Peak Watch

Let It Burn

Monkeys spend all their time picking bottoms, OK? And I refuse to pick bottoms because I don't live in trees
   —Hugh Hendry taking questions on CNBC, April 28, 2009

A fish doesn't know about the water it swims around in
   —variation on a old saying

I have talked about the FIRE economy (Finance, Insurance and Real Estate) on several occasions in this column (Harpers, February 2008). iTulip's Eric Janszen invented this apt metaphor. Today I will explain why such an economy is an aberration which must be dismantled if the United States is to have any chance of a sound recovery.

Last week I presented the Goldman Sachs/High Speed Rail scorecard, which showed that the capital funneled through AIG to its bank counter-parties far exceeds the capital that will be devoted to studying (not building) new high-speed rail systems.

I want those trains because I like trains and they would reduce our oil consumption. If we are to prevent such travesties in the future and build some actual trains, we need to understand the predicament we are in and why we need to extricate ourselves from this mess as quickly as possible. So this article is really about answering the question when am I going to get my trains?

I also want to squash this "glimmers of hope" notion making the rounds. Here is The Economist talking about hope and the dangers of optimism.

The rays are diffuse, but the specks of light are unmistakable. Share prices are up sharply. Even after slipping early this week, two-thirds of the 42 stock markets that The Economist tracks have risen in the past six weeks by more than 20%...

But, welcome as it is, optimism contains two traps, one obvious, the other more subtle. The obvious trap is that confidence proves misplaced—that the glimmers of hope are misinterpreted as the beginnings of a strong recovery when all they really show is that the rate of decline is slowing. The subtler trap, particularly for politicians, is that confidence and better news create ruinous complacency. Optimism is one thing, but hubris that the world economy is returning to normal could hinder recovery and block policies to protect against a further plunge into the depths.

Regarding the United States, even cautious talk of an economy returning to normal, let alone beginning a strong recovery, is utter nonsense. A return to previous "normal" conditions would recreate the same disaster that got us into this mess in the first place. Anticipating the BEA's preliminary GDP number for 2008:Q1, Marketplace raised the possibility of another jobless recovery like the one in the early 1990's or earlier this decade in 2002-2003.

Anemic but positive GDP growth could come in the third or fourth quarters, but most economists don't expect the unemployment rate to peak until sometime next year as the economy struggles with another "jobless recovery"...

[Note: Jobs are now said to be a "lagging indicator", meaning that the last thing that happens in a "recovery" is jobs creation. The U.S. will likely hemorrhage jobs throughout 2010. ]

The best aspect of the GDP report is likely to be consumer spending, which is expected to increase slowly after plummeting at a 4% annual rate for six months. Consumers got a huge boost in their after-tax incomes during the quarter amounting to about $200 billion from large tax refunds and cost-of-living adjustments, according to economists at Barclays Capital.

Heavy job losses are also weighing heavily on consumers, who are trying to pare their expenses, pay down their debts and build up their savings. Small increases in spending are the best we can hope for this year, economists say.

[Note: The BEA's advance estimate of 2008:Q1 real GDP is now in. Output "shrank at an inflation-adjusted 6.1% annual rate in the first quarter" according to the Wall Street Journal's Hopeful Signs Seen In GDP's Fall (April 29, 2009). The "hopeful signs" include a drawing down of inventories and a very slight (2.2%) rise in consumer spending compared to the 4.3% decrease in 2008:Q4. Tell the bank you want to make your mortgage payment with "hope."]

Do I really have to say that another "jobless recovery" is not a recovery? I guess I do. Ridiculing such ideas still doesn't get to the heart of the matter. No return to a sound economy occurred, jobless or not, after our well-deserved recession following the crash of the Dot-Con Bubble. There was merely a postponement of something approximating current economic conditions accomplished by means of the Housing Bubble, which has been far more destructive to wealth than monies lost from investing in dogfood.com. Janszen described it this way—

Nowadays we barely pause between such bouts of [bubble] insanity. The dot-com crash of the early 2000s should have been followed by decades of soul-searching; instead, even before the old bubble had fully deflated, a new mania began to take hold on the foundation of our long-standing American faith that the wide expansion of home ownership can produce social harmony and national economic well-being...

Only in an economy dominated by finance and real estate would signs like the recent stock market "rally" or 1st quarter bank "profits" be regarded as pointing to eventual "recovery" while ordinary Americans remain down for the count. And it will take many years for them to get off the floor. A $200 billion bribe in the form of "tax refunds and cost-of-living adjustments" does not even begin to address the huge debt and wage problems in the United States.

A FIRE economy creates, promotes and requires ever-growing debt to achieve "growth." Banks make money on transaction fees and interest on loans. Insurance companies take large, growing monthly payments, especially for soaring health care costs. Lots of self-interested parties get a healthy cut whenever a house changes hands and a new mortgage is underwritten. College tuition is also rising at over twice the inflation rate.

It's all about debt. I give you Exhibits A and B.

Figure 1 — Total U.S. debt as a percentage of GDP. The orange circles show specific data points. The graph is from John Mauldin's The Great Experiment. Debt levels in 1933 (at the height of the Great Depression) were surpassed in 2003.

Figure 2 — X marks the spot. The lines crossed in 1995. As savings declined in the period 1982-2007, household debt soared. Source.

The technocrat in charge of managing the "recovery" is Lawrence "Larry" Summers, who led efforts to oppose regulation of credit derivatives in the finance industry in the late 1990's. Summers outlined the administration's goals in a recent speech.

... and therefore the essence of the economic policy challenge is at the specific level to counteract the vicious [deflationary] cycles and turn them into virtuous circles. And at the broadest level to replace a spiral of growing fear with a more positive spiral of increasing confidence. If at the broadest level level the problem two years ago was that there was too much greed and opportunity seeking and too little fear, the problem today is that there is too much fear and too little seeking of opportunity. and so it is the very paradox of crisis, and especially of crises associated with de-leveraging, that the very behaviors that one most wanted to discourage to prevent the bubbles that led to to the crisis are the very behaviors — spending, borrowing, investing — that one needs to promote an expansion. It is this insight, this view, that in essence undergirds the policy program that has been undertaken in the United States, and while no doubt it would be expressed in different ways ... it is the need to stop vicious cycles associated with de-leveraging that is essential to a policy response to a crisis like this...

[Note: Virtuous circles? Of what? More debt? Also read Simon Johnson's commentary on the speech.]

It is remarkable, but not unexpected, that Summers can not understand or accept that Americans are now considerably over-leveraged as it is and are now sensibly trying to spend less, save more, and pay down their debt, a situation which promotes a deflationary trend that was reflected in the March, 2009 numbers. Apparently Summers (and by extension Obama) want Americans whose jobs are under threat to buy more stuff they don't need or can't afford by instilling in them some unwarranted confidence. This position—buy more stuff or we're all gonna' die—has been called the paradox of thrift.

How did we into a situation in which what is good for Americans (saving and paying down debt) is not deemed good for the American economy? How did it come to pass that the term "jobless recovery" entered the techno-jargon of our economic experts?

Let's talk about real wages over the last 30 years, the role of the FIRE economy and the steady erosion of the Middle Class. 

The FIRE Economy Rides to the Rescue

Eric Janszen describes how the FIRE economy works in his Harpers' article The Next Bubble, so I will not review that material other than to note that the principle goal of such an economy is to blow and profit from asset bubbles.

FIRE is a credit-financed, asset-price-inflation machine organized around one tenet: that the value of one’s assets, which used to fluctuate in response to the business cycle and the financial markets, now goes in only one direction, up, with no more than occasional short-term reversals.

I want to tell the same story from the point of view of American workers. A simple, compelling narrative emerges from the next two graphs.

Figure 3 — Household net worth as a percent of GDP. Cited in my article The Kiss of Death and taken originally from Calculated Risk.

Figure 4 — Average weekly earnings since 1970 in 1982 dollars. From the BLS.

You can see that 1) the net worth of households regained its historical level of about 350% of GDP in the mid-90's but then soared twice during the bubble & crash cycle; and 2) average weekly earnings fell precipitously in the late 1970's/early 1980's and has floated around its 1982 level since the late-90's.

I hesitate—no, actually I am delighted!—to quote Rick Wolff, a Marxist professor of economics at UMass Amherst, to tell us what happened.

Real wages in the US rose during every decade from 1830 to 1970... No comparable steady rise in real wages has occurred since...

Stagnant or falling real wages undermine workers' basic expectations of rising levels of consumption. Those expectations had become key parts of what it meant to be "an American." Rising consumption has long functioned as the evidence of success in achieving the American Dream. When, after the mid-1970s, real wages no longer allowed for rising consumption, wage-earners turned, with growing urgency, toward other ways and means to maintain rising consumption...

In one "solution" to counteract the problem of shrinking real wages, many families sent more members out to work more hours...  A second "solution" -- when longer work hours did not generate enough money to increase consumption -- was to borrow. Multiple credit cards per family and increasing mortgages added to vehicle financing to generate historically unprecedented levels of total consumer debt across the last 25 years -- and especially since 2000.

One need not be a fan of Das Kapital to understand these simple truths. In fact, all you need to be is an American worker of sufficient age to have lived through it all. I am not so much interested today in the many malignant causes of stagnant wages over a 25 year period as I am in relating this hardship to how Wall Street prospers when Main Street does not.

