Peak Watch

Some Holiday Reading

Happy Thanksgiving. I thought you might enjoy some light reading for the holiday. Here are some things that caught my eye in the last week or so.

Item #1 — Deep Thought

In Douglas Adam's The Hitchhiker's Guide to the Galaxy, the computer Deep Thought said the answer to the ultimate question of life, the universe and everything was 42. It turns out that here on Earth, the answer is 9.7 ± 0.3. Is Global Warming Unstoppable?

The study - which is based on the concept that physics can be used to characterize the evolution of civilization - indicates [among other things that]

• Throughout history, a simple physical "constant" - an unchanging mathematical value - links global energy use to the world's accumulated economic productivity, adjusted for inflation. So it isn't necessary to consider population growth and standard of living in predicting society's future energy consumption and resulting carbon dioxide emissions...

[Utah professor] Tim Garrett treats civilization like a "heat engine" that "consumes energy and does 'work' in the form of economic production, which then spurs it to consume more energy," he says...

"If society consumed no energy, civilization would be worthless," he adds. "It is only by consuming energy that civilization is able to maintain the activities that give it economic value. This means that if we ever start to run out of energy, then the value of civilization is going to fall and even collapse absent discovery of new energy sources"...

That "constant" is 9.7 (plus or minus 0.3) milliwatts per inflation-adjusted 1990 dollar. So if you look at economic and energy production at any specific time in history, "each inflation-adjusted 1990 dollar would be supported by 9.7 milliwatts of primary energy consumption," Garrett says.

Item #2 — Never 90!

A recent issue of Science examined the oil supply question in Splitting the Difference Between Oil Pessimists and Optimists (subscription required). It's kind of UK version of the U.S. GAO survey report—do you remember that one? (Reports come, and reports go, and don't make a lick of difference.)

I am proud to say that NONE of the peaking forecasts shown match my own (and Sadad al-Husseini's) view as I described last week in Staking Out the Middle Ground. I've pointed out the one closest to my view in the left graph. See page 144 of the report (left graph) and page 147 (right graph).

My take on future production capacity is easy to sum up: Never 90!

I'm slightly more pessimistic than al-Husseini.

You can download the UKERC report here (big pdf). If you read the entire report, and you understand every word of it, you would be in a position to evaluate the peak oil question yourself. I would never again have to say anything about the subject. It's pretty good, especially if you are confused about the weaknesses of Hubbert curves, the hard-to-swallow views of Cornucopians, etc. If you read it, and you have any questions about it, shoot me an e-mail.

Item #3 — More than the combined federal budgets for ...

The New York Times weighs in on the growing Federal deficits in Wave of Payments Facing U.S. Government. Apparently this is the first of a series of articles called, appropriately enough, The Debt Bomb.

With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

Here's part of the Times' graph.

Figure 2 — From the New York Times article. Payments on the debt exceed 3% of GDP by 2019 assuming interest rates return to normal rates.

Item #4 — If it walks like a duck, and it quacks like a duck ...

In A Tale of Two Economies, Nouriel Roubini says that "the American economy is actually much weaker than official data suggest." I agree. The 3.5% preliminary number for GDP in the 3rd quarter was revised down to 2.8% based on weaker net exports, non-residential investment and consumer spending, but that's only half the story.

David Rosenberg had calculated that growth would have been nil in the 3rd quarter without stimulus spending, and he made this estimate based on the higher preliminary number. Thus we might conclude that without government spending, growth would have been negative. We don't have an economy which is able to stand on its own two feet.

Many economists, including Paul Krugman and James Kwak, believe we will need much more stimulus before we're out of the woods. New monies would be targeted to spur job creation. Obviously, the first $787 billion didn't do the trick. These economists don't worry about federal deficits (see Item #3 above). It seems that no amount of debt is too high for Krugman.

How can there possibly be a repeat of the vigorous but phony debt-based growth that took place between 1983 and 2007? This was Ben Bernanke’s “the Great Moderation.” The clear implication was that technocrats had learned something new about how to manage economies, i.e. the human race was making progress. See Item #7 below.

You need vigorous growth to pay down the deficits, or you must raise taxes, or you must inflate the public debt away, or some combination of these. Of these 3 possibilities, which do you think is mostly likely? (Hint, the answer is not behind door #1.) See Item #2 above.

But gruesome as they are, forget the current jobs numbers says Roubini. He thinks things are much worse than government statistics say.

Consider the following facts. While America's official unemployment rate is already 10.2 per cent, the figure jumps to a whopping 17.5 per cent when discouraged workers and partially employed workers are included. And, while data from firms suggest that job losses in the past three months were about 600,000, household surveys, which include self-employed workers and small entrepreneurs, suggest a number above two million.

Many of the lost jobs – in construction, finance, and outsourced manufacturing and services – are gone forever, and recent studies suggest that a quarter of U.S. jobs can be fully outsourced over time to other countries. Thus, a growing proportion of the work force – often below the radar screen of official statistics – is losing hope of finding gainful employment, while the unemployment rate (especially for poor, unskilled workers) will remain high for a much longer period of time than in previous recessions.

[My note: And don't forget about the bogus Birth/Death revisions through which the BLS has added hundreds of thousands of fictional jobs to the economy throughout 2009.]

If many more people are unemployed than the official numbers suggest, and many of these jobs are gone forever, then further stimulus packages may be pointless unless the U.S. makes major structural changes to the economy whereby we start producing things again and investing in the infrastructure (energy, transportation) we will need for the 21st century. This process which could take decades.

In other words, additional spending is justified to help people get through hard times only if you've got a plan to put the economy on a sound footing long-term. We will not return to the phony prosperity of yesteryear. The real problem is that we spent so much money bailing out banks without helping American workers... Did I mention that many of the States, which typically provide benefits to the jobless, are in deep fiscal trouble?

And what about the duck? Roubini concludes—

So, while the United States may technically be close to the end of a severe recession, most of America is facing a near-depression. Little wonder, then, that few Americans believe that what walks like a duck and quacks like a duck is actually the phoenix of recovery.

Item #5 —  More Americans swimming underwater...

Do you think the housing bottom is in? Think again. Calculated Risk reports on the latest First American CoreLogic report.

Negative equity, often referred to as “underwater” or “upside down,” means that borrowers owe more on their mortgage than their homes are worth.

• Nearly 10.7 million, or 23 percent, of all residential properties with mortgages were in negative equity as of September, 2009. An additional 2.3 million mortgages were approaching negative equity, meaning they had less than five percent equity. Together negative equity and near negative equity mortgages account for nearly 28 percent of all residential properties with a mortgage nationwide.

You don't need to be a rocket scientist to figure out that being upside down leads directly to foreclosure in a significant number of cases. Given that house prices are unlikely to rise for some time to come, especially in Nevada, Arizona, Michigan, Florida and California, what would you do? I would stop paying and hand in the keys.

Speaking of foreclosures, the Mortgage Bankers Association (MBA) expects foreclosures to peak in 2011.

Figure 2 — We're all subprime now! These graph shows foreclosure (red) or delinquency (blue) rates for prime mortgage borrowers.

MBA chief economist Jay Brinkman expects foreclosures to peak in 2011. As of the latest report, 14.41% of all mortgage loans were in foreclosure or at least one payment past due. Unemployment piled upon underwater loans is driving this process. Households are getting hammered. This also bodes well for the banks...

Item #6 — Tough times? Don't eat...

No job? Lost your house? On Thanksgiving we should take time to remember that 49 million Americans lacked consistent access to adequate food in 2008 according to the USDA's Household Food Security study.

Figure 3 — Eighty-five percent of American households were food secure throughout the entire year in 2008, meaning that they had access at all times to enough food for an active, healthy life for all household members. The remaining households (14.6 percent) were food insecure at least some time during the year, including 5.7 percent with very low food security—meaning that the food intake of one or more household members was reduced and their eating patterns were disrupted at times during the year because the household lacked money and other resources for food.

In contrast, we might consider the wise words of Giant Vampire Squid CEO Lloyd Blankfein. The sea monster's peerless leader was responding to a reporter after being asked if there should be limits on Wall Street compensation. The Times of London reports on the conversation—

Is it possible to make too much money? “Is it possible to have too much ambition? Is it possible to be too successful?” Blankfein shoots back. “I don’t want people in this firm to think that they have accomplished as much for themselves as they can and go on vacation. As the guardian of the interests of the shareholders and, by the way, for the purposes of society, I’d like them to continue to do what they are doing. I don’t want to put a cap on their ambition. It’s hard for me to argue for a cap on their compensation.”

So, it’s business as usual, then, regardless of whether it makes most people howl at the moon with rage? Goldman Sachs, this pillar of the free market, breeder of super-citizens, object of envy and awe will go on raking it in, getting richer than God? An impish grin spreads across Blankfein’s face. Call him a fat cat who mocks the public. Call him wicked. Call him what you will. He is, he says, just a banker “doing God’s work.”

Item #7 — Mark Twain refuses to comment...

As re-published in this month's Harpers Magazine and reprinted at salon.com.

SITTING IN DARKNESS

From a November 26, 1902, letter by Mark Twain to Carl Thalbitzer, a Danish writer, who, after reading the short story The Man That Corrupted Hadleyburg. has asked Twain if he had plans to write about "The advantages and drawbacks of civilization."  

The short story appeared in the December 1899 issue of Harper's Magazine. In 1906, two years after the death of his wife, Olivia Langdon, Twain published the manuscript mentioned as What is Man? 

Dear Sir,

You have read me between the lines. What I have tried to do, and what I still try to do, is to allow only a little to leak out between the lines. This has been a strain on me for thirty years. I have put this restraint upon me and kept it there all these years to keep from breaking my wife's heart, whose contentment I value above the salvation of the human race.

This is a confession that in building a wall across my Nile and damning my feelings and opinions behind it, and trying to caulk the leaks, I am not actuated by principle, but by something much stronger—sentiment.

I shall continue to leak, but shall not write the book unless I survive my wife—which I hope will not happen.

I believe that many a person has examined man with a microscope in every age of the world; has found that he did not even resemble the creature he pretended to be; has perceived that a civilization not proper matter for derision has always been and must always remain impossible to him--and has put away his microscope and kept his mouth shut.

Perhaps because the microscopist (besides having an influential wife) was built like the rest of the human race—ninety-nine parts of him being moral cowardice.

I am such a person myself. I used my microscope during fifteen years, and then put the result on paper five years ago. When ever I wish to account for any new outbreak of hypocrisy, stupidity, or crime on the part of the human race, I get out that manuscript and read it, and am consoled, perceiving that the outbreak was in obedience to the laws of man's make, and was not preventable.

My wife does not allow the manuscript to be published, and as ninety-nine parts of me forbid me to make myself comprehensively and uncompromisingly odious, it has been difficult to persuade me to restrict the reading of it myself!

But you shall read it when you come to see me; then perhaps you will believe with me that civilizations are not realities, but only dreams; dreams of the mind, not of the heart, and therefore fictitious, and perishable; that they have never affected the heart and therefore have no valuable progress; that the heart remains today what it always was, as intimacy with any existing savage tribe shall show. Indeed the average of the human 'brain' is not a shade higher today than it was in Egyptian times ten thousand years ago.

All this elaborate explanation of why I am not likely to write that book which you speak of amounts to this, when boiled down:`ninety-nine parts of me are afraid, and my wife, who is the bulk of the remaining fraction, forbids it.

Sincerely Yours,

S.L. Clemens

Riverdale, N. Y.

Contact the author at [email protected]

Staking Out the Middle Ground

Extreme positions are not succeeded by moderate ones, but by contrary extreme positions
    —Friedrich Nietzsche

Last week I took the view that The Oil Situation Is Really Bad as we look out 5, 10 or 20 years from now. My article was prompted by the whistleblowers story published by the UK newspaper the Guardian in which current or former anonymous International Energy Agency (IEA) employees asserted that the agency is covering up the precarious oil situation to appease the Americans and prevent panic in the oil markets.

These warnings are plausible to anyone familiar with the current state of world oil production. Once the current spare capacity—I believe it is approximately 4 million barrels-per-day—is worked off after demand rises at some unknown point in the future, it is hard to see how oil production can rise much thereafter.

This week the Guardian followed up on their initial story by highlighting the far more pessimistic Uppsala University study The Peak of the Oil Age by Kjell Aleklett, Mikael Höök, Kristofer Jakobsson, Michael Lardelli, Simon Snowden, and Bengt Söderbergh. (Also see the Guardian's Peak Oil: what does the data say?)

The Guardian stories compare and contrast the 2008 IEA and Uppsala studies, thus creating for its readers a stark choice between them (Figure 1).

Figure 1 — The views of the IEA (top) and Uppsala (bottom). The IEA sees oil production rising smoothly to about 104 million barrels-per-day in 2030. In contrast, Uppsala sees oil production falling below 80 million barrels-per-day immediately and staying there throughout the forecast period. Oil production in their scenario ends up at ~75 million barrels-per-day in 2030. (I don't know why the Uppsala graph starts out at a slightly lower initial production level than the IEA graph. Look at Figure 4 below for a closer look.)

In my view, the Uppsala study is unduly pessimistic, implying an immediate crisis (in 2010 and thereafter) which is not in accord with reasonable expectations about future production levels both within OPEC and outside the cartel. In alerting the public to the peak oil issue, the Guardian is doing good work. But not knowing any bettter, they picked the wrong study in my view. The false choice the Guardian offers us, the IEA or Uppsala, amounts to a kind of all or nothing proposition.

It is not the barrels-per-day figure for 2030 arrived at by the Uppsala team that I find objectionable. In fact, I think that ~75 million barrels-per-day in 2030 is probably too optimistic! However, I must remind you (and myself) of a fundamental principle about forecasts, including oil production forecasts—

• The further forward in time a forecast goes, the more worthless that forecast becomes.

We can not believe any number anybody gives us for 2030. The converse in time is also true—a study should be reasonably accurate within shorter time frames for it to have any value whatsoever. This latter consideration depends on the subject under study. For example, interest rates can change quickly (in a matter of days or weeks) whereas global oil production can not under normal circumstances (outside big, exogenous shocks to the system, e.g. a devastating act of terrorism or war).

The Uppsala reference forecast calls for global oil production to drop to a very low level in 2010 (about ~77 million barrels-per-day, Figure 1, Figure 4) and decline over much of the next decade. I don't believe that such a sharp drop-off in world productive capacity is possible next year or for some years thereafter. I do believe that Uppsala's short-term views, in alignment with other catastrophic forecasts, are used by naive observers to support End of the World prophesies I don't subscribe to.

My view does not reflect that of ASPO-USA, which is easy to say in so far as ASPO-USA does not have an official view. Also, I do not mean to single out Uppsala. There is no dearth of alarmist forecasts or Chicken Little predictions for true believers to choose from. The chances that oil will hit $200/barrel in 2010, as some have predicted, are vanishingly small, absent a geopolitical shock. I picked the Uppsala study because the Guardian featured it.

And one more caveat: do not mistake demand for oil with oil production capacity. This distinction seems simple enough, but in my experience people sometimes confuse these issues. Suppose, for instance, that the global economy Crashed Big Time, and oil consumption fell to 79 million barrels-per-day. That would certainly have a devastating effect on future oil production via low prices & investment, but it would not mean that the world oil production capacity had fallen to 79 million barrels-per-day.

Methodology & Uncertainty in the Uppsala Study

The goals of the 2008 Uppsala study are to overturn the IEA forecast and offer an alternative. These are good goals. To accomplish this, the Uppsala team employed the methodology described in #1-#3 below for the crucial contribution from yet-to-be developed oil fields. This is a bit technical, so bear with me.

1. They "unpacked" (digitized) the IEA oil production graphs to get annual oil production numbers for yet-to-be-developed fields. This process yields the production curve shown in Figure 3 below. The Uppsala team also revised downward the IEA's forecasts for gas liquids, unconventional (tar sands) production and enhanced oil recovery (EOR). I will not be dealing with those topics today, but I don't discount their importance in the Uppsala forecast.
2. They applied the depletion-rate-of-recoverable-resources  production parameter shown below to the IEA data.
   
   In plain language, the depletion rate d_δt measures how much you are depleting an oil field (or a set of fields, a region) with known ultimately recoverable reserves R₀ (URR, in billions of barrels Gb) as it is produced over time t (e.g. 3% per year).
3. Historical production in various countries or regions—the North Sea is their main example—shows that depletion rates never exceed 7%. But IEA projections for fields-to-be-developed call for depletion rates well in excess of 7%, i.e. the production rates are much higher than historical experience would suggest is possible given the URR, which the IEA puts at 257 Gb. See Figure 2 below. 

Figure 2 — Uppsala's Figure 5. Look at the caption in the figure for the explanation of the graph as explained in my #3 above. The IEA assumes unrealistically high depletion rates compared to the North Sea, which already had the highest depletion rate in the historical cases the Uppsala team examined.

I have left out some theoretical niceties they discuss, but another crucial observation in the Uppsala model is that depletion rates rise until peak production occurs and then flatten out. (You can see some flattening of the normalized North Sea depletion rate in Figure 2 roughly coincident with its production peak year 2000 as shown in Uppsala's Figure 4, which is not shown here.)

Based on historical experience, the Uppsala team sets flattened, post-peak depletion rates at 2-3% and close to 6% for non-OPEC offshore production for fields yet-to-be developed. This contrasts sharply with the much higher rates assumed by the IEA in Figure 2. The revised depletion rates allow them to conclude that future production from these fields will fit the profile shown in Figure 3 below.

Figure 3 — As above, read the Uppsala Figure 7 caption. Fields-to-be-developed will never attain a peak production rate of 29.33 million barrels-per-day as predicted by the IEA. Instead, production will climb to a lesser peak at a much slower growth rate as shown. I have put in an alternative Why not this? (in red) scenario for contrast.

This sums up the Uppsala team's essential argument for future production from yet-to-be-developed fields. As theoretical arguments go, I've seen worse. The Uppsala team's argument is sound. For fields-to-be-developed, it is clear that the IEA's production rates are exaggerated to the high side. I have no quarrel with that.

The flaw in the Uppsala argument is their assumption that the volume of oil that will ultimately be recovered is fixed. Regrettably, the IEA specifies that there are exactly 257 Gb of new reserves in fields-to-be-developed, so the Uppsala team runs with that number.

