Peak Watch

The Almighty Dollar

Do not do to others what you do not want them to do to you
   —One version of the rule of reciprocity, the Golden Rule

I only hope that we don't lose sight of one thing—that it was all started by a mouse
    —Walt Disney

Each week I look at the economic and energy data. While there are indeed some actual green shoots in the monthly reports, I can not escape the feeling that our society is like Disneyland, a magic kingdom where life is a fairy tale and dreams really do come true. I call it Disneyland because the crazy rise in the S&P 500 and the oil price in recent months has happened despite, not because of, fundamentals in the economy.

The disconnect between the markets and the economy is almost total. The markets reside in a fantasy realm, while most of us must deal with depressing day-to-day realities. There will eventually be a downward "correction" in the markets, but only because there's no avoiding the fact that reality always gets the last word.

These market price movements do not happen by accident, of course. The "logic" behind these market rallies is best explained by movements in the value of the Almighty Dollar. Amy Jaffe and Kenneth Medlock of Rice University's Baker Institute further confirmed that view this week with the release of their study Who Is In the Oil Futures Market and How Has It Changed?

This view of America as a Magic Kingdom will never be popular. People vested in a crazy system—consider the wacky idea that an economy can thrive based on trading in residential real estate while household debt grows and real income languishes—will remain vested in that system long after it has ceased to function.

I don't know why I should take the world seriously if the world is no longer a serious place. Altruism is dead. Morality is considered quaint. Many of us are left with a survival problem—that is the only truly serious business at hand. We've been abandoned in the economic wilderness, left to fend for ourselves. Speaking of life, no one ever told me "you'll need to be a currency trader if you want to survive the worst of it."

Before turning to the dollar and the Baker Institute study, let us take a brief excursion through the Magic Kingdom. The first stop on our tour is not the must-see Indiana Jones™ Adventure, but rather the S&P 500 P/E (price to earnings) ratio as it exists today. The guided tour comes with a special Magic Kingdom graphic to enhance your chart-gazing experience.

Figure 1 — Barry Ritholzt's Chart of the Day: S&P 500 PE Ratio from August 21st. "The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the recent plunge in earnings and recent stock market rally, the PE ratio spiked and just peaked at 144 – a record high. Currently, with 97% of US corporations having reported for Q2 2009, the PE ratio now stands at a lofty 129." Starting in about 1983—it's always 1983 when the trouble starts!—stock prices became more and more disconnected with actual earnings. But that growing unreality was nothing compared to now. The S & P 500 P/E ratio is now in Disneyland.

Figure 2 — From Recent Concentration of Volumes in Financial Stocks: Coordinated Capital Infusion? C = Citigroup, FNM = Fannie Mae, and FRE = Freddie Mac. Trading volumes for these 3 stocks have been accounting for 40% of NYSE volume lately. Is this a coordinated capital infusion? Does a bear defecate in the woods? Thus, "the directionality of the involvement suggests that large financial institutions are systematically buying the beaten-up shares of the poster children for TARP: C, FNM, FRE, AIG, and the like. It is worth noting in this regard that other major (healthy) financial firms, such as Goldman Sachs (GS, alternative trading symbol = GVS) and J.P. Morgan Chase (JPM), have seen no such surge in their volume or their trading prices. Zero Hedge rightly wonders why this hasn’t triggered alarms at the exchange. And why is it happening with only the weakest financial institutions?" Well, that's an easy question to answer: They are way too big to fail but they must be recapitalized on the sly.

Figure 3 — The Magic Kingdom meets the oil price. World oil demand is about 2.5 million barrels per day lower now than it was in the 3rd quarter of 2007, but the price of oil is the same. OPEC cuts have boosted the price, but it was the dollar trade that got us where we are today. There seems to be some "resistance" in the $72-74 range as reality intrudes. I'll discuss the current oil price in some detail below.

Analyst Dave Rosenberg wants to know What Growth Is the S&P 500 Pricing In?

Based on past linkages between earnings trends and the pace of economic activity, believe it or not, the S&P 500 is now de facto discounting a 4¼% real GDP growth rate for the coming year. That is what we would call a V-shaped recovery. While it is possible, though in our opinion a low-odds event, it is doubtful that the economy is going to be better than that. So we have a market that is more than fully priced for a post-recession world — any further gains would suggest that we are moving further into the “greed” trade...

We realize that the market has to climb a wall of worry and that it will often price in a lot of bad news, but for the first time ever, it has rallied nearly 50% amidst a two-million job slide since March. That is either whistling past the graveyard or at the lows the market was indeed pricing in a full-fledged depression. Whatever the market was pricing in at the March lows was obviously a pretty bad outcome, but isn’t that what we saw in the end? To be sure, the government established a floor under the financials, but when you go back and think about the fresh lows posted in late 2002, it was about earnings and the economy, not about financials.

In the four months after the recent lows in March, employment plunged by two million, which is as much carnage as we saw in the entire 2001 recession — and we are talking about the entire cycle including the jobless recovery that spanned from March 2001 to June 2003! We will guarantee you one thing — it is doubtful that the two million folks who lost their jobs are going to be heading to the malls, dealerships or restaurants anytime soon. And while that is only a sliver of the 130 million U.S. workforce, change does occur at the margin.

Rosenberg understands that 4¼% annual real GDP growth will not happen anytime soon. As recently as 2002, when we were well into the Bubble Era, markets still moved on "earnings and the economy." That doesn't happen anymore, things are different in the Disney Era. I will quote again from the New York Times' Rise of the Super Rich Has Hit A Sobering Wall—

Without a financial bubble, there will simply be less money available for Wall Street to pay itself or for corporate chief executives to pay themselves. Some companies — like Goldman Sachs and JP Morgan Chase, which face less competition now and have been helped by the government’s attempts to prop up credit market — will still hand out enormous paychecks. Over all, though, there will be fewer such checks, analysts say. Roger Freeman, an analyst at Barclays Capital, said he thought that overall Wall Street compensation would, at most, increase moderately over the next couple of years.

[My note: See my article The New Gilded Age.]

The recent rise in the S&P 500 is the financial bubble that makes it possible for Wall Street to pay itself the princely fortunes they think they so richly deserve—this is the "greed" trade.

The rally in S&P 500 is as phony as a three dollar bill. It's hard to know exactly how, and by whom, the market has been manipulated. We have important hints, of course. Trading volumes have been dominated by financials (Figure 2), volumes are generally low, and most trading is done by machines (Figure 4).

Figure 4 — From the Wall Street Journal's Rivals Play Catch-Up As Goldman Thrives: "Goldman is known on Wall Street for its sophisticated computer-trading platform. It has become a dominant player in high-frequency trading, in which computers use complex formulas to conduct rapid-fire trades in markets around the world. In the week ending July 3, Goldman accounted for 24% of all program trading, or computer-generated trading, on the New York Stock Exchange, according to NYSE data, making it No. 1." I don't think any additional comment is required.

Turning to the oil markets, it can easily be demonstated that the price of crude moves with the S&P 500 (Bloomberg, August 14, 2009).

The Standard & Poor's Index added 0.7 percent to 1,012.73, while the Dow Jones Industrial Average increased 0.4 percent, to 9,398.19. The S&P 500 has a correlation of 0.8 with New York oil futures in the past year. A correlation of 1 means the two move in lockstep.

Bloomberg reported on such tandem moves back on June 29th. The already record-setting simple correlation has only gotten stronger since then.

The S&P 500 has added 37 percent from a 12-year low in March, increasing on 56 percent of the days during that span. The Reuters/Jefferies CRB Index of commodities has advanced 27 percent from its trough, rising 58 percent of the time.

The gains pushed correlations between the indexes to 0.74 this month, based on percentage changes over the past 60 days. That’s the highest in at least five decades, data compiled by Bloomberg show. A reading of 1 means two assets move in tandem, while zero means no relationship.

The correlation never rose above 0.66 before this month. 

Let's sum up what life looks like in Disneyland—

• The S&P 500 "rally" is phony.
• Oil moves with the S&P 500, so the oil price is phony too. (See my Mr. Market Gets It Wrong Again.)
• We no longer live in a society that bothers to pretend that things are on the up and up. The markets are manipulated in plain sight.

I don't think this is what Adam Smith had in mind when he wrote about the wondrous powers of the "invisible hand."

Janet Tavakoli, founder and president of Tavakoli Structured Finance, explains whey she has liquidated almost all her market positions—

I just went to (almost) 100% cash in my favorite hedge fund, my personal portfolio...

On Monday, Austin Goolsbee, one of President Obama’s economic advisors, told The Daily Show’s John Stewart that the large deficit is necessary, TARP backed us away from the brink of disaster, and the stimulus is working. If only words were magic. Many more banks are in trouble, a chunk of housing activity is due to foreclosures/short sales/resales (the $8,000 housing incentive often went for down payments from people who couldn’t scare up one of their own), credit card problems are on the rise, one-quarter to one-third of all mortgages in the U.S. are underwater, the mortgage “modification” program is a failure with only around 200,000 done so far—half of which are already failing (the same fraudsters who got us in this mess are modifying mortgages), 3,000,000 mortgages are in serious default (90 days or more past due), the unemployment picture is grim, the cash-for-clunkers fake auto stimulus is a non-green short-term artificial pump-up, profits seem due to inventory management and cost cutting rather than demand, and industrial production has plummeted (other than military production which is up). More TARP money will be needed for many smaller banks that are in trouble due to current and coming loan losses. The international picture is mixed, but I’ve even liquidated those positions.

As Ms. Tavakoli knows all so well, we are in a giant game of Survivor. You're on your own. If you're skillful & lucky, you might not get kicked off the island. The Revolution will not be televised. In fact, The Powers That Be have postponed The Revolution indefinitely. They hope you will enjoy watching re-runs of Friends or Seinfeld instead, assuming you still have a roof over your head and you can still pay your exorbitant cable TV bill.

Let's turn to the Baker Institute study to show how fluctuations in the value of the dollar drive market movements.

The Almighty Dollar

The next two graphs show how the markets have moved with the dollar in the 21st century.

Figure 5 — The chart is taken from U.S Dollar/S&P 500 Correlation (August 28, 2009). "A serious [inverse] correlation between the US$ and the US equity markets has developed over the last 9+ years. This correlation is strong and for policy makers in Washington, rather disturbing. The relationship is as follows: If the US$ loses value the equity markets have rallied and if the US$ strengthens equity markets have sold off."

Figure 6 — The graphic is from Medlock and Jaffe. "Analysis of the dollar-oil price data for 2001-2009 shows a dramatic change in price correlation from historical patterns. Figure 6 indicates the daily oil price and daily value of the dollar against the currencies of major U.S. trading partners. For the period January 2001 through August 2009 [in the bottom panel], these two measures are very highly correlated, exhibiting a simple correlation of -0.82 [inverse correlation]. However, for data from a prior period—January 1986 through December 2009 [top panel]—the correlation was -0.08, implying virtually no correlation during that period. The strong -0.82 measurement implies that oil prices and the value of the dollar tend to have a negative [inverse] correlation. In plainer terms, depreciation in the dollar will very likely coincide with a rise in the price of oil or vice versa."

Medlock and Jaffe are describing how the simple numéraire effect, in which the price of a commodity traded in dollars reflects changes in the dollar's value, has overwhelmed fundamental (supply & demand) conditions in the marketplace. This has happened because non-commercial traders who could care less about physical oil are the ones doing most of the trading. (Of course the technical picture is more  complicated than this, e.g. longs versus shorts, how futures prices push up spot prices, and so on.)

It just so happens—I am unhappy to report—that up until the recent Fall/Winter dollar bounce due to the view that Treasuries were a safe haven, the dollar had declined for 7 straight years. It appears now that dollar has now reverted to trend (i.e. it is declining again). Thus the price of oil has been rising since March at a time when the fundamentals are particularly weak (Figure 6).

I am not going to go through the Medlock and Jaffe paper in tedious detail. I just want to make the obvious points that need to be made, so read the original paper if you want to know more about how the Commodity Futures Modernization Act "effectively cleared the way for more lax regulation of new oil risk management products, including index funds and price swaps, setting the state for a rapid increase in financial players' participation in over-the-counter (OTC) markets."

The oil market has been financialized in the sense that it serves as a means for investors to hedge against a rising or (mostly) falling dollar. What can one say about this? I believe Judy Dugan, research director at Consumer Watchdog, put it best—

Using an essential commodity as [an investment tool] is crazy. If you want a double dip recession, let's just get $100 oil again."

Of course it's crazy. Investing in stocks to hedge against a deteriorating dollar is one thing, but jacking up the price of gasoline for everyone so a relatively few non-commercial players can cover their ass is quite another. Welcome to Disneyland.

Let be clear about what I am not saying. I am not saying that—

• All the price rise during 2003-2008 was due to dollar hedging, not the collision between a demand shock and a supply ceiling (peak oil). I covered this material in my article It's Not Black Or White. Medlock and Jaffe say "analysis must also take into account that the physical crude oil market had to be tight in order for speculative activity to be able to exert such extensive upward pressure on price. Thus a more complete discussion of the physical characteristics of the market and its interactions with speculative trader behavior is needed for a more conclusive analysis." This is not quite right because speculative activity is indeed exerting upward pressure on the oil price in the absence of a tight market.

The rumor on the street is that the CFTC is going to impose position limits on non-commercial oil traders. (This linked document is really worth reading if you care about these issues.) In the absence of new regulation of the oil market, and if no bona fide attempt is made by the Central Bank and the Federal Government to defend the dollar in future years, then the oil price, however high the fundamentals might drive it, will be higher still because of dollar hedging on the NYMEX.

So the future of the oil price becomes, to some extent, the future of the dollar, to which I now briefly turn.

The Future of the Dollar

A lot of ink has been spilt arguing about the future of the dollar. I am not going to add much fuel to that raging fire. Suffice it to say that—

1. No serious attempt has been made to defend the dollar as far I can see.
2. The official projected Federal deficit has now been raised to $9,000,000,000,000.
3. The United States was already the biggest debtor nation in the history of the world and now we have lots more debt to look forward to.
4. The Federal Reserve is printing lots of money to implement the financial system bail-out. They say they have an exit strategy. We'll see.

Medlock and Jaffe add another important factor to the discussion. The large trade imbalance contributed to the dollar's precipitous decline since 2000.

Figure 7 — The U.S. trade balance from Calculated Risk. Medlock and Jaffe say: "The high oil price contributed to a weakening of the dollar through mounting trade deficits and U.S. debt. In 2007 and 2008, dramatically rising oil prices fed the U.S. trade deficit leading to increased U.S. indebtedness. This, in turn, contributed to an even weaker dollar, which further drove oil prices higher in a self-perpetuating pattern. Oil-linked index funds became an asset class for investors wanting to escape the falling dollar and weakening stock market, adding to the speculative fervor in oil." Theoretically, a declining dollar boosts exports and inhibits imports. The graph shows that the balance of trade has narrowed considerably since the economic crisis began. However, imports and exports are both down considerable.

Medlock and Jaffe are describing a dollar/oil death spiral, a positive feedback loop in which the declining dollar raises oil prices, which further deflates the dollar through the trade imbalance, which raises oil prices, and so forth.

I am not a seer of the stature of Nouriel Roubini. So let's have him gaze into his crystal ball to discern how the dollar might fare in coming years. 

There are also now two reasons why there is a rising risk of a double-dip W-shaped recession. For a start, there are risks associated with exit strategies from the massive monetary and fiscal easing: policymakers are damned if they do and damned if they don’t. If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation [recession and deflation].

But if they maintain large budget deficits, bond market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation [recession and inflation].

Another reason to fear a double-dip recession is that oil, energy and food prices are now rising faster than economic fundamentals warrant, and could be driven higher by excessive liquidity chasing assets and by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly towards $100 a barrel.

Roubini thinks there are two possible outcomes: recession plus deflation, in which the purchasing power of the dollar will go up here at home, or recession plus inflation, in which the purchasing power of the dollar will go down. It is impossible to understand—at least, for me it is—how either scenario will affect the overall value of the dollar on international markets (the exchange rate) and thus the price of oil. There are too many variables to consider.

Almost anything is possible in Disneyland, and most of it is not good.

Contact the author at dave.aspo@gmail.com

The New Gilded Age

Blessed are the poor in spirit: for theirs is the kingdom of heaven.
Blessed are they that mourn: for they shall be comforted.
Blessed are the meek: for they shall inherit the earth.
Blessed are they which do hunger and thirst after righteousness: for they shall be filled.
   —the Sermon on the Mount, Matthew 5:9

Everybody knows that the dice are loaded
Everybody rolls with their fingers crossed
Everybody knows the war is over
Everybody knows the good guys lost
Everybody knows the fight was fixed
The poor stay poor, the rich get rich
That's how it goes
Everybody knows
  —Leonard Cohen, Everybody Knows

My subject today is the grotesque wealth & income inequality that exists in the United States. I have dubbed our times the new Gilded Age, which was Mark Twain's name for the post-Civil War period when "the rich wore diamonds and many others wore rags." I could also have called it the "last" Gilded Age because our slowly disappearing Middle Class will never exist again as it once did. Never before in human history have so many people shared in a society's wealth as Americans did in the decades just after World War II.

In the 1960s, Lyndon Johnson put forward his Great Society program to eliminate poverty in the United States. That laudable goal seemed doable back then—everything seemed doable back then, before Vietnam and the oil shocks of the 1970s got in the way. Now, some forty-five years later, the natural order of things has reasserted itself, where a relative few have most of the wealth as the rest struggle to eke out some kind of living.

Before I unleash a flood of graphs and charts which demonstrates the income & wealth inequality problem beyond any reasonable doubt, I would like to relate a revealing story I heard on NPR Sunday as I was preparing to write this piece.

Liane Hansen brought in typical NPR "expert" Roben Farzad of Business Week to talk about how rich Americans hide their money in Swiss bank accounts to avoid taxation, and to talk about "the markets" in general. Here's how the last part of their conversation went—

HANSEN: Let's talk a little bit about the markets this week. Did you see dark clouds or a silver lining?

Mr. FARZAD: Well, the market, however monolithic we want to look at this thing, is at a year high. I mean, this has been a spectacular run if you think about it. I saw a stat somewhere that over the span of time where the economy hemorrhaged two million jobs, the market's gained 50 percent. That's unprecedented. And this is the best, I think, six- or seven-month run since 1938. So, it shows you how far we've come from a perception standpoint. Back in March, people really thought that we were on the brink of absolute abysmal calamity. And what's noteworthy is that riskier asset classes have outperformed the safe and stable security. So, that flies in the face of this whole reckoning argument, that we've been so chastened, that people are going to be husbanding cash under their mattresses for the foreseeable future. So, at least that's promising but maybe we've gotten a tad ahead of ourselves.

HANSEN: There were new numbers from the Mortgage Bankers Association this week. More than 13 percent of American homeowners with a mortgage have either fallen behind on payments or are already in foreclosure. What effect is this having on the U.S. economy as a whole?

Mr. FARZAD: It's a significant overhang going forward. We as an economy really binged on housing, really had this - almost this real estate new paradigm fetish, and I don't think that kind of excess inventory is going to be worked off in a year or two. We have several other shoes to drop in terms of delinquencies. There is a certain level of amnesty right now between the banks and delinquent borrowers, for them not to foreclose, for them to maybe seek out remediation. And you're going to see a lot of these things fail over the next year or two. The question is how much has the market already priced that in.

The market was pricing in, once again, calamity just a few months ago, and now it seems that things aren't going to be as horrific as expected. So, it remains to be seen. 

[My note: What is really happening is that 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 currently level of 6.6%. ...

Also see Barry Ritholtz's Bad Bears or Road to Recovery? to see a graph comparing the current Splenda market "rally" to previous bear market upswings.]

A spectacular run. The best six- or seven-month run since 1938. And so forth. To be sure, a few poor schmucks (over 13% of American homeowners in this case) are very likely to lose the roofs over their heads, but not to worry—the market already priced in an abysmal calamity back in March. To be sure, some things remain to be seen, but it seems like things aren't going to be as horrific as expected. Except if you're in foreclosure, of course, and about to lose your house.

Do you ever get the sense that you're drowning in a toxic sea of lies and distortions, and there's nothing you can do about it?

Who is profiting from the stock market run-up Roben Farzad is so excited about? Let me quote from A Detailed Look at the Stratified Consumer, an excellent guide to reality from the essential blog Zero Hedge that I will be referencing later on.

The main reason for this disproportionate loss of wealth [in the Lower and Middle Classes] has to do with the asset portfolio of the various consumer strata. A sobering observation is that while 90% of the population holds 50% or more of its assets in residential real estate, the Upper Class only has 25% of its assets in housing, holding the bulk of its assets in financial instruments and other business equity [stocks]. This leads to two conclusions: while average house prices are still dropping countrywide, with some regions like the northeast, and the NY metro area in particular, still looking at roughly 40% in home net worth losses, 90% of the population will be feeling the impact of an economy still gripped in a recession for a long time due to the bulk of its assets deflating. The other observation is that only 10% of the population has truly benefited from the 50% market rise from the market's lows: those better known as the Upper Class.

The ongoing "absolute abysmal calamity" Farzad refers to has now been mostly confined to the Lower and Middle classes—90% of the population—whose main source of wealth used to be the appreciating value of their house. Crisis contained!

So who are these "people" that Farzad tells us are flocking toward risky assets, the ones who are not going to be husbanding cash under there mattresses? The consumer price index (CPI-U) shows a decrease of 2.1% over the last 12 months, mostly due to lower energy costs. Energy prices decrease because there is less demand for it. There is less demand for energy because economic activity of all sorts has diminished.

