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Running out of options

by Jerome a Paris Mon Aug 15th, 2005 at 06:25:35 AM EST

The graph below (from The Economist this week) shows the Fed rates (i.e. short term interest rates) going steadily up in the past year, and the bond yields, i.e. the long term interest rates, which have remained steady or have even gone down in the same period.

The second graph below (pulled from an April 2005 Political Animal post by Kevin Drum) shows the approximate supply and demand curves for oil worldwide:

I know that these graphs only look superficially similar and represent very different things. I will nevertheless argue that they are both very symbolic of Bushco's policies of taking whatever's on the table for their (rich) friends and not give a damn about the future.

Let's take them both in order.

The first one, at first sight, does not show bad information (and that's how it's spun):

  • Greenspan is acting as a reasonable Central Banker by increasing interest rates when the economy is doing well, so that it does not overheat, and thus so that growth remains viable longer;

  • low long term rates reflect market expectations of low inflation for the foreseeable future, and are a testimony to the capacity of the USA to easily and cheaply attract foreign money to fund its twin deficits - which, in a virtuus circle, fuel world growth; such low rates allow US consumers to manage their debt burden easily and allow them to get better valuations for their houses.

The problem, of course, is that short term interest rates which get as high as long term rates are actually very bad news. It means that markets would rather lend you money for a long period than a short one, meaning that they expect money to lose its purchasing power in the meantime, i.e. they expect deflation. That's historically been a very strong sign that a recession was around the corner.

This is nowadays conveniently explained away by some "savings glut" in the rest of the world, where people don't have a better thing to do with their money than buying US Treasuries and other dollar denominated bonds, thus keeping interest rates low.

The Economist considers that this explanation is not satisfactory, as an excess in savings should also result in lower overall growth, which is not what is currently happening. This article (behind subscription wall), which brings back the famous IS-LM curve that most students that have dabbled in economics should be familiar with, suggests that current circumstances (low interest rates and high growth) are much more compatible with a situation of excess liquidity:

(on the left, an increase in savings moves the  IS (investment/saving) curve down, thus leading to lower interest rates AND lower output. On the right, excess liquidity pushes the LM (liquidity/money) curve down, thus leading to lower interest rates and higher output.)

This suggests, and this is the Economist's conclusion, that Greenspan's interest rate rises are too little, too late; combined with the also-accomodative monetary policies of Japan (short term rates = 0.01%) and Europe (short term rates = 2%), the world has literally been drowning in money in recent years, and the excess liquidity created in the past few years has not been absorbed yet. Usually, such excess liquidity would have translated into inflation, but China's emergence as a low cost producer has conveniently taken place as the same time (at least on the scale where it can have a global impact) and has had a deflationary effect on the price of goods. Thus the excess liquidity has gone into other asset classes - real estate, and bonds (the interest rate goes down when the bond price goes up).

So the first graph shows that the markets do not take Greenspan seriously when he raises the Fed rates, because he is raising them much too slowly to have an impact. However, we are getting close to the point when this will all become irrelevant, when the continuing, if insufficient, increases in short term rates will make these reach, or overtake, long term rates (an "inverted yield curve"). This will lead to a movement of money away from long term assets into the more remunerative short term money markets, thus leading to higher long term rates and decreasing asset prices. What will make this process painful and unpredictable is that, instead of happening slowly, over a long period, this will have to happen very fast and thus could lead to brutal price shocks in various markets. In effect, excess liquidity is preventing the necessary orderly slowdown after years of excesses.

This is where the comparison with the oil prices comes in. Here, similarly, we have been living on the resources of the past (the excess production capacity available since the early 80s):

(see how the recent price shocks, in 2000 and 2004 are associated with lower spare capacity)

(see the left graph for the worlwide refinery capacity utilisation).

(from CNN, via Kevin Drum, image added after the diary was initially posted, I forgot it)

Investments throughout the 90s were minimal, i.e. just enough to keep up with fairly predictable demand increases. The oil industry was living with the nightmare of the mid-80s in its collective mind, when a glut of production after heavy investments lead to collapsing prices (and, in the US, to serious economic pain in the oil producing regions). Thus, when demand increased at a markerdly higher rhythm in the last few years, the industry was caught unaware and has now reached the point when it is purely and simply unable to produce significantly more than the world consumes.

This means that, on the oil front, we are now also extremely sensitive to external shocks that disturb supply. Consumers are showing that prices are not yet high enough to make them lower their demand, and whole chunks of Asia are on the brink of the car civilisation, and will not be deterred by somewhat highish gasoline prices. Therefore any adjustments to make demand equal supply currently come form the supply side, and any disruption of supplies that would prevent that will force an adjustment on the demand side, which can only come from massively higher prices (and I mean multiples of today's prices, not just 10 or 20$/bl more).

