The Incredible Power of the Capital Markets

The power of free capital markets can be hard to understand.  Often,  people believe incorrectly that there needs to be a central governing power in order to overcome the human challenges as they occur.

However, when people (and their capital markets) are able to work to improve their own lives, they are able to overcome the challenges that they face better than any centralized decision-making government.  An example of this occurred recently.  In 2010, China realized that they controlled approximately 95% of what are called “rare earth metals” and the Chinese government tried to gain a competitive advantage with this monopoly.  How did that work out?  First,

What are Rare Earths?

The Japanese call them “the seeds of technology.” They make possible the high-tech world we live in today – everything from the miniaturization of electronics, to the enabling of green energy and medical technologies, to supporting a myriad of essential telecommunications and defense systems.  They are the elements that have become irreplaceable to our world of technology owing to their unique magnetic, phosphorescent, and catalytic properties.

For example, an iPhone uses eight rare earths – for everything from its colored screen, to its speakers, to the miniaturization of the phone’s circuitry.  All modern cars use them in their technology.

Before exploring this illustrating market example with rare-earth metals,  let’s take a general view that comes up from time to time regarding the Earth’s resources.  The  doomsayers are constantly discussing how the earth will run out of this valuable resource or another.  When I was growing up, it was how we going to run out of oil; however, due to great American ingenuity, they would discover ways of unlocking additional resources of oil and gas. There are now more confirmed oil and natural gas resources today in the U.S. than there was in 1964.

Natural resource scarcity predictions often underestimate the flexibility of markets and the ingenuity of humans to overcome these issues.  Economist Julian Simon has written extensively about this issue.  He calls the ingenuity of the human brain “the ultimate resource”.  Simon has noted that high prices encourage investment in new supplies and also creates opportunities for possible substitutes.

How did this affect the rare earth markets? When the Chinese central government decided to take advantage of their dominant position with heavy rare-earth metals, it highlighted the power of the free capital markets to provide possible substitutes.  

After China cut exports of these rare-earth metals by 40% in the hope of increasing the price, the capital markets went to work.  When the expected price increase in the metals did occur, additional potential resources became economical in both Australia and the U.S.  In addition, recycling of the product began, as well as engineering of the products to reduce the need of the metals.

Inside China, the increased prices encouraged more production with the resulting increase of metals available. This along with the reduced demand worldwide eliminated the “scarcity” by spurring innovative new technologies.   Honda, Ford and other auto companies also engineered hybrid batteries to be less reliant on rare earths.

Markets at work.

As the WSJ recently wrote,

The rare-earths roller coaster of recent years has again shown the ability of markets and human ingenuity to adapt to ill-advised attempts to hold natural resources hostage. When they are allowed to work, markets always defeat mercantilism—a useful lesson for Beijing’s economic reformers.

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