Many fewer consumers are spending money. Retailers are in serious trouble. Sears sales are down 8.6%. Dillards is down 13%. Macy's is down 9.5%. J.C. Penney is down 9.5%. The Gap is down 8%. And so on. The retail numbers, along with the CPI-U, among many other economic indicators, seems to show that people are indeed stashing cash under their mattresses—if they've got any cash left, that is. See 34% of workers have one week or less of savings.

When Farzad talks about what "people" are doing, he doesn't mean the hoi polloi, the 90% of us in the Lower and Middle Classes. He's talking about Business Week's constituency, the Super Rich or the Merely Rich. Although the New York Times seems very concerned that the Rise of The Super Rich Has Hit A Sobering Wall, things are starting to look up for them just as Farzad says—

The possibility that the stock market will quickly recover from its collapse, as it did earlier this decade, is perhaps the biggest uncertainty about the financial condition of the wealthy. Since March, the Standard & Poor’s 500-stock index has risen 49 percent.

Yet Wall Street still has a long way to go before reaching its previous peaks. The S.& P. 500 remains 35 percent below its 2007 high. Aggregate compensation for the financial sector fell 14 percent from 2007 to 2008, according to the Securities Industry and Financial Markets Association — far less than profits or revenue fell, but a decline nonetheless.

Praise the Lord, the very-well-off are being made whole again as the S & P rises 49% during a time when the economy lost 2 million jobs. Better still, Goldman Sachs (aka. the giant vampire squid) roams the putrid seas again free of any possible risk or regulation. The sea monster's particular specialty is ripping off ordinary investors—what schlubs they are!—via high-frequency computer trading. Low stock prices? A slump in bonus compensation in the finance industry? Problems getting solved!

Why do Roben Farzad (and NPR's Liane Hansen) confuse our collective fortunes with those of the wealthy? Figure 1 shows the history of income concentration in the United States.

Figure 1 — This graph is taken from the New York Times (cited above). Since 1983, the share of the income in the United States of the richest 1% rose from 10% of the total to 24% of the total. The share of income for the bottom 90%—bottom 90%? when did 90% of the population become the bottom?—fell to 50% from ~67% during this same period.

As John Kenneth Galbraith was fond of pointing out, human memory is short. Business Week's Roben Farzad was born in 1976. He graduated from Princeton in 1998. This talented young man has never been a working adult in a world in which great wealth inequality did not exist. He thinks this disparity is normal, despite what Figure 1 makes obvious. The novelist Upton Sinclair pointed out another obstacle for young Mr. Farzad to overcome in this regard: “It is difficult to get a man to understand something when his salary depends upon his not understanding it." But I shall give the last word about Farzad's blind obedience to the status quo to Marshall McLuhan—

• "We don't know who discovered water," Marshall McLuhan would say, "but we know it wasn't a fish." 

I do not mean to single out Farzad for special treatment—reporters like him are everywhere¹. It is just unfortunate for him that I happened to be listening to NPR Sunday as I was preparing this report. Now that we've got a proper perspective on the wealth & income disparity in the United States, let's look at some disturbing graphs and charts.

The "Myth" of the Over-leveraged Consumer

One of the sources for Zero Hedge's report on the stratified consumer was Bank of America's The Myth of the Overlevered Consumer (L.A. Times' Money & Company blog, August 14, 2009).

The well-heeled might be able to save the U.S. economy from a long period of dismally weak consumer spending—if only we don’t jack up their taxes.

That’s one conclusion to draw from a new Bank of America Merrill Lynch report this week, "The Myth of the Overlevered Consumer."

The report hammers home what you might already suspect: The consumer debt problem in the economy really is a debt problem for the middle class. The need to work off a chunk of that debt will sap middle-class families’ spending power for perhaps years to come.

By contrast, the upper 10% of income earners face a much smaller debt burden relative to income and net worth.

Bank of America has reached—one hopes without great difficulty—an incisive conclusion: relatively speaking, the wealthiest Americans have little debt compared to the rest of us! Surely it is upon such startling insights that great empires have been built.

The captions to Figures 2 through 6 tell the story of wealth inequality in the United States. All the graphs & charts are from Zero Hedge's Stratified Consumer report except for Figure 6. Figure 3 explains why Bank of American/Merrill Lynch believes they have exposed the "myth" of the over-leveraged consumer.

Figure 2 — As of 2001, the wealthiest 10% of Americans accounted for 42% of total consumption in the United States. Taken together, the top 20% of American wage-earners accounted for an astonishing  55% of total consumption. The graph and others below are based partly on the Survey of Consumer Finances and the Bank of America Merrill Lynch report.

Figure 3 — The Middle Class financed their spending with debt, especially after 2001 during the Housing Bubble.The "myth" of the over-leveraged consumer is that it is only the Middle Class (50% of the population) that is mired in debt. The Lower Class normally don't have access to credit or don't own homes or both. The Upper Class don't need to borrow to finance their spending because they hold most of the wealth (see Figure 5). Because the Upper Class, which accounts for 42% of spending, is not over-leveraged, Bank of American Merrill Lynch concludes that the Upper Class alone can fuel an economic recovery.

Figure 4 — The desperate Middle Class used their homes as ATM machines by either 1) taking out home equity loans or 2) refinancing and extracting equity as cash. Activity peaked in 2005-2006 (left panel). People assumed house prices would never go down. A Ponzi Scheme in real estate requiring a constant infusion of new home buyers supported soaring house prices which led to equity extraction and speculation in real estate. A bubble in real estate should not be mistaken for a real economy, a lesson we hope newly appointed Fed Chairman Ben Bernanke has now finally learned.

Figure 5 — Comparing the disposable income (left) and net worth (right) of the rich versus everybody else. In 2001, the top 10 received 40% of the disposable income and held an amazing 57% of aggregate net worth. Zero Hedge says: "This is an impressive conclusion: on a lowest common denominator, the Net Worth variance between the 10% of the population that make up the wealthy and the 50% that comprise the middle class is over 8x! No wonder the aspirational consumer was the most vibrant retail category at the peak of the bubble: if the middle class can not accumulate 8x the net worth it needs to migrate into the top decile, it can at least dress like it. Unfortunately, it did these purchases on credit and is now paying for it (or not)." See my article The Incredible Shrinking Boomer Economy to learn why the Middle Class Boomer Consumer's spendthrift days are over.

Figure 6 — This is an updated graph from U.C. Berkeley professor Emmanuel Saez, who has been tracking income inequality for many years.The top 10% wage earners now receive 50% of income in the United States. This percentage is slightly higher than the previous 20th century high in 1928 just before the stock market crash of 1929 and the Great Depression.

The great "insight" of the Bank of America report is that the wealthy "should have ample spending power to help fuel an economic recovery."  From the banks' point of view, this take on things has the twin virtues of being self-serving while also preserving the status quo in which the rich have most of the wealth while the rest of us have relatively little. There is little hope that the status quo will change. Professor Saez talks about the future of income concentration in the United States—

The economic landscape has obviously changed dramatically since 2007 which marks the peak of Bush expansion. We know from National Account statistics that real incomes per family will fall in 2008 and 2009. Evidence from past recessions suggests that, in general, the top percentile income share falls during recessions, as business profits, realized capital gains, and stock option exercises fall faster than average income. Therefore, the most likely outcome is that income concentration will fall in 2008 and 2009. Based on the US historical record, falls in income concentration due to recessions are temporary unless drastic policy changes, such as financial regulation or significantly more progressive taxation, are implemented and prevent income concentration from bouncing back. Such policy changes took place after the Great Depression during the New Deal and permanently reduced income concentration till the 1970s. In contrast, recent downturns, such as the 2001 recession, lead to only very temporary drops in income concentration.

I've argued on several occasions that large policy shifts, such as those Saez mentions that might redistribute income and wealth in the United States, are very unlikely (see my The Decline of the American Empire, for example). Barack Obama has been compared to Herbert Hoover. The likeness between the two is apt. Obama's go-slow, ineffectual approach to pressing problems in Finance accommodates the current oligarchs.

The President's current inaction stands in stark contrast with the progressive policies of Franklin Roosevelt during the Great Depression (see Figure 1 or Figure 6). It is fair to say that wealth inequality in the United States will get worse before it gets better, if it ever does get better. I think this very unlikely.

Grotesque income and wealth disparity also has potentially strong effects on future energy consumption in the United States. The income elasticity of oil demand is usually measured as just below unity (e.g. ~0.92), which means that oil demand rises almost as rapidly as income. Although income is falling for everyone during the Great Recession, the income share of the top 10% wage earners will only increase in the future if Saez is correct, which he surely is. In 2007, that share stood at 50%. But if total income does not grow at at least the rate at which income expands for the wealthy, the real income of the "bottom 90%" will shrink.

Thus we might expect energy (oil) demand to fall if income declines in the "bottom 90%" (all other things being equal). I further assume that the richest 10% of the population will not use much more energy than they already do. Falling incomes would thus imply "peak demand" for oil in the United States.This conclusion is bolstered when we consider that the days of easy credit are over (e.g. people will not be paying for gasoline with credit cards).

The status of the housing market, which gave a phantom boost to Middle Class net worth during the bubble, remains uncertain. Calculated Risk, whose knowledge about the residential real estate markets is second to none, doesn't believe the housing bottom is in yet. If he is right, the Middle Class stands to lose even more of their net worth in the next year or two.

Simon Johnson had this to say about wealth & income equality in The Two-Track Economy—

The traditional U.S. recession remedy is: move to another, more prosperous part of the country.  But nowhere is exactly booming at present. And how do you move if you can’t sell your house?

The overall numbers on outcomes by groups can get complicated (here’s a partial guide), but the simple version is: the top 10% of people are going to do fine, the middle of the income distribution have been hard hit by over-borrowing, and poorer people will continue to struggle with unstable jobs and low wages.

Can the richest people spend enough to power a recovery in overall GDP? Perhaps, but is that really the kind of economy you want to live in?

No, Simon, that's not the kind of economy I want to live in. I assume many of you feel the same way. Do we really have any choice about it? The Powers That Be take the self-serving position that astonishing wealth inequality is normal, and even somehow desirable. Mainstream media reports on how the "economy" is faring are little more than updates on the status of the rich. The elites—the "haves"— say things are getting better, but to the average man on the street—the "have nots"—it feels more like a depression.

Bank of America is bullish on the economy because, wonders of wonders, the rich are still rich. Thus they conclude that the wealthy will provide the spending impetus that will pull us out of recession. Conveniently, the Bank of America view does not require any change to the way wealth & income are distributed in the United States.

I feel like A Man Without A Country. It's sad, really, to watch this once great country go to pot so a relative few can prosper.

Contact the author at dave.aspo@gmail.com

Notes

1. If you want to know how the other 90% of the people are doing in this country, you need to read various websites, including (in no particular order, not comprehensive)—

• Calculated Risk
• The Big Picture
• Baseline Scenario
• Zero Hedge
• Global Economic Trend Analysis
• iTulip
• Tech Ticker
• Naked Capitalism

The Incredible Shrinking Boomer Economy

Hope I die before I get old
    —The Who, My Generation

The vagabond who is rapping at your door
Is standing in the clothes that you once wore.
Strike another match, go start anew
And its all over now, baby blue.
   —Bob Dylan, It's All Over Now, Baby Blue

I am 53 years old, which makes me a post-World War II "Baby Boomer" (those born between 1946 and 1964).  First off, I want to issue a blanket apology to younger cohorts (generations X & Y) for the excesses of my generation. No generation in the human history was given so large an opportunity to ravage the Earth through excess consumption, and Boomers did not squander that opportunity. No generation has adversely affected the welfare of future generations as the Boomers have. So much for Woodstock and the Age of Aquarius.

Cam Marston, author of Motivating the 'What's In It For Me' Workforce, talking about the 1983 film The Big Chill: “The young cast, all of whom became major stars, epitomized the Baby Boomers’ new version of the American Dream: “You can have your cake and eat it, too.” Again, I'm sorry.

I'm sure you've heard the expression "spend money like there's no tomorrow." That's precisely what the Boomers did. It was unprecedented debt-fueled spending spree made possible by easy credit. See my Don't Buy Stuff You Can Not Afford for some details. As Bill Bonner put it at the Daily Reckoning, that household debt now "represents spending that has been taken from the future."

The first Boomers reach retirement age in 2011. Business Week reports that it has long been expected that aging Boomers would cash out and decrease their spending. But the real Big Chill arrived a few years early.

When 79 million people—nearly a third of Americans—start spending less and saving more, you know it won't be pretty. According to consulting firm McKinsey, boomers' conversion to thrift could stifle the economy's hoped-for rebound and knock U.S. growth down from the 3.2% it has averaged since 1965 to 2.4% over the next 30 years. "We would have gotten here in 5 or 10 years as boomers retire, but [the economic crisis] pushed it up," says Michael Sinoway, managing director of consulting firm AlixPartners. "Now [companies] are scared things won't come back"...

Not so long ago, boomers were never going to die. Filled with a self-confidence born of unprecedented prosperity, many thought rising markets would assure their future. If the economy faltered, well, it would rebound more strongly than ever, as it had so many times before. And so boomers spent—and borrowed—as if there were no tomorrow.

[My note: The U.S population is 304,224, 211. The Boomers are 26% of it. So much for fact checking.]

Tomorrow is here. With retirement looming, the Great Recession has put Boomers into emergency thrift mode. Unsurprisingly, McKinsey Quarterly reports that most of them are unprepared for their golden years.

The low savings rate and extensive liabilities of the boomers have left about two-thirds of them unprepared for retirement. We reached this conclusion by assessing the level of post-retirement income and assets that the boomers would need to maintain 80 percent of their peak pre-retirement spending.This analysis—based on net financial assets such as bank deposits, stocks, and bonds, minus credit card balances, car loans, and other non-mortgage debt—indicates that 69 percent of the boomers are not prepared to maintain their lifestyles. The inclusion of home equity, whose value is declining in many regions below the levels prevailing when we undertook our analysis, only reduces the proportion of the unprepared to 62 percent.

The home equity situation is not improving. According to American CoreLogic, more than 15.2 million (32.2%) of all mortgaged properties were in negative equity in June, 2009. (Negative equity means your mortgage debt exceeds the value of your house.) An additional 2.5 million homeowners were nearly underwater. Although the rate of decline in home prices has slowed, it is not at all clear that we have reached the bottom in the housing market. Beyond home equity, Boomers' net worth has taken a huge hit as asset values fall. Many Boomers will have to work longer than they anticipated.

Economists and demographers say Boomers will need to replace some $2 trillion of wealth lost in retirement funds [e.g. 401k plans] during the recent stock meltdown, plus the billions in home equity that have vanished in the housing crash. Government policy makers will have to figure out how to provide for a huge cohort of people who could live well into their 80s.

McKinsey found that the Boomer spending accounted for an astonishing 78% GDP growth during the "bubble years" from 1995 to 2007. Much of that spending will disappear. The "generational crash" will be a drag on the economy for years to come.

"The generational crash is when there are too many older homeowners and not enough buyers," says Dowell Myers, a University of Southern California professor.

"This is like winter coming," adds Harry S. Dent, an author and consultant who says the U.S. is headed for a slump that will last until 2020. It will take that long for the financial wreckage from this boom-bust cycle to be cleared away, he says, and for the 79.4 million strong "Millennial Generation"—most of whom are still in high school or college—to enter adulthood and start buying homes, cars and gadgets of their own. "It happens once every 80 years," Mr. Dent says of this sort of demographics-driven economic cycle. "It's going to be difficult."

If this sounds like a looming disaster for the economy, it is. But elderly Boomers will require much more medical care than they did when they were lighting embargoed Cuban cigars with $20 bills. That's the real disaster.

The Medicalization of America

As the destructive financialization of America runs its course, and President Obama's health care initiative stumbles through the Congress, the "medicalization" of America continues apace (Figures 1 & 2).

Figure 1 — Health care spending as a percent of GDP, from Calculated Risk's Health Care Spending And PCE. (PCE = personal consumption expenditures, as described in Don't Buy Stuff You Can Not Afford). In 1983, all health care spending (green line) was slightly more than 10% of GDP. Now it is 16.2% according to the government's National Health Expenditure data.

Figure 2 — Personal consumption expenditures, with and without health care, as a percent of GDP (also from Calculated Risk as cited in Figure 1). The growing share of health case, especially since the early 1980s, is alarming. As a percent of GDP, which was growing this whole time, the ex-health share has been mostly flat since 1960. In 2007-2008, ex-health PCE was 57% of GDP and health spending added 13%. The graph does not include investment (green line in Figure 1), so the consumption only share is lower than the Figure 1 total (16%). Medicare & Medicaid spending is counted as part of personal consumption expenditures, and makes up 5% of GDP. Hence private health care consumption makes up 8% of GDP.

With most consumption growth fueled by ever-greater debt, the inescapable, tragic conclusion is that many American citizens were borrowing to pay for medical care, which everyone regards as a necessity. Most personal bankruptcies are caused by unpayable medical bills according to the American Journal of Medicine.

Using a conservative definition, 62.1% of all bankruptcies in 2007 were medical; 92% of these medical debtors had medical debts over $5000, or 10% of pretax family income. The rest met criteria for medical bankruptcy because they had lost significant income due to illness or mortgaged a home to pay medical bills. Most medical debtors were well educated, owned homes, and had middle-class occupations. Three quarters had health insurance....

But the worst is yet to come. Calculated Risk tells us the bad news.

But the more important point is what will happen in the future. From a demographic perspective, these are the best of times for health care expenses. The original baby busters (from 1925 to the early 1940s) are now at the peak medical expense years, but their medical care is being heavily supported by the baby boomers (now in their peak earning years).

[My note: Thus the question becomes who will support the Boomers in future years in an economy that will be weak for years to come?]

This is as good as it gets health care-wise, a point which is made forcefully in the Health & Human Services national health expenditure projections.

Growth in national health expenditures (NHE) in the United States is projected to be 6.1 percent in 2008. National health spending is expected to increase from $2.2 trillion in 2007 to $2.4 trillion in 2008. Average annual NHE growth is expected to be 6.2 percent per year for 2008 through 2018.

Over the full projection period (2008-2018), average annual health spending growth is anticipated outpace average annual growth in the overall economy (4.1 percent) by 2.1 percentage points per year. By 2018, national health spending is expected to reach $4.4 trillion and comprise just over one-fifth (20.3 percent) of Gross Domestic Product (GDP).

Driven in large part by the recession, NHE growth is expected to significantly outpace GDP growth in 2008 and 2009. In 2008, NHE growth is expected to be 6.1 percent while GDP growth is anticipated to be 3.5 percent. For 2009, health spending is projected to increase 5.5 percent while GDP is expected to decrease 0.2 percent (the first decrease in GDP since 1949).

[My note: Actual GDP growth was -0.4% in 2008 according to the BEA's revised numbers.]

And here's the kicker—

From 1965 to 2007, health spending as a percent of GDP has increased steadily from 5.9 percent to 16.2 percent, roughly an average of 0.25 percentage point per year. History has shown, however, that the health share of GDP has increased most rapidly during periods of recession. For example, the share increased by 0.7 percentage point per year during the recessionary periods of 1990 and 1991, as well as 2001, as growth in health spending did not fall as quickly as overall economic growth.

[My note: According to the BEA, GDP has decreased 2.8% at an annual average rate during the Great Recession (through the 1st quarter of this year). Thus the health care share is growing faster than usual during the downturn relative to the overall economy.]

The reason health spending does not fall as quickly as general spending during a recession should be obvious: health care is usually not discretionary.

Most astonishing of all, Health & Human Services assumes an annual growth rate of 4.1% for the period 2008-2018. This is absurd. Health care spending & investment may be close to 20% of total economic output by 2020, but it won't be because the economy grew at annual rate of 4%. Indeed, that's the problem—we're likely to have a "lost decade" in which non-discretionary health care spending rises far beyond our ability to accommodate it. Just the aging of the population itself practically guarantees this outcome.

Today, for every person age 65 or older, there are five people 20 to 64 years old. That figure is projected to fall to below three by 2030. Even after the retirement of the baby-boom generation, the population will continue to age, demographers project, as life expectancy continues to increase and fertility rates remain low by historical standards.

In this and other columns I have cast doubt on a prosperous future for the United States. Since 1983, the American consumers—rhymes with Boomers—spent tomorrow's wealth today. GDP growth depended on ever-greater borrowing and was thus systematically inflated. All this time America's industrial base declined (moved to China) and its (no longer cheap) imported oil dependency grew to ~66% of total consumption. To  keep the party going after 1995, the U.S. blew two enormous bubbles, one in the NASDAQ and a much larger one in housing. We used those bubbles to float up to the mountain top, where all that thin air made us giddy. Now we're sobering up as reality propels us down the other side.

The boom times are over. A secular change has now taken place. The U.S. will look more and more like a Third World country. In health care, compared to Canada or Europe, it already does. Thus our prospects for another economic boom in the next decade are like those of Monty Python's famous Norwegian Blue parrot—

“This bleeding parrot wouldn't boom if I put 4 thousand volts through it! It's bleeding demised... It's not pining for fjords, it's passed on. This parrot is no more. It has ceased to be! It’s expired and gone to meet its maker. This is a late parrot. It’s a stiff! Bereft of Life, it rests in peace! If you hadn’t nailed it to the perch, it would be pushing up the daisies! It's run down the curtain and joined the choir invisible. This is an ex-parrot!!!”

American Economy 1983-2007: Requiescat in pace

So much for a "V-shaped" recovery or "green shoots." This parrot is no more, it has ceased to be.

I think it is safe to assume that some version of President Obama's health care bill, should one pass through the Congress, will not rein in soaring costs because it will not address the root causes of health care cost inflation (e.g. incentives to perform unnecessary tests or lack of preventative care.) Let's summarize the relationships among aging Boomers, health care spending, and various economic factors.

