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Fundamentals Are … Fundamental

Mises Daily: Thursday, October 30, 2008 by

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Imagine that you and a friend are sitting on a bench across the street from a construction site. In quick succession, two trucks arrive and dump a pile of sand, one pile next to the other. Moments later, a bulldozer appears and pushes the two piles together. After some thought, your friend has an "a-ha" moment.

"Interesting," he notes, channeling Jacques Derrida, "one and one are no longer two."

His comment slowly invades your thoughts. Finally, you respond, "What did you just say?"

Repeating his statement, only with more certainty and strength, "One and one are no longer two, under all circumstances. See that pile of sand. Before it was two piles of sand, and now it's one. So, one pile plus another pile is just one pile. One and one are no longer two."

Floored, you stare at your friend hoping to find a sign of jest.

He continues, "This isn't the first time that fundamentals have changed. During this past year, we've witnessed the fundamentals of economics — you know, supply and demand — rocked by oil speculators. It is no longer supply and demand setting the price, it's now the speculator. The fundamentals changed. Times have changed. We are living in a different world."

Taking a deep breath, you slowly note, "Fundamentals are just that: fundamental. By definition, they can't change, regardless of the time or place."

"But they do, and they did," he replies.

Throwing aside the linguistic deconstruction of a pile of sand, the pronouncement "This is the dawn of a new economy, an economy where scarcity and supply and demand are no longer constraints," is as cyclical as our fiat-driven economy. And, in the face of the history of such pronouncements, many folks still believe that the fundamentals of the market can change under certain circumstances.

Speculation in the Oil Market

Speculation can change the market price if and only if speculation causes a change in supply or demand. A futures price driven by speculation may induce producers to modify the amount produced. The price may also encourage speculators to buy current supply for later sale or induce producers to exercise their demand to hold. In both cases, the actions can cause the spot supply curve to be other than it would have been in the absence of speculation — a change in supply that is covered by the fundamentals of economics.

Additionally, there are instances where oil speculation can change the spot demand curve. Suppose company X wants to expand a product line that uses oil as a primary factor of production. Seeing the price of oil futures rise may lead X to delay its planned expansion. Or X may plan to reduce production — and, hence, consumption of oil — based on the price of the futures. But, again, the changes to the demand curve are covered by the fundamentals of economics.

But, speculation per se is not the issue here. The issue is not whether speculators manipulated the spot price of oil;[1] the issue is the insistence that the fundamentals of economics can change. Once such a position is accepted, further analysis is subject to political propaganda and nonsense. Once the foundations of economics are removed, any idea can be assumed true.

Austrians to the Rescue

The Austrian school is the only school of thought built on a solid foundation. The Austrian school's a priori knowledge is apodictically true, and not subject to time or place. Contrast that with the other schools of thought, schools that try to define knowledge based on observed data.

In these schools, any observed trend or correlation trumps the fundamentals. If the observed data appear to refute a fundamental law, the observation is reaffirmed and the law suspended. But such an epistemology is nothing more than poking in the dark — or poking in the data.

Outside of deconstructed linguistics, no one is going to accept the dawning of a utopia where one plus one is one. We turn our backs on such nonsense. Yet when someone shows correlated data implying a fracture in the law of supply or demand, many folks accept the conclusion.

The Filter

These are the questions to ask: What's your epistemological filter? Do the fundamentals rule? Or do the data rule?

When it's the data that rule, all things can be proposed, but are not all possible. When it's the fundamentals, all things can be understood, even when not observed.

Conclusion

We have not entered a new age — a utopia of sorts — and we never will. Yet we continue to hear the claim that this time things are different; this time the new age has dawned. However, the proclaimed utopia never arrives — it can't. Scarcity and the law of supply and demand can not be waved away.

Instead, the vision of each utopia is destroyed in a blaze of capital destruction. The new economics driven by tech stocks: ashes. The world of exponentially increasing property values: ashes. The savior of credit derived exclusively from notations on the books of the Federal Reserve: quickly burning to ash. And, of course, the list goes on and on.

While playing with piles of sand can be a fun mental exercise, the fundamentals of math are not affected. The same is true with economic data or intervention. The fundamentals of the market rule, regardless of the observation or desire.

Note

[1] I will let Robert Murphy explain speculation and the current market for oil.