When the levee breaks

Gold, like Led Zeppelin, is bringing it on home – inflationary '70s wipe-out and all...

"THE TEMPORARY PROSPERITY which springs from an extensive paper currency not only blinds the eyes of the public at large, but raises up numerous interests among individuals whose profits depend upon a continuance of the delusion. The patient is accordingly flattered by nostrums which give immediate ease, but really increase the malady; until at length a crisis comes, which demands a desperate remedy.

   "The alternative is either a debasement of the coinage (which is national bankruptcy... the usual remedy for insolvency with all the governments of Europe) or a severe reaction on the victims of the delusion, which causes embarrassment and stagnation in trade, and ruin to thousands who lived and flourished upon the ideal property. A dreadful dilemma! America is now suffering under it, and is probably doomed to undergo greater convulsions before the cure can be effected, boundless as her physical resources are."
A Treatise on Currency & Banking, Condy Raguet (1840)

What Is and What Should Never Be

WITH THE BRITISH HIGH STREET transformed by the crumbling of Northern Rock into a scene straight from Frank Capra's Depression-era classic, It's a Wonderful Life, a whole new generation has been alerted to the inherent dangers of that legal fraud known as "fractional reserve banking".

   Hardly were the words "Tough love" out of the mouth of Bank of England Governor Mervyn King ("the provision of...liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis...") than Northern, one of the UK's more aggressive mortgage lenders, succumbed to the inevitable and had to be offered special financing facilities by – err – well, Mr King, actually.

  
Even more remarkably, with queues forming around its branches for several days running – and with the news bulletins carrying lurid pictures of nonagenarian savers forcibly demanding their money back amid a visible and nervous police presence – the Labour government took the step of formally guaranteeing all existing deposits in the firm – its desperation to stem the spreading panic and thereby to minimise the political fall-out clearly visible to all.

Swiftly reinforcing its political masters, the 'independent' Old Lady then chose a course it had earlier strongly disavowed and announced it would forthwith inject £10 billion in reserves for a full three months – with three further increments of unspecified magnitude to follow – and all to be advanced against the same mortgage collateral it had previously set its face against accepting!

  
While we have every sympathy for individuals concerned for their savings, this episode should serve as the perfect illustration of a few oft-neglected truths about banking as a whole.

Trampled Underfoot

  
Firstly, by established legal privilege (though with no grounding in logic, equity, or economic science), banks are not a kind of financial warehouse where 'your' money is kept safe for a fee: they are simply your debtors and – in this golden age of securitization – not even ones bound to give you the first sniff at whatever's left in the pot after they mess things up.

  
Secondly, the practice of lending out demand or short-notice deposits to third parties at term (deposits, moreover, predominantly created by the prior granting of the same loans which they will end up financing), means that banks are all inherently illiquid and so require for their functioning that violation of the free market called the central bank, often backed up by the compulsory collectivisation of a government-backed deposit guarantee (a "crook's charter", to use Charles Goodhart's pungent phrase).

  
Thirdly, since their capital base is so slender in relation to the pyramid of on-balance sheet items and (more significantly in today's institutional setting) to the mountain of contingent liabilities which rests upon it, the pressure brought to bear on asset prices when the illiquidity condition starts to weigh, means that they are all only a whisker away from insolvency, too.

  
With all this in mind, it should be no surprise that we stand on the verge of yet another of those crises which have so marred our economic history, though the lesson that such disasters do not only inflict countries 'far away' and 'people of whom we know nothing', but can also break out here, at home, in the supposedly sophisticated West, should be a salutary one.

   What has brought us to this pass is that the inherently inflationary trend of a fractional reserve, fiat money system has – as so often in the past – extended increasing amounts of credit not to people who employ it in manner which they hope will generate the income needed to service and amortize the obligation, but instead to two ultimately parasitical groups:

1. the feckless mass which simply consumes the goods purchasable with it and tomorrow go hang; and
2. those whose hope is that they are sufficiently early in the great chain letter of this inflation that a subsequent borrower will relieve them of their leveraged possessions at a higher price than is due back to their own creditors – and that they can therefore live handsomely off the difference.

