Former Fed chief Ben Bernanke now has a blog. This is mostly good news, because he will certainly do less damage as a blogger than he did as a monetary central planner. However, it means that he is still promoting bad ideas.

I doubt that I’ll be a regular reader of Bernanke’s blog, because his thinking on economics is riddled with logical fallacies. Some of these fallacies were on display in his second post, which was titled “Why are interest rates so low?“. Some examples are discussed below.

In the fourth paragraph Bernanke states: “The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth — not by the Fed.” However, earlier in the same paragraph he states that the real interest rate is the nominal interest rate minus the inflation rate, that the Fed sets the benchmark nominal short-term interest rate, that the Fed’s policies are the primary determinant of inflation and inflation expectations over the longer term, and that inflation trends affect interest rates. Also, the Fed clearly attempts to influence the prospects for economic growth. So, by Bernanke’s own admission the Fed exerts considerable control over the “real” interest rate. In other words, he contradicts himself.

A bit further down the page he states: “…[the Fed's] task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or — more realistically — its best estimate of the equilibrium rate, which is not directly observable.” And: “[the Fed] must try to push market rates toward levels consistent with the underlying equilibrium rate.”

So, having said in the fourth paragraph that the Fed has minimal control over the real interest rate and then contradicting himself by saying that the Fed controls or influences pretty much everything that goes into determining the real interest rate, he subsequently says that the Fed’s task is to push the market interest rate towards the “equilibrium rate”, which, by the way, is unobservable. Now, the so-called “equilibrium rate” is the REAL interest rate consistent with optimum usage of resources. In other words, he’s now saying that the Fed’s task is to push the REAL market interest rate as close as possible to an unobservable/unknowable “equilibrium rate”, having started out by claiming that the Fed doesn’t determine the real interest rate. I wish he would at least keep his story straight!

As an aside, the equilibrium rate is the rate that would bring the supply of and demand for money, capital and other resources into balance, which is the real rate that would be sought by the market in the absence of the Fed. In other words, if the Fed did its job to perfection, which is not possible, then it would be constantly adjusting its monetary levers to ensure that the market interest rate was where it would be if the Fed didn’t exist.

Bernanke goes on to say that today’s US interest rates aren’t artificially low, they are naturally low. Apparently, the Fed’s ultra-low interest rate setting is a reflection of a naturally-low interest-rate environment, not the other way around. This prompts the question: Why, then, can’t the Fed just get out of the way? To put it another way, if default-free nominal interest rates would be near zero and real interest rates would be negative in the absence of the Fed’s gigantic boot, then why can’t the Fed allow interest rates to be controlled by market forces?

It seems that Bernanke cleverly anticipated this line of thinking, because in a beautiful example of circular logic he says “The Fed’s actions determine the money supply and thus short-term interest rates; it [therefore] has no choice but to set the short-term interest rate somewhere.” That is, the Fed can’t leave the short-term interest rate alone, because if the Fed exists it will inevitably act in a way that alters the short-term interest rate. Clearly, Ben Bernanke can’t even imagine a world in which there is no central bank.

Ben Bernanke ends his post by putting aside all the talk in paragraphs 5 through 9 about the Fed’s efforts to control the real market interest rate and by reiterating his comment (from paragraph 4) that the Fed doesn’t determine the real interest rate. As a final piece of evidence he notes that interest rates are low throughout the world, not just in the US, but forgets to mention that central banks throughout the world are behaving the same way as the Fed.

If the free market can’t be trusted to set the most important price in the economy (the price of credit) and if government intervention can help the economy work better, then total government control of the economy must be the optimum situation. Therefore, if Keynesians were consistent they’d advocate for either Communism or Fascism.

In practical terms, Keynesian economics, which is the type of economics that dominates policy-making throughout the world today, involves using monetary and fiscal policy to ‘manage’ the economy. The overarching idea is that a free market is inherently unstable and that by modulating interest rates and something called “aggregate demand” the government can keep the economy on a smooth upward path. The fact that the results of putting this idea into practice have typically been the opposite of what was predicted doesn’t, according the Keynesians, indicate a major flaw in the underlying concept; it just means that the right people weren’t in charge.

Anyhow, the purpose of this post isn’t to argue against Keynesian economic theories, it’s to make the point that completely logical proponents of these theories would recommend a Communist or a Fascist political system. The reason is that these are the political systems that are most consistent with Keynesian economic theory.

As an aside, I’m applying the word “theory” very loosely to what the Keynesians believe, because what they believe is not encompassed by a coherent set of principles. It is more like an endless stream of anecdotes than a theory. Actually, it is a bit like Elliot Wave (EW) analysis. In the same way that EW analysis can always explain what happened in the past but is not useful when it comes to explaining the present or making predictions, Keynesians are always able to come up with an anecdote that explains why historical performance, while seemingly being totally at odds with their theories, fits perfectly into their theoretical construct after the special set of circumstances associated with the time period in question is taken into account. Since there are special circumstances associated with every period, Keynesians will always be able to come up with anecdotal explanations for why things didn’t pan out as expected. There is never any perceived need to question the underlying ideas.

