According to the economic law of supply and demand, if there is more and more supply for a given commodity, the prices should decrease if everything else remains equal. Conversely, if the supply decreases, prices should rise.

Normally this is the case for commodities like base metals. The level of stock for a given metal in the London Metal Exchange (LME) should give a good indication of the quantity supplied. So, we invite our readers to take a look at the supply/demand situation for lead, nickel, zinc, copper and aluminium. In particular look at the 5-year charts for the trend starting in January 2009. What do you see?

When? you look at the charts, you will notice something very strange. Since January 2009, the prices of these base metals rose as the supply grew as well. What is going on? Had the economic law of supply and demand being suspended as well?

Good question.

Remember what we wrote in Does rising house prices imply a housing shortage??

The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ?demand,? which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ?demand? and so on and so forth. When this happens, higher prices lead to even higher ?demand.? Such artificial demand can act as a sink-hole for whatever quantity of supply until money runs out in the financial system (which is not possible under today?s a fiat credit system).

Indeed, this is our interpretation of what happened to base metals as well. The expectation of rising prices acts as a sink-hole for whatever quantity of supply. The most common word used to sum up this phenomenon is “speculation.” Another word that is also often used is “investment demand.”

Advertisement

When you look at the big picture, there is a big growth in “speculation” and “investment demand” over the past 10 years. From real estate, stocks, bonds, commodities, foreign exchange and even art-work (see Epic, unprecedented inflation). Today, with advances in financial engineering and information technology, it is possible to speculate in the global commodities market in the comforts of your home with the click of a mouse.

What is the root cause of this? As we wrote in Why oil cannot function as currency reserves?,

… when governments undermine the store-of-value function of money (something that can only be done in a fiat monetary system), investors will flock to useful, vital and scarce commodities to store their wealth. This in turn will result in those scarce commodities becoming scarcer. The food riots around the world in 2008 were an example of how this can happen (see Who is to blame for surging food and oil prices?).

For the fundamental economic law of supply and demand to work, prices have to convey accurate market information. Prices are expressed in terms of monetary units. That means the monetary unit is the yardstick which is used to measure the relative value of things. What if the integrity of this yardstick is being compromised? As we wrote in our book, How to buy and invest in physical gold and silver bullion,

Let?s suppose you want to compare the length of two boxes. You may use a ruler to measure their lengths and from the results of your measurement, conclude which one of them is longer. A ruler can do such a job because its length is reasonably consistent for the foreseeable future.

Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the boxes? An elastic ruler is useless because you can always make up the measurement of the boxes to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let?s take a look at oil prices. Since oil is priced in US dollars and if the supply of money and credit (in US dollars) can be expanded and contracted by monetary inflation and deflation, how useful do you think it is as a calibration for measuring the value of oil relative to other things?

The rise of “speculation” and “investment demand” is a sign of a funny monetary system.