   Given the fetish which most modern macromancy makes of end, exhaustive consumption, the fact that Categories 1). and 2). will, for a while, keep both supermarket tills and supercar salesmen busy, can of course be misread as a sign of prosperity – though one of the warped kind only to be extolled as 'prudent' economic management by the spin doctors of the incumbent government of the day.

The Immigrant Song

   In the particular instance of the UK, the ironies abound, for here is a country where:

• the employment figures look good only because half a million-odd, industrious Eastern Europeans have arrived to do jobs deemed too demeaning and low paying for the domestic welfare hordes to get out of bed to perform;
• where over a million productive manufacturing jobs have been transformed into public sector inefficiency and waste inside a decade;
• where the total of net household dissaving has reached £120 billion in just over six years and where household debt soared from 90% to 160% of income during PM Brown's much-lauded chancellorship;
• where the trade gap has plumbed unprecedented new depths;
• where the nation's status as an energy exporter has sharply reversed;
• and where, outside of the speculative financial oligopolis of London, the state sector accounts for so much of economic activity that it would put a Ceausescu to shame.

   Were it not for the largesse of those foreign central banks who have convinced themselves – to the tune of an identifiable minimum of £20 billion a year during this infant century – that sterling somehow represents a safe alternative to the shaky Greenback, such a list of vulnerabilities might have counted for more; but now, with the banking sector seemingly reliant on the printing press for survival and with financial market earnings about to plunge, the chickens might at last be set to evict the guardian Ravens from their talismanic roost at the Tower.

Bring It On Home

   But we must not dwell on the UK alone, for a quick scan of the newswires shows that:

• house price inflation has not only been running hot and hard in Denmark and Ireland, but that insolvencies are now rising in the first and property prices falling in the second;
• seven or eight property lenders and specialist finance houses in New Zealand have fallen over in recent months;
• the Reserve Bank of Australia has had to categorically deny it is providing a lifeline to its own Northern Rock analogues;
• a consumer finance house crash may be unfolding in Japan;
• a number of mid-tier builders have gone belly-up in Korea; and that
• there are calls for Taiwan to desist from raising interest rates as personal indebtedness has risen so sharply that calamity looms.

   It will be of little comfort either to hear that David Taguas – economic guru to the Spanish prime minister – has denied that industry estimates of a supply of new housing 75% in excess of projected demand this year can possibly have any ill effects, dismissing suggestions to the contrary as both 'ridiculous' and 'unthinkable', while insisting that the financial system there has never been better prepared to meet such a test.

  
(Mortgaged) castles in Spain, indeed!

  
It is becoming harder to deny that the impact of the credit restriction in the real world seems to be intensifying, even if, at this stage, the evidence is largely anecdotal. Certainly, there is much talk of commercial property deals being discounted or shelved outright in Europe and America – not to mention as far afield as in Kazakhstan, according to Bloomberg News – while stories of small businesses finding a frosty reception from formerly open-handed bank branch managers have become much more common newspaper fare, too.

  
If substantiated, this would amount to a classic freezing out of sub-marginal expansion, leaving able to break ground only those firms generating enough cash internally, alongside those able to persuade themselves that externally-financed projects really do promise sufficient investment returns to bear the extra costs and tighter loan terms now likely to be applied.

  
Ultimately, no matter what the short-term pain associated with this, such a stricter rationing of scarce resources would represent a thoroughly beneficial development as it would alleviate unnecessary price pressures, limit the further misallocation of capital and labour, and increase the chances that the associated credit can one day be repaid without placing undue stress on either borrower or lender. But, sadly, such a self-regulating mechanism is not likely to be allowed to run its course – as demonstrated by the spate of extraordinary central bank and government support measures already enacted.

Whole Lotta Love

  
Driven initially by their imperatives of shoring up the financial system – though, Heaven forfend, we think they are 'bailing out speculators'! – this has already led to a compete volte face on the part of the Fed as Chairman Bernanke – the man who apologised on behalf of the 1930s Fed for not slashing rates quickly enough once the stock market tanked – showed his willingness to emulate the damaging 'pump, dump 'n' mop up later' prescription of the man he succeeded in office.

