Cezary Salad

I posted a new paper under the philosophy section of my blog in response to George Soros’s new book - The New Paradigm for Financial Markets: the Credit Crisis of 2008 and What it Means. I reproduce it below as a blog post.

Reflecting on Reflexivity

In 1962, a (now famous) philosopher of science named Thomas Kuhn drew much attention for his controversial claim that, when scientific theories of the world change, the world itself changes, too.

Since 1987, financier and philanthropist (and self-admitted amateur philosopher) George Soros has been making a similar claim, but with a focus not on the natural sciences that Kuhn spoke of but instead the social sciences – specifically, economics.

Soros’s dictum – the theory of reflexivity – asks that we set apart sciences which have thinking and non-thinking participants and those which have only thinking participants. A chemist studying a molecule can make independently valid statements about the molecule that may qualify as knowledge. An economist studying the behavior of crowds to make judgments about supply and demand can do no such thing: his theories, in the Kuhnian sense, will impact the world of his participants and thus put knowledge out of reach.

If Soros’ theory is true, it cuts a wide swath. It implies at once a need for a new ethics, a new epistemology and – of course – the need to tear up our classical economics textbooks.

Yet, as Soros confesses in his latest treatise on the subject - The New Paradigm for Financial Markets: the Credit Crisis of 2008 and What it Means – published a year ago in response to the financial crisis, philosophers, economists and financiers alike have failed to give his theory serious consideration.

Naturally, this begs the question: why? Is Soros wrong or is the establishment wrong?

When was an undergrad at Penn, I never thought there would be much synergy from being a philosophy major and a business student. Here, I found my challenge.

What follows is a critique of Soros’s philosophy that I hope can shed some light on where his theory of reflexivity excels and where it falters.

My main claim is very simple: Soros commits the same mistake as Kuhn did in his magnum opus The Structure of Scientific Revolutions: he carries a good idea to an unjustifiable conclusion.

Just as one can read Kuhn and be convinced by his account of how new scientific theories become prevailing paradigms, one can ready Soros and be convinced about his account of how markets influence and are influenced by our attempts to understand them. But when he concludes from this that market participants “cannot base their decisions on knowledge,” Soros makes the same mistake as Kuhn did when he said that our scientific theories change the physical world: he carries his theory a step too far.

Part I of this post outlines Soros’s theory in greater detail to make sure that anyone who has not read it can be on equal footing. Part II outlines my criticism of his theory. Part III, in good faith, contains some advice for how he can strengthen his theory.

Part I: Soros’s theory explained

First, some background: Soros’s theory of reflexivity is based on another theory – the correspondence theory of truth – without which his whole paradigm could not work.

In its simplest form, correspondence holds that a proposition is true when it corresponds to reality, and false when it does not (cocktail party tidbit for you: this is what philosophers term “altheic realism” – the notion that truth hinges not on us, but on the world in which we live).

Soros argues that correspondence works well in the world of natural science but breaks down when applied to social science:

I contend that social events have a different structure from natural phenomena. In natural phenomena there is a causal chain that links one set of facts directly with the next. In human affairs the course of events is more complicated. Not only are facts involved but also the participants’ views and the interplay between them enter into the causal chain (New Paradigm, pg. 7 – emphasis added).

Another way to view this is in mathematical terms: a function is uniquely determined (and therefore true) if it has one independent variable which determines the value of the dependent variable. In natural science, there is just one variable – the natural world – but in social science, there are two variables: our understanding of social phenomena and the impact that our actions have on them.

Soros terms the first variable the “cognitive function” and the second variable the “manipulative function”. In other words, we seek to understand social phenomena but, as a result of being participants in them, we can simultaneously change, or manipulate them. And as we manipulate them, our understanding of them changes. As our understanding changes, so does our interaction with them. So changes in one function are reflected in the other, and vice versa. Soros calls this “reflexivity” and hence the name of the theory

“Reflexive situations are characterized by a lack of correspondence between the participants and the state of affairs,” Soros writes (emphasis his). Participants are always manipulating the state of affairs, so as soon as they make a statement about it that purports to be true, their actions can render the statement false.

Soros provides the following example to make this distinction clear:

Consider a statement about the objective aspect: “It is raining.” That is either true or false; it is not reflexive. But take a statement like: “Your are my enemy.” That may be true or false, depending on how you react to it. That is reflexive (New Paradigm, pg. 28).

Reflexivity is best studied and demonstrated in the financial markets, Soros argues, because market developments are not independently given by natural phenomena but instead are driven by human expectations. Classical economics, he argues, ignores this insight:

Demand and supply curves are presented in textbooks as though they were grounded in empirical evidence. But there is scant evidence for independently given demand and supply curves. Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market developments. Rising pries attract buyers and vice versa. How could self-reinforcing trends [bubbles] persist if supply and demand curves were independent of market prices? (New Paradigm, pg. 55).

Our expectations (cognitive function) are reflected in the market when we buy or sell (manipulative function), which in turn impacts our expectations (cognitive function), and so on, ad infinitum. One reinforces the other. This, Soros argues, is how market bubbles are born.

