Block’s Indicator of Sustainable Growth

BY Ray Block

The Dow Jones-AIG Commodity Index lost 11.9 per cent in July 2008, the largest monthly drop since the index was first published in 1991. But even so, the 12 month return in the commodity index to end July was still an astonishing 21.5 per cent. 33 per cent of the Dow Jones-AIG index consists of components in oil and gas.

The fall in both agricultural commodities and in oil reflects partly at least the sharp decline in economic growth in Europe, North America and Japan. This is shown up in the Baltic Dry Index, a measure of the cost of shipping raw materials, which plummeted 37 per cent since hitting a record on May 20 2008.

The Baltic Dry Index tends to swing widely, rising 110 per cent between June and November 2007, then falling 49 per cent through January 2008, and later recovering 110 per cent through May, prior to the most recent fall.

But how much of the volatility in commodity prices is due to financial speculation, as distinct from the normal movements in demand and supply? That indeed is the $64,000 question, but there are clues.

Four US Senators- Ron Wyden of Oregon, Byron Dorgan of North Dakota, Maria Cantwell of Washington and Bill Nelson of Florida in a August 14 2008 letter to the Inspector General of the Commodity Futures Trading Commission (CFTC) asked for an investigation into a flawed report on oil prices released by the Commission. The July 2008 interim report was prepared by economists from a number of government agencies, especially co-opted at the request of the Futures Commission to give an air of gravitas to the oil study.

Democrat Senators are convinced that there is too much financial speculation in the setting of oil and agricultural commodities, while Republican Senators disagree. The July report goes out of its way to declare that the rapid increase in institutional purchases of commodity index funds and the commodity swap dealers, who act as their intermediaries were not responsible for the sharp rise in oil speculation leading to large price rises. The institutions involved are mainly the large pension funds and endowment funds, while the dominant commodity swap dealers are from the Wall Street investment banks and other financial groups.

As Senator Joe Lieberman, the one time Democrat and now Independent Senator for Connecticut and chairman of the Senate homeland security and government affairs committee, and two other Senators-one Republican the other Democrat in an article in the Financial Times in London (July 25 2008) pointed to the giant rise over the last five years in institutional investment in commodity index funds, swelling from $13 billion to $260 billion.

Over the same five year period, commodities tracked in these funds rose 200 per cent. The Senators said that more than 71 per cent of the commodity futures contracts are owned by speculators, compared with 37 per cent in 2000. There may be a case for some speculation, such as providing liquidity. “But speculation at this level wreaks havoc on the economy-unnecessarily driving up prices and threatening both businesses and household budgets.”

“Combine the increasing commodity investments from private, state and local government pension plans, university endowments, insurance companies and other institutional investors, and the result is clear. Speculators are overwhelming our commodity markets and leading to substantial increases in food and energy prices for years to come.”

“In a series of hearings held by the homeland security and governmental affairs committee, we heard testimony that this kind of excessive speculation in the commodity markets may be adding as much as $40 to $60 to the cost of a barrel of oil.”

“Unfortunately, the CFTC has ignored its mission as our front line defence against rampant and unmanaged speculation. To this day, the commission has yet to recognise that speculation affects commodity prices.”

What is needed at all times is transparency, and this is the missing element.

18 months ago, the CFTC decided to suppress the data on the activities of speculators trading in commodities. The only group who applauded that decision was the International Swaps and Derivatives Association, which lobbies on behalf of Wall Street firms. Yet remarkably, the former chief lobbyist from the swaps and derivatives association has been appointed a member of the CFTC.

Hopefully, 2009 will see reform, but I’m not confident.

Ray Block
economies, food, inflation