Development Through Wage-Led Growth
 
By
Henry C.K. Liu


 
Part I: Stagnant Worker Wage Income Leads to Overcapacity

This article appeared in AToL on November 24, 2010

 
In the economics of development, there is an iron-clad rule that “income is all”. The rule states that the effectiveness of developmental policies, programs and measures should be evaluated by their effect on raising the wage income of workers; and that a low-wage economy is an underdeveloped economy because it keeps aggregate consumer demand below its optimum level, thus causing overcapacity in the economy that needs to be absorbed by export.
 
Workers income is the key factor in generating national wealth in a country. Export through low-wage production is merely shipping under-priced national wealth outside the national border without adequate compensation, by under-pricing labor within the nation. During the age of industrial imperialism, export of manufactured goods was promoted by high-wage economies to the low-wage colonies in return for gold-back money, so that more investment could be made to provide more jobs for high-wage workers at home. In post-industrial finance economies, cross-border wage arbitrage in unregulated global trade exploits workers in low-wage economies to produce for consumers in higher wage economies to earn fiat crrency in the form of the dollar that cannot be spent in the exporting economy. 
 
Globalization of Trade Preempts Domestic Development in All Countries
 
This “income is all” rule has been mostly obscured in recent decades during which globalized foreign trade promoted by neoliberals has pre-empted domestic development as the engine of economic growth in all market economies around the world. In today’s game of globalized international trade, the new operative rule is that “profit is all” and that high profit in competitive export trade requires low domestic wages, even if low local wages retard domestic economic development by reducing aggregate purchasing power in the domestic market to cause overcapacity that rely on export. As workers wages are not sufficient to buy the goods they produce, domestic markets fall into underdevelopment and export to high-wage economies is needed to produce profit for companies.
 
Excessive Corporate Profit From Low Wages Leads to Overcapacity
 
This new rule of globalized trade is designed to produce short-term maximization of corporate profit for an export sector. But in the post industrial finance economy, the export sectors in low-wage economies are largely owned or financed by cross-border international capital. This type of international trade incurs inevitable long-term stagnation in the domestic economies of all trading nations because the low wages paid by international capital lead to insufficient aggregate domestic consumer demand. Stagnant wages everywhere in turn reduce aggregate global purchasing power needed for the expansion of international trade. It is a clear case of imbalanced economic sub-optimization.
 
Foreign Capital Invested in International Trade Has No Incentive to Raise Local Wages
 
The export sector of foreign trade in any economy naturally does not consider the purchasing power of local workers as being of any consequence because the goods produced and services provided by local workers in the export sector are sold in higher-wage foreign markets for profit denominated in the reserve currency generally accepted in international trade, which since the end of World War II has been the US dollar.
 
As a result, the import sector in foreign trade in all economies also underperforms because of insufficient domestic purchasing power for both domestic products and needed imports. This is true in varying degrees for all economies that participate in international trade. The only exception is the US economy whose gold-backed currency had been generally accepted as the reserve currency for international trade since the end of World War II. But the dollar has been a fiat currency since 1971 when it was detached from gold.
 
In the advanced financial economies, consumer debt is used to overcome stagnant consumer purchasing power caused by low wages. Low wages have been the fundamental cause of recurring debt bubbles in advanced economies. Even for the US, cross-border wage arbitrage has also kept US wages stagnant, which US policy makers compensated with a policy of high consumer debt that was unsustainable by stagnant wages. The biggest item in consumer debt is home mortgage. This excessive debt in relation to wage income has been the real cause behind the current global financial crisis.
 
Demise of the Bretton Woods International Finance Architecture
 
Towards the end of World War II, an international conference of the victorious allies was held in the US at Bretton Woods, New Hampshire in 1944 to fashion a post-war international finance architecture in which the monetary regime would be based on the dollar as a reserve currency for international trade, pegged to gold at $35 per ounce. The exchange rates of currencies issued by trade-participating governments were fixed and relatively stable. Currency exchange settlements were conducted only between central banks. There was no open currency trading market as most nations practiced capital control within its borders. Economies that incurred persistent trade deficits would not be able to devalue their currencies to achieve trade surpluses. Economic theory at the time did not view cross-border capital flow as necessary for or beneficial to domestic development.
 