More importantly, he argues that reflexivity “introduces an element of contingency or uncertainty into the course of events, and it prevents the participants’ views from qualifying as knowledge” (New Paradigm, pg. 4). In other words, market decision markers cannot base their decisions on knowledge.

Part II: A critique of reflexivity

Given this background, there are two possible readings of Soros’s philosophy.

One, I would argue, is uncharitable and the other is charitable (in philosophy, these terms typically mean taking the philosopher’s argument at its most extreme meaning versus giving it the benefit of the doubt).

Let’s start with the uncharitable interpretation:

In social situations, reflexivity produces uncertainty and thus prevents our views from qualifying as knowledge. Social science can therefore only succeed in producing opinion, whereas natural science can succeed in producing facts about the world.

This implies that we cannot make any claim to knowledge from observing our behavior and creating Newtonian rules such as the law of supply and demand. And so much, if not all, of economics, sociology, psychology and other social sciences are futile exercises.

Carry this line of thought further and soon you end up being the caveman in Plato’s Allegory of the Cave, mistaking shadows on a wall for a true account of the world. As with the allegory, where concealed persons chatting and carrying various objects before a fire result in the false impression that they are the real world, studying social situations inevitably results in a false view of the world in this Sorosian paradigm.

But is that what Soros is really advocating? I think not; one very easy way to disprove this reading is just to assume that it is correct. If Soros’s observations about the human position are true and reflexivity obtains, then social science can indeed produce some sort of knowledge. After all, what is The New Paradigm for Financial Markets if not a work of social science?

The real question is therefore not the black-and-white, “can we as participants in the social world order come to gain knowledge about it?” but rather, “how perfect is that knowledge?”

Ponder that question vis-à-vis his philosophy, and a much more charitable interpretation results:

In social situations, reflexivity produces uncertainty and thus prevents us from having perfect knowledge. Social science, like natural science, can therefore help us better understand the world, but it cannot reveal the ultimate truth about the world we inhabit.

To his credit, I think Soros believes as much. In later parts of The New Paradigm, he seems to soften his stance, arguing that “people are participants, not just observers, and the knowledge they can acquire is not sufficient to guide them in their actions. They cannot base their decision on knowledge alone” (New Paradigm, pg. 26, emphasis mine).

To make up for this shortcoming, Soros argues that we use various techniques – generalizations, similes, metaphors, habits, rituals – to organize information and make decisions. In doing so, though, various biases, emotions and other non-factual elements can enter our reasoning.

Now think back to Soros’s discussion of financial markets and what results is a pretty convincing case against the efficient market hypothesis.

This hypothesis (which Soros loathes) is predicated on the notion of perfect information: stock prices always reflect all relevant information and therefore trade at their fair value.

But apply the notion of reflexivity to the markets and it soon becomes clear that markets don’t always price in everything they should or exclude everything they shouldn’t price in. Like a river that collects sediment along the way toward its mouth, market biases, emotions, rumors and fictions get swept in with actual facts about a stock, all of which impact participants’ views (cognitive function) and impact the market (manipulative function) when they buy/sell.

Market information is thus not perfect (like the dirty river, it is filled with impurities), markets are not efficient, and they certainly do not tend toward equilibrium; rather, they tend toward whatever prevailing biases preoccupy investors any given point (ex. housing prices will continue to rise) until the bubble pops and the market corrects itself.

Viewed this way, I think Soros’s ideas are far more serious than many economists realize. Reflexivity is not an argument against the very viability of economics (in which case it would be understandable why social scientists would want to thumb their noses at him), but rather a call to arms to better understand the fallibility of our existing paradigms, like the efficient markets hypothesis.

It seems, though, that philosophers, economists and social scientists alike have turned a deaf ear to him for the past 20 years, perhaps opting for the uncharitable interpretation argument of his work and dismissing it accordingly.

So with Kuhn. People originally interpreted his book as a crazy argument that we can change the world with our thoughts: Copernicus comes along and all of a sudden the planets realign around the Sun?  Surely not. Eventually, a more charitable reading of his work gained consensus and his account of how scientific revolutions occur is now a key consideration in any class on the philosophy of science.

Will the same thing happen to Soros? Only time will tell; but in the meanwhile, he can certainly do some things to make his theory more tenable.

Part III: Some advice

Here are some questions that I believe Soros should answer to strengthen his theory of reflexivity (with the important caveat that I’m not an expert; undergraduate degrees in philosophy and economics only – no fancy stuff).

Questions of interest to philosophers:

1. Does reflexivity solely rely on the correspondence theory of truth, or could it co-exist with another theory of truth, such as coherence or identity
2. Reflexivity implies that the Cartesian view of the world (separation of body and mind) is wrong, so what is the proper place of the mind in a reflexive world?
3. What are the boundaries of reflexivity? The theory in its current form implies that all social situations are reflexive. But what’s a social situation and what is not? (Philosophers are notorious for thought experiments; sooner or later, someone will throw a remote control robot into this discussion).

