Falling prices can signal end of cycle

The prices of many primary commodities, agricultural, mineral and fuel, have fallen significantly. Crude oil is down by 40 percent to 50 percent just in recent months. Copper is down 18 percent since July and 28 percent from the beginning of 2012.

Corn in international trade is down 43 percent from March 2013. Iron ore, for Asian ports, fell by half since December 2013. There are many other examples.

Just what is going on? Is it good news or bad news for the U.S. economy in general? What about for U.S. families?

One explanation is banal. The simultaneous and drastic price drops indicate a healthy market response to changes in underlying global conditions. Most importantly, China’s rate of economic growth is slowing, and many argue this not only is inevitable but healthy in the longer run.

There also is slowing in other important regions, especially in the European Union. Many EU countries, particularly those that participate in the euro, have problems in government finances, slow overall economic growth overall and fragile banking systems.

Then there are the nations such as Venezuela, Russia, Iran, Argentina and Ukraine, seemingly responding to suicidal impulses. The consequences of long- and even medium-term stupidity in economic policy win out in the end, and that is happening for some of these.

The sanguine view of commodity price declines focuses on the slowing of growth in China, that it will force the Chinese economy to end a persistent pattern of investment in unproductive infrastructure and housing. Yes, temporarily, at least, China will import less iron ore, coal, corn, soybeans and other commodities. But it will waste fewer tons of steel output in apartments that have no buyers or factories with few viable customers.

Prices do drop a lot in a situations such as this because of the particular structure of supply and demand. For many primary commodities, both supply and demand are highly “inelastic,” where large percentage changes in price are associated with relatively small changes in quantity. For the global price of iron ore to drop by 50 percent, for example, it is not necessary for shipments to drop by 50 percent, also. Perhaps declines in international sales of as little as 10 percent to 15 percent will trigger such swings.

From this perspective, any slowing now, any price sags, represents a healthy and short-term catching of breath, after which now-flagging nations largely will return to some level of growth of output.

Other observers, however, see the current commodity price slump as more ominous, longer term and with deeper implications for the global economy. To them, ongoing drops in primary materials prices are evidence of the end of a historic “commodity supercycle” that developed over nearly two decades. This cycle indeed was fueled by growth in places like China and India and by a halting escape from Latin America’s “lost decade” of the 1980s.

But the cycle also derived, especially in recent years, from excessive central bank money creation. It stemmed from speculation in future commodity prices, through the use of derivative securities, moving from the province of a relatively small number of specialized firms to become an everyday practice of enormous investment banks.

And, perhaps above all, somewhere along the line it became a self-perpetuating economic phenomenon, a self-inflating bubble. Alan Greenspan may have coined the term “irrational exuberance,” but only Hyman Minsky, Charles Kindleberger and others who have studied financial bubbles really understand the self-propagating nature of price inflation.

In this now more ominous view, eroding commodity prices are seen not just as a harbinger of a short-term and much-needed economic catching of breath, but rather the dawn of a new and grim era for the world economy. We are not looking at a temporary recession for commodity producers, but rather something along the Biblical lines of Joseph’s seven lean years, and perhaps many more.

Couple this specter with ideas of pessimistic gurus, like Robert Gordon, of slowing growth in underlying economic productivity, and one can spin grim scenarios, indeed. Instead of viewing the remarkable global expansion in the half century after World War II as a normal situation to which we must inevitably return after minor slowings, the period is seen rather as an anomalous and difficult-to-explain historic oddity that might not recur for decades if not centuries.

The “commodity supercycle” gurus include the prolonged run-up in commodity prices in their analysis, not just the declines of the past few years. They consider the 13-fold increase in iron ore prices from early 2003 to early 2011 as the fascinating anomaly, not just the past 15 months. Also the quintupling of copper prices in the five years after 2001 and similar increases for other metals and ores.

This view is not based on an assumption of efficient markets responding rationally to new information. Nor does it ignore factors such as the spectacular growth of China and the inevitable slowing of that growth. But the dynamics of still-imperfectly understood irrational psychological factors do play a big role. The possibility of short-term financial manias is accepted by most economists outside of a cadre of hard-core efficient-market theorists. But no economist has grappled with the possibility of a bubble lasting a decade. Perhaps coming events will motivate someone to do so.

We live in interesting times. The economic world is a dangerous one in 2015, with high uncertainty. Trends in commodity prices are unknown and currently unknowable. We may be nearing the bottom of a short-term bobble or we may be on the cusp of a decade-long depression for primary commodity producers. Only time will tell how it all will play out.