  
Nor should we expect this to be the last such action. The urgency with which these U-turns have been executed implies that further, ad hoc relaxations of policy will be enacted to the point the central bankers think they have eased the present, market-led stringency for good.

  
And if not from the central banks directly, let's not forget that the US Treasury has conducted some rather significant auctions of its own, temporary cash surpluses (against the provision of which asset-backed paper qualifies as collateral). A couple of these, indeed, neatly coincided with the private sector bailout of Countrywide which Sec. Paulson seems to have 'encouraged' at a meeting with the large money-centres.

  
Again, the Federal Housing Bureau system's total advances soared by close to $140 billion in July and August alone, while Fannie and Freddie's regulator has also overcome his earlier misgivings and given the two Hydras some extra headroom to expand beyond the current $1.5 trillion cap on the size of their retained portfolios. Backing that up, said Mr. Paulson is plotting to get the Chinese to finance bonus-shy Global Alpha managers' upstate mansions by allowing the GSEs to buy the so-called 'jumbo' mortgages formerly beyond their remit.

  
Unfortunately, to the extent all these interventions do not provide an exact Dollar-for-Dollar offset for the stragglers – and, clearly, this is a practical impossibility – the set of beneficiaries of this new inflation will not be identical with the old. Hence an interregnum of lowered profits and rising unemployment will still have to be endured as capital is written off and men and machines redeployed from the ranks of the losers to where they better fit a changed economic landscape.

  
Once this shows up in the macro numbers, however, the central banks will be tempted to loosen policy yet again in the attempt both to cushion the shock and to speed the required transition, all the while failing to realise that all interference with the market process will simply lay the foundations upon which the next – and much more grandiose – Hall of Delusions will be erected, before the dust has even settled on the rubble of the old.

Nobody's Fault But Mine

  
Yes, Chairman Bernanke, you were right to apologise for the Fed's causative role in the Great Depression, you were only wrong in the identification of the crime to which you anachronistically confessed: it was your institution's instrumentality in the putting the Roar into the Twenties which visited so much grief on its fellow citizens, not any supposed tardiness in responding to the inevitable bust which unwound that truly exceptional boom.

  
So, should you be sizing up the sackcloth and collecting the ashes in preparation for making your Mea Culpa's again, please remember that it was your predecessor's deeds as the head of the Monetary Medellin cartel – an office in which he was ably assisted by certain members of his board ("We have a technology called the printing press") – which has today left us once more all strung out and desperate for the next fix, even if it kills us.

Good Times, Bad Times

  
Perhaps the most revealing thing about all this has been the reaction in a market not known for its deeper appreciation of such matters.

  
Firstly, as we have written elsewhere, gold was sold when the crunch first hit, as the liquidation of any and all assets was an imperative in the dash for cash, but, subsequently, the Gold Price began its move back up from $642 per ounce the very day the Fed cut the discount rate.

  
Were any proof really needed, this should underline the fact that gold no longer comprises 'money' in any meaningful sense and is therefore not a deflation hedge. What it is, however, is a highly liquid, scarce, real asset – a combination which therefore makes it a vehicle offering the chance of avoiding the worst losses to be suffered during a paper money inflation.

Real Gold Prices in 1971 Dollars

   As such, it is readily conceivable that the present pop marks the start of a broader run which could eventually see it trading at, say, $900 (and more if the Dollar simultaneously continues to fall against the other, equally anchorless promises to pay against which it jostles for preference).

   Approaching $740 per ounce in the immediate aftermath of the 50 basis-points reduction in the Fed funds rate, the Gold Price was joined in pushing to, or through, new highs by crude (+16%), wheat (+24%) and soybeans (+19%), while copper (+17%) and nickel (+32%) rebounded smartly from recent weakness.

   The Fed cut also added 16 basis points immediately to each of the T-bond yield and the long-end break-even inflation rate, while steepening between the two-year and 30-year bond yields by 23 basis points. Meanwhile, volatilities in both stocks and bonds and observable credit spreads fell noticeably and the previously moribund interbank market in London made Lazarus look like a post-operative malingerer.

