The Real Cost of Free Money: A lesson in supply and demand

Understanding Your Dollar: Part five of seven

Blackjack Table - Wikipedia
Blackjack Table - Wikipedia

WASHINGTON, January 26, 2015 – My three siblings and I recently took our families to Las Vegas for vacation. My big sister and I conspired to spend some sibling family time at the Blackjack table.

Now, as a conservative with an Evangelical background, that is probably a bit of an over-extension of the idea of “family time.” But it was an interesting lesson. For my big sis, it was a lesson in why you don’t play Blackjack with relatives who have no idea what they’re doing. I can still remember her dirty looks at my stupid decisions.

Read: Understanding Your Dollar: The Tale of the Tape

For me – being interested in economics – it was an interesting lesson in supply and demand.

The dealer has the supply (the cards). The players represent the demand. And from what I’ve heard, if you keep really close track of that supply and demand, you can bet high when the count is in your favor. They call it “card counting” – and it’ll get you kicked out of the casino.

But what if you could get away with it? What if you could make a little computer to track what cards have been played and tell you not only when to bet, but how much? And to make it even more interesting, what if you could borrow your chips for free at the window?

In my last article I observed that our money supply basically goes to three things: politically preferred uses (government spending), speculation and objectively productive uses. Here I want to focus on two related things: 1) how free money distorts the money supply in favor of speculation; and 2) how that speculation then further distorts the economy.

Read: Organized labor, the minimum wage and the money supply

Let me start by pointing something out about typical conservative rhetoric. We are advocates for the free market. We typically react to those who call speculation into question as if they were trying to repeal the laws of supply and demand. I’ll call speculation into question here – but I will do this in defense of the free market. But it is important to understand exactly what speculation is.

The price of oil has been in the news of late, and probably very much to the delight of most of us. From highs of about $120 per barrel to under $50 today. Let’s use $50/barrel as an example. If I have reason to believe the price will go up (more about that in a moment), I might place my bet right now. I’ll do this by signing a “futures contract” for 1,000 barrels of oil to be delivered in 60 days. That is a $50,000 contract.

If I am right, and within those 60 days the price goes back up to $70, the difference is $20/barrel. My contract is for 1,000 barrels, so it now represents a $20,000 discount to the spot price. I can now sell that contract to a refiner. The refiner can spend $70,000 buying oil at the “spot price.” Or they can buy my contract, and then buy the same oil for $50,000. Of course I am going to charge a price for this, so I’ll just say “let’s split the $20,000 discount… You give me $10,000 for my contract and buy the oil for $50,000. You save 10K and I get 10K.

Great deal, right?

Read: The economic rise of the ‘American Ruling Class’

Well, let’s step back a moment. If the refinery signed that contract, it would be an example of “hedging.” (Southwest Airlines is famous for how it did this with aviation fuel… ever wonder how it is that “bags fly free?”) It would also be an example of “true demand.” The refiner can actually take the commodity (oil) and use it to produce something others will buy (motor fuel, home heating oil, aviation fuel, etc.). But if I sign that same contract – right here in my home office in my pajamas – well, I don’t have a refinery now, do I?

Because I cannot use the commodity to produce something others will buy, the demand reflected by my contract is “false demand.” And because I sell the contract to a third party, I am not hedging – I am speculating; these two things are not the same. When this false demand is added on top of the true demand of those who actually make productive use of the crude oil, the price rises higher and faster than it otherwise would. This is not an objection to the price rising due to free market forces of supply and true demand. It is an objection to prices rising higher and faster because the market is, in fact, distorted by the false demand of speculation.

Now think about the numbers again, let’s just drop some of the zeroes. If I offered you the chance to give me $50, and I would give you the $50 back in 60 days – and an additional $10, would you take it? $10 on an investment of $50 is a 20 percent return!

But wait… you have a great idea for building a better mousetrap. You’ve done your research and you can put that $50 into your effort to build a better mousetrap, bring it to market, sell it and make… oh… say 5-10 percent profit.

“Tell me about that 20 percent return again…” you say.

What’s the difference here? It is the difference between the transfer of wealth (the 20 percent gain betting on price activity in the oil market – which does not improve anything) and the creation of wealth (by actually improving the mousetrap). If you could borrow $50,000 for free, bet on price activity in oil and make 20 percent, why would you bother actually trying to create wealth?

Read: Understanding your dollar: Whose money is it anyway?

Some will argue that speculation like this is highly risky and that speculators probably lost their shirts on oil lately. Maybe some – the dumb ones like me at that Blackjack table – took a hit. But the ones who understand “Big Data” got out long before the prices collapsed.

Let’s go back to the Blackjack table. Remember how great it would be to have that little computer to count the cards for me? The sophisticated speculators have that – and it isn’t a little computer; there’s a reason they call it “Big Data.”

So there they sit, with Big Data to track the supply and demand picture in the energy markets. The longer they do this, the more data they have. The faster the computers get, the more data can be processed. They are card counting at the Blackjack table of the commodity markets in an absolutely spectacular way.

And they are betting with free money! Why bother creating jobs?

And when the price of gas rises again, take note of how high and how fast it rises. And calculate the difference between what you’re spending now and what you spend then. A very large part of that difference will be ending up in the accounts of speculators – who with Big Data saw it all coming.

The Board of Governors of the Federal Reserve are the Bishops in the Temple of the Free Market. And with free money, they have turned it into a den of thieves.

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John H. Horst
John H. Horst earned his Master of Arts in Theology from Asia Pacific Theological Seminary and holds a Master of Divinity from Bethel University. As an active member of his community, Horst is the Treasurer of three organizations including, the Mira Mesa Town Council, the San Diego Chapter of ICS2, and Pacific Lighthouse Christian Fellowship. He is currently an information security engineer and trainer. He resides in San Diego, CA with his wife and two sons. Website: Facebook: Twitter: Google+: CommunityConservative/posts The Secret to Winning the Hearts and Minds of the Next Conservative is available for purchase at Amazon and Barnes and Noble.