The Wall Street Journal reports Companies Stock Up as Commodities Prices Rise.  This is a good thing, no?  It means suppliers see they can make more money and then get busy expanding output, which ultimately yields the demand expansion necessary for aggregate economic performance to improve. 

But only temporarily, if commodities prices have increased because of inflation–a price rise caused a change in the metric (i.e., dollars, Euros) through which prices are calculated, not one in which the underlying supply and demand metrics have changed.  In a market in perfect competition, a price increase is a signal for suppliers to expand output, or it is when prices for their output increases before their costs also increase.  Suppliers in perfectly-competitive markets, such as is most closely represented in the markets for internationally-traded commodities, are price takers.  Market prices (theoretically, at least) resolve to where the marginal cost of producing one more barrel or bushel exactly equal the marginal revenue generated by that last barrel or bushel.   When prices increase, so too will output, until marginal costs and revenues come back into equilibrium.  If the basis for the increased price is inflation, i.e., a cheapening currency, there will be a time lag between the increased prices realized in the market and increased costs of production such that things move back towards equilibrium, where marginal cost just equals marginal revenue.  This is particularly true in commodities markets, where inflation shows up quickly in market prices but takes longer to impact costs–things like heavy equipment and transportation assets–employed in commodities production.  

The supplier’s push to expand output due to increased prices itself feeds into the inflationary tempest, causing a real, if temporary, increase in demand for whatever it is that is needed for production, making it quickly appear that aggregate demand has increased.  Which it has, but only because of the temporary illusion produced by devalued money.  It won’t last unless the underlying quantity demanded actually increases enough such that it soaks up the excess supply being provided the market.  

Furthermore, consumers of items increasing in price will quickly realize the need to pull future purchases forward, hoarding as much as is sensible in anticipation of continued price increases.  Quantity demanded for gasoline spiked much higher than could be accounted for by actual miles driven during the oil embargoes of the seventies.  In the face of rising prices and the fear of shortages, people drove around with gas tanks that they never let get past half-empty.  As the Journal article indicates, much the same is happening today agricultural commodities, et al.

But what is the basis for expansion in the underlying quantity demanded such that demand will eventually catch up to excess supply?  Aggregate demand is nothing more than the summed demand of all the individual economic actors–the people and families of the economic system acquiring the things they need and want to live.  How does this demand increase?  Either from an expansion in needs and wants, or an expansion in the number of people and families comprising the economic system. 

Old, rich economic systems such as in the West (and within the US white population, which is still 75% of the US total) and Japan, with populations of rapidly aging individuals and families that already have all that they need and most of what they want,an expansion in aggregate demand from either indigenous population growth or increased consumption is quite unlikely.  Growth, if it comes, will be mainly from immigrants.  Japan’s near-prohibition against immigrants even as its population rapidly ages and has already started decreasing in size is all you need to know about why Japan’s economy has hardly grown at all in over two  decades.

Younger and poorer economic systems, such as in China–although it too is rapidly aging–may see increased aggregate demand simply by dint of rising living standards.  Though China is the second largest economic system in aggregate, per capita income is still only about $5,300.  There’s still quite a bit of demand growth that will have to happen if her people are to one day enjoy a standard of living comparable to the West and Japan.

Then there’s the profoundly young and poor economic systems.  Such as in Egypt, or Yemen.  Aggregate demand in these systems will continue to grow simply because their populations, young and fertile as they are, will continue to grow.    But they can also grow as their populations become richer and acquire more of the conveniences that modernity offers.  India is the star of this group.  It’s population is still very young (median age 25.1); fertile (2.76 children born per female), poor (per capital GDP of $2,700).  It’s p0ssible in such young and poor countries that aggregate economic growth could catch up to any temporary supply excesses caused by the monetary mischief of central bankers, domestic or abroad.   But the poverty of these economic systems make them less important than others in resolving supply excesses and setting market prices for internationally-traded commodities.

For the West and Japan, excess supply might eventually force a crash in prices, once it is realized that demand won’t grow to match supply.  A real estate market oversupplied due to inflationary forces across the developed world precipitated the Great Recession in the US and Western Europe, and signaled what seemed to be the permanent cessation of sustained expansion in Japan’s economy in the early 90’s.   It may do so again, with commodities inflation being instead the source of instability.  And so far as the bulk of demand for internationally-traded commodities originates in the West and Japan, aggregate world demand won’t likely grow to sop up the inflation-induced oversupply of markets. 

Unless the developing world, particularly countries like China that are poised on the cusp of full modernization, increases demand enough to compensate for the oversupplied condition of the markets in the developed world, prices will decline such as they did during the Great Recession, and the world may be pushed again into a debt and deflation-spiral where sellers try to sell as quickly as possible while buyers try to wait as long as they can before purchasing.   In such a scenario, it would be hard to see where China continues without misstep its long march toward modernity as all its main trading partners consequently and substantially decrease the amount demanded of her factories.   If the West and Japan suffers a debt and deflationary spiral, China suffer as well, and her demand, muted as it will be by the weakness of her customers, will not expand to sop up the excess supply due to inflationary illusions.

What to take from all this?  That monetary policy matters, but perhaps not as most people think.  The monetary strategy of devaluing currency that attempts to create an expanding demand where none existed before and won’t likely ever exist again serves to exacerbate, rather than cure, the problem.  Unless aggregate demand, which is not monetarily determined, sustainably increases, inflationary monetary policy will ultimately result in collapsing demand and prices. 

Monetary policy should have as its guiding value price stability.  A bushel of wheat yesterday, today and tomorrow should not fluctuate so wildly in price that market participants can’t figure out the real supply and demand metrics underpinning it.  Wheat demand, like other agricultural commodities, is fairly stable and supply is far more predictable than historical price fluctuations would indicate.   Thus it is the monetary hijinks of central bankers, particularly of the US Federal Reserve (controlling as it does the currency in which prices are negotiated) that are the driving force behind commodity-price fluctuations.   Great Recession Part II will be, just as was Great Recession Part I, precipitated by the feckless incompetence of political economists pretending that changing the money changes anything real.