   Commodity currencies (CAD, AUD, NZD) and former high-yield favourites like the Icelandic Krona, the Turkish Lira, and the South African Rand found an immediate bid, while lagging with the sickly Greenback and rocky (!) Sterling were the usual carry trade patsies, the Yen and the Swissy.

   So, despite the fact that he economy was still perceived to be running reasonably well and regardless of the fact that the cost and availability of labour sits at the top of the expressed list of worries for all too many surveyed firms, the Fed cut rates by more than expected.

   In doing so, it not only gave some of the same old 'risk'-trades an amphetamine boost, but it also unleashed an unmistakable drive towards building in a markedly higher inflation premium even though this was accompanied by the clatter of macro-economists frantically revising down their GDP projections along with their Feds funds targets (and to think that many of the species has the gall to criticize the ratings agencies for their perennial 20:20 hindsight!).

Over the Hills and Far Away

   It should also be wryly observed that when Western credit markets were 'broke' and Western equity analysts were at a loss for what to tout next, emerging markets were spruced up for the job of 'safe haven', with a good deal of special pleading being employed to argue that their overdeveloped export sectors and inefficient, quasi-monopolistic, domestic fiefdoms would be mostly immune to the shake-out.

   So, when Blackhawk Bernanke, Tigre Trichet, Westland Sea King and their friends temporarily bedazzled us with their monetary largesse and the prospect of speculative gain drove the S&P500 to within a percent or so of its all time high, do you think we saw those same EM positions correspondingly reduced as part of this incipient flight from quality?

   No, of course not! After all, if they can keep the party going without any help from us Occidental over-imbibers, just think how well they will do if we take our newly-issued beer vouchers straight back to their bar for more! So emerging markets, too, shot back to within a whisker of their own all-time outright – and decade-long relative – highs.

   In fact, Oriental confidence is simply breath taking. China Construction Bank, for example, the country's largest mortgage lender (here readers may pause to make the sign against the evil eye) had the misfortune to be scheduled to float just under 4% of its stock barely a week after the PBoC again edged rates and reserve ratios up in order to cool the rampant stock market, while it also threatened to impose more administrative measures aimed at damping down an irrepressible property market.

   The result? Only $300 billion chasing a paltry $7.7 billion allotment – a 36-times oversubscription which valued the whole shebang at roughly the same market capitalisation as that accorded to Bank of America!

   Yet, such are the problems inherent in China's dysfunctional financial system that a mere 24 hours later, the government promulgated a Diocletian diktat as the latest step in its Schachtian programme of state-directed development, banning price rises in the many goods and services still controlled by the state until the end of the year, while simultaneously urging an increase in the minimum wage to compensate for the officially recorded 6.5% rise in consumer prices this year.

   Monopthalmic sinophiles might like to tell us how taking policy lessons from Hugo Chavez is supposed to strengthen the investment case for this most dangerous of bubble economies. They might also like to explain why price caps will not lead to both outright shortages and smuggling, or how boosting labour costs while fixing selling prices will do anything to help expand employment.

Dazed and Confused

   So where does all this leave the commodities market? Strong or strengthening in simple terms, though such a bald statement does little to answer the crucial question of where we go from here.

   Perhaps the most perplexing issue is that of crude oil.

   As anyone glancing at the papers will not fail to be aware, the market has rallied to make new highs and this holds true whether we look at Dubai, at Brent or at US barrels of the stuff. At the same time, the curve has taken on a steeper backwardation than at any time for the past three years, a phenomenon usually strongly suggestive of a threatened supply constraint.

   The puzzle is that stock:use ratios are not, in fact, abnormally low (whether we take use as refinery runs or as total product supplied). Further, both OPEC and the IEA reckon there was an OECD inventory build last quarter while, in the US, neither distillate stocks nor crude stocks are especially depressed either.

Real Dubai Crude Price, 1971 Dollars

  Though the motor gasoline picture seems as stretched as it has been, nor can this be the main cause of crude strength since gasoline prices themselves have lagged to the point that they have dragged the crack spread down 75% from its May highs, taking it all the way back to where it started the year.