Arguments based upon fixed ultimate recoverable reserves (URR) numbers have a very low probability of being correct. As former BP executive Jeremy Gilbert told the recent ASPO-USA conference, the key words in reserve/supply forecasting are uncertainty, uncertainty, and uncertainty.

Although it is not all it's cracked up to be, reserves growth does occur. This is especially true in new oil developments in which reservoir trends are further delineated and new, associated oil oil pools are discovered. If you base your result on a moving target, as Uppsala does, you must prepared to revise production levels up if the recoverable reserves grow over time.

Major discoveries occur too, albeit rarely nowadays. Brazil will no doubt make a large upward revision in their proved reserves as they delimit the potential of Tupi and the other pre-Salt ultra-deepwater fields in the Campos basin. This revision may be in excess of 65 Gb as detailed in Rose Anne Franco's presentation to the recent ASPO-USA conference. Brazil has ambitious plans to produce 1.8 million barrels-per-day from the pre-Salt fields by 2020. Petrobras is a serious organization that is very good at what they do. Again, this would require a revision to Uppsala's projections. Even in the North Sea, Euan Mearns reports that—

There are signs that the decline trajectory has already been influenced by a third cycle of giant field development with the Buzzard oil field and Ormen Lange gas field both coming on stream in 2007.

Although these new hydrocarbons will only lift slightly the tail end of the declining North Sea production curve, it does illustrate the hazards of holding URR fixed, even in mature oil production regions. Oil production is, at minimum, a function of geology, price, technology and investment. Uppsala's model takes only geology into account, and incorrectly fixes that variable because it neglects the other factors determining oil production.

Beyond keeping recoverable reserves numbers constant, I have more serious concerns about Uppsala's reference forecast. Look at Figure 4 for a closer look.

Figure 4 — The burnt-orange line shows Uppsala's reference case. Oil production falls off a cliff. Production (capacity?) is only 77 million barrels-per-day by the end of 2010. The fast and slow cases illustrate their two scenarios for production of fields-to-be-developed, but neither scenario boosts the total number of barrels produced as implied in Figure 3 (faster production sooner results in lower production later). I have staked out the middle ground in my moderated forecast (red line). Oil as defined by Uppsala and the IEA in keeping with Figure 1 includes gas liquids, tar sands and conventional crude.

If I am to take the Uppsala's 2008 world oil outlook seriously, I would also have to believe that the world currently has little or no spare oil production capacity. No serious oil analyst believes this, and lately OPEC has been putting more oil onto the market because they fear that prices are too high for a weakened global economy to handle. OPEC has lost control of the situation, however, because the continuing devaluation of the dollar has overwhelmed the supply & demand fundamentals in the oil markets.

As to the crucial question of Saudi capacity and reserves, both Ray Leonard and Sadad al-Husseini believe that Saudi capabilities are not overstated, at least in the medium term. Leonard is a world class geologist who presented his views to the recent ASPO-USA conference. Leonard also believes that Russian production can be maintained at about 10 million barrels-per-day for quite some time to come. Sadad al-Husseini worked at every level of Saudi Aramco for decades, and recently gave his views to ASPO-USA.  Both oil industry veterans strongly support a peak oil scenario, but not in the extreme form presented by Uppsala.

Figure 5 shows al-Husseini's supply & demand forecast.

Figure 5 — al-Husseini's forecast for supply & demand out to 2020. This scenario depends on sufficient investment in production capacity, so it may viewed as an assessment of production potential based on al-Husseini's assessment of recoverable reserves. This view is similar to my red line alternative in Figure 4.

If my choice is between Leonard and al-Husseini on the one hand, and a well-intentioned group of (mostly) Swedish academics on the other, I'm going to go with the seasoned industry professionals every time. That's just the way it is.

Staking Out The Middle Ground

The oil situation is very bad. How bad is it? The Uppsala team's forecast posits a nightmarish scenario as early as next year. This position is not supported by theoretical considerations or by current realities. Recoverable reserves uncertainty undercuts their arguments. If "fast" production of yet-to-be-developed fields is accompanied by reserves growth in those fields, the production might follow the red line I showed in Figures 3 & 4. Existing spare capacity belies their short-term forecast for 2010-2012.

Sadad al-Husseini’s forecast represents the middle ground on peak oil. I endorse his position, which represents a kind of “best case” which is still not very good.

I also do not believe that serious oil analysts—think PFC Energy, not CERA—would find Uppsala's  forecast credible. And neither do I. Oil production in the years 2010-2012 will reveal who is wrong and who is right. The fact that oil production is mostly a demand-side story over the next few years complicates the situation. And of course there is always the problem of figuring out what the Saudis will do.

As I said last week, being taken seriously by the world-at-large has been an enduring, insurmountable problem for those concerned about the upcoming peak oil crisis. It's Cassandra's curse. Still, our being marginalized is not helped when untenable forecasts are presented to the public.

The Guardian unwittingly  does the public a disservice when they present a choice between the IEA, who are very likely wrong on the high side, and the Uppsala team, who are very likely wrong on the downside. Highlighting one study and not other less extreme views implies that the peak oil group is monolithic, which is to say that everyone worried about peak oil speaks with one voice. Nothing could be further from the truth.

The Uppsala study does not represent my views. Many of those who attended ASPO-USA's recent conference also would agree that the situation is not so dire. That is not to say that the situation is not very serious as we look out 5 or 10 years—it is. The goals of the Uppsala study are admirable, but I think their results miss the mark.

Contact the author at [email protected]

The Oil Situation Is Really Bad

This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes
   —Morpheus, from the movie The Matrix

On the eve of the International Energy Agency's release of its annual World Energy Outlook (WEO), a whistleblower at the IEA claims the agency "has been deliberately underplaying a looming [oil] shortage for fear of triggering panic buying" in the world markets. As the young fan said to "Shoeless" Joe Jackson, who was wrongly convicted of helping to throw the 1919 World Series, but knew the fix was in, say it ain't so, Joe.

Ah, but apparently it is so. Another dose of disillusionment for the naive. The Guardian's informant went so far as to say the situation is really bad—

The senior official claims the US has played an influential role in encouraging the watchdog to underplay the rate of decline from existing oil fields while overplaying the chances of finding new reserves.

The allegations raise serious questions about the accuracy of the organization's latest World Energy Outlook on oil demand and supply to be published tomorrow – which is used by the British and many other governments to help guide their wider energy and climate change policies...

A second senior IEA source, who has now left but was also unwilling to give his name, said a key rule at the organization was that it was "imperative not to anger the Americans" but the fact was that there was not as much oil in the world as had been admitted. "We have [already] entered the 'peak oil' zone. I think that the situation is really bad," he added.

Why would the United States "encourage" the Paris-based energy watchdog to overstate how much readily producible oil the world will have over the next 20 years? After all, American policy-makers have been so smart, open & forthright about everything else! Is it arrogance? Starry-eyed optimism? An abiding faith in the United States Geological Survey?

I believe it is the continuing futile attempt by Those In Charge to cover their collective ass after 29 years of abject neglect of the oil situation in the United States. The actual but unofficial oil policy of the United States is the exact opposite of what it should be were this policy designed to serve the Public Good instead of the interests of those holding power. Move on folks, nothing new to see here.

A healthy dose of skepticism applied to Figure 1 last year might have rendered the whistleblowers' revelations this year a non-event, but skepticism, whether it pertains to self-serving Fed statements about the virtues of bubbles in the economy or self-serving CERA statements about long-term peak demand, is always in short supply.

Figure 1 — The 2008 IEA oil production forecast to 2030. Taken from the Guardian article cited at the top. Annotated to show where we are. Presumably, the graph shows productive capacity, not actual demand, for oil.

There was a time a few years back when I would have written an extensive, tortuous data-driven analysis demolishing this IEA nonsense. But why bother? It didn't do any good then, as I explain below. Why would such an analysis make any difference now? Let's just examine the graph itself.

Among the chart's many happy features, I call your attention to these two miracles of bureaucratic forecasting:

• Miracle 1 — accompanying the onset of steep declines in existing production (darker blue), natural gas liquids production takes off just in time to save us, making up the bulk of the increase from ~86-87 million barrels-per-day now to 105 million in 2030.
• Miracle 2 — outside of gas liquids, non-conventional tar sands production (orange) and a sliver of EOR (black), oil from fields under development (lighter blue) keeps oil production steady until oil from undiscovered fields (pink) seamlessly takes up the slack.

Here's another, more dramatic view of the same data from IEA Executive Director Nobuo Tanaka's presentation to the press on November 10, 2009. This one's a real howler!

Figure 2 — Do you see that big light blue portion of the column in 2030? That's the oil coming from fields yet-to-be-developed or yet-to-be-found. But perhaps you are looking for an investment? Dollars are cheap! I've got some swampland in Florida you may be interested in...

Clearly the IEA's forecast has been cobbled together to get things to work out just right. The final, Overarching Wonder proclaims an untroubled future in which the Grand Total rises linearly up to 105 million barrels-per-day, following the same gentle upslope we saw from 1990 to the present in Figure 1. From the Guardian—

Now the "peak oil" theory is gaining support at the heart of the global energy establishment. "The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year," said the IEA source, who was unwilling to be identified for fear of reprisals inside the industry. "The 120m figure always was nonsense but even today's number is much higher than can be justified and the IEA knows this.

"Many inside the organization believe that maintaining oil supplies at even 90m to 95m barrels a day would be impossible but there are fears that panic could spread on the financial markets if the figures were brought down further. And the Americans fear the end of oil supremacy because it would threaten their power over access to oil resources," he added.

What must be explained away, of course, is how 120 million demand-driven daily barrels became 116 million, and then became 105 million. And why wouldn't it become 95 or 90 now? Apparently, 103 is where the IEA has drawn the official line (WEO 2009, page 84). On the near side of that line lies the DANGER ZONE. Hence we get these statements by the IEA whistleblowers cited by the Guardian.

Fears of Panic, Cassandra's Fate

Outside of American pressure, why does the IEA issue reassuring forecasts? Allow me to quote from an extraordinary piece by the Guardian's Madeleine Bunting called Too fearful to publicize peak oil reality.

It is very hard for the average person in the street to come to a sensible conclusion on peak oil. It's a subject that prompts a passionate polarization of views. The peak oilists sometimes sound like those extraordinary Christians with sandwich boards proclaiming that the end of the world is nigh. In contrast, the the international economic establishment – including the International Energy Authority (IEA) – has one very clear purpose in mind at all times: don't panic. Their mission seems to be focused on keeping jittery markets calm...

Faced with these options the majority of people shrug their shoulders in confusion and ignore the trickle of whistleblowers, industry insiders and careful analysts who have been warning of the imminent decline in oil for over a decade now.

Remember the Queen's question – that uncannily accurate and strikingly obvious question she put to economists at the London School of Economics a year ago after the financial crisis: did no one see it coming? Apply that question to peak oil and the answer is that many people did see it coming but they were marginalized, bullied into silence and the evidence was buried in the small print.

Yes, we've clearly been marginalized, but bullied into silence? No. Marginalizing those sounding the alarm, however, is always sufficient to get the job done if the overriding concerns are to maintain the status quo, stay upbeat and avoid panic at all costs (even when a fear-based call-to-arms is clearly called for). Panic in the markets would set off a wave of buying and hoarding, which would drive the oil price into outer space, which would cause another Great Recession, and so forth.

Bullish opinions fanning the flames of Hope is the only thing we've got supporting a strong economic recovery in the United States, in so far as the fundamentals—household debt, bank solvency, unemployment, foreclosures, etc.—suck. In these times, hopeful optimism is always the key to ... something—exactly what escapes me right now. Nasty surprises later?

Yes, peakists often do sound like Christians on street corners proclaiming the Day of Judgment. This is an understandable but regrettable reaction to being marginalized, a stance that is often made worse by exaggerated takes on future oil production decline rates. 

Views proclaiming the End Times are often based on bogus Hubbert Curves which M. King Hubbert himself almost certainly would not have endorsed, given fluctuations in demand (like now during the Great Recession) or geopolitical factors (i.e. within OPEC or Russia) affecting production rates. Hubbert curves accurately model transparent, freely operating oil markets (e.g. in the U.S, the North Sea) but can not capture production rates over time in politically skewed, opaque markets (e.g the Persian Gulf). As usual, a little knowledge is a dangerous thing.

It is remarkable how many phrases the English language has for those sounding a false alarm: cry wolf, chicken little, doom merchant, prophet of doom, scaremonger, fearmonger, doomsayer, alarmist, shouter of fire in a crowded theater, and so on. Indeed, erroneous eschatology has a long and glorious history which also includes some regrettable, premature peak oil prognostications made mostly in the 1990s.

Still, the peak oil argument has been compelling in recent years if one combines 1) a straightforward assessment of production declines versus new oil coming on-stream with 2) a realpolitik view of the long-term economic interests of the big exporters. The real problem is not that we peakists are wrong, technically or politically speaking. The real problem is that we live under Cassandra's curse.

Cassandra in Greek mythology ... received the gift of prophecy but was later cursed never to be believed

Cassandra was the daughter of the Trojan king Priam and Hecuba. Apollo, the god of light, who also controlled the fine arts, music and eloquence, granted her the ability to see the future. But when she didn't return his love, Apollo condemned her never to be believed. Among other things, Cassandra warned about the Trojan horse that the Greeks left but her warning was ignored.

[My Note: In modern times, a “Cassandra” has become someone who constantly predicts bad news, which misses the point that Cassandra was always right too. One important point of the myth is that no mere mortal should be allowed to know the future.]

Cassandra would not succumb to Apollo's charms. Thus, the simple lesson of Cassandra's curse is play ball or you're cast out, you're outta here. We peak-oil-types have never been team players. Refusing to play ball, we were marginalized. The myth expresses a Universal Truth about human group behavior. (My use of the word "group" in that last sentence is redundant.) In my personal life, I've experienced this kind of exile over and over again. It's not a rockin' good time, I can tell you.

The venom heaped upon peakers was duplicated in recent years by the scorn heaped upon those who correctly predicted a crash in the global economy. Some of them, like Nouriel Roubini, are now superstars of the airwaves, so maybe there's hope for us. (I don't believe it!)

If past experience is any guide, this Guardian whistleblowers story and Reality will pass each other like two ships in the night, never to meet again. The release today of the IEA's World Energy Outlook will garner all the attention, the news cycle will cycle on, and tomorrow the media will move on to something else. Few people have an attention span longer than a single day anyway.

A Note on Non-OPEC Production

The only new oil result in the IEA's 2009 WEO was their acknowledgment that growth in non-OPEC oil production is kaput, regardless of any rise in the price. (Figure 3, with an accompanying quote below).

Figure 3 — The IEA's Figure 1.9 from page 86 of the 2009 WEO. Past price shocks led to production surges. Not this time.

Non-OPEC conventional production (crude oil and NGLs) is projected to peak around 2010 and then begin to decline slowly through to the end of the projection period. A continued decline in the number and size of new discoveries is expected to drive up marginal development costs. Production has already peaked in most non-OPEC countries and is expected to peak in most of the others before 2030 — despite an assumed steady increase in oil prices. Kazakhstan, Azerbaijan and Brazil are the only non-OPEC producing countries to see any significant increase in output.

Non-OPEC conventional oil production is expected to drop by 330 thousand barrels per day (kb/d) between 2008 and 2011; by contrast, after the first two oil-price shocks, production surged (Figure 1.9).

The IEA's non-OPEC forecast out to 2011 is about the same as my own estimate published in Are We in The Post-Peak Era? on February 19, 2009 (Figure 4).

Figure 4 — My non-OPEC low price/low investment forecast. The gray bar shows my estimate for the Great Recession, which I am sticking with even if GDP is occasionally positive. The IEA's numbers includes crude oil, natural gas liquids (NGLs), extra heavy oil from Venezuela and chemical additives. My numbers also include production from the tar sands. The further out you go, the fuzzier things get. Perhaps the decline will not be so steep after 2012 as the IEA believes.

My forecast and that of the IEA are not so different in the short-term. I note for the record that—

• I am not a well-funded, highly organized international organization, nor do I write for one.
• I get paid a pittance compared with salaries at the IEA.
• I live in Pittsburgh, not Paris.
• I work independently (alone). No one, including the dreaded Americans, influences what I say.
• I put my prediction together in a few hours using publicly available data—it wasn't hard to do.

These contrasts help to put the IEA's 2009 WEO in proper perspective.

It's All In How You Spin It

The excerpt below is from the IEA's press release.

Press Quotes 

The WEO 2009 is currently making headline news around the world, see the following selected quotes:

• 10 November 2009, Bloomberg
  
• 10 November 2009, Reuters India
  
• 10 November 2009, Financial Times
  

see all press quotes

I followed the Financial Times link and read the following:

The International Energy Agency warned today that the world’s use of fossil fuels will have to peak by 2020 if it is to escape a dangerous spike in global temperatures.

Well, well! I guess the good news is that oil production will certainly have peaked by 2020, and likely already has for all practical purposes. (We could be on a long undulating plateau—some of you veterans out there will catch this reference.) The bad news is that outside of adding a little moonshine to your gas tank, nothing much has been done to prepare for it.

Dr. Tanaka is peeved with the Guardian story.

The IEA brushed off as groundless an article in the Guardian newspaper, which quotes anonymous sources saying the IEA was pushed by US officials to downplay the risk that the world was running out of oil.

Nobuo Tanaka, executive director of the IEA, said:; “I think that article is just groundless. We are very much a neutral agency and we are proud of our analysis. We have always been saying investment is necessary.”

In fact, the IEA last year undertook the most comprehensive global study of oil field production decline rates and today warned that the world would have to find “four new Saudi Arabias” - the country with the world’s biggest oil resources, with production capacity of about 12.5m barrels per day - to overcome the production decline from old fields over the next 21 years. Like many in the energy industry, the IEA maintains that the world has plenty of oil and natural gas reserves, but that access to those reserves is constrained by politics and countries erecting investment barriers. It adds that the recent drop in the oil price to around $80 a day today from $147 a barrel last July, has reduced investments. The IEA warns that a quick world economic recovery and lack of environmental policies that reduce oil demand, would create a supply crunch by the middle of the next decade.

[My note: Here's a video of Tanaka talking about these groundless reports.]

