Iron ore consolidation produces an iron grip.

Iron ore prices have recently been in the headlines, having jumped by 85 percent. This news is troubling, as such price increases threaten to raise steel prices, which will add to cost inflation and further undermine economic activity.

Behind these price increases lies the unusual structure of the iron ore market, which is best characterized as a bi-lateral oligopoly.

The structure makes enormously troubling the Bush administration's decision to give regulatory clearance to a combination of the second- and third-largest ore producers: Rio Tinto and BHP Billiton. Unlike other commodity markets, iron ore prices are set through annual negotiations between the ore producers (Big Iron) and the ore users (Big Steel). Recent contractual negotiations have resulted in huge price increases that reflect the ore market's structure.

On one side is Big Steel, consisting of an increasingly few large steel producers. On the other side is Big Iron, made up of an even fewer number of ore producers. Thus, the top three ore producers--Vale do Rio Doce, Rio Tinto, and BHP Billiton--account for 75 percent of total global production. Moreover, the oligopolistic power of the producers is reinforced by geography. Vale do Rio Doce is Brazilian and located in the western hemisphere, while Rio Tinto's and BHP Billiton's operations are in Australia. That creates a geographic split that helps Big Iron's profits.

In recent years, steel production has been marked by significant mergers and right-sizing of capacity, combined with growth of state-directed steel capacity in China. The result has been a huge boom in steel profits that is reflected in steel company stock prices.

For instance, consider U.S. Steel that traded at $12 a share five years ago. In June 2008 it peaked at $196 dollars a share.

Big Steel's earnings rolled in first, being at the end of the production chain. Now, Big Iron is trying to muscle in on the action and grab a share of those profits for itself. It is able to do so because of its bargaining power, and it would be no surprise if there also were some informal collusion among ore producers given their small world.

With limited alternatives, Steel has been forced to cough up some of its oligopoly profits, turning them into Iron's mining rents. That is a bad switch. Higher earnings in iron ore mining will have negligible impact on their economic plans as the industry was already earning large excessive profits. However, higher ore prices will raise steel prices, undermining manufacturing and causing inflation. Meanwhile, lower steel profits will reduce steel investment.

Lastly, speculation may also have contributed to the jump in ore prices, albeit not the speculation associated with other commodity markets in which speculative trading is rampant. Since iron ore is not traded on global commodity markets, financial speculators cannot be responsible for higher prices.

Instead, iron ore speculation is best characterized as "joint speculation" by the ore producers and users about the continuation of steel profits and the ability of steel companies to pass on higher costs. In this light, the jump in ore contract prices can be viewed as a combination of profit capture by the ore producers plus a big bet on future macroeconomic conditions.

Such user-producer speculation is hard to argue against, but one can argue against an oligopolistic market structure that amplifies speculation's destructive effects. That makes the Bush administration's decision to approve a Rio Tinto-BHP Billiton combination another terrible public policy decision. The approval of the combination reveals the worst proclivities of the Bush administration, which is peppered with extractive industry boosters, particularly oil. The quest for combination shows that the much maligned Karl Marx was right about capital's proclivity to combine.

-- Dr. Thomas Palley is an economist living in Washington D.C. He holds a B.A. degree from Oxford University, and a M.A. degree in International Relations and Ph.D. in Economics, both from Yale University. Palley, who has recently started a project, Economics for Democratic & Open Societies, was formerly chief economist with the U.S.-China Economic and Security Review Commission: www.thomaspalley.com.