HERE is a story that explains our economic dilemma.

Two hundred years ago, ships would get wrecked on the submerged rocks surrounding 'Coconut Island'.

The first time it happened, 10 sailors made it safely to shore. They found a small but beautiful island with 10 large coconut trees.

It wasn't all paradise since the island was surrounded by sharks. There was also just one thing to eat - coconuts - but it kept them alive.

By luck (good luck?), one of the surviving crew was an economist. He relaxed in the shade of a coconut tree and advised the other sailors on how to work.

When they ran out of food, he suggested picking more coconuts. Sure enough, it increased the food supply.

As the years passed, more and more ships got wrecked on the rocks. The island's population grew to 100 and then 200 sailors.

With only 10 coconut trees, food became scarce. Everyone was getting hungry. What to do?

Happy ending #1: The economist changed his advice to: 'Forget coconuts. Instead, imagine lots of delicious food. Now, let's eat!'

With their active imagination, developed through years of lonely living, the sailors were able to survive on imaginary food and lived happily ever after.

End of story.

Sad ending #2: The economist advised: 'Use sea shells as money to buy and sell coconuts with one another. Trade first, then eat!'

It seemed to work. Lots of coconuts and sea shells changed hands and it diverted attention from their hunger.

But in a few months, the sailors realised they were still hungry. A few tried swimming to a nearby island but were eaten by sharks.

The others continued trading. The five smartest ended up with all the sea shells AND the coconuts. The other sailors became beach bums, which was fun for a while but they eventually starved. End of story.

The lesson: The world is rapidly running out of coconuts. It is a problem with no solution.

Are we seeing a bubble or crisis?

1) IT'S A BUBBLE: Michael Masters runs a hedge fund. On 20 May, he testified before the US Senate and said speculators are causing high oil prices. I read his testimony and it's convincing.

US Central Bank chairman Ben Bernanke went one step further. Two weeks ago, he told the graduating class at Harvard that the economy's problems are not as bad as the stagflation of the 1970s.

Back in 1973, Arab nations got angry with the US and stopped selling it oil. Prices shot up, causing both inflation and recession.

Economists called it 'stagflation' and, even today, it is the most dreaded economic condition since no one knows how to fix it.

The good news: Most economists believe stagflation is unlikely.

2) IT'S A CRISIS: Commodity prices have shot up a record 50 per cent in the past 12 months. Who is to blame? Is it speculators?

Probably not. Most speculators buy derivative contracts, a type of gambling.

It doesn't affect how much is actually consumed. That is what determines prices and consumption is up sharply in booming economies like China, India and the Middle East.

Take oil. The world produces 85 million barrels per day and uses exactly thatamount.

But when Ren Xi in China buys his first motorcycle, he nudges demand slightly above 85 million barrels.

Since no more oil is available, someone must consume less. To make that happen, prices rise.

Ren Xi and billions of other consumers - not speculators - are pushing oil prices higher.

Here is the proof: There has never been a speculative price bubble that didn't burst. This one will too IF it is a bubble. Then, you will see oil prices quickly fall to below US$100 per barrel.

If the demand is real, however, it will continue pushing up the price of food, energy and minerals. It will lead to perpetual shortages and stagflation, making each future generation poorer than the last.

Watch and wait.

This article was first published in The New Paper on Jun 16.

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