I don't know about you, but I have read this "4 new Saudi Arabias" crap so many times—whereas in fact, everyone knows, including Tanaka, that it is certainly the case that none exist—that I can hardly keep my eyes open whenever it pops up again. (It used to be "5 new Saudi Arabias.") Invest away! Go for it!

So, in 2009 we are exactly where we were in 2008 except for the fact that upstream investment has declined in the past year (see Tanaka's slide presentation linked in above). If the IEA were to admit that there are no new Saudi Arabias left to exploit, they would effectively step into the DANGER ZONE alluded to above in which panic ensues, resource wars commence, and recessions follow.

Personally, I think it is absurd to get worked up about how many Saudi Arabias we will not find, so I refuse to play this silly game anymore. But don't let me dissuade you if you want to duke it out with Nobuo Tanaka, Daniel Yergin, Michael Lynch or other oblivious glass-half-full types—do whatever floats your boat. Remember, you are subject to Cassandra's Curse.

Oil Is Our Achilles Heal

If you've been reading my column regularly and managed to stay awake, you will be aware that I expect 1) the U.S. (and global) economy to be in the doldrums for some time to come and 2) another crash in global Finance & assorted asset markets some time in the next year or two. Thus I do not think that the long plateau of oil production capacity is going to have much effect on world economies for several years as demand remains depressed.

Looking longer term, peak oil will eventually catch up with us. If I am wrong, and there is robust global GDP growth in the short to medium term, the oil supply ceiling will dampen growth sooner rather than later. So in the next 5 years, we have the following alternatives—

• Vigorous global GDP growth causes the world to hit the oil supply ceiling, causing another oil price shock
• The world experiences anemic GDP growth, with little or no expansion of the OECD economies

Pick your poison—we're hosed if there is a strong revival of economic growth and we're hosed if there isn't one. Peak oil is the world's Achilles Heal. Only the passage of time will make this clear.

But don't listen to me—I'm a Cassandra!

Contact the author at [email protected]

Decline of the Empire — Now What?

All the world's a stage,
And all the men and women merely players
They have their exits and their entrances
And one man in his time plays many parts
    —Shakespeare

The greatest action is not conforming with the world's ways...
The greatest effort is not concerned with results...
    —the Buddhist teacher Atisha

It is now 4 months since I wrote The Decline of the American Empire. The time is ripe for a follow-up. I will tell a sad story first, talk a little about our precarious banking system, and then relate the lessons learned back to my Decline theme. At the end I will talk about what all this means for the loosely structured peak oil "movement".

This is important stuff, folks. America's tragic decline is affecting your life everyday. I urge you to read through this through from beginning to end, even if doing so is painful. (As usual, I feel compelled to document everything I write so that current and future readers fully understand the context of my remarks.) 

CIT Files For Bankruptcy, Taxpayers Lose

I was watching Tech Ticker's Aaron Task and Henry Blodget interview Professor William Black, a former top federal banking regulator, on the CIT bankruptcy (AP, Yahoo). Why should you care about CIT? "For over 100 years, CIT has provided lending, leasing & advisory services to small and middle market businesses." But now—

[CIT's] Chapter 11 filing is one of the biggest in U.S. corporate history, following Lehman Brothers, Washington Mutual, WorldCom and General Motors...

CIT is the financier for about 2,000 vendors that supply merchandise to more than 300,000 stores, many of which are gearing up for the critical holiday shopping season. They rely on the lender to cover costs ranging from paying for orders to making payroll. Any disruption caused by bankruptcy could wreak havoc on their operations, [said] Joe Alouf, a partner with Eaglepoint Advisors...

"CIT is the 600-pound gorilla in the industry," Alouf said.

Put that in your pipe and smoke it.

CIT received $2.3 billion from the U.S. Treasury on December 31, 2008 when the Treasury purchased CIT preferred stock and warrants (Bloomberg). CIT's senior bondholders will receive 70 cents on the dollar but we taxpayers will not get any of that money back.

“We will be following developments very closely with an eye towards protecting taxpayers during the bankruptcy proceeding,” Treasury spokesman Andrew Williams said today in an e-mailed statement. “But as the company’s disclosure on the prepackaged bankruptcy makes clear, with debt holders receiving less than face value of their instruments, recovery to preferred and common equity holders [including the taxpayers] will be minimal.” 

[My note: Recovery for preferred equity holders will be "minimal", that is to say — zero.]

Professor Black comments—

We put ourselves on the hook in a completely inept way where we lose first. We lose entirely as the taxpayers. It's just like the AIG bailout... [we shouldn't have had to pay the AIG counter-parties at par, i.e. 100% of claims.]

Why do we keep a Treasury secretary [Tim Geithner] who negotiates supposedly on behalf of the United States of America that does the opposite of what any commercially reasonable person would do ... it's like he burned billions of dollars again in government money, our money, gratuitously.

Blodget then asks "what was the thinking, if we assume that this was not just bad faith, that in fact it's just incompetence, what was the thinking [by the Treasury] at the time?" Here is the gist of the discussion that follows. Black believes the Treasury, flying in the face of reality, would argue that—

If we [the Treasury] had put ourselves up as senior bondholders in CIT charging a high rate of interest on our $2.3 billion investment, we would have simply increased CIT's debt obligations rather than providing equity to the company, and CIT would have died. Since CIT could not meet its debt-carry already, we would have made it obvious that they were insolvent.

The Treasury would not admit that CIT was insolvent. Instead, they pretended CIT had a temporary liquidity problem, so they gave them $2.3 billion of the taxpayer's money. If the Treasury had protected the taxpayer money they put into CIT, it would have exposed CIT as insolvent, which of course they were! Got it?

And now CIT is officially bankrupt, an outcome which was unavoidable. Black comments on the Treasury's apparent "logic"—

I'm not a psychotherapist... [laughs] ... It's the insanity of not resolving insolvent places, and instead feeding money in, good after bad... it's a trap, I can't cause a liquidity crisis by charging much interest, I can't make myself [a] senior [bondholder], we just hose money down the drain... The answer to accounting fraud is more accounting fraud... You hide the losses, and you let them grow, and you hope they'll get better."

Hiding the losses, letting them grow, and hoping they'll get better is known as Extend & Pretend. Black believes "the [denial] problem stems from regulators' fears that if the banks recognize a loss on the bad assets [they hold], it will create a domino effect that will wipe out the entire financial system."

So in the story above, where it says CIT, you could substitute Citigroup, or Bank of America, or Wells Fargo, or JP Morgan Chase, etc. The only difference between CIT and Citigroup is that the latter was deemed Too-Big-To-Fail whereas CIT was not.

That's the end of this sad story. As you read on, remember Henry Blodget's important qualification: if we assume that this [CIT deal] was not just bad faith.

Extend & Pretend

This chart from Rolfe Winkler's Banks' Capital Cushions: Thicker, But Still Not Comfy scares the bejesus out of me (Figure 1 and the quote below).

Figure 1 — Leverage = Tangible Common Equity/Tangible Assets. From Winkler: "Measured by tangible common equity, the biggest banks are levered [on average] 20 to 1, a solid improvement from last quarter’s 24 to 1 and a giant leap from 30 to 1 in the third quarter a year ago. (These figures exclude off-balance sheet assets, which will increase leverage when they are consolidated beginning next year)... Now it’s up to regulators to deliver higher capital requirements so that banks can withstand the end of government support. After all, 20 to 1 leverage is still very high. It only looks prudent against the insane levels reached last year."

Tangible common equity is the crucial measure of bank capital because it is the primary cushion banks have to absorb losses. When it gets too low, creditors panic and bank runs ensue. From a systemic risk perspective, it’s great that banks are rebuilding this cushion.

The crucial question is how they’ll fare in a less favorable monetary environment. While consumer prices show little sign of inflating, asset prices are another story. Interest rates near zero have encouraged investors to chase risky assets. If that trend continues, the Fed may have to unwind its balance sheet and raise rates sooner than it would like, putting banks in a tough position.

FBR Capital Markets points out in a recent note to clients that many banks have poured excess liquidity into their securities portfolios, “which could present significant interest rate risk” when the Fed reverses course.

Compared with last year, the top 10 commercial banks have increased the size of their securities portfolios nearly 40 percent, with JPMorgan Chase’s rising over 150 percent.

I discussed the dangers of the carry-trade asset bubble fueled by free dollars in Big Crash Coming?  If asset values suddenly deflate once the Fed unwinds its balance sheet and raises interest rates, the banks will be imperiled to the extent that they have purchased these risky assets to inflate their balance sheets. There are also concerns about increased bond purchases by the banks—see Bank Insolvency Is Not A Dead Issue by Daniel Aaronson and Lee Markowitz.

For bank solvency, loan portfolios may be a greater danger than investments in Treasury bonds or riskier securities (Figure 2).

Figure 2 — As of September 1, 2009, the banks held $3.776 in outstanding real estate loans. Source: FRED.

Here is the crucial passage from Winkler—

And while securities prices are more immediately sensitive to monetary policy, loan portfolios would be impacted as well. Early next year, after the Fed turns off its printing press and after the home-buyer tax credit expires, real estate prices could resume falling. This will put more owners upside down on their loans, keeping default rates high.

Banks are extending loans, pretending that asset prices will recover past peaks, an unlikely prospect if the Fed does its job.

[My note: "Upside down on their loans" refers to negative equity in which you owe more on your mortgage than your house is worth. This is also called being underwater.]

Extend & Pretend. This is a variation on the CIT theme presented above, in which the Treasury extended credit (through stock purchases) to CIT and pretended they were solvent.

The real estate market in the United States continues to be very shaky. I could write an entire column on this subject, so I will just touch on a few high points here, relating the market weakness to officially sanctioned delays in which banks do not fully account for their actual losses. To wit—

• From a USA Today report: "Moody's Economy.com estimates the number of underwater borrowers will peak at 17.4 million in the third quarter of 2010. An even higher estimate comes from Deutsche Bank, which predicted in an August study that the number of homeowners underwater will grow from 14 million (or 27% of all homeowners with mortgages) in 2009 to 25 million homeowners, or 48% of all those with a mortgage, by the time home prices stabilize." So-called "strategic defaults"—you walk away from your mortgage—rise when people get upside down on their loans. 13.2% of all mortgage loans were in foreclosure or delinquent as of the last Mortgage Bankers Association survey. Foreclosures or delinquencies now threaten prime mortgages, and joblessness is now the major factor driving foreclosures.
• There is a ticking time bomb with maturing pay Option Arm (POA) mortgages. "However, there is a significant problem with POA recasts, as those payments can double or triple at recast, and – due to negative amortization – an estimated 80% or more may owe more than the value at the time of recast. So the risk of POA defaults is both larger and more concentrated than the risk from Alt-A [mortgages]"
• The commercial real estate (CRE) market is still crashing. Calculated Risk reports that "the Moody’s/REAL Commercial Property Price Index (CPPI) ... showed commercial real estate prices fell 3 percent in August, and are down almost 41 percent since the peak in October 2007."

Of course a bank can not re-finance (extend) an Option ARM home mortgage and pretend everything will work out once the property goes into foreclosure. But it is the deteriorating CRE market that makes the Fed nervous.

Prices of existing commercial properties have already declined substantially from the peak in 2007 and will likely decline further. As job losses have accelerated, demand for commercial property has declined and vacancy rates have increased...

As a result, Federal Reserve examiners are reporting a sharp deterioration in the credit performance of loans in banks’ portfolios and loans in commercial mortgage-backed securities (CMBS). At the end of the second quarter of 2009, approximately $3.5 trillion of outstanding debt was associated with CRE, including loans for housing developments. Of this, $1.7 trillion was held on the books of banks and thrifts... Also at the end of the second quarter, about 9 percent of CRE loans in bank portfolios were considered delinquent, almost double the level of a year earlier...

Of particular concern, almost $500 billion of CRE loans will mature during each of the next few years...

[My note: Read Jon D. Greenlee's full testimony (link above) for all the grim details. He is the Fed's top bank regulator.]

This is where things get interesting. Federal regulators have issued new guidelines for Extending & Pretending! These guidelines are apparently a kind of "how-to" guide for the banks. The Wall Street Journal reported on the new rules in Banks Get New Rules on Property on October 31, 2009.

Federal bank regulators issued guidelines allowing banks to keep loans on their books as "performing" even if the value of the underlying properties have fallen below the loan amount.

The volume of troubled commercial real-estate loans is skyrocketing. Regulators said that the rules were designed to encourage banks to restructure problem commercial mortgages with borrowers rather than foreclose on them. But the move has prompted criticism that regulators are simply prolonging the financial crisis by not forcing borrowers and lenders to confront, rather than delay, inevitable problems... [i.e. extend & pretend]

Regulators have been expressing increasing concern that problems in commercial real estate could unglue the nascent economic recovery by slamming financial institutions with billions of dollars in new losses. FDIC Chairman Sheila Bair told a Senate subcommittee earlier this month that reworking the terms of these loans could help banks avoid larger losses. She likened it to the push regulators made last year for banks to rework troubled residential mortgages.

About $770 billion of the $1.4 trillion commercial mortgages that will mature in the next five years are currently underwater, according to Foresight Analytics. As of last week, 106 banks had failed this year, the most since 1992—the peak of the savings-and-loan crisis. Regional and community banks especially have been paying dearly for their aggressive push into commercial real-estate lending during the boom years.

This concludes my brief summary of where we stand concerning the real estate markets and looming bank losses. As with the Treasury's investment in CIT, the strategy of choice is denial—Extend & Pretend. How does this relate to my original article The Decline of the American Empire? It's no great surprise that the relationship is simple and straightforward.

More Futility—And Bad Faith, Too

In the Decline article I presented the Vicious Circle of Futility—it's kind of a Buddhist Wheel of American Suffering. Here it is again with the original caption (Figure 3).

Figure 3 — As problems become more intractable over time, our resistance to making real changes to confront those problems, our social inertia, becomes more entrenched. Thus the solution to debt-based economic problems is more debt. The solution to liquid fuels problems is marginally more fuel efficient cars, not alternatives to driving. We study an expansion of the rail system instead of building one to provide an actual alternative to flying or driving between cities. We dream of hypothetical biofuels in the far-off future to solve an oil supply problem in the here & now.

The only real difference between my remarks here and those in my original article is that this time I am relating the vicious circle to the wacky world of make believe bank solvency. And if you think about it, what's the difference between Extend & Pretend and Futility's Vicious Cycle? There is no difference. Conceptually, they are identical.

The problem is Bank Solvency. Social inertia manifests as dithering or active obstruction by banks, Federal regulators, the Fed, the Treasury, and the Congress. The President talks pretty, but does nothing of substance. Unrecognized bank losses continue to pile up but resistance to remedial actions and reform in Finance only becomes more entrenched. Policy-makers act as if the crisis does not exist. Futility reigns as we approach a new day of reckoning.

As Professor Black said above, "it's the insanity of not resolving insolvent places ... [but] instead feeding money in, good after bad." The longer this unwillingness to come to grips with reality goes on, the more likely it becomes that the banking system will blow up again, and again take all of us down with it.

Let us explore another aspect of America's decline. You will recall that Tech Ticker's Henry Blodget qualified his question to Professor Black, assuming that this [CIT deal] was not simply a matter of bad faith. He framed his question in terms of Tim Geithner's incompetence instead. There is little doubt that Geithner is incompetent, but that's not the whole story.

I am not criticizing Henry Blodget, whom I respect, when I say out loud what he didn't care to go into: the entire Finance reform issue has been a charade, a matter of Bad Faith, since the October, 2008 post-Lehman meltdown. Here is the legal definition of Bad Faith—

The fraudulent deception of another person; the intentional or malicious refusal to perform some duty or contractual obligation.

In this case, the fraudulent deception has been carried out against the American People by the Too-Big-To-Fail Banks in cahoots with the Federal Reserve, and the Executive (e.g. the Treasury, the regulators) and Legislative branches of government. It is plainly the duty of the Federal government, if not that of the banks, to reduce our exposure to insolvent banks which pose a systemic risk should they fail.

The law always imputes intentionality. Hence the definition of Bad Faith. But I don't care whether this is a complex conspiracy—a conscious collaboration—between the banks and policy-makers, or whether it's just that all these people see things exactly the same way—an unconscious collusion. Nothing relies on this distinction, for it does not change the ultimately destructive effects of an unreformed Finance system.

(However, if you follow the money, apparent influence is exactly where you'd expect it to be. And if you look at Tim Geithner's appointment book, he does spend an inordinate amount of time on the phone with the heads of Goldman Sacks, Citigroup and JP Morgan Chase. As usual, we can prove nothing.)

In perpetuating this fraud, Wall Street & Washington ensure that we are forever stuck on the Futility merry-go-round.

I would have to write a book to fully document the persistent pattern of government catering to Big Finance. Like Kevin Phillips, many people have written one or are doing so now. The entire raison d'etre for Simon Johnson's Baseline Scenario is to tell you about this stuff everyday. So I will only mention a couple egregious recent examples of Bad Faith here. And away we go—

• "The U.S. government plans to alter the way that a similar rescue would be handled in the future. Draft legislation proposes that banks, hedge funds and other financial firms holding more than $10 billion in assets would pay to rescue companies whose collapse would shake the financial system" (Bloomberg). For additional details, read the New York Times' Bill Seeks To Shift Rescue Costs To Big Banks. Barney Frank helped craft this brainstorm, which is called the Financial Stability Improvement Act of 2009.

  The best part of the "Stability Improvement" legislation decrees that "the identification of systemically dangerous financial firms by federal regulators remain entirely secret, and never be revealed to the public" (Baseline Scenario). This clandestine group of Too-Big-To-Fail institutions will be regulated by "a powerful financial services oversight council, led by the Treasury secretary and composed of top regulators, to set policy and tougher regulations for the largest companies and mediate disputes between federal agencies. It would also give the Federal Reserve Board a lead role in directly supervising many of the largest financial conglomerates" (New York Times).

The "Stability Improvement" act applies to a super-secret list of institutions who will be regulated by the Treasury secretary and other regulatory ne'er-do-wells. The Fed will supervise this group of never-to-revealed-to-the-public super-sized institutions. No one will be accountable to the public for anything this group does or does not do. Perfect!