Questions of interest to economists:

1. One of the assumptions of the efficient market hypothesis is that no one market participant is big enough to influence the market on his/her own. Does reflexivity accept the same assumption? (Another way to phrase the question: does someone like Warren Buffet – who can say “the economy has fallen off a cliff” and slice 80 points off the Dow - have more “reflexive” power than some guy with an internet connection and a blog?)
2. Are some markets more reflexive than others? If so, what distinguishes a reflexive market from a non-reflexive market – is it the number of participants, the type of security, or what? For example: I can bet on fed fund futures all I want, but at the end of the day, unless I break into an FOMC meeting and force the Fed Governors to raise or lower the fed funds rate, my bets can do little to move the target. But if I own a large stake in a company, become bearish and start selling, my outlook can influence the market much more. So where do we draw the line?
3. If markets are indeed reflexive, does that mean that we are doomed to forever go through bubbles and busts and super-bubbles and super-busts, or does reflexivity allow us to forge a cure for this?

One last piece of advice for Soros: pick a discipline, because philosophers and social scientists often don’t see eye to eye. I learned the hard way: I once had to spend a whole summer re-writing a thesis because one of my philosophy professors thought the paper I handed in belonged more in the realm of political science than philosophy.

So as long as reflexivity is rooted in both disciplines, chances are that some philosophers and economists will inevitably choose to ignore it because it’s out of their realm.

Good luck, George.

Way down in New York’s financial district, tucked away inconspicuously on the southern end of Wall Street, there’s a little gem of a museum - the Museum of American Finance - filled with all kinds of goodies from 200+ years of booms and busts on, well, Wall Street.

With $8 admisson and a new exhibit about the credit crisis that just opened up this week, it is well worth a Saturday afternoon visit - followed up with a beer at Ulysses down the street.  

The museum’s been around since 1987 but it is only in the last two years that it’s held its current spot on Wall Street - an old Bank of New York branch converted into a giant exhibition hall.

Below are some of my highlights - enjoy.

Obscure monies

My favorite exhibit was the museum’s collection of obscure coins and notes spanning the pre-colonial era to the latest money coming out of the US mint.

We used to have a lot of higher-denomination notes in circulation but Nixon apparently axed them in 1969 in an effort to fight organized crime. McKinley graces the $500 bill and Grover Cleveland landed himself a sweet spot on the $1,000 bill.

You can still use them as legal tender but if you come across one, might as well sell to a collector: they sell for multiples of their face value these days.

I had no idea that these people sat on dollar bills:

$5,000 bill - James Madison

$10,000 bill - Salmon Chase (the banker who puts the “Chase” in JPMorgan Chase)

$100,000 bill - Woodrow Wilson (the president who created the Federal Reserve)

The Wilson note was only used in circulation among Federal Reserve Banks. It makes you wonder, though: if we’re so into putting obscure presidents on our higher-denomination bills, why isn’t there a Millard Fillmore note? It’s about time he got a seat on US currency.

The museum also has a fascinating selection of Depression-era currencies created by localities suffering cash shortages. My favorite was the hand-writtten 50 cent scrip (upper left hand corner in picture above) from Albany County, Wyoming.

Stock and bond certificates

They also have on display some famous stock and bond certificates that have been issued in the US, going back to an IOU signed by George Washington. My favorite, though, was this stock certificate for the Erie Railway, company:

The Erie was the focus of the legendary showdown between industrial tycoons Cornelius Vanderbilt and Jay Gould. Gould spurned Vanderbilt’s takeover of the Erie by issuing watered-down stock that was worth more than the value of the company - which, apparently, was legal back in those days.

This one’s signed by “the Devil of Wall Street” himself:

Also on display: some pretty interesting municipal bonds, like this one issued by New York for bridge repairs:

How Wall Street got its start

One of the coolest things I learned was how Wall Street - specifically, the New York Stock Exchange (below) got its start.

Apparently, back in the early days of the Republic brokers used to trade stocks in the open on Wall Street and would gather under specific lamp posts along the street to deal in specific securities. People would stand on roofs to make announcements and give signals, so it must have been a pretty hectic scene.

In 1792, a group of 28 brokers got tired of this system and organized a brokerage club that served as the beginning of what is today the NYSE.

Old equipment

The museum also has a lot of technological relics from the old days of Wall Street, including an early form of a calculator that belonged to the comptroller of Lehman Brothers - now itself a Wall Street relic. Below are some of my favorites:

A 1981 Quotron - one of the first computer systems used for trading stocks:

And, of course, the first stock tickers. They were invented in 1867 - this one vintage 1875:

Together, the stock ticker and the telegraph revolutionized the speed at which stocks could be traded. The two inventions put the New York Stock Exchange - and with it, American Capitalism - on growth steroids for decades.

Vintage newspapers

As a journalist, I was particularly drawn to the collection of famous editions of newspapers from panics and crises over the ages. To be fair, American printing presses have probably created their own collection of these future museum pieces just within the last 18 months, but it is interesting to look back to see how thoe events were covered.

An edition of the Daily News from 25 October, 1929 read: “Billions lost in Wall St. Debacle”. Much more interesting than the headline, though, is the advice given by the paper’s “Trader” columnist.

Four days before Black Tuesday - when the Dow Jones Industrial Average dropped 12% and officially heralded the beginning of the Great Depression-  his advice read as follows (emphasis added):

If half the suicides which were reported to “TRADER” yesterday had proved true, Wall Street would be a deserted village this morning.