• Boomers will start retiring in 2011 and will continue to retire until 2029. Their disposable incomes and ex-health spending will decrease. Their spending on health care will increase, as will Medicare & Medicaid expenditures (see the last section).
• There will be only slow growth in GDP over the next decade. As a result, health care spending & investment as a percent of GDP will rise more rapidly than "normal" relative to the overall economy. GDP itself will be effectively overstated as Boomers require more health care in their golden years because, perversely, taking more medications, being sick, or dying adds to GDP. But many of these expenditures will be "unproductive" for the economy as a whole in so far as money will be spent to keep the elderly Boomers alive rather than keep the workforce healthy. (I know that sounds hardhearted to say, but this is the mess we've created. It's not called the Dismal Science for nothing.) 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.
• The ranks of the uninsured will increase. Household debt will be pared down slowly. We will experience an extended jobless recovery. Disposable real income will stagnate (or may even decline) over time. Underemployment—part time workers who desire full time jobs—usually disqualifies workers from access to employer-sponsored health insurance plans. The effective unemployment rate (now 18.35%, MS Word file) will also remain very high (>12%) for many years to come. Household wealth continues to decline, but will eventually bottom out. It will not rise much thereafter in the absence of new bubbles in the economy. Non-discretionary health care needs will force more and more people in the Middle Class into bankruptcy and foreclosure. In the normal course of things, the disposable, uninsured poor will remain poor, uninsured and disposable.

This is all grim news, but that's not the half of it.

Growing Federal Deficits

The non-partisan Congressional Budget Office (CBO) told us the bad news in it's June, 2009 Long-Term Budget Outlook.

Under current law, the federal budget is on an unsustainable path—meaning that federal debt will continue to grow much faster than the economy over the long run. Although great uncertainty surrounds long term fiscal projections, rising costs for health care and the aging of the U.S. population will cause federal spending to increase rapidly under any plausible scenario for current law. Unless revenues increase just as rapidly, the rise in spending will produce growing budget deficits and accumulating debt. Keeping deficits and debt from reaching levels that would cause substantial harm to the economy would require increasing revenues significantly as a percentage of gross domestic product (GDP), decreasing projected spending sharply, or some combination of the two.

For decades, spending on the federal government’s major health care programs, Medicare and Medicaid, has been growing faster than the economy (as has health care spending in the private sector). The Congressional Budget Office projects that if current laws do not change, federal spending on Medicare and Medicaid combined will grow from roughly 5 percent of GDP today to almost 10 percent by 2035...

[My note: See Figure 2 above and the attached note.]

We might sensibly ask what the CBO thinks future GDP might be (Figure 3). Figure 4 shows the projected deficits under the CBO's two scenarios.

Figure 3 — This graph of "potential" GDP  in real (inflation-adjusted) 2000 dollars is taken from The CBO's Budget and Economic Outlook: Fiscal Years 2009 To 2019. I have injected some reality into the projection with my low (blue), reference (red) and green (high) growth cases.

Figure 4 — Projected federal debt under the Extended-Baseline and Alternative Fiscal scenarios from the CBO.

The Alternative Fiscal scenario "deviates from the CBO's baseline projections, beginning in 2010, by incorporating some changes in policy that are widely expected to occur and that policy-makers have regularly made in the past. In other words, it is the expected outcome if politics continues as usual.

Under the alternative fiscal scenario, deficits would decline for a few years after 2009 but then grow quickly again. By 2019, debt would reach 83 percent of GDP [and 100% in 2022, Figure 4]. After that, the spiraling costs of interest payments would swiftly push debt to unsustainable levels. Debt would exceed its historical peak of 113 percent of GDP by 2026 and would reach 200 percent of GDP in 2038.

[My note: 2038 is a long way from now as far as making predictions go. Even 2026 is a stretch.]

Figure 5 shows where the new debt comes from.

Figure 5 — This is the CBO's crucial graph. I marked it up to show the date range in which Boomers turn 65 years old. Growth in Federal spending on Medicare & Medicaid (dark blue) far outpaces Security Spending (very light blue). The dark blue line show expected revenues. Expenditures above the revenue line represent deficit spending.

The remarkable things about Figure 5 are the things you can't see. Historically, Federal revenues (tax receipts) have averaged about 18.5% of GDP since 1950, despite some wild swings during the Bubble Era (1995-2007). That is why the revenue line is flat in Figure 5. Revenues will increase or decrease with GDP, other things being equal (e.g. tax policy). However, if GDP does not grow to "potential" as shown in Figure 3, revenue in real dollar terms will be less than anticipated (again, sans tax policy), whereas Medicare & Medicaid (and other entitlement) spending, which is subject to terrible cost inflation, is currently fixed by law. Thus the health spending deficit could also be much larger than the CBO anticipates in its Alternative Fiscal scenario.

The second remarkable thing about Figure 5 is that the graph does not include interest on the debt.

The current recession has little effect on long-term projections of non-interest spending and revenues. But CBO estimates that in fiscal years 2009 and 2010, the federal government will record its largest budget deficits as a share of GDP since shortly after World War II. As a result of those deficits, federal debt held by the public will soar from 41 percent of GDP at the end of fiscal year 2008 to 60 percent at the end of fiscal year 2010. Higher debt results in permanently higher spending to pay interest on that debt (unless the debt is later paid off ). Federal interest payments already amount to more than 1 percent of GDP; unless current law changes, that share would rise to 2.5 percent by 2020.

On August 8th, Tim Geithner asked Congress to raise the debt ceiling to $12,100,000,000,000 (trillions). If this were the year of my birth, 1953, running these kinds of deficits wouldn't be so irresponsible. We had plenty of oil and decades of strong economic growth in front of us. But a lot of the oil is gone now, and the Boomer debt party is over. I'm not alone in thinking that we are looking at years and years of slow or no growth ahead of us. The aging of the Boomers, and the accompanying health care costs, are just one, albeit important, part of this scenario.

Most analysts who aren't "gold bugs" think it unlikely that the United States will default on its debt. Such an event would mark the official End of the Empire, and would trigger an Argentina-like collapse—the dollar would be effectively worthless. Alarmingly, there is perceived to be a non-zero chance of default now, and that risk will rise in the future. I'll leave you with this quote from We're Borrowing Like Mad, Can The U.S. Pay It Back?

The notion seems absurd: Banana republics default, not the world's biggest, richest economy, right? The United States has unparalleled wealth, a stable legal tradition, responsible macroeconomic policies and a top-notch, triple-A credit rating. U.S. Treasury bonds are routinely called "risk-free," and the United States has the unique privilege of borrowing in the currency that other countries like to hold as foreign-exchange reserves.

Yes, default is unlikely. But it is no longer unthinkable. Thanks to the advent of credit derivatives -- financial contracts that allow investors to speculate on or protect against default -- we can now observe how likely global markets think it is that Uncle Sam will renege on America's mounting debts. Last week, markets pegged the probability of a U.S. default at 6 percent over the next 10 years, compared with just 1 percent a year ago. For technical reasons, this is not a precise reading of investors' views. Nonetheless, the trend is real, and it is grounded in some pretty fundamental concerns. 

Grounded in some pretty fundamental concerns? I would say so.

Contact the author at dave.aspo@gmail.com

The Next Oil Shock

There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is a part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
   —John Kenneth Galbraith

Those who cannot learn from history are doomed to repeat it
   —George Santayana

When will the next oil shock occur? This is a question of interest to many, but it's not much in the news lately. People tend to forget last year's crisis. They're now preoccupied with a barely functioning economy which was further hobbled by the oil price spike in 2007 and the first half of 2008.

Today I attempt to set reasonable expectations about the timing of the next oil price spike. For simplicity's sake, I will define an oil shock to be a 2 month period where oil prices exceed $110/barrel. My working assumption is that such a shock, after some time lag, will once again help bring a structurally unsound world economy to its knees.

The world is awash in spare oil production capacity. This is not surprising, given—

1. An estimated drop in daily consumption of 2.5 million barrels  in 2009, following a drop of 0.3 million barrels-per-day in 2008 (see Figure 1 below).
2. Saudi Arabia has finally reached a capacity of 12 million barrels-per-day (b/d) with the recent additions of Khurais and Nuayyim, and the expansion at Shaybah. Their July production was only 8.04 million b/d. The Saudis are reworking Ghawar to take advantage of the opportunity offered by low global demand.

Determining when the next oil shock will occur is deceptively simple: it will happen when world demand rebounds to 2007 levels. On the supply side, there's no reason to believe the Saudis will ever produce more than 10.5 million barrels-per-day, and even this ceiling is probably too high. If you add in the other Persian Gulf unused capacity, and subtract non-OPEC production lost from field declines or lack of investment, it's basically a wash. Demand at 2007 levels will once again test the oil supply. But when will demand pick up another 2.8 million barrels-per-day?

The International Energy Agency (IEA) believes we could add another 1.4 million b/d of new demand in 2010 (Figure 1).

Figure 1 — Taken from the IEA's July, 2009 Oil Market Report. Historical demand growth data are shown on the left, and I have circled the years 2008-2010. The IEA draws a strange curve fit (gray line) that shows that if global real GDP grows 4% year-over-year, oil consumption will grow by nearly 2%. (On the other hand, oil demand hardly rises at all if global GDP grows by 2%, and growth below 2% implies negative oil demand growth!)  You can see the IEA's demand growth estimate in barrels-per-day on the right.

The IEA explains its bullish forecast—

In 2010, by contrast, the picture could be dramatically different. As a starting point, this report uses IMF economic assumptions (World Economic Outlook, April 2009), which posit that global economic growth will reach +1.8% in 2010, compared with ‐1.4% in 2009 – that is, a swing of over three percentage points. Under this scenario, oil demand is expected to rebound by +1.7% or +1.4 mb/d year‐on‐year to 85.2 mb/d – but still way below 2008 levels. Unsurprisingly, this strong rebound is poised to be led by non‐OECD countries, where demand should expand by +3.5% or +1.3 mb/d, close to levels seen in previous years and following zero growth in 2009. China, the Middle East and to a lesser extent Latin America will play a prominent role. The OECD, meanwhile, should also post a modest recovery (+0.2% or +100 kb/d) as most of its economies gradually emerge from their deepest slump in over half a century, with North America being arguably the engine of growth.

Almost all the new demand comes from emerging markets (China, the Middle East and South America). The IEA bases its conclusion on the International Monetary Fund's April, 2009 World Economic Outlook, but the IMF has already upped its forecast since the IEA published its July report.

The world economy is stabilizing, helped by unprecedented macroeconomic and financial policy support...

Accordingly, global activity is forecast to contract by 1.4 percent in 2009 and to expand by 2.5 percent in 2010, which is 0.6 percentage point higher than envisaged in the April 2009 WEO (Table 1). The higher annual average growth rate for 2010 largely reflects carryover from a markup in growth during the final half of 2009. On a fourth-quarter-over-fourth-quarter basis, real GDP growth is projected at 2.9 percent in 2010, compared with 2.6 percent in the April WEO forecast.

[My note: there is discrepancy of 0.1% between the IMF's April number and that cited by the IMF. I will ignore it.]

Whereas the IEA thought oil demand would grow by 1.4 million b/d, it would now appear that the more bullish IMF revision, which forecasts a year-over-year swing of ~4% GDP growth in 2010, implies (via Figure 1) that oil consumption will grow by nearly 2% in 2010 (~1.6 million barrels-per-day).

If the IMF's forecast is correct, we might expect the next oil shock as soon as 2011 as demand revisits 2007 levels. So now the question becomes: will the global economy rebound as sharply as the IMF believes?

Beware Official Forecasts!

The next three graphs illustrate why it is always necessary to question official growth forecasts. Debunking these estimates is like shooting fish in a barrel.

Figure 2 — The graph is taken from Six Impossible Things Before Breakfast, a critique of the Efficient Markets Hypothesis by James Montier of Societe Generale in London. Official U.S. forecasts (gray line) always expect GDP growth of between 2 and 3.5% with only minor variations. In the real world (red line), growth is erratic and recessions (or downturns) occur. Note the "V-shaped" recoveries from prior recessions. Mistaken analysts believe this pattern will reappear after the current Great Recession ends.

Figure 3 — The prospects for world GDP growth (year-on-year percent change, top frame) from the IMF's April, 2007 World Economic Outlook. The IMF estimated the percent change in growth in 2008 would be at worst +3.3% with 90% confidence. The IMF assessed the global risk factors affecting their forecast (bottom frame). Note that the assessed risk from the U.S. housing sector and the oil supply was lower in 2007 than it was in 2006.

Figure 4 — The actual percent change outcome for world GDP growth from the IMF's April, 2009 World Economic Outlook. Contrast the outcome with Figure 3 (top panel) above. In 2009 the worst case (in the 90% confidence interval) is a -1.4% percent change in 2010. In other words, the baseline forecast reflects official optimism, but the world economy could shrink again in 2010 in the worst case.

We should not have much faith in the IMF's baseline forecast for world GDP growth of 2.5% in 2010. The IEA's oil demand growth scenario depends on the IMF estimate, so we should not necessarily believe that story either.

Chimerica

I'm no better than the IMF at predicting what the percent change for global GDP will be in 2010, not to mention the greater uncertainties associated with the years beyond that. All I can do is discuss a few factors that cast doubt on predictably rosy official estimates.

By far the largest economy in the world is the one which has no name. Niall Ferguson calls it Chimerica.

We are living through a challenge to a phenomenon Moritz Schularick and I have christened “Chimerica.” In this view, the most important thing to understand about the world economy over the past decade has been the relationship between China and America. If you think of it as one economy called Chimerica, that relationship accounts for around 13 percent of the world’s land surface, a quarter of its population, about a third of its gross domestic product, and somewhere over half of the global economic growth of the past six years.

[My note: Read my A Resurgence In China? for some necessary background on the symbiotic relationship between the U.S. and China, and the prospects for future GDP growth in China.]

Chimerica is responsible for over half of world GDP growth in the past 6 years. As this theoretical entity goes, so goes the world.

I presented my forecast for the GDP growth in the United States in Don't Buy Stuff You Can Not Afford. Our prospects for a robust economic expansion in the next few years—a "V-shaped" recovery—appear to be dismal. I would only add that the unreformed financial sector creates substantial downside risks. Despite a temporary lull in our level of alarm, too-big-to-fail banks Citigroup and Bank of America, among others, are still insolvent.

The threat of new bubbles—grossly inflated asset values like those we're starting to see in the S&P 500—still persists, and the continued existence of an unrepentant, unfettered, politically powerful and voracious giant vampire squid on Wall Street (aka. Goldman Sachs) heightens the dangers. Former chief IMF economist Simon Johnson of Baseline Scenario had this to say about Wall Street's role in America's economic future.

If the bubble (or metaboom with a series of bubbles) was in finance and pulled resources into that sector, we face an adjustment away from Peak Finance – and perhaps this will even more overshadow the next decade than peak oil.

The economic adjustment will not be easy for the [United States, which] will likely struggle with the political adjustment – the financiers will not easily give up their license to extract resources from citizens, either directly or through newly found rents channeled through the state (and coming ultimately out of your pocket, of course).

The political consequences of Peak Finance greatly complicate our economic recovery.

[My note: That's what giant vampire squids do, they extract resources (rents), even as they spurn making $36,000 loans to small businesses.]

While the United States flounders, China is said to be booming. On the face of it, China's economy is flourishing amidst the global carnage.

China bought record volumes of oil and iron ore in July as automakers, steel producers and builders expanded output to meet rising demand driven by the nation’s $586 billion stimulus spending. Oil imports jumped 18 percent to 19.6 million metric tons [4.52 million b/d], and iron ore purchases rose 5 percent to 58.1 million tons from a month ago...

Crude steel production in China, the world’s biggest maker, surged 13 percent last month to 50.7 million tons, the National Bureau of Statistics also said today in Beijing. That’s the third consecutive record monthly high... Iron ore is used in steelmaking. “Iron ore restocking pushed up the imports and prices as the stimulus package drives up steel demand..."

[My note: But China's "crude output [production] fell 0.3 percent to 16.14 million tons [3.8 million b/d] last month." This yields a record-setting consumption total of 8.32 million barrels-per-day. But the important question is whether Chinese oil production is now in permanent decline following its peak/plateau phase? This subject has to be examined at length some other time.]

Based on commodity imports alone, we might conclude that China will lead the world out of the economic doldrums in 2010. But all is not as it appears on the surface (Bloomberg, August 11, 2009). 

China’s exports and new loans tumbled in July and industrial output rose less than estimates, underscoring government concern that the world’s third-biggest economy is yet to establish a solid recovery. Exports fell 23 percent from a year earlier, the customs bureau said. Industrial production gained 10.8 percent, the statistics bureau reported. New loans plunged to 355.9 billion yuan ($52 billion), less than a quarter of June’s level, the central bank said...

Urban fixed-asset investment for the seven months to July 31 climbed 32.9 percent, the statistics bureau said. That was less than a 33.6 percent gain through June and the 34 percent median estimate in a survey of 22 economists. “The fixed-asset investment number is worrying because government-sponsored investment is a pillar of the recovery,” said Toa Dong, chief Asia-Pacific economist at Credit Suisse AG in Hong Kong. “This set of data should postpone any thought of more aggressive tightening; the economy is slowing down a little bit.”

[My note: In an attempt to inflate stock prices, the giant vampire squid is bullish! "China’s economy will grow 9.4 percent this year, topping the government’s 8 percent target, Goldman Sachs Group said yesterday."]

There are disturbing signs that China's economy is overheating, which typically leads to massive misallocation of resources as asset values over-inflate. The Shanghai Composite Index is very bubbly, and so are house prices in China's cities, as reported by the Wall Street Journal in China's Market Bubble Not Close To Bursting—Yet.

For months, Chinese markets have been in the grip of a growing speculative frenzy. The run may have further to go, because bubbles frequently last longer than observers expect they will. The situation should raise concerns for investors in all emerging markets, especially in Asia. If the mania leads to a crash, the damage will not be contained.

Signs of an emerging Chinese bubble are all around. The Shanghai and Shenzhen stock markets have doubled from their lows last fall. Retail investors, who show up at every bubble, are back in action: Trading volumes last week on those markets surpassed the peaks seen in late 2007. And shares are expensive: According to Credit Suisse, the domestic A shares in Shanghai now trade for about 23 times forecast earnings, and nearly four times book value...

Chinese real estate, already at lofty levels, has risen alarmingly fast lately. According to Frank Chen, a Hong Kong-based analyst with brokerage Yuanta Securities, average home prices in some cities on the mainland, such as Shanghai and Shenzhen, may have risen by more than a quarter since the start of the year. That may leave average prices in relation to household incomes higher than they are in New York, London, San Francisco and Sydney.

With economies in the rest of the world flagging, what’s driving the China boom? The Chinese economy continues to grow—it expanded by 7.9% in the second quarter—the real juice, as usual, has come from easy money.

Bank lending is at high levels. The Chinese government has embarked on a $586 billion stimulus plan that includes giant infrastructure projects to keep the economy rolling. Interest rates are low: Since last September the typical three-month deposit rate has fallen by about half, to 1.7%. So mainland Chinese investors are looking for other ways to grow their money.

But don't worry about the Shanghai stock market bubble or inflated house prices, says Vitaliy Katsenelson in China's Bubble's Coming—But Not The One You Think (Foreign Affairs, July 23, 2009).

Forget about a Shanghai stock bubble. The whole Chinese economy's getting ready to burst...

Now, China needs to stimulate its economy. It's facing a very delicate situation indeed: It needs the money internally to finance its continued growth. However, if it were to sell dollar-denominated treasuries, several bad things would happen. Its currency would skyrocket -- meaning the loss of its competitive low-cost-producer edge. Or, U.S. interest rates would go up dramatically—not good for its biggest customer, and therefore not good for China.

This is why China is desperately trying to figure out how to withdraw its funds from the dollar without driving it down—not an easy feat.

And the U.S. government isn't helping: It's printing money and issuing Treasuries at a fast clip, and needs somebody to keep buying them. If China reduces or halts its buying, the United States may be looking at high interest rates, with or without inflation. (The latter scenario is most worrying.)

All in all, this spells trouble—a big, big Chinese bubble. Identifying such bubbles is a lot easier than timing their collapse. But as we've recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer excesses persist, the harder the financial gravity will bring China's economy back to Earth.

The Chinese half of Chimerica is becoming dangerously overheated, which spells trouble for the United States. Even if Katsenelson's worst case outcome—China dumping dollars to finance their domestic growth—does not occur, there can still be little doubt about the eventual outcome when China's current stock market and real estate bubbles collapse. Since we are interested in the timing of the next oil shock, we need to look at the typical time frame in which bubbles rise and fall (Figure 5).

Figure 5 — Taken from Six Impossible Things Before Breakfast (referenced in Figure 2). James Montier says "In my own work I’ve examined the patterns that bubbles tend to follow. By looking at some of the major bubbles in history (including the South Sea Bubble, the railroad bubble of the 1840s, the Japanese bubble of the late 1980s, and the NASDAQ bubble1), I have been able to extract the following underlying pattern. Bubbles inflate over the course of around three years, with an almost parabolic explosion in prices towards the peak of the bubble. Then without exception they deflate. This bursting is generally slightly more rapidly than the inflation, taking around two years." The Wall Street Journal notes that "Though [China has bubbles], investors shouldn’t necessarily get out now. The frenzy has not yet reached the epic, wild proportions that typically mark the end of a bubble. There’s much money to be made there, and it could be awhile til the bubble pops."

A very complex picture is now emerging. The key questions are—

• Will China's bubbles proceed apace and pump up world oil demand over the next few years? In this case, the bubbles will burst, thus causing 1) economic collapse in China, and 2) the next oil shock prior to or simultaneous with that event. Or will the Chinese leadership realize the dangers, and sensibly slow down China's economic growth?

