Real economy suffers while financial markets stuff around with prices

October 9th, 2008

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In yesterday’s ABC 7:30 Report, Associate Professor Steve Keen commented that in the context of today’s global financial crisis,

Well I think Kerry I can actually make a reference to what’s happened to the Australian dollar say every price you see is crazy.

There is no way the prices of anything make any sense at the moment.

Prices in the financial markets are extremely volatile right now. Even prices of commodities (e.g. base metals, oil), gold and silver are moving much more rapidly then we expected (remember a few weeks ago when gold rose by almost US$100 in 2 days?). Currency exchange rates are also very extremely volatile, as we witnessed the fall of the Australian dollar from around US$0.97 to US$0.64. It was just a couple of days ago when the Aussie dollar was around $0.73. Now, at this time of writing, it is US$0.70.

Such volatility and irrationality of prices, if sustained over a much longer period of time, can eventually damage the economy structurally. To understand why, consider what we said in The myth of financial asset ?investments? as savings,

… saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

The accumulation of capital goods requires a time lag whereby current consumption is postponed for future benefits. Improved standards of living come to the public from the fruits of capital investment.

For example, producing metals is a very capital-intensive activity. The stages of production includes:

  1. Exploration
  2. Digging large quantities of dirt, which requires expensive, complex and expensive equipment.
  3. Construction of nearby infrastructure (e.g. roads, railways, power stations, development of water supplies and townships) due to the remoteness of mining projects.
  4. Protection of environment, which increase capital and operating cost.
  5. Extraction of ore from dirt.
  6. Processing of ore.
  7. Refining of metal concentrates.
  8. Shipping and transporting to destinations.

Thus, a mining project from start to finish can take several years. Therefore, you can see that the accumulation of capital goods is long term processes in the economy. As such, all these industrious activities require long-term planning.

What if in the interim, prices are extremely volatile, ‘crazy’ and irrational?

As the late Professor Murray Rothbard wrote in What Has Government Done to Our Money?,

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations.

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinders long-term planning.

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades (see Example of a secular trend- commodities and the upcoming rise of a potential superpower and The Problem that can throw us back into the age of horse-drawn carriages). Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

With long-term planning made much more difficult, how is it possible to engage in investments that allows the nation to continue to accumulate capital goods? Without the ongoing accumulation of capital goods and too much monetary capital wasted on either hoarding, bailing out bad investments and patching a dysfunctional financial system, there wouldn’t be a proper and efficient allocation of monetary capital. The economy will be engaging on capital consumption. If a nation starts to consume its capital, how can there be real economic growth. Without real economic growth, how can future generations enjoy a more plentiful and prosperous existence?

As we ponder on the long term implications of today’s volatile, ‘crazy’ and irrational prices, we saw a sampling of such a phenomenon in one of the news article today, Volatile economic conditions unsettle farmers,

UNDER normal circumstances, an interest rate reduction coupled with a devaluing of the Australian dollar would make farmers very happy indeed.

But not this time, according to National Farmers Federation vice-president Charles Burke.

“There are some other factors at play at the moment that none of us really know how to measure,” Mr Burke said.

“Nor do we know how to deal with it because we don’t know how long it will last.”

That’s why the Austrian School of economic thought advocate a painful deflationary liquidation of mal-investments (read: severe recession/depression) in order to clean out the rot in the system, put on a sound monetary system so that the economy can get back on its feet as soon as possible from a clean slate. But central bankers and governments are trying their utmost to drag on this war between deflation and inflation indefinitely, which means more uncertainty ahead for the foreseeable future.

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  • Bosley

    our economy has gone bizzare !

  • Bosley

    our economy has gone bizzare !