WEEKEND READ: Food, not finance

The revisions to the US gross domestic product figures for the first quarter were released on Thursday. Instead of being revised downward as some expected, they were revised slightly upward. The bottom line was that while the economy had slowed dramatically, it did not enter a recession in the first quarter. We won't know about the second quarter until it is over, of course, but employment figures released by Automatic Data Processing today were surprising. They showed an increase in employees, where many expected a decline. The US Federal Reserve cut interest rates as expected, but the betting – and the hint from the Fed – is that the cuts have pretty much come to an end.

With the S&P 500 about 10 percent below its all time high, and interest rates quite low and stable, we can take some stock of the sub-prime crisis. The financial institutions have taken a beating, and the Securities and Exchange Commission and Justice Department have launched their obligatory investigation of who among many will get blamed. The financial markets have gone through a painful period, with lack of transparency (translation: no one was sure who was lying to whom) causing institutions to hold back on lending until they got a handle on creditworthiness. That healthy caution was interpreted as a liquidity crisis. Having come through that period, with the help of the Fed, the system is coming back to stability. In the meantime, the rest of the economy, save the financial and housing sectors, did okay.

All the returns are not in, but we reiterate the view we have held from the beginning – and for which we were excoriated by some of our readers – which is that the sub-prime crisis would cause the economy to slow and, in extremis, cause a short recession, but that it was merely a cyclic economic event well within the framework of previous cycles. At the moment we are not even sure that the slowdown will cause a recession, and slowdowns can hurt like hell. But we rejected months ago – and see no evidence for – the idea put forward that we are in the greatest financial crisis we have seen since 1929. Americans have a tendency to get overly excited – a national manic-depression – but when the layoffs come in the financial sector, we become positively operatic.

That is the good news. The bad news is that there is a very real crisis looming much closer than the horizon. At about $120 a barrel, oil prices are about 20 percent above all-time highs in real terms. This is just beginning to hurt economies, particularly of countries like China. Everyone is hurt, but the countries that have de-industrialised the most are hurt less than those that have industrialised. The pressure on Chinese export prices is rising, and the weakness of the Chinese financial system remains. But at these prices, everyone is hurting and that pain is going to start cycling through the global economy.

That isn't the most worrisome part. All commodity prices are up, but the surge in food prices and, more ominously, significant spot shortages in key grains are the most disturbing. Oil has risen in an orderly fashion. There is plenty at high prices. Food has not risen in an orderly fashion, with export controls, internal distribution breakdowns and other factors are creating shortages in key areas – again, in many cases, in the industrialising world, where domestic food production was cut in favour of industry. The turmoil in food markets, and the fact that it cuts across the board in grains, is the single most troubling event. Food shortages can cause not only financial dislocations, but internal upheaval and, in extremis, war.

We do not understand the reason for the rapid surge in commodity prices. Supply and demand didn't shift that fast, but then we do not pretend to understand how markets behave. We merely note what they do. To the extent that the cause was the decline in the US dollar, forcing a re-pricing of dollar-denominated commodities, there is a possibility that the dollar will now begin to rise, as the fears about the American financial system recede. If that were to happen, some of the pressure on the commodity prices would ease and, to the extent there is a speculative factor in the prices, the speculators might be forced out, creating a downward spiral.

That is speculation. The fact is that the global surge and shortage of commodities represents a far greater threat to the global economic system than the sub-prime bubble ever did. Just imagine the complexities involved in China raising prices on exports to the United States as demand contracts because of the slowdown, and how that could play out internationally.

We are, therefore, not always so relaxed. We did think the sub-prime debacle was overstated. We think the potential havoc of commodity price rises is understated. Unless they start dropping soon, and the export controls and other interventions ease, this will play out not only economically, but geopolitically. We think that prices will ease, but we don't know that. If they stay at their current levels or continue to rise, there will be problems that will dwarf the sub-prime threat.