Because China has a command & control economy, all the important economic decisions lie in the hands of the state. If the Chinese leadership decides to go full speed ahead, we might expect the time to bubble collapse to be faster than the 3-year average shown in Figure 5. I believe the timing of the next oil shock largely depends on what happens in China.

The Next Oil Shock

I have not changed my view of future oil prices. I described that view in The Price Is Not RIght (December 17, 2008).

Figure 5 — The Boom & Bust view of future oil prices as explained in The Price Is Not Right. The figure has been annotated to show where we are and my best guess concerning the timing of next oil shock. I believe it will occur in 2012 plus or minus 1 year, given the uncertainties about Chimerica discussed above.

I have ignored many secondary variables (e.g. more oil demand in the Middle East, Europe's shrinking economy, Japan's severe downturn) that will have an impact on future oil demand. I did so to simplify the discussion. I believe the future of Chimerica, which is undergoing great changes now, is the most important factor affecting the timing of the next oil shock.

The global economic situation is very fluid. Uncertainty reigns. The IEA admits that the oil demand growth they estimated for 2010 could "fail to materialize." Stay tuned.

Contact the author at dave.aspo@gmail.com

Don't Buy Stuff You Can Not Afford

Everyone is a genius in a bull market
   —old financial saying

Disbelief in magic can force a poor soul into believing in government and business
   —Tom Robbins

I would argue that the most serious threat to the United States is not someone hiding in a cave in Afghanistan or Pakistan, but our own fiscal irresponsibility
   —David Walker, former comptroller of the United States

Last week I described friedmanism, defined as the dissemination of dangerous positive illusions, in the context of the ongoing sixth mass extinction of life on Earth in the 21st century. I come down to Earth in a different sense today, discussing the dangerous positive illusions that have been evident in the equities and commodities markets lately. I argue that the American economy is likely to be sluggish for many years to come. It's not a hard argument to make.

I am also (not so) amazed to report that the oil price, which now follows the S&P 500^{see note 1}, is over $71/barrel today despite the fact that the weak global demand situation has not changed at all.

Be that as it may, the Bureau of Economic Analysis (BEA) has determined preliminarily that Gross Domestic Product (GDP, or output) in the United States declined at only a 1% annual rate in the 2nd quarter of this year. This news cheered the financial markets, where it is assumed that GDP is now positive in 3rd quarter. Thus traders have convinced themselves that a robust recovery is just around the corner. Newsweek announced the good news with an asterisk (Figure 1).

Figure 1 — The infamous magazine cover indicator. The graph on the right shows Time Magazine's Home Sweet Home cover from June 13, 2005 in the context of the S&P/Case-Shiller home price index. The cover story was America's House Party, from which I quote: "The house has always reflected its occupants' place in society. But now it also determines their place in society. The boom has divided haves from have-nots—owners from renters, hot markets from cold. The median U.S. home price jumped in April to $206,000, up a stunning 15% over the past year and 55% over the past five years, according to the National Association of Realtors. The fact that houses are bought for pennies on the dollar magnifies the windfall." Barry Ritzholtz supplied the graph. You can find Daniel Gross' Newsweek story here.

My story last week did not talk about the truly positive part of positive illusions: if you know how to spot them, they can be very entertaining! Black humor, along with a lively sense of your insignificance in the cosmos, is going to be essential if you want to get through the next decade with all your mental faculties—if not your household balance sheet—intact.

You, me, all of us, are about to experience a propaganda blitz about a recovering economy the likes of which we have probably never seen before. The spinmeisters are going to be out in force because GDP is very likely to turn positive in the 3rd or 4th quarters. Over-exposure to bullish financial media, which is never good for you, will pose an extreme danger to your mental health (Figure 2).

Figure 2 — Successful cheerleaders want to invade your brain. Prepare for a shock & awe psychological assault when GDP edges into positive territory. From Eric Janszen's Explosion Fallout — Part I: Recession Ends, depression begins (iTulip, July 27, 2009).

You have been warned. Today I go back to basics to explain why the United States will remain mired in a deep hole for a long time to come. I need to briefly explain how Gross Domestic Product is calculated and what that really means, but it's not so hard to understand.

Back To Basics

Let's return to the clarity of February, 2009, when the stock market was pricing in a Great Depression, now said to have been averted. The Financial Times' Martin Wolf talked about Japan's lessons for a world of balance sheet deflation.

What has Japan’s “lost decade” to teach us? Even a year ago, this seemed an absurd question. The general consensus of informed opinion was that the US, the UK and other heavily indebted western economies could not suffer as Japan had done. Now the question is changing to whether these countries will manage as well as Japan did. Welcome to the world of balance-sheet deflation.

As I have noted before, the best analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute.* His big point, though simple, is ignored by conventional economics: balance sheets matter. Threatened with bankruptcy, the over-borrowed will struggle to pay down their debts. A collapse in asset prices purchased through debt will have a far more devastating impact than the same collapse accompanied by little debt.

[My note: I will not get into the intricacies of the "inflation versus debt deflation" discussion today. I am trying to keep things simple. You can think of the Great Recession as a "balance-sheet recession."]

The United States is in the midst of a balance-sheet recession as households and firms (financial or otherwise) attempt to pay down their enormous debt. Before we look at the debt, let's look at how GDP is calculated.

(1) Gross Domestic Product = PCE + I + G + (Ex - Im)

PCE is classified as private consumption, or in BEA-speak, personal consumption expenditures. It is the spending done by consumers on final goods and services. Virtually all consumer spending is counted excluding home purchases. However this component does include rents paid.

I is the investment portion of GDP. However, as one would typically assume, it does not include purchases of stock and/or bonds since such transactions are essentially just changes of title and do not involve capital goods and/or services. Components of I are business investment in capital goods, and purchases of new housing units by consumers.

G represents the government spending portion of GDP. It represents the government’s purchases of final goods, payment of government employees, and investment in capital goods. Transfer payments such as Social Security and Medicare are not included in the GDP calculation.

(Ex - Im) is essentially our trade balance, with Ex = exports and Im = imports. If we run a trade surplus, then this component contributes to GDP. If we run a deficit, then it subtracts from GDP. Imported goods are subtracted here because they have already been counted once in PCE, I, or G since the goods/services came into the country and were purchased in some manner be it as final goods or capital goods.

[My note: I have slightly edited the original text for clarity.]

GDP is the principal measurement of growth in the economy. If GDP is negative, the economy is said to be shrinking. If it is positive, the economy is said to be growing. Depending on the quarter measured, private consumption PCE makes up 66 to 71% of GDP in the United States. The balance of trade term, (Ex - Im), has been negative for many years because we import more than we export.

The San Francisco Fed published a very important paper in May called U.S. Household Deleveraging and Future Consumption Growth. Figure 3 is going to look very complicated at first glance. I have marked up the Fed's original graph (their Figure 1). This is the one graph you need to understand to get a feel for where the U.S. economy is headed over the next decade, so please take the time to absorb its many lessons.

Figure 3 — The Fed's data key is shown in the upper left. Note that all the lines start out together. Now, look at real household debt (thick black line) versus real household disposable income (thin black line). You can immediately see that the two lines diverge (decouple) in the early 1980s. This is Event I. Now look at housing wealth (dashed black line) versus disposable income. The two trends diverge around 1997. This is Event II. Let's turn to the bubbles. Look at stock wealth (dotted black line). Stock prices lagged real income until the late 1990s, but were rising in support of greater debt. Stock prices then got very bubbly—this was the web/tech (dogfood.com) equities bubble. Bubble tops are marked by light gray arrows & text. The Tech bubble tops out in 2000 and the housing bubble (Event II) tops out in 2006. The entire debt bubble tops out 2007-2008. The vertical gray lines (key lower right) mark the Event I period of debt-based consumption growth, i.e. PCE. Finally, the real income trend line is extended to 2020. Housing wealth versus income reverts to the pre-Event II trend (dashed red line) and most importantly, debt versus income (thick red line) reverts to the pre-Event I trend.

Figure 3 teaches us that what goes up must come down. PCE fell 1.2% in 2009:Q2, but this is just part of a longer future decline. Condensing all the information, we get—

• Phenomenal GDP growth, especially from 1992-2007, depended on ever-greater debt-fueled personal consumption PCE.
• Ever greater household debt depended first on rising stock market wealth, which ended with the tech bubble & crash. However, even as stock wealth declined sharply for a while thereafter, steeply rising house prices stepped in to fill the "wealth gap." This trend ended with the collapse of the housing bubble in 2006.
• The U.S. economy, which was driven by greater debt after the early 1980s and two massive bubbles starting in the late 1990s, must (or should) now revert to the long-term trend which ties debt & consumption to real disposable income & wealth. This will be done by paying down debt over the next decade as shown by the thick red line in Figure 3.

Does it seem complicated? It is not. The simple message of Figure 3 and our conclusions is summarized in Figure 4.

Figure 4 — Saturday Night Live summarizes our economic situation. Watch the video. We can not or should not buy stuff we can not afford for the next 10 years. This could be amended to read "Don't buy stuff you can not afford and do not need."

Now you can understand what Martin Wolf meant when he talked about "balance-sheet deflation." Households and businesses have to pay down their debts for a long time to come. Assets are sold off to pay off debt. If many people are selling and few are buying, asset prices fall, which makes it harder to get out of debt.

The Great Recession is nothing like previous recessions. There can be no "V-shaped" recovery despite CNBC propaganda, which is based on the recent bear market rally—a new bubble struggling to be born—in the S&P 500 and commodities. From Martin Wolf—

First, comparisons between today and the deep recessions of the early 1980s are utterly misguided. In 1981, US private debt was 123 per cent of gross domestic product; by the third quarter of 2008, it was 290 per cent. In 1981, household debt was 48 per cent of GDP; in 2007, it was 100 per cent...

When interest rates fell in the early 1980s, borrowing jumped. The chances of igniting a [new] surge in borrowing now are close to zero. A recession caused by the central bank’s determination to squeeze out inflation [as in 1981] is quite different from one caused by excessive debt and collapsing net worth [like now]. In the former case, the central bank causes the recession. In the latter, it is trying hard to prevent it.

[My note: Here's another view of the data—it's no longer the Land of the Free.]

Thus the San Francisco Fed dryly concludes—

A simple model of household debt dynamics can be used to project the path of the saving rate that is needed to push the debt-to-income ratio down to 100% over the next 10 years--a Japan-style de-leveraging^{see note 2}.

Assuming an effective nominal interest rate on existing household debt of 7%, a future nominal growth rate of disposable income of 5%, and that 80% of future saving is used for debt repayment, the household saving rate would need to rise from around 4% currently to 10% by the end of 2018. A rise in the saving rate of this magnitude would subtract about three-fourths of a percentage point from annual consumption growth each year, relative to a baseline scenario in which the saving rate did not change...

Until recently, U.S. households were accumulating debt at a rapid pace, allowing consumption to grow faster than income [Event I, Figure 3]. An environment of easy credit facilitated this process, fueled further by rising prices of stocks and housing, which provided collateral for even more borrowing. The value of that collateral has since dropped dramatically, leaving many households in a precarious financial position, particularly in light of economic uncertainty that threatens their jobs.

Going forward, it seems probable that many U.S. households will reduce their debt [thick red line, Figure 3]. If accomplished through increased saving, the deleveraging process could result in a substantial and prolonged slowdown in consumer spending relative to pre-recession growth rates.

Really, this is almost all you need to know about the economic prognosis for the United States over the next decade. More precisely, it is 66-71% (= the private consumption part of GDP) of what you need to know. (Sans peak oil, which will make things worse, of course, but that's not my subject today.) That's the meat & potatoes. Let's talk about the gravy, i.e. the other 29-34% of the American economy as measured by GDP.

Piled Higher and Deeper

Please recall the formula (1) for calculating GDP. If private consumption PCE is down now and will be for some to come, and private investment I can't find a bottom, as the BEA data indicates, then growth is possible only if government spending G increases or exports gain relative to imports (Ex - Im). Thus Martin Wolf wrote back in February that—

... when the private sector tries to repay debt over many years, a country has three options: let the government do the borrowing; expand net exports; or let the economy collapse in a downward spiral of mass bankruptcy.

Assuming that a downward spiral of mass bankruptcy is not the preferred option, let's take a look at the trade balance (Figure 5) and government spending.

Figure 5— U.S. imports & exports from 1994 to the present from the ever-helpful Calculated Risk. The gap between imports and exports has narrowed, which adds to GDP. However, both are declining, albeit at a slower rate lately. There's not much help here for some years to come because our major trading partners (Europe, Japan) are even worse off than we are.

If the trade balance is not likely to boost output much in the next few years, we must look to government spending G for salvation. Many commentators, including Jim Jubak, noted that the second quarter's relatively small contraction was boosted by greater government spending. Our greater reliance on G to fuel growth is the reason why you hear so much talk about the size and timing of the Obama administration's economic stimulus package enacted last February. That is also the reason why you hear vociferous arguments over whether we need to further stimulate the economy.

It should go without saying that it will not be possible over the long run to replace past consumption fueled by inordinately large household debt with new consumption fueled by more public debt. The publicly held federal debt of the United States today is $7,330,489,761,535. Additional intra-governmental holdings debt is $4,318,058,383,034, which gives a grand total of $11,648,548,144,569. (I like to write the numbers out.) A trillion here, a trillion there, and pretty soon you're talking about real money. All current and future stimulus money must be borrowed, of course.

The interest expense to the government of all this debt is $320,650,178,293 so far in 2009, and amounted to $451,154,049,950 in fiscal year 2008. (These numbers are billions.) The creation of new debt to stimulate the economy is very inefficient. Not only must the government pay interest on the new debt, but, as Newsweek points out, it takes roughly $92,000 in government spending to create (or save) one new job!

So far, only a fraction of the stimulus funding has entered the economy via tax cuts ($43 billion), and another chunk via aid to state and local governments ($64 billion). Much of that, however, was used to avert cuts rather than to create jobs. New York City, for example, was able to avoid laying off 14,000 teachers. And because the contracting process is more complicated than it was in the 1930s, the investment component will take more time. So far, only about $120 billion in new spending has been promised to specific programs. Using a rough guide that $92,000 of government spending creates a job, the White House assumes the stimulus will preserve or create 1.5 million jobs by the fourth quarter of 2009 and another 3.5 million by the fourth quarter of next year. But the White House says less than 10 percent of the employment impact from the stimulus will take place during 2009.

[My note: I don't know if this $92,000 number counts the interest on this new debt or not. I doubt it.]

For a mere $92,000 one household is saved from ruin, at least for now. Presumably the new job recipient will pay taxes back into the system, and no longer requires unemployment insurance, so the government gets part of their investment back. But what about tax revenues generally? How are they doing? If you're going to run big deficits, you need big revenues too, either now or in the future.

Figure 6 — The percent change in tax receipts in descending order of decline for all 50 states and the United States as a whole. It's not looking good! Arizona is #1. See Arizona May Sell State Capitol Building To Balance Budget. State expenditures make up about 12% of GDP. One can guess how federal tax receipts are faring by looking at the states. The graph is from iTulip as cited in Figure 2.

We can add a new rule for governments (at all levels) to supplement the Saturday Night Live rule for households.

• Don't Fund Stuff With Future Tax Revenues You Will Not Collect
  

The threat to those still working is that desperate governments will be under pressure to raise taxes in future years despite a dead-in-the-water economy. The states, which received some stimulus help, are directly responsible for unemployment compensation, so the situation is dire. When things fall apart, they really do fall apart, don't they?

Most of the federal stimulus money will be spent in 2010, so it will add to GDP during that year. But it is worth repeating that private debt-financed consumption can not be replaced with debt-financed public spending for any length of time, especially in light of the fact that the consumption PCE and investment I components of output will be a drag on the economy for many years to come.

Gimmicks and Magic Tricks

It is hard to avoid the conclusion that the American economy is a flimsy house of cards. And if all you've got is a deck of cards precariously stacked thin end to thin end, you must continually resort to gimmicks and magic tricks to prevent it from falling down. Thus we get programs like cash for clunkers.

The Toyota Corolla has overtaken the Ford Focus as the top new vehicle purchased through the "cash for clunkers" program, the Department of Transportation said Wednesday. That means foreign automakers produce five of the six top-selling vehicles, although several of those, including the Camry, are built in the United States or Canada...

Some Republicans have criticized the program as subsidizing sales for foreign manufacturers. To counter that, the Obama administration had touted that "cash for clunkers" buyers were choosing the Ford Focus more than any other vehicle...

I'm sure we still have a few excellent elected representatives in Congress, but I generally think of them (all together) as a bunch—I believe the word is "scurry"—of blind squirrels. And even blind squirrels find an acorn now and then. The Democrats believe they've found an edible nut in their "cash for clunkers" program, but it's just another gimmick, a magic-trick giveaway funded with borrowed money.

The "cash for clunkers" program provides an incentive for you to improve your vehicle's fuel efficiency, which is a good thing. Michael J. Jackson, chief executive of AutoNation Inc. called the program "an absolute success. There's a very compelling case the government should put more money into it. It's a great stimulus to the economy." But all the program really does is provide a limited-time incentive that temporarily moves future demand for cars forward.

When you don't have a real economy in which investment is based on real income and savings, gimmicks are all you've got left.

Contact the author at dave.aspo@gmail.com

Notes

1. The chart below compares oil prices to changes in the S&P 500. It's basically the same chart.

fjkdakls;

2. Japanese-style deleveraging comparing U.S. household debt/income (black line) and Japan's non-financial corporate loan debt/GDP (dashed line). Debt/income is expected to fall for the next 10 years.

The Sixth Extinction

Hope is the thing with feathers
That perches in the soul,
And sings the tune--without the words,
And never stops at all
    —Emily Dickinson

Hope is a duty from which paleontologists are exempt.... If hope is the thing with feathers, as Emily Dickinson said, then it's good to remember that feathers don't generally fossilize well. In lieu of hope and despair, paleontologists have a highly developed sense of cyclicity. That's why I recently went to Chicago, with a handful of urgently grim questions, and called on a paleontologist named David Jablonski. I wanted answers unvarnished with obligatory hope.
    —David Quammen

Occasionally I am asked what I think the future will look like, not just in the next few years or in 10 years, but several decades from now. Frankly, it's hard not to cringe, because my honest appraisal is not likely to be met with much enthusiasm. Some people harangue me via e-mail, asking why I don't write about over-population and other great disasters. Well, I write for the association for the study of peak oil & natural gas, so I usually confine myself to energy supply & consumption, alternatives to fossil fuels, and economic or scientific issues that bear on these subjects.

I've been accused of being ignorant of, or not caring about, the Big Planetary Issues. Today I depart from my usual stuff, not just to answer a few critics, but more importantly to put our current energy & economic problems in proper perspective.

If the 20th century was a time of expansion and growth for human population and economies, the 21st century will surely usher in a peak and decline in both. Today I talk about my "favorite" disaster, called The Sixth Extinction. Even in the age of politically correct environmentalism, most people could care less about the Earth's plant & animal species unless their decline bears directly and immediately on their own welfare. Accordingly, I will talk about some clear-cut examples where the health of the natural world adversely affects our future survival.

Before I do that, however, I want to touch on what I call, for lack of a better term, friedmanism.

I am referring to Tom Friedman, the influential Op/Ed columnist for the New York Times. I want to make it clear before I proceed that I am not launching a personal, ad hominem attack on Mr. Friedman. I'm sure he's a nice guy, sincere and well-meaning. However, he exemplifies an all-too-common way of thinking about the Big Planetary Issues that virtually guarantees that they will not get fixed.

Tom Friedman was zeroing in on Reality in his March 7th column The Inflection Is Near? but the Awful Truth was too much for him to handle.  

“We created a way of raising standards of living that we can’t possibly pass on to our children,” said Joe Romm, a physicist and climate expert who writes the indispensable blog climateprogress.org. We have been getting rich by depleting all our natural stocks — water, hydrocarbons, forests, rivers, fish and arable land — and not by generating renewable flows...

Over a billion people today suffer from water scarcity; deforestation in the tropics destroys an area the size of Greece every year — more than 25 million acres; more than half of the world’s fisheries are over-fished or fished at their limit...

One of those who has been warning me of this for a long time is Paul Gilding, the Australian environmental business expert. He has a name for this moment — when both Mother Nature and Father Greed have hit the wall at once — “The Great Disruption.”

“We are taking a system operating past its capacity and driving it faster and harder,” he wrote me. “No matter how wonderful the system is, the laws of physics and biology still apply.” We must have growth, but we must grow in a different way. For starters, economies need to transition to the concept of net-zero, whereby buildings, cars, factories and homes are designed not only to generate as much energy as they use but to be infinitely recyclable in as many parts as possible. Let’s grow by creating flows rather than plundering more stocks.

Gilding says he’s actually an optimist. So am I. People are already using this economic slowdown to retool and reorient economies. Germany, Britain, China and the U.S. have all used stimulus bills to make huge new investments in clean power. South Korea’s new national paradigm for development is called: “Low carbon, green growth”...

I eagerly await the day when the Laws of Thermodynamics have been repealed, a happier time to come when "net-zero" aluminum smelting generates as much energy as it consumes and Nissan Pathfinders have become perpetual motion machines. But let's examine why, aside from being uninformed about physics, Friedman is optimistic. The short answer is: he's got to be! Friedman has to be a "blue skies" kind of guy if he wants to be a mover and shaker, and a fixture at the New York Times. The alternative is quite literally unthinkable. What football coach, on the eve of the Super Bowl, would sincerely respond like this to a question about his team's chances in the big game?

That other team's pretty good... they're favored by 3 touchdowns, and for good reason... I don't think we can win this game, my guys are already whipped.... Honestly, we can't compete with them physically, that's the problem. We've got no shot.

This realistic coach would be fired in a heart-beat. A good football coach rallies his team, even if things look grim. But nothing important is riding on the outcome of a football game. 