Yet even after the US suspended the dollar’s peg to gold in 1971 in response to the depletion of the amount of gold held by the Federal Reserve, the US central bank, due to the country’s persistent trade and fiscal deficits, the dollar continues to be accepted by trading nations as the dominant reserve currency for international trade by default, for lack of an alternative reserve currency and because US geopolitical prowess has managed to cause trades in basic commodities, most notably oil, to be denominated in dollars after 1973.
 
Today, about 60% of world currency reserves are denominated in dollars, as compared to its top competitor, the Euro, in which only about 24% of world reserves is denominated. This is only a technical distinction as all other freely convertible fiat currencies are essentially derivatives of the dollar as long as prices of all basic commodities are denominated in dollars.
 
The Dollar now a Fiat Currency issued by the World’s Most Indebted Nation
 
The exchange value of any fiat currency is a function of the level of outstanding public debt owed by, and the quantity of money issued by its government. The dollar, the world’s dominent reserve currency for trade, is the fiat currency of the world’s most indebted nation. This is because US sovereign debt is denominated in dollars, not foreign currencies. The US has no foreign debt, only sovereign debt denominated in its own currency held by foreigners.
 
US public debt outstanding, or debt owed by the public collectively, is in excess of $13 trillion in 2010 against a GDP of $14.6 trillion. US public debt continues to grow at a rate of about $3.83 billion each day, or $1.4 trillion a year. Annual growth of US public debt is at 10%, in excess of its GDP growth at less than 2%. US public debt of 100% of GDP in 2010 is in excess of the generally accepted level of 60% debt to GDP ratio. Yet the dollar’s reserve currency status for international trade remains firmly secured, albeit the dollars exchange rate against other currencies has been declining steadily since 2002.
 
Total US Debt Unsustainably High
 
Total US public debt (debt owed collectively by all citizens) and private debt (debt owed privately by individuals and by private entities) was $50.2 trillion at the end of Q1, 2010 or 3.5 times concurrent GDP. What makes US public and private debts different from those held by other countries is that all US debts are denominated in its own currency which the US can issue at will with little penalty beside possible devaluation of the dollar’s eschange value.
 
Total net worth of the US as a nation stood at $44.2 trillion at the end of Q1, 2010, about 3.02 times of concurrent GDP. US domestic financial assets totaled $131 trillion and domestic financial liabilities totaled $106 trillion, leaving a net worth of $25 trillion, or 1.42 times GDP. Non-financial assets net worth totaled $19.2 trillion, or 1.32 times GDP.
 
Acording to Federal Reserve data, the total net worth of the United States remained between 4.5 and 6 times of annual GDP from 1960 until the 2000s, when it rose as high as 6.64 times GDP in 2006, principally due to an increase in the net worth of US households from the wealth effect of the housing bubble. However, by the end of 2008, the net worth of the United States had declined sharply from 6.64 to 5.2 times annual GDP due to the sharp decline in the market value of corporate equities and real estate in the wake of the collapse of the securitized sub-prime mortgage market and the resultant global financial crisis. US household net worth alone amounted to only 3.55 times annual GDP. This net worth/GDP ratio does not accurately reflect US net worth because ehile nominal US GDP has grown slightly, it has declined after adjusting for inflation since 2007 .
 
Between 2008 and 2009, the net worth of US households had recovered slightly from a low of 3.55 times annual GDP to 3.75 times annual GDP as a result of government intervention to transfer private debt into public debt by the Treasury bailing out too-big-to-fail financial institutions and by the Federal Reserve expanding its balance sheet though quantitative easing. The median sale price of existing homes is still lower in September 2010 than it was five years earlier. Before the current recession thatbegan in mid-2007, home prices always increased at a rate of at least 2.5% a year over five-year periods, meaning the market price of home doubled every four years during that period of debt bubble.
 
