We live in interesting economic times. Over the past two weeks, the step-wise down trend of stock prices in China accompanied by wild gyrations in U.S. share prices is getting much media attention. These financial markets are part of the “monetary economy.”
Meanwhile, the “real economy” of actual goods and services garner much less attention. Yet here we find an ongoing decline in primary commodity prices that may have greater impact on the lives of many people in our country than swings in the prices of stocks or bonds in New York or Shanghai.
Of course, there are interactions between the monetary economy of financial markets and the real economy of goods and services and we saw that this past week. A serious drop in the values of stocks and bonds can sap household and business confidence, cutting consumption and investment and thus willingness to buy real goods. This decline in demand cuts willingness of manufacturers to buy raw materials. This certainly affects mining, farming, forestry and energy.
The ongoing adjustments in commodity prices, however, are part of a much longer process than fluctuations in financial markets or consumer demand. The blowing up and deflating of the Chinese share price bubble is measured in months rather than years. Commodities such as iron, oil and crops, in contrast, continue to come down from highs that, in some cases, have been high compared to historic trends for a decade.
Why did they go up and why did they go down? Why did it take so long and why are the fluctuations so large?
Products that require long lead times to increase production such as oil and other minerals inherently have bigger fluctuations in output and price than those for which output can be ramped up more quickly. These products tend to be very capital intensive, requiring large amounts of money up front to be spent on facilities or infrastructure. Once these expenditures are made, however, the “marginal costs” of running a mine or mill or oil field often are low relative to the price of the product turned out. That means owners tend to keep production running even if revenues are not covering all the costs. And that ongoing increased supply can accentuate price swings when demand goes down.
Consider the magnitude of the gyrations. Corn, vital to the U.S. farm economy, nearly tripled in price from the fall of 2004 to a high in the summer of 2012 but since has fallen by nearly half. Soybeans followed a virtually identical pattern from 2006 to now. Beef in international trade increased by a factor of 2.5 from early 2008 to late 2013, but has since fallen by a third.
Iron ore followed an even wilder pattern. From early 2003 to early 2012, the spot price of internationally-traded ore increased from under $13 a metric ton to over $187, a factor of nearly 15. By last month, it had fallen to $51 and probably will drop further. Copper rose from 72 cents a pound in April 2003, to $4.48 in February 2011. It is now under $2.50 and dropping. Moreover, this is all unadjusted for inflation, which accumulates to 18 percent over the last decade.
These large fluctuations in commodity prices since early in this century are particularly anomalous when compared with previous long-run trends. Adjusted for inflation, with some variations, the prices of nearly all primary commodities had drifted slightly downward for decades.
The upward spikes that began in 2003-2005 are unusual both for their amplitude and duration. Why?
Well, as with the stock market, the single most important factor was China. Its unbroken burst of growth dates back to 1978, when Premier Deng Xiao Ping officially renounced the Maoist model. But it was not until the turn of the century that absolute growth of the Chinese economy made demand there large enough to become a dominant factor in commodity markets. And it became that with a vengeance. This was certainly clear on the upside until hitting peaks in 2011-2014. The question is how much a slowing, or even shrinking, Chinese economy will depress world commodity prices on the downside.
There are inherent characteristics of commodity production that tend to amplify swings. This brings us back to large up-front fixed investments and “marginal” versus “fixed” or even “sunk” costs.
Prices in a market economy send signals that modify the behavior of both producers and consumers. A rising price tells producers to turn out more of the product in question. But this can seldom be done immediately.
Opening a new copper or iron mine can take years and cost hundreds of millions of dollars, not to mention political capital.
When producers see the promise of long-term higher prices, many respond simultaneously to the same signal. Yes, experienced managers know that competitors are doing the same thing. They know that prices will drop again eventually. But it is hard to coordinate with others. And, like financial firms in the collateralized mortgage mania that blew apart in 2008, the impulse that “as long as the music is playing, you’ve got to get up and dance,” is a powerful one.
The problem is that when all the new facilities come on line, the market can quickly become flooded with output. The Chinese boom was so accentuated and lasted so long that many new mines and mills were opened in response. But now that it is apparent that at least a portion of China’s growth was an unsustainable bubble itself, the price adjustment in commodities is turning out to be harsh.
Copper is still high relative to historic trends. But don’t expect that to last and don’t assume that proposed mines will remain financially viable. And don’t be surprised if any new or existing iron ore ventures go through even more financial restructurings. The entire global iron ore and steel sectors are going to take a deep-knee bend.
Farming is different from mining. In the United States, there no longer is a great deal of unused land. But some is drained and some is irrigated. Farmers and related businesses invest in storage and machinery. More fertilizer is used. And the price of farmland goes up, as British economist David Ricardo explained 194 years ago.
One now sees stories about how Midwestern farmers will “lose money” in 2015. If land prices and rental rates still were at 2003 levels, few would face any significant problem. Neither would their lenders. But land prices have risen a great deal and the shake-out will be painful, even if not necessarily as traumatic as the mid-1980s.
This story is far from over. Just how dramatic it will be and just how long it will play are variables that no one knows. But it will be a key part of long-term economic history.
St. Paul economist and writer Edward Lotterman can be reached at firstname.lastname@example.org.