Tom Friedman's job is to rally the Human Team, to make us all feel good about ourselves and our prospects. Cheerleading is deemed essential to leadership. Ben Bernanke did not think "the national housing boom is a bubble that is about to burst" in 2005. He was sticking to his story in 2007, long after housing prices took a nosedive. Here's another made-up example—all examples must be made up—that illustrates the point.

When asked if California could eliminate the growing $26.3 billion deficit in Sacramento, balance the state's budget, and make state government work again, Governor Arnold Schwarzenegger said "no way, Jose," referring to his earlier remark that there was "no way in hell" California would be able to balance the budget at this point. He added that "paring deficits in the absence of new revenues will probably wipe out most state jobs & services and California's bond rating will be total junk. The last one out the door should turn out the lights."

You'll never hear this in the real world, even if it's true. Governor Schwarzenegger will continue to rally the troops. California will not fold up its tent. The state will do something else instead, like stealing money from—sorry, I meant "borrowing money from"—local municipalities.

Although we humans have been trashing the planet, and continue to trash the planet, Tom Friedman must cling to positive illusions about outcomes. But such unreflective optimism is not supported by reality. Unless a miracle occurs, there is little doubt about the species extinction outcome in the 21st century if we keep doing what we're doing.

But the power of positive illusions is that "people who remain optimistic in the face of insurmountable odds are healthier and finally more successful than those who have a more realistic attitude." Thus friedmanism is almost universal among high-functioning, successful human beings. It thus afflicts almost all of our society's leaders and elites, i.e. those people who are charged with keeping the growth machine running.

Any salesman will attest to the upside of maintaining positive illusions, but there is a downside as well—bankruptcy and destitution.

The antidote to unwarranted optimism—Keanu Reeves takes the Red Pill, not the blue pill, in the movie The Matrix—also reflects the cause of The Sixth Extinction. Walt Kelly, the creator of Pogo, tried to put us on the road to sanity on a poster for the first Earth Day in 1970 (Figure 1).

Figure 1 — The road to sanity. It is only when we acknowledge that we—all of us, not just those guys over there—are the problem we're trying to fix that we can possibly do anything about the problems we create. This is the "consciousness" solution—we need a lot more of it. This is the opposite of friedmanism, in which often self-serving cheerleading is a substitute for thought & awareness. More darkly, the dyed-in-the-wool pessimist believes that with Homo sapiens, just as with any other species, what you see is what you get. In other words, Human Nature properly understood forms an insurmountable barrier to making real changes in our collective behavior. Thus over-population or the destruction of other species are non-preventable outcomes of the human condition, even if some people are aware of the need for change. For example, many marine biologists despair about extinctions in the oceans. These biologists are not optimistic, but they carry on, they still fight the good fight. Watch this video of oceanographer Jeremy Jackson talking how just how dire the situation in the oceans is.

We humans will have to sleep in the broken bed we have made unless—mirabile dictu—we undertake large concerted actions to clean up our act. Genuine progress is possible only if we acknowledge our sins, but doing so conflicts with friedmanism, which offers reassuring but unjustified optimism based upon naive overconfidence in human capabilities and total disregard for human failings.

Let's now turn the cause and some of the consequences of The Sixth Extinction.

The Holocene Extinction Event

The Holocene Extinction Event is the widespread, ongoing mass extinction of species during the present epoch (10,000 years ago—present). It is called the Sixth Extinction because there have been five other mass extinctions in the Phanerozoic Eon which started at the beginning of the Cambrian Period 543 million years ago.

1. The oldest mass extinction occurred at the Ordovician–Silurian boundary (≈439 Mya, [million years ago]). Approximately 25% of the families and nearly 60% of the genera of marine organisms were lost, including deep-shelf benthic faunas (trilobites, graptolites, and conodonts).
2. The next great extinction was in the Late Devonian (≈364 Mya), when 22% of marine families and 57% of marine genera, including nearly all jawless fishes, disappeared. This extinction decimated coral reefs, brachiopods, and calcareous foraminifera.
3. The Permian–Triassic extinction (≈ 251 Mya) was by far the worst of the five mass extinctions; 95% of all species (marine as well as terrestrial) were lost, including 53% of marine families, 84% of marine genera, and 70% of land plants, insects, and vertebrates. This extinction is called "The Great Dying."
4. The End Triassic extinction (≈199–214 Mya) was associated with the opening of the Atlantic Ocean by sea floor spreading related to massive lava floods that caused significant global warming. Marine organisms were most strongly affected (22% of marine families and 53% of marine genera were lost), but terrestrial organisms also experienced much extinction, including sponges, gastropods, bivalves, cephalopods, brachiopods, insects, and vertebrates
5. The most recent mass extinction was at the Cretaceous–Tertiary boundary (≈65 Mya); 16% of families, 47% of genera of marine organisms, and 18% of vertebrate families were lost. Most notable was the disappearance of nonavian dinosaurs, plus substantial to complete losses among such diverse groups as ammonites, rudists, and certain marine reptiles.

99.9% of all species that lived during the Phanerozoic are now extinct. Species go extinct as a matter of course. What marks a mass extinction is the rate of extinction. When the rate at which species go extinct far exceeds the background, or natural, rate of extinction, you have a mass extinction.

The "fossil" background rate has been estimated at 1 species per year. Another estimate gives 0.5–5 species/year.

Amphibian declines and extinctions are critical concerns of biologists around the world. The estimated current rate of amphibian extinction is known, but how it compares to the background amphibian extinction rate from the fossil record has not been well studied... These calculations suggest that the current extinction rate of amphibians could be 211 times the background amphibian extinction rate. If current estimates of amphibian species in imminent danger of extinction are included in these calculations, then the current amphibian extinction rate may range from 25,039–45,474 times the background extinction rate for amphibians. It is difficult to explain this unprecedented and accelerating rate of extinction as a natural phenomenon.

Living amphibians are not the only taxon (Phylum Chordata, Class Amphibia, Subclass Lissamphibia) affected. Reptiles, birds, fishes and invertebrates, and other classes are also dying out. Extinction rates exceed the fossil record background across the board. This is not a "natural" phenomenon if you rightly take human actions as part and parcel of Nature, not apart from it. Michael Novacek explains the sole cause of The Sixth Extinction (Figure 2). Figures 3 and 4 show some extinction data.

Figure 2 — Paleontologist Michael Novacek of the American Museum of Natural History explains The Sixth Extinction to an earnest but ultimately uncomprehending Charlie Rose. "Unfortunately when it comes to the sixth extinction, we don't have any argument about the cause. It's us. It's deforestation, destruction of habitats, overhunting, invasive species. These are kind of like the "Four Horseman" of environmental destruction that are contributing to the loss of species today. But what's important from the perspective of people like myself, who study this long history of organisms, is that this is major, this is a big deal. This is something on the scale of the Cretaceous Extinction, in the ball park. And we're in the midst of it. What an interesting time we live in, in some perverse way, you might say that we're witnessing the major events [mass extinctions] in the history of life in our lifetime." Novacek is the author of Terra: Our 100-Million-Year-Old Ecosystem—And the Threats That Now Put It At Risk.

Figure 3 — Declines since 1970 in marine, freshwater and terrestrial vertebrates. From Global Biodiversity Outlook 2, a publication of the of UNEP's Convention on Biological Diversity. "Based on published data from around the world, the Living Planet Index aggregates trends of some 3,000 wild populations of species. It shows a consistent decline in average species abundance of about 40% between 1970 and 2000; inland water species declined by 50%, while marine and terrestrial species both declined by around 30%"

Figure 4 — A summary of the IUNC's Red List of Threatened Species, taken from the blog Dodos Are Gone Forever (see here). Of the species evaluated, 37.8% are threatened with extinction.

In the interest of demolishing friedmanism wherever we find it,  let's read a now forgotten press release from 1998 describing the results of a poll commissioned by the American Museum of Natural History.

April 20, 1998. The American Museum of Natural History announced today results of a nationwide survey titled Biodiversity in the Next Millennium, developed by the Museum in conjunction with Louis Harris and Associates, Inc. The survey reveals that seven out of ten biologists believe that we are in the midst of a mass extinction of living things, and that this loss of species will pose a major threat to human existence in the next century.

Among the findings revealed by the survey, scientists identified the maintenance of biodiversity - the variety of plant and animal species and their habitats - as critical to human well-being; they rate biodiversity loss as a more serious environmental problem than the depletion of the ozone layer, global warming, or pollution and contamination. The majority (70%) polled think that during the next thirty years as many as one-fifth of all species alive today will become extinct, and one third think that as many as half of all species on the Earth will die out in that time.

[My note: This was 11 years ago. if 20% of all species alive in 1998 were predicted to go extinct in the next 30 years, I would say we're running right on, if not ahead of, schedule.]

In 1998, most biologists thought biodiversity loss was a more serious environmental problem than global warming. Nobody seems to have asked these underfunded biologists for their opinion since then, or asked them how things are going. No wonder. In 2009, all the politically-correct news focuses on the threats to human welfare posed by anthropogenic climate change. In response, Energy Secretary Steven Chu wants to further screw around with Nature to make 4th generation biofuels so we can all drive to Wal-Mart.

Apparently, biologists don't study a subject—all life on Earth and all the interdependent ecosystems upon which that life depends—that people deem important. What is the principal cause of The Sixth Extinction? This is taken from Are we in the midst of the sixth mass extinction? A view from the world of amphibians—

Human activities are associated directly or indirectly with nearly every aspect of the current extinction spasm. The sheer magnitude of the human population has profound implications because of the demands placed on the environment. Population growth, which has increased so dramatically since industrialization, is connected to nearly every aspect of the current extinction event.

Climate change merely adds to the extinction problem we've caused because we're not willing to put the brakes on our exponentially increasing population. Dr. Chu wants to create genetically engineered monocultures, a form of geoengineering to keep growth going. Thus some proposed "solutions" to mitigate global warming will just make an already bad situation worse. We have met the enemy, and he is us.

Let's press on. I briefly discuss some recent developments and findings concerning The Sixth Extinction.

Honeybees and Amphibians

In 2006, honeybees started disappearing. Scientific American tells the story of Don Hackenberg, a beekeeper who moves his hives from place to place to pollinate Florida melons, Pennsylvania apples, and California almonds. Business was brisk, but then an alarming thing happened—

... when [Hackenberg] came back a month later, he was horrified. Many of the remaining colonies had lost large numbers of workers, and only the young workers and the queen remained and seemed healthy. More than half of [his] 3,000 hives were completely devoid of bees. But no dead bees were in sight. "It was like a ghost town," Hackenberg said when he called us seeking an explanation for the mysterious disappearance.

Hackenberg was not the only victim.

[A] survey ... in the spring of 2007 revealed that a fourth of U.S. beekeepers had suffered similar losses and that more than 30 percent of all colonies had died. The next winter the die-off resumed and expanded, hitting 36 percent of U.S. beekeepers. Reports of large losses also surfaced from Australia, Brazil, Canada, China, Europe and other regions. More recent data are not available yet, but some beekeepers say they have seen their colonies collapse this [last] winter, too. [published in April, 2009].

The bee loss has raised alarms because one third of the world's agricultural production depends on the European honeybee, Apis mellifera the kind universally adopted by beekeepers in Western countries. Large, monoculture farms require intense pollination activity for short periods of the year, a role that other pollinators such as wild bees and bats cannot fill. Only A. mellifera can deploy armies of pollinators at almost any time of the year, wherever the weather is mild enough and there are flowers to visit.

The die-off of Apis mellifera is now called colony collapse disorder (CCD). Honeybee losses mounted in the 20th century.

Even before colony collapse, honeybees had suffered from a number of ailments that reduced their populations. The number of managed honeybee colonies in 2006 was about 2.4 million, less than half what it was in 1949. But beekeepers could not recall seeing such dramatic winter losses as occurred in 2007 and 2008. Although CCD probably will not cause honeybees to go extinct, it could push many beekeepers out of business.

Probably A. mellifera will not become extinct, at least in the foreseeable future, but that's actually begging the question, isn't it? If there were a single, remediable cause of the honeybee die-off, the question of possible extinction would lose much of its force. We need to know why honeybees are dying.

[We] ruled out many potential causes for CCD and found many possible contributing factors. But no single culprit has been identified. Bees suffering from CCD tend to be infested with multiple pathogens, including a newly discovered virus, but these infections seem secondary or opportunistic much the way pneumonia kills a patient with AIDS. The picture now emerging is of a complex condition that can be triggered by different combinations of causes. There may be no easy remedy to CCD. It may require taking better care of the environment and making long-term changes to our beekeeping and agricultural practices.

Honeybees are dying of everything, just like AIDS sufferers with weakened immune systems. This points to environmental stress as the primary cause of the ongoing demise A. mellifera. If we continue to degrade the environment, the stresses on bees will increase. This will further weaken the bees, which will result in more die-offs, which will increase the probability of extinction over time. Barring extinction, honeybee population declines could easily be severe enough to preclude industrial scale pollination for the various fruits and nuts we eat.

Amphibian declines are a second smoking gun pointing to general environmental degradation as the primary cause of species die-offs. This is described in A view from the world of amphibians—

Paradoxically, although amphibians have proven themselves to be survivors in the past, there are reasons for thinking that they might be vulnerable to current environmental challenges and, hence, serve as multipurpose sentinels of environmental health. The typical life cycle of a frog involves aquatic development of eggs and larvae and terrestrial activity as adults, thus exposing them to a wide range of environments. Frog larvae are typically herbivores, whereas adults are carnivores, thus exposing them to a wide diversity of food, predators, and parasites. Amphibians have moist skin, and cutaneous respiration is more important than respiration by lungs. The moist, well vascularized skin places them in intimate contact with their environment. One might expect them to be vulnerable to changes in water or air quality resulting from diverse pollutants... [etc.]

Chytridiomycosis, a disease of amphibians caused by a newly discovered pathogenic fungus called Batrachochytrium dendrobatidis (Bd), appears to be the proximate cause of many amphibian extinctions. But the root cause is general human degradation of the environment which makes weakened (reduced) populations of frogs (all toads are frogs), salamanders, and caecilians vulnerable to new pathogens.

A new and significant threat to amphibians is a virulent, emerging infectious disease, chytridiomycosis, which appears to be globally distributed, and its effects may be exacerbated by global warming. This disease, which is caused by a fungal pathogen and implicated in serious declines and extinctions of >200 species of amphibians, poses the greatest threat to biodiversity of any known disease... A general message from amphibians is that we may have little time to stave off a potential mass extinction...

Amphibians may be taken as a case study for terrestrial organisms. They have been severely impacted by habitat modification and destruction, which frequently has been accompanied by use of fertilizers and pesticides. In addition, many other pollutants that have negative effects on amphibians are byproducts of human activities. Humans have been direct or indirect agents for the introduction of exotic organisms [introduced predators]. Furthermore, with the expansion of human populations into new habitats, new infectious diseases have emerged that have real or potential consequences, not only for humans, but also for many other taxa, such as the case of Bd and amphibians.

[My note: The origin of Frog Chytrid as an amphibian pathogen and how it has spread around the world is not precisely known, but the leading theories support human meddling.]

Amphibians are victims of The Sixth Extinction and this die-off is a harbinger of more losses to come in other plants and animals.

Peak Fish

A study of fisheries data in 2006 concluded that if the current trend in marine species population declines continues, all such populations will have collapsed by 2048 (Figure 5).

Figure 5 — The graph is based on results reported in Impacts of Biodiversity Loss on Ocean Ecosystem Services by Boris Worm, et. al. (Science, November 3, 2006). "Globally, the rate of fisheries collapses, defined here as catches dropping below 10% of the recorded maximum, has been accelerating over time, with 29% of currently fished species considered collapsed in 2003. This accelerating trend is best described by a power [function], which predicts the percentage of currently collapsed taxa as a function of years elapsed since 1950... The data further revealed that despite large increases in global fishing effort, cumulative yields across all species and large marine ecosystems had declined by 13% (or 10.6 million metric tons) since passing a maximum in 1994." This last text puts peak fish in 1994.

As I said earlier, people don't seem overly concerned about plants and animals unless their decline has an immediate negative impact on human welfare. It's hard to get people worked up about amphibian extinctions in the tropics. (Go here for the full text). That being the case, try this on for size—

Human-dominated marine ecosystems are experiencing accelerating loss of populations and
species, with largely unknown consequences. We analyzed local experiments, long-term regional
time series, and global fisheries data to test how biodiversity loss affects marine ecosystem services across temporal and spatial scales. Overall, rates of resource collapse increased and recovery potential, stability, and water quality decreased exponentially with declining diversity. Restoration of biodiversity, in contrast, increased productivity fourfold and decreased variability by 21%, on average. We [Worn, et. al.] conclude that marine biodiversity loss is increasingly impairing the ocean's capacity to provide food, maintain water quality, and recover from perturbations. Yet available data suggest that at this point, these trends are still reversible.

It's not clear how many species in the oceans will actually go extinct in the 21st century as opposed to becoming very rare. In either case, you can forget all about eating the wild-caught seared sea scallops at The Aquagrill in SoHo, no matter how much money you have. But I don't want to make light of the fact that vast numbers of people depend on seafood for their survival. Good arguments can be made for giving up seafood altogether if eating it is discretionary. Any fish, crustaceans or mollusks you might eat in 2048 will have to come from aquaculture (Figure 6).

Figure 6 — World fish production and seafood consumption, 1976-2030 from the FAO's The State of World Fisheries and Aquaculture. "By the year 2030, aquaculture will dominate fish supplies and less than half of the fish consumed is likely to originate in capture fisheries." You can see peak fish (from capture fisheries) in the data. Of course, aquaculture has its own problems: "Without proper management, aquaculture can put a great deal of strain on the surrounding natural ecosystems. The high densities of organisms, high artificial feed inputs and the subsequent generation of heavy organic loads in the water stream are the primary sources of most of the environmental problems associated with aquaculture."

The FAO's projections for wild-caught fish production in 2030 are a tad optimistic in view of the results of Boris Worm and his colleagues (Figure 5). We would reasonably expect all the world's fisheries to collapse long before the ocean is devoid of healthy fish populations.

Dr. Worm believes the fisheries collapse is still reversible.

According to Mr Worm, it can. "The data show us its not too late. We can turn this around." The answer he says is to create more marine parks. "But less than one percent of the global ocean is effectively protected right now," Mr Worm said. "We won't see complete recovery in one year, but in many cases species come back more quickly than people anticipated — in three to five to ten years. And where this has been done we see immediate economic benefits."

The researchers have concluded that restoring marine biodiversity through an ecosystem based management approach is the only way to reverse the trend. That will require "integrated fisheries management", pollution control, maintenance of essential habitats and the creation of marine reserves.

They say doing nothing would impose a serious threat to global food security.

Depleted fisheries are another tragedy of the commons. Will a miraculous change in human predation of marine species preserve wildlife in the oceans? I'll let you be the judge.

Planet of Weeds

If you read only one article or book on The Sixth Extinction, I recommend David Quammen's Planet Of Weeds (originally published in Harpers, October, 1998). You've probably already thought about the obvious question: Will Homo sapiens become a victim of its own misdeeds?

Now we come to the question of human survival, a matter of some interest to many. We come to a certain fretful leap of logic that otherwise thoughtful observers seem willing, even eager to make: that the ultimate consequence will be the extinction of us. By seizing such a huge share of Earth's landscape, by imposing so wantonly on its providence and presuming so recklessly on its forgivingness, by killing off so many species, they say, we will doom our own species to extinction. This is a commonplace among the environmentally exercised. My quibbles with the idea are that it seems ecologically improbable and too optimistic. But it bears examining, because it's frequently offered as the ultimate argument against proceeding as we are.

[Paleontologist David] Jablonski also has his doubts. Do you see Homo sapiens as a likely survivor, I ask him or as a casualty? "Oh, we've got to be one of the most bomb-proof species on the planet," he says. "We're geographically widespread, we have a pretty remarkable reproductive rate, we're incredibly good at co-opting and monopolizing resources. I think it would take really serious, concerted effort to wipe out the human species." The point he's making is one that has probably already dawned on you: Homo sapiens itself is the consummate weed [or weedy species, as Quammen explains in the article.]

I agree with Jablonski. It seems that nothing short of a catastrophic bolide impact, oceans filled with hydrogen sulfide oceans or a near-by gamma-ray burst will kill us off, though we can expect human populations to be much reduced in the future. I doubt global warming will do it. And what will happen “after” the extinction?

What will happen after this mass extinction, assuming it proceeds to a worst-case scenario? If we destroy half or two thirds of all living species, how long will it take for evolution to fill the planet back up? "I don't know the answer to that," he said. "I'd rather not bottom out and see what happens next." In the journal paper he had hazarded that, based on fossil evidence in rock laid down atop the K-T event and others, the time required for full recovery might be 5 or 10 million years. From a paleontological perspective, that's fast. "Biotic recoveries after mass extinctions are geologically rapid but immensely prolonged on human time scales," he wrote. There was also the proviso, cited from another expert, that recovery might not begin until after the extinction-causing circumstances have disappeared. But in this case, of course, the circumstances won't likely disappear until we do...

... Even rats and cockroaches are capable -- given the requisite conditions; namely, habitat diversity and time -- of speciation. And speciation brings new diversity. So we might reasonably imagine an Earth upon which, [5 to] 10 million years after the extinction (or, alternatively, the drastic transformation) of Homo sapiens, wondrous forests are again filled with wondrous beasts. That's the good news.

I can't top David Quammen. As he says, in some millions of years the planet will fill up with life again—that's the good news.

Contact the author at dave.aspo@gmail.com

Is Business-As-Usual Likely In A Peak Oil Scenario?

But the guessers, in fact, know no more than the common people and sometimes less, even when, or especially when, they gave us the illusion that we were in control of our destinies.