   Moreover, if we look at the DOE demand statistics, we see that usage has effectively stalled out (that for kerosene, these past three months, has actually fallen on the same period last year), while both coal and natural gas prices look unusually favourable in comparison to heating oil to tempt those with capability to switch fuels this winter. Indeed, Sandy Barge coal has hit a relative price extreme which makes it more than twice as cheap as the twenty-year norm, while Henry Hub gas is 1/3 less expensive than usual, having reached relative levels not seen in fifteen years or so.

Sick Again

   No wonder, then, that OPEC has been so wary about opening the taps that – despite much browbeating from an IEA surely far too aggressive in its fourth-quarter forecasts – the cartel has cautiously pledged an extra half million bpd, adding that it will review the situation again if oil sustains the $80 level for more than a couple of weeks.

   So, if not increasing physical demand, restricted supply, or falling stockpiles, what is the cause for oil's strength?

   Not the weather, for though it is far too early to dismiss all thought of disruption, so far, the hurricane season has been benign – at least, as far as the critical installations in the Gulf are concerned. Yes, as we write, we have a precautionary shut-in as the latest depression forms, but we can hardly blame a 48-hour fall on the barometer for a four-week rally in the basket, can we?

   A speculative burst? Perhaps, but if so, it has not yet shown up on the CFTC reports where net non-commercial longs have added back barely 10,000 lots of the 85,000-odd they dumped during the course of August's general liquidation.

   Granted, the Dollar's decline has certainly not hindered the rally, but even this is not enough of an explanation for, since its August 22nd low, crude has not only risen 18.5% against the Greenback, but it has also gained 18.4% versus the Yen, 17.2% against Sterling, 13.9% against the Euro, and even 6.2% versus the Dollar Gold Price.

   All of which only leads us to wonder whether or not the sabre rattling over Iran is a touch closer to degenerating into something calamitous than is usually admitted in polite company.

   Certainly, the AMEX defence stocks index has shone of late, gaining 16.5% outright and 7.7% relative to the S&P since the first discount rate cut, the icing on a multi-tiered cake of total gain which reaches close to 760% from the time of the last stock market peak. (Incidentally, an ascent which means that the Merchants of Death have outperformed the Nasdaq 100 by a whopping nineteen times in that stretch. The industries of tomorrow left in the dust by the industries of no tomorrow, we might say).

   Though at 640,000 barrels it is probably too small to be meaningful, it nonetheless also seems curious that, after three months of complete inactivity, the US authorities should pick a period of record prices to add to the Strategic Petroleum Reserve. But enough of such thoughts – that way madness lies.

   The upshot of all this is that the charts suggest that gains of just under 10% could be seen before this move exhausts itself, making for a target of, say, $90/bbl in round numbers on the WTI contract. The nearer it gets to there, however, the more desperately the market will need to unearth some new evidence (or, alternatively, will have to re-interpret the existing pattern) to convince itself that the fundamentals really do support such an elevated price.

Hots On for Nowhere

   Nor does that mark an end to it, for the inflation trade has also given a lift to some –though not all – of the base metals.

   Copper, for example, has moved smartly away from a five-month low. Helping the reversal has been the fact that long-climbing stockpiles at the LME and in Shanghai have finally started to dip, adding credence to industry estimates that there has been a small physical deficit in the year so far.

   What is less encouraging, however, is that some of those same estimates reckon that almost the whole of the 5% or so consumption increase over the same period in 2006 has occurred in China, with users elsewhere barely troubling the scorer. This disproportion is unlikely to be reversed any time soon since the cloudy credit picture is hardly going to be conducive to a sudden rebound in residential – or even commercial – property development in the West. Nonetheless, having all the metal's eggs in the one Bird's Nest Soup basket might leave it a little vulnerable to a further setback, if Beijing ever succeeds in reining in the nation's furious over-expansion, as it pretends it must.

DCI Metals v USD TWI

   Lead may also have rallied – dragging tin with it – as supply problems persist, but even so, increased production is rapidly eroding its deficit, advancing the point at which ever dwindling stocks will firstly stabilise and then rebound. Furthermore, 2007 is shaping up to be second successive year of anaemic, 2-point-something consumption gains, making the 6.8% compound rate of 2004-5 which laid the groundwork for the metal' s rise look ever more anomalous in retrospect (note too, that, even including this burst, the compounded annual return for the whole of the past 12 years comes in at only around 2.8%).