The net worth of US non-financial businesses fell from 1.37 times annual GDP in 2008 to 1.22 times as the economy continued to contract in 2010. As a double dip recession or a drawn out stagnation appears likely in 2011 because of the ineffectiveness of US stimulus measures, US total net worth can be expected to decline further from the historical low of 3.02 times GDP at the end of Q1, 2010.
 
The net worth of US households and non-profits has accounted for 3.5 times of annual GDP since 1980 and has constituted three-quarters of total US net worth. Since 1960, until 2008, US households had consistently held this net worth position, followed by non-financial businesses (137% of GDP in 2008) and by state and local governments (50% of GDP in 2008).
 
The US financial sector, where most of the wealth had been created in recent decades, has hovered around zero net worth since 1960, reflecting its high leverage, while the federal government has fluctuated from a negative net worth of (-7%) of GDP in 1946, a high of 6% of GDP in 1974, to -32% of GDP in 2008. While the federal government cannot go bankrupt, the US financial sector was technically insolvent for the first third of 2008. These weak financial fundamentals will make economic recovery difficult without adding to the already excessively high financial leverage in the US economy. 
 
Stock Prices Affect Household Wealth More Now than 3 Decades Ago
 
There was a similar prolonged period of weak stock prices in the US in the 1970s, but stocks were far less important component in most US household wealth at the time. Stocks are more important in US household wealth makeup now because more people are now seeing their retirement as dependent on their own investments in the stock market. That change inn personal financial planning had come gradually in recent decades as fewer companies offered defined-benefit pension plans and more people had 401(k) defined contribution plans, which were often invested in stock mutual funds. By early 2000 — as the stock market was peaking on its path to a drastic correction — 43% of household financial assets were in stocks, triple the proportion in the mid-1980s. This is why a collapse in the US equity market was a big hit to US household along with the collapse of the housing market.
 
The wealth of US families plunged nearly 18% in 2008, erasing years of sharp gains on housing and stocks and marking the biggest loss since the Federal Reserve began keeping track after World War II. US household net worth tumbled by $11 trillion -- a decline in a single year that equals the combined annual output of Germany, Japan and the U.K. The data signal the end of an epoch defined by widespread ownership of first and second homes, rising retirement funds and ever-fatter portfolios.
 
Past downturns have been mere blips compared with the losses Americans faced in 2008, which set them back to below 2004 levels. The decline in net worth, which was the first in six years, follows an extraordinary boom. Not accounting for inflation, household wealth more than doubled from 1990 to 2000, and then, after a pause, rose nearly 50% before the bust of 2008.
 
While the market value of their assets was falling, US total private debt remained roughly flat. Total household debt increased by half a percentage point in 2008 as families faced tighter lending standards and many started trying harder to live within their means. After years of splurging with an eye on their rising assets, that phenomenon, known as the wealth effect, now cuts the other way, spurring frugality.
 
Collectively, US homeowners had 43% equity in their homes -- the lowest level since records have been kept. Amid foreclosures and tighter lending, the total amount of mortgage credit was down last year for the first time since the Fed started keeping track in 1945.
 
The recession that began in December 2007 has reversed a particularly long boom.
The Federal Reserve estimates that US citizens and residents had $43.8 trillion in financial assets at the end of June, 2010, 15% below the figure for June 2007, shortly before the recession began. Standard & Poor’s index of 500 stocks in June 2010 remained below where it was five years earlier in 2005, 2 years before the market peaked in Q2, 2007.
 
Auction-Rate Securities Market Still Frozen
 
The Wall Street Journal reports on October 30, 2010 that more than two years after the $330 billion auction-rate securities market froze—deepening the most severe economic crisis since the Great Depression—hundreds or possibly thousands of individual investors are still stuck holding the securities.
 