Persuasive guessing has been at the core of leadership for so long, for all of human experience so far, that it is wholly unsurprising that most of the leaders of this planet, in spite of the information that is suddenly ours, want the guessing to go on. It is now their turn to guess and guess and be listened to.

Some of the loudest, most proudly ignorant guessing in the world is going on in Washington today. Our leaders are sick of the all the solid information that has been dumped on humanity by research and scholarship and investigative reporting. They think the whole country is sick of it, and they could be right. It isn't the gold standard that they want to put us back on. They want something even more basic. They want to put us back on the snake oil standard.
   —Kurt Vonnegut, A Man Without A Country

In The Radical Hypothesis, I explored the plausibility of whether economic growth can continue in the 21st century under conditions where CO₂ emissions—a proxy for fossil fuel consumption—are falling (Figure 1). The world experienced phenomenal economic growth in the 20th century, but history suggests that the concomitant historical rise in emissions was a necessary condition of that growth. The rule is expressed in (1) & (2).

(1) If the global economy grows, then CO₂ emissions grow

It follows that—

(2) if CO₂ emissions are not growing, the global economy is in recession ^{see footnote 1}

See Carbon Dioxide Emissions Declined by 2.8% in 2008; Transportation-Related Emissions Down 5.2% (Green Car Congress, May 20, 2009) and The Radical Hypothesis, Figure 2. Emissions were not growing in 2008, so it follows (logically, empirically) that we must have been in recession (which we were).

Figure 1 — A conceptual depiction of the Radical Hypothesis. Economic growth (dotted line) has always been accompanied by growth in CO₂ emissions (black line). Emissions are a proxy for fossil fuels consumption. Now, at the Turning Point, the consensus view sees economic growth diverging from emissions growth, which contradicts our historical experience as stated in rules (1) & (2) above. Thus the Radical Hypothesis rejects the idea that emissions have been a necessary condition for economic growth. A third alternative, a reduction in the carbon intensity of economic growth, is also shown (dashed line). Carbon intensity is a measure of how much carbon equivalents (CO₂e) are emitted per capita of GDP. In this case, economic and emissions growth are still tightly linked (only the rate of emissions growth has changed).

Emissions are seen as falling in the 21st century for one or both the following reasons:

• Depletion of fossil fuels leading to permanently declining production rates for oil (starting in the medium term) and for natural gas & coal (starting some number of decades hence)
• Voluntary efforts to cut emissions to mitigate climate change by switching from fossil fuels to renewable "clean" energy (wind, solar, biomass-to-liquids conversions, etc.)

If voluntary efforts are not made or fail, regardless of the depletion outcome, the consensus view—typified by Joe Romm of the influential Center For American Progress or the President's science adviser Dr. John Holdren—sees business-as-usual (BAU) as continuing in the 21st century (Figure 2).

Figure 2 — A modified version of the business-as-usual (BAU) scenario depicted in The Radical Hypothesis. Economies (dotted line) and CO₂ emissions (black line) grow unchecked in the 21st century. In a BAU scenario with peak oil, emissions are still presumed to increase steadily, not decrease (dashed line), as technology readily fills the gap (e.g. coal-to-liquids replaces lost oil production). See below for a more thorough discussion.

Today I explore assumptions about BAU scenarios under the assumption that we have now reached the peak of oil production rates or will shortly. This is the "peak oil" hypothesis. If oil production peaks in 2020 or later, then current concerns about peak oil are unfounded. Time will tell, but the peak oil hypothesis is now gaining wide acceptance. Today I assume the peak oil hypothesis is correct for the sake of analysis.

BAU In A Peak Oil World

Those concerned about anthropogenic climate change routinely refer to future CO₂ levels in the atmosphere of 550 ppm (parts-per-million) or greater (Figure 3). Business-as-usual, in which economic and emissions growth are not constrained, is assumed in all these cases.

Figure 3 — An assumption of very high levels of CO₂ in the atmosphere (up to 750 ppm) taken from the congressional testimony of climate scientist Ken Caldeira (February, 25, 2009). Caldeira was testifying about the effects of ocean warming on coral reefs: "Coral reefs are unlikely to survive in regions colored yellow, orange, or red. In the absence of strong policy, atmospheric CO2 will reach 550 ppm in several decades. Our analysis show that before the industrial revolution when atmospheric CO2 level was about 280 ppm, 98.4% of coral reefs were found near open ocean waters with an aragonite saturation state above 3.5. With a CO2 stabilization of 450 ppm only 8% of coral reefs would be surrounded by open ocean waters with aragonite saturation state above 3.5, and with a stabilization level of 550 ppm no existing coral reefs would be near such waters."

There is every reason to believe that a doubling (or more) of CO₂ in the atmosphere over pre-industrial levels (~275-280 ppm) would be catastrophic for the world's coral reefs. The relevant question here is whether anthropogenic emissions could ever get this high in world in which oil production has peaked, and in the absence of significant carbon-cycle feedbacks (e.g. large methane releases from hydrates or Arctic permafrost—atmospheric chemistry converts most methane to CO₂). This feedbacks caveat can't be taken for granted, of course.

The peak of world oil production, defined simply here as a permanent, growing gap between an insufficient supply and potential demand, will presumably cause large crude oil price spikes in the future. Such spikes are called "oil shocks" by economists. Historical experience strongly suggests that oil shocks precede and (in part) cause recessions (Figure 4).

Figure 4 — Nominal and inflation-adjusted crude oil prices 1970-2009, taken from Steven Kopits' Oil: What Price Can America Afford? Oil shocks precede and are a major cause of recessions. The latest example is the price shock of 2007-2008 in which both the oil price rose sharply in 2007 just before the Great Recession began in December, 2007. The literature on the connection between oil shocks and recessions is large, and the results connecting such shocks with recessions are robust. Economist James Hamilton of the University of California (San Diego), who recently testified before Congress, is an expert on the link between oil prices and recessions. Read Hamilton's Causes and Consequences of the Oil Shock of 2007-08 (2009) and Oil and the Macroeconomy (2005).

Thus, in a peak oil future—

1. business-as-usual (BAU) assumes economies & emissions grow without limit, BUT
2. an insufficient oil supply creates oil price spikes
3. such oil shocks reduce fossil fuel demand across the board, thus reducing CO₂ emissions
4. the permanent peak & decline of oil production itself, aside from the direct effects of oil price shocks, will reduce emissions over time (the dashed line in Figure 2) if fossil-fuel based substitutes are not immediately available
5. if CO₂ emissions are not growing, the economy is in recession

Rising emissions, a proxy for fossil fuel consumption, appear to be a necessary condition (#5) supporting past or future economic growth. Thus, given the well-supported assumptions #2 through #4 above, we are not entitled to conclude that—

• Business-as-usual (BAU) will continue if the peak oil hypothesis is correct

The consensus takes the view that business-as-usual can continue, even in a peak oil scenario. To support this assumption, the consensus invokes assumption (3) as stated in The Radical Hypothesis.

(3) Technological progress marches on and improvements are always sufficient to meet our needs (including our need for energy)

To support the assumption of business-as-usual, even after peak oil has occurred, technologies such as coal-to-liquids conversions are assumed to provide seamless, just-in-time substitutes for oil production shortfalls. Thus "technology fills the gap" as shown in Figure 2.

A few examples will make the consensus position clearer. Here is a report on Ken Caldeira's remarks at last year's American Geophysical Union meeting (Scientific American, December 18, 2008).

Caldeira reported on recent forecasts of how the climate would respond if the world completely stopped using oil today. In the one case, it is replaced with coal-based liquid fuels and in the other with renewable resources, such as wind, solar, or nuclear power.

The results are clear, Caldeira said. If liquefied coal powered the world's vehicles ... the Earth would warm 2º Celsius (3.6º Fahrenheit) by 2042, three years sooner than if society continued to use oil. If, however, society replaces oil with renewable energy, that 2º C rise would occur in 2056, 11 years later than with oil.

The reality, Caldeira said, is that we will never run out of oil. As it becomes scarcer and more expensive to extract, industry will switch to other fuels for economic reasons. The danger is that coal will likely appear to be the cheapest alternative.

So rather than view peak oil as a climate savior, he said, those scientists, engineers and economists should see the end of oil as a "new challenge" to efforts to cut carbon dioxide emissions.

[My note: As reported in Nature, "Caldeira and colleagues used a climate and carbon cycle model to look at how running out of oil could affect future climate scenarios." Here's the abstract: "A coupled climate and carbon (CO₂) cycle model is used to investigate the global climate and carbon cycle changes out to the year 2300 that would occur if CO2 emissions from all the currently estimated fossil fuel resources were released to the atmosphere. By the year 2300, the global climate warms by about 8 [°C] and atmospheric CO2 reaches 1423 ppmv (parts-per-million-by volume)."]

At issue here are Caldeira's working assumption that 1) it is possible to quickly (instantaneously) replace oil with liquefied coal and 2) his implicit assumption that economic growth will continue unabated even if we are "running out of oil." Another issue, which I will not pursue here, is how little bang for the buck we get by replacing oil entirely with renewable sources such as biofuels or wind-driven electric transport instead of liquefied coal—locking in a 2°C temperature rise above pre-industrial levels is delayed only by 11 years! Even the oil to liquefied coal conversion makes only a tiny difference.

Using a coupled climate and carbon cycle model is appropriate if you want to want to estimate future anthropogenic emissions from presumably vast fossil fuel resources, but such a model does not capture what might actually happen "on the ground" in the real world. A prompt transition from oil to coal-based liquids is clearly impossible, as I'm sure—I'm hopeful— Caldeira would admit (Figure 5).

Figure 5 — Making the transition from oil to liquefied coal, from Volume II of the report of the Task Force on Strategic Fossil Fuels (2007). In the "high oil price" case, which is very likely in a peak oil scenario, it will takes more than 20 years for the U.S. to achieve 2 million barrels-per-day of from coal-to-liquids conversions if the required investments are made over time. I also note that very efficient coal-to-liquids conversion is not yet an off-the-shelf technology, although the Fischer-Tropsch process itself is many decades old. The Rand study Producing Liquid Fuels From Coal states that "liquid yield from direct liquefaction is very process dependent, but, in general, yields are projected to be considerably higher than those of Fischer Tropsch CTL plants designed with current commercial technology. Based on conceptual designs of two-stage and catalytic multistage direct-liquefaction CTL plants, prospective yields are reported to be between 2.7 and 3.0 barrels per ton of as-received coal" (page 27).

Caldeira's model, like every other model used to predict climate outcomes, does not take real-world economic conditions into consideration. Such modeling presupposes—the assumption is unstated and unexamined—continuing economic growth, even in a business-as-usual scenario where peak oil occurs. 

The recent work of Pushker Kharecha and James Hansen, Implications of "peak oil" for atmospheric C02 and climate, provides a second, more complete, case where economic growth is likely overstated (Figure 6).

Figure 6 — In the BAU scenario (top, left) oil peaks before 2025 (blue line) but coal emissions (orange line) still grow without limit out to 2100. The Less Oil Reserves ("peak oil") scenario (bottom, left) assumes the coal phase-out case (top, middle), so coal emissions are limited by policy, not economics and technology.

Kharecha and Hansen met a lot of hostility in the climate community for even raising the question of what peak oil's effects on emissions would be. They should be commended for sticking to their guns and publishing anyway. However, their standard BAU assumption does not jibe with the probable economic consequences of peak oil. I have taken the liberty of modifying their BAU graph in Figure 7.

Figure 7 — A modified business-as-usual scenario. Kharecha and Hansen's future coal emission curve (solid orange line) has been replaced with a more realistic scenario (dashed orange line) which takes future recessions and the timing of technological fixes into account. Coal emissions still grow, but not nearly at the pace envisioned in most BAU climate scenarios. One could make a similar change to projected coal emissions in the Less Oil Reserves scenario as well.

Current calculations of business-as-usual in a peak oil scenario are, practically speaking, almost useless. Allow me to repeat my summary, suitably modified, from The Radical Hypothesis.

1. Mitigating climate change or overcoming limits on available fossil energy will require or force massive decreases in CO₂ emissions over the 21st century.
2. Economists assume future generations will be richer than the current one The belief that economic growth is a necessity and will continue in the 21st century is not debatable.
3. The idea that 2.9% annual economic growth in the 20th century depended on a steady rise in CO₂ emissions is rejected.
4. The assumption that economic growth in the 21st century growth will take place without an accompanying rise in emissions is justified by the stipulation that technological progress solves all problems as stated in (3) above.

Even in the peak oil case, our ability to carry on business-as-usual is not questioned. The assumption of continued economic growth (#2, #3) remains unassailable. The assumption of just-in-time technological fixes (#4), which is contradicted by Figure 5, is also not debatable. In all BAU scenarios, it is presumed that energy technology (coal-to-liquids, biofuels, electric cars, any or all of these) will seamlessly step up to replace oil as the need arises. This assumption is not yet proven, and it appears to be tragically unrealistic.

History suggests that a continuation of business-as-usual in a peak oil scenario is implausible. But granting that I could be wrong, I urge climate scientists and policy-makers to at least examine the assumption of future economic growth made possible by our presumably limitless technological prowess.

2010-2020 — The Decisive Decade

If the peak oil hypothesis is correct, world oil production will be (at best) flat or in decline by 2020. During this same period, the United States may (or may not) implement a cap & trade system to rein in CO2 emissions. The proposed legislation aims to cut emissions 17% below 2005 levels by 2020. Emissions declined in 2008 following on the oil shock of 2007. The financial meltdown in 2008:Q3 guarantees a similar emissions decline in 2009.

As I described in The Reign of Error, Europe already has a cap & trade system in place. Europe's carbon market, created under the Kyoto Protocol, has not actually resulted in reduced emissions in the Eurozone. This sleight-of-hand is due to allowable offsets whereby a putative reduction outside of Europe (e.g. in Asia, or Africa) is counted as a reduction within Europe. At best, Europe has reduced the carbon intensity of any economic growth that took place since the formation of the carbon market. The proposed cap & trade system in the United States contains the same loophole.

Assuming that peak oil occurs in the next decade, and the currently envisioned cap & trade system, which goes into effect in 2012, is actually implemented, we can expect an overall decline in carbon emissions in the United States during the period 2010-2020. If growing emissions are a necessary condition for economic growth, as I have argued here and in The Radical Hypothesis, it follows that the American economy will shrink, not grow, in the coming decade.

If world oil production peaks, I predict most people will forget about terrifying business-as-usual climate scenarios. Instead, they get down to the hard business of replacing oil by any means possible. If the economy is shrinking, any means necessary will be used to jump start growth.

Thus, the years 2010-2020 will likely be the decisive decade of the 21st century. We should know by 2020 whether economies can grow as emissions decline. The result will define our response to anthropogenic climate change in all the decades to follow. We will know whether the consensus view espoused by Al Gore and many others is, as I have believed all along, a politically expedient "green jobs" fantasy.

Contact the author at dave.aspo@gmail.com

Notes

1. In the propositional calculus, which is a subset of 1st order logic, (1) implies (2) by a rule of inference called modus tollens:

(1) if P, then Q

(2) if NOT(Q), then NOT(P)

Q is said to be a necessary condition for P, and P is a sufficient condition for Q.

This has the same form as (1) & (2) in the text. I could simply have said, more intuitively, that "Recessions cause reduced emissions," which is roughly equivalent to (3)—

(3) If the economy is not growing, then CO₂ emissions are not growing

In all cases relating to the economy and anthropogenic emissions, proposition (3) appears to be true. The problem with proposition (3) is that it is not true in all cases, i.e. it is false. It implies the false statement (4), which again is derived by modus tollens—

(4) if CO₂ emissions are growing, then the economy is growing

Proposition (4) is false because emissions could be rising (e.g. due to carbon-cycle feedbacks, volcanic eruptions) for reasons other than economic growth. This is the same as saying that rising emissions are not a sufficient condition for growing economies. In fact, business-as-usual scenarios say that rising emissions (of all sorts) will have disastrous consequences for economies (contradicting propositions (3) & (4)).

Of course I am arguing that rising emissions in the 20th century have been a necessary condition for economic growth. Sorry to put you through this. I used to be theoretical linguist and logician a long, long time ago in a galaxy far, far away.

A Resurgence In China?

同舟共濟
"same boat, mutual help" (help one another, we're all in the same boat)
   —Chinese saying

If you plan for a year, plant a seed. If for ten years, plant a tree. If for a hundred years, teach the people. When you sow a seed once, you will reap a single harvest. When you teach the people, you will reap a hundred harvests.
   —Kuan-Tzu (Taoist, died 645 BC)

China is a big country, inhabited by many Chinese.
   —Charles De Gaulle

The world's hopes for economic growth now revolve around a resurgence in China. The IMF recently upped their forecast for China, and now expects GDP growth to be 7.2% in 2009. In a similar move, the IEA issued a bullish oil demand forecast, saying that it expects global crude consumption, led by China and other emerging-market states, to grow 1.4 million barrels-per-day (mb/d) to 85.2 mb/d in 2010. Everybody, including those predicting our imminent demise from an inadequate oil supply, is gung-ho on China.

I have my doubts about these stories, and so does Hugh Hendry of Eclectica Asset Management. The Financial Times spoke to Hendry on July 5, 2009 about why he is bearish on China. What Hendry said makes a lot of sense.

... [people think] China is very much [like] Santa Claus. China ... has the prospects of bestowing all of us gifts, and the gift of a great escape [from the global recession]. And I dramatically ... want to take that on.

China, I believe, and the Asian surplus [savings] countries, are the most exposed, the most vulnerable, in this whole episode. And while that sounds fanciful, I can point to the even more dramatic correction in their trade statistics, in their stock market, etc.  And the flaw that they have is that they've swapped a dependency on foreign capital for a dependency on foreign demand. OK? There's no change, as I see it, between 1998 and today. Secondly, I believe that this presence of leveraging by households, and the corporate sector, where we  [in the United States] took leverage [debt] to something like 4 times the GDP of the country... what we were doing is, we were overstating the size of America, by bringing [in] future consumption and spending it today... So, it's almost as if Bernie Madoff were responsible for the accounting of [U.S.] GDP. And if he'd been responsible, he would have overstated it.

Now, I think that China looks like an investor in a Madoff fund. [They] bought into a [scenario] which was fictitious. Now, if you go back to 1989 in Tokyo, at the height of the bubble [in the Japanese stock market] and you looked at the projection of nominal GDP [in Japan] looking forward, it was a continuation of 5 to 6% per annum in perpetuity. The reality, however, according to the post-bubble difficulty, is that nominal GDP expanded as 1% per annum, which created an enormous surplus capacity, which has destroyed the profits of the corporate sector... Now, that's my feel, that China and its contemporaries have built productive capacity, not only to service a $14 trillion economy [in the U.S.], but to service an economy in America which they believed would be $20 trillion in 7 years time... My fear is that it could be closer to $15 trillion... so I see China as a deep out-of-the-money, call option on America. China only has a chance of succeeding if the American economy proves to bigger and bounces back. And I don't see the prospects of that happening.

[My note: GDP is gross domestic product, the value of all final goods & services in a given country. This is my transcript of the video interview with Hendry, but you must actually watch the video (and others) to get a sense of just how smart this man is.]

Hendry's contention that the newfound "wealth" fueling ever greater debt & spending in America was illusory should no longer be controversial. It was indeed a ponzi scheme in which we spent—borrowed from—future income to pile up immediate gains, just as Madoff found new investors to pay steady 12% dividends to older ones. All these schemes have now collapsed. See my essay Bad Signs, New Bubbles (and other articles referenced therein) for some related commentary.

China is now in trouble to the extent to which they were caught up in our foolish behavior. Indeed, China was almost as complicit in seeding the meltdown as Wall Street was. China and the United States have been referred to as the G2, and for good reason.

The dysfunctional symbiosis between the two countries should be a familiar story by now: Americans consume more than they produce, the Chinese produce more than they consume. Americans are spendthrift, the Chinese are parsimonious. The Chinese make the stuff Americans buy. Americans run large trade deficits, while the Chinese have a large trade surplus. The Chinese manipulate the value of the Renminbi (the Yuan) to keep the imbalance going. The Chinese buy our debt but will not abandon the dollar to protect their investment—Chinese purchases of U.S. Treasuries have actually accelerated over the past year, but not at the same rate as we have grown the debt (Figure 1).

Figure 1 — From the New York Times' China Grows More Picky About Debt, May 20, 2009. Note the middle panel showing the rise of China's purchases of Treasuries in 2008-2009.

Let us accept the reasonable premise that the American economy is going nowhere for a long time to come. Thus, the rampant consumption half of the China-America G2 equation is kaput. We need to get a sense of the extent to which the Chinese economy can be decoupled from the American economy. So, the question is how much can the Chinese economy grow independently of dismal economic performance in the United States (and Europe, Japan, etc.)?

To show why Hendry's argument that China is not Santa Clause makes sense, I need to bore you with the size of the Chinese economy, their trade balance with the United States, and the recent dramatic drop in their exports. Truly, economics is a dismal science.

China On The Ropes?

No one seems to know (to a reasonable approximation) just how big the Chinese economy is. Last February, Euromonitor reported, based on a World Bank survey, that the size of China's economy had been overstated by 40% in 2005. The revised number, based on a purchasing power parity (PPP) adjustment of GDP, was $5.3 trillion. Some economists make a much lower assessment.

Take China. At its most basic level, GDP is the total market value of final goods and services a nation produces in a given year. Andy Xie, a Shanghai-based independent economist, puts China’s GDP at $4.1 trillion to $4.3 trillion. Xie isn’t alone. Some put the figure at $4.4 trillion...

Xie’s calculations are as follows. China’s exports were about $1.4 trillion last year, while total labor income was about $2.4 trillion, capital income was about $550 billion and government income was about $600 billion. Then he subtracts about $800 billion to account for the depreciation of roads, properties and other facilities.