The allure of easy wealth glitters very brightly if your wages have not kept up with inflation for over two decades while two principal wage earners struggle to support the household where once—a long time ago in a galaxy far, far away—one would do. The bubbly asset inflation created by the FIRE economy (as reflected in Figure 3) gave Americans the illusion of increased wealth, which spurred unsustainable levels of consumption in the period 1995-present.

It is perfectly understandable why cash-strapped Americans, given the escalating value of residential properties, speculated in real estate, bought houses they could ill afford—and received the mortgage interest tax deduction in doing so—took on second mortgages or withdrew money from equity as you would draw on your checking account at an ATM machine.

FIRE interests also did their part for penurious wage earners still hoping to live the American Dream by extending easy credit in the form of credit cards, student loans, "liar loan" 1st mortgages, 2nd mortgages, home equity loans—you name it. Add to these the pointless loans for already over-built commercial real estate development. You can see where credit goes in Figure 5.

Figure 5 — FIRING UP the economy. From Calculated Risk's early report on government stress testing for banks. Note the relative size of residential mortgage + home equity + commercial real estate + credit cards (taken together) as opposed to commercial/industrial loans. The numbers cited are for potential losses, but the absolute sizes can be calculated by using the loss numbers and the percentages.

You can easily see in absolute terms that the lion's share of loans are forms of consumer credit (or financing for commercial real estate) as opposed to "productive works" that might support new manufacturing, urban re-development & mass transit, smart grids, wind farms or even those new high-speed rail systems that the Department of Transportation will think really hard about.

The FIRE economy "rode to the rescue" of poorly compensated American workers by filling up the 25-year income gap with easy credit and after 1995, inflated asset values in stocks and housing. Such an economy is parasitic in the sense that it fuels and feeds off of much greater borrowing & spending than would be warranted by traditional—antiquated?—measures like real wages, debt and savings. It did not matter whether Americans were credit-worthy—FIRE doesn't care. But in the end, it always matters.

I'll sum up with an example of the FIRE in action. As usual, the Federal Government is conniving in the farce. The newspaper blog Opinion LA is all over it.

The original Making Home Affordable program, which the Treasury Department announced earlier this year, enabled more troubled borrowers to refinance their Freddie Mac- or Fannie Mae-backed mortgages. It also provided subsidies to encourage lenders, loan servicing companies and borrowers to agree to temporary loan modifications that reduced monthly payments to 31% of the borrower's income. But the program didn't do anything about second mortgages, nor did it address many troubled borrowers with loans that were deeply underwater (that is, their homes were worth 95% or less of the amount they owed).

[Note: This last condition is called negative equity.]

One of the new features announced today would enable borrowers with second mortgages -- a situation that describes about 50% of those in danger of foreclosure -- to get a temporary cut in interest rates on both their loans... This initiative addresses two problems with the loan modification program: the need to pay off a second loan made it impossible for some borrowers to afford their homes, even with a steep reduction in the primary mortgage, and the refusal by some lenders holding onto first mortgages to accept lower monthly payments as long as the second mortgage holder kept collecting the full amount.

Wait, there's more. Bloomberg reports that—

Fannie Mae and Freddie Mac mortgage delinquencies among the most creditworthy homeowners rose 50 percent in a month as borrowers said drops in income or too much debt caused them to fall behind, according to data from federal regulators.

The number of so-called prime borrowers at least 60 days behind on mortgages owned or guaranteed by the companies rose to 743,686 in January, from 497,131 in December, and is almost double the total for October, the Federal Housing Finance Agency said in a report to Congress today.

Of all borrowers who ended up in default, 34 percent told Fannie and Freddie they were earning less money, about 20 percent cited excessive debt as a reason for missing mortgage payments, and 8.1 percent blamed unemployment, FHFA said.

Here are some details on subsidies for lenders from the Washington Post's Foreclosure Prevention Plan Expanded to 2nd Mortgages—

Under the new plan, lenders would receive $500 for modifying the second mortgage [or home equity line], plus $250 a year for three years if the loan remains current. The borrower would be eligible for $250 a year for five years to lower their principal balance. The borrower could have the interest rate lowered to 1 percent, depending on the type of loan, with the government sharing the cost of the rate reduction.

Bribe lenders to refinance second mortgages? People are underwater, they're drowning. There's a pretty serious underlying issue here that Larry Summers won't acknowledge. Larry, do you think there might be a catastrophic wage & debt problem in the United States? Ya' think?

Let It Burn

When will I see those high-speed rail lines? And the answer is: not for a long, long time. When assets deflate, debt remains. I discussed this in my article The Kiss of Death referenced in Figure 3. And there's no new bubble on the horizon to FIRE up.

In an interview back in September, Bill Moyers asked Kevin Phillips what he thought we should do about our predicament.

KEVIN PHILLIPS: ...So I think what we're looking at here is an attempt really like a drunk will feel better and get over his hangover better sometimes just by having more liquor. And I think what we're seeing with the actions of the Federal Reserve Board is the people who are the arsonists, the people who pumped it all up, who blew up the bubble are now racing to show up in firemen's hats and say, "We're gonna solve it. We're gonna take care of all this. Oh, and by the way, we're gonna keep pumping in the gasoline that we pumped in before that made a good flame." But, you know, nobody knows that.

BILL MOYERS: Are you suggesting that the best thing to do is let the house burn down and build it over again?

KEVIN PHILLIPS: I would say, first of all, you never should have blown the bubble this way. If we could invent a time machine and go back and cure it that would be the best economics of all. Having blown it up, I think the case is that they should have accepted more of the tough medicine beginning last year and not tried to rescue every stray tentacle of the financial octopus...

Janszen's FIRE metaphor brings so much to mind—a conflagration, something burning out of control, too much smoke (and mirrors). The politicians and the technocrats have the hoses out, and they're showering vast amounts of water (money) on the FIRE in a futile effort to put it out. This country needs good paying jobs in manufacturing again. So-called "consumers" should be encouraged to pay down debt and save. The Middle Class desperately needs a revival. Health care costs must be extended and brought under control. A college education must be affordable again. Accomplishing all of this will take at least a decade. As for the FIRE economy, I say Let It Burn.

Contact the author at [email protected]

Planes, Trains and Automobiles

You talk the talk. Do you walk the walk?
   — from Stanley Kubrick's Full Metal Jacket

Just as there are imaginary¹ "glimmers of hope" in our economy, recent announcements assure us that our dependency on petroleum in transportation is coming to a happy conclusion. I review some of that Good News today. I find that if wishing could make it so, our oil problems are solved. When our society systematically confuses its desire to do the right thing with actually doing the right thing, you know that the Glory Days of a once mighty Empire are gone forever.

In both economic and energy policy, the Obama administration clings to cherished beliefs that have little basis in reality. I hope to make this obvious in my discussion of energy today, but we also see it in their policies toward the banks. The mythology says that if only we inject enough public money into insolvent financial institutions, credit will start flowing again, "toxic" mortgage-backed credit derivative "investments" will recover their value, and we can all go back to where we were in early 2006 before the Housing Bubble collapsed. Even Bank of America's CEO Ken Lewis doesn't believe that.

Let me make a couple comments about our given environment. Credit is bad and we believe credit is going to get worse before it will eventually stabilize and improve. Whether that turn is later this year or in the first half of 2010, I'm not going to hazard a guess ... For the rest of the year we look for charge-offs to continue to trend upward. I think it will be at a slower pace than we've experienced.

Focusing on the deteriorating credit situation is only part of the story. The bigger, unresolved problems include America's enormous private debt and the threat of deflation accompanied by rising unemployment. If Paulson or Geithner had simply sent every American family a big check (thus forgiving some of the debt) instead of trying to salvage Citigroup and other banks in their current flawed form, our economy would probably be in better shape than it is now. I am quite sure that most American families would be better off.

Things are equally askew in an oil policy characterized mainly by wishful thinking and lack of funding.

Trains? — Or Bailing Out Goldman Sachs?

Criticizing the Obama administration's trains policy is like shooting fish in a barrel. Almost a week after Glimmers of Hope Day, President Obama talked about his plan for high-speed rail in America.

Our highways are clogged with traffic, costing us $80 billion a year in lost productivity and wasted fuel. Our airports are choked with increased loads ... we're at the mercy of fluctuating gas prices all too often, we pump too many greenhouse gases into the air. What we need then is a smart transportation system equal to the needs of the 21st century, a system that reduces travel times and increases mobility. A system that reduces congestion and boosts productivity. A system that reduces destructive emissions and creates jobs. What we're talking about is a vision for high-speed rail in America.

Obama is right—he is indeed talking about "a vision for high-speed rail in America." Unfortunately for us, a vision of a high-speed rail line is not the same as an actual high-speed rail line. What is the reality behind the rhetoric?

There is not much "new" news here. On top of the $8 billion already committed to upgrades to existing rail lines in the stimulus package, the President will ask for an additional $5 billion over the next five years to identify corridors where high-speed rail lines might be built (Figure 1).

Figure 1 — Possible high-speed rail corridors, named in black text (e.g. the KEYSTONE line in Pennsylvania would link Pittsburgh, my home town, with Philadelphia through Harrisburg, the state capital).