Happily, however, they all turned out to be baseless rumors, although it was amazing how many stories were in circulation as to operators who jumped out of windows at 120 Broadway. The Equitable building certainly got a lot of free advertising, although it wasn’t the kind usually welcomed.

The market today is in the position of a convalescent who has just successfully passed a crisis in an illness which bid fair to be fatal.

Improvement is indicated, with the practical certainty of eventual recovery, but there will be relapses.

“TRADER” therefore advises against speculative purchases, although he expects prices will be materially higher today. If you have money to buy stocks outright, go in and do so, because current prices are bargains which probably will never be sustainable again as long as the United States continues its present prosperity.

Some parallels are clearly visible to today - especially in light of the recent debate sparked by Jon Stewart’s spoof of stock picker Jim Cramer and CNBC coverage of the credit crisis. People routinely call the bottom prematurely, so the only way to know for sure that stocks have hit a bottom is to read about it in a history book - not by reading “Trader” or watching Fast Money on CNBC. However, the sin isn’t calling a bottom too early or voicing an opinion. Stewart had a bone to pick with CNBC - as I’m sure the Stewarts of his day did with “Trader” - because there was so little humility in the way the opinion was being voiced and advertised. At the end of the day, “buy stocks” four days before Black Tuesday and “buy Bear Stearns” a couple of weeks before it collapses are calls that should be heeded as  just another piece of food for thought in deciding where the market might go; slogans like “In Cramer we Trust”, as if he were the god of stock-picking, go against that very important caveat.

It is also useful to point out that Stewart’s criticism of Cramer pales in comparison with what John Kenneth Galbraith had to say about “Trader” in his account of the 1929 crash:

. . . by 1929, numerous journalists were sternly resisting the more subtle blandishments and flattery to which they have been thought susceptible. Instead they were demanding cold cash for news favorable to the market. A financial columnist of the Daily News, who signed himself “The Trader,” received some $19,000 in 1929 and early 1930 from a free-lance operator named John J. Levenson. “The Trader” repeatedly spoke well of stocks in which Mr. Levenson was interested. 

Some progress was made, though. Fast-forward 58 years, and press coverage of the next big stock market debacle was much different:

Another noteworthy decaying newspaper was a copy of the very first edition of the Wall Street Journal: July 8, 1989: 

It is amazing how similar it looked in design until the recent face lift post-Newscorp acquisition.

The Journal’s first lead-left article? A laundry list of price movements: 

The second article from the top - ”The Market To-Day” - references a “bear party” that depressed American stocks. One of the videos at the museum explains that the terms “bull market” and “bear market”, used to describe down markets and up markets, respectively, originated from the way those two animals attack. A bear will claw down its prey, whereas a bull will strike up at its prey.

Strange but true or true but strange?

Credit Crisis

On March 25 the Museum of American Finance unveiled a new exhibit on the financial crisis: a giant timeline that organizes all the key events of the last two years into regulatory, financial, foreign policy and other buckets. It is accompanied by a brief video that sheds some analysis on the crisis’s causes and effects. 

It does a good job of objectively laying out what happened when and organizing it in a logical manner. But it doesn’t yet gel together the events into a cohesive narrative that lets you walk away with clear take-aways on what exactly is going on. I don’t think it is the museum’s fault though: perhaps it is just too early yet for us to completely understand all the dimensions of this crisis and how it will play out.

They should, however, update this exhibit - a chart of the DJIA over the years that has not yet taken the huge dive indicated on the crisis exhibit: 

This one could also use an update: a Bank of America family tree, conspicuously missing Merrill Lynch:

Other exhibits still reference Lehman Brothers as a bond trading powerhouse, etc. I’m sure these will all get corrected over time - after all, these days, if they were to wipe out defunct Wall Street names from their exhibits they might not have time for anything else.

These nips and tucks aside, if you’re ever free on a Saturday afternoon and looking for a good time, I nerdily suggest the MoAF. 

This is part two of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Thursday’s post focused on the role of dollar depreciation. Today’s post will focus on the tightening outlook for global supply and demand.

The outlook for diminishing supply combined with surging global demand for oil is probably the best-documented of the three long-term trends that are driving up oil prices - the other two being the depreciating dollar, which I wrote about on Thursday, and speculation, which I will write about in a future post. It is also the explanation most favored by everyone from the business press to regulators and talking heads on CNBC.

However, there is reason to believe that its impact on current oil prices is not as powerful as everyone believes. True, expectations of higher demand and lower supply do add upward pressure on futures prices and, in turn, spot prices today. But since longer-term supply and demand expectations regarding China and India are “old news,” they are to a great extent already priced into the market and thus cannot by themselves trigger an oil shock of the magnitude we are seeing now.

Hard truths

Let’s start with the facts. As the Energy Information Administration (EIA) detailed in its latest short-term energy outlook, world consumption of oil is continuing to grow despite 7 years of conscutive increases in oil prices, with decreases in demand from the U.S. being more-than offset by increases from places like China and the Middle East. Meanwhile, the pace of supply growth in non-OPEC countries is expected to continue to fall short of expectations and consumption growth - as it has in years past - thanks to faster declines in older oil fields and delays in expansion projects.

