For more than 200 years, free trade, low taxes, open markets, stable currencies and minimal government intervention benefited all. The citizens of Stuart and Hamlin prospered.

One day, a fertile iron mine in the heart of Stuart runs out of ore. So Hancock Steel, the nation’s largest integrated steel producer, must turn to other sources. Unfortunately, the next great domestic iron deposit rests 2,000 miles away. Transcontinental rail freights aren’t cheap. Hancock’s production costs rise. To stay profitable, management pushes these costs to the end-user. Steel prices double.

The Garland Motor Co. depends on Hancock’s refined cold-rolled products to produce lightweight body panels for its automotive fleet. Steel prices dramatically affect the auto industry’s bottom line. Higher domestic prices force Garland to import less expensive steel from Hamlin producers.

Hancock’s sales plummet. Layoffs ensue. Steel workers with mouths to feed form a union. They lobby their national politician. The politician needs their vote. He asks for a few favors. Within days, the Democratic Nation of Stuart slaps a tariff on Hamlin steel. Garland Motor reverts back to Hancock. The steel union celebrates.

The SUVs rolling off Garland’s assembly lines now cost more to produce. Car prices double. Unfortunately, most consumers can’t absorb the price hike. They turn to cheaper imports from Hamlin. Garland’s sales drop. The company cuts costs. Once again, layoffs ensue.

Unemployed autoworkers quickly lobby political support. Their politician acquiesced on the steel pact. Now he demands mutual legislative support. Stuart slaps Hamlin with another tariff.

Now the good citizens of Hamlin get testy. For years, trade between the two countries prospered. But Stuart’s protectionist ways inflame national pride. The citizens of Hamlin demand retaliation.

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You see, for years, Hamlin has reaped the benefits of Stuart’s abundant forests, forsaking local producers. But no more… The Independent Republic of Hamlin retaliates with a massive tariff on imported timber. Hamlin’s high-cost producers rejoice.

Unfortunately, construction costs rise nationwide. New home sales fall. Layoffs now engulf mortgage brokers and construction workers. The entire Hamlin economy slows.

Meanwhile, Stuart’s logging industry contracts. The cycle continues. Prices on all economic goods and services (steel cans, cars, houses, etc.) continue rising the world over. Both economies contract. Unemployment rates rise. A global recession results.

Once again, the world turns to politicians for a solution. Elected officials in both countries reach for the quick fix. They appease the unemployed via subsidies (taxpayer money).

Unfortunately, there’s no such thing as a free lunch. For the sake of maintaining a balanced budget, subsidies require more government revenue. More revenue means more taxes. Higher taxes inhibit domestic growth. Less growth means fewer jobs.

Unemployment rates keep rising. The citizens of Stuart and Hamlin find themselves back at square one.

However, a Stuart-educated economist – let’s call him Cain – steps up to save Round Hill from total economic meltdown. He suggests that massive deficit spending (on public works) will increase aggregate demand. Laidoff workers from the mills, factories and forests will build roads, bridges, schools and dams. The unemployed will effectively be hired in service to the state. They’ll use their wages to buy houses and cars. In turn, these industries will demand more iron, steel and lumber. The whole economy prospers. The recession ends. The government effectively solves the paradox of full employment.

It’s simple, Cain explains. Think of deficit financing as using a credit card to get you through a rough month.

Stuart’s legislative body takes the bait. Stuart’s treasury revs up the printing press. Within weeks, the government awards contracts to engineering firms nationwide. With the push of a button, corporate bank accounts are overflowing. The construction industry takes off. Everyone in Stuart receives a paycheck. Cash seemingly falls from the sky.

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The first two years are bliss. But eventually, the 1-1 gold parity of Stuart’s currency (the bandit) feels the heat. The printing press has injected too much paper money. M3, Stuart’s fullest measure of the base money supply, keeps growing at a 12% per year clip. The market now requires two bandits for a single ounce of gold – effectively lowering the bandit’s value by 50%. Prices for milk, bread and eggs start rising. In fact, they begin rising faster than domestic wages. Inflation fears start to percolate.

But currency devaluation brought some unanticipated benefits. Stuart’s export industry re-emerges. The cheap bandit means cheap exports sail from Stuart ports. More exports create more jobs. More jobs mean more votes. Political pressure to keep the money flowing keeps rising like the waters that carried Noah.

Stuart’s president, Robert Chatham, faces a dilemma. On one hand, unemployment rates have reached historic lows. The economy keeps humming. On the other, inflation fears keep mounting. Saving the bandit will ensure the emergence of inflation’s ugly cousin: deflation (the opposite of inflation, promising a decrease in the general price level). Recession will surely follow.

Chatham’s dream of a second term falls like a dead leaf in a dry wind.

Meanwhile, across the sea, cheap imports from Stuart cripple Hamlin’s industrial base. As Stuart’s economy takes off, Hamlin’s unemployment rate soars to record highs.

Hamlin’s politicians have no choice. They quickly follow Stuart’s lead. Seemingly overnight, Hamlin precipitates currency devaluation. Depreciation ensures currency parity once again. Imports from Stuart subside.

In a perfect world, the two countries would save their respective currencies. But they live in an imperfect world. As do we.