About $130 billion of retail and institutional investor money remains stranded in the troubled auction rate securities, according to SecondMarket, a broker-dealer and secondary market for illiquid assets, and they continue to be a drag on companies’ bottom lines.
 
Auction-rate securities, which were issued by cities, schools, hospitals and others, are long-term debt instruments that are resold with updated interest rates in periodic auctions held by banks. Many investors bought them on the advice of their brokers, who often touted them as a higher-yielding, but still safe, alternatives to cash. Then, in early 2008, Wall Street dealers abruptly stopped buying the securities at auction as the credit market failed.
 
Since then, dozens of big banks and brokerages have repurchased billions of dollars of auction-rate securities from investors in settlements with regulators. But some investors, such as those who bought auction-rate securities at one firm and then moved their accounts to another, have been left out of the settlement. And some brokerages that sold auction-rate securities created by other firms have not yet settled.
 
Economies with Trade Surpluses Are Victims of Dollar Hegemony
 
As for the exporting economies that regularly sustain trade surpluses denominated in dollars, such as China and Japan, the trade surplus dollars cannot be spent in their domestic economy without causing inflation because the wealth behind this surplus has already been shipped outside the country as exports. Thus the trade surplus dollars must then be used to buy US sovereign debt which in turn allows the US to buy more imports with dollars it receives from selling sovereign debt denominated in dollars and with more new dollars that it can print at will without incurring immediate monetary penalty. The US can run up external debt denominated in dollar without fear of inflation for long periods because inflation will be kept tame by low-price imports from low-wage exporting economies, such as China’s.
 
International trade then has been reduced in recent decades to a game in which the US makes dollars by fiat and the exporting countries, such as China, make goods with low wages and environmental abuse that fiat dollars can buy. This dysfunctional monetary arrangement in international trade is known as dollar hegemony. (Please see my 2002 article on Dollar Hegemony for more details.)
 
Rise of the Foreign Exchange Market
 
The rules of the Bretton Woods regime, set forth in the articles of agreement of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), provided for a system of fixed exchange rates for all currencies that participated in international trade. The rules further sought to encourage an open system by committing members to free trade via the convertibility of their respective currencies into other currencies at pegged rates.
 
Trading nations were required to establish a parity of their national currencies in terms of gold (a “peg”) and to maintain exchange rates within plus or minus 1% of parity (a “band”) by intervening in their foreign exchange markets (that is, buying or selling foreign money) conducted among central banks.
 
In theory, the reserve currency in the Bretton Woods regime would be the bancor, a World Currency Unit suggested by John Maynard Keynes that was never implemented due to US objection. Instead, the United States succeeded in making the dollar the “reserve currency” for international trade. This meant that other countries would peg their currencies to the US dollar, and—once convertibility was restored—would buy and sell US dollars to keep market exchange rates within plus or minus 1% of parity. Thus the gold-back US dollar took over the role that gold itself had played under the gold standard in the post-war international financial architecture.
 
President Richard Nixon de-linked the dollar from gold in 1971 and closed the gold window. But dollars was still traded among central banks at $35 per troy ounce of gold but the dollar could no longer redeem gold at the Federal Reserve.  In February 1973, after a last-gasp devaluation of the now fiat dollar from $35 to $44 per troy ounce of gold, the Bretton Woods fixed exchange rate regime based on a gold-backed dollar maintained by central banks of all trading nations was replaced by open currenies markets of floating exchange rates that primarily traded in London. Thus began a floating rate currency trading regime for those currencies whose central banks had abandoned cross-border capital control and fixed exchange rates.
 