   For tin, too, largely political derangements have meant a drop-off in mine output, but it should be noted that higher prices have also seen appetite in China and Japan drop a sharp 6% so far this year.

   Helped the most by the central bank 'Surge' has been nickel – the metal which had, of course, been the sorriest loser prior to the rescue operation. By itself, a 40% trough-to-peak recovery sounds impressive enough, but, technically the metal needs to trade sustainably above $33,400 per tonne (the halfway mark in the thirteen-month mania which fizzled out so spectacularly in May) if this is to be seen as anything other than the post-mortem recoil of a ninth-life feline.

   Yes, the market may have been in deficit in the year to August, despite a double-digit production increase, but with the likes of Baosteel declaring it will not increase stainless output for the remainder of the year – and that up to 50% of that balance would be devoted to low-to-no nickel content ferritic alloys, further optimism needs to be tempered, along wit the steel. Nor should nerves be calmed by talk of the existence of large stockpiles of both traditional ore as well as of nickel pig iron (local reports boast that enough of this lower-grade alternative to displace up to 100,000 tonnes of traditional metal may be forthcoming).

   Meanwhile, for zinc – already in a surplus which could stretch on to 2010 – the immense 1.25 Mt smelter capacity expansion coming on stream in China looks set to remove a processing bottleneck which has seen treatment charges hit unprecedented heights and piled up stocks all awaiting finishing. If banking on the monetary effects to make a buck here, stops should therefore be placed somewhere between June's low of $2,800/tonne and the more recent $2,680 minimum.

   Finally, turning to aluminium, even a 10% rise in consumption this year was not enough to absorb 12% greater supply and so pushed LME stocks to a 3 year high. Talk by the new Russian giant, Rusal that, over the next five years, it aims to ramp up production by no less than two-thirds from a base which already accounts for one in every eight tonnes of worldwide metal cast and one in every six of global alumina refined does not hint at the existence of any serious resource shortage ahead. It might make Rio shareholders a touch twitchy, to boot!

   In this sector – particularly if we strip out the influence of a declining US Dollar – much depends on the exact size and scale of any credit-based deceleration in the major economies and whether these can be offset by a prolongation of the Chinese boom, juiced up with a little help from the expansions projected to take place in the likes of India and the major energy producers.

Stairway to Heaven

   All of which leaves us to look at an agriculture component where the impact of the business cycle is clearly much attenuated, if not entirely absent (crop short foreigners get at least some discount if they buy US produce in dwindling Dollars, for example).

   Here, in brief, we have Round II of Mother Nature versus Government/Green stupidity.

   Wall-to-wall corn was planted in the US, you will remember, in order to harvest the maximum amount of biofuel tax money (sorry, to save the planet while hitting any number of 'enemies of the people' in the pocketbook) and this, naturally, squeezed out the acres which could be devoted to wheat, cotton, and barley, in the process.

   By the way, it might raise a wry smile to hear that, problems completing the necessary ethanol-subsidy refineries on schedule, coupled with low capacity utilisation at those already in operation, has actually meant that the land on which some three million tonnes of that corn was grown could have been dedicated to meeting what have turned out to be more pressing needs elsewhere.

   Then – Bingo! – La Nina doesn't arrive with enough force to save all the Aussie wheat harvest. Half of Britain spends the summer doing its best impersonation of Atlantis (NB farmers' groans now centre around it being too dry for the recently drilled rape crop!), while the same caprice of the jet stream bakes the Eastern grain belt to a crisp. Canada, meanwhile, has all of hot, dry, wet, and cold weather, all at just the wrong moments in its growing season.

   To cap it all off, just when you thought Al Gore had guaranteed that manmade loft insulation in the atmosphere would cut your heating bills for ever, record low seasonal temperatures hit the Midwest states and lead to worries that soybeans might have suffered frost damage.

   Then, the world's most populous nations all start trying to increase imports at once, while, among the growers, the likes of the Ukraine and Russia begin to tinker with the idea of export bans and special surcharges in order to keep more of what they grow at home.

