Monday, June 01, 2009

Return of the Friedmanites..

Suppose commodity prices keep going up. The closed mines will open up as soon as selling price crosses their cost of production. However, because demand would not have come back to the same degree, their production will go into inventories - unless the cost of production also moves up so that the mines remain unprofitable. That would require some giant scheme so that the general price level in the world economy goes up. In particular, wages need to go up, which doesnt seem likely looking at the state of world affairs.

So, production goes into inventories. There are no end buyers. Do prices go down, or bulls keep arguing that China will take care of the inventories in a year? Does dollar weakness keep commodity prices high which leads to stockpiling of inventories. 

The key to inflation is not output gap. It is commodity prices, at least in emerging markets like India. The last year was the year of Keynesians. I think Friedmanites are going to get an opportunity to strike back very soon. How exactly we get inflation - I am not very sure. Investors are taking Libor + 50bps funding provided by the brokers to take a flyer on everything risky.   

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