This currency market in 2010 trades $4 trillion a day, a 23% gain from $3.3 trillion in 2007. Trade directly involving the dollar accounted to 84.9% of the transactions in 2010, down only slightly from 85.6% prior to the financial crisis in 2007. The rest of the trades (15.1%) still involves the dollar indirectly. The currency market is by far the biggest financial market in the world. It now overwhelms by a factor of 15:1 the US equity market which traded $134 billion a day in April 2010, down from $248 billion average daily volume in 2007. Aside from trading in US dollars of $4 trillion a day, trading in US sovereign debt (Treasuries) amounted to $445 billion a day in April, 2010, down from $570 billion daily average in 2007, .
 
High Leverage Routine in Currency Trading
 
Astronomically high leverage is standard practice in currency trading even for individual market participants. An individual trader can routinely borrow up to $100 for every dollar of equity from his broker/dealer, subject to real-time margin calls. The Commodities Exchange Commission tried to cut the leverage from 100:1 to 10:1 but after a vocal wave of protest from market participants, settled to a leverage limit of 50:1.
 
The Dollar’s Value in Gold
 
It is not informative to track the price of gold in dollars. The meaningful way is to track the value of the dollar in gold because gold is the element with constant value. While the US has been facing general deflationary price pressure from the global financial crisis since mid 2007, the price of gold has been rising to reflect the true depreciation of the dollar in a generally deflationary environment.
 
Gold is More than a Commodity
 
Prices of most key commodities denominated in dollars have been falling since mid 2007 except gold. The global financial panic and the economic slowdown have put at least a temporary end to the commodity bull market of the previous seven years, sending prices tumbling for many of the raw ingredients of the world economy. The bear market for commodities may now stretch out to a decade or more.

Since the spring and early summer of 2008, after prices for many commodities peaked amid pre-crisis speculation driven by fears of permanent shortage, wheat and corn — two cereals at the base of the human food chain — dropped more than 40%. Oil dropped 44%. Metals like aluminum, copper and nickel declined by a third or more. But gold in Q3 2010 traded about 1:57 against the price of silver, vastly out of sync compared to the historical gold-silver ratio of 1:16. Traders generally have high expectations for silver widely exceeding gold’s gain.  They expect to see silver not only to rally with gold, but to amplify gold’s gains.  A non-confirmation of gold’s strength by silver is widely perceived as a warning sign that gold’s rally is somehow flawed or false, likely to fail suddenly, since silver has not come along for the ride.
 
Gold has gone up since 1999 in value and is now more than 5 times its low of 11 years ago. This is not caused by a sudden shortage of gold versus silver. It is an indication of market distrust of the dollar. Gold is a store of value rather than just another commodity. One ounce of gold in 2010 stores $1,350 rather than $35 in 1970.
 
Commodities Prices Fell but Still High
 
The swift downturn of commodity prices in 2008 was by default the brightest economic news of a terrible year for harassed consumers, keeping more money into their pockets after paying for necessities at a time they needed the money badly. Gasoline prices in the United States fell precipitously after peaking in July 2008 at $4.17 a gallon, to a national average price of $1.71 a gallon in December.
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Prices for most other commodities remained elevated by historical standards. But the market trend was downward as traders weighed the prospect that a prolonged global economic crisis would lead to sharp drops in demand. The big question was whether prices would drop all the way to long-term norms or whether Asia’s continuing economic boom amid a worldwide recession could be sustained to set a floor for commodities.
 
The rapid decline of commodity prices eased fears of inflation, a reason central banks were able to lower interest rates around the world since 2008 in an effort to salvage economic growth in a deflationary environment. It also represented a fundamental shift of market sentiment from that driven by excessively optimistic views that had been behind debt-driven commodity bull markets since 1980.
 
Uncertain Demand Going Forward
 
Up until 2008, US consumers had been seen as forceful participants in a bidding war with emerging middle class consumers in the BRIC (Brazil, Russian India, China) economies for the same pool of commodities worldwide. But that was before an extreme slowdown in demand for commodities as diverse as gasoline and aluminum and the retreat of investment money from commodity futures into the safer havens of sovereign debt.
 