Let's get some the relevant details from IBM hops aboard high-speed rail, which was written a few weeks before High-Speed Rail Vision Day (CNET's Green Tech Blog, March 24, 2009).

IBM on Wednesday plans to announce details of three rail projects outside the U.S. that bring that vision of efficient and convenient rail travel closer to reality. Overall, the projects in China, Taiwan, and the Netherlands show how rail travel can reduce urban congestion and cut down on pollution from transportation, said IBM...

The Federal Railroad Administration is scheduled to publish a strategic plan for spending the $8 billion in the stimulus plan, which is expected to include a vision for high-speed rail corridors. Already, 1.3 billion has been set aside for Amtrak for intercity travel and $450 million to upgrade the safety of existing rail infrastructure.

However, transportation experts point out there are at least 11 proposed high-speed rail corridors in the U.S., each of which would cost billions of dollars to install. A project to build a fast train between northern and southern California alone would cost $45 billion.

If the President had said "we're going to emulate Europe and China, we're going to commit an initial $100 billion with more on the way after that to get these rail lines built," I would have been among the first to stand up and applaud. $100 billion amounts to 58% of the charitable donations the Central Bank and Treasury have made to insurance giant AIG's counter-parties so far.

IBM estimates that $300 billion will be spent worldwide over the next five years to build high-speed rail lines. The United States will spend 4.3% of this total to upgrade existing lines and think really hard about building new ones.

I give you the Goldman Sachs/High-Speed Rail scorecard.

	Goldman Sachs	High-Speed Rail
Committed or Spent	12.9	8
Still To Pay	7.1*	--
Potential Money	?	5*
Total	20*	13*

The scorecard reads Goldman Sachs 20, High-Speed Rail 13 (with uncertainty indicated by *)

Otherwise, the scorecard reads Goldman Sachs 12.9, High-Speed Rail 8.

Notes: All figures in billions of dollars. $12.9 was laundered through A.I.G. to Goldman Sachs to pay off credit default swaps at par. An additional $7.1 is probably still owed (and here). Goldman "has never confirmed that figure, but ... has said that its "net exposure to AIG - after collateral it received and hedging it did - was minimal." Perhaps I misunderstand what the word "minimal" means.

I used to think $20 billion or $13 billion was a lot of money, but I don't anymore. In No We Can't? I asked an important question—

What is the biggest impediment in 2009 to mitigating the harmful effects of energy problems in the 21st century? The answer may surprise you—it is insolvent zombie banks and our entrenched FIRE economy (Finance, Insurance, Real Estate).

Now you can easily see what I meant when I wrote that.

In Obama's televised sales pitch, the president referred to clogged highways and airports, lost productivity and greenhouse gases (twice). I suppose we should be grateful for his sole reference to "wasted fuel." There's no sense in his remarks that the United States (in particular) and the world (in general) has an oil depletion problem. Identifying high-speed rail lines we might build rather than actually building them does little to solve that problem, let alone address the other issues Obama cites.

Are we supposed to believe that we need high-speed rail because flying is a nuisance and there's too much traffic on the roads? How does high-speed long distance passenger rail alleviate rush hour traffic in metropolitan areas like Chicago or Los Angeles? It doesn't. The main advantage of long distance high-speed passenger trains is that they substitute for air travel, which lowers our consumption of middle distillates like kerosene-type jet fuels.

Before moving on I want to show you what you're not likely to get any time soon (Figure 2).

Figure 2 — A high-speed train that could service the Keystone corridor in my home state Pennsylvania but very likely won't in the next decade (or beyond).

That disposes of trains. That was way too easy. Let's move on to automobiles and gasoline, where the Department of Energy has adopted an Orwellian approach to fuel problems. Unlike the novel 1984 in which the totalitarian state alters the past, our new liberal leadership is rewriting the future.

Automobiles? — If you tap your ruby red shoes together 3 times...

A preacher commonly takes a chapter of the New Testament and bases his sermon on it. The minister explains the lesson we are supposed to draw from the text. One of our secular bibles in energy matters is the Energy Information Administration's 2009 Annual Energy Outlook (EIA AEO). The Wall Street Journal's sermon on the text is Oil Industry Braces for [a] Drop in [the] U.S. Thirst For Gasoline (April 13, 2009). What's the lesson we're supposed to learn?

Since Henry Ford began mass production of the Model T nearly a century ago, car-loving Americans have gulped ever-increasing volumes of gasoline. A growing number of industry players believe that era is over.

Among those who say U.S. consumption of gasoline has peaked are executives at the world's biggest publicly traded oil company, Exxon Mobil Corp., as well as many private analysts and government energy forecasters...

Exxon believes U.S. fuel demand to keep cars, SUVs and pickups moving will shrink 22% between now and 2030. "We are probably at or very near a peak in terms of light-duty gasoline demand," says Scott Nauman, Exxon's head of energy forecasting.

The lesson is that our gasoline consumption problem has been automagically solved! The Journal's report depends on an insincere expert at Exxon Mobil, which has grown tired of low or risky margins in the refining business, but mostly relies on the EIA to make its case. The experts assure us that gasoline consumption in the United States is past peak and just in case you're feeling a bit skeptical about that, here's the chart that proves it (Figure 3).

Figure 3 — "Refined Tastes" (left from the WSJ) is the winner of our newly inaugurated (but perhaps short-lived) Fantasy Graph of the Month award. The graph is based on the EIA's projection of biofuels production and future gasoline consumption (right).

The Energy Independence and Security Act of 2007 (EISA) specifies the Renewable Fuel Standard (RFS), which requires producers to come up with 36 billion gallons per year of biofuels by 2022. Contributions will be made by corn ethanol, cellulosic ethanol, biomass to liquids (gasification), biodiesel and imports according to the EIA's Figure 72. Imported gallons—from Brazil?—actually exceed the contribution from cellulosic ethanol in 2030, which ought to tell you where that technology stands. The contribution from corn is about the same in 2030 as it is now.

As with baseball's Corn Field of Dreams, we can ask if you mandate biofuels, will they come? But we might also ask do we really need these biofuels? This is where things get interesting.

In a new twist, the 2009 AEO turns former both-feet-on-the-ground realities on their head.

Progress toward meeting the RFS is complicated by slowing growth in U.S. petroleum use through 2030. The push for more fuel-efficient automobiles, which slows the increase in motor gasoline consumption in the reference case, also slows progress toward meeting the RFS, because more efficient gasoline engines and growing penetration of hybrids reduce the demand for ethanol in gasoline fuel blends. A 10-percent limit on ethanol in gasoline for most of the current fleet of passenger vehicles delays further market penetration until more E85-compatible vehicles are in use and the market infrastructure for E85 and other biofuels is expanded to accommodate the distribution and sale of growing volumes.

How could I have missed this? We will have trouble meeting the Renewable Fuels Standard because we'll be using so much less petroleum in the future? Previously, we needed biofuels because we would consume so much more petroleum without them that it would be nearly impossible to get that oil at reasonable prices. Previously, we might have had trouble meeting the Renewable Fuels Standard because corn ethanol is a bad idea and cellulosic ethanol is not ready for prime time.

Now the problem has become reduced future demand for ethanol due to "more efficient gasoline engines and growing penetration of hybrids." Do I detect the guiding hand of Obama's Energy Secretary Steven Chu in the EIA's bizarre but rosy assessment of our future liquid fuels consumption?

The EIA is telling a different story under Dr. Chu than the one they told under Bush's Energy Secretary Samuel Bodman. Here's a representative sample from the 2008 AEO. Contrast these selected passages with the one quoted above.

In the AEO2008 reference case, however, only 32.5 billion gallons of RFS credits are generated in 2022, because cellulosic biofuel production is not expected to increase rapidly enough to provide the credits that would be needed to meet the advanced biofuels requirement. If the available quantities of biofuels are inadequate to meet the initial targets, EISA2007 provides for both the application of waivers and modification of applicable credit volumes...

As a result of the EISA2007 RFS, the biofuel component of motor fuels in the transportation sector is projected to grow substantially, as the fossil fuel content of gasoline and diesel declines from 136 billion gallons (96 percent) in 2006 to 125 billion gallons (83 percent) in 2030 (Figure 89). The biofuel content of all gasoline and E85 consumed in the United States, which totaled about 5.6 billion gallons in 2006, increases to 25.8 billion gallons in 2030. In addition, a smaller increase in biofuel content is projected for diesel fuel, from 0.3 billion gallons in 2006 to 3.8 billion gallons in 2030.

[Whether you believe these numbers is beside the point right now.]

There's no inkling in 2008 that meeting biofuels production goals will be complicated by "slowing growth in U.S. petroleum use." The future sure looks different in Obamaland than the one I remember.

In the real world² nothing has changed on the ground—when did smaller cars and fuel efficiency (35 average mpg by 2020) become our National Religion? Where are the plug-in hybrids? Sales for gas electric (standard) hybrids have tanked in recent months and may remain low for years to come. Despite these weak measures, dearths and unfavorable indicators, our new Energy Secretary remains fanatical when it comes to efficiency as I discussed in Steven Chu's Energy Miscalculations.

Maybe I've been wrong all along—maybe just believing is enough. Maybe we don't have to actually use less oil now or ever. Maybe all we have to do is imagine we're using less oil.

