To the Keynesian economist, the world of economics is a sequence of random events — an endless stream of anecdotes. Things don’t happen for any rhyme or reason, they just happen. And when they happen the economist’s first job is to come up with an explanation by looking at the news of the day, because there will always be current events that can be blamed for any positive or negative developments.

It’s futile to look any deeper, for example, to consider how policies such as meddling with interest rates might have influenced investment decisions, because, even though the real-world economy involves millions of individuals making decisions for a myriad of reasons, the individual actors within the economy supposedly form an amorphous mass that shifts about for unfathomable reasons. In fact, in the Keynesian world the economy can be likened to a giant bathtub that periodically fills up and empties out for reasons that can’t possibly be understood, although if an explanation that goes beyond the news of the day is needed the economist can always fall back on “aggregate demand” or its more emotional cousin — “animal spirits”. Specifically, a slowing economy can be said to be the result of falling “aggregate demand”, and when the pace of economic activity is rapid it can be said to be the result of surging “animal spirits”. There’s no need to try to explain the changes in these mysterious entities, because they are inexplicable. They just happen.

Having explained what’s happening to the economy by pointing at seemingly random/unpredictable events or citing unfathomable changes in “aggregate demand”, the economist’s second job is to recommend a course of action. And since the economy can supposedly be likened to a bathtub filled with an amorphous liquid, the level of which periodically rises and falls, it’s up to the economist to suggest ways that add liquid when the level is too low and drain liquid when the level is too high.

Fortunately, adding and draining liquid is very easy to do. For example, to add liquid all that has to be done is for the government to increase its spending and/or for the central bank to create some money out of nothing. It doesn’t matter that the government’s spending is unproductive and that the central bank’s money-pumping falsifies the price signals upon which the market relies; it only matters that more liquid is added to the bathtub.

This approach to economics might seem ad-hoc. It might seem superficial. And it might seem short-sighted. That’s because it is all of these things, which is why Keynesian Economics should be re-branded ASS (Ad-hoc, Superficial and Shortsighted) Economics.

The price of a commodity futures contract is not the market’s forecast of what the spot price will be in the future. For example, the fact that at the time of writing the price of the December-2016 WTI Crude Oil futures contract is $64.44 does not imply that ‘the market’ expects the price of oil to rise from around $59 (the current spot price) to around $64 by the end of next year. Moreover, the true message of the difference between the futures price and the spot (cash) price can be the opposite of the superficial message, in that the lower the futures price relative to the spot price the more bullish the price implication. If you understand why this is so then you understand more than former Fed chief and present-day blogger Ben Bernanke about how the commodity futures markets work, which, admittedly, is not saying very much.

Part of the reason that the price of a commodity futures contract is not a prediction of the future price of the commodity is that many of the largest participants in the futures markets do not buy/sell futures contracts based on a forecast of what’s going to happen to the price. Instead, they use the futures market to hedge their exposure in the cash market. For example, when an oil producer sells oil futures it is probably doing so because it wants to lock-in a cash flow, not because it expects the price to go down.

The main reason, however, is that the difference between the futures price and the spot price is driven by arbitrage and, in all commodity markets except the gold market, the extent to which current production is able to satisfy current demand (in the gold market there can never be a supply shortage because almost all of the gold mined in world history is still available to meet current demand). In effect, regardless of what people think the price of the commodity will be in the future, arbitrage trading will prevent the futures price from deviating from the spot price after taking into account the cost of credit (the interest rate) and the cost/availability of storage.

Considering the case of the oil market, I mentioned above that the spot price is currently about $59 and the price for delivery in December-2016 is about $64. This $5 difference does not imply that ‘the market’ expects the price of oil to be $5/barrel higher in December-2016 than it is today; it implies that the cost of storing oil for the next 18 months plus the interest income that would be foregone (or the interest that would have to be paid) equates to about $5/barrel. If not, there would be a risk-free arbitrage profit to be had.

For example, if a large speculator who was very bullish on oil bid-up the price of the December-2016 oil contract from $64 to $70, it would create an opportunity for other traders to lock-in a profit by purchasing physical oil and selling the December-2016 futures with the aim of delivering the oil into the contracts late next year. This trade (selling the December-2016 futures and buying the physical) would continue until the difference between the spot and futures prices had fallen by enough to eliminate the profit potential.

For another example, if a large speculator who was very bearish on oil aggressively short-sold the December-2016 oil contract, driving its price down from $64 to $60, it would create an opportunity for other traders to lock-in a profit by selling physical oil and buying the December-2016 futures with the aim of eventually replacing what they had sold by exercising the futures contracts. Even though in this example the December-2016 futures contract is still $1 above the spot price, there is a profit to be had because the cost of storage plus the time value of money amounts to significantly more than the $1/barrel futures premium.

I also mentioned above that the true message of the difference between the futures price and the spot (cash) price can be the opposite of the superficial message, in that the lower the futures price relative to the spot price the more bullish the price implication. I’ll use the same oil example to explain why.

As I pointed out, if the futures price falls by enough relative to the spot price it will lead to a situation where there is an essentially risk-free arbitrage profit to be made by selling the physical and buying the futures. However, this trade is only possible if the physical market is well supplied. If this isn’t the case and all the oil being produced is needed for current consumption, then the price of oil for future delivery can drop to an unusually low level relative to the spot price and stay there. If the current supply situation is tight enough then the futures price could even drop below the spot price. That’s why a sustained situation involving an unusually-low futures price relative to the spot price has bullish, not bearish, price implications.