[For more information on these fundamental trends, check out the EIA's slideshow, "Next Stop for Oil Prices: $100 or $150," available here. Hint: it was written by economists, so the answer, of course, is "it depends."]

No one denies that these are the cold, hard facts on the ground (or rather, underneath). But what is of interest is how these longer-term realities impact prices today and where the rational limits of that impact lie. It is here that the plot thickens.

High expectations

The answer to the first question can be found in the role that expectations play in the oil market. As supply and demand conditions get more and more attention in the business press, sellers of oil have more reason to expect that they can capture a better price tomorrow than today and are therefore more likely to hold on to the marginal barrel of oil for sale at a future date. As a result, we’ve seen a steady upward revision in sellers’ future price expectations. For example, the price of crude oil for delivery in 2011 has more than doubled since January 2007, rising to $120 in May 2008, as economist Stephen P.A. Brown of the Federal Reserve Bank of Dallas illustrates in this chart from his article, “Crude Awakening:”

But how does a rise in futures prices impact spot prices today? As with many financial instruments, oil is priced over a benchmark - similar to a loan being quoted as LIBOR plus a credit spread. In the past, this benchmark used to be based on spot prices for certain crudes, such as West Texas Intermediate (WTI) or dated Brent. However, as this somewhat technical, but clearly-written and well-sourced post from the blog “Peak Oil Debunked” explains, since the mid-1980s, the oil industry has gradually shifted away from spot benchmarks to benchmarks based on futures prices because the former are easier to manipulate and corner than the latter. So when you see oil prices surging higher, what you’re seeing is a price formula that reflects changes in a weighted average of futures contracts for certain “benchmark” crudes (the WTI benchmark for U.S. oil, the Brent benchmark for oil sold by the Middle East to Europe, the Dubai-Oman benchmark for Middle East oil) plus a premium or minus a discount. Thus, higher futures prices lead to higher spot prices today.

This is why the venerable Economist was wrong when it argued in its July 3rd edition that futures contracts are simply “bets on which way the oil price will move” that “do not affect the price of oil any more than bets on a football match affect the result.” If football games were won by taking a weighted average of expectations over which team will win and then adding or subtracting some points for actual team performance, then the analogy would be apt. But since oil futures act as the benchmark for spot prices and therefore directly impact their levels, it is not.

So it’s clear that the bleak global supply and demand outlook is helping drive oil prices higher; here there is no bone to pick with analysts, the business press and talking heads. Instead, there is only the caveat that this is happening because of the way oil is priced over futures benchmarks - not spot prices.

Old news

Still, there is a hard limit as to how big the impact of this upward pricing pressure can be. That’s because none of the bleak macro supply and demand projections are news to investors. That is, it’s not as if late last year the world all of a sudden realized that India and China have very large and rising energy needs. We’ve known about this for years and it’s been priced into the markets for years. And at the end of the day, markets react to new information, not old news. Thus, unexpected announcements of buildups in oil inventories will move the needle one way or the other, but having a talking head on TV say that demand from China and India is growing doesn’t add any new information that hasn’t already been priced into the market.

Hence, the same old story of rising demand from India and China couldn’t by itself trigger such a precipitous rise in prices: it needed a spark. And that spark - as with the depreciating dollar and (as I will argue in a future post) speculation - came from the onset of the credit crunch. After the debt markets shut down last summer, billions of dollars that couldn’t be invested in debt securities went looking for a safe haven, which they found in the commodities markets. As I will explain in a future post on the role of speculators, this had an upward impact on the price of futures contracts and - via the same pricing formula desribed above - on spot prices. And once this happened, everyone from the business press to Treasury Secretary Hank Paulson and the EIA reiterated the tight supply and demand picture, which only exacerbated the panic and reinforced expectations of higher oil prices in the future.

This suggests that supply and demand forces aren’t as powerful here as one might think. This becomes even more evident when we consider the fact that the bleak global supply and demand outlook is a longer-term macro trend which stays pretty constant over time. That is, we know that China and India are probably going to be consuming more oil over the next few years and that supplies in non-OPEC countries will likely not keep pace with demand. But consider the fact that between the beginning of March and the middle of June nothing much changed in this fundamental supply and demand picture while the price of oil nevertheless jumped nearly $40/barrel over the same period. To say that this jump was all due to fundamental demand from India and China and tight supply in non-OPEC countries would be like explaining a particularly hot summer day by referencing global warming. Point being: it’s a long-term trend whose explanatory power diminishes as we focus on short-term oil shocks rather than gradual price increases over longer periods of time.

So yes - tight oil supply and real growing demand are powerful forces and serious problems that need to be dealt with. But their impact on the price of oil likely takes a passenger seat to the depreciating dollar and - as I will argue in my next post - the impact of speculators.

I originally wrote this as one post reflecting on the trends and catalysts behind the rapid increase in oil prices. But after receiving feedback from readers, I decided to split it up into three shorter posts that examine each of the long-term trends more in-depth. The following post examines the first trend: dollar depreciation.

As oil prices continued their drop today, falling more than $18 since last Friday, analysts and commentators began to question whether oil is finally in retreat thanks to any one of a variety of pet causes and issues blamed for its dramatic rise.

