Carrying Cost

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Carrying Cost

Carrying costs have played both a practical and a theoretical role in economics. From the practical standpoint, carrying costs are known as the costs of interest, warehousing, wastage, and possible decline in marketability, which holding for future use implies for marketable commodities. Thus those goods for which there has historically arisen a formal method of grading and of trading over time—forward or futures markets—are subject to such carrying costs and the existence of them is a well known fact for financial traders and commentators.

Theoretically, carrying costs entered the literature with Henry Crosby Emery’s influential Speculation on the Stock and Produce Exchanges of the United States (1896). Emery noted that the level of carrying costs forms one determinant of future prices, along with expectations of price change, themselves dependent on expectations of future supplies and demand. In this way Emery put forward a doctrine of the social usefulness of commodity exchanges to end users, such as farmers and manufacturers, by virtue of the possible unburdening from these economic actors to traders of the risk of price fluctuations by the buying or selling futures contracts. Further, this explanation acquitted the commodity exchanges of the charge (frequently leveled in the nineteenth century) that they fostered antisocial speculation. Emery’s view was given wide exposure in the works of Irving Fisher and Alfred Marshall, among many others.

The further development of the carrying cost concept was mostly due to the work of the English economist John Maynard Keynes. Keynes first suggested in his A Tract on Monetary Reform (1923) that a theory of the (then new) organized forward markets in different international currencies could be based on the short-term interest rates available to holders of currency in different money markets. This notion was to become carrying cost more generally in his later work, and his discussion centered on its role in the currency trade (in which he himself was actively engaged).

Keynes laid out a theory according to which such trading would be driven to a configuration of spot and future prices such as to ensure the traders could both pay the inevitable carrying cost of taking a long position and also make a (typically small) competitive profit. The premium or discount at which the future price stands in relation to the spot price is thus a barometer of expectations about the course of the price in the future. In normal times, under the expectation of steady or growing output the future price will be above the spot, and the traders can earn their “turn” and still pay their carrying costs (in currency in interest) out of this difference. In the parlance of his A Treatise on Money (1930), this is known as a “backwardation.” In abnormal times, though, when there is a sudden onset of a “bear” position on any currency (as in the expectation of a recession or of political upheaval), it might be that the spot price prices are forced to fall below both the quoted and expected future price in order to induce traders to hold stocks of the good in question for the period of the contract. Such a “contango” on futures markets was evidence of the need to continue to pay mounting carrying costs (in the special case of easily stored and infinitely lived money, purely an interest charge) into an uncertain period of decline expected in its value.

In A Treatise on Money this theory of carrying costs and the economic role of futures trading was expanded to commodity markets (which Keynes also actively speculated in) and the term and concept was explicitly introduced. There it also played a part in a more systemic view of economic cycles. The main point made (in argument with Ralph G. Hawtrey) is that one should not look to futures trading to alleviate the severity and duration of downturns, because carrying costs severely limit the degree to which such markets may profitably carry over redundant stocks of liquid capital goods during the downturn. In consequence those stocks cannot be expected to be available to provide the working capital, and so ease the transition to, the next upturn (as Hawtrey had argued). In pursuing this line of reasoning, Keynes also suggested that the concept was of wider import, as even “less organized markets” (p. 128) were subject to carrying costs, but not in so formal and obvious a manner. This is the hint that was to be expanded into of full-blown theory of unemployment in his next book.

In The General Theory of Money, Interest and Employment (1936) Keynes suggested, particularly in chapter 17, that this theory of the forward market could be generalized to the whole economy, and, significantly, that it contained the clue to the answer of why economies might get “stuck” in unemployment equilibria (such as was then happening in Europe and North America). His generalization started from the notion that all outputs have carrying costs (often so high as to make their carrying over of them in inventory all but impossible). These costs formed a third element alongside the essential liquidity and productivity that all goods might possess in some degree. But some goods, considered as an asset, had the peculiar and socially defined quality of having the highest liquidity in excess of their carrying costs among all outlets for storing saved income. Such “money” goods would be sought, for their superior ability to maintain their value through time. This quality, Keynes argued, was of particular importance in periods of economic downturns, since it provided harbors of safety for owners of wealth, who might therefore be reluctant to engage in alternative investments such as purchasing and using employment-generating “productive” assets. The lack of any social mechanism to discourage this individually rational, but perhaps socially dysfunctional, “flight to money,” could explain the phenomena of high and persistent unemployment such as characterized the advanced capitalistic economies of the world in the 1930s and still often threatens them in the early twenty-first century.