Monday, 22 September 2008

Oil - Our Deadly Addiction

"Now the only thing that saved the U.K. was the North Sea oil fields, even though Prime Minister Margaret Thatcher likes to take credit, but Margaret Thatcher has good PR. Margaret Thatcher came into office in 1979 and North Sea oil started flowing and the U.K. suddenly had a huge balance-of-payment surplus. You know, even if Mother Teresa had come in [as prime minister] in ’79, or Joseph Stalin, or whomever had come in 1979 – you know, Jimmy Carter, George Bush, whomever – it still would have been great. You give me the largest oil field in the world and I’ll show you a good time, too. That’s what happened."
Jim Rogers, Chairman Rogers Holdings

Since the modern world began to industrialise we have seen huge advancements in all aspects of technology and living standards in the West. Since the application of fossil fuels into our industries we have been able to grow our material wealth immeasurably compared to any other point in human history. Most of human history is marked by an agrarian focused system with closely knit communities that did not produce much of an economic surplus, other than to feed itself, a basic civil service, taxation system and law and order. But over the course of the last 200 years that has changed. Society suddenly began producing increasing amounts of labour surplus. Jobs became ever more specialised and productive leading to a feedback process of more productive surplus in society. There seemed to be no limits to the growth of the modern world as it embarked on the experimentation of modern globalisation into the next millennium. But where and how did all this wealth get created along with the extra productivity gains? People had not evolved significantly for thousands of years, yet their economies and populations had grown exponentially. The answer lies in the fossil fuel revolution that began roughly 200 years ago.

Rule Britannia

Beginning around the end of the 18th and the early 19th Century, a technological revolution was underway. The invention of the steam engine allowed the production of powerful machines that could do huge amounts of work and this meant large factories could be built on a massive scale. With the introduction of iron founding, railways and steam powered ships could be built and thus a mass haulage system was built to move the goods that were being produced in significant volumes by the new factories. The Coal age had arrived and with it a revolution in the way modern society would function. People would migrate from rural areas into the urban towns and cities to further produce more goods which in turn generated wealth that had never been seen before.

Land of Plenty

Oil had been known for hundreds of years however it was not until the mid and late 19th Century that it became used for productive purposes. It was originally used for lighting domestic homes due to the shortage of sperm whale oil, that was used before it. America was beginning to rise as a prosperous industrial nation spurred on by home grown technical innovation. As a resource rich nation it did not need a vast empire like Britain to grow. The turn of the 20th Century marked a great transition from coal to oil, something America possessed in abundance. With the advent of flight by the Wright brothers and the Model T Ford in 1908, new applications were found that required Oil, a hydrocarbon substance that was packed with energy. Demand for oil increased as the 1920's came along with increased use in agriculture and the start of Amercian's romance with suburbia as the motor car became more affordable. Further uses of energy became increasingly common with domestic labour saving devices running off electricity powered by various fossil fuels, creating further productivity gains in the economy. The Great Depression ushered in an era where the fossil fuel economy had simply being too over productive as people began to stop buying these new devices that had drove the unsustainable boom. A Second World War erupted in Europe, marking industrial countries reliance on oil. The Germans had ensured oil supplies from the start of the war with Russia in signing the Molotov-Ribbentrop pact. Hitler would later conquer western Europe - well almost. Later he would try to take Russia by surprise in an attempt to capture their oil reserves, that Hitler so desperately needed to sustain an efficient war machine. He simply didn't trust Stalin or Communism. Like Napoleon, over 100 years before him, he was beaten by the harsh Russian winter and the vastness of its terrain.

After the war America emerged as the new superpower of the world and its people over the course of the next two decades would enjoy some of the biggest improvements in living standards in human history. Oil is by far the most energy rich and versatile fuel humans have every come across and learned how to use successfully. The abundance of domestic cheap oil meant the American economy was powering ahead.

Dr M King Hubbert

In 1956 a geoscientist named Marion King Hubbert gave a talk proclaiming that American oil production would peak somewhere around 1965 - 1971. He was laughed at, as America had huge amounts of Oil, enough for many years and generations to come. Then in 1970, the US hit peak oil production. They would never again in history produce more domestic oil then they did in that year. Dr Hubbert had been proved right and suddenly America was now a net importer of Oil as demand continued increasing with domestic supply embarking on a long decline.