I like Obama and Chu's simple approach. We don't have to build actual high-speed rail lines if we can't afford to because insolvent Wall Street banks need all our money to keep operating. If our gasoline consumption is going to be declining, maybe we can go slow on biofuels. All we have to do in this happy scenario is close our eyes, clap the heels of our ruby red shoes together three times and repeat to ourselves "there's no place like home, there's no place like home, there's no place like home..."

The Wall Street Journal does include two paragraphs giving a skeptical view of peak gasoline demand in the United States. Oil analyst Tom Kloza, a cold, hard realist who has been watching the oil markets for decades, had this to say—

Skeptics of the notion that gasoline demand has peaked point to a population that is likely to keep growing as Americans have children at roughly the same pace and the flow of immigrants increases. "Anyone who looks at population must think there is going to be some big bird flu if they think we've peaked," says Tom Kloza, chief analyst at Oil Price Information Service, a firm in Wall, N.J., that tracks prices and consumption.

Lower gasoline prices are back after a multiyear spike in prices. That could re-ignite consumers' desire for big, fuel-guzzling SUVs and tolerance of long commutes, especially when the economy strengthens. After the 1979 spike in crude-oil prices, U.S. gasoline consumption dropped for four years, but then rose again when fuel prices plummeted in the mid- to late-1980s.

You could be wrong, Mr. Kloza, about our need for a big Bird Flu epidemic. Maybe in Obamaland the population doesn't grow anymore. Anything is possible in a world like Star Trek where Picard simply says "Engage" or "Make it so." Resistance to Dr. Chu's efficiency dream is futile.

That disposes of automobiles, where government spinmeisters are still dreaming the impossible dream. Let's move on to airplanes.

Planes? — Microbes Save The Day (Again)...

I'm sure that Dr. Chu believes that oil from blue-green algae, once it has been properly synthesized in the lab, will be powering our transportation in the beautiful post-carbon world to come. But whereas our Energy Secretary says that 4th generation biofuels are still a research project, some intrepid entrepreneurs are trying to make that dream a reality today. How's it going?

Biofuels expert Robert Rapier called my attention to a real current price attached to producing oil from algae. At almost $33/gallon, it's not a bargain yet for the airline industry.

You can grow algae with carbon dioxide and sunlight, but that doesn't mean it's free...

Algae biofuel startup Solix, for instance, can produce biofuel from algae right now, but it costs about $32.81 a gallon, said Bryan Wilson, a co-founder of the company and a professor at Colorado State University. The production cost is high because of the energy required to circulate gases and other materials inside the photo bioreactors where the algae grow. It also takes energy to dry out the biomass, and Solix uses far less water than other companies (see Cutting the Cost of Making Algae by 90%).

By exploiting waste heat at adjacent utilities [like coal-fired plants] ... the price can probably be brought down to $5.50 a gallon (see Will Waste Heat Be Bigger Than Solar?). By selling the proteins and other byproducts from the algae for pet food, the price can be brought to $3.50 a gallon in the near term.

But that's still the equivalent of $150 a barrel of oil. "We were excited in July [when oil was approaching that level]," he joked. "But we knew it wasn't sustainable."

It's only in phase II of Solix's business plan that it will be able to drop production costs to $3.30 to $1.57 a gallon, or around $60 to $80 a barrel. Solix has set a goal of cutting the cost of making algae by 90 percent.

Phase II? $1.57 to $3.30 a gallon? I suppose it must be possible because it's in the business plan. And we're going to be getting some dog food out of the deal too!

Cleantech reports that Amyris Biotechnologies is "making progress" too.

Emeryville, Calif.-based Amyris Biotechnologies today opened its first of two pilot plants to produce bio-based diesel from sugarcane...

Unlike traditional biodiesel from lipids and fatty acids, Amyris uses synthetic biology to reprogram microbes, or "bugs," to function as living factories for the environmentally-friendly production of high-value chemicals. The end result is a hydrocarbon that Amyris said is designed to closely resemble components in current gasoline, diesel and jet fuel...

A biofuel for jet engines is expected to be in commercial production by 2012 or 2013, Melo said, citing the additional requirements for that market (see Game-changing day for jet biofuels)...

Amyris plans to use the cheapest nonfood feedstock available, which for now means sugarcane, Melo said. The company could also use algae for its biodiesel—much like Solazyme, LiveFuels, GreenFuel Technologies and many others—but Melo said he thinks algae-based biodiesel is still 5 to 10 years from commercial-scale economics

[Amyris' target is 206 million gallons annually in their Brazilian commercial plant.]

And here's a new, exciting item Yeast and bacterium turned into gasoline factory published just this week (New Scientist, April 20, 2009). On average, our oil depletion problem has been solved by engineered microbes about once a week every week over the last 2 years.

Will somebody please wake me up when 1 million gallons of jet fuel from algae or some other biosource can be produced for less than $5/gallon each and every day?

Final Thought

I was talking to the guy on the stool next to me at my local watering hole the other day. I was reading and marking up the Wall Street Journal article cited above as I drank my customary glass(es) of Pinot Grigio. I showed him the Fantasy Graph (Figure 1) and told him that I was skeptical that the future would look like that. And he said to me—I'm paraphrasing here—something like the following:

The only thing I know about the future is that it won't take care of itself. You've got to worry about it. If you don't, if you pretend everything's going to be OK, you're setting yourself up for some massive screw-ups down the road.

[To which I replied: Exactly right!]

I can only hope that our energy "thought leaders" will one day have the common sense of a random barfly in Pittsburgh.

Contact the author at [email protected]

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Notes

1. I took the title of this column from the great John Hughes movie. The "glimmers of hope" refer to the 2nd derivative of growth (Globe & Mail, April 17, 2009).

Before a shrinking economy rebounds, the pace of decline must slow.

Economists call it the "second derivative," a bit of calculus they are using a lot these days as they search for the bottom of the biggest global recession since the Second World War.

A spate of economic data yesterday suggested that mathematical moment has arrived.

In the United States, for example, a government report yesterday showed that new claims for unemployment benefits decreased by 53,000 to 610,000 last week, the lowest level since January.

2. For those who say the days of the Light Truck/SUV are over, look at this graph.

There was substantial rise in light truck sales in the period circled when 1) oil prices had declined 2) the economy hadn't melted down yet.

Real GDP and the Oil Shock of 2007-08

If it looks like a duck, and quacks like a duck, we have at least to consider the possibility that we have a small aquatic bird of the family anatidae on our hands
    —Douglas Adams

Dr. James Hamilton (JDH) recently released his study Causes and Consequences of the Oil Shock of 2007-08. The paper concludes that if the oil price shock that started in 2007 and ended after 2008:Q2 had not occurred, the U.S. economy would have been described as growing slowly in 2007:Q4-2008:Q3. Here is JDH’s conclusion and the main result (Figure 1).

Eventually, the declines in income and house prices set mortgage delinquency rates beyond a threshold at which the overall solvency of the financial system itself came to be questioned, and the modest recession of 2007:Q4-2008:Q3 turned into a ferocious downturn in 2008:Q4. Whether we would have avoided those events had the economy not gone into recession, or instead would have merely postponed them, is a matter of conjecture. Regardless of how we answer that question, the evidence to me is persuasive that, had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession.

Figure 1 — “The green dotted line is the forecast if we ignored the information about oil prices, while the red dashed line is the forecast conditional on the huge run-up in oil prices that subsequently occurred. The black line is the actual observed path for real GDP. Somewhat astonishingly, that model would have predicted the course of GDP over 2008 pretty accurately and would attribute a substantial fraction of the significant drop in 2008:Q4 real GDP to the oil price increases.” See Consequences of the Oil Shock of 2007-08 or the original paper cited above. Based on Hamilton’s model What is an oil shock? (2003).

Hamilton is making a subtle point by examining a counterfactual proposition. Imagine there had been no oil shock in 2007Q:3-08:H1. In this case Hamilton believes that the U.S. economy would have been “growing slowly” during the period in question. This point is confusing because our economy was growing slowly as measured by real GDP (+0.7 or 0.8 percent as shown in Hamilton’s Table 3, and discussed on page 34). JDH’s point is that without the oil shock, our economy would have been seen as growing at a slightly faster rate than the data shows—declining light truck sales provide empirical support for this view (see the last section below).  Hamilton says his conclusion is one “that I don’t fully believe myself.”

The NBER finally declared a recession in December, 2008, but many economists had made the call long before that. First out the gate was Calculated Risk, who declared the downturn in March based on a correlation between recessions and new home sales. In an informative post Gross domestic income (GDI) and recessions, JDH discussed Jeremy Nalewaik’s analysis of how the economy was faring in 2008 (September 28, 2008). Based on the GDI, which differs from GDP by only a statistical discrepancy, Nalewaik’s model “unambiguously” signaled that the U.S. economy was in recession based on the 2007:Q4-2008:Q2 results. On October 30, 2008, after the negative 3rd quarter result was in, JDH’s recession indicator index was not officially calling it a recession yet, although he said “you could easily call it either way.”

It seems to me that JDH has gone out on a limb in assuming real GDP growth in 2008:Q1-Q2, which are the only two positive quarters in the last five—a limb that could easily be sawed off when the final “final” numbers come in. I believe that the U.S. economy was shrinking throughout 2008. In fact, there is evidence that the oil shock actually inflated real GDP growth in 2008:H1.

My doubts about Hamilton’s story begin—and mostly end, actually—with BEA measurements of real GDP in 2008 and prior years (Figure 2). Did the oil shock make the economy worse in 2007:Q4-2008:Q3? Undoubtedly. Although I am less impressed with the correlation in Figure 1 than Hamilton is, his thesis loses much of its force if real GDP measurements have been distorted by anomalous or new economic events and trends in recent years.

Thus if there is good reason to doubt that the U.S. economy in 2007:Q4-2008:Q3 was growing, it is hard to support Hamilton’s conclusion that the oil shock (as interpreted through his model) was a good predictor for GDP in 2008. I agree with JDH that the oil shock both exacerbated and accelerated the downturn in 2008:Q4.

Figure 2 — Quarter-to-quarter real GDP growth as measured by the BEA. Real GDP is calculated by subtracting the GDP Deflator from nominal GDP. Real growth slows after the Housing Bubble collapses starting in 2006:Q2 (based on Case-Shiller). Bucking the trend, we see two strong quarters in mid-2007 and then another in 2008:Q2. You can see the great volatility since 2006:Q2. If someone handed me this chart without telling me what it was, I would immediately conclude that something’s wrong. In this way, it’s like OPEC proved reserve revisions in the 1980’s.

JDH reminds us that real GDP data do get revised. Our economy is not what it used to be, and perhaps what it used to be isn’t what it was. Economic distortions introduced by the Housing Bubble and its collapse, the false wealth effects—now being unwound—introduced therein, the inordinately large profit flows in—and now out of— banking and insurance, the continuing destruction of manufacturing in the U.S. due largely to globalization, a declining dollar from 2005-2008:Q2, and (last but not least) the oil shock following on rising prices since 2003 all cause me to question whether the real GDP measurement can yield a meaningful signal in the face of an onslaught like this.

New circumstances in our economy give us good reason to doubt real GDP measurements in recent years. I couldn’t possibly do the subject justice in a short essay, so I’m going to do some hand waving. I am an energy analyst, not an economist, but I am now compelled to examine these issues, especially because we’re in dire straits in 2009:Q2. I will bring up a few examples and hope that others will do a more in-depth analysis that substantiates (or not) the points I raise.

To get the ball rolling, here is what Michael Mandel said about the economy on July 31, 2008, when the negative 2008:Q3 result and the terrible Q4 result still lay in the future.

I’ve steadily maintained that the economic data overstated the strength of the economy, and today we had the first confirmation. The BEA issued its revision of the past three years of GDP statistics, and guess what? The fourth quarter of 2007 was revised down to negative growth (-0.2% from the previous 0.6%).

In my view, this process of downward revision of the stats for 2007 and 2008 will continue over the next several years. It takes that long for all the source data to catch up (for example, tax return data for 2008 is not available until mid 2009 or even later). By the time that the data revisions are done, it will be clear that GDP growth in the first half of 2008 was negative, despite what the stats say now.

In other words, I believe that the statistics will eventually show that we are in a recession now, no matter what the official data says now.

Let's start by taking a close look at the 2nd quarter of 2008.

Effects of Trade On 2008:Q2 Real GDP

Whether the economy was growing slowly at an annual rate of 0.7 or 0.8% between 2007:Q4 and 2008:Q3 depends directly on the large positive result in the 2nd quarter and to a lesser extent, the smaller gain in the 1st quarter. The BEA’s advance report in the second quarter showed real growth of 1.9%, raised this number to 3.3% in the preliminary report after the trade numbers came in, and finally settled on the expected 2.8% in the final report. JDH discussed the revisions in Last Quarter’s Fundamentals, where he noted that “a good 0.37 ppts of the -0.5 ppt [final] revision could be accounted for by [personal] consumption.” There were much smaller downward revisions in net exports and investment as well.

Perhaps it is hard to remember now in April, 2009 just how controversial the positive 2nd quarter report was last summer—many did not find it credible. Menzie Chin, Hamilton's writing partner at Econbrowser, wrote an insightful article on the result in Why Does It Feel Like a Recession? (RGE Monitor, August 31, 2008).

Figure 1 [my Figure 3 below] illustrates real GDP growth in ppts SAAR (blue bars), and the contributions from Net Exports (red line) and Imports (green line)...

Interestingly, the change in trade sectors accounts for almost all of growth (in the advance, it accounted for more than all GDP growth). And while the proportions coming from export growth and import shrinkage are about the same, here I think absolute percentage point contributions are important. Reductions in real imports now are calculated to contribute 1.45 ppts, as opposed to the earlier estimate of 1.26 ppts. Of course, some of this reduction is due to the weaker dollar, as journalistic accounts have stressed. But unlike exports, imports are -- according to macroeconomic estimates -- highly insensitive with respect to exchange rates, and much more elastic with respect to income. So I suspect that real income is either actually stagnant or falling, or perceived to fall in the near future...

It's clear [from Chin's Figure 3] that the amount that we're expending on (Gross Domestic Purchases from consumers, businesses, and government only) is barely growing; given q/q annualized growth of 0.3 ppts (log terms), it's essentially zero. So the factories may be humming, but that's because exports are up, thereby illustrating how much continued growth in GDP depends upon the trends in the rest of the world.

Figure 3 — Real GDP with contributions from Net Exports and Imports. This graph reflects the preliminary (3.3%), not the final (2.8%) BEA assessment. GDP = C + G + I + (Ex - IM), where these terms represent consumers, government, businesses, and exports & imports. The term (EX - IM) = Net Exports. The term is negative, but a higher (but still negative) net exports value raises GDP while an increase in imports lowers GDP, all else being equal. So, this graph shows that 1) imports shrank, 2) exports rose, and 3) net exports contributed almost all of the growth shown.

Although Chin notes (based on his Figure 2) that "the steep drop-off" in the Net Exports ex oil/GDP ratio "suggests to me a big income (and perhaps wealth) effect"—this is the only reference to oil—he does mention the huge distortion that the surge in oil prices in 2008:Q2 had on the trade balance and therefore the real GDP measurement. Others, like Jake at EconomPic Data, were not so reticent.

Due to a rise in the price of oil from less than $110 to $145+, the import portion of the GDP Deflator raised Real GDP by 4.6% [based on the preliminary 3.3% report]. This is more than 2x the level seen at any other point during this decade and the highest amount EVER (we have to go back to Q1 1974 and Q1 1980 for levels even remotely close to that of this past quarter [as shown in Figure 4 below].)

Figure 4 — the anomalous contribution of imports to the GDP deflator in 2008:Q2, based on the preliminary BEA report that showed a 3.3% rise in real GDP. You can see 1974:Q1 and 1980:Q1 in the data.

[And from here]: So what do we find? Nominal imports increased in Q2 by 18.8% annualized. Real imports DECREASED in Q2 by 7.5% annualized. In other words, even though we paid 18.8% more out of our pockets, we received 7.5% less units of these imports. Why? The Import GDP Deflator decreased imports by more than 25%.

Had we paid the same price level quarter over quarter for our imports, and thus received more given the level of nominal GDP, real GDP would have been -1.3% [when this calculation was made]. I understand this WOULD NOT necessarily be a more accurate version of GDP, but it illustrates the size of the impact/just how odd this calculation is.

We paid much more for imports (e.g. oil & food) so we imported much less stuff according to the BEA. Once the price distortion introduced by the oil spike is adjusted via the deflator, the BEA calculates that the actual quantity of U.S. imports dropped 7.5%, and this decrease contributed substantially to the net exports gain in real GDP (from -462.0 to -381.3, current BEA data) as shown in Figure 3. I want to make it clear that we did not import significantly less oil during the 2nd quarter as this might seem to imply—we just paid a lot more those barrels.

Paradoxically, the sharp oil price rise gave a large boost to real GDP. That’s one (very destructive) way of getting your trade balance moving in the right direction, I guess.

I don’t see any way to wiggle out of this one—the oil price shock itself contributed substantially to a final 2.8% rise in 2008:Q2 real GDP by lowering our imports just as the weak dollar was supporting an increase in exports. Oil prices also seem to have made a positive contribution to slow 2008:Q1 growth. I believe Chin made the right call when he said “real income [was] either stagnant or falling” in 2008:Q2, and that was likely true in Q1 as well.

Thus if the skyrocketing oil price contributed substantially to slightly positive real GDP growth in 2007:Q4-2008:Q3, the economy might have performed much worse without it! It is very hard to separate causes from effects regarding how the oil shock affected growth.

This oil price surge also explains the difference between the GDI and GDP measurements. (The real GDI number was 1.8%, not 2.8%.)

In a recent working paper, Marshall Reinsdorf, economist at the Bureau of Economic Analysis, takes a new look at the impact of changes in export and import prices on the U.S. economy as measured by their effects on real gross domestic income (GDI), calculated by deflating gross domestic product (GDP) by the gross domestic purchases price index...

According to Reinsdorf's paper, the petroleum price shocks that occurred in 1973 and in 1980 subtracted more than a full percentage point from the annual growth of real GDI, and in the first half of 2008, price increases in petroleum and other imported commodities subtracted 2 percentage points from the annualized growth of real GDI, making it negative despite the steady growth of real GDP.

[Confession: I haven't read Reinsdorf's paper]

Let's now turn to some other reasons to believe that balance of trade issues are distorting real GDP.