So we have the combination of Bush (borrow and spend like there is no tomorrow, give money to the rich and to the corporations), Greenspan (flood the zone with money), the US consumer (stagnant wages, but cheap money from home equity withdrawals or plastic, thus still consuming - including lots of gas-guzzling SUVs), and the oil producers (unable or unwilling to invest), and we are getting very near the end of this exercise in burning your reserves:

  • this is supposed to be an economic recovery, yet debt levels are at record highs and interest rates are still low. What will be available to cushion the shock when it comes? Not public deficts, not private debt, and not lower interest rates.

  • this is an economy built on cheap oil. When it stops being cheap, what will happen to those that have suburban houses, 50 mile commutes, 15 MPG cars and no access to public transport? what will happen to the corresponding real estate markets? what will happen to the manufacturers of the gas-guzzlers?

The recent apparent prosperity comes from having burnt through all our capacity to absorb shocks. It can last for a while, so long as there are no shocks, but we all realise that this is not very reasonable (especially when your foreign policy consists in creating massive instability in the most sensitive area of the world). We are highly vulnerable, and the consequences of any shock will be brutal - and we know that shocks are coming on the money and oil fronts.

As an individual, you still have the chance today to protect yourself from these inevitable trends, becuase the country as a whole will not escpae it, and neither will the rest of the world.

the only solution is to nuke china as soon as possible

it's hard to imagine that it can be so bad and hard it 's coming by surprise.

Bush familly is in petrol industry for a while, they know excactly what is happening, and i do not think they are playing against the US's interest.

who have the ace ?

by fredouil (fredouil@gmailgmailgmail.com) on Mon Aug 15th, 2005 at 08:49:08 AM EST
The only solution to what? To avoid unnecessary death?

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Mon Aug 15th, 2005 at 10:31:00 AM EST
[ Parent ]
Not even mentioned the impact of the pension crisis, or is that still in the long term?

Brown and the UK economy

City suits become Whitehall mandarins with ever greater frequency, government spending on management consultants rising every year under Blair, to over £1bn in 2004.

The flourishing offspring of intimate relations between the Treasury and the financial institutions, as chaperoned by the "politically independent" Bank of England, personal debt in the UK has soared to a record of over £1trillion, 80% of which is used to finance house-buying.

Guardian - Revealed: Brown and Blair's pact  

ASIA 1998 - The Year the Bubble Burst

Will 1998 be remembered as the year in which, in the words of George Soros, capitalism started to "come apart at the seams"?

It was certainly a very uncomfortable economic year for much of the world, with currencies plunging in the Far East and Russia, Japan going into recession, large-scale job losses in the UK and stock markets seemingly charting new peaks and troughs every week.

Twelve months ago, however, the focus was on the Far East where the problems of 1997 were continuing, particularly in South Korea and Indonesia.

South Korea renegotiated much of its debt at the start of the year, but its economy continued to flounder. A rescue package was put together in September which involved boosting consumer demand and restructuring the banking sector.


'Sapere aude'

by Oui (Oui) on Mon Aug 15th, 2005 at 09:32:08 AM EST
Some comments from the 'merican viewpoint.

First, this is not narrowly a problem with Bush, it's a problem that transcends our parties. The main complaint of Kerry, Pelosi, Nader, and the rest of the mainstream left is that Bush is not doing enough to keep the price of gasoline down! The lack of will to do anything about energy (or global warming) is a broad problem in American politics (and European, too). One may fairly say that Bush has tight connections with the oil industry that distort his view, but it's also fair to say that neither party proposes a solution.

Second, your analysis does not adequately take into consideration the fall in demand that can be driven by only a small change (downwards) in the economy. U.S. demand reached a high of 18.8 million barrels per day in 1978, then plunged by 20% in just five years, reaching a low of 15.2 million B/D in 1983. Does anyone recall the terrible depression of 1980?

Finally, I think you underestimate the flexibility of the common man. What will happen to the people with the 50 mile commutes and 15 MPG cars is that they will start to carpool, buy a different car, do more telecommuting, take the bus, and gradually move from one home (or job) to another.

Clearly there is a long term problem, but it's not so clear that a short term crash is on the way. The real question, I think, is whether it will be a hard landing or a soft landing, and that is unknown and probably mostly depends on events in the Middle East...

by asdf on Mon Aug 15th, 2005 at 12:46:47 PM EST
Actually, the reduction in oil consumption came, for the most part, fromthe heavy users in industry and power generation that switched to other fuels (coal and then natural gas). This solution is no longer available today. We need drivers to make the effort, and it is not going to be easy.

Prices will increase until the inconvenience of car pooling or taking the bus is less than paying for gas, which means, in the USA, a relly high gasoline price.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Mon Aug 15th, 2005 at 01:55:09 PM EST
[ Parent ]
asdf, Jérôme, I like reading your exchanges :-)

*Lunatic*, n.
One whose delusions are out of fashion.
by DoDo on Tue Aug 16th, 2005 at 04:54:06 AM EST
[ Parent ]

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