The commodity market bust began way before the broader market declines in 2008, though the ensuing panic in 2008 did exacerbate the downward price pressure on commodities. Oil dropped by 10% in the second week of October 2007 alone, but then recovered some of that loss a week later from technical reaction to settle at $81.19 a barrel, still far below its high of $145.29 in July 2007, the month credit markets froze.
 
While welcoming the multi-year price declines, most market participants expected commodity prices to still remain above long-term historical norms. Price increases of recent decades had served their economic function of generating additional supplies of many commodities, as farmers planted every idle acre they could, mining companies reopened dormant mines and oil companies went to the far corners of the earth to drill deep undersea wells far offshore. In many cases, high prices also caused demand to decline even as supply started rising after investment were lured towards alternative energy solutions.
 
Food Market Failure
 
Food, in particular, has been singled out as a continuing long-term problem because there is no economic alternative to food for human survival. Despite the prolonged recession, food prices are still too high to allow large number of people in developing economies to afford adequate diets. Nor have the recent declines in wholesale food prices been passed along to consumers in advanced economies. The United Nations has projected that global food prices will remain elevated for years to come. Yet low-price food needed to feed the world’s poor will also discourage food producers in the global market economy to produce more food. And hunger, which drives demand for food, does not decline in economic recessions. Food economics is a clear case of a commodity sector that operates in a failed market in which profit from food production is paid for with mass hunger.
 
Food as Substitute Fuel
 
The US, with the world’s largest fuel consumption per capita, has been cutting back on gasoline since the onset of the big recession in mid 2007, with decline approaching double digits. US motorists pumped 9.5% less gasoline during the first week of October 2007, compared with the same week a year earlier. An International Energy Agency (IEA) report cut its forecast for global oil consumption yet again, projecting that 2008 would end with the slowest demand growth in 15 years.
 
Big increases in world wheat production because of increased acreage in the United States, Canada, Russia and much of Europe have brought wheat prices to $4.3 a bushel in June, 2010 from nearly $13 in March. But it rose back to $7.4 in September as farmers cut back on wheat production to produce corn. There were also concerns about wheat crops in the Ukraine and Russia, which either have imposed quotas or banned wheat exports after a drought devastated crops there earlier in 2010.
 
The United Nations Food and Agriculture Organization (UNFAO) called for a review of biofuel subsidies and policies, noting that they had contributed significantly to rising food prices worldwide and hunger in poor countries.
 
With policies and subsidies to encourage biofuel production in place in much of the developed world, farmers often find it more profitable to plants crops for fuel than for food, a shift that has helped lead to global food shortages and rising food prices.
 
The UNFAO report said national agricultural policies should be “urgently reviewed in order to preserve the goal of world food security, protect poor farmers, promote broad-based rural development and ensure environmental sustainability.” In releasing the report, the United Nations joined a number of environmental groups and prominent international specialists who have called for an end to subsidies for biofuels, which are cleaner, plant-based renewable fuels that can sometimes be substitutes for oil and gas.
 
An Organization for Economic Cooperation and Development (OECD) report concluded that government support of biofuel production in member countries was hugely expensive and that while it “had a limited impact on reducing greenhouse gases and improving energy security,” it did have “a significant impact on world crop prices” by helping to push them higher. “National governments should cease to create new mandates for biofuels and investigate ways to phase them out,” the OECD report concluded.
 
A contrary view is voiced by EuropaBio, a biotechnology industry group, that the world possessed the land and agricultural ability to produce enough food and fuel through subsidy programs with high sustainability criteria, including consideration of the fact that biofuels could help reduce poverty by providing new revenue options for farmers all over the world, including poor farmers. This may be an arguable point theoretically but the argument is muted by facts: food prices have been rising even in a severe and prolonged recession.
 
