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Why are commodity prices rising so fast?
Well, today they're not, they seem to be plummeting. Still they have been rising rapidly for years. Paul Krugman surveys some views, click through to the Frankel post as well. Yes I do think high and rising commodity prices have been a bubble -- but not just a bubble -- and no I don't think that low real interest rates are much of a factor. (Recall Cowen's Third Law: "All propositions about real interest rates are wrong.")
My basic explanation for rising commodity prices is simple. Most commodities are produced under conditions of short-run rising costs, often quite steeply rising short-run costs. Furthermore many production processes cannot do without these commodities in the short run. Coal, copper, and the like are not always easily substitutable for a factory within the medium run. (Furthermore until you are sure that the price increase is permanent, why re-gear at all? Why switch from copper plumbing to plastic plumbing, when price of copper might fall again?)
Now China has become wealthy quite fast but the country didn't become wealthy by producing more commodities. That's Albert Hirschman's "unbalanced growth." So demand for most commodities has outstripped the supply, production can't make up the difference in the short run, and commodity prices can rise sharply. Don't forget that logistics and transport are a big part of the production process and so infrastructure often constrains the flow of supply.
In the long run price will adjust (even if you believe we are near "peak oil" this is true for most commodities.) People will substitute or find new sources of the commodity or find new ways of producing the commodity more efficiently. Infrastructure improves. But yes those adjustments can take ten years or more. And in the meantime we have a commodity price boom and on top of that a bubble to make these items look even more expensive.
One final kicker: lots of commodities are produced by governments and/or their production is heavily controlled by governments, most of all oil. Then supply adjustments will be especially slow and cumbersome. Read this article about coal:
...94 percent of India's coal mining is in the hands of government-owned companies. The biggest, Coal India, produces four-fifths of the country's coal. Because the government is worried about social unrest, the prices for coal and electricity are kept low.
See the problem?
The bottom line: The best long-run bet is still that there is nothing special about risk-adjusted rates of return on commodities. That probably means falling real prices and falling real costs over time. The Chinese demand aberration is a temporary blip superimposed on very consistent longer-run trends.
Posted by Tyler Cowen on March 20, 2008 at 03:22 PM in Economics | Permalink
Comments
You can find some evidence of the short-run inelasticity of supply in the oil market here.
XOM can earn an eye-popping return on capital of 32% at current levels of output and face little incentive to invest in increased output.
Posted by: John Sterling at Mar 20, 2008 5:05:15 PM
Cowen's Third Law: "All propositions about real interest rates are wrong."
Are propositions about propositions about real interest rates themselves (indirectly) propositions about real interest rates?
(With apologies to Bertrand Russell)
Posted by: jbm at Mar 20, 2008 5:35:04 PM
Academic paper that may be of interest (addresses the risk-adjusted return of commodity futures issue):
"Facts and Fantasies about Commodity Futures"
Posted by: at Mar 20, 2008 5:36:59 PM
"That probably means falling real prices and falling real costs over time."
Um, Hotelling?
Posted by: Stephen Gordon at Mar 20, 2008 7:08:09 PM
RE: China demand is an aberration
From the 1/16 WSJ: “While wealthy nations still use the majority of oil consumed globally in barrel terms, the annual growth in crude consumption is coming from developing-nation consumers, who have little incentive to conserve because of huge government subsidies that shield them from high prices.
Reflecting that new development, the IEA said overall demand in China, the world's second biggest oil consumer after the U.S., "would probably be largely unaffected" by high oil costs because of price caps.”
A very well-capitalized, socialist regime doesn't come along every day. That, plus price caps, is the perfect cocktail for an aberration.
Posted by: BrotherMaynard at Mar 20, 2008 7:33:55 PM
I could be remembering wrong, Stephen, but doesn't Hotelling apply to a monopolist?
Posted by: cure at Mar 20, 2008 8:49:47 PM
On Hotelling, he assumed no extraction costs and a constant supply. In the real world technology has pushed down the cost of extracting resources be it lumber, oil or coal. Think about the dramatic improvment in lumber harvesting technology over the last 75 years and its not hard to imagine why real prices have fallen. Second, hotelling also assumed a constant supply. Since the 1950s the proven reserves of most major commodities have been increasing. When you add in these two factors I think the observed prices are consistent with the basic intuition that Hotelling provided.
Posted by: Sam at Mar 21, 2008 2:45:26 AM
'Because the government is worried about social unrest, the prices for coal and electricity are kept low.
See the problem?'
What - a government concerned about hindering social unrest is a problem? As compared to one that actively promotes it?
Or one that accepts social unrest as just the cost of doing business - and, yes, China does come to mind, in terms of how it handles worker protests. Maybe that is one reason that lead had such a spectacular rise in price - the Chinese government was hoarding it strategically.