   Before you know it, there are tortilla tumults in Mexico, bread brouhahas in the Central Asian 'Stans, rice riots in Guinea, yoghurt yowls in Jordan, and spaghetti stoppages in Italy.

   Pig prices start causing political problems in Peking and shoppers worldwide are warned that they face further sizeable hikes in the price of dairy produce, eggs, milk, chicken, and bacon as soaring feed prices (added to the EU's ban on genetically-modified organisms) drive the more marginal livestock producers to the wall, reducing supply at a time of increased scarcity.

   The popular bet now is that the enormous relative shift in the price of wheat versus that of its rivals will see a massive swing back towards planting this very expensive grass next year. So, as wheat for immediate delivery has scaled new peaks against corn and beans, positions are starting to build up in the opposite direction in the deferred months, pushing the wheat backwardation to a record level. Coupled to this discount in the futures, reports from the US suggest the cash price is lower still, possibly touching $5/bushel, in some cases.

Wheat vs. Corn

   The gamble rests on the superficially reasonable theory that next year's growing conditions cannot possibly be so infernally poor again in so many places. This may be a sound enough supposition (although the same could have been said this time last year), but one risk to overplaying this theory is to remember that wheat stocks will probably plumb a three-decade low as a result of this year's disasters, while the stock:use ratio is likely to drop off the bottom of the chart completely.

   Under such constraints, it won't necessarily require a poor realised harvest, only even the most fleeting of fears of such an event to spark another buying panic. Moreover, there are suggestions that major grain end-users are seeking to secure long-term delivery contracts, rather than relying on the spot market for so many of their purchases. If so, not only will a floor tend to be put under the market price, but, should fears of another impaired crop really emerge, it will become apparent that there is less of a 'float' with which to satisfy the remaining demand – making this another recipe for a possible spring price spike. Caveat vendor, indeed.

Heartbreaker

   Be that as it may, in terms of monetary policy, as we are frequently reminded, the exigencies of agronomy play little role since our esteemed central bankers routinely remove food and energy prices from their precious 'core' inflation indices. Thus, they can continue to fool themselves that all is well, regardless of the cost of wheat or corn.

   They should try telling those at the sharp end of the business that this is little more than an irrelevance. For instance, ConAgra CEO Gary Rodkin told analysts this month that prices for some of his company's most important ingredients were "through the roof." Heinz CFO Arthur Winkleblack, for his part, opined that "We are witnessing some of the worst commodity inflation in many, many years." General Mills boss Steve Sanger added that his company was "actively monitoring the need to pass along additional input prices", having already shrunk the size of its cereal boxes as a sly way of overcoming resistance to a higher unit price.

   Ivory tower concepts of 'price stability' notwithstanding, if you add a higher heating and driving outlay ('ex'-ed out), a hike in mortgage costs (also ignored), and a steep increase in a groceries bill (not counted) which is undeniably rebounding rapidly from a record low 10% of the average family outlay, you have definitively reduced living standards for workers in perhaps the most palpable manner possible. You have thus introduced a dangerous element of friction into an already fraught economic system.

   Not the least of the consequences might be that – confronted daily with genuine, statistically-unmassaged evidence that their pay packets are effectively shrinking – inflation 'expectations' might jump the barricade and send us straight back to the sort of economic war of all against all we have not suffered since the final quarter of the last century.

The Battle of Evermore

   So, we find ourselves at a singularly unappetising juncture.

   On the one hand the lower rungs of the credit ladder are being sawn off to furnish fuel for a latter day Bonfire of the Vanities.

   Not only have new leveraged-buyout deals dried up, but – ominously – the first cancellations of those already announced are beginning to appear. On many others, terms are being frantically revised, post hoc, in the buyers' favour and the associated loans are being offered by the major banks at big discounts – haircuts which are beginning to be reflected in large write-offs at the lenders in their turn (see Deutsche's $2.4 billion hiccough).

   At the other end of the scale, the likes of Barclays and GE are among the many large players scrambling to get out of giving consumer credit to deadbeats, while HSBC issued its first profit warning in a century-and-a-half as a result of the costs of reversing its late-cycle purchase of a US sub-prime outfit.

