economics) biases verdicts towards increasing both federal power and the rights of other parties as narrow exceptions to those powers in order to increase the number and importance of disputes, and thereby increase the importance of the federal courts. The same logic applies to state courts interpreting the powers of state legislatures and executives under state constitutions.

An example of selection bias at work: you will almost always see Senators ask judicial nominees their opinion on the Commerce Clause. To be approved, the nominee cannot declare an intention to overturn preposterous interpretation by which "commerce among the States" includes growing marijuana or wheat in your own backyard for your own consumption. If a nominee does not declare allegience to this legal monstrosity, which has vastly increased the power of the President and Senate, most Presidents and Senates will not allow him on the federal bench. (The occassional joker, like Justice Thomas, does slip past both the President and Senate, but it's very rare).

Before the Incorporation Doctrine and the same-scope assumption, federal courts rarely enforced the Bill of Rights against the federal government. They enforced the small handful of limitations on the States in the original Constitution far more zealously. The combination of selection and operational biases produces this result -- the federal courts want to inrease their influence by enforcing rights, but have to commit to Senators (and often the President) who select them to not enforce them strongly against federal legislative or executive acts. They don't need to commit to States -- the States are not a source of selection bias -- so they can exercise their power freely by enforcing rights against the States.

Thus the federal courts have always been eager to enforce individual rights against the States, but very reticent to do so against the federal government. The Incorporation Doctrine and the same-scope assumption cause the federal courts to enforce the Bill of Rights against the federal government, going against their selection bias, as a price they are willing to pay to enforce a larger set of rights against the States.

A much better solution for keeping governmental powers in check and rights protected would be to have federal courts interpret state constitutions, and set up a new super-federal court, selected completely independently of federal politicians, to interpret the U.S. Constitution. Until such radical modification, the Incorporation and Same-Scope doctrines are crucial to incentivizing federal courts to enforce the Bill of Rights today.

Logic and Legal Drafting 101

In common English, "or" and "and" are often ambiguous. "Or" can mean either inclusive or exclusive or, among other things. "And" often means set union, which might correspond to either inclusive or exclusive "or" or logical "and." For example, "choose from a box containing X and Y" might mean "choose X or Y" (inclusive), "choose X or Y" (exclusive), or "choose X and Y" -- depending on whether you get to choose once, once or twice, or you must make two choices. There are any number of other ambiguities that arise when trying to deduce the logic, if any, behind many plain English uses of "and" and "or."

Nevertheless, it's not hard for a legal drafter to make the logic of a legal document clear. This should be Legal Drafting 101, a class which should be required in all law schools: use "X or Y, but not both" for exclusive or, "X or Y, or both" for inclusive or, "both X and Y" for logical and. It would probably save billions of dollars and many erroneous decisions per year if lawyers followed these three simple drafting tips. For that matter, technical writers and any other writers trying to make logical relationships clear might benefit from this advice.

Link here for a hilarious thread of some of America's smartest lawyers trying to decipher a Supreme Court opinion and decide whether it breaks one of De Morgan's Laws -- not (A or B) = not A and not B (where the "or" is inclusive). It may depend on what the meaning of "or" is.