The Obama administration and the Congress are putting forward a new plan to handle the next, inevitable round of Too-Big-To-Fail bank failures instead of breaking up large institutions that pose a systemic risk. Rather than dispose of the problem, the government proposes to drain the rest of the banking system and put ordinary citizens—those of us who are not Masters of the Universe— at risk again. The Powers-That-Be would rather bend over backwards to preserve the status quo than put JP Morgan Chase or Citigroup out of the rent-seeking business (whereby one obtains competitive advantage through political manipulation).

Nobody, including Barney, seems to have asked a pertinent question. What happens when runs on 3 or 4 Too-Big-To-Fail banks cause them all to fail more or less at the same time? See Rolfe Winkler's article cited above. This would have happened in October, 2008 if then Treasury secretary and former giant vampire squid CEO Hank Paulson hadn't extorted us—ah, sorry, I meant "scared us silly"—to get $700 billion from Congress to bail out the banks.

What was it Einstein said? Insanity is doing the same thing over and over again and expecting different results.

Here's a second item from Yves Smith at Naked Capitalism—

• Harper’s Magazine has written up the lengths to which the authorities will go in censoring views that dissent with what is the unstated official policy: that no demand of the banking industry is too unreasonable not to be catered to.

  The object lesson is the gutting of the falsely-branded derivatives reform bill. It arrived with a loophole so large you could drive a truck through it, namely that customized derivatives were not covered. So this bill will do nothing to impede the growth of complex opaque products; in fact, it encourages it, since banks will have no oversight if they tweak a product so that is can be deemed “customized.” It was further weakened by excluding most of the banks in America and by excluding a whole swathe of end users. The final insult was making the derivatives clearing house self-regulating.

  The hearings on the bill had testimony scheduled only from what amounted to industry flacks. Someone apparently realized at the 11th hour that that might not go over with the correctly angry public too well. So less than 24 hours prior to the session before the House Financial Services Committee, an invitation was issued to Rob Johnson, a former managing director at Bankers Trust Company and former economist at the Senate Banking Committee and Senate Budget Committee.

And what happened to genuine reformer Rob Johnson? Congresswoman Melissa Bean (D, Ill), filling in for the curiously absent Barney Frank, cut his testimony short. At first, Johnson refused to quit.

Johnson gamely continued. “When I hear the testimony today that are largely financial institutions and end users, I believe that I represent a third group that comes to the table, which is the taxpayers, the working people of the United States,” he said.

But Melissa, whose 2009-10 campaign committee has collected $107,700 from the Securities and Investment industry, cut Johnson off again. And then came the final insult, not only to Johnson, but to all of us—

The House Financial Services Committee has refused to publish [Johnson's] testimony, offering “the dog ate my homework” level excuses, first that they hadn’t gotten it, then that it was in the wrong format, then that their IT department was experiencing difficulties (always a good one when real reasons are running thin). The last one was pure Catch-22: that he had gotten his written testimony in too late.

You can read Johnson's statement to the committee, which they themselves never heard or published, at the Roosevelt Institute.

It's Bad Faith everywhere you look. There is no escaping the Futility's Vicious Circle in the current, entrenched political arrangement. As with the all-encompassing Buddhist Wheel of Suffering, our tragic Fate appears to be Cast In Stone.

Now What?

Mike Shedlock (Mish) of Global Economic Analysis asks Where the Hell Is The Outrage? That's a good question, but it appears that the American people are now incapable of fostering the revolutionary acts required to take down the corrupt clowns that govern us. If we elect a new set of bozos in 2010 and 2012, we will quickly find out that only the words have changed—the song remains the same.

If you doubt that entrenched power and corruption runs very, very deep, I suggest you watch Bill Moyers' interview with Glenn Greenwald. Washington is now a place unto itself. Those of us outside the Beltway are merely a backdrop that lends the Capital a false legitimacy. Empires in decline always go through this phase.

Those of us who have written about the dangers of peak oil, declining domestic oil production, and recessions accompanying oil price shocks must come to grips with the Vicious Circle of Futility. If our goal was to promote public interest and understanding in these problems, we have succeeded to some extent. Sophisticates in the university and investment communities know all about peak oil. It's mostly denizens of our Nation's capital who have never heard of it.

We must also come to grips with Bad Faith. If our interest was to foster policy actions to mitigate future oil supply problems, we have failed and will always fail. We are merely bit players on the Wheel of Suffering. In this, we do not differ much from those concerned  about health care costs—Congress has done nothing, climate change—Congress has done nothing, and Financial Reform—Congress has done nothing. In this sense, we are like any other group with a cause, no more, no less.

(Of course, many would argue that peak oil is a civilization-changing issue, and they are right. But we are living & doing things now, not a decade from now or two decades from now.)

This is not to say that we have wasted our time raising concerns about energy availability—far from it. I am merely describing the hand we’ve been dealt. We have to play the cards we’re holding. Progress is always an illusion anyway. Oil made lots of stuff possible, but the Really Big Picture tells us that oil comes and oil goes.

Many people don’t realize that it’s hope that’s killing them. Almost invariably, our greatest hopes are dashed. When we realize that our hopes are unattainable, disillusionment and bitterness often follow. And then, maybe, wisdom. This is the Human Condition. It is our Fate to live in Times when we are much closer to the end of the American Empire than we are to its beginning. When life gives you lemons, make lemonade.

Contact the author at [email protected]

Big Crash Coming?

I think policy is currently quite accommodative. I think it can remain quite accommodative for a while to come
   —Ben Bernanke

Delay is the deadliest form of denial
   —C. Northcote Parkinson

In More Like A Depression Every Day, I described strong deflationary pressures in the American economy despite the Shock & Awe fiscal & monetary stimulus being applied. The flow of free money is supposed to counter deflation by boosting both asset values and government spending. Economist Nouriel Roubini, otherwise known as "Dr. Doom", notes that this "wall of liquidity" is inflating asset values, not just in the United States, but all over the world.

The BEA's advance estimate showed growth of 3.5% in the third quarter (July-September) just passed. So Shock & Awe appears to be "working" if you go by real GDP. Don't you believe it. I warned you about a "statistical" recovery last week. Get ready for another round of nonsense announcing that the recession is over. In absolute (2005 chained dollars) terms, real GDP is down 9% year-over-year, even after you throw in the "cash-for clunkers" program which gave an artificial boost to personal consumption expenditures.

One important consequence of the Fed keeping interest rates low and its quantitative easing has been a weaker dollar. The world's reserve currency has depreciated 14.6% relative to a basket of other currencies since March 5, 2009 as measured by the U.S. Dollar Index (DXY). The depreciating dollar, combined with the Fed's stated intention to keep interest rates low for an extended period to come, has prompted investors to short the dollar—bet that the value of the dollar will continue to fall. Investors short the dollar via what is called the carry trade (and Figure 1).

Critics focus on the fact that low U.S. interest rates enable investors around the globe to borrow dollars for next to nothing and invest them elsewhere at higher rates.

This bet — known as the dollar carry trade — appears to be one of the forces pushing down value of the dollar. Though there are few reliable figures on the size of the carry trade, the dollar's trend has clearly been down since stock and bond markets revived.

Figure 1 — The Fed has frozen short-term interest rates at 0-0.25% (left) as the dollar declines(right). This allows investors to borrow dollars a little cost and re-invest them in assets that return higher yields.

Roubini believes that continued low interest rates are inflating asset values beyond what the fundamentals dictate all over the world—a new global bubble. He argues that when the Fed finally does raise rates and the dollar strengthens, as it eventually must, there will be another resounding crash in the global economy. Readers here may not be familiar with this kind of material, so I have summarized Roubini's argument as he presented it in this interview with Index Universe and in a guest appearance on CNBC.

1. There is a "wall of [excess] liquidity" inflating asset values (in equities, real estate, commodities, credit, gold, in emerging markets) all over the world.
2. The Fed has fixed short-term rates at zero (0-0.25%) and is expected to keep them there for the time being. The Fed has also set investor expectations by "controlling and reducing volatility" in the long-term by indicating that they will keep rates low for some time to come.
3. Investors borrow at near-zero percent interest rates and get a capital gain by investing elsewhere in assets that yield a higher rate, so "we're in the mother of all carry trades." The carry trade makes the bubble global as investors borrow dollars and invest in foreign assets (for example, in Australian dollars, Brazilian reals, and so on).
4. Because the dollar is falling, investors are effectively shorting the dollar and borrowing at negative real interest rates. The carry trade itself results in a dollar sell-off, which causes further weakening. Investors are going long on global assets based on expectations set by the Fed about future interest rates (#2 above).
5. The dollar can not keep on falling forever, i.e. the Fed must raise interest rates at some point.
6. When the dollar suddenly stops falling and reverses, investors will have to close their dollar shorts, and dump their assets.
   
7. The strengthened dollar will cause a market crash all over the world as assets deflate.
   

One class of "assets" that is inflating as the dollar depreciates is commodities, including crude oil. (A commodity can viewed as a "hard asset.") The oil price and the dollar's value are inversely correlated, which means that the price of crude rises when the dollar falls. Reuters data shows that this correlation between oil prices and the dollar has reached a coefficient of -0.9 in 2009, .

The dollar had a bad week from October 19-23, so the oil price jumped to over $80/barrel. Then on Monday October 26, the dollar had a "good" day, which caused the oil price to fall back to $78 and change. As of right now, it is , but the longer-term trend is clear.

It is particularly alarming that even relatively small decreases in the Dollar Index (DXY) can cause rather large upward movements in the oil price. The DXY fell from 76.43 on Friday October 9th to its low of 74.92 on Wednesday the 21st, a 2% percent drop. The oil front month contract was selling around $70/barrel during the week October 5-9, but had increased 15% at its highest point last week (Figure 2).

Figure 2 — NYMEX front month closing prices since October, 2008. Note the recent, unwarranted jump. Source.

Roubini discussed crude oil prices together with asset price inflation in the Index Universe interview. I'll quote it at some length because Roubini makes all the important points.

Index Universe — You’ve said that you’re worried we’re already sowing the seeds of the next crisis. Where do you see that most directly?

Roubini — Well, in commodities, I look at oil prices. They fell from $145 last summer, came down to $30 earlier this year and now they’re back close to $80. But if I look at the fundamentals of demand and supply, demand is down to 2005 levels, supply and inventories are at all-time highs. In my view, the movement in oil prices is not fully justified by the fundamentals.

There are improving fundamentals. There is a global recovery. But that justifies oil going from $30 to maybe $50. I think the other $30 is all speculative demand feeding on it—speculators and herding behavior. Last year, when oil was at $145, that killed the global economy. I worry that oil is going to go up above $100 for reasons that have nothing to do with the fundamentals of supply and demand. Oil at $100 would have the same negative effects on the global economy as oil did at $145 last year.

Last year, when oil was at $145, the global economy was still growing. Right now it has collapsed, and is recovering. Oil pushing above $100 would have nasty, negative real trade effects and real disposable-income effects on all importing countries: the U.S, Europe, Japan, China, India; all the countries that were hit by the oil shock last year. So that’s an element that is in my view totally speculative, and dangerous to the global economy.

Index Universe — Is that true elsewhere?

Roubini — I could make a similar argument for other commodity prices. In my view, rising commodity prices are not justified by the fundamentals.

There’s a huge bubble, because we have zero rates in the U.S, zero rates around the world and a huge carry trade. Everyone is borrowing at zero interest rates in dollars and getting a capital gain because the dollar is weakening, so they are borrowing at negative rates. And then they invest in risky assets:commodities, equities, credit. We’re creating a bigger bubble than before [Lehman].

It’s going to go crashing down, in an ugly way. That’s the basics of the argument.

[My note: I'm not sure oil demand is down to 2005 levels, and oil never quite got to $30/barrel, but who can quibble with Roubini?]

I have made many of the same points in several columns, most recently in It's Not Black Or White. Unwarranted oil price inflation is certainly a threat to a global economic recovery in the next year, but another real danger lies in the renewal of systemic risk in global finance, to which I now turn.

A Sense of Foreboding

Gillian Tett of the Financial Times sounded the alarm on October 22, 2009 in Rally fueled by cheap money brings on sense of foreboding (registration/subscription required).

Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and [he] was feeling deeply shocked.

“Forget about the events of the past 12 months ... the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players ... jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.

“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.

“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”

I daresay this missive reflects some element of hyperbole. But I have quoted it at length because the question is becoming more critical...

I doubt Roubini would think that Tett's banker friend is exaggerating the problem. I don't think he is. Was October, 2008 just a dress rehearsal for another crash when this latest bubble bursts?

As the the earnest folks at Baseline Scenario never tire of reminding us, we have a financial system here in the United States, in Europe and elsewhere that has not been reformed at all. In fact, it has been bailed out and thus operates regardless of risk. What has changed is that there is a new, enormous free flow of capital for it to gamble with.

This new carry-trade bubble, like all previous ones, encourages reckless behavior. Banks, hedge funds and other investors appear to be leveraging up again like there's no tomorrow—which may be the right strategy for some because there may not be a tomorrow, figuratively speaking.

The Titans of Finance understand that the surest way to re-capitalize themselves and make outrageous short-term profits is to make over-leveraged bets on risky assets just as they did during the Housing Bubble. The Masters of the Universe can count on Central Bank policies which have encouraged this very behavior. (Throw in your favorite conspiracy theory about relationship between the Fed, the Treasury, and the Wall Street Banks here.)

And for Finance, let the consequences be damned. Here is Tett again—

Yet, if you talk at length to traders – or senior bankers – it seems that few truly believe that fundamentals alone explain this [renewed appetite for risk]. Instead, the real trigger is the amount of money that central bankers have poured into the system that is frantically seeking a home, because most banks simply do not want to use that cash to make loans. Hence, the fact that the prices of almost all risk assets are rallying – even as non-risky assets such as Treasuries bounce too.

Now, some western policymakers like to argue – or hope – that this striking rally could be beneficial, in a way, even if it is not initially based on fundamentals. After all, the argument goes, if markets rebound sharply, that should boost animal spirits in a way that could eventually seep through to the “real” economy.

Could eventually seep through to the "real" economy? Boosting animal spirits will magically erase household debt and boost the flow of credit to people who don't want any? How does this work?  Pimco's Bill Gross discusses the relationship between inflated asset values and the "real" economy in Midnight Candles. One obvious way in which inflated assets (in stocks, housing) pump up the economy you and I live in is to create phony wealth effects which make us feel rich—bubbles boost our animal spirits!

Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services..

[My note: See my ASPO-USA conference presentation and related articles. I have covered this ground a number of times.]

In other words, the cart has been placed before the horse. Inflated assets boost spending and GDP, but in a healthy economy, savings & investment in actual production would drive GDP and thus asset values gradually over time.

Gross concludes that in the U.S. alone, assets are overvalued by 15,000,000,000,000 (trillion) dollars as it is (prior to future inflation brought on by Fed policies). 

A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually. That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds.

Putting a compounding computer to this 1.3% annual out-performance for 50 years, produces a double, and leads to the conclusion that the return from all assets was 100% (or $15 trillion – one year’s GDP) higher than what it theoretically should have been. Financial leverage, in other words, drove the prices of stocks, bonds, homes, and shopping malls to extraordinary valuation levels – at least compared to 1956 – and there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner’s platform.

I will return to Gross' analysis in my conclusion.

The bottom-line is that investors are once again trading in paper instead of the production of goods & services (in factories, machinery, public transportation, alternative energy, and so on). The separation of the "real" economy from the Wacky World of Finance in nearly complete. Why bother with the "real" economy if you can make guaranteed money running a casino? Gillian Tett understands what's going on, but hopes she's wrong—

In the meantime, it is crystal clear that the longer that money remains ultra cheap, the more traders will have an incentive to gamble (particularly if they privately suspect that today’s boom will be short-lived and want to score big over the next year). Somehow all this feels horribly familiar; I just hope that my sense of foreboding turns out to be wrong.

Anyone living in the real world knows today's "boom" will be short-lived. Maybe it will all fall apart a year from now, maybe a few quarters earlier, maybe a few quarters later. Who knows what the Central Banks will do? Who knows how high the oil price will go?

What Roubini knows for sure is that the eventually the Fed must raise interest rates and withdraw its quantitative easing. How does he know this? Because if the Fed doesn't ease the throttle back, the U.S. economy and that of the world generally—the dollar is still the world's reserve currency after all— will look like Argentina's in 2002. (I can't do this scenario justice  here, so follow the link and do some Google searches.)

Raising interest rates and withdrawing quantitative easing will destroy the "rally" in the S&P 500 if it hasn't blown up already. These steps will end the life-support keeping the U.S. housing market alive, and stop the carry trade fueling a global asset bubble.

It is quite obvious that traders are hoping to "score big" while interest rates remain low. Many of them will take a bath because few will correctly anticipate the timing of events, and not everyone can get out at the top of the bubble. Even small changes in interest rates can set off a wave of defaults, especially in a currency carry trade, if investors are leveraged at 10 to 1, 20 to 1 or more. This is the first rule of Bubbleology.

Once could see this as a reminder that no one in Finance learned anything in the last 10 years. More cynically, we could say that traders know the risks, but the potential rewards are just too tempting to pass up in a world with little economic future. If slow or no real economic growth over the next decade and beyond is not going to cut it, you might as well go for broke. Many banks and hedge funds will go under, but some firms—fewer than there used to be—remain Too-Big-To-Fail.

So I regard any talk about inflated asset values eventually being a boon to the "real" economy as either a self-serving rationalization, an exercise in self-delusion, or an outright lie. Frankly, I don't even know why the Powers-That-Be bother to reassure us little people that things will be OK anymore. But I'll let Joe Saluzzi do the talking.

Joe Saluzzi to Tim Geithner: What planet are you living on?

Returning to Bill Gross—

This 100% overvaluation [of $15 trillion] from recent price peaks of course is crude, simplistic, and unrealistically pessimistic. It implies that stocks should be at – gasp – Dow 7,000 – and that home prices – gasp – should be cut in half from 2007 levels, and that commercial real estate (Las Vegas hotels, big city office buildings that are 20% empty) should likewise face the delevering guillotine. Some of these price adjustments have already taken place...

This is where it gets tricky, however, because policymakers, (The Fed, the Treasury, the FDIC) recognize the predicament, maybe not with the same model or in the same magnitude, but they recognize that asset prices must be supported in order to generate positive future nominal GDP growth somewhere close to historical norms. The virus has infected far too many parts of the economy’s body, for far too long, to go cold turkey...

Gross then goes on theorize the the Fed will likely require 12-18 months of 4%+ nominal growth in GDP before abandoning the 0% short-term benchmark interest rate!