Mandel's Critique of Manufacturing Real GDP Data

On December 2, 2008, Michael Mandel asked why is real GDP growing in a recession?

As I noted yesterday, we have now been in recession for a year, but reported real GDP has actually risen. How can that be? I’ve looked a bit deeper into this. One of the big problems, I think, is the measurement of the manufacturing sector. According to the BEA’s figures, production of goods in the U.S. has risen since the end of 2007 (for those of you keeping track at home, that’s Table 1.2.6. Real Gross Domestic Product by Major Type of Product, Chained Dollars).

Which number doesn't fit?

Measure	Source	Time Period	Change
Manufacturing Output	BLS	07IV-08III	-2.5%
Manufacturing Employment	BLS	Dec07-Oct08	-3.6%
Manufacturing Production	Fed	Dec07-Oct08	-5.5%
Goods Production (from GDP)	BEA	07IV-08III	0.5%

If we assume that real goods production is actually falling across this period, it pulls real GDP growth since the end of 2007 into the negative column as well.

If BEA reporting of growth in manufacturing (production of goods, including motor vehicle output) has been systematically inflated as Mandel believes, this would constitute one more reason to doubt that the economy was growing slowly from 2007:Q4 to 2008:Q3. But why would such a gap exist between the BEA and other data sources?

Mandel's gives part of his answer in The Real Cost of Offshoring (Business Week, June 18, 2007). This issue relates directly to the growing importance of trade in the U.S. economy (Figure 5).

Figure 5 — Taken from this document by Susan Houseman and Timothy Bartik of the W.E. Upjohn Institute For Employment Research. Globalization is just one of the many difficulties facing American workers. A distortion in the net exports calculation that inflated 2008:Q2 real GDP as discussed above.

By way of introducing Mandel's pessimistic view, consider Menzie Chin's comments on an academic study of how GDP is affected by import price calculations:

If import prices were actually higher than reported by the usual statistics, then the volume (or "real" quantity) of imports would be lower than reported. Given that measured import prices have been rising, this means the decrease in imports has been more pronounced than indicated in the BEA statistics. Taking this chain to its logical conclusion, actual GDP growth is larger than has been reported -- but not for a "good" reason, but rather because imports have been collapsing even more than we already think.

By the way, this is a "partial" exercise, in the sense that, while mis-measurement of imports tends to drive up recent growth rates, other mis-measurement may well work the other way (e.g., Michael Mandel [same link as above]).

Like Mandel, I believe the "real world" works the other way. If import prices were actually lower—think lots of cheap stuff from China—than reported by the BEA statistics, then "real" quantities of U.S. imports would be higher than is usually reported. The imports deflator adjustment would thus be too large, which would artificially boost the net exports (EX-IM) contribution to real GDP. Perhaps we saw this effect in the 2008:Q2 data discussed earlier.

Here's an excerpt from the Mandel off-shoring article with a telling example from the domestic furniture industry.

• The underlying problem is located in an obscure statistic: the import price data published monthly by the Bureau of Labor Statistics (BLS). Because of it, many of the cost cuts and product innovations being made overseas by global companies and foreign suppliers aren't being counted properly ... which spells trouble because the government uses the erroneous import price data directly and indirectly ... to calculate the output of the manufacturing sector, and real gross domestic product (GDP) The official statistics show that productivity, or output per hour, grew at a 1.8% rate over the past three years. But taking the phantom GDP effect [from import price data] into account, the actual rate of productivity growth might be closer to 1.6%--about what it was in the 1980s... More broadly, it becomes clear that "gains from trade are being measured instead of productivity," according to Robert C. Feenstra, an economist at the University of California at Davis and the director of the international trade and investment program at the National Bureau of Economic Research. "This has been missed."


• Furniture — In some sectors, productivity growth may be an indicator not of how competitive American workers are in international markets," says [Susan] Houseman, "but rather of how cost-uncompetitive they are." For example, furniture manufacturing has been transformed by off-shoring in recent years. Imports have surged from $17.2 billion in 2000 to $30.3 billion in 2006, with virtually all of that increase coming from low-cost China. And the industry has lost 21% of its jobs during the same period. Yet Washington's official statistics show that productivity per hour in the furniture industry went up by 23% and output by 3% between 2000 and 2005. Those numbers baffle longtime industry consultant Arthur Raymond of Raleigh, N.C., who has watched factory after factory close. "And we haven't pumped any money into the remaining plants," says Raymond. "How anybody can say that domestic production has stayed level is beyond me."

If gains from trade are mistakenly measured as positive productivity growth or output in domestic manufacturing, and if past and present real GDP must be revised downward as a result, any argument (not just Hamilton’s) that depends on recent growth calculations is undermined.

A baffling 3% rise in output (along with a 23% rise in productivity) is supposed to have occurred in our domestic furniture industry between 2000 and 2005 when economic conditions (on average) were better than in 2007-2008. I’m with Michael Mandel and furniture industry consultant Arthur Raymond on this one—most of us have seen all those cheap Chinese goods at Wal-Mart.

Accounting properly for globalization and off-shoring in measuring real GDP will no doubt keep some economists burning the midnight oil now and in the future. I’ll finish up with some comments about finance and wealth effects.

A Note On Financial Corporate Profits And Wealth Effects

Writing at Baseline Scenario, Simon Johnson, the former chief economist of the IMF, expressed his doubts about reported profits in the finance industry over the last several years.

We don’t know how much of banking profits in recent years were illusory and should not have been booked as GDP. In fact, it would not be a big surprise if - eventually - we go back and mark down our true production of goods and services in 2007 by 2 or even 5 percent. In this sense, we face a statistical situation similar to that of the Soviet Union at its demise - once they figured out that all their military production had no real value, they had to reduce measured GDP sharply.

In so far as the banking industry, with considerable help from the Treasury and the Fed, is winning its war to keep itself intact, I doubt there will be any downward revisions of financial corporate profits in future years. That does not detract from Johnson's point, however. And if many of these banks are insolvent, as Nouriel Roubini maintains, then losses in 2008 would be much larger than write-downs to date indicate.  Mandel graphed real financial corporate profits versus total profits since 1987 in Figure 6. The BEA's data for 2004-2007 is shown in Figure 7.

Figure 6 — Mandel's explanation: "The top line is non-financial corporate profits, adjusted for inflation (in 1997 dollars). This number is ‘after-tax profits from current production’ as calculated by the Bureau of Economic Analysis (they call it “Profits after tax with IVA and CCAdj”—don’t ask). It does not include write-offs, and it adjusts for various distortions imposed by the tax code. That is, it’s supposed to be the best economic measure of profits."

Figure 7 — From the BEA: In the services sector, growth in finance and insurance slowed to 0.1 percent in 2007, down from 6.3 percent in 2006. In the goods sector, construction continued to decline, dropping 11.2 percent in 2007 after falling 4.1 percent in 2006, reflecting the further decline in residential building. Durable-goods manufacturing slowed to 4.8 percent from 8.1 percent. Eight out of 11 durable-goods industries decelerated.

Here's Mandel's take on Figure 6.

I continue on my recent task of abusing the decade from 1997-2007. The question is—how much of corporate profit growth during this decade was driven by the financial sector? The answer is: Almost all of it... Here’s another way of getting at the same point. This table shows the real profits of both nonfinancial and financial corporations in 1997. It also shows the average profits over the next ten years, measured in 1997 dollars. For nonfinancial corporations, the decade from 1998-2007 was worse, on average, than 1997. After-tax domestic corporate profits, in billions of 1997 dollars—

	1997	1997-2007
non-financial corporations	411.5		370.0
financial corporations	100.0		172.1

Two caveats here. First, there are quite a few different profit measures…some of them give different answers. Second, and more important, these figures measures “domestic” profits, which includes exports from U.S. production but does not include manufacturing and other operations overseas. It may be that non-financial corporations had profitable plants overseas—but that does not take away from the point that the decade 1997-2007 was a bad one for the U.S.

If almost all corporate profit growth in 1997-2007 was driven by the financial sector, and we now have good reason to doubt that these profits were "real" in some sense, there are obviously implications for real GDP as Simon Johnson points out. I find it remarkable that 2007 financial sector profits—all corporate profits have now dropped for six straight quarters—remained virtually unchanged in 2007 over 2006 (when the Housing Bubble collapsed) according to the BEA data in Figure 7.

I'm not going to go further with this line of argument because I really don't know where to go from here. I do know that my sense of smell tells me that something stinks, and reassessments of financial profits could—even if they don't—eventually justify major downward revisions in 2007-2008 GDP.

JDH factors in the Housing Bubble in his assessment of the economy from 2006:H2 to 2008:Q3.

… a few points about the respective contributions of housing and the oil shock deserve mentioning. I would note first that housing had been exerting a significant drag on the economy before the oil shock, despite which economic growth continued. Residential fixed investment subtracted an average of 0.94% from the average annual GDP growth rate over 2006:Q4-07:Q3, when the economy was not in a recession, but subtracted only 0.89% over 2007:Q4-2008:Q3, when the recession began. At a minimum it is clear that something other than housing deteriorated to turn slow growth into a recession. That something, in my mind, includes the collapse in automobile purchases, slowdown in overall consumption spending, and deteriorating consumer sentiment, in which the oil shock was indisputably a contributing factor.

