Programming Note: Testing out something new in Cap Gains—it's fun to write general explainers, but there are also some incidents from financial history that fit into the same model, where they're not particularly timely but are worth knowing about. Please let us know if you'd like to see more of this or less of it in the future.

Milton Friedman once observed that a communist can live a pretty communist lifestyle in a capitalist country: a group of them can get together and buy some housing that they distribute in an egalitarian way, put together a nonprofit co-op for groceries, use capitalist ink and paper to publish a communist magazine, etc. And that it's hard to imagine a similar enclave of capitalism inside a communist society.

Like many points made by clever ideologues, it's entertaining, illuminating, and directionally but not completely true. Some people were born to be commissars, and they have a hard time in multi-party democracies, but eventually find a decent spot. Natural-born central planners just end up with well-paid jobs optimizing supply chains. People who would have been revolutionaries if they'd been born in 1880s Lithuania become SaaS founders if they were born in 1980s California, etc. But every system does this. The USSR had a place for people who belonged in hedge funds, and that place was managing the USSR's own commodities trading.

You can usually think of commodities trading as two related businesses. One of them is trading claims on abstract commodities (oil futures, SLV, etc.). The other is transacting in the physical products these abstractions represent: arranging for X amount of a particular grade of oil to be loaded onto a ship and then offloaded somewhere else. These are obviously closely-related businesses; many grades of crude oil are priced in reference to the benchmark futures contracts, and of course those contracts eventually settle and there's money to be made in figuring out which particular storage tanks will be filled when, etc.

And there's a third form of vertical integration, where a commodity trader is also responsible for building and infrastructure, protecting it, and enforcing deals. Internally, the USSR was a communist state. But when it dealt with the capitalist world, it wasn't working with people who were trying to achieve the greatest good for the greatest number, but with people who wanted to buy and sell goods and services; just as anarchists like to point out that the relationship between countries is anarchism, and mostly works, capitalists get to note that communist countries plug into a capitalist system unless they're completely autarkic.

Two incidents illustrate this fully-vertically-integrated commodities trading with Soviet characteristics. The first is a bit ambiguous, but it seems like, strictly speaking and with a great deal of questionable account, the Soviet Union basically stole Spain's gold reserves. That's not quite accurate, but it's more accurate than anything else you could realistically say: early in the war, the army went one way and the remnants of the government went another, which meant that one side of the war had the government's financial resources (including what was then the fourth largest gold reserves in the world) and the other had weapons. A natural way to restore equilibrium was to exchange this money for military equipment, and the USSR was happy to oblige. Republican Spain could have shipped gold in increments to settle individual transactions, but an easier approach was to ship a large volume of gold to Moscow for safekeeping, and to periodically move it to different positions in the same vault to settle payments.¹ At some point in this process, there was a prepayment with no counterparty. At which point Russia had two choices: either they could return the gold to Spain, i.e. provide funding for Franco, or they could treat the remaining proceeds as a donation to the global workers' revolution. They made the profit-maximizing decision to just keep the gold, and to this day Russia's gold reserves are the fifth largest globally. At some point, all financial engineering and complex contractual stipulations collapse down to the question of who is in physical possession of the asset in question, and what means they have to defend it. So a country with Spanish gold and the Red Army got to keep both.

Decades later, Russia was involved in an incident with a differently piratical flair, less Blackbeard and more Jay Gould. The basic situation in the early 70s was that the USSR was the swing producer in wheat, but not by choice. If they had a good harvest, there was a wheat glut and they didn't get much for their output, and if production declined, wheat prices were high and they weren't selling any. But they had an advantage in comparison to Cargill and the like: they weren't a private business subject to the usual constraints, but also that they were a trading business attached to a (very effective) intelligence operation and a (big) army.

So, in July and August of 1972, the USSR bought about 28% of US wheat output, or 3.6% of global output—it's a decentralized market, because most of the places with the agglomeration effects necessary to buy lots of food are in fairly close proximity to the places where food was easy to grow. They agreed to pay about $1.64/bushel, and by the time they were actually getting deliveries, wheat was over $3/bushel.

This was pretty clever! Russia had an information advantage about the supply of wheat (they grew a lot of it), and they knew that their counterparty expected them to be dumb. So they locked in some cheap supply, and turned a local famine into a windfall (and a more general global food shortage—but it's easier for everyone to cut 100 calories a day than for a handful of people to cut 1,000).

One of the questions every investor has to ask is: why hasn't someone else taken this opportunity. "Nobody noticed" is often true, but also a dangerous null hypothesis. In the USSR's case, one good reason not to corner the market in grain was that it would be a PR black eye, to say the least. But the Soviets didn't have to worry about that much: internationally, it was just another Cold War headline, and domestically it was either a nonissue because bread prices didn't change, or a chance for them to brag that they'd outsmarted the plutocrats.

All this is a good reminder that supply chains are real, physical things. It almost never matters where someone stores whatever physical thing your financial assets reference, though that's occasionally the only thing that matters. And some of the time, traders who find a good opportunity for profit will back down, not because of some implementation problem, but because they worry about public backlash. But even at that level of abstraction, markets tend to be efficient: you'll either have rogue states or roguish, stateless traders like Marc Rich who make the market clear.

We've covered commodity trading, geopolitical hardball, and gold many times in The Diff, including:

• What's gold for?

• When should you short gold ($)?

• Why do commodity trading firms exist ($)?

• We also profiled LNG exporter Cheniere ($).

Join the discussion!

1  This general setup persists to this day, with various countries' gold reserves stored in the vaults of whichever central bank is most likely to intermediate transactions.