The longer asset prices inflate beyond fundamental levels based on real supply & demand, and the more leveraged-up investors become in those assets, the worse the crash will be when the carry-trade goes belly up. Allow me to repeat from the summary above—

• The dollar can not keep on falling forever, i.e. the Fed must raise interest rates at some point.
• When the dollar suddenly stops falling and reverses, investors will have to close their shorts, and dump their assets.
  
• The strengthened dollar will cause a market crash all over the world as assets deflate.

When the "carry-trade" bubble collapses, I anticipate a strong round of debt-deflation to take hold in the developed world (OECD) economies — and this next time there will not be a another stimulus fix even if inflation is positive (owing to all the previous stimulus). This latter scenario would mean an extended period of stagflation. Otherwise we will have stag-deflation.

This all goes to show that you can delay, but not prevent, a prolonged severe recession, or if you prefer, Depression. The fundamentals of the "real" economy say there is no real basis for renewed growth. Inflating asset values is politically expedient but merely postpones the inevitable. You must have the recession you need to have—there is no getting around it. As in health care, providing life-support to a doomed patient needlessly raises costs which someone must bear later on. I say pull the plug. Only then can we build a real future.

Contact the author at [email protected]

More Like A Depression Every Day

We have improved the prospects we won't be consigned to a long period of subpar growth [but] it's going to be a slower than typical recovery, and right now, downside risks continue to outweigh those that are positive. We've got the first stage [of recovery], better than I would have expected
   —Tim Geithner

There is no "there" there
   —Gertrude Stein

The American economy has reached a dangerous new phase. We are now in the "recovery" period, but what kind of rebound will we have? In No L,  Professor James Hamilton (along with Paul Krugman) takes note of some positive news from the Fed. Capacity utilization has been climbing since June (Figure 1 below).

Output is up, there's no doubt about it. Calculated Risk notes that "an increase in capacity utilization is usually an indicator that the official recession is over." Putting this in perspective, "in September [2009], the capacity utilization rate for total industry increased to 70.5 percent, a level 10.4 percentage points below its average for 1972 through 2008." That's not much of a comeback.

Figure 1 — Capacity Utilization in the United States, 1965 to the present. Utilization remains at its lowest level since 1960s. You can see that a rise in utilization signals the "official" end of the recession (gray bars). Source: FRED.

Few understood in 1930 what lay ahead. The Wall Street Journal disputed a pessimistic view on October 17, 1930—

Gov. Black of the Atlanta Fed. takes a defeatist attitude in saying that the US must accept a lower standard of living and that the “load of debt around our necks” is the root of the problem. Contrast this with President Hoover's optimism: “Any retreat from our American philosophy of constantly increasing standards of living becomes a retreat into perpetual unemployment and the acceptance of a cesspool of poverty for some large part of our people.” Can Gov. Black really say going into debt has been a net negative for the American people? “Has there been any greater blessing than the building and loan associations which have lent billions of dollars to millions who would never otherwise have had the means to build.” Home ownership has stimulated people's desire for the other comforts of life, resulting in activity and progress; the fact that some excesses have taken place doesn't negate our whole course. “Governor Black says that what is needed in American business today is not confidence but courage. But surely courage lies in going forward, not backward. The American emblem is an eagle not a crab.”

Poor Mr. Black. He had the temerity to tell the truth and got lambasted for it.

It is the very nature of the "recovery" itself in October, 2009 that tells me that it's looking more and more like a Depression every day. I will explain myself, but first let's be clear on what we do not have—yet. We do not have a collapse of the financial system with the accompanying debt-deflation spiral that we had in the early 1930s. It is said we averted this outcome, and maybe we have.

In the 21st century, in a new kind of Depression, it is possible to have a statistical recovery (positive GDP growth) and rising asset values (in equities, in housing) in the short-term. We are witnessing this now. The difference between the Great Depression and now is due to the massive fiscal & monetary stimulus applied to fix the problem. The Fed's short-term benchmark interest rate was also set to zero and could not be lowered further. All this "free money" is meant to counter deflation by reflating the economy (e.g. stimulating new demand).

To be sure, the big banks would have collapsed in 2008, and still would in many cases, were it not for the massive bailouts and guarantees from the Central Bank and the Treasury. To be sure, we would not be seeing rising asset values without the flood of newly printed money from the Fed. 

But the magic of additional liquidity only goes so far. Bearish commentators sometimes refer to this as pushing on a string. It is helpful to quote President Obama to contrast the stated goal for recovery with what is actually happening.

Of course, there are some who argue that the government should stand back and simply let these banks fail – especially since in many cases it was their bad decisions that helped create the crisis in the first place. But whether we like it or not, history has repeatedly shown that when nations do not take early and aggressive action to get credit flowing again, they have crises that last years and years instead of months and months – years of low growth, low job creation, and low investment that cost those nations far more than a course of bold, upfront action.

And although there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – "where's our bailout?," they ask – the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.

[My note: Here is Obama's economic top adviser Larry Summers talking about a multiplier on government stimulus dollars.]

Here the President sketches out his vision of a credit-driven recovery by citing the money multiplier effect in which a dollar of capital in a bank can result in eight to ten dollars of new loans for families and businesses. Presumably, families will want more credit to expand their consumption while firms will borrow money to expand their inventories to meet the new demand. Presumably, the banks are eager to make these new loans.

The President also refers obliquely to deflation and the need for renewed household spending. Nowhere does he refer to household debt.

To begin with, economists on both the left and right agree that the last thing a government should do in the middle of a recession is to cut back on spending. You see, when this recession began, many families sat around their kitchen table and tried to figure out where they could cut back. So did many businesses. That is a completely responsible and understandable reaction. But if every family in America cuts back, then no one is spending any money, which means there are more layoffs, and the economy gets even worse. That's why the government has to step in and temporarily boost spending in order to stimulate demand. And that's exactly what we're doing right now.

[My note: Perhaps it is merely a coincidence that the neoclassical economic theory practiced by Larry Summers and evinced by the President neatly coincides with the extraordinarily cozy relations between Wall Street and Washington.]

The President is referring to the paradox of thrift. 

The notion is generally credited to Englishman John Maynard Keynes—seemingly the source of every important economic idea these days—although he doesn't appear to have actually used the phrase. Paul McCulley, an economist and portfolio manager at bond giant Pimco, defines it like this: "If we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person's spending is another's income—the fountain from which savings flow."

But what if people absolutely can not spend money because they're broke? Or what if they will not spend money because of their considerable uncertainty about the future? One way to force some of them to spend money is to print a bunch a new money, get it circulating & multiplying in the economy, and thus create some inflation. (The bond market has currently priced in 1.75% inflation at an annual rate as measured by inflation-adjusted treasury bond yields.) Unless your income is rising at the inflation rate, inflation erodes the purchasing power of your dollars. Thus inflation provides an incentive for you to spend money now instead of later.

This liquidity-with-inflation trick does not work unless that fresh money is getting loaned out and thus those crisp, new dollars are propagating in the economy like an exploding population of rabbits. President Obama trotted out the money multiplier effect in April, 2009, so it behooves us to examine how we're doing in that regard in October, some six months later. Jim Jubak covers some of the territory in Are banks starving the recovery?

We've got a little problem in the economy. Tiny really. Nothing to worry about.

The government and the Federal Reserve are pumping money into the economy as fast as they can, yet the supply of money in the economy has started to fall -- and that, in turn, could endanger the entire economic recovery.

The Fed is buying mortgage-backed securities ($1.25 trillion) and debt from Fannie Mae and Freddie Mac ($200 billion), expanding its lending to banks by keeping interest rates close to zero and buying up U.S. Treasuries [$300 billion].

All that, according to the textbooks, should be flooding the economy with money. And that's exactly what you're supposed to do to get the economy running again and to avoid turning the Great Recession into a rerun of the Great Depression.

Let's look at the details (Figure 2 and another quote below from Jubak).

Figure 2 — Comparison of the monetary base MO and the M2, which is the broadest measure of the money supply the Fed compiles. You can see the multiplier working in the years 1985 to 2008 as the M2 grows at a much higher pace than MO. The upward surge in the monetary base in 2008 was due to Fed printing. After a smaller surge in the M2 accompanying that boost in the base, there has been no multiplier effect—those dollars aren't breeding like rabbits in the economy. Source: FRED.

... this isn't good, folks. It's a problem big enough to jeopardize the recovery that the economy seems to be building. And that's because what's called the velocity of money, the speed with which a dollar moves through the economy, has fallen. That's not unexpected. During the Great Depression the velocity of money fell 22%. In tough times, people from consumers to bankers sit on more money longer.

Look at what's happened to M2 since it hit $8.39 trillion on June 22:

• By July 20, M2 had dropped to $8.34 trillion, down $50 billion.
• By Aug. 24, it was down to $8.28 trillion, down $110 billion.
• By Sept. 14, the latest data point from the St. Louis Fed, M2 recovered slightly to $8.30 trillion, still down $90 billion from June 22.

Economists who study this data use a four-week moving average to eliminate some of the week-to-week noise. At the worst point in the decline, the four weeks ending Aug. 24, M2 was dropping at an annualized rate of 12%. That's the kind of contraction you get in a financial panic. Not the kind of growth you want to see as you're trying to guide an economy to recovery.

[My note: The falling velocity of money is "not unexpected" only if you're expecting a Depression.]

I do not want to be excessively wonkish, but I need to relate how a slowing velocity of M2 money and a falling M2 money supply stand in the way of a credit-driven recovery—

We are now entering treacherous waters for monetary authorities in highly-leveraged economies. Given the decade(s)-long dependence on the credit mechanism to spur economic growth, the financial crisis has brought about a precipitous decline in the velocity of money- i.e., how much economic activity is generated per unit of money supply.

Bloomberg helpfully calculates a velocity indicator; as you can see [in Figure 3 below], while the recent fall has been steep, velocity never really recovered from the heady days of the 90's productivity boom (and..err....internet bubble.)

[My note: Velocity V of money supply M is conventionally measured as GDP/M. Look at Wikipedia. Holding GDP constant, a decrease in the money supply M (the denominator) results in a decrease in the velocity of money V.]

Figure 3 — Bloomberg's velocity indicator. Except for temporary rebound at the height of the Housing Bubble after the Fed reflated the economy following the Tech Bubble recession, velocity has been dropping since its peak in 1997. In fact, this graph demonstrates that increasing the money supply to spur new economic activity has been less and less effective over the last 12 years—less bang for the buck (economic activity per unit of money, as above).

In short, adding new money to the economy has not increased the speed at which the dollar moves through the economy (the velocity). In tough times, people from consumers to bankers sit on more money longer. Thus economic activity appears to be decreasing in so far as the amount of M2 money circulating in the economy was actually falling in the 3rd quarter. For a credit-driven recovery to work in a fiat money system, fiscal & monetary stimulus must increase the amount of money flowing through the economy (which creates inflation, which spurs spending & investment, and so forth).

On the other hand, Professors Hamilton and Krugman (correctly) foresee a rise in GDP into positive territory in the 3rd quarter just passed. Technically speaking, and holding the M2 money supply constant, the velocity of money (V above) would again decrease in this anomalous case (Look again at Figure 3.) And as we've just seen, the amount of M2 money circulating in the economy appears to have actually decreased in the 3rd quarter just passed, which makes things worse.

Thus we will have a statistical recovery in GDP even as economic activity stagnates and unemployment rises, despite the fiscal & monetary stimulus. Welcome to a new kind of Depression.

What has happened to the new cash reserves the Fed made available to the banks? From Jubak again—

The problem is that the banks still aren't lending. They're sitting on a huge proportion of all the money that the Fed is pumping into the economy, and because the money they're sitting on isn't moving, that's putting the brakes on the velocity of money... [M2] doesn't include the reserves that banks keep in their own vaults or at the Fed...

Why are banks cutting back on their lending?

Part of it is that they don't trust the recovery. With unemployment still rising and consumers still not spending as before, being cautious about extending new credit doesn't seem particularly outrageous.

But that's not the major part of the problem. Banks aren't lending because they still haven't cleaned up their balance sheets. Many of them are still in the process of writing down credit card debt or mortgages or commercial loans -- not to mention the complex derivatives they've still got in their portfolios... [and they face stricter capital requirements]

[The Fed] knew that they potentially faced exactly this problem. But they hoped that by unleashing a campaign of financial shock and awe that involved heavy fire from all monetary and fiscal weapons, they'd be able to convince banks that it was only sensible to lend more rather than to sit on their money.

It's not clear that this policy has failed. The worrying trends really include just four weeks or so of data. But the short-term trend is worth worrying about because, having fired all their guns, the world's central banks really don't have much left in their arsenals to roll out in a new assault.

Watch the data. We're not out of the woods yet.

Financial Shock & Awe! It's the American Way.

Jubak is certainly right, but only up to a point. He provides a finance-centric, neoclassical economic view of the recovery. The implicit assumption is that when the banks have finally cleaned up their balance sheets, met their capital requirements and started lending again, the economy will grow vigorously as it did before the crisis. The money multiplier will kick in and the velocity of money will pick up as it did after the post-Tech Bubble recession. This is Summers' and Geithner's view, the Wall Street view, and thus Obama's view. Remember the President's words—

... the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.

So much is left out of this calculation. What about demand for credit? What about household debt? What about Middle Class households, as opposed to the banks, repairing their balance sheets? What about Baby Boomers retiring? Money is not circulating vigorously despite the Fed's large increase of the monetary base. Can this be due entirely to the fact that the banks are not lending?

On the surface, so it might appear. But beneath the surface? Certainly not. Are hoards of credit-worthy borrowers lining up at Bank of America or Citigroup clamoring for new loans? Of course not.

And getting the impaired financial system straightened out, especially in view of the crashing commercial real estate market, will take several years.

The notion of a credit-driven recovery is a repeat of the very blindness—a fundamental error in neoclassical economic theory—that got us into this mess in the first place. The underlying problem is too much debt, not just in over-leveraged banks, but also in over-leveraged households. The fundamental principle, as I reiterated at the ASPO-USA conference, is—

• Endless growth based on endless debt is impossible

Any reflation of the economy will only work for a short while. You can not borrow from the future forever. You can not push on a string. The time has come for American households to pare down debt and increase savings, which is very hard to do when

1. unemployment is very high & rising;
2. asset values are falling but debt levels are not (e.g. in mortgages, credit cards);
3. real (inflation-adjusted) wages are stagnant.

Recessions are always fundamentally due to a lack of demand for goods & services. You can print money to stimulate demand, but the "economic activity generated per unit of money supply"—the velocity—need not increase, as we have seen, if lenders are unwilling (or unable) to lend and borrowers are unwilling (or unable) to borrow.

Recessions (or Depressions) are always ultimately due to lack of final demand for goods & services. When will consumption return to pre-2008 levels in the United States? Your guess is as good as mine, but I suspect it will take many years, assuming it ever happens at all. We will likely have an short-lived statistical recovery, but it will feel like a Depression nonetheless. Watch out for 2010. I am now in the W ("double dip" recession) camp. That's my best guess.

It's not your Grandfather's Great Depression...

... it's this one.

Contact the author at [email protected]

The Future of the Dollar

It is hard to imagine a happy future for the dollar, and I was going to say that before Robert Fisk published his The Demise of the Dollar, in which he describes secret talks among central bankers and finance ministers of various countries on how to move away from trading oil in dollars.

Is Fisk's report true? I have already been told once today that the story was a bit too "conspiratorial" to be taken seriously. The expected official denial followed quickly.

But top officials of Saudi Arabia and Russia, speaking on the sidelines of International Monetary Fund meetings in Istanbul, denied there were such talks. The two countries are the world's largest and second-largest oil exporters.

Asked by reporters about the newspaper story, Saudi Arabia's central bank chief Muhammad al-Jasser said: "Absolutely incorrect." He repeated the same response when asked whether Saudi Arabia was in such talks.

Kuwait's oil minister and a well-placed source in the Organization of the Petroleum Exporting Countries made similar remarks. Russia's deputy finance minister Dmitry Pankin said: "We did not discuss this at all."

Did not discuss trading oil in dollars at all?  The gadfly Robert Fisk just made this story up? I doubt that very much. Why is the fabrication angle implausible? — aside from the hit to his credibility Fisk would take.

Given the continuing deterioration of the dollar, and current U.S. fiscal & monetary policies propelling that deterioration forward, it would be strange if such discussions were not taking place. This is not to say that such a change in how oil is traded is guaranteed to be implemented. There are many obstacles, not least of which is what Eric Janszen calls economic mutually assured destruction in which Asians (and the Persian Gulf States) subsidize U.S. debt to maintain their export markets and the U.S. depends on that "vendor financing" to prop up its economy.

Such a crazy economic arrangement must collapse sooner or later. In October, 2008, Brad Setser provided an example of how things work in The end of Bretton Woods 2?

One irony of the past year is that the US was borrowing far more from China that it was buying from China. Campaign rhetoric that the US was paying for Saudi oil with funds borrowed from China isn’t far off — though it leaves out the fact that the US also borrows from Saudi Arabia to pay for Venezuelan, Mexican and Nigerian oil.

Economist Brad DeLong refers to these arrangements as a financial "balance of terror" (see below).

Surely it is in the best interest of oil consuming & producing countries outside the U.S. to discuss a move away from the dollar. After all, we are talking about a change that is tentatively scheduled to take place within 9 years. A lot can happen in 9 years—or in 9 months or 9 days, as we saw in 2008. From Fisk—

In the most profound financial change in recent Middle East history, Gulf Arabs are planning – along with China, Russia, Japan and France – to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and...

The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years...

The decline of American economic power linked to the current global recession was implicitly acknowledged by the World Bank president Robert Zoellick. "One of the legacies of this crisis may be a recognition of changed economic power relations," he said in Istanbul ahead of meetings this week of the IMF and World Bank. But it is China's extraordinary new financial power – along with past anger among oil-producing and oil-consuming nations at America's power to interfere in the international financial system – which has prompted the latest discussions involving the Gulf states.

Again, what is implausible is that high-level talks are not taking place, not Fisk's report that they are. The Conventional Wisdom always assumes that what has been is what shall be. T'aint so.

Ever since the Bretton Woods agreements – the accords after the Second World War which bequeathed the architecture for the modern international financial system – America's trading partners have been left to cope with the impact of Washington's control and, in more recent years, the hegemony of the dollar as the dominant global reserve currency.