In the past eight years, as oil prices and global concerns about carbon emissions increase, rich countries, including the United States, and European Union states have put into place subsidies and incentives to energize the fledgling biofuel industry. As a result, the production of biofuels made from crops that could have been used for food increased more than threefold from 2000 to 2007, according to the UNFAO. Support to encourage biofuel production in OECD countries amounted to more than $10 billion in 2006.
 
But recent studies concluded that the rush to biofuels had some disastrous, even if unintended, consequences for food security and the environment. Less affordable food is available in poor countries because global grain prices have skyrocketed and precious forests have been cut down as farmers created growing fields to join the biofuel boom.
 
Worse still, so much energy is required to convert plants into fuel that the process does not result in a net reduction of carbon emissions. The OECD report said only two food-based fuels (used cooking oil and sugar cane) were clearly environmentally better than fossil fuels when considering the entire “life cycle” of their production. Sugar cane is far easier to convert to biofuel than most other crops.
 
Already in 2010, the European Union has stepped back from its target of having 10% of Europe’s fuel for transportation come from biofuel or other renewable fuels by 2020. The European Parliament suggested that only 5% come from renewable sources by 2015, and that 20% come from new alternatives “that do not compete with food production.”
 
The food as fuel strategy seemed to have reached a high point in 2008 when Congress mandated a fivefold increase in the use of biofuels. Since then , a reaction is building against policies in the United States and Europe to promote ethanol and similar fuels, with G20 political leaders from poor countries contending that these substitute fuels are driving up food prices and starving poor people. Biofuels are fast becoming a new flash point in global diplomacy, putting pressure on G7 politicians to reconsider their policies, even as they argue that biofuels are only one factor in the seemingly unavoidable rise in food prices.
 
In some countries, higher food prices are leading to riots, political instability and growing worries about feeding the poorest people in the world. Food riots contributed to the dismissal of Haiti’s prime minister in April 2008, and leaders in some other countries are nervously trying to calm anxious consumers.  At a 2008 conference in Washington, representatives of poor countries that had been hit hard by rising food prices called for urgent action to deal with the price spikes, and several of them demanded a review of biofuel policies adopted recently in the West.
 
Many specialists in food policy consider government mandates for biofuels to be ill advised, agreeing that the diversion of crops like corn into fuel production has contributed to the higher food prices. But other factors have also played big roles, including droughts that have limited output and rapid global economic growth that has created higher demand for food.
 
That growth, much faster over the last four years than the historical norm, is lifting millions of people out of destitution and giving them access to better diets and prolonging longevity. But farmers are having trouble keeping up with the surge in demand.
 
While there is agreement that the growth of biofuels has contributed to higher food prices, the amount is disputed. Work by the International Food Policy Research Institute in Washington suggests that biofuel production accounts for a quarter to a third of the recent increase in global commodity prices. The UNFAO predicted late in 2008 that biofuel production, assuming that current mandates continue, would increase food costs by 10 to 15 percent. This may not be a significant increase for developed economies, but to the poor in developing economies that already are suffering from inadequate diets, such increase can push large number of people into starvation.
 
Ethanol supporters maintain that any increase caused by biofuels is relatively small and that energy costs and soaring demand for meat in developing countries have had a greater impact. In Washington, despite criticism from abroad, support for ethanol remains solid. The policy is solidly anchored in effect on US trade deficit through the trade off between importing less oil and exporting less food.
 
According to the World Bank, global food prices have increased by 83% in the three years before 2008. Rice, a staple food for nearly half the world’s population, has been a particular focus of concern in recent months, with spiraling prices prompting several rice-producing countries to impose drastic limits on exports as they try to protect domestic consumers. While grocery prices in the United States increased about 5% over all in 2009, some essential items like eggs and milk have jumped far more. New data on domestic food prices are expected to have notable increases.
 
Commodity Prices in Steep Fall After the 2001-08 Boom
 
Commodity prices are still at the beginning of a steep fall as recurring Fed quantitative easing in response to the intractable credit squeeze would move the world economy from a melt down crisis into a long deep recession. More deflation is expected in the housing sector, in capital assets, and in commodities even as newly injected liquidity is absorbed by institutional de-leveraging rather than stimulating the seriously impaired economy.
 