   In between, we can expect a good number of highly-indebted corporates to fail once their own NINJA loan access to cheap credit is withdrawn and they accordingly find that their cost of capital begins to better reflect the risk they really entail. Add in a dash of lower sales revenues and a slice of shrunken profit margins if the economy does turn less benign and the prospect of setting a new record for defaults is not as remote as some might hope.

   The fact that the non-bank Ponzi scheme of lavish credit has collapsed (removing the so-called 'asset shortage' at a stroke) means that the banks themselves are thus having to take up more of the slack, at a time when they are desperately trying to disarm suspicion by presenting a whiter than white aspect to both regulators and investors. Here, then, we have a twofold source of contraction sufficient to crush a good deal of unwarranted past exuberance out of the system.

   Against this, we have seen that, for all their harsh rhetoric, central bankers know on which side their bread is buttered; that their de jure independence from base politics is a de facto myth.

   Given that they are congenitally predisposed to bailing out their constituents at the first hint of trouble and that they are hard-wired to attempt to smooth out a business cycle for which only they are to blame, the inescapable conclusion is that a localised deflation in the above sectors of the economy may spread pain well beyond its borders, but that it will be vigorously resisted by means of a deliberate inflation ignited everywhere else.

   Draw back a moment and look at the proud record of modern finance.

   The mid-80s boom ruined commodity producers' balance sheets. The late-80s boom ruined householders', mortgage lenders', and Japanese balance sheets. The mid-90s boom ruined emerging market balance sheets. The late-90s boom ruined Western corporate balance sheets. The latest boom has been driven by putting vast cohorts of householders in jeopardy, once again.

   It is vital to realize that each time, even as the victims of previous excesses were writhing in agony, the next turkeys were rapidly being fattened for a Christmas to come.

   Sometimes we had a large dose of recession and a low seasoning of higher prices, sometimes the converse. Occasionally, we endured a combination in which only those long options on the Misery Index made any serious dough. At no point, however, did the rise in prices do more than decelerate for anything but the briefest of intervals – Boskin Commission, or no!

   So, where will this next inflation most likely take root, bearing in mind that, because no-one ever seems a better candidate for a loan than the person who doesn't really need one, at least some pretence of caring about the present solvency and future prospects of all non-state actors must be maintained when dishing out the bills rolling in greater quantity off the printing presses?

   Well, under current circumstances, we can expect that those in the commodity business, for one, will find fewer problems harvesting some of the poisoned fruits of this new inflation than will their counterparts in, say, media or telecoms.

   Emerging market economies, too, are presently flush with cash and their regimes are (rightly) anxious about the value of the Dollars which comprise so large a share of that stockpile. As a result, they are likely to be misled into cracking open their bulging war chests in an indiscriminate endeavour to stimulate the domestic economy as and when their over-distended export sectors falter.

   Finally, government finances everywhere have waxed and waned with the ups and downs of the economic rollercoaster, as an inveterate – if distinctly lop-sided – Keynesianism has seen exclusively the deficit spending half of the old phoney's quack remedy implemented, with a greater or lesser degree of enthusiasm as circumstances seem to warrant. Expect more belligerent declarations that 'deficits don't matter' as things head south.

Whatever the outlet, those who succumb to the temptation and reach out for the next wad of easy money will find themselves held to a decidedly Faustian bargain for, one day, Mephistopheles will certainly demand a payment unable to be made without causing anguish.

   However, while the borrowers and spenders are enjoying the illusory pleasures of the exchange, their scale of activity might be enough to ensure that while one column in the business section is bemoaning job losses and declining profitability, the adjacent one is complaining equally plaintively about price rises, industrial unrest, and expanding fiscal deficits.

Founded in 1968 – the year that the collapse of the London Gold Pool signalled that endemic inflation was about to disrupt the post-War monetary order; folded in 1980 – the year that gold hit its all-time high as that same inflation neared its peak – the news that the legendary Led Zeppelin, have chosen this, of all years, to play a long hoped-for reunion concert is replete with ominous resonances.

   Not least of these is that, as the title of the band's mid-70's 'rockumentary' put it – The Song Remains the Same.