The Oil Shocks

1973 and the Yom Kipper War erupted in the middle east, in which an Oil embargo on the west would coincide. Overnight the price of Oil rocketed and the price went from roughly $3 a barrel to $5. With it the western economies suddenly began to break down, as everything was either made or transported with oil. Panic buying began with prices rising. Amercians and Europeans woke up to the fact that their economies could not function without Oil. This set off a decade of stagflation and general discontent. A Second Oil Crisis was to erupt in 1979 as the Shah was overthrown in Iran thus creating another Oil price spike (one of the reasons that the Americans would later bank roll Saddam Hussein against Iran).

North Sea Oil and the Alaskan Oil fields - The false illusion

Around the end of the seventies North Sea Oil and the Alaskan Oil field slopes had been discovered, giving Western Governments control over their own supplies once more. This extra supply along with improved middle eastern relations would bring prices back under control and bring in the illusion that the seventies was a false alarm, there would always be plenty of oil. During Britain's long decline since the First World War they had become the basket case of the West on the verge of going bankrupt and resorted to begging the IMF for money just before North Sea Oil began to come to the market. As Jim Callagahan would say, whoever won the 1979 election would retain power, the revenues from Oil would see to that. Thatcher won and had the full benefits of north sea oil and gas, the real Thatcherism was in fact surplus energy. Oil began two decades of stagnant prices and was as low as $10 a barrel in the late nineties. I remember my dad at the time having to announce a lot of redundancies in his industry and his remarks at how low the price of Oil was. It was not to last. Alaska peaked around 1988 while North Sea oil peaked around the turn of the millennium. The West was running on empty again.

A New Age of Price Shocks

The Globalised economy was beginning to take shape. Factories and jobs had been relocated to Asia with the emerging far east economies being titled as 'Tigers'. The mass investment of capital from West to East spurred forward further demand for oil and coal. China had once been a net exporter of oil. Now it had become a net importer with an insatiable appetite. Geological Analysts began reviving Dr King Hubberts work suggesting we were near worldwide peak oil. Again they were laughed at or denounced, just like Hubbert was 50 years ago. Meanwhile Countries began peaking in oil production. Mexico, Oman, UK, Indonesia all past their peak. The Saudis told us there was no problem they could cover the demand, however for years they had been pumping their oil wells with seawater to sustain the output. Some say the Saudis are now pumping at peak or will reach peak soon. From the turn of the millennium prices began a slow and long climb upwards, supply seemed to be hitting limits yet the further industrialisation of Asia demanded more. Americans and Europeans had been consumming, buying bigger cars with a 4x4 culture further increasing demand. The end of cheap oil and energy had come. A new era of price rises and economic turmoil had been ushered in. The first significant price spike occurred over the course of late 2007/2008 with Oil reaching just under $150 a barrel. Gordon Browns Solution - go ask the Saudis to pump some more. The price dropped to sub $100 prices as the global economy began to slow. People thought the earlier price spike was driven by speculators and oil companies and cheap energy would soon return with oil prices collapsing. In reality the price had been driven by the most simple economic dynamic - supply and demand. A new period of Oil Shocks was only just beginning with the potential to cause chaos in the industrialised economies of the world.

There's plenty of Oil still left

Of course there is plenty of Oil left. Estimates of proven oil reserves are around 1 trillion barrels of oil. Humans have currently used to date around the same amount, 1 trillion barrels. However the oil we have already used has been the easiest to access. Oil was first discovered on parts of the earths surface, you didn't even need to drill to get the stuff. Then to get further reserves you had to drill, but this was on land and there was little energy expended for the amount of energy returned. In the first part of the Twentieth Century you could expect to get 30 barrels of Oil for every 1 barrel you used in energy for getting the stuff out of the ground and to the market. This ratio has been going through a slow decline as time has gone on. Oil fields were routinely left with half the oil still there as it was not economical to extract the remaining amount. No doubt in time as prices rise these will be re-drilled. As oil in the reservoir declines so does the pressure therefore you have to expend more energy to pump the stuff out. As Oil became more scarce offshore drilling was used, however this is a lot more expensive to do than drilling on land and I don't mean economically but the return on the energy. Those offshore rigs have to be constructed and built through the burning of more fossil fuels. The early oil that was discovered and extracted was also the best quality oil, with little refinement costs, but as there has become less and less there has become more and more refinement costs.

The point is we may have lots of oil left. Everyone accepts this. The point is we have run out of cheap and easily accessible oil. Most of the oil in the world would be so hard to get that you would get negative energy returns. There's no point extracting a barrel of oil if it took 2 barrels to get it. Oil fields extract following a very exact pattern, following a bell shape curve. Production ramps up ever more until it reaches a peak. Once this peak is hit, you can never get more Oil at any given time again. This means even if there is lots of oil in the reservoir it can only flow at a specific rate, thus if demand increