GMOs Jeremy Grantham’s recent commentary on commodities, Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever, is a must read. His basic argument is that the pace of the world’s consumption of natural resources is outstripping man’s ingenuity in pulling finite resources out of the ground cheaply. For Grantham, the price movements of the commodities in the last decade or two serve as confirmation that we are in a new regime, a “Paradigm Shift” from the 100 or so years of falling prices that productivity has yielded.
He does, however, seem to be missing one very, very important piece of the puzzle. And that is the fact that all of his work on the price signal of commodities is priced in NOMINAL US Dollars (a reader pointed out the GMOs chart is actually in Real or 2010 dollars), a currency which is about to celebrate its 40th year of being free from any intrinsic value other than faith. This chart (through early 08) from Wikipedia looks at Oil from a period just 20 years prior to the start of GMOs data. It paints a very different picture than the GMO chart seen below in terms of declining prices.
We could use another currency with stable value over the last 100 years to measure the price movements of commodities, but none exists. So we are stuck with Gold as a unit of measurement, as we have been for centuries. A currency with no political masters or central bank open market operations. In fact, there is ample evidence that Gold and Oil, for example have always been linked. Consider these excerpts from a lengthy post at FOFOA.
It is important here to realize the attitude of OPEC, and notably the Middle East. In the mid 1970′s, the finance ministers of both Kuwait and Saudi Arabia stressed that their needs were only to provide for the welfare of their citizens, and that oil in the ground is better than paper money. Who from the West can argue with that? They called our money’s bluff, fair and square. So in 1971, while the Texas price of oil was $3.45, OPEC re-priced their Middle Eastern oil up from $1.80 to $2.20 (such audacity, don’t you think?) only to see the market price due to demand in 1973 overtake the official posted price, at which point OPEC saw the writing on the wall, and in October raised the price per barrel to $5.12 while curbing production. By December, the Shah of Iran called a press conference to announce the official price would now be $11.65. Well, why not? It’s only paper to you if you are not in NEED of this currency through a debt to someone else. And so began the First Oil Crisis of the 1970′s.
Historically, the price of oil had been simply posted by the producers for contracted delivery until it was unleashed to respond to daily supply/demand forces on the “spot” Rotterdam market, at which time the price exploded in 1979-80. Although the dollar had been historically fixed to Money (Gold), after it was unpegged in 1971, the currency price of Money (Gold) was determined by the daily supply and demand, similar to Rotterdam. Gold auctions began in May of 1978 because the U.S. had trouble getting international entities to accept its dollar currency. After “booking” their trade balances with dollars, the House of Saud, among others, wanted to “pocket” their profits with Money (Gold), and therefore competed with everyone in the world for Gold on the spot market. As the price shot right through $700 it was clear that every ounce purchased made it that much more difficult to purchase the next ounce. There was little trouble raising the price of oil as needed, except the financial structure of the world was coming apart at the seams.
Grantham adds Gold to his list of commodities showing such price movements as opposed to a unit of measurement against which to measure the other hard assets.
Why is this important? Let’s look at the Zimbabwean Dollar as an extreme example to prove the point. During the year 2001, a barrel of Crude cost $23 USD on average and the equivalent in ZWD. Today a barrel of Crude cost $112 or 4.9x as much as it did in 2001. Today a barrel of Crude $11,200,000,000,000,000,000,000,000 ZWD. Did the cost of Crude Oil go up by a magnitude of 4.9x or a magnitude of 1 ^23 as it seems priced in ZWD? Most people would say that Oil did not go up by that much, but that the Zimbabwean Dollar declined by that much. Other than order of magnitude, why should we look at the USD or any other fiat currency in any other manner?
Wikipedia: Zimbabwe’s $100 billion banknote with the number of eggs it could purchase on its release date.
GMO's work does adjusted for real terms- you will note he clearly labels his chart "2010 U.S. dollars". I believe they use CPI rather than GDP deflator adjustments. Of course, you can argue that CPI is a govt manipulated fiction, but understand that Grantham does not use nominal data unadjusted for inflation.
