The west goes full Diocletian

When it comes to inflation, our policymakers learned nothing from 2000 years of history .

On Friday, 2 September G7, the group of seven most industrialized nations said that they have agreed to implement a price cap for global purchases of Russian oil. The effort was led by US Treasury Secretary Janet Yellen and the plan includes prohibition of services that enable maritime transportation of Russian oil and oil products globally. "The provision of such services would only be allowed if the oil and petroleum products are purchased at or below a price determined by the broad coalition of countries adhering to and implementing the cap." This plan aims to set a specific price point for Russian crude and another two price points for refined products. While G7 hasn't yet specified these prices, Volodimir Zelensky's senior economic advisor Oleg Ustenko said he expected the range to be between $40 and $60 per barrel.

Mr. Ustenko and the G7 finance ministers clearly emerged from the virtual conference with a sense of accomplishment about the formation of the "buyers' cartel." Ustenko said, "this is fantastic, it's exactly what we needed." UK chancellor, Nadhim Zahawi said the price cap would curtail Putin's capacity to fund his war in Ukraine with oil export revenues. German Finance Minister Christian Lindner reaffirmed that the price cap would reduce Vladimir Putin's revenues and also reduce inflation in the West: "At the same time, we want to curb rising global energy prices. This will minimize inflation globally." In all, it was high-fives, ra-ra-ra all around. With such impressive unity of leadership, we should expect Putin's war machine to finally collapse, Russia (probably) plunge into a deep economic recession and as an added bonus see inflation in the west come down. Why didn't anyone think of this sooner?

Price caps never work

Well, for one thing, price caps don't work. Throughout history, profligate governments have tried to stop inflation by setting price caps. One of the earliest recorded examples (though not the first), was Rome's emperor Diocletian (A.D. 244-312). He became emperor in A.D. 284 and embarked on massive government spending projects that included a huge increase in military spending, construction of a new planned capital of the empire on the territory of present-day Turkey and an expansion of the government's bureaucracy. As government's tax revenues weren't sufficient to pay for all this, Diocletian increased taxes, but that suffocated economic activity and tax revenues still fell short of the needed funds.

From there, Diocletian resorted to "quantitative easing" by further diluting denarius' silver content so he could coin more money with the same amount of silver. That, in turn, caused inflation to accelerate. Of course, an all-powerful emperor could always crush inflation by simply imposing price caps, and so in A.D. 301 the notorious Edict of Diocletian was passed, fixing the market prices of over 1,000 articles including grain, eggs, beef and clothing. The penalty for violating Diocletian's price controls was death, so merchants were strongly incentivized to comply. Unfortunately and in spite of hundreds of executions, the price caps failed. Merchants simply stopped supplying the goods to the markets causing widespread shortages, which made black market inflation even worse. In fact, Diocletian's Edict was such a disaster that after only four years, Diocletian abdicated the throne.

Our leaders are dumb or evil. Probably both.

Price caps reliably lead to shortages, which reliably exacerbates inflationary pressures. But in today's fragile economy with 'just-in-time' supply lines, it could have catastrophic effects on entire industries. It is simply staggering that the finance ministers of today's most advanced 'democracies' decided to tread the same worn path. There are two possibilities: either (1) we are being led by absolutely the dumbest, low-caliber, low-IQ ignoramuses that could be recruited in each nation, or (2) they are taking advantage of the crisis to deliberately make things much worse, because their agenda is something different from what we assume. I tend to go with the second option, even though the first one can't be far from the truth either.

Add all this to the collapsing capital expenditure in commodity production, geopolitical instability, anti-Russian sanctions (recall, starting on 5 December 2022, the latest round of EU sanctions ban all imports of Russian oil), deliberate wrecking of industrial capacities and the gathering geopolitical storm and the writing is on the wall: over the coming years we will likely get that commodity super-cycle, only it might prove significantly worse than the current projections. Prices of energy, metals and agricultural commodities are likely to continue rising over the coming years. Historically, commodity super-cycles have tended to span ten to 25 years.

How to defend your purchasing power

I’ll have much more to write on this topic but a growing body of empirical evidence is clear on this point: the only effective defence against price inflation is to gain meaningful exposure to commodity prices through futures contracts.

Unfortunately, this asset class has traditionally been available only to wealthy investors, either through commodity futures or managed futures funds (also called CTAs or Commodities Trading Advisors). In recent times, retail investors can gain exposure to commodity prices also through ETF funds or retail CFD instruments (Contract for Differences).

Alex Krainer - @NakedHedgie has worked as a market analyst, researcher, trader and hedge fund manager for over 25 years. He is the creator of I-System Trend Following, publisher of TrendCompass reports and contributing editor at ZeroHedge based in Monaco. His views and opinions are not always for polite society but they are always expressed in sincere pursuit of true knowledge and clear understanding of stuff that matters.