But much to the chagrin of scapegoaters everywhere, unlike in years past - such as in 1973, when the OPEC oil embargo caused prices to spike - there really isn’t any one central factor that we can squarely pin the blame on for rising oil prices. Instead, three long-term trends that have been converging since the early 2000s - dollar depreciation, tightening global oil supply combined with rising demand, and increasing commodity price speculation - provided the powder keg, while the fallout from the credit crunch lit the fuse that caused oil prices to explode so fast and furiously.

Over the next three posts, I will examine each of these trends in turn - beginning with Congress’s current favorite: the depreciating dollar.

Mind the gap

As fears over Fannie Mae and Freddie Mac recently brought the dollar within a penny of its record low against the Euro, members of Congress have increasingly focused on the depreciating dollar as the source of and solution to all our woes. Witness Congressman Ron Paul (R-TX) informing us at Tuesday’s biannual Humphrey-Hawkins hearing that we don’t need “a world-class regulator that is going to solve all our problems” but rather “a world class dollar - a dollar that is sound, not a dollar that continues to depreciate.”

To be sure, as Chairman Bernanke acknowledged in his testimony, the falling dollar has definitely played a role in oil’s spectacular rise over the last year. To see why, just look at the gap that’s been slowly emerging between the price of oil in dollars vs. gold:

While the price of oil in dollars has nearly doubled, the price of oil in gold has risen by 50% over the same period. This discrepancy becomes an even more jarring 3-to-1 if we turn the clock back to late 2001, when the dollar began its tumble. Small wonder that in January of this year the Financial Times crowned gold as “the new global currency.”

This has led some economists - notably Stephen P.A. Brown at the Federal Reserve Bank of Dallas - to estimate that the depreciation of the dollar is responsible for a large percentage of the rise in oil prices over the last seven years. “If the U.S. currency had held its 2001 value against the Euro, oil would have traded at about $80 a barrel in early 2008, about $21 below its actual price,” Brown wrote in May. And as if that weren’t high enough, in early July - sourcing Brown - New York Times business columnist David Leonhardt cited this gap as $31.

Symptoms of addiction

The dollar depreciation trend only became exacerbated by the onset of the credit crunch, which forced the Fed to slash interest rates at a time when federal banks around the world were hiking interest rates to stem inflation pressures. Consequently, the already-weakened dollar plunged even more and the changes in dollar-denominated oil became even more pronounced.

To see why, think back to America’s “addiction” to foreign oil. The United States currently imports over 70% of its oil as a way to meet its energy needs. During times of elevated oil prices, this dependency leads to large capital outflows from the U.S. to the rest of the world (what Texas oil tycoon-turned-environmentalist T. Boone Pickens called “the largest shift of money in the history of mankind” in a recent interview with the Chicago Tribune editorial board). And just as strong capital inflows tend to strengthen the dollar - as they did throughout the 1990s and early 2000s when central banks around the world were selling their gold reserves and buying up dollars - strong capital outflows tend to weaken it. The result: a vicius cycle in which oil becomes more expensive but the U.S. continues to buy it at a higher price, adding more downward pressure on the dollar, upward pressure on oil, and so on and so on.

Possible cure

Naturally, one way to break that cycle is for the U.S. to import less oil. But as global oil demand from places like India and China surges, decreased domestic demand is unlikely to make a big dent in the price of oil. Oil demand is, after all, highly correlated to income and, as Brown of the Dallas FRB points out, China’s GDP per capita rose from $1,103 in 1990 to $4,088 in 2005 while India’s went from $1,202 to $2,222 over the same period (adjusted for inflation and purchasing power parity). Couple this with the sober fact that non-OPEC supplies of oil have consistently been lower than what the industry has expected and what results is the second long-term trend that’s been driving oil prices higher: tight global supply and demand conditions.

More on this in my next post in this series.

It’s no news that energy and commodity prices have been rising at breakneck speeds; just look at the Dow Jones AIG Commodity Spot Index - which tracks commodity price levels and is up nearly 40% over the last nine months. Instead, the $126/barrel question that’s stirring up controversy and making news is: why?

There seems to be broad agreement among economists as to who the culprits are: rising demand from countries like India and China for food and energy (exacerbated by a weak dollar), weather-related crop shortfalls reducing supply, speculation in the commodity markets and - perhaps most controversially - the use of corn crops for biofuels.

There is broad disagreement, though on which one of these structural/speculative factors is most to blame, and the tug-of war is just beginning. On Friday, the Wall Street Journal reported that 51% of economists in its latest forecasting survey said that demand from China and India was the prime factor in soaring energy pries, and 41% said that demand was the chief contributor to food costs. Perhaps most strikingly, only 11% saw a bubble developing due to speculation.

Now, no one can deny that growing demand for a refrigerator in every Chinese kitchen and a car in every Indian garage isn’t a powerful driving force behind commodity demand for everything from grains to metals to petroleum. However, looking at the timing of this latest explosion in commodity prices, one is tempted to give the speculation thesis a bit more weight in this debate.