The data show that personal consumption peaked in 2008:Q2, a fact which is consistent with a narrative that says it took about a year for the large negative wealth effect to kick in. The oil shock no doubt contributed to falling consumption, especially in vehicle sales, which started declining, especially for light trucks, in 2007:Q2 as Hamilton argues (Figure 8, and pages 34-35 of Hamilton’s paper).

Figure 8 — U.S. car sales from 2007:Q2-now. Without declining sales, the economy would have been growing at a +1.2% pace in 2007:Q4-2008:Q3 according to the BEA data (follow the personal consumption link above, and look at Hamilton’s Table 3).

However, I would argue that even without the oil shock, the large loss of household wealth from declining home equity and the falling stock market was extracting a heavy toll on output. I can not agree with JDH when he says, speaking of the “ferocious downturn” in the 4th quarter of 2008, that it is a matter of conjecture “whether we would have avoided those events had the economy not gone into recession, or instead would have merely postponed them.” I believe a meltdown was ongoing and inevitable. We probably would have postponed the terrible events of 2008:Q4 for a while without the oil shock, but we certainly would not have avoided them.

Thus my position on the oil shock is that it made an already bad situation worse regardless of what real GDP says (and GDI does not). I believe it was a case of piling on—the oil shock was one more straw that broke the camel’s back.

I agree with almost everything that JDH said regarding the supply & demand fundamental causes of the oil shock, although I disagree somewhat with his assessment of why the oil prices got so high. I’ve focused here on real GDP (mis)measurements and whether we were in recession or not in the first half of 2008. I believe a revised accounting would show that we were, and along with Michael Mandel, I believe that things were also much worse in previous years when this economy blew two major bubbles. But that’s all over now.

Contact the author at [email protected]

Obama's Energy Experts

Genius may have its limitations, but stupidity is not thus handicapped
   — Elbert Hubbard

With Americans focused on a prolonged economic downturn, problems with the oil supply don't appear as urgent as they did in the summer of 2008. We are prone to forget, however, how little Americans and their elected representatives know about energy regardless of whether the problem is on their doorstep or not.

A new survey The Energy Learning Curve published by pollster Daniel Yankelovich's Public Agenda reveals that many, many Americans know next to nothing about energy. Finding #4 suffices to demonstrate this unsurprising conclusion, as shown in Figure 1 below.

I'm not going to bash the hoi polloi for their lack of knowledge about energy, which is a hard subject to understand, but I will dispute this opening statement by Public Agenda—

There may be some public policy decisions that can safely be left to the professionals: experts who spend their lives examining various issues. Energy isn't one of them.

Energy issues touch almost every part of our lives, from the economy and the national security implications of our dependence on oil to the changes proposed to prevent and slow down global warming. And energy is too intertwined in daily life to change without public input. No other public issue is so dependent on personal conduct and public attitudes – and on no other issue do we have as far to go in bringing the public into the picture.

If energy is too important to be left to the professionals, and "on no other issue do we have as far to go in bringing the public into the picture," then we clearly have a dilemma. If we wait until the public's knowledge about energy approaches reality, we will all be toast because both the climate and oil depletion situations get worse with each passing year. Such phenomena can not be put on hold until everybody gets up to speed on the issues. Energy policy is like foreign policy and where oil is concerned, heavily tied to it—it is a domain requiring some special expertise.

Figure 1 — About 40% of Americans can not tell you what a "fossil fuel" is (left). Most could not name a "renewable energy source." Nearly as many Americans think "natural forces unrelated to human activity" cause global warming as think that burning coal causes it (right). Natural forcings have obviously caused enormous shifts in paleoclimates, but are not implicated in the rapid onset of Industrial Age warming resulting from human interference in the Earth's carbon cycle (i.e. burning fossil fuels).

Yankelovich touches on the difficulties of educating people about energy.

It is hardly surprising that the public lacks important facts about the energy problem. The problem is complicated and the public is far less attentive than experts and activists. But it would be a terrible mistake to assume that if and when the knowledge gap is filled, the public will then be ready to support sound policies. People can absorb factual information much faster than they can overcome wishful thinking and denial or accept far-reaching changes in habits and lifestyles. When people are given a few facts to take into account, it doesn’t take any more time to absorb them than it does to impart them (e.g., AIG gave the employees of its Financial Products Division $168 million in bonuses). But it may take months (and even years) to accept the need for painful change. Factual information is a necessary but insufficient condition for accepting change.

That is why we have adopted the concept of the learning curve to describe the complex process whereby the public grapples with the need for change on difficult issues. The metaphor of a “learning curve” suggests that the process will take time and will not proceed in a straight line...

Even if the public was ascending the learning curve, Yankelovich rightly says that it would be "a terrible mistake" to assume that a knowledgeable public would be ready to support sound policies because there is a subtle but crucial difference between a superficial intellectual understanding of something and actually getting it so as "to accept the need for painful change." It usually takes many years to understand a problem and fully absorb its implications.

The large majority of the public will always favor gradual, non-disruptive change. (See the last section Political Realities Are Human Realities of my column The Secretary of Synthetic Biology, March 26, 2009.) 89% of Americans worry a lot or somewhat about "increases in the cost of gas or fuel" and 83% worry that "the United States economy is too dependent on oil." These results seem to show that Americans have grasped that the two issues—price and over-dependence—are related.

While 78% of the public is willing to cut back on leisure driving on weekends and vacations, which is a painless adaptation that can easily be accommodated, a consistent majority oppose a modest 40¢/gallon gas tax increase to be used for any purpose, including achieving so-called "energy independence" or developing "clean, renewable energy sources." Raising gasoline taxes is potentially disruptive to many Americans' lives, so it is not popular. Imposing such taxes may or may not be the right policy, but if the public makes that decision, we already know the outcome. And if our elected representatives are not willing to override the wishes of the public on occasion, then the outcome will be the same again.

The American public looks to their elected representatives to hire experts who can solve our problems in domains like energy, and rightly so—the "free" market is not going to fix it. Things go badly wrong when those leaders fail to provide the right answers or offer us catastrophically wrong answers. The invasion of Iraq was an example of the latter.

The survey says that 80% of Americans worry a lot or somewhat that our dependence on foreign oil will result in wars or conflicts in the Middle East. Will result? How about did result? Even Alan Greenspan was "saddened that it is politically inconvenient to acknowledge what everyone knows: the Iraq war is largely about oil" before he was forced to clarify his remarks. The costs of invading and occupying Iraq have been incalculable, but the war didn't change our energy situation in the least as long as Iraqi oil production remains mired below 2.5 million barrels-per-day.

It's a revealing but pointless exercise to ask the public what they know about energy and find out, predictably, that they don't know much. A far more constructive exercise in 2009 is to ask what the Obama administration knows about energy because we are now depending on them to lead us to the Promised Land. What do Obama's appointed experts know?

What Do Obama's Energy Experts Know?

Obama's 2010 budget plan, which Congress is still hashing out, proposes to repeal traditional tax breaks in the domestic oil & gas industry. Platts provides an overview of the proposals and the consequences should they be passed (March 30, 2009).

US exploration and production companies may find that the Obama administration's proposed oil and gas taxes in the 2010 budget have a silver lining -- higher commodity prices as domestic output is reduced, investment bank Raymond James' energy analyst Marshall Adkins said Monday.

In fact, Adkins thinks the most controversial "tax" -- the elimination of the favorable tax treatment of intangible drilling costs (wages, materials, transportation) -- has only a 30% chance of making it through a budget process that he, like others, has compared to a sausage maker. Those costs won't be completely absorbed by operators, Adkins said, they will just be capitalized and then recouped via depreciation, which takes longer than the immediate deduction of the IDC. Adkins said E&P executives have told him that repealing the IDC might result in another 25% to 30% cut in drilling budgets.

Several of the nine other gas and oil tax provisions Adkins identified also have less than a 50% chance of making it into the budget, he said, such as the repeal of the 15% deduction for depletion for oil and gas wells. This would hit companies with mature wells harder than others, stripper wells account for about 8% of US gas production and 18% of US oil production.

Eliminating the [depletion] deduction would have producers shutting in the no longer profitable marginal wells, resulting in the loss of royalty revenue from that production stream. "As a result, it is likely that the Treasury would lose tax revenue with this policy—can somebody please give these guys a calculator?" Adkins said.

The "benefit" will be higher commodity prices?  I prepared this graph to put the proposed changes in context.

Figure 2 — U.S. crude oil (+ condensate) production has exhibited an irregular but relatively steep decline since 1990 as shown on the left. (U.S. production peaked in 1970.) Active oil rigs in the U.S. are shown on the right. A doubling of active drilling rigs after 2003 did nothing to stem the decline. The number of rigs in service has dropped precipitously in 2008:H2 and 2009:Q1 due to the economic downturn (Baker Hughes, April 3, 2009).

Stripper wells (< 15 barrels-per-day) account for about 18% of U.S. oil production. What would the effect of Obama's proposed elimination of tax breaks for depletion and intangible drilling costs be on stripper well operators in places like White County, Illinois? It would wipe many of them out. I will quote at some length this well-written report from Carmi, Illinois—this small town in Obama's home state lies far downstate along the Little Wabash River—so you can understand exactly what is at stake here (The Carmi Times, April 1, 2009).