Things have changed a lot since 1944 when Bretton Woods went into effect. Some economists have called the recent, now unstable, arrangement Bretton Woods 2. This is from Brad Setser, who was cited above—

In late 2004, Nouriel Roubini and I wrote that “the tensions created [by the Bretton Woods 2 system] are large, large enough to crack the system in the next three to four years.” In a 2005 Wall Street Journal online debate with Michael Dooley I tried to hedge a bit, and gave the system six years...

The Bretton Woods 2 system — where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports — will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won’t be exporting much...If Bretton Woods 2 ends in 2009 — if US demand for imports falls sharply in the last part of 2008 and early 2009, bringing the US trade deficit down — it won’t have ended in the way Nouriel and I outlined back in late 2004 and early 2005. We postulated that foreign demand for US debt would dry up — pushing up US Treasury rates and delivering a nasty shock to a housing-centric economy. The US and European banking system collapsed before the balance of financial terror collapsed. Dr. Brad DeLong writes:

All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the ‘Balance of Financial Terror’ between Asia and America to collapse and produce chaos. We are not having that financial crisis. Instead we are having a very different financial crisis. Catastrophic failures of risk management throughout the entire banking sector caused a relatively minor collapse in housing prices to freeze up global finance to a degree that has not been seen since the Great Depression.

The end result of this crisis though could be rather similar: a sharp contraction in credit, a fall in US economic activity, a fall in US imports and a fall in the amount of foreign financing the US needs. The US government is (possibly) trying to offset the fall in private demand by borrowing more and spending more — but as of now there is realistic risk that the fall in private activity will trump the fiscal stimulus.

Consequently, this still strikes me a crisis of the Bretton Woods 2 system..

Recall that Brad Setser wrote this in October, 2008 before the fiscal & monetary madness of the last year played out. Setser notes that in the crisis he and Roubini had in mind, Treasury rates would rise to make the dollar more attractive. Instead, treasuries have fallen to historically low levels, and short-term rates are close to zero. (Here's the current yield curve.)

Just as Setser feared, U.S. demand for (Asian) imports fell sharply in subsequent quarters (Figure 1). For the first time in 68 years, there has been a sharp contraction in credit (Figure 2). And of course U.S. GDP is down considerably from last October (Figure 3).

Figure 1 — The continuing U.S. current accounts (trade) deficit. Trade is off sharply since the financial meltdown of 2008:Q3. The graph is from Calculated Risk.

Figure 2 — Total loans and leases at U.S. commercial banks. Loans held (credit) has shown the first marked decrease since 1940. The graph is from the St. Louis Fed courtesy of John Mauldin.

Figure 3 — U.S. Gross National Product (GDP) since 2004. Data are from the Bureau of Economic Analysis (BEA)

The only thing missing from Setser and Roubini's scenario for a collapse of the Bretton Woods 2 system is "a fall in the amount of foreign financing the U.S. needs" or worse still, a sharp contraction in foreign demand for U.S. debt. U.S. foreign financing requirements have increased, not decreased. The preconditions of a crisis have arrived (Figures 1-3). Can the total collapse of economic mutual assured destruction (Bretton Woods 2) be far behind?

The precarious "balance of terror" between Asia and America continues for now, but if foreign demand for U.S. dollars dries up, the dollar will not be worth the paper it's printed on unless Treasury rates are raised sharply and quickly. Such a rise would put a severe crimp in future economic "growth" in the United States, which is not guaranteed as things stand now even with short-term rates near zero.

It seems that the United States has gone out of its way to piss off its foreign creditors, to wit—

1. Committed U.S. entitlements debt is estimated to be approximately 55,000,000,000,000 (trillion) over time (for Social Security, Medicare, Medicaid, etc.)
2. The Obama administration forecasts additional government deficits of 9,000,000,000,000 (trillion) over the next decade. Anticipated "growth" in the economy (i.e. larger federal tax receipts) will not cover this new bill.
3. The dollar is imploding—the Dollar Index stands at 76, down from its high of ~89 in March, 2009
4. Significant deflationary pressures in the next year or two will be countered with continued low interest rates, which discourages foreign investment in Treasuries.
5. The U.S. Central Bank (the "Fed") has printed about 1,600,000,000,000 (trillion) brand new dollars over the last year.
6. The secular change in American consumption patterns means that the American market for Asian exports will likely never return to pre-2008 levels, or at least not for a very long time.
7. To take advantage of an ever weakening dollar, re-allocation of capital to create export-oriented industries in the U.S. (e.g. in alternative energy) will take a very long time, assuming such a re-allocation ever happens at all. The U.S. would be less of a basket case in this event, which would support future imports from China and elsewhere.

If you are still sanguine about the future of the dollar because you have faith that mutually assured destruction will continue, consider the long-term history of the purchasing power of the dollar (Figure 5).

Figure 5 — The long-term history of the purchasing power of the dollar from Zero Hedge's "Tyler Durden"

The future of the dollar is very shaky indeed, and if history is any guide, the dollar has no where else to go but down from here on out. People talk about deflation pressures in the next year or so, and they are right to do so, but serious inflation, perhaps hyper-inflation, is the only possible outcome longer-term.

Can you think of any scenario—let your imagination run wild—in which the dollar's value is going to rise vis-a-vis exchange rates with the Euro, the Yen, etc. 5 to 10 years from now?

Now that you have a proper context for evaluating the veracity of Fisk's story, does it strike you as unlikely that secret talks are being held to move away from trading oil in dollars? I hope not! As Tech Ticker's Henry Blodgett said, in agreement with me, "how can these meetings not be taking place?" This is just commonsense.

An Orderly or Disorderly Wind Down?

There is little doubt the dollar is going to depreciate further in current years. The crucial question is whether this depreciation will be sudden and catastrophic, or planned and orderly. The Bretton Woods 2 arrangement could fall apart quickly. Willem Buiter of the Financial Times calls this a sudden stop event—

The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the ’sudden stop’ - the cessation of capital inflows to both the private and public sectors. There has been a partial sudden stop of financial flows, both domestic and external, to the banking sector and the rest of the private sector, but the external capital accounts are still functioning for the sovereigns and for the remaining creditworthy borrowers.  But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world’s leading reserve currency. A large fiscal stimulus from a government without fiscal credibility could be the trigger for a ’sudden stop’.

Buiter wrote this in February, 2009, before the ineffective $787 billion stimulus package was enacted and before the Fed had fully expanded its balance sheet. His fear was that continued fiscal irresponsibility might trigger a sudden stop. It hasn't so far, but this ballgame is far from over.

In an early morning interview with CNBC, Jim Rickards, director of market intelligence for scientific consulting firm Omnis, laid out a scenario in which the government inflates its debt obligations away in an "orderly" way over the next 17 years.

Rickards— ... it has to do with gold. What [Fed Governor Kevin Warsh] is doing is pre-empting the collapse of the dollar. If gold goes to $1500/ounce ... it has to do with the fact that the dollar is imploding, and so Warsh is saying to the G-20 that we're not going to let that happen. Now, he can't come out and say that [because] if a Fed governor starts to talk about the collapse of the dollar, the dollar would start to collapse, so he's doing by indirection, but when says "asset prices" I assume he means gold, which is inversely related to the dollar...

CNBC— You said off camera [the Fed] should have raised interest rates 6 months ago?

Rickards— Sure, the dollar is the lynch pin of national security. How are we going to conduct a war... The Fed needs the dollar to go down by about half over the next 14 years. We have $60,000,000,000,000 (trillion) of liabilities, that's TARP, baseline budgets, stimulus, Ginnie Mae, Fannie Mae, Freddie Mac, Medicare, student loans, FHA ... you go through all these contingent liabilities, it comes to about $60 trillion. There's no feasible combination of growth and taxes that can fund that liability ... We need to pay half, we can pay $30 trillion, not $60 trillion, so 4% [annual] inflation for 17 years cuts the value of the dollar in half. That's what the Fed does best. If you had a nickel and three pennies in your hand, you had eight cents, that's what value of the dollar relative to 1913 when the Fed was created.

The idea of price stability is nonsense. What they do is inflate the dollar to ... prop up the banks. They need to that [inflate] but that's a dynamically unstable process. They will love to do it gradually, and that's the plan, but  if the market gets ahead of it, if the market sees this playing out, which they probably will, you could have a very rapid collapse of the dollar ... and you would see that in gold [prices].

[My note: Look again at Figure 5. Kevin Warsh published an editorial in the Wall Street Journal while the G-20 was meeting in progress, and that article is what Rickards was responding to.]

[My note: Rickards' remarks relate to Triffin's Dilemma, which demonstrates the impossibility of any one country's currency being the world's reserve currency for any extended period of time.]

Rickards goes on to discuss the IMF's Special Drawing Rights (SDR), which China has proposed as a replacement for the dollar as the world's de facto reserve currency. China's stance, and the oil meetings Fisk reports on, are meant to pressure the United States to move toward fiscal responsibility.

Unfortunately, any such move to defend the dollar will destroy any economic "recovery" the United States might have. Rickards' contends that it was Fed Governor Kevin Warsh's intention to say, albeit indirectly, that the Fed will indeed move to defend the dollar to head off its collapse regardless of the economic consequences. Rickards also says the Fed wants to move from the dollar to SDR as the world's reserve currency in a gradual, controlled fashion. It is not clear whether this will be possible because when the markets figure out what's up, they will move away from the dollar into gold, a move which would further propel the dollar's collapse.

Many believe the twilight of the dollar has arrived. This is not some lunatic conspiracy theory. The Telegraph's Ambrose Evans-Pritchard reported on one major bank's view in HSBC bids farewell to dollar supremacy.

"The dollar looks awfully like [British] sterling after the First World War," said David Bloom, the bank's currency chief.

"The whole picture of risk-reward for emerging market currencies has changed. It is not so much that they have risen to our standards, it is that we have fallen to theirs. It used to be that sovereign risk was mainly an emerging market issue but the events of the last year have shown that this is no longer the case. Look at the UK – debt is racing up to 100pc of GDP," he said.

Crucially, China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles. Asia's "mercantilist mindset" of recent decades is about to be broken by the specter of an inflation spiral.

Here's one version of what may happen: As time goes on, it will become clearer to China, Japan and others that investing in the United States is a waste of time. Inflation will be eroding the value of their dollar reserves. Specifically, it will become more obvious to them that the American consumer is down for the count. When this realization sets in, the already unstable past (and present) Bretton Woods 2 arrangement will likely break down. The demand for dollars will slow considerably, and there may even be a headlong flight from the dollar. This latter possibility is Buiter's "sudden stop" event.

No one can no how all this will play out, but I find little room for optimism regarding the dollar's longer term future.

Contact the author at [email protected]

The Aftermath of the Great Recession, Part II

Today's article is a follow up to The Aftermath of the Great Recession, Part I. I am covering the material I will present at ASPO-USA's Denver conference on October 11-13, 2009. I am making this presentation available before the conference in part because there is more material here than I will be able to cover during my introductory talk on the economics panel.

The outlook for consumption growth in the over-leveraged United States is bleak. Economists Menzie Chinn and Jeffrey Frieden discussed the origins of the financial crisis, the debt situation in the U.S. and the global outlook in Reflections on the Causes and Consequences of the Debt Crisis of 2008. This text broadly describes the origin of the crisis.

The United States has borrowed and spent itself into a foreign debt crisis. Between 2001 and 2007, Americans borrowed trillions of dollars from abroad. The federal government borrowed to finance its budget deficit; private individuals and companies borrowed so they could consume and invest beyond their means. While some spending went for physical commodities, including imports, much of the spending was for local goods and services, especially financial services and real estate. The result was a broad-based, but ultimately unsustainable, economic expansion that drove up the relative price of goods not involved in foreign trade—things like haircuts, taxi rides, and, most important, housing. The key “nontradable” good was housing; that boom eventually became a bubble...

This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash. In broad outlines, the cycle describes the developing-country debt crisis of the early 1980s, the Mexican crisis of 1994, the East Asian crisis of 1997-1998, the Russian and Brazilian and Turkish and Argentine crises of the late 1990s and into 2000-2001—not to speak of the German crisis of the early 1930s or the American crisis of the early 1890s.

[My note: This is an economist's view of the causes of the meltdown. The oil price shock of 2007-2008 contributed significantly to the downfall, as James Hamilton has documented. Menzie Chinn is Hamilton's writing partner at their blog Econbrowser.]

Of course, a prolonged debt crisis in the United States has much larger global effects than a crisis in Mexico or Argentina. You will recall from last week that—

• Massive debt-fueled consumption in the United States drove the global economic boom of recent years, and thus the oil demand shock of 2002-2007.

In thinking about where we stand right now, this summary from Chinn and Frieden is helpful.

We are now witnessing the unwinding of this process of debt accumulation. Households and firms are busily trying to reduce their debt loads, in the face of dimmer prospects for income and profits. For households, savings rates are rising, but at the cost of stagnant consumption. For firms, the reduction of debt load is consistent with a reduced rate of investment in plant and equipment. In some sense, this process of retrenchment is necessary. For many years, the United States consumed more than it produced. We borrowed and for a while thought that the old rules had been suspended. But now it turns out that we do have to pay back what we have borrowed. The attendant higher saving rate and lower investment rate will lead to a substantial improvement in the current account balance, or in other words, the paying off of our debt.

More broadly, though, this also means that the United States cannot rely upon the driver of growth that has sustained it over the past three decades—namely consumption. But the consequences extend beyond the nation’s border. The world can no longer rely upon the American consumer. Who will take up this role remains to the next big question.

The world can no longer depend on the American consumer. What country will fill the consumption gap? Many have pinned their hopes on China, to which I now turn.

A Resurgence in China?

Figure 11 — China's balance of trade, 2007-August, 2009.

• China's exports were down 23.4% year-over-year in August, 2009. This is a disaster for an export-oriented economy.
• The decoupling theory, wherein China could escape relatively unscathed from an economic crash in the United States and the Eurozone, is dead. (See this bullish article from the WSJ which attempts to resuscitate this view based on recent bubbly economic growth in China.)
• I highly recommend this video about China's export economy, which features a tour of some of their empty factories.
• China has a huge over-capacity problem. They built a manufacturing base to service (via exports) large & growing consumption in the United States (and elsewhere) that no longer exists as it did prior to the crash. (See remarks by financial adviser Hugh Hendry in my A Resurgence in China? He compares China to an investor in a Bernie Madoff-like Ponzi Scheme in America.)

Figure 12 — U.S. Trade Balance (in billion dollars per month) from 1994 through July, 2009

• The other side of the Chimerica coin. The U.S. trade imbalance reached it's highest point in the first half of 2008 after widening steadily since 2002.
• Between 2001 and 2007, the American current account (trade) deficit averaged between $500 billion and $1 trillion every year, resulting in a deficit equal to an unprecedented 6% of GDP in 2006. In other words, the U.S. effectively "borrowed" this much money every year. Much of that money went toward purchases of residential real estate causing the Housing Bubble.
• The exports-imports gap has narrowed considerably as the U.S. imports much less stuff generally and particularly from China. There has been a small uptick in both exports & imports in the last few months.
• Exports - Imports is a (negative) term in calculating GDP (see Part I). So, a narrower gap between the two boosts GDP even if exports are down year-over-year.

Figure 13 — China's GDP growth, 2006-2009:Q2

• 2nd quarter growth reflects the massive Chinese stimulus (4 trillion RMB, $586 billion, ~14% of GDP, Ren Min Bi, or the People's Money). This explains growing oil demand since March, 2009. August came in at 7.71 million barrels-per-day, down from the peak in July.
• Is this growth for real? The problem arises with how China figures GDP growth. See China: Bogus Boom? "China's 8% output growth target will be met because [their] economic statistics are based on recorded production activity (spending), rather than being a measure of expenditure [final demand] growth." The mere dispersal of stimulus funds [e.g. to provincial governments] are counted as GDP growth, whether that money is used or not.
• Most of this Chinese investment goes to fixed assets (e.g. infrastructure), not manufacturing where there is so much overcapacity. My favorite example involves tearing down and then rebuilding perfectly good structures. "A 2.9-kilometer elevated highway in Hunan [was] demolished when it was meant to last for 36 more years. A "bridge of strength," nicknamed as such because it was unscathed by last year's devastating earthquake, [was] dynamited in Sichuan." The Chinese will rebuild these structures and thus boost GDP.
• All this explains why the Financial Times' Martin Wolf has suggested that "China should forget having a GDP target, instead of having an 8% growth GDP target, it should have a real domestic demand target. It should think of its policy in terms of generating real domestic demand, [and] GDP will follow."
• It's hard to imagine that this craziness is sustainable, and thus will drive China's future oil demand up and up.

Figure 14 — China is blowing bubbles in their economy as stimulus money floods into assets (equities, housing) or bogus fixed investment instead of into over-built manufacturing capacity

• China's growing bubbles are just where you would think they would be—the stock market (e.g. the Shanghai Composite) and urban residential housing. From Bank of China's Zhu Sees 'Bubbles' in Asset Values (Bloomberg, September 10, 2009)—

• Bank of China, Ltd. led the nation’s $1.1 trillion lending spree in the first half of 2009, said ample liquidity has caused “bubbles” in stocks, commodities and real estate...

  “There’s no way for the real economy to absorb so much liquidity,” said Liu Yuhui, a Beijing-based economist at Chinese Academy of Social Science. ”Policymakers in China and around the world are well aware of the harm that could do, but they are unwilling to sacrifice short-term growth and wean the economy from addiction to the stimulus policies.”

  The Shanghai Stock Exchange Composite Index has gained 61 percent this year, compared with a 20 percent increase in the MSCI World Index of 1,659 companies. House prices in China’s 70 biggest cities rose at the fastest pace in 11 months on record lending and climbing confidence, according to a National Bureau of Statistics report today.

• China's bubbles are a direct result of the Chinese massive stimulus program and Bank of China's lending, but Premier Wen Jiabao is keeping the pedal to the metal, just as Tim Geithner and "Helicopter" Ben Bernanke are in the United States (see below).
• Similar bubbles are inflating all over Asia. Singapore recently moved to curb speculation in its real estate market, putting the lie to Dr. Alan Greenspan's (and Bernanke's) peculiar view that speculative inflation of assets can not be detected or managed in advance.
• The Chinese leadership presses on with the stimulus because they are running scared politically. China must have very high growth rates to provide work for the many millions of young people entering the job market each year. But in trying to forestall an economic crisis that threatens their power, they are risking an even worse collapse of their economy.
• China expert Andy Xie makes an apt comparison between China in 2009 and Japan in 1989.