I have never understood the paradox implicit in a true free market perspective - the state should remain distant from all economic decision making, while ensuring that those making economic decisions remain insulated from its results. For example, by using the power of government to suppress any attempts of workers to form effective unions.
Posted by: not_scottbot at Mar 21, 2008 6:47:53 AM
The answer is simple: there was a demand shock.
Normally, the demand curves for commodities move outwards in a slow but basically continuous fashion. The supply curve moves outwards in step-wise fashion as new chunks of production capacity get built. This results in price cycles, which are easily observed in the past.
As the good professor notes, rising maerginal costs are prevalent, and in an industry with a finite capacity, the supply curve goes vertical when we hit those capacity constraints.
What is different this time is that the demand curve moved out in a step-wise fashion when China started its building binge about 5 years ago. We quickly started to hit the capacity constraints in raw commodities, and prices shot up. This is beginning to reverse, as new capacity for metals and minerals comes online. If Chinese growth slows down after the Olympics, expect to see commodity prices fall to their 2003 levels.
And about Hotelling, the biggest false assumption that one has to make to apply it is the assumption that the stock of the commodity is finite and known from the beginning. The second of these propositions is almost never true.
Posted by: bartman at Mar 21, 2008 9:51:55 AM
A well-known investor who specializes in commodities has written that investment by commodity producers in capital equipment follows a 20-yr cycle. When prices are high for several years, they expand production by purchasing very expensive equipment in order to improve economies of scale. As a whole, they tend to overinvest in the good times. That leads to greater supply and falling prices. It takes about ten years for demand to catch up to supply and cause prices to rise again.
Posted by: fundamentalist at Mar 21, 2008 10:01:17 AM
Commodity prices now plunging.
Stock market next.
Posted by: jomama at Mar 21, 2008 10:42:17 AM
Interesting article.
Posted by: Prestige Bridging at Mar 21, 2008 10:52:00 AM
Look at stocks (inventories of commodities) are they rising or falling? look at the rates of increases in consumption. Look at the rates of replenishment of stocks vs those rates of increases in consumption.
Look at the factors necessary for replenishment (crop lands, infrastructures needed for mining and other extractions, equipment, etc.)
Note the rising restrictions on exports in command economies; the limits on transport, etc.
And don't overlook dwindling water.
Tune in on Demopolis, Alabama's Jimmy Rogers.
Posted by: R. Richard Schweitzer at Mar 22, 2008 6:19:25 PM
In commodity markets one can exchange money for commodities at almost zero transaction costs. These markets thus reflect not just the supply and demand of the commodity, but also the supply and demand of the money.
Because they combine liquidity with short-term supply inelasticity, commodities are an ideal way to hedge a falling currency. When the supply of money increases or is expected to increase, whether because of lower nominal or real interest rates, because the Fed is buying treasuries or mortgage-backed securities, or for any other reason, a disproportionate amount of the expected or initial increase in money supply is soaked up by commodities. This makes them a leading indicator of inflation. Indeed the commodities with the most liquid markets, such as oil and gold, tend to move in lock-step with each other. Such price movement is strong evidence for the movement being primarily a phenomenon of money supply rather than demand for particular commodities. If oil prices were rising primarily due to rising industrial demand for oil, we'd expect them to move quite differently than gold, which is demanded for primarily non-industrial reasons. That's not what we see -- we see oil and gold moving together, and indeed the price of oil in terms of gold and silver has been practically flat in the recent commodity boom.
This inflation only slowly percolates into price rises in other goods and services, which tend to be far more rigid than commodities. Wages are particularly rigid. Because the Fed and most other central banks regulate their money supplies based on trailing indicators of inflation (e.g. consumer price indices) rather than leading indicators (commodity prices), it is no surprise that their decisions tend to produce boom-and-bust cycles in commodities, and that to a lesser and more delayed extent they cause both general inflation and recessions. No uncommon demand from China or the like is needed to explain the recent commodity boom, just as no such rise in demand or long-term fall in supply was needed to explain the very similar commodity boom in the 1970s. But since most people judge supply and demand of a commodity by nominal price, both in the 1970s and now we get a lot of irrational hysteria about "running out", "peak oil", how our energy industries and consumption are "unsustainable", etc. I'll believe that when oil per barrel doubles or more with respect to gold and silver. When they move together, we're just being fooled by monetary instability.
Posted by: nick at Mar 24, 2008 6:53:52 PM
I'm a bit puzzled as to the price of rice in particular, It was my understanding that both China and India produce their own rice consumption, unless the exports from these countries have come down drastically (India has banned exports, but i donno how significant that is), can the increased demand or mass migration to cities from these two countries be of any relevance to the increase in price of rice?
Posted by: Deane at Apr 26, 2008 6:19:19 PM