[My note: The Chinese economy is approximately 1/3 the size of America's according to Xie's estimate.]

The overall size does matter, because if China is going to lead us to the Promised Land, they must be able to generate enough additional economic activity to fulfill that promise. We see from Xie's breakdown that China's net exports added $1.4 trillion to China's GDP, which is about 33% of the total. We can take that as a relative share regardless of the overall size. How are China's exports doing? Black Swan Capital believes it is China Panic! Time.

Figure 2 — China's exports month-to-month percent change, official statistics since September, 2008. Jack Crooks of Black Swan LLC. says "China is dead in the water without exports. They are in panic mode. That is why they are flooding their economy with massive amounts of capital and suppressing any hint of [dissent] everywhere. That is why they have chased out the major financial news outlets, and forced them to take all cues from the state. But no matter how many bridges they build, excess capacity they expand, stock market propping they do, dollar reserve currency jawboning they employ, or internet sites they shut down, it doesn’t change the fact that exports have crumbled and until Mr. US Consumer starts buying again, it will get worse instead of better."

Crooks may be exaggerating a bit, but not by much. China's export income is going downhill rapidly. The decline is consistent with Hugh Hendry's view that "China ... and the Asian surplus [savings] countries, are the most exposed, the most vulnerable" to the economic meltdown. But why has the IMF raised their GDP forecast for China? Why has oil consumption rebounded (Figure 3) from it's January/February low?

Figure 3 — China's oil imports, a partial update to a chart I used in my Trouble With Oil Down the Road, published on October 22, 2008. At that time I was still predicting phenomenal growth in non-OECD oil consumption up to 2011 and beyond. Now I am not so sure. The most recent data is from Platts.

The Chinese "demand" surge after February was partially due to stockpiling while prices were low, but they must now build additional storage facilities to expand their strategic reserves (Reuters, March 9, 2009).

China plans to build a second-phase strategic reserve that will nearly triple the first batch to 280 million barrels [from 100 million barrels] by 2011, and industry executives have said the current storage capacity has already become a hurdle to bringing in more imports.

China's massive stimulus program (taken as a percentage of GDP) accounts for most of the increase in their oil consumption and estimates of higher (7.2%) economic growth for 2009 (Business Week, April 22, 2009).

Things are looking up for Xugong Group, China's largest heavy machinery maker. Driven by Beijing's five-month-old $586 billion fiscal stimulus, sales of its bulldozers, wheel loaders, and construction cranes reached an all-time high in March, a spokesman says...

Across China, steelmakers, cement producers, and construction companies are seeing sales soar as Beijing's stimulus plan opens the spigot on funding for railways, airports, and power plants. The economic surge isn't just about earth-moving. The Shanghai stock market is up 35% so far this year, one of the fastest-growing bourses in the world. The long slumbering property market is showing signs of a revival, with sales volume growing 29% in seven of China's biggest cities including Beijing, Shanghai, and Chongqing in the first two months, says Jing Ulrich, managing director of China equities at JPMorgan Chase in Hong Kong, though prices have not yet recovered. And in March auto sales grew 27.2%, following a cut in taxes on smaller vehicles that took effect on Jan. 20 and helping first-quarter sales grow a respectable 3.9%.

Apparently, the stimulus is so large that China's GDP is growing over and above huge export losses. But is this strategy sustainable? China is flooding its domestic market with new loans. We all know what happens when you do that.

China’s new lending more than doubled in June from a month earlier, increasing concerns bad loans and asset bubbles will emerge amid a credit boom. New lending was 1.53 trillion yuan ($224 billion), the central bank said on its Web site today, bringing total lending this year to 7.4 trillion yuan. The calculation for new loans is preliminary, the central bank added.

The government is countering an export collapse by flooding the economy with money to fuel domestic demand. Rapid credit growth poses a risk to the nation’s lenders and a concentration of credit in some industries and businesses may damage the stability of the financial system, the banking regulator said yesterday.

“Excess liquidity is fueling speculation and that means asset bubbles and wasteful investment,” said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. “Expect credit to slow dramatically in the second half [of this year].”

Veteran China watchers like Michael Pettis do not believe that China's short-term stimulus strategy can be sustained without causing more problems than it solves. The longer term solution for China requires them to make the transition from savings & exports to a more balanced economy that enables more domestic spending & imports.

Doing the Right Thing

Western observers seem to be unanimous in their view that China must re-balance their economy. Here is Martin Wolf of the Financial Times talking about how the world might crawl out of the Great Recession.

You want expanded demand in the rest of the world. Well, who are [in] the best position to expand demand? Obviously countries with very strong balance of payment positions, with very strong current account surpluses and reserves: countries like Germany, Japan, and China. [If] they don't expand demand relative to supply, then I think we have the danger of chronic excess capacity in the world, chronic deflationary pressure. In other words, the whole world starts looking like Japan in the 1990's: that's sort of my worry...

[My note: Hugh Hendry, voicing Wolf's fears, refers to a state of "chronic excess capacity" in China. Capacity was built-up to service a future exports market which is very unlikely to exist.]

So we do have to expand demand. Now [to] understand completely, we take the case of China, which is simply the most important single country ... they can't change the structure of their economy, the structure of demand, overnight, except through a massive fiscal boost, which is what they're now doing, they're engaged in a huge investment program, and in the short-run that’s the right thing to do. In the long-run, however, it is right for the Chinese to try and absorb more of their production at home and re-balance their economy with more service production which would generate actually many more jobs. They have not done a good job of generating jobs recently, because their development path has been quite capital-intensive, much too much dependent on investment and household disposable income is only 40% of GDP which is why they're not benefiting fully. So what I suggested ... is [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.

Wolf's key point for our purposes is that China "can't change the structure of their economy, the structure of demand, overnight." This indisputable observation lies behind Hugh Hendry's take on China's medium term economic prospects, which he regards as rather dismal outside of the enormous stimulus they are currently applying. But what does "long-run" mean? Surely a significant expansion of Chinese domestic income & demand will take a decade or more.

University of Maryland professor Peter Morici's Recalibrating U.S.-China provides a thorough review of the issues facing the U.S. and China if they are to break out of the dysfunctional—the New York Times suggests "codependent"—economic relationship shown in Figure 4.

Figure 4 — Balance of trade between the U.S. and China from Peter Morici's Recalibrating U.S.-China. On the left the blue bars show China's rising trade surplus with the United States. On the right the blue bars show America's growing trade deficit with China. The last year shown is 2008, and no doubt the trade balance is changing in 2009. See Morici's paper to see the graphs at full scale.

I recommend reading Morici's paper for an in-depth analysis of what needs to happen to put both economies on a sound footing. The bottom line is that the trade imbalances shown in Figure 4 need to be adjusted so as to be in rough equilibrium.

Rome Wasn't Built In A Day

Nouriel Roubini’s RGE Monitor forecasts 7.0% GDP growth in China in 2009 and 7.7-8.0% growth in 2010. While such growth rates seem high to those living in the United States, these anemic numbers worry the Chinese leadership because their economy is not expanding fast enough to provide work for the many millions entering their job market each year. RGE Monitor notes that domestic consumption is holding up due to the stimulus from a low base of 36% of GDP, but “China is not able to take up the global slack stemming from increased savings by the U.S. consumer.” Diminished exports and high unemployment will continue to be a drag on Chinese economy over (at least) the next few years.

I often think of oil demand in the United States and China (taken together) as a zero-sum game. China’s expanding industrial capacity requires ever more oil, while America’s shrinking capacity means that China consumes the oil we would have consumed had we not become a “service” economy. While America’s real estate expansion—now over, I think—has required more and more oil in the transportation sector, we did not see a concomitant increase in our shrinking manufacturing sector. China stepped in to fill the production gap, so their oil consumption grew rapidly. If America’s industrial capacity (to service both domestic consumption and exports) were to expand in future years, oil demand in that sector would also grow.

If the zero-sum view is correct, putting the two economies on more wholesome footing would not significantly change the overall oil demand growth picture over the long term. This is yet another reason that the peak demand view of CERA, Energy Secretary Steven Chu, and others is complete nonsense. The only way China & America (again, taken together) have reached peak demand is if both countries experience, each in its own way, a “lost decade” (now longer) as Japan did in the 1990s. This is actually a possible outcome. However, CERA and Dr. Chu think we’ve reached peak demand but will still enjoy vigorous economic growth. That’s the nonsense part of the story.

I started with Hugh Hendry’s plausible view that China overshot the mark in building up capacity to service export markets (in the United States, Japan, and Europe) which have now collapsed. Thus, China now needs to turn their economic focus inward, not outward. It is not clear that China has fully absorbed this lesson. Their complaints about the unstable dollar being the world’s reserve currency are valid, but miss the main point.

China was enjoying double digit GDP growth during the years when their oil demand was surging. With their economic growth slowing, I expect China’s future oil demand growth to be below trend (Figure 3). In the longer term, Chinese oil demand will substantially depend on re-balancing their economy vis-à-vis the United States. Until such a time as China develops its domestic market and implements monetary reforms (e.g. letting the Yuan float), their economy and oil demand will not return to pre-crash growth levels. China’s economy will not see sustained double digit growth again unless substantial re-balancing takes place.

Restructuring the Chinese economy will take many, many years—Rome wasn’t built in a day.

Thus I take issue with the IEA’s (currently) bullish view of oil demand growth in China in 2010. I also do not see how a depressed world economy will drive a surge in oil demand in 2010, or in 2011 or, depending on how things go, in 2012-2013. However, oil prices may rise significantly because prices have an unfortunate tendency to reflect excess liquidity in the market rather than supply & demand fundamentals. At some point in the coming decade, we will revisit the oil shock of 2007-2008. (See the postscript).

The future is always impossible to predict, but my general view is that the future looks worse than the present, not better, unless the world’s major players make a conscious effort to change course. The need for change is reflected in the problems facing China (and the United States) I have described. Thus the G20 leadership, who will meet in Pittsburgh in September—only a few miles from where I’m sitting—need to define & implement policies to change the way the world works instead of posing for group photos and eating beef au jus.

I’m not going to hold my breath waiting for the G20 to depart from business-as-usual.

Contact the author at dave.aspo@gmail.com

Postscript

Lest we forget this strong possibility, I casually throw Figure 5 on the table for your thoughtful inspection...

Figure 5 — Ka-Poom! The economies of China and the United States are coming more into balance some years from now only to be blown up by Peak Oil

The Radical Hypothesis

Plus ca change, plus c'est le meme chose
   — an old saying

And what rough beast, its hour come round at last,
Slouches towards Bethlehem to be born?
   — from The Second Coming, a poem by W. B. Yeats

It is hardly an exaggeration to say that humanity has reached a fork in the road, and future generations await our decision. Our energy & economic prospects are at stake, and these two necessities are inextricably linked. At such turning points, it is natural for apprehension to cloud our judgment. We want to hang on to what we have, or improve upon it, but our uncertainty is greater than our ability to discern the long-term future. The only things that seem clear are that the future will not resemble the past, and must not resemble it.

Today I make some elementary but crucial observations about the relationship between fossil fuel energy and economies. I go on to question normal assumptions about future economic growth.

A revolutionary idea about energy and economies which is meant to banish our uncertainty and apprehension has taken hold among our decision-makers and elites. I call it the Radical Hypothesis (Figure 1).

Figure 1 — A conceptual depiction of the Radical Hypothesis. Economic growth (dotted line) has always been accompanied by growth in CO₂ emissions (black line). Emissions are a proxy for fossil fuels consumption. Now, at the Turning Point, economic growth diverges from emissions growth. A third alternative, a reduction in the carbon intensity of economic growth, is also shown (dashed line). Carbon intensity is "a measure of how much carbon equivalents (CO₂e) are emitted per capita of GDP."

The decoupling of economic and emissions growth after the Turning Point is not usually seen as a radical departure from the norm because it is (now) the consensus view. I have intentionally turned this generally accepted view on its head to put it in clear perspective.

Given the historical trend shown in Figure 2, we might plausibly expect an outcome like that shown Figure 3. I call this the Conservative Hypothesis.

Figure 2 — Taken from How Can We Reconcile Growth, Emissions and Resources? by Simon Roberts. The slides from his presentation can be found here. Emissions shrink during recessions. No doubt a similar decrease is happening now during the Great Recession (2007-?).

Figure 3 — A conceptual depiction of the Conservative Hypothesis. At the Turning Point, shrinking emissions (black line) are accompanied by shrinking economies (dotted line). Economic abatement does not necessarily follow emission reductions due to technological progress (see below). Thus, the economic growth curve might be flatter or steeper, but the global economy (GDP per capita) must diminish in the conservative view as available fossil fuel energy declines.

At issue is the true nature of modern civilization's relationship to fossil energy. What we know historically is expressed in proposition (1).

(1) If the global economy grows, then CO₂ emissions grow

It follows that—

(2) if CO₂ emissions are not growing, the global economy is in recession (like now).

It is not the case that—

if CO₂ emissions grow, then the global economy grows

because emissions could rise for all sorts of reasons unrelated to economic growth

The consensus, politically-correct opinion, represented (for example) by Al Gore or Obama's science adviser John Holdren, says that a past tight correlation between economic and emissions growth does not necessarily imply that modern economies have depended on burning fossil energy to fuel growth. The Radical Hypothesis says you can have your cake (grow the economy) and eat it too (reduce emissions).

Logically speaking, the radical position contradicts proposition (1). It thus goes against our historical experience. The Conservative Hypothesis takes our previous experience (Figure 2) at face value—reducing emissions will reduce economic growth. You can not have your cake and it eat too. This is very much a minority view.

The Radical Hypothesis rests upon the complex assumption (3).

(3) Technological progress marches on and improvements are always sufficient to meet our needs (including our need for energy)

At the Turning Point, and "forever" after, technological improvements permit the decoupling of economic growth from fossil fuels consumption. For example, wind or solar replace coal, biofuels replace oil, etc. Net energy calculations (EROEI) don't matter because they are based on present science & technology. Technological improvements will enhance energy extraction efficiency in all areas (e.g. in biomass to liquids conversions, or even in exploitation of oil shales, should it come to that).

Some taking the conservative view reject assumption (3) outright—we have run out of technological solutions to our energy predicament. Others grant that some technological progress will take place, but reject the notion that such progress will be sufficient to break our dependency on fossil fuels to achieve economic growth (proposition 1). The latter expresses my own view.

Our expectation of reduced CO₂ emissions over time is due to two factors:

• resource constraints (e.g. the peak of oil production rates, or peak natural gas and coal some decades hence)
• pro-active measures taken to reduce emissions to mitigate climate change in 21st century (e.g. policies that encourage switching to renewable "clean" energy sources, a moratorium on new coal-fired plants and a phase-out of old ones, and so forth)

Those adapting the Radical Hypothesis either deny that limits on exploitable fossil energy exist, or adopt the fall back position that fossil fuel resources don't matter due to the inevitable dominance of "clean" energy made possible by technological progress. If resource limits do not exist and or pro-active measures are not taken—or don't work because technological progress comes up short—we get a business-as-usual (BAU) scenario as shown in Figure 4. In this case, future economic growth would be taken for granted because nothing has changed.

Figure 4 — A business-as-usual (BAU) scenario. In this case, the best science available assures us that humanity faces a climate catastrophe in this and coming centuries. The BAU scenario is impossible if 1) prompt (between now and 2040) resource limits exist or 2) technological improvements do indeed come to the rescue. Assuming CO₂ emissions rise at a rate of 2 ppmv/yr, we will reach 450 ppmv (parts per million by volume) in the atmosphere in 2041 (from ~386 ppmv now). Alternatively, the world might follow a reduced carbon intensity path (as shown in Figure 1) whereby carbon emissions grow at a slower rate. The science says that such a reduction will help, but not enough to avoid dangerous anthropogenic interference with the climate (e.g. we will get catastrophic sea level rise).

I've only scratched the surface of interlinked economic & energy problems in this brief introduction. Let's explore another facet of the Radical Hypothesis.

Discounting the Future

Human beings discount the future, whereby "society places a lower value on a future gain or loss than on the same gain or loss occurring now. And so do economists because—

If people’s preferences count and if people prefer now to the future, those preferences must be integrated into social policy formulation. Time-discounting is thus universal in economic analysis, but it remains, as it always has, controversial.

In 2005 the British Government asked Sir Nicholas Stern to review the economics of climate change. The end result of Brown's request was the Stern Review on the Economics of Climate Change published in late 2006.

To my knowledge, no comparable review has ever been carried out to work out the economics of resource depletion. The so-called Hirsch report comes closest, but has neither the scope (in terms of economic analysis among other things—Stern's report is more than 576 pages long) nor the weight of a report specifically requested by (then) British Chancellor Gordon Brown. This is not an accident. Rather, it follows from the general acceptance of the Radical Hypothesis (Figure 1), in which our reliance on fossil energy is devalued, and the presumed continuation of technological progress as stated above.

Stern's conclusions were (and still are) controversial because he used a very low discount rate, as explained in Frank Ackerman's The Stern Review vs. its Critics: Which Side is Less Wrong? Ackerman's review, along with Figure 5, provide a simple but good-enough introduction to discounting in general and how it relates to climate change in particular. I thus quote Ackerman at length—

... In Stern's view, inaction on climate change would lead to damages worth at least 5% of world output per year, and, depending on how the damages are calculated, perhaps as much as 20%. Most of these damages could be prevented, according to Stern, by spending 1% of world output annually on mitigation...

The discount rate is central to the economics of climate change. When costs are incurred to reduce emissions today, the benefits of reduced climate change will occur decades or centuries later. How much less valuable are those benefits, because they will happen in the future? At a discount rate near zero, future benefits are almost as valuable as if they occurred today, implying that it is “worth it” to take action now to secure those future benefits. At a high discount rate, future values fade rapidly into insignificance, implying that very little climate mitigation is “justified” by its (heavily discounted) benefits in generations to come.

Economic theory distinguishes between two components of the discount rate: the “rate of pure time preference” that would apply if all generations had equal incomes; and a growth-related rate, assuming that if the future will be richer than the present, then there is less need to make investments on their behalf today.

Stern endorses the philosophical argument that present and future generations are of equal ethical standing, implying that pure time preference should be zero. Your granddaughter is no less important than your daughter simply because she will be born a generation later. Other economists frequently object that people display impatience and short time horizons at a level incompatible with zero pure time preference. Moreover, a rate of precisely zero causes technical problems in some economic theories. Perhaps to avoid this technical issue, Stern introduces a miniscule rate of pure time preference, 0.1% per year, based on an arbitrary estimate of the annual probability that the human race will not survive.

Like other economists, Stern includes a second part of the discount rate, tied to economic growth. His discount rate thus becomes the rate of growth of per capita consumption, plus 0.1%. Since economic growth averages 1.3% in his model, his discount rate averages 1.4%. Other economists assume both a more substantial rate of pure time preference, and a larger growth-related component, yielding discount rates as high as 6%. The difference this makes is enormous: $100 of benefits 100 years from now would be worth $25 today at a discount rate of 1.4%, versus $0.25 at 6%. In short, economic analysis can “see” much more of the future at a discount rate as low as Stern’s, but becomes myopic at a rate as high as 6%.

[My note: so, the discount rate = the rate of pure time preference (0.1%) + the economic growth rate (1.3%) = 1.4%/year.]

[My note: I emphasize the "arbitrary estimate of the annual probability that the human race will not survive."]

Figure 5 — From The Ethics of Climate Change by John Broome, Scientific American, June, 2008. William Nordhaus of Yale is one of Stern's severest critics. As the image text states, his "6 percent discount rate places far less value than Stern's rate of the well-being of future generations."

Before examining Stern's low discount rate, let's make sure we understand the answer to a key question: why discount future goods & services at all?  Ackerman alludes to a "future ... richer than the present." John Broome, cited in Figure 5, fills in some of the details—

The Richer Future
Why discount future goods at all? The goods in question are the material goods and services that people consume—bicycles, food, banking services and so on. In most of the scenarios predicted for climate change, the world economy will continue to grow. Hence, future people will on average possess more goods than present people do. The more goods you already have, the less valuable are further goods, and so it is sound economic logic to discount them. To have one bathroom in your house is a huge improvement to your life; a second bathroom is nice but not so life-changing. Goods have “diminishing marginal value,” as economists put it.

I am more interested right now in Stern's calculation of future economic growth at 1.3%/year than the laudable ethical stance implicit in his choice of a near-zero rate of pure time preference (see my remarks at the end). How did Stern arrive at this growth rate?

Beyond the human preference for the here & now, the stipulation of continuing economic growth is just what it appears to be—it's an a posteriori (experience-based) assumption based on past growth in the 20th century. As Ackerman notes in a longer treatment of the Stern Review, the 1.3% average growth rate is a "plausible" choice among others—

This is not to say that Stern’s specific discount rate is precisely correct; it is hard to be confident of Stern’s 0.1% annual risk of global catastrophe, an admittedly arbitrary estimate. The 1.3% average growth rate of per capita consumption is plausible but far from proven to be correct. A balanced conclusion might be that Stern demonstrates that 1.4% is among the plausible discount rates – and that such low rates have profoundly different implications from rates like 5-6%, used in many other analyses.

Simon Roberts, who is referenced in Figure 3, tells us more about Stern's average growth rate and provides some perspective on the unassailable presumption of continuing economic growth. Here are his informal remarks—

Economic growth. Actually, it’s quite a recent concept, because up until about a hundred years ago, the way that you get more money is by having more people or raising taxes, or invading other countries. It was only about a hundred years ago which is to say, you can actually produce greater value than you need merely for subsistence.

So, the idea of economic growth is comparatively recent. The last century is the economic growth century, really. What it means is that government policy is about encouraging economic growth, without encouraging a rise in prices, which means inflation. That’s the language of what we want governments to do, and the other point about it, it must continue. You can’t question the need for growth. Also, to leave the markets to sort out the appropriate mix between the factors of production, but the market is a way to achieve it and also technology will deliver....