Getting back to my point, consider the control of interest rates by a central planning agency called the Central Bank. All Keynesians (and pretty much everyone apart from the “Austrians”) believe this price-setting power to be not only legitimate and appropriate, but also necessary to facilitate the smooth running of the economy. OK, but given that the price of credit is influenced by a greater number of variables than any other price and would therefore be the most difficult price for a central planner to get right, if central planners can do a better job of setting interest rates than a free market then it stands to reason that central planners could do a better job than the free market of setting all prices. Therefore, anyone who claims that it is right that a central bank controls interest rates would, if they were being consistent, also claim that similar agencies should be established to control all other prices.

Now consider the Keynesian notion that the government should modulate “aggregate demand” to create a more stable economy. The thinking here is that 1) a free-market-economy periodically gets ahead of itself and then plunges into an abyss, 2) dramatic economic oscillations are caused by largely unfathomable changes in “aggregate demand”, with the devastating downswing the result of a mysterious collapse in “aggregate demand”, and 3) by adding and removing demand via its own spending, the government can smooth the transition from one boom to the next. In effect, the economy is treated as if it were a swimming pool that sometimes, for no well-defined reason, loses a lot of water, while the government is treated as if it were an institution capable of replenishing the water, even though in the real world the government has no water of its own.

If the economy really were like an amorphous mass of liquid that could be manipulated, via changes in government spending, in whatever direction was needed at the time to create the optimum outcome, then total government control of the economy would definitely work.

The upshot is that if uber-Keynesian Paul Krugman went on television and argued in favour of a Soviet-style system, he would be taking his economic principles to their natural political conclusions. In doing so he would be totally logical. He would be totally consistent. And he would be totally discredited.

This post is a slightly-modified excerpt from a recent TSI commentary.

The following chart shows that Commercial traders, as a group, were heavily net-long euro futures almost all of the way down (the blue bars indicate the net-position of the Commercials). Since the Commercials are reputedly the “smart money”, how could they have been so wrong?

The answer is that they weren’t wrong. Here’s why.

First, if large speculators and small traders are lumped together under a category labeled “speculators”, then the commercial net-position is simply the mathematical offset of the speculative net-position. If speculators, as a group, are net long to the tune of X contracts, then commercials, as a group, will be net short to the tune of X contracts. Second, in the currency market and also in the gold market (gold trades like a currency), speculators drive short-term price moves. This is evidenced by the fact that speculators (as a group) become increasingly ‘long’ as the price rises and then become increasingly less long, or short, as the price declines.

Due to the fact that every long position in the futures market must be associated with a short position (it’s a zero-sum game), speculators cannot increase their long exposure in the futures market unless commercials increase their short exposure by exactly the same amount. To put it another way, it would not be possible for speculators to drive the price upward by going ‘long’ if there weren’t commercials prepared to take the other side of the trade and ‘go short’, and it would not be possible for speculators to go short or liquidate their long positions unless commercials were prepared to go long or exit their short positions.

Looking at it from a different angle, it would not be possible for commercials to hedge their long exposure in the cash market by going short in the futures market unless speculators were prepared to do the opposite (go long) in the futures market, and it would not be possible for commercials to hedge their short exposure in the cash market by going long in the futures market unless speculators were prepared to do the opposite.

Both commercials and speculators are needed to establish a liquid futures market. The speculators create the opportunity for commercials to do what they do, which is to hedge by selling into strength and buying into weakness, and the commercials create the opportunity for speculators to do what they do — speculate on price direction.

That’s why the relentless complaining in some quarters about commercial short selling of gold futures and other precious-metals futures is so silly. Complaining about a large commercial net-short position is the same as complaining about a large speculative net-long position, because they are two sides of the same coin — you can’t have one without the other. Limit the extent to which the commercials can go short and you also limit the extent to which speculators can go long.

Getting back to the euro futures market, it’s not correct to say that the commercials have been wrong, because a substantial commercial net-long position in the futures market does not imply that the commercials are betting on a rising euro. In general, the commercials don’t bet on price direction; that’s what speculators do.

In the euro futures market the commercials weren’t wrong, but it’s fair to say that speculators, as a group, were very right all the way down. That’s unusual. The Commitments of Traders (COT) situation is nothing more than a sentiment indicator, and it’s rare for speculative sentiment to reach either a bullish or a bearish extreme and for the price to continue in the direction expected by speculators with almost no interruption for many months thereafter. So rare, in fact, that I can’t recall ever seeing it before.

Considering the overall commodity backdrop, the recent sharp rebounds in base metal prices and the copper price in particular are both interesting and incongruous.

Under the heading “Copper Bottom” in a TSI commentary a few days ago I discussed last week’s upward reversals in the copper price and the Industrial Metals Index (GYX). I assumed, at the time, that last week’s price gains were partly due to the risk that supply would be disrupted by the blockade of Freeport’s massive Grasberg copper mine in Indonesia, and therefore that the removal of this risk at the end of last week would result in some of the price gains being given back this week. Strangely, however, the copper price spiked higher at the beginning of this week and briefly challenged the bottom of the major $2.90-$3.00 resistance range before pulling back to the high-$2.70s (a few cents above last week’s closing level). It seems that games are being played by large-scale participants in this market.

I plan to write some more about copper later this week at TSI, but at this time I wanted to point out that the bearish participants in the copper market have relative valuation on their side. As illustrated by the following charts, the copper price is presently at a multi-decade high relative to the CRB Index and at its highest level since 1998 relative to oil.