Regards,

Christopher Hancock

P.S. Just like Christopher’ s story, the US economy is going through volatile times with inflation, energy and politic issues all while embarking into a recession. It’s highly inevitable that we will see waves of layoffs… leaving pensions and 401k’s in jeopardy…

Source: A Tale of Two Countries

–That’s the percentage increase in the annual iron ore contract price Aussie producers charge major Chinese steel makers. It includes the much sought after “freight premium” which recognizes that its cheaper to ship ore from Australia to China than from Brazil to China.

–So what does it mean? Well, Chinese producer were hoping to NOT have pricing power in the ore industry lie with suppliers. But that hope seems to have faltered. Time for plan B. Plan B is to take equity stakes in a large number of smaller Aussie ore producers (see yesterday’s DR, and don’t discount the possibility of China Inc. taking a large stake in BHP a la Chinalco in Rio Tinto).

–Plan B also includes raising steel prices. Granted, as you can see from the chart below, courtesy of Macquarie Research, steel prices are already up 65% this year alone. But as you can also see, Chinese steel prices trade at about a US$400 discount to U.S. and world export steel prices. Whether this is how the Chinese subsidise domestic steel consumption or not, we can’t really say.

–But we can say that Chinese producers will increase exports this year and raise prices. Prices for domestic steel in China might differ from export prices. Who knows? But either way, you can be sure the Chinese steel producers aren’t simply going to absorb the huge increases in coking coal and iron ore. Chinese steel is going to get more expensive, whomever the buyer is.

–Normally, you’d expect to see higher commodity prices curtail demand. But for both steel and oil (see below) you haven’t seen any evidence yet that higher prices are slowing down demand. In fact, as this second chart from Macquarie shows, Chinese steel production is slated to grow by 10% this year. It even looks like the double bottom in steel production growth rates is in. Is it the beginning of a new steel boom?

–One company that hopes steel prices keep going up is Aquila Resources (ASX: AQA). The company told investors yesterday that it could produce about 25 million tonnes of iron ore per year from its ore bodies in the Pilbara…for the tidy sum of $4.1 billion.

–Welcome to the iron ore boom, Aquila (a company which also has coal and manganese assets). The company’s announcement was a little like a new doctor in a small town hanging out his shingle right across from the old doctor. The company isn’t producing anything yet. But like the other ore hopefuls in the Pilbara, it believes that with a little capital and a little deep water port facility at Cape Preston, its pre-feasibility study indicates it would have a nice little business.

–What is the difference between a shingle and a “for sale” sign?

–Meanwhile, the original third wheel in the Pilbara, Fortescue Metals (ASX:FMG), begins loading its ore for shipment to China this week. It’s been a long time coming. But FMG’s business has opened the door in the Pilbara and the Mid West for a long roster of other, smaller ore producers. The good old days of just BHP and Rio are long gone.

–What about oil? It just keeps going up. It reached nearly US$123 in New York trading over night. The Masters of the World at GoldmanSachs repeated their claim that a ’super spike’ in oil could drive it to US$200, on the back of red-hot demand in the developing world and the “non-recession” in the U.S. Supply bottlenecks won’t help.

Last week the Associated Press reported, “Utilities nationwide are raising rates and are likely to push for even more dramatic increases in electric rates in the coming months.”

Americans are already strapped for cash due to rising gas and food prices and a sinking real estate market. So why’s electricity joining the scrum?

Well, a large part of the blame lies with steel… As I wrote last week, steel prices worldwide are skyrocketing. This week, we’re going to look at one of the ramifications of soaring steel prices… soaring coal prices.

Coking coal is the type of coal used in steelmaking. Demand from steelmakers is driving prices higher. In fact, many steelmakers, including the world’s second-largest producer (Nippon Steel), recently agreed to pay triple what they previously paid for coking coal.

Take a look at the following chart of coal prices since 1996…

The Global Insight coal index doesn’t contain any U.S. coal – it’s 60% South African, 30% Colombian, and 10% Australian. But the market for coal, like oil, is global. When the price of foreign coal spikes, the U.S. exports more of its coal… resulting in higher U.S. prices.

So the steel rally has swept coal along with it. But coal prices have not yet gone parabolic like steel prices. Does that mean coal is a good buy for people who are bullish on steel?

Trend followers might find coal attractive. But there’s no easy way to bet on the price of coal except through coal stocks… And coal stocks are expensive right now.

Take a look at the following chart…

Coal Stocks are Expensive

Investors are excited about the coal industry and have bid up the price of coal producers in relation to the price of coal. And any falter in the growth rate of coal prices could lead to a sharp drop in these stocks. So here’s how to play the coal boom.Wait for just such a pullback before buying your favorite coal stock. A few of the big names are Peabody (BTU), Consol (CNX), Massey (MEE), and Arch (ACI). Or you can buy a basket of coal producers with the Market Vectors Coal ETF (KOL).

Coal produces about half of all the electricity generated in the U.S. With coal prices soaring, it’s likely you’ll feel the effects of soaring coal prices in your electricity bill… But if you buy coal producers at the right prices, you should see some profit, too.

Good investing,

Ian Davis