Devil's advocate here. Gold surges in times of heightened inflation expectations and thus shows a correlation to rising commodity prices. Hence it is natural that gold would act as a deflator to GMO's probablility table. Compared to the currency markets, gold is a tiny market and so much more susceptible to excessive froth or disinterest. Hardly a stable source of value in other words. You are correct in suggesting that the dollar's decline leads GMO's probabilities to be overstated. However it it just as likely that using gold as base currency understates these same probabilities.
I'm not entirely sure Grantham is underestimating human ingenuity. The 100-year decline shown in his commodity index is a trend fueled by increasing availability and use of hydrocarbons. A shift in the trend may just be a case of mean-reversion which will be disrupted when another source of energy finally takes over from oil. Hopefully that will happen sooner rather than later.
Thanks for the comments.
Indeed the GMO work is expressed in real USD. I updated the post. I think it is still interesting how the chart from Wikipedia (methodology here: http://en.wikipedia.org/wiki/File:Oil_Prices_1861_2007.svg) paints a different picture of declining prices by going back some 20 years earlier when prices were apparently higher. Of course, that was a different time and it's difficult to say how meaningful that data is. However, as mentioned in my post, I actually agree with GMOs assertion that we are experiencing step functions up in commodity prices and GoodBread's comment interlinking the price of hydrocarbons and that of other commodities. I still maintain however, that a substantial portion of that burden is happening at the expense of the measuring currency (USD).
As far as GoodBread's difficulty with me using Gold as a superior measuring stick, it all comes down to one question. Is Gold money? I think an objective look at history beyond the last 50 years reveals the answer as unequivocally yes. Other currencies, which basically start as paper debts with Gold as collateral, end up losing their validity as they become increasingly separated from the value of that collateral and replaced instead by faith (fiat currencies). The process has existed for centuries, even with Roman coins that started as gold or silver and then were "depreciated" or "debased" by adding other, less valuable metals. Our Nickel coin is a perfect example.
As a less liquid market, Gold may appear to be less stable as a store of value. But remember, all exchange rates are ratios. It is not Gold which goes in and out of fashion so much as the currency that it is measured against. The idea that Arab holders of Oil reserves have always ultimately demanded Gold for payment speaks to this.
There has been NO currency in the history of man that has held its purchasing power over multiple generations.
While the track record for fiat currencies has been poor over the long-term, the size of the global economy, globalization of trade and spread of democratic regimes make it nearly impossible for a gold standard to be sustainable. I'd recommend Barry Eichengreen's Globalizing Capital for more on the subject.
Furthermore the dollar's value is really judged against other currencies. In that regard, the past 100 years haven't been so dismal. I personally doubt gold will ever become money again although I do think it stands up as a source of value so long as people believe in it.
With regards to Arab oil holders receiving gold as opposed to dollars, they still recycle a massive amount of petrodollars and have been a major reason for the success of the eurodollar market. The desire for gold shows faith in it, but the preference for it is most likely due to low nominal dollar rates and political reasons.
Thanks for responding.
Grantham doesn't seem to want to confront his mantra, 'Regression to the Mean', in his 'paradigm shift'. Now, its different, I guess. He did show some interesting data that he neglects to read properly. He shows that a great majority of commodities are being used by China to the tune of 40% of the world's output. But, China has only 20% of the world's population and 14% of the PPP GDP. So, I'd have to guess that China is consuming (or hoarding) at least twice as much of these commodities as they normally should be using. Mean Regression coming to China's consumption, here. Paradigm Shift will go into reverse.
Norman- I think Grantham would agree with you on a cyclical basis. That is, mean regression is inevitable as China's coming slowdown due to overcapacity will take prices down (and potentially hard). He is making the argument that on a secular basis, the trend has changed. Hard assets, unlike paper assets, are not limited in supply ONLY by the ingenuity and ambition of man (or politicians) and thus the mean reverting forces of fear and greed may be a less powerful force.
IMO, the Paradigm Shift of the USD toward debasement is irreversible absent political revolution or a complete restart (default) and resumption of sound money policies. One or both of these things are likely to happen. It just might not be in our life times.