In early 2009, Paul Krugman gave a series of lectures at the London School of Economics on the global economic crisis in which he warned about the danger of a ‘perfect storm’ hitting the economy. The scenario he sketched was that of a fragile recovery in 2010-11 being hit by an inflationary spike, leading to knee-jerk rise in interest rates and a recessionary relapse. Krugman treated this as further proof that the world has become too beholden to financial markets.

Last week, it suddenly looked as though Krugman’s worst fears were about to come true. Driven mainly by higher energy prices, annualised Consumer Price Index (CPI) inflation for April hit 3.7%, the highest for 17 months—nearly twice the target figure set by the Bank of England (BoE); April inflation measured by the Retail Price Index (RPI) was even higher. Despite barely perceptible growth of the UK economy in the first quarter, many City pundits forecast that the BoE would be forced to tighten monetary policy.¹ And of course, because higher energy prices are world-wide, a spike in the Eurozone might force the ECB to take similar action making a double dip recession in the EU a near certainty.

The price of petrol will not have escaped the attention of the man-in-the-forecourt. He knows that despite the recession and the lapse in world demand, petrol prices are higher than ever. Why? One reason in Britain could be Sterling’s weakness and the rising price of oil imports. But that can’t be the full answer since energy prices are rising everywhere.

According to a new study, the main reason is speculation: flows of hot money are swamping commodity markets and Exchange Traded Commodities (ETCs) have grown enormously. Traders are betting that energy prices will rise, and such is the herd instinct that the prophecy becomes self-fulfilling. In the case of oil, exchange-traded futures have gone from being twice the size of the market in 1995 to 12 times its size today. One of the analysts at Absolute Return Partners, a London based hedge fund, has found a near-perfect fit between the growth in these funds and the price of US benchmark crude oil. Starting in January 2007, the two sets of figures rise together until the peak in May 2008, then fall until the trough in January 2009, then rise again until the present.

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Of course one can take issue with any statistical study, but the evidence in this case looks pretty solid. The basic lesson is that speculative activity is greatly amplifying the magnitude of the underlying fluctuations in the price of oil (and other commodities). Since oil lubricates the world economy, the larger fluctuations in oil prices mean bigger booms and busts, and higher oil prices – as we know from the 1970s – lead directly to economic tightening, stagnating incomes and unemployment.

In Hilton’s words:

It is not impossible to imagine a world in which speculators create inflation by pushing up the oil price and then, en masse, short the bonds of those countries whose inflation-fighting credentials they doubt.

I urge the reader to think about that for a moment. What does it have to do with the opening paragraph of this piece? Krugman in his book, The Conscience of a Liberal, argues that when the IMF urged Asian countries to balance the books during the 1997 financial crisis, they did so not because they believed it was the right medicine. The IMF forced its drastic medicine upon Thailand, Korea and Indonesia because it was what the international financial markets demanded.

Now fast forward to today’s financial crisis. World financial markets have an annual turnover of nearly one quadrillion dollars – one thousand trillion dollars, or about 20 times the size of world GDP. That’s a lot of clout – certainly enough to bet against Eurobonds and dictate that Greece or the other Club-Med countries should undergo serious economic surgery. That’s enough to speculate against Sterling in case Britain’s cuts are not timely and drastic enough. That’s enough to ensure that the cost of the financial crisis is borne not by the banks and hedge funds, but by you and me.