• China can learn a lot from Japan's experience as well. Its bubble formed when companies began focusing on financial investments rather than core business. In the 1980s, Japan's corporate sector tapped the corporate bond market and raised massive amounts of capital for asset purchases. Recently, Chinese enterprises borrowed money and pumped it into asset markets. They essentially provided leverage for asset markets. When leverage was rising, asset inflation occurred, letting companies book profits that were many times greater than operating profits from core businesses. That gave them greater incentive to pursue asset appreciation rather than operating profitability. The corporate sector became a shadow banking system for financing asset speculation.

  Thus, China's corporate sector is now behaving in a way similar to what was seen in Japan two decades ago.

Here's my China summary—

• China will not provide the consumption engine the global economy requires for sustained growth—their economy (domestic demand) is too small.
• China's corporate sector is focused on profiting from inflated assets instead of their core businesses. Little growth is possible for core businesses because exports have been shrinking rapidly and internal demand is not growing significantly.
• The Chinese, traditionally a nation of savers, needs to build up that their domestic demand. This requires steady "organic" growth over the next decade or longer. Otherwise, the economy overheats and you get mis-allocation of resources(capital) and bubbles (like now).

Let's return to stimulus, deficits and indebtedness in the United States. After that, I'll sum up.

Figure 15 — Total U.S. debt by sector (households, non-finance business, finance, government)

• All debt is approximately 350% of nominal GDP (~$14 trillion).
• Government debt has remained at a relatively consistent percentage of GDP for the past 50 years, but the debt of companies, consumers, and financial businesses has soared.
• The government is now making up for pass lack of excess (see Figure 16 below).

Figure 16 — Federal revenues and non-interest spending from the Congressional Budget Office

• This is fiscal debt (e.g. the current $787 billion stimulus shown as a bump in the graph) as opposed the Fed's monetary stimulus.
• See my The Incredible Shrinking Boomer Economy for details.
• The CBO's "Alternative Fiscal Scenario" is the one considered most realistic given past political decisions and current realities.
• Health care spending (Medicare & Medicaid) increases the debt as the Boomers retire.
• The Obama administration recently raised its 10-year budget deficit projection to $9 trillion (from $7.1 trillion).
• This graph does not reflect interest payments that must be made on the debt.
• If the U.S. does not have steady GDP growth, future revenues will fall below trend unless taxes are raised.

Figure 17 — The Federal Reserves assets (uses of funds) since December, 2007.

• A short history of printing money. Assets were $2.119 trillion as of September 2, 2009.
• The sizable declines in short-term lending to financials and non-bank credit markets have largely been offset by increases in holdings of Treasury securities, agency mortgage-backed securities (MBS), and agency debt (Fannie Mae, Freddie Mac). (Only fixed-rate agency MBS securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are eligible assets for the program.) Treasury purchases monetize some of the U.S. debt.
• Quantitative easing refers to a series of steps to flood financial markets with liquidity, including the purchase of mortgage backed securities, to help keep long term (mortgage) rates low.The Federal Open Market Committee has held the fed-funds rate at a lowest-ever range of 0% to 0.25% since December 2008. (Technical note: Open market operations—purchases and sales of U.S. Treasury and federal agency securities—are the Federal Reserve's principal tool for implementing monetary policy... The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.)
• The value of the Fed's agency MBS purchases depends on a shaky real estate market (see Figure 9, part I)
• Some expect QE—monetary and rate stimulus—to continue right through 2010 and perhaps into 2011!

Summary And Outlook—Factors Affecting Recovery

There is an Alphabet Soup describing the shape of the recovery for the short to medium term (next few quarters out to 2013) or long term (out to 2020): V (rapid, sustained recovery), U (longer, slower recovery), W (double-dip recession) or L (long-term depression).

• The shape of the recovery determines future oil demand, and thus the timing of The Next Oil Shock.
• The Fed's exit strategy presents a fundamental dilemma: (1) if interest rates are tightened too fast, the risk is that any economic "expansion" will be nipped in the bud; (2) if rates stay too low for too long, the risk is for new bubbles as described next.
• The longer that QE and fiscal stimulus go on unabated in the United States, China and elsewhere, the more certain it becomes that new destructive bubbles will develop in world markets. This is already occurring in China. Excess liquidity looking places to invest drives unwarranted asset price inflation. The S&P 500 is looking very bubbly already as money flows into equities.
• There have been no reforms of Big Finance, so highly-leveraged risk-taking proceeds apace. There is no check on risky bets because losses have been "socialized" (put on the shoulders of current or future tax payers). See Peter Boone and Simon Johnson's The Next Financial Crisis.
• Only government spending is driving GDP growth in the United States and China. None of the other factors—consumption expenditures outside health care, fixed investment, or the trade balance—will significantly contribute to GDP for some time to come.
• Consumption will remain depressed in the United States for a long time as households repair balance sheets. The loss of wealth (in housing, stocks) and the threat of unemployment also curtail spending. Retiring Boomers make the situation much worse in the long term.
• Unemployment will remain high in the United States for a long time as weak banks repair balance sheets (limiting credit) and businesses limit investment until such time as renewed consumption warrants expansion.
• The real estate markets (residential, commercial) in the United States will remain weak for many years. Prices will remain depressed in the medium to long term and excess inventory must be worked off in the short to medium term.
• China will not lead the world out of recovery as described above.
• If China and the United States do not lead a global recovery, then who will?

Thus, in considering the shape of the global economic recovery (as measured by GDP) in the short to medium term, it seems highly unlikely that we will get a V-shaped recovery. I agree with William White, who is quoted in the Financial Times' Leading Economist Fears Double-Dip Recession—

The world has not tackled the problems at the heart of the economic downturn and is likely to slip back into recession, says one of the few mainstream economists who predicted the crisis.

Speaking at the Sibos conference in Hong Kong yesterday, William White, the former chief economist at the Bank for International Settlements, also warned that government actions to help the economy in the short run might be sowing the seeds for future crises.

"Are we going into a W [-shaped recession]? Almost certainly. Are we going into an L? I would not be in the slightest bit surprised," he said, referring to the risks of a so-called -double-dip recession or a protracted stagnation such as Japan suffered in the 1990s.

"The only thing that would really surprise me is a rapid and sustainable recovery from the position we're in."

Nouriel Roubini has noted the heightened risks for a W-shaped double-dip recession. The majority of economists still see a U-shaped recovery. In either case, we can not expect a sharp rebound in global economic growth, and thus oil demand, in 2010 and perhaps 2011 as well. In The Next Oil Shock, I predicted that the next oil price shock would occur around 2012 as shown in Figure 18. This forecast was consistent with a U-shaped global recovery.

Figure 18 — Another oil price shock in 2012 +/- 1 year. Whenever it occurs, the next oil shock will have a severe impact on a fragile world economy.

That's my story and I'm sticking to it. But it could be wrong for any number of reasons. We could have a prolonged L-shaped depression. Or the Fed's exit strategy could be botched and we will end up with another severe recession. And then there are the inflation/deflation issues—Eric Janszen will talk about those at the conference. A global economy that depended so heavily on Chimerica is unsound. There is great danger all around us. No one knows what the next shoe to drop will be. Or when that will happen.

Contact the author at [email protected]

The Aftermath of the Great Recession, Part I

The only function of economic forecasting is make astrology look respectable
   —John Kenneth Galbraith

There are two kinds of economists: those who can count and those who can't
   —old joke

Today's article is the first of a two-part series in which I attempt to forecast general economic conditions that will affect the oil market over the next 10 years. Despite Galbraith's sensible warning, what we will experience in the aftermath of the Great Recession is not a complete mystery. Strong evidence suggests that during the next decade, the global economy will struggle to regain a sound footing supporting vigorous growth.

This article and the next mirror closely what I will say at ASPO-USA's upcoming conference on October 10-13 in Denver, Colorado. I am moderating the "Great Recession and the Energy Markets" discussion. I will be joined by Eric Janszen, Adam Robinson, and author Kevin Phillips.

This is not necessarily the final version of my introductory remarks in Denver, but it is close enough. I am publishing these slides early to allow those attending the conference (or those who are not able to attend) to study the issues prior to the panel itself. There is probably more material here (and next week) than I will have time to present in Denver.

I can not cover the world in a short presentation. Therefore, most of my slides examine the economic prognosis for the United States and China. These countries can be viewed as a single entity called Chimerica.  By and large, a resurgence in economic growth outside Chimerica (e.g. in Japan, the Eurozone, the other BRICs) is unlikely unless both the U.S. (the world's largest economy) and China (the world's largest emerging economy) are prospering.

I believe substantial, perhaps overwhelming, evidence exists that points toward a protracted global downturn like that experienced in Japan during the 1990s (and beyond) following the crash of their stock market and real estate bubbles of the mid to late 1980s. The next slides lay out that case.

Overview

Figure 1 — The historical relationship between oil demand and global Gross Domestic Produce (GDP) since 1981. Year-over-year GDP/oil demand growth (percent). Source.

• Oil demand growth mirrors GDP growth, but is lower than GDP (percent-wise). The relationship varies over time.
• World oil demand has fallen for the last two years. The last time this happened was 1982-1983.
• Oil demand fell off ~2.8 million barrels-per-day at the economic bottom this time around.

Figure 2 — Two scenarios for oil demand from the IEA.

• In the bullish scenario, the world experiences a "V"-shaped recovery due to fiscal and monetary stimulus, but also "eventually" leads to the next oil price shock.
• In the bearish scenario, the downturn is protracted (a global "lost decade"). OECD demand has peaked and demand in the emerging economies (the BRIC countries, the Middle East) grows slowly, barely offsetting OECD declines.
• Those predicting a near-term (2010) oil price shock—roughly defined here as sustained prices > $100—must also be assuming a "V"-shaped recovery or a very rapid decline in the oil supply. There is at least 3 million barrels-per-day of spare capacity today, not all of which would be produced if demand spiked again to 2007 levels (Saudi Arabia).

Figure 3 — Relative sizes of the main world economies. The source is Menzie Chinn's How Important is China to World Growth?  The shaded area indicates the IMF forecast.

• Menzie Chinn's take on things: "Notice that indeed things are looking up in the BRICs (Brazil, Russia, India, China), with perhaps the exception of Russia. Or, more accurately, things are looking less bad in those countries. To keep things in perspective, 2008 US GDP (evaluated at market exchange rates) was about 23.5% of world GDP (all ratios from April 2009 IMF World Economic Outlook database), while these three economies in aggregate accounted for 54% of world GDP. The BRICs accounted for 14.6%. China is 7.3% of world GDP, so even with growth resuming, something else will be needed to get world growth back to near normal rates."
• Most of the rest of world GDP is in other OECD countries (e.g. South Korea, Canada, Mexico) or the Middle East.
• China's economy is only slightly larger than Japan's (as of 2008).
• Even 3-4% year-over-year GDP growth in the BRICs (taken together) starts from a relatively small base.
• Emerging economies tend to be dependent on exports with relatively small internal demand.

The Economic Outlook for the United States

It is said that prompt actions by the Fed & the Treasury last fall averted another Great Depression. We may have staved off a repeat of the cascading bank failures and deflation of 1929-1933, but we are left with something else that is perilous in its own way. It does not matter if you call it a "depression" or a "prolonged downturn" or something else.

Economist Richard Koo calls this a balance sheet recession to distinguish it from "normal" recessions in which consumption picks up quickly from where it left off prior to the downturn. (And look here for Koo's technical overview.)

Figure 4 — Real household debt, wealth and income 1960-2008 from the San Francisco Fed's U.S. Household Deleveraging and Future Consumption Growth. See my Don't Buy Stuff You Can Not Afford for more details.

• The trend is established from 1960 to 1983. Real household debt and housing wealth followed the real income line.
• In 1983, household debt, supported by rising stock wealth, decouples from real income (Event I).
• In 1997, housing wealth decouples from real income (Event II).
• The two bubble tops are shown (light gray circles). The Web/Tech Bubble burst in March, 2000. The Housing Bubble collapsed in mid-2006.
• The entire period 1983-2007 can be thought of as a Credit Bubble supporting debt-based personal consumption (vertical bars, key lower right). The savings rate fell to zero by 2005-2006.
• Now we enter the long period in which households and banks must repair their balance sheets. But it is much harder to pay off debt while asset values fall (dotted red line and the real stock wealth line).
• One "solution"—the "solution" preferred by the Treasury & the Fed?—is to inflate our way out of the debt.
• The future of real income is in doubt. High unemployment puts downward pressure on income, and we've just had a decade (1998-2008) with no income gains. Perhaps real income has nowhere to go but down from here on out.

All of this spells real trouble for the consumption (PCE) part of GDP. GDP is calculated by the formula—

• Gross Domestic Product = PCE + I + G + (Ex - Im)
  where PCE = personal consumption expenditures, I = fixed investment, G = government expenditures and (Ex - Im) = exports minus imports

In recent years, personal consumption has accounted for nearly 70% of total U.S. GDP. That massive debt-fueled consumption drove the global economic boom of recent years, and thus the oil demand shock of 2003-2007.

One obvious consequence is that GDP growth in the U.S. was financed by ever-larger debt and two catastrophic bubbles. The Tech bubble led to a large loss of stock market wealth but gave us the internet and a powerful telecommunications infrastructure. The much larger Housing Bubble led to a disastrous misallocation of capital with no apparent upside.

The future of personal consumption in America looks bleak.

Figure 5 — The history of personal consumption in the United States since 1994, year-over-year change in billions of dollars. From iTulip's August 2009 FIRE Economy Depression - Part I, Snowball in Summer.

• You can see that consumption peaked right before the Great Recession began in December, 2007 has fallen dramatically since.
• What would support large consumption increases matching pre-2008 levels going forward? It is hard—well-nigh impossible—to find any good news in that area, to wit—
• Unemployment will be high for a long time to come (See Figure 6 below).
• The Boomer spending spree is over. They start retiring in 2011. See my The Incredible Shrinking Boomer Economy (See Figure 7 below.)
• There is greater wealth inequality in the United States than any time since 1928. The Middle Class now carries most of the household debt. See my The New Gilded Age. (See Figure 8 below.) The income share of the bottom 90% of people in the U.S. stood at 50% in 2007, down from about 67% in the 1960s and early 1970s.
• During the bubbles, people felt rich. In the absence of new bubbles, the loss of wealth (in stocks, housing) combined with a shaky job market will dampen consumption for many years to come.

Figure 6 — From the San Francisco Fed's Jobless Recovery Redux? See my Bad Signs, New Bubbles for details.

• This chart shows projections for the "official" joblessness rate, which now stands at 9.7%.
• The U6 number is said to be 16.8%. This number counts all the unemployed, including those who have stopped looking for work, and all the underemployed, which includes all those who have accepted involuntary cutbacks in their hours worked.
• The Bureau of Labor statistics has understated all the numbers because of adjustments made via their bogus birth/death model for businesses.
• A prolonged "jobless" recovery is the most likely scenario.

Figure 7 — Personal consumption with and without health care spending as a percent of GDP since 1960. From Calculated Risk's Health Care Spending and PCE.

• Health care spending has been growing as a percentage of GDP since the early 1980s. (Remember, all this time GDP was growing and so was consumption, but growth in health care expenditures rose faster than all other consumption.)
• As the Boomers retire, health care spending will go up & up but ex-health consumption will not. Health care costs will soar unless effective reform is implemented.
• Medicare & Medicaid spending is counted as personal consumption (PCE) in GDP calculations.
• So health care spending will add to GDP, but much of that money will be spent to support the medical needs of an aging population.
• As health care rises rapidly as a percent of GDP, the rest of the real economy (ex-health) may actually be shrinking (depending on the overall rate of growth). This continuing imbalance makes it more and more difficult for the dwindling working population to support the aging Boomers.

Figure 8 — The overleveraged Middle Class in America, from a Bank of America Merrill Lynch report, and reprinted by Zero Hedge in A Detailed Look at the Stratified Consumer.

• In the left panel, you can see the debt-to-income (left) and the debt-to-assets (right) ratios. In the right panel, you can see that Middle Class borrowing soared during the Housing Bubble.
• People thought house values would never go down. They felt rich, so spending was supported by imaginary equity in residential real estate. (All bubbles must crash, what goes up must come down.)
• This was the time when the Middle Class used their homes as ATM machines by taking home equity loans or second mortgages, or extracting cash from equity by refinancing.
• Housing prices have crashed and won't come back for a long, long time.

Figure 9 — Mortgage debt (blue lines) versus equity (red line) from 1945 to the present, taken from T2 Partners’ More Mortgage Meltdown.

• More than 15.2 million U.S. mortgages, or 32.2% of all mortgaged properties, were in a negative-equity position (underwater) on June 30, edging down from 32.5% at the end of March. Negative equity is when you owe more on your house than you can sell it for.
• 13.2% of all mortgage loans were in foreclosure or delinquent as of the last Mortgage Bankers Association survey. Foreclosures or delinquencies now threaten prime mortgages
• There has been a dramatic decrease in cure rates for delinquent mortgage loans. Delinquency cure rates refer to the percentage of delinquent loans returning to a current payment status each month. Cure rates have declined from an average of 45% during 2000-2006 to the current level of 6.6%.
• House prices have probably not bottomed out yet according to Calculated Risk.
• All this spells big trouble for small or medium-sized banks holding these loans.(Fannie Mae, Freddie Mac an banks that are "too big to fail" will be bailed out.)

Figure 10 — Total real estate debt held in the United State from Rolfe Winkler's America's Japanese Banks.

• Banks have $4.656 trillion dollars in loans outstanding in residential and commercial real estate (yellow line in Figure 10).
• Residential real estate has been crashing since 2006, and commercial real estate—a lagging indicator—is crashing now. This is the dreaded "second wave" of defaults.
• Commercial real estate, valued at some $3.5 trillion, has experienced a 39 percent decline in prices from the peak only two years ago, according to the MIT Center for Real Estate. The 18 percent price decline in second quarter was the largest quarterly drop in the 25 years since MIT first published the commercial real estate price index.
• As asset values fall, banks become insolvent. We can expect approximately 1000 small and medium-sized banks to fail in the next two years.