Last week, the U.S. Joint Economic Committee on the Economy held a hearing on precisely this issue, with Tom Buis, President of the National Farmers’ Union and U.S. Department of Agriculture Chief Economist Joseph Glauber leading the testimony (watch the C-SPAN video here). About the first hour was good old-fashioned political grand-standing and speechmaking, but the last hour contained a few excerpts worth sharing:

[1:37:23] Rep. Carolyn Maloney (D-NY): According to the New York Times, commodity-exchange traded funds, which was developed barely 4 years ago, have grown nearly seven-fold since 2005, and to what extend are higher food prices being driven by speculation in commodity markets?

[1:37:42] Tom Buis: I appreciate that question because this has been a big concern. [. . . ] It’s something we’ve been hearing in farm country for quite some time is we can’t capture this price as I mentioned before this futures market has which markets have counted on forever has been eliminated and part of the reason is because the speculation into the market price has caused the market to explode. In the case of wheat, they reached contract limits day after day and, well, when you do that, that country elevator or that farmer has to pay a margin call and one country elevator I talked about that had pre-bought wheat for fall delivery had a million bushels and the price of wheat was going up 60 cents a day. Nothing was changing in the fundamentals at that point. There was lot of speculation, export markets coming in, that was costing him 600 thousand dollars per day to meet the margin calls and as a result he hit his credit limits. Hitting those credit limits forced him to cut off buying that grain from the farmer. So we raised these concerns and we were told nothing extraordinary was wrong except they could not explain: cotton. Cotton - we have a huge surplus of cotton, we had a great crop, it’s all over the country, you can’t hardly give it away and cotton prices spiked upon speculation. Now, when they went up, every farmer’s hoping that they would be able to get that price but weren’t able to. There’s explanations that need to be made. I think its similar to some of the other bubbles we’ve seen recently, and it could be the biggest train wreck we ever see.

[A quick primer on margin calls: let's say I own a grain elevator. The way I make money is basically via a broking business: buy grains low, sell high. To enhance my returns, I may buy grains on margin, meaning that I borrow funds to make the purchase. If my margin limit is 50%, then that means that I must keep my equity at least at 50% until I sell the grains and close my position. So if I buy $100 worth of grains and the price goes up, say, 20%, then I get a margin call from my lender asking me to deposit an additional $10 of equity to meet my 50% margin limit (which went from $50 to $60 as a result of the purchase.]

Long story short: if you are grain elevator posting margin and are locked-in for future delivery via a futures contract, then your short-term liquidity dissipates and you don’t have money to purchase additional grains - even if your grain elevator is just sitting there half empty. If this is indeed what’s happening in farm country right now, then this may indeed be a train wreck waiting to happen since it means that speculation in grain commodities is essentially causing a bottleneck in the supply chain: grain elevators are being maxed out, but not by fundamentals like overproduction but by speculation.

So what impact does this have on the commodities markets? To check it out, I took Buis’s example - cotton - and plotted a USDA-published index for U.S. cotton production alongside a middling index for average U.S. cotton prices on a relative scale starting in July 2007 (see below):

By any standard, this does not look like a healthy price vs. production index graph, where you expect the two variables to move in opposite directions. From August through September, and from November through December, cotton prices actually increase at a faster rate than production (to compare this with price vs. production curves I ran for other commodities on Bloomberg, click here).

Sure, it could be because of higher demand, but the timing here makes me think otherwise: money seems to be pouring into the market about the same time that the credit crunch hits - August - and comes back with a vengeance - November. That it could be dislocated money from the credit crunch looking to find a new home - especially in the midst of a Fed easing cycle - is not entirely implausible.

Granted, so far this amounts to nothing stronger than a hop-skip from correlation to conviction. But when you combine it grain elevators being effectively maxed out due to margin calls, a sharper image starts to take shape. As Buis notes in his written testimony (see below), “with stocks and bonds in turmoil as a result of the mortgage crisis, investment firms seized opportunities in the commodity futures markets. Billions of dollars from pension and other investment houses poured into the hot commodity markets. As a result, many commercial entities of farm commodities have faced skyrocketing margin calls on hedge contracts which have for a long-time been a financial risk tool for farmers and grain elevators.”

Granted, Buis lists higher energy costs (to which food prices are very highly leveraged due to transportation), weather-related supply shocks and the weak dollar and export demand as his top three reasons for hot commodities (ethanol - as expected from a farm man - is not the culprit).

But if this disturbing scenario is indeed playing out in farm country right now, then the bubble which economists seem to be hitherto dismissing - while not the main culprit behind hot commodities - could be far uglier, far larger, and far more damaging than we currently acknowledge.

* * * UPDATE: After I wrote this post, a friend alerted me to an article on the the impact of margin calls on grain elevators from the April 2 edition of the Wall Street Journal. Check it out to get a better understanding of how this all works, and what the potential consequences may be.

Ahead of next week’s Federal Reserve on meeting on Tuesday and Wednesday, markets seem convinced that another 25 basis point reduction in the fed funds rate is likely. But whether it’s necessary is whole different matter.

Since the Fed embarked on its latest easing cycle in September of last year, it has cut the fed funds rate from 5.25% to 2.25% - ostensibly to defend against further deterioration in the economy due to the fallout from the credit crunch. But now, as the risk of higher inflation becomes more and more pronounced, there is reason to question whether a seventh cut in eight months would make much difference.

