It's an index of prices, not volume

This is one of those little economic stories that does the rounds from time to time. Zero Hedge is famous for getting the implications of changes in the Baltic Dry Index wrong for example. What gets missed being that the index is a measure of the price of shipping, not the volume of it. Prices being dependent, of course, upon supply and demand. The supply and demand intersection for shipping being different than the volume of shipping going on.

Thus a fall in the Baltic Dry does not mean that world trade is drying (sorry) up, nor does a rise in it mean it is booming. At least, not necessarily. More examination needs to be done to work out what is happening.

This thus ain’t right:

Baltic Dry Index recovery eases global economy concerns

No, at least not necessarily.

The Baltic Dry Index has surged 45pc in just three weeks, easing fears that the world economy has slammed on the brakes.

It could just mean that a few more ships have been scrapped. Or fewer launched.

The Baltic Dry Index is a trade indicator that measures shipping costs for commodities, tracking global trade and indicating the future direction of economic growth. It is seen as a global growth bellwether.

People using it that way are using it the wrong way.

As background, the volume of such shipping – dry is referring to dry bulk cargoes, wheat, grains, cement, that is, not container stuff and not oils – is an important indicator of global growth. Trade tends to, tends to note, increase faster than growth itself. If the volume of trade falls off a cliff then we would indeed think that there’s going to be a kablooie in our global GDP figures.

The Baltic Dry is an index of the prices of shipping these cargoes. It’s thus the interaction of the supply of shipping as against the demand for it. That’s rather more than subtly different to the volume of world trade.

The basic background here is that there are reasonably long lead times to get more shipping afloat. And once it is afloat then it tends to stick around for a decade or two. Building the boat is a sunk cost (sorry) so you keep trying to use it as long as income from doing so is above marginal costs, of maintenance and fuel (and maintenance will be skipped in some circumstances) and bugger the mortgage. The supply of shipping is near entirely inelastic on an annual basis, near entirely elastic on a two decade basis.

Demand for shipping is much more elastic in that shorter term. As is usual when we’ve an inelastic supply meeting an elastic demand in a marketplace we get wild price swings. They being what causes that longer term elasticity – as with, say, oil from conventional reservoirs.

The Baltic Dry can drop because more ships are being launched, it can rise because more are scrapped. Not because – note the can here – the volume of trade has changed at all.

What has actually been happening in shipping in general is that the ship owners all looked at how trade was growing before 2008. So, they thought, aha! 5% volume growth! (Numbers here are made up but indicative of the major points) Let’s order more spanking new ships! Which then start arriving in 2010, 2011. Flooding the market with new supply. And shipping volume didn’t grow at 5%. It grew at 2% instead. (Again, these numbers are made up, reflecting memory and thus not accurate, but the relationships between them are about right) So, prices plunge.

But it’s those prices which plunge, not the volume of world trade.

Equally, Baltic prices could rise because someone goes bust pulling ships off the market. Or even fall because someone goes bust and the bank puts the ships out to work at bargain rates just to get something back.

Or, indeed, shipping volumes could rise and meet that inelastic supply and thus prices rise.

As with any other economic statistic we cannot extract the information unless we understand exactly what is being measured and how. The Baltic Dry Index measures the price of a certain kind of shipping. It’s thus influenced by supply as well as demand – something we’ve got to understand.