They ignore the combination of risks that is accumulating inside the system and which may very well produce a renewed downwards movement of economic activity – namely, unemployment shooting up rapidly; pressure to moderate or to cut wages increasing; rising defaults on loans forcing banks to engage in a second round of credit tightening later this year; premature stories about ‘exit’ strategies to cut deficits.

However, less fragile but of serious concern are the ‘green shoots’ already reappearing in the sphere of financial market speculation. With OECD governments massively saving the banking system from its own ‘toxic asset’ mess (in Europe alone, governments have now injected and guaranteed three trillions (!) of banking capital, liabilities or assets), and with high amounts of liquidity being available, financial markets have recently started to move some of the liquidity being available from ‘safe haven’ assets (long term government bonds) into commodity markets. It is indeed striking that the price of oil and some commodities (copper, platin, soja) has recently started to rise rapidly and this in the middle of the deepest recession since World War II.

Graph I: Spot price of oil, copper and aluminium

The extent to which financial flows and speculation can drive up prices over and beyond the so-called fundamentals is well known from what happened on the oil market in the period between mid-2008 and mid-2009: Oil prices simply exploded to reach a level of US $150–160 per barrel by mid-2009. At that time, many commentators, including central banks, were linking this explosion of oil prices with a structural and global disequilibrium between the limited supply and rising world demand for oil.

However, a closer look at the statistics from this period now reveals that oil prices were exploding at a time when more oil (above 85 million barrels a day) was being produced than there was demand for, with the demand for oil actually falling (see Graph II below). Moreover, productive capacity of oil was also rising and overshooting the benchmark of 90 million barrels a day. The latter implies a potential reserve of oil production of 10 million barrels, a reserve which has never been so high over the past six years. Nevertheless, oil prices ignored the fundamentals of the market and financial speculation, made possible by allowing pure financial actors on US commodity futures’ markets, drove the prices of oil upwards.

Graph II World demand, supply and productive capacity of oil

We know what followed afterwards. High oil prices squeezed the purchasing power of wages to the bone and provided the European Central Bank (ECB) with the alibi to hike interest rates despite an unfolding financial crisis. In the end, the recessionary forces were made even stronger than they otherwise would have been, resulting in a more pronounced fall of the euro area economy compared to the US. Put simply, workers paid the price for financial speculation.

Will history repeat itself again? If oil prices continue to rise, real wages will be squeezed once again. And the monetary policy ‘hawks’ inside the ECB are certainly very keen to abuse the situation and argue for higher interest rates and reverse the flow of liquidity that the ECB has provided to the financial markets. This may help to reduce the risk of a renewed speculative oil bubble somewhat; however, the price to pay is a certain relapse of the economy into a prolonged depression.

The only way out is to tackle ‘casino capitalism’. Instead of massively pouring liquidity into the banking system and simply hoping that the banks will use this liquidity to provide credits to productive investors and not to financial speculators, central banks need to inject liquidity in a targeted and more selective way. This can be done, for example, by requiring banks which lend money to hedge funds which specialize in commodities and/or oil, to post a 80 or 90% non interest bearing deposit with the central bank. In that way, it becomes quite expensive for banks to lend money to speculative activities. Or, another way to inject targeted liquidity is to engage in unconventional monetary policy with the central bank bypassing the banks and directly buy and finance securities. For example, the ECB could buy European bonds, backed up by a guarantee of European member states’ governments and to be used exclusively to finance much needed European investment projects.

Of course, all of this presumes central bankers and governments are willing to discard the old and discredited paradigm of ‘efficient’ markets that always know best and to replace this paradigm with a policy in which it is the public hand that steers the liquidity in the financial market place and not the other way around.

Discussion note for download

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