My final point is that one of the most important influences on the difference between spot and futures prices for many commodities is the prevailing interest rate. In the gold market it is the most important influence by a country mile. The lower the interest rate the smaller the difference will tend to be between the spot price and the prices for future delivery, so in a world dominated by ZIRP (Zero Interest Rate Policy) the differences between spot and futures prices will generally be smaller than usual.

In conclusion, anyone who views an unusually-large premium in the commodity futures price as bullish and an unusually-low (or negative) premium in the commodity futures price as bearish is looking at the market bass-ackwardly.

There’s a line of thinking to the effect that Quantitative Easing (QE) is not inflationary because it involves the exchange of one cash-like instrument for another. Taking the case of the US, the Fed’s QE supposedly adds X$ of money to the economy and simultaneously removes X$ of “cash-like” securities, leaving the total quantity of “cash-like” instruments unchanged. However, even putting aside the fact that many of the securities purchased as part the Fed’s QE programs are not remotely “cash-like” (nobody with a modicum of economics knowledge would claim that a Mortgage-Backed Security was cash-like), this line of thinking is patently wrong.

The simplest way for me to explain why it is patently wrong is via a hypothetical example that accurately reflects the situation in the real world. In my example, Jack is a securities dealer who deals directly with the Fed.

As part of a QE program the Fed wants to buy $1B of 2-year T-Notes with newly-created cash. Jack has $1B of T-Notes to sell, so a transaction occurs. If the Fed and Jack had simply swapped securities then there would be nothing inflationary about this transaction. Instead of holding the $1B of T-Notes yielding, say, 0.6%, Jack would be left with $1B of some other income-producing asset. However, what Jack is actually left with is a bank deposit containing 1 billion dollars of money earning 0%. Moreover, whereas he previously had no risk of suffering a nominal loss (assuming that he was prepared to hold the Notes to maturity), he now bears a low-probability risk of suffering a large nominal loss since only a tiny fraction of his $1B deposit is government guaranteed. Consequently, Jack will be quick to spend the money received from the Fed, most likely by purchasing some other bonds or perhaps by purchasing some equities.

Let’s assume that Jack uses half of the money received from the Fed to buy bonds from Bill and the other half to buy bonds from Ted. Bill and Ted are hedge fund managers. Following this transaction, Bill and Ted now each have the ‘problem’ of finding something to do with $500M of cash, because, like Jack, they can’t just leave such a large sum in a zero-interest bank deposit. They therefore quickly turn around and buy other assets, shifting the ‘problem’ of what to do with the cash to the sellers of those assets.

Get the picture? When the Fed injects money via its QE programs it is, in effect, passing a hot potato to securities dealers. The hot potato quickly gets handed off to other dealers and speculators, giving the demand for various financial assets an artificial boost along the way. Eventually the money will leak out of the bank accounts of large-scale speculators and begin to boost prices outside the financial markets, but, as we’ve seen, that process can take a long time.

The Bloomberg article posted HERE reports that after a decade-long 5-times increase, the worldwide stash of foreign currency reserves held by central banks has begun to shrink. Is this good, bad, or irrelevant?

The answer is no — it’s not good, it’s not bad, and it’s not irrelevant. To be more accurate, it would be good if it indicated a new long-term trend, but it almost certainly doesn’t indicate this. Instead, it is just part and parcel of the way the current monetary system works.

The key to understanding the implications of global reserve changes is knowing that these changes are mostly driven by attempts to manipulate exchange rates.

During the first stage of a two-stage cycle, many central banks and governments perceive that their economies can gain an advantage by weakening their currency on the foreign exchange market. Although it is based on bad theory, this perception is a real-world fact and often guides the actions of policy-makers. It prompts central bankers to buy-up the main international trading currency (the US$) using newly-printed local currency, resulting in the build-up of foreign currency reserves, growth in the local currency supply, and an unsustainable monetary-inflation-fueled boom in the local economy.

The build-up of foreign currency reserves during the first part of the cycle is therefore not a sign of strength; it is a sign of a future “price inflation” problem and a warning that the superficial economic strength is a smokescreen hiding widespread malinvestment.

During the second stage of the cycle the bad effects of creating a flood of new money to purchase foreign currency reserves and manipulate the exchange rate become apparent. These bad effects include economic weakness as investing mistakes become apparent, as well as uncomfortably-rapid “price inflation”. Pretty soon, policy-makers in the ‘reserve-rich’ country find themselves in the position of having to sell reserves in an effort to arrest a downward trend in their currency’s exchange rate — a downward trend that is exacerbating the local “price inflation” problem. This is the situation in which many high-profile “emerging” economies have found themselves over the past two years, with Brazil being one of the best examples.

In other words, the world is now immersed in the stage of the global inflation cycle — a cycle that’s a natural consequence of today’s monetary system — in which reserves get disgorged by central banks as part of efforts to address blatant “inflation” problems. This would be a good thing if it indicated that the right lessons had been learned from past mistakes, leading to a permanent change in strategy. However, that’s almost certainly NOT what it indicates.

The disturbing reality is that at some point — perhaps as soon as this year — a large new injection of money will be seen as the solution, because bad theory still dominates. As evidence, I cite two comments from the above-linked article. The first is by the author of the piece, who implies in the third paragraph that emerging-market countries need to boost their money supplies to shore-up faltering economic growth. The second is from a former International Monetary Fund economist and current hedge-fund manager, who claims via a quote in the fourth paragraph that emerging markets now need more stimulus.

So, emerging-market economies have severe problems that can be traced back to earlier monetary stimulus, but the solution supposedly involves a new bout of monetary stimulus. Let the idiocy continue.