So, let’s just see what the Stern Review, a year old, to see what Stern said about growth. How much should it be? Here’s an extract I found at about page 200, global GDP is around 2.9% on average for the last century. Therefore, projections for growth “to continue at that rate does not seem unreasonable”, and that’s it! That’s the only basis for picking that number 2.9%, but that’s what it says there. I can’t find anymore details about it within the Stern review.

[My note: The actual quote is on page 182 (chapter 7) and reads as follows: "But given that the growth rate of global GDP was around 2.9% per year on average between 1900 and 2000, and 3.9% between 1950 and 2000, projecting world growth to continue at between 2 and 3% per year (as in the IPCC SRES scenarios, for example) does not seem unreasonable." Stern believes we should devote 1%/year of global GDP to mitigating climate, so we get the plausible but arbitrary value of 1.3%/year.]

[My note: My own view is that for almost all people throughout prehistory and human history before the 20th century, a standard assumption was that—outside the occasional disaster—future generations would be no worse off than the present generation.]

Let's sum up.

1. Mitigating climate change or overcoming limits on available fossil energy will require or force massive decreases in CO₂ emissions over the 21st century.
2. Economists assume future generations will be richer than the current one. Stern's estimates economic growth in the 21st century to be 2-3%/year based on an average growth rate of 2.9% in the 20th century. Less the 1% devoted to climate mitigation, he comes up with a "plausible" value of 1.3%.
3. The conservative idea that 2.9% annual growth in the 20th century depended on a steady rise in CO₂ emissions is rejected—this is The Radical Hypothesis. The belief that economic growth is a necessity and will continue is not debatable.
4. The assumption that economic growth in the 21st century growth will take place without an accompanying rise in emissions is justified by the stipulation that technological progress solves all problems as stated in (3) above.

There's a whole lot of assuming going on here. The apparent contradiction is the use of a posteriori reasoning to justify future economic growth (#2), while rejecting such reasoning when evaluating the need for a concomitant rise in CO₂ emissions (#3).

The $64,000 Question

It is far easier to envision shrinking economies in 2009 than it was in 2006 when William Nordhaus was criticizing Stern's choice of a low discount rate in evaluating how much we must invest to fight climate change. Shrinking economies are driving lower emissions now, but it is not hard to imagine that lower emissions might constrain growth in the future. The Conservative Hypothesis (Figure 3) simply extrapolates past trends, and thus does not require a big leap of faith like the Radical Hypothesis (Figure 1) does.

Stern's choice of a near-zero time preference in which future generations are valued as highly as the present one expresses an idealistic ethical stance. In reality, the present generation will always take care of its own needs before seeing to those of future generations. The climate science tells us we must invest heavily now to preserve a high quality of life in the future, but current actions (e.g. the pending Cap & Trade legislation) suggest that preserving something close to the status quo is the path we will pursue. For example, we may follow the less carbon intensive path shown in Figure 1. See my essay The Reign of Error for some discussion.

Will we have economic growth in the 21st century? That's the $64,000 question. I've described the Radical Hypothesis and the assumptions that underpin it. Whether you believe those assumptions will hold up is another matter. The relationship between energy and economy is complex, and I should probably do some kind of follow-up.

But that's enough to chew on today. As newsman Ed Morrow used to say, good night & good luck.

Contact the author at dave.aspo@gmail.com

It's Not Black Or White

2009:H2: [We have] a cyclical bull market as the economy stabilizes and OPEC maintains cuts to draw inventories to 10-year average levels. We are raising our end of 2009 WTI [West Texas Intermediate crude oil] price forecast to $85/bbl from $65/bbl.
   —Goldman Sachs, June 3, 2009

I admit the human element seems to have failed us here.
   —General "Buck" Turgidson, from Dr. Strangelove

Layer upon layer of confusion pervades the discussion of why oil prices have been so volatile over the last 3 years. People often yearn for simple explanations. Some want somebody to blame, while others hold on to cherished theories. In these cases observers demand a Black Or White view of events which caricatures more complex realities.

I was reminded of these tendencies when a friend told me about Matt Taibbi's Rolling Stone article The Great American Bubble Machine. Taibbi trashes Goldman Sachs, accusing them of blowing or taking advantage of one bubble after another—the run-up to the the Crash of 1929, the Tech Stocks (dogfood.com) fiasco, and the Housing Craze. It's a great read and chock full of damning information, at least for those of us who can still concentrate long enough to get through something longer than a 140-character Tweet. 

In the interest of full disclosure, I must admit to a tinge of jealousy here because Taibbi despises Goldman Sachs even more than I do and expresses his contempt so well ^{see note 1}. And of course he writes for Rolling Stone and I don't! But seriously...

My problem with Taibbi's account is his Bubble #4, called $4 A Gallon. I need to quote this at some length.

With the public reluctant to put money in anything that felt like a paper investment, the Street quietly moved the casino to the physical-commodities market—stuff you could touch: corn, coffee, cocoa, wheat and, above all, energy commodities, especially oil. In conjunction with a decline in the dollar. the credit crunch and the housing crash caused a "flight to commodities." Oil futures in particular skyrocketed, as the price of a single barrel went from around $60 in the middle of 2007 to a high of $147 in the summer of 2008...

That summer. as the presidential campaign heated up, the accepted explanation for why gasoline had hit $4.11 a gallon was that there was a problem with the world oil supply.... But it was all a lie. While the global supply of oil will eventually dry up. the short-term flow has actually been increasing. In the six months before prices spiked, according to the U.S. Energy Information Administration [EIA], the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million. Not only was the short-term supply of oil rising, the demand for it was falling - which, in classic economic terms, should have brought prices at the pump down.

So what caused the huge spike in oil prices? Take a wild guess. Obviously Goldman had help – there were other players in the physical-commodities market – but the root cause had almost everything to do with the behavior of a few powerful actors determined to turn the once-solid market into a speculative casino. Goldman did it by persuading pension funds and other large institutional investors to invest in oil futures – agreeing to buy oil at a certain price on a fixed date. The push transformed oil from a physical commodity, rigidly subject to supply and demand, into something to bet on, like a stock. Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent. By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.

Hold your horses, Matt! Did you happen to notice that the demand number you cite (86.07 million barrels-per-day) is higher than your supply number (85.72)? I give you Figure 1.

Figure 1 — All liquids data for supply and demand from the EIA from 2007:Q1 (quarter 1 above) to 2008:Q4 (quarter 8). Taibbi quotes the 2008:Q2 numbers (quarter 6).

Demand easily outstripped supply as 2007 wore on, and as oil prices rose, demand started easing as supply strained mightily to rise enough to bring the market into equilibrium in the summer of 2008. There is no reason to think, as Taibbi claims, that oil prices should have been falling while demand still exceeded supply, even if the former was falling and the latter was rising—July, 2008 was the historical peak supply month at 86.653 million barrels-per-day. Finally, after 6 straight quarters in which supply fell short of demand, the market achieved a very temporary balance in 2008:Q3.

Figure 1 illustrates the early stages of the peak oil problem. Production was unable to rise in a timely fashion to meet burgeoning new consumption in the emerging economies (China, India, etc.). July, 2008 was the only time that all-liquids supply ever surpassed 86 million barrels-per-day, and there is a good chance that it will never exceed that level ever again (or 87, or 88, or something in the 86-88 range).

But what about the oil price? Taibbi believes speculators drove prices in 2008:H1 far beyond where they should have been. And he's right! But multiple factors were pushing up the price. What caused gasoline prices to shoot up over $4/galllon is not a Black Or White issue. It was not exclusively EITHER bloodsucking speculation OR supply & demand fundamentals (OR hedging against a constantly falling dollar since 2003). All these problems combined to create a record high of $147 for a barrel of oil on July 12, 2008, and there is a subtle relationship among these factors.

The mature, calm observer see shades of gray and multiple causation. Black Or White thinking is called "primitive" by psychologists. Adults under stress can easily backslide (regress) into mutually exclusive dualities typical of childhood.

When small children are learning to use words and organize their thoughts, it is normal and expected for them to see and express their world in very black and white terms. When a young child feels they are not loved, they feel they must be hated. When a child feels his or her parents don't pay enough attention to them, that child will say, "You never pay attention to me." Developmental psychologists call this primitive thinking.

Unfortunately, under duress, adults often regress to primitive thinking. Adults are most prone to regressing to primitive thinking when they are having a hard time and feel overwhelmed by their own emotions. A regression, in psychoanalytic parlance, is a backsliding from mature functioning and thinking to immature ways of functioning and thinking. For that one moment, when the adult starts relying on the words "always" or "never," and seeing the world in black and white terms, they are slipping back to the way they saw the world as a child.

It is perfectly understandable why we might feel freaked out in 21st century America. Everything is really screwed up—our cliff-diving economy, our unrepentant, bailed-out financial oligarchy, our overwhelming debt, our paralyzed political system, our impoverished state governments, you name it. Writing a diatribe blaming all the world's ills on Goldman Sachs is better than a headlong flight from reality, which is the preferred solution of most Americans. I largely agree with Taibbi: if America is now circling the drain, Goldman Sachs has found a way to be that drain. But Goldman Sachs is not our only problem, not by a long shot.

If we are to have any chance^{note 2} of working our way out of this mess, we must avoid regressive thinking, stay calm, appreciate complexity, and think clearly about the right course of action. I'm going to take a proper look at speculation in the oil market to see what the problems are and what we might actually do about them. It's one big problem among many, I know, but you've got to start somewhere.

Not Everything That Can Be Traded Should Be Traded

Let's start with a mature approach to price distortions in the oil markets. The quote and Figure 2 are from Jeffrey Korzenik's Crude Oil Trading Regulation: A Terrible Idea Whose Time Has Come. He's talking about index speculation made possible by the swaps loophole.^{note 3}

If we’re going to trade crude oil like a currency, we should regulate it like a currency, too.

I hold an apparently quaint and obsolete belief: Not everything that can be traded should be traded. Specifically, there’s great danger in using long-term, long-only commodity futures positions as an investment asset class. The same is true of the derivative baskets of commodities that replicate such futures positions. Please note that I’m not talking about futures funds (which trade both sides of the market and are generally in positions only for the short term), but rather the way that commodities are increasingly being used by pensions, endowments and hedge funds as investments rather than short term speculations; this has sometimes been called index speculation, to distinguish it from the traditional variety.

Investment flows into the futures market can distort the pricing that should instead be determined by producers and users of commodities. Price distortions of this type cause enormous economic inefficiencies, are deeply injurious to the world’s poorest, and create significant structural risk in the markets. The chart below is a good illustration of just how “financialized” energy prices have become... [Figure 2, and I've included a recent snapshot taken June 17th of oil prices in 2009. Click on the image to see a larger version.]

[My note: Long traders are betting on a longer term price rise, whereas those "going short" are betting the price will fall.]

Figure 2 — The trade-weighted U.S. Dollar index (the dashed line) versus the DJ-UBSCI Energy Spot index^{note 4} (the solid line) since the beginning of the year. Korzenik says "as emphasized by the arbitrarily drawn horizontal line, these plots are virtually mirror images of each other (running a regression results in a correlation of -0.88). This corresponds to the type of linked price action we saw during the buildup to the commodity frenzy last year. It’s interesting to note that commodities like gold show nowhere near the correlation (-0.177) with the dollar over this same period. Clearly, the pricing of crude oil and energy products have become dominated by financial, not commercial interests."

Taibbi fixated on price speculation in the run-up to $147/barrel in 2007-2008. Better he should have focused his attention on—he does mention it—the recent rise from an average monthly price of $39.16 for crude oil in February to about $68.00 now during the worst economic downturn since the Great Depression. While some of the price rise might be due to OPEC cuts and stockpiling in China, no data I'm aware of show an increase in demand, or even a definite stabilization of the recent downward trajectory in global oil consumption.

Therefore we must conclude, and it's no secret, that the recent price rise has been due to long-term, long-only community futures positions taken by index traders (e.g. pensions, endowments, hedge funds) using the avenues available to them. Conveniently, the means are furnished by Goldman Sachs, among others. Here is economist James Hamilton writing about how the speculation works on May 17, 2008.

An important recent trend in management of pension and hedge funds is the increasing allocation of investment dollars to commodity speculation. There are lots of ways you can do this. Perhaps the simplest is to purchase, say, the July NYMEX oil futures contract. If you'd bought that contract Friday, it would enable you to take delivery of oil in Cushing, Oklahoma some time in July for $126/barrel. As a pension fund, you don't actually want to receive that oil, so in early June you'd plan on selling that contract to someone else and using the proceeds to buy the August contract. If oil prices go up and you can sell the contract for more than $126/barrel next month, you will have made a profit. By rolling over near-term futures contracts in this way, your "investment" will earn a return that follows the path of oil prices.

The Goldman Sachs Commodity Index is essentially a mechanical calculation of how much money you'd have each day if you followed a strategy like this for each of the major commodity contracts, with energy prices comprising about 70% of that index. There are a number of firms [like Goldman Sachs] that offer products that could implement such strategies on your behalf, such that the dollar value of your investment will essentially follow the GSCI (or similar index) less trading costs and management fees.

Long-only index traders are now said to be hedging against expectations of future inflation, which manifests as a hedge against a falling dollar as shown in Figure 2. Wall Street bankers, who know that short-term inflation expectations are nonsense, are no doubt driving & riding the long wave, as I described in Mr. Market Gets It Wrong Again. Thus Goldman Sachs issues bogus oil price forecasts to keep the ball rolling (like the one in our opening quote at the top).

Taibbi approvingly quotes hedge-fund operator Michael Masters, who believes the influx of index speculators into the oil market has been the sole factor driving up prices since 2003, and was the biggest factor in the price rise from end-2007 until July, 2008 (Figure 3).

Figure 3 — The open-interest (contracts) in oil rose steadily until the end of 2008. The rise was largely due to the influx of index (pensions, endowments, hedge fund) traders. This graph is taken from the Air Transport Association's Energy Matters presentation dated June, 2009. The airline industry is understandably upset about index speculators. Some airlines took a bath when they tried to hedge their risk by locking in forward (6-month) prices at $120/barrel or more. At the time, few foresaw the crash in September. Some airlines were thus stuck with exorbitant oil prices long after the price had fallen below $50.

Masters' position is a caricature of reality. If it's Black Or White, let's call his view the "Black" alternative. He can explain Figure 2 (recent speculation) but he can not explain Figure 1 (the supply & demand imbalance). Nevertheless, the recent price rise strongly suggests that there was speculative froth over and above what the "fundamentals" price should have been in 2008:H1. This premium might have been somewhere in the $25-35 range, as it is today. That would suggest that the "real" price at the top should have been somewhere between $100 and $110/barrel, as I argued in Mr. Market.

The "White" position ascribes the entire upward price movement in 2007-2008 to supply & demand fundamentals. From the June 17, 2009 CNN Money story Obama vs. the Oil Bubble—

Scott Irwin, an agricultural economist at the University of Illinois, says there is little evidence to support the notion that index fund buying is playing a substantial role in the level of commodity prices. "The academic work to date finds no evidence that the massive run-up of commodity prices can be traced to the index funds," he said.

Irwin said a recent study of dynamics in the corn market, where prices spiked last year as well, shows that the rise in futures buying by index funds and other long hedgers was met with increased selling by large commercial interests—the entities that these markets were created to serve.

Back on September, 2008, Hamilton published Scott Irwin takes down Michael Masters at Econbrowser.

My purpose in writing this post is to show that Mr. Masters' bubble argument does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money [Figure 3] has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters' argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC derivative markets.

The first and most fundamental error Mr. Masters makes is to equate money inflows into futures and derivatives markets with demand, at least as economists define the term. Investment dollars flowing into either the long or short side of futures or derivative markets is not the same thing as demand for physical commodities. My esteemed predecessor at the University of Illinois, Tom Hieronymus , put it this way, "for every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it." These are zero-sum markets where all money flows must by definition net to zero. It makes as much logical sense to call the long positions of index funds new "demand" as it does to call the positions of the short side of the same contracts new "supply." 

[My note: Irwin presents other economic fundamentalist arguments in this vein.]

I wonder how Irwin explains away the recent rise in oil prices, an increase which apparently reflects a "financialized" market that does not serve the interests of oil end-users and is almost entirely divorced from supply & demand fundamentals. Given his recent remarks to CNN Money quoted above, I guess he thinks everything is OK and there is nothing to explain. Worse still, his argument that the commodities markets are always in (or only temporarily out of) equilibrium—this is his "zero sum" game—seems to imply that bubbles are impossible in principle!

The key word here is "temporarily." In the longer run, the tail (speculation) does not wag the dog (fundamentals). Bubbles are temporary by definition—they must all collapse sooner or later. But while they are going on—they go on for months at a time—a lot of damage is done to the commercial interests the market is supposed to serve. Why should buyers & sellers of commodities be put at such risk? If you doubt this, just ask Delta Airlines.

The upshot of Irwin's argument is that the skyrocketing price in 2008:H1, the precipitous fall in 2008:H2, and the recent rise in 2009:H1 were all due entirely to supply & demand fundamentals. Like Masters' view, Irwin's position is a caricature which ignores the human—you know, crazy—element in economics, now properly modified to be behavioral economics. See Scientific American's recent article The Science of Bubbles and Busts (July 9, 2009).

It's not Black Or White. But let's go to the heart of the matter. Why speculate in energy (oil)? Why is oil being treated like a currency?

If you've been paying any attention to events in the oil markets over the last 5 or 6 years, you probably "know" four things: 1) economic growth always seems to be accompanied by growing oil consumption; 2) thus, growing emerging economies like China and India are using more and more of the stuff; 3) the price got really high in 2008 and rose for 5 years before that; and 4) there's a persistent rumor about something called "peak oil"—even if you're not quite sure what that actually means. (Does it mean oil production starts declining when half the reserves are gone? or are we Running Out Of Oil?, or some other nonsense?)

If you are a pension fund or an endowment armed with this "knowledge" that oil is really precious stuff, betting that oil prices will rise in the future looks like a sure thing. So we see that Figure 1 and Figure 2 really do fit together, despite what Taibbi, Masters and Irwin say, and despite the mistake index traders are making by going long on oil far too early.

You've got it wrong if you believe that only speculation pushed oil prices up from 2003 to 2008 or only fundamentals drove all the price increase—an existing market disequilibrium between available supply & potential demand gave and still gives legs to speculation in oil. Both factors played a role in inflated oil prices, with supply & demand being the underlying cause—that's what the word "fundamentals" means. It's Black And White. Goldman Sachs is merely a morally-challenged facilitator of short-term price bubbles, i.e. they are the drain we're going down.

There's No School Like the Old School

Speculation causing temporary bubbles in the commodity markets is a bad thing. Unwarranted price distortions & volatility cause needless pain for producers and consumers. I don't know enough about the gory details of how the NYMEX currently works to recommend specific solutions, but I do know this: the "swaps loophole" must closed and "bona fide hedging" exemptions should be repealed. The market should probably work as it was set up in 1936. I agree in principle with Taibbi when he writes—

In 1936, however, Congress recognized that there should never be more speculators in the market than real producers and consumers. If that happened, prices would be affected by something other than supply and demand, and price manipulations would ensue. A new law empowered the Commodity Futures Trading Commission – the very same body that would later try and fail to regulate credit swaps – to place limits on speculative trades in commodities. As a result of the CFTC's oversight, peace and harmony reigned in the commodities markets for more than 50 years.

Depression-era regulation has been repealed over and over again in the last 20 years. You can clearly see where that got us. There's no school like the old school. The derivatives industry is against proposed CFTC changes. That's bona facie evidence that something good might be in the works.

Taibbi describes how Goldman Sachs is preparing to blow or take advantage of a new bubble in the Cap & Trade carbon trading market (Bubble #6, Global Warming). Inflated "asset" values (carbon?) are a likely outcome if the legislation passes. A society that can not define and police its markets properly has no chance of fixing the longer term problems (the oil supply, the climate) that underlie them.

Contact the author at dave.aspo@gmail.com

Notes

1 This is a slide from the American Transport Association (see Figure 3).

Investment banks must issue bullish reports to drive the index investor herd (the Goldman Sachs theme song...)

Rollin', Rollin', Rollin'...

Keep Movin', Movin' Movin'
Though they're disaprovin'
Keep them doggies moving,
Rawhide!

Don't try to understand 'em,
Just rope and throw and grab 'em,
Soon we'll be living high and wide.
My heart's calculatin'
My true love will be waitin',
be waiting at the end of my ride...

Rawhide!

2  A few protests in the streets à la Iran might be helpful too. Americans can't afford to hit the snooze button on the alarm clock anymore. Even if the protests wouldn't accomplish anything, they could still demonstrate that we're awake and watching something other than TV.

3  From the Senate testimony of Michael Masters last summer:

When Congress passed the Commodity Exchange Act in 1936, they did so with the understanding that speculators should not be allowed to dominate the commodities futures markets. Unfortunately, the CFTC has taken deliberate steps to allow certain speculators virtually unlimited access to the commodities futures markets. The CFTC has granted Wall Street banks [like Goldman Sachs] an exemption from speculative position limits when these banks hedge over-the-counter swaps transactions. This has effectively opened a loophole for unlimited speculation. When Index Speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative position limits.

The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.

In the CFTC’s classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as “Commercial” rather than “Non-Commercial.” The result is a gross distortion in data that effectively hides the full impact of Index Speculation.

4  About the Dow Jones-UBS Commodity Index: "UBS Securities LLC has acquired AIG Financial Product Corp's commodity business has of May 6, 2009. As such, the Dow Jones-AIG Commodities Indexes have been rebranded as the DJ-UBSCI effective May 7, 2009." I'm not going to make a big deal out of this; I just thought you ought to know.