The first argument in favor of a pause in the easing cycle rests squarely with inflation. The recent inflation data from the Bureau of Labor statistics (plotted below on a year-over-year basis) has not been encouraging. Year-over-year inflation in the U.S. is now hovering around 4% - about twice the comfort level for most investors. Netting out food and energy costs (the red trendline), it’s clear that it is the commodities boom and concern about food prices that’s adding on the extra 1.5-2.0% to the inflation rate (see below). And considering that food and energy collectively hold a 25% weight in the CPI, what we’re seeing is one-fourth of the index driving about half of its year-over-year growth. But that has an impact on the rest of the index as well since consumers can’t very easily cut down on food and energy spending, meaning that everything else effectively occupies a higher percentage of their income post-food and energy. Point being: regardless of the gap between universal (blue) and core (red) CPI, inflation has been gaining strength in the economy, and is likely to do so unless some part of the equation changes.

(Note: if you’d like to play around with the inflation rate and come to your own conclusions, I can recommend no better source than the Federal Reserve Bank of Cleveland’s U.S. inflation page).

One potent part of the equation is, of course, the level of interest rates since more money in the economy made available by cheaper cost of capital means more inflation. Now, banks’ unwillingness to lend in the wake of the collapse of the credit markets last year, a lowering of interest rates was in many ways a necessary and appropriate policy step on the part of the Fed. But keep in mind that there is usually a 9-18 month lag from the moment that there is a shift in fed policy to when the real economy starts to respond. So, the argument goes, why not wait and see whether the medicine (combined with all the other credit crunch solutions the fed has rolled out) is working before you apply more of it, especially if it means risking stoking the fires of inflation which we already see lighting up.

The counter-argument is, of course, that we’re currently staring into the abyss of a recession - if we’re not already in one - and so it would be wise to have additional insurance against the downside risk of a recession, even if it means risking higher inflation in the short term. If credit conditions continue to worsen and consumer confidence weakens, spending and investment could continue to decline, leading to higher unemployment and an even-worse recession scenario (for a fantastic summary of this whole issue, see Greg Ip of the Wall Street Journal discuss his article on this subject in the video below). That leaves the fed in the difficult spot of having to choose between the potential for higher inflation or higher unemployment - the classic dilemma of fed policymaking.

So what’s the tiebreaker?

Legitimate concerns about inflation and unemployment aside, it is time that we start to consider another, less orthodox argument in favor of raising interest rates: the fed funds rate just isn’t the center of attention that it used to be. In today’s globalized economy, interest rates abroad and the actions of foreign investors have a much stronger impact on the strength of our economy than they used to. One potent example of this is the prevalent use of the London interbank offered rate, or Libor) as a benchmark interest rate in much of U.S. lending and - just as importantly - credit default swaps (CDS), which have become an increasingly popular financial instrument for managing and transferring the risk of default to someone more willing to accept it - obviously, for a price. I recently asked a friend of mine who deals credit default swaps what the first indicator he looks at in the morning is, expecting him to say something along the lines of the 10-year treasury or some other U.S. interest rate benchmark. Not so: it’s the spread between Libor and U.S. interest rates - just another example of how important this rate has become.

But the spread between U.S. interest rates and foreign rates is particularly important in an easing cycle because if trillions of U.S. corporate debt and mortgage loans are tied to a foreign rate on dollars like Libor, and foreign rates are higher, then lowering our interest rates simply doesn’t make as much of a difference as we would like it to. A clear indication of this is the fact that the average rates submitted by U.S. banks vs. European banks to calculate the Libor formula have consistently been lower since about the middle of the month, as reported by the Wall Street Journal this week. As a result, some are calling for the creation of a “NYbor,” or a Libor formula that reflects the borrowing costs of U.S. banks only, since it’s clear that U.S. borrowers are currently paying higher rates that exist on the other side of the pond.

Hence, it’s right to ask whether lowering the fed funds rate target is likely to make that much of a difference in this interconnected global environment, especially since interest rates at most other major central banks currently set higher (see table below or complete world interest rate data here). That spells further devaluation of the dollar against the Euro, the Pound and currencies of other major world economies if we continue to cut our interest rates relative to theirs. Sure, that may aid exports, but it is also likely to add even more inflationary pressure to the economy due to higher costs from imports.

Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan, comes to the same conclusion using a different argument. In a recent editorial in the Wall Street Journal, “Enough With the Interest Rate Cuts.” Feldstein argues that cutting the interest rate won’t make as much of a difference as we’d like it to in stimulating our economy since “in previous recessions, lower rates stimulated aggregate demand by inducing increased home building. But with the massive inventory of unsold homes – up 50% from a few years ago – a further cut in the fed funds rate would have little effect on housing construction.”

So whether you look at it from the domestic standpoint or more globally, a cut in the fed funds rate at this point doesn’t carry as much upside as it does potential risks. Small surprise, then, that ahead of next week’s fed meeting, there isn’t as much excitement about the prospect of a rate cut as there is nervousness. Perhaps giving interest rate cuts a breather, then, is not such a bad idea.