Now if I were to ask you to take a guess on which county produces the most oil in Illinois, what might you say? If you were to say White County, you would be correct. Yes, out of the approximate 9.42 million barrels of oil produced in Illinois during 2008, White County tops the list with a little over 1.1 million barrels or 11.8% of the total. This vital resource generated approximately $103 million of direct value to the many operators and royalty owners of our County. The total economic benefit is huge when one considers the wages earned, supplies sold and taxes collected in the county as a result of this industry.

The Illinois oil industry is considered a "stripper or marginal well" business. This means that the average well produces fewer then 15 barrels of oil per day. As a matter of fact, considering the 2008 production and the estimated 16,000 active producing wells, Illinois wells average only 1.6 barrels per day...

President Obama, in his 2010 budget request, has proposed changes to the oil & gas tax code that will serve to devastate this vital industry in White County, the State of Illinois and across the US. More specifically, the president has proposed the elimination of the Percentage Depletion Allowance for oil & gas production. This item was established in 1926 because oil and gas reserves deplete or are used-up over time as you produce a well. Percentage Depletion allows one to write-off 15% of the sales for every marginal well because the asset we have is dwindling away a little bit each and every day. When the well eventually runs dry and has to be abandoned, there is no asset remaining that has value. The allowance provides incentive to continue drilling and looking for new oil to replace it. Every royalty owner receives this deduction as well as the operator.

The Second item proposed for elimination allows for the Expensing of Intangible Drilling Costs. This provision was also established many years ago, in 1913, for a reason. To successfully raise the capital to take the extreme risks associated with oil & gas exploration this mechanism was put in place as a way to write-off some of the investment against their income. These intangible items include labor, contract services, consumables, etc. The tangible items such as casing, tubing, pumping units, tanks, etc. are depreciated over time as the accounting rules allow. Without this provision people are less inclined to invest in this high-risk endeavor where typically a producer is found once from every seven wells drilled.

Neither one of these items have anything to do with "Big Oil" as they try to make you believe. The items are only available to companies that produce 1,000 barrels or less per day. It is however an attack aimed directly at small independents like many of your friends and neighbors.

The proposed changes would thus 1) affect mostly small independent operators, not Exxon Mobil; 2) shut-in a large share of 18% of U.S. oil production; 3) destroy many family incomes and local revenue streams; and 4) result in a loss of federal tax revenue according to Atkins' analysis in Platts.

Obama's Treasury Secretary defended the changes. Tim Geithner is not knowledgeable about the petroleum industry—his expertise lies in laundering the public's money to Goldman Sachs through AIG. However, his remarks no doubt reflect the consensus of the energy mavens who wrote this part of the budget.

During a hearing of the Senate Finance Committee on March 4, Senator Kent Conrad (D-ND) asked Treasury Secretary Geithner to explain how the tax revisions would encourage more domestic production.

“Senator,” Geithner replied, “we don’t believe it makes sense to significantly subsidize the production and use of sources of energy that are dramatically going to add to our climate change imperative. We don’t think that’s good economic policy, and we think changing those incentives is good for the country.”

I'm stunned, I can't believe it. We are going to shut down stripper well operators in White County, Illinois to fight anthropogenic climate change? Is this supposed to demonstrate that we are serious about global warming?

The problem for climate is growing world coal consumption, not oil—see Pushker Kharecha's summary of his work with James Hansen. In absolute terms, emissions from oil in the U.S. are greater than those from coal. However, China's carbon dioxide emissions surpassed those in the U.S.in 2006, now making up 24% of total globally, yet they only consume slightly more than a third as much oil as we do. (The U.S. now emits 21% of the world's CO₂.) New emissions from coal-fired plants in China and India pose the gravest threat—

World coal-fired power plant capacity will grow from 1,759,000 MW in 2010 to 2,384,000 MW in 2020. Some 80,000 MW will be replaced.  So there will be 705,000 MW of new coal-fired boilers built. The annual new boiler sales will average 70,000 MW.  The annual investment will be $140 billion. These are the most recent forecasts in Coal-fired Boilers: World Analysis and Forecast published by the McIlvaine Company. Coal-fired power in Asia will rise to 1,464,000 MW in 2020 up from 918,000 MW this year. This will account for an increase in CO2 of 2.6 billion tons. So even if the U.S. and Europe were to cut CO2 emissions by far more than the targeted 20 percent, the total CO2 increase from Asia will offset it by a wide margin.

I fail to see how further reducing our declining oil production is going to make any difference global warming—the United States has a serious oil depletion problem!

Let me lay out the logic of our oil problem for "experts" like Energy Secretary Steven Chu, Interior Secretary Ken Salazar and Energy Czar Carol Browner—

1. The stated goal of the Obama administration is to return the country to economic growth.
2. Oil consumption in the United States rises or falls with growth in real GDP (or what James Hamilton calls "income" in his recent study Causes and Consequences of the Oil Shock of 2007-08).
3. The stated goal of the Obama administration is to reduce our foreign oil dependency.
4. The U.S. must import about 66% of the oil it consumes.
5. You can not possibly achieve both #1 (growth) and #3 (reduced foreign oil) if you make a large share of domestic production uneconomic, regardless of any efficiency improvements you might make.
6. Reducing domestic oil production will likely jack up oil prices so high that you will destroy any real GDP growth you do achieve.

We hope that Obama's experts can not be this obtuse, but there it is. We must also seriously consider that #6 (much higher oil prices) is the actual, clandestine goal of the Obama administration, but that still leaves us with the unintended but catastrophic effects of another oil shock on real economic output.

Steven Chu is on the record as saying that "“somehow we have to figure out how to boost the price of gasoline to the levels in Europe" (Wall Street Journal, December 12, 2009). 

But Mr. Obama has dismissed the idea of boosting the federal gasoline tax, a move energy experts say could be the single most effective step to promote alternative energies and temper demand. Mr. Obama said Sunday that a heightened gas tax would be a "mistake" because it would put "additional burdens on American families right now."

The Public Agenda survey makes it clear that Americans oppose disruptive new gasoline taxes, so Obama does too. Chu wants gasoline prices like those in Europe to discourage consumption. Reducing domestic oil production will raise oil and thus gasoline prices. Thus Obama's experts want to raise the price at the pump without imposing new taxes—quod erat demonstrandum, at least to my satisfaction. The only "mistake" in their reasoning is the failure to take into account the consequences of disruptive higher fuel prices on economic growth in the United States, an effect that was demonstrated just last summer.

Here's a news flash for Obama's experts:

You've got to promote a multi-year/decadal transition to an economy that can be sustained without so much oil consumption. You just can't bludgeon people into submitting to your misguided notions of how to fix climate change. Work on the coal problem both here and internationally because renewable electricity replaces coal some of the time but does not replace precious liquids fuels in the United States except by means of non-existent plug-in hybrid vehicles.

Ken Salazar recently mounted a lame defense of Obama's war on small, independent oil producers in an address to the American Petroleum Institute's (API) board of directors (as reported in Salazar sees role for industry in developing full U.S. energy strategy from the Oil & Gas Journal, March, 2009).

"Yes, this administration is changing how things have been done before. [It's] restoring honesty and fiscal responsibility to the budget, making hard choices [and] seeing where we can get a better deal for the American taxpayer. But this is not, as some have suggested, a war on the oil and gas industry," he said...

[more mush in this vein]

"This year, we will hold over 40 onshore federal oil and gas lease sales. Through the Bureau of Land Management, we have already held seven oil and gas lease sales in the last seven weeks. The 830 leases we have offered cover almost 1.2 million acres in the West. The 326 leases that sold generated $32 million in revenue for American taxpayers," Salazar said...

[thanks so much]

But America's oil and gas supplies are not endless, and the country consumes 25% of the world's oil while sitting atop 3% of its reserves, he continued. "We rely on imports. And more and more, the readily recoverable oil and gas reserves of our planet are under the control of nationalized oil companies... "Our dependence on foreign oil is as much a dependence on the countries that directly supply our oil as it is a dependence on the markets and forces that can, in a six-month period, drive oil up to $147/bbl and then down to $45/bbl. It is a dependence on our military to keep oil flowing through the Strait of Hormuz. And it is a dependence on carbon that, for the sake of our planet, we cannot sustain," Salazar said.

[more motherhood & apple pie]

Salazar made no mention the proposed tax changes in his remarks to the API. I wonder how our dependence on foreign oil and the dangers of climate change will be fixed by shutting down stripper well operators without providing plausible fuel or transportation substitutes for that oil. I wonder if we are supposed to feel grateful that the Interior department is still selling oil & gas leases on public lands or offshore, sales that were prepared years in advance.

I should also note that the largest oil companies (like ExxonMobil, Shell, Devon, etc.) will benefit from the most from any price increases that come at the expense of stripper well operators. Why is it politically expedient for the Obama administration to step on the little people while mostly letting the big boys off the hook?

Americans are energy illiterate, there's no doubt about it. But energy is a very complex, hard problem, so we elect politicians we trust to appoint experts that will come up with the best possible solutions to the very deep energy hole we find ourselves in. If those experts are clueless, then we are in big trouble. The United States has always lacked a coherent energy policy. Jimmie Carter tried to get one going, but Ronald Reagan took care of that. What followed was nearly 30 years of profligate energy consumption without a thought to tomorrow's needs. The United States still lacks a coherent energy policy as we enter the Obama Era.

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