While price dynamics varied for different commodities, prices generally hit a low point for the decade after the terrorist attacks of September 11, 2001, then rose as the global economy strengthened in the following years as the Federal Reserve led all central banks in the world with monetary easing policies. From late 2001 until mid-2008, the price of oil rose 800%, copper rose 700% and wheat rose 400%. This rise amid steady supply suggests only a price effect of a depreciating dollar.  Yet wages were not kept a pace with asset inflation.
 
But the price decline in 2008 took virtually every key commodity more than halfway back to its late 2001 price adjusted for inflation. By 2010 the gains of the bull market of the 2000s had been erased entirely, even as the dollar’s value fell against gold. Wages declined sharply when measured in gold.
 
On July 11, 2008, oil prices rose to a new record of $147.27, settling around $125 a barrel on July 24, 2008.  Oil traded below $70 a barrel on October 16, 2008. On December 21, 2008, oil was trading at $33.87 a barrel, less than one fourth of the peak price reached five months earlier. Prices of oil did not rebound in 2009. Instead, after initially climbing above $48, prices descended by mid-February to below $34, hurt by forecasts for further declines in world demand. Through March and April 2009, oil traded at about $40 per barrel. By August 2009, prices returned to $70 a barrel. The world economy had not grown during this period, only the dollar had fallen in value.
 
The costs of finding oil below deep waters or mining oil sands in Canada remain high, in the $60 to $70 a barrel range — and since those are now increasingly vital sources of supply, they could help put a floor under the oil price after the oil glut is absorbed in the speculative market. Additionally, the Organization of the Petroleum Exporting Countries (OPEC) can always cut production over time to shore up prices, even to the point of reducing gross revenue from lower sale volume. The continuing credit crisis and economic slowdown will inevitably stall new industrial projects, reducing demand for oil and metals worldwide, even for China. Falling prices will also discourage new mining and drilling to increase long-term supply which would push commodity prices up in an eventual recovery. This supply dynamics will keep any eventual recovery anemic.
 
The biggest single factor that will decide whether a prolonged bull market in commodities is over, or just in a lull, is the performance of the Chinese economy. Industrial development of China in recent years was responsible for much of the world’s increased consumption of copper, aluminum and zinc, and almost a third of the increase in oil consumption.
 
Chinese growth has slowed since the beginning of the global financial crisis in mid-2007 but it is still running near 10%. China has launched a massive stimulus package and is expected to undertake many huge projects in coming years as it repairs damage from natural disasters such as earthquakes and storms and to take actions to solve long-range development challenges in social security, health services, education, environmental restoration and protection, transportation, food and water. Unless China succeeds in shifting its excessive dependence of export, which is currently at 70% of GDP, to develop its domestic market by raising wages aggressively, China’s massive stimulus package will end up as an unsustainable asset bubble.
 
Of all the major commodities, only oil at its peak in July 2008 traded at a higher price than in bull markets of the last decade, adjusted for inflation. The previous commodity market bull runs of 1970s and 1980s, stimulated by decades of high economic growth from asset bubbles unleashed by irresponsible central bank monetary easing and accompanying inflation, were followed by nearly two decades of weak prices that accompanied the transition in the US from an industrial to a finance economy by shifting industrial production off shore.

Economic growth in China and India at the turn of the 21st century, followed by the oil-driven economies of Brazil and Russia and greater consumer spending in the Middle East in the last five years pushed commodity prices up in a final long debt-fueled bull run that finally ended in 2007. But these new economic powerhouses are beginning to seek ways to moderate their growth from quantity to quality by making more efficient use of commodities. This will mean that even if the grow rate remains high, the demand for commodities would moderate.

Nevember 11, 2010
 
Next: Gold Keeps Rising as Other Commodities Fall