By saving Fannie Mae, Freddie Mac, "too big-to fail" banks like Bank of America, and Wall Street, (i.e. the credit system), the Fed & the Treasury did not also save over-leveraged American consumers. We have probably reached "peak credit" now, and demand for credit will be down for some time to come as households struggle to save and pay off debt.

The Fed & the Treasury have been fighting the wrong battle in the last war. Their wacky assumption has been that we can have endless economic growth based on endless debt. The idea that reviving the credit markets (via the bail-outs) would lead to a quick turnaround (a "V"-shaped recovery) is just plain wrong. Both Ben Bernanke and the San Francisco Fed's Janet Yellen now acknowledge the new reality. Up until fairly recently, the Fed Chairman was in denial.

That's enough grim news for today.

Next week I will publish Part II, including U.S. government deficits, the U.S. balance of trade, China and a summary of the situation.

Contact the author at [email protected]

The Mistakes Economists Make

What has been is what will be, and what has been done is what will be done; there is nothing new under the sun
    —Ecclesiastes 1:9

It's almost worth a Great Depression to learn how little our big men know
    —Will Rodgers

Paul Krugman's remarkable article How Did Economists Get It So Wrong? reminds us that the high priests of modern societies often have a muddled understanding of the economy they preside over. Their poor track record of late has not deterred many economists from making their usual prediction—despite the small bump in the road we've encountered lately, prosperity is just around the corner.

Before I am accused of making sweeping generalizations, let me be clear that I am referring to the kinds of economists Krugman discusses in his article. Winston Churchill allegedly said that "if you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions." Unfortunately, all the economists Krugman talks about had the same opinion.

Let's talk about the mistakes economists make. This is an awfully big subject, so it's hard to know where to begin. There are the Big Misconceptions, and the smaller ones that follow from them. Here are the overriding fundamental errors as I see it.

1. People are rational
2. Endless growth is possible.

Right away we run into trouble, for it is not reasonable to assume that endless growth on a finite planet is possible. The math alone tells us that sooner or later, humanity will get its comeuppance. These large mistakes are founded on another error.

• Markets, driven by the power of price & technological innovation, always overcome apparent limits on growth or obstacles arising from human imperfection.

I call this the Assumption of Human Progress. Economists rarely make this assumption explicit, but this is what they have in mind. The progress assumption implies that markets, a human invention, are like God—omnipotent (all-powerful), omnipresent (always present) and omniscient (all-knowing). Whereas a rational individual suffers from limitations such as imperfect knowledge, a market does not.

It follows that markets assure ongoing and orderly human progress whereby human populations increase while economies grow concomitantly to provide greater and greater comfort to more and more people. I found a pure statement of this position at the blog The Futurist.

Needless to say, this degree of acceleration in economic growth [over human history] affects nearly every possible facet of the world in the 21st century. From a continually rising stock market to the proliferation of millionaires to the rapid uplifting of all metrics of human development, massive abundance is a certainty. The inevitable derivatives of wealth, such as the spread of democracy, the uplift in the sophistication of human psychology, and thus a corresponding drop in warfare, will soon follow. Resolving current problems, such as reducing poverty in developing regions, to funding sophisticated health care technologies, to increasing literacy, to funding ambitious space exploration, are merely just a matter of time.

Because markets ensure economic growth, limitations on resources such as conventional crude oil, fresh water, and fish are apparent, not real. The power of price and technological innovation will provide more of the resource should its supply run low, or substitutes for the resource as needed.

When an economist speaks of people as rational actors—this is the definition of Homo economicus—he means they are predictably self-interested in making financial decisions. If people are viewed as automatons—accurate accounting machines—who can be counted on to increase their personal advantage in all transactions at all times, their collective actions can be more easily plugged into mathematical models of economic behavior. As Richard Thaler puts it, "this is similar to doing physics without bothering with the messy bits caused by friction." Krugman agrees—

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Imputing rationality to human beings itself convincingly demonstrates that people—economists in this particular case—are not rational. If you doubt that people harbor an almost endless capacity for self-delusion, I suggest you review today's news. A recent example from the oil industry illustrates the delusional quality of every day life—

BP has reopened the debate on when the "peak oil" supply will be reached by announcing a big new discovery in the Gulf of Mexico which some believe could be as large as the Forties, the biggest field ever found in the North Sea.

BP, already the largest producer of hydrocarbons in the US, said its "giant" Tiber discovery in 4,100ft (1,250m) of water was particularly exciting because it promised to open up a whole new area.

Shares in BP were up 4% to 539p in afternoon trading, making it the biggest riser in the FTSE 100 despite the company saying much more drilling appraisal work was needed before Tiber's commerciality could be guaranteed.

Does it make sense to buy BP stock now based an oil find 1) whose commerciality has not been guaranteed and 2) whose oil will not be produced until God Knows When, but will only be produced if the discovery is indeed deemed commercial? Of course not. From the Houston Chronicle's BP's oil find Is big, but miles out and down—

But experts said it could be a decade or more before BP begins pumping oil from the field, given the technical hurdles and huge costs involved with operating in the harsh environment.

“I would say 2020 would be a good target [for producing Tiber],” said Matt Pickard, analyst with Quest Offshore Resources, a Sugar Land company that studies deep-water oil discoveries.

The same may be true for other high-profile Lower Tertiary discoveries [in the Gulf of Mexico] in recent years, including Chevron Corp.'s Jack field. Three years ago at Jack, an industry-first well test confirmed that the trend contains a vast quantity of oil and that it can be brought to the surface.

The Jack discovery made by Chevron, Devon and Statoil in 2006 also "reopened" the peak oil debate. Now we are told that we might expect to see some oil from Jack in 2020, a mere fourteen years after their successful test well. Chevron has put plans in motion to produce 120 to 150,000 barrels-per-day at some unspecified time in the future. They now have a five-year lease on an ultra-deepwater drillship, Transocean's Discover Clear Leader. Does this mean we may see this some oil—150,000 barrels per day is not a lot of oil—a mere 10 years (with a usual 2-year delay) after the successful Jack test? Stay tuned, but don't hold your breath.

And what happened to Chevron, Devon and Statoil stock values after the Jack announcement almost exactly three years ago on September 5, 2006?

Devon shares climbed $7.99, or 12 percent, to $72.14 in New York Stock Exchange composite trading, the biggest daily gain since May 1992. The stock is up 15 percent this year.

Chevron stock rose $1.51, or 2.3 percent, to $66.34. Statoil shares rose 1.5 Norwegian kroner to 176.5 kroner in Oslo.

BP's Tiber is out in the boondocks. Producing this oil means overcoming a very challenging high pressure/high temperature (HT/HP) physical environment several miles under the seabed. The oil will probably not be produced until 2020 in the best case.

As with Jack, the notion that Tiber—this is not an easily accessible Ghawar—reopens the peak oil debate is absurd. No one concerned about peak oil ever said there was no more oil to find. What I and others have said is that most of the easy oil has already been discovered and new finds will be much harder and more expensive to put into production. Tiber is a case in point. So was Jack three years ago.

There is nothing extraordinary about the unwarranted hype surrounding the Tiber discovery. Irrational is normal for most people most of the time. We humans are designed by nature to overvalue recent information, especially if it is perceived as good news. In behavioral finance, this is called overreaction and availability bias. That explains why oil company stock prices went up.

There are many other biases, including confirmation bias, which is "a tendency to search for or interpret information in a way that confirms one's preconceptions." In this vein, the Tiber discovery confirms Daniel Yergin's faith that markets and technological innovation solve all problems.

From Foreign Policy — "Again and again, in researching oil's history, I was struck by how seemingly insurmountable barriers and obstacles were overcome by technological progress, often unanticipated."

From the Washington Post — Daniel Yergin, chairman of Cambridge Energy Research Associates, said that the [Tiber] discovery "demonstrates how technology continues to expand the horizon of the Gulf of Mexico."

Given the difficulties in producing Tiber stated above, PFC's Bob MacKnight, a neutral observer, took a more rational view of the discovery—

Bob MacKnight, a senior consultant with the Washington consulting firm PFC Energy, cautioned that while the big new discoveries [like Tiber] were welcome news, they might not boost overall U.S. oil output because other Gulf of Mexico fields are expected to decline. "We really need this," he said. "After 2012, given current developments, we will see production start to decline. Without continued discoveries . . . that decline could be steep."

Economists did not stop with the delusional premise that people are rational. They took the next logical step by assuming that markets were rational too. This is a natural move to make if you believe that markets price & allocate resources efficiently to solve any economic problems that might crop up. This astonishing theory, called the Efficient Market Hypothesis, follows from the Assumption of Human Progress stated above. From Richard Thaler—

From the starting point of rational investors came the idea of the efficient market hypothesis, a theory first elucidated by my colleague and golfing buddy Gene Fama. The EMH has two components that I call “The Price is Right” and “No Free Lunch”. The price is right principle says asset prices will, to use Mr Fama’s words “fully reflect” available information, and thus “provide accurate signals for resource allocation”. The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account...

On the price is right, if we include the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be “right”, then these bubbles would not occur. But they have, so what are we to do?

[My note: Thaler is referring to the NASDAQ equities bubble in the late 1990s and the Housing Bubble. See Figure 1 below.]

The economic consensus thought bubbles were a thing of the past. Krugman divides that consensus into two groups, the "Freshwater" (Midwest) and "Saltwater" (East Coast) economists, but takes pains to show that there was no significant difference between them regarding their firm belief in rational individuals and markets. The "Freshwater" group, whose views depart from reality in a most alarming way, is dominated by those who came after Milton Friedman at The University of Chicago, my alma mater. Here's Krugman again—

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

[My note: The economic "theory of everything" is not "a long way off." There will never be such a theory (see below). Human Nature, properly perceived and understood, precludes it.]

Krugman compares the assumption of efficient markets to the naivete of Voltaire's Dr. Pangloss, who teaches that "all is for the best in the best of all possible worlds." And, really, Krugman's not kidding—that was the mainstream view. Ben Bernanke, no less, called the tranquil period 1985-2004 of mostly unperturbed economic growth The Great Moderation.

The shared delusion among economists was far worse than Krugman lets on anywhere in his text. During the so-called Great Moderation, the consensus forgot to make graphs like Figure 1 and ponder their deeper meaning.

Figure 3 — This graph is explained at length in my article Don't Buy Stuff You Can Not Afford. During the Great Moderation, income & debt decouple in 1983 (Event I). Later, housing wealth decouples from real income during the Housing Bubble (Event II). The bubble tops are circled (light gray). Apparently, it didn't occur to either the Freshwater or the Saltwater economists that endless growth can not be based on endless debt. Even worse, the rich were getting richer but the Middle Class was saddled with most of the debt.

The Great Moderation turns out to be counterfeit. For example, "the private sector ended up with a net loss of 223,000 jobs since August 1999, according to the latest figures from the Bureau of Labor Statistics. Meanwhile, the nation's population has grown by 33.5 million people." It is not rational to believe that economic growth is sustainable if that growth depends on an ever-growing mountain of debt. Such growth is not even real if it depends on moving future demand forward. Once again, economists placing their faith in efficient markets populated by rational actors failed to acknowledge their own unreasonable assumptions.

It was irresponsible Big Finance that caused much of our current troubles. But this is nothing new. Krugman quotes John Maynard Keynes—

And Keynes considered it a very bad idea to let such [financial] markets, in which speculators spent their time chasing one another’s tails, dictate important business decisions: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

Keynes was passé or treated with disdain during the Great Moderation, as was John Kenneth Galbraith, who wrote A Short History of Financial Euphoria in 1990. The story of our downfall is simple: "rational" economists ignored the entire centuries-long history of finance. This quote is taken from a review of Galbraith's small book—

Galbraith describes the characteristics of the mass psychosis that typifies the period of financial euphoria that precedes the inevitable crash. In the first instance, the general paper profit-making becomes (temporarily) a self-fulfilling prophecy, that leads to self-sustaining and self-congratulatory behavior, what Galbraith terms "a vested interest in error" on the part of the participants, who, as members of a crowd are willing to suspend disbelief: Galbraith quotes Walter Bagehot - "all people are most credulous when they are most happy". To this, the author adds an elegant statement of the power of the vested interests who condemn and criticize doubting voices in an almost tribal manner.

Galbraith does not spare sarcasm in his characterization of the attitudinal follies that lead to and sustain these episodes. He is brutally succinct in describing the extreme shortness of financial memory and the ignorance of history which leads to the same mistakes being repeated under similar circumstances within a few short years...

The real world is populated by Homo ovinus—ovinus is the Latin word for sheep. Bubbles could not occur if investors, like sheep, did not move together in the same direction during these exuberant episodes. Homo economicus is a convenient fictional construct. Economists forgot that markets, which were thought to be efficient but are full of irrational human beings acting in concert, must be properly regulated to inhibit fraud & theft, prevent natural risk-takers from getting carried away, and prevent bad money from driving out good money.

Beyond groupthink, how could economists have made such Big Mistakes? I believe the answer lies in the underlying assumption of continuous human progress I spelled out above. In the real world, however, things do not always get better. Sometimes, like now, they get worse. It has always been that way. 

[Irving Fisher] used the Panic of 1837 as an example. It was caused by heavy demand for loans to buy land, build businesses, and invest in the country's development. Prices began rising, economic strains built up, and a speculative bubble developed that burst in New York on May 10 when every bank stopped payment in specie (gold or silver coinage). A five year depression followed. Many banks failed, and unemployment soared to record levels...

The Panic of 1857 ended the boom years following the 1846 - 1848 Mexican War. It gave America undisputed control of Texas, established the US - Mexican border at the Rio Grande River, seized the present-day states of California, Nevada, Utah, and parts of Colorado, Arizona, New Mexico, and Wyoming, and opened this vast new area to speculation and development. Much of it was to expand railroads. It proved unsustainable and led to crisis. The failure of the New York branch of the Ohio Life Insurance and Trust Co. was the proximate cause. It ignited panic as a result of massive embezzlement and heavy losses on depreciated railroad investments. Eroded public confidence took over, setting off a chain of events...

The Panic of 1873 (near the onset of the Gilded Age) was called "the real Great Depression" by some. It began eight years after war ended and started a six-year depression until 1879. It was triggered by the Vienna Stock Exchange crash in May (the so-called Grunderkrach or "founders' crash"), then spread to America in the fall... [and so on]

[My note: Based on Irving Fisher's Debt-Deflation Theory of Great Depressions (1933).]

Bernanke's Great Moderation, which turns out to have been a sham, represents an insignificant blip in time even when time is measured in mere centuries.

Most economists, including the behaviorists, accept the Assumption of Human Progress (or they used to). You may have run across the term technocracy, whose short definition is "a government or social system controlled by technicians, especially scientists and technical experts." Economists are our technocrats, and their belief is that enlightened monetary policy, along with sophisticated mathematical models, will always provide the "best of all possible worlds" lampooned in Voltaire's Candide. This is best explained by example. This passage is from Ben Bernanke on the causes of the Great Moderation (cited above).

My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation... Let us begin by asking what economic theory has to say about the relationship of output volatility and inflation volatility... This apparent trade-off between output variability and inflation variability faced by policymakers gives rise to what has been dubbed the Taylor curve [figure below] reflecting early work by the Stanford economist and current Undersecretary of the Treasury John B. Taylor...

As I will shortly discuss further, an insufficiently strong response to inflation let inflation and inflation expectations get out of control and thus added volatility to the economy. At the same time, strong responses to what we understand in retrospect to have been over-optimistic estimates of the output gap created additional instability. As output optimism and inflation pessimism both waned under the force of the data, policy responses became more appropriate and the economy more stable. In this sense, improvements in policymakers' understanding of the economy and the role of monetary policy allowed the economy to move closer to the Taylor curve (or, in terms of Figure 1, to move from point A to point B)... [much technical discussion ensues]

The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.

Figure 2 — The Taylor Curve. Pay no attention to the man behind the curtain...

Don't worry about the actual meaning of "the relationship of output volatility and inflation volatility" as shown in the Taylor Curve. I am not trying to explain that relationship, even if I could. Bernanke is demonstrating how improvements in monetary policy allow the economy to move closer to the ideal described by Taylor's curve (A --> B) in which both inflation and output volatility are muted. In other words, output (GDP) growth is steadier and more reliable. Recessions are shorter and less severe when they occur. This was Bernanke's Great Moderation.

Bernanke had faith that technocratic cleverness always improves economic conditions over time. All-powerful markets were allowed to function on their own even when they were clearly deranged. The Fed did not need to enforce its regulatory powers. All that was required of the Fed was a little fine-tuning in monetary policy to curb destructive volatility. This policy approach reflects Bernanke's technocratic faith in the human progress.

Moreover, there were many technological "innovations" in Finance. All of those fancy derivatives (e.g. collateralized debt obligations) were said to reduce risk, not increase it. The derivatives Casino was based upon other "innovations" like credit cards or interest-only mortgages. Galbraith knew better than to trust such alleged improvements—

The second important insight of [A Short History of Financial Euphoria] is the summary of common denominators in all such episodes, many of which are visible in the period we are currently experiencing [in 1998]. Among these (and probably inevitable given the shortness of financial memory) is the appearance of specious financial innovation. This is treated at length in the discussions of the South Sea Bubble, John Law, and [junk-bond king Michael] Milken... Galbraith argues that most of these seeming innovations were essentially variations on the theme of [increasing] leverage [debt-based speculation]

[My note: In the Housing bubble, increasing speculative leverage involved the use of fancy new derivatives to increase short-term profits during a Ponzi Scheme in residential real estate.]

We now know that the Great Moderation ended very badly, an outcome Galbraith surely predicted but did not live to see. And we're nowhere near the end of the Great Recession's harmful effects; these will last for many years to come. The technocrats were wrong, and always will be.

True progress—I'm not talking about washing machines or iPhones here—is an illusion. The economy is entirely a human affair and as such, flawed. Ecclesiastes was right—there is nothing new under the sun. These things only work out in science fiction. Do you remember Isaac Asimov's Foundation series? Hari Seldon, the inventor of Psychohistory, created a social science based on statistical models that allowed him to predict the general flow of human events thousands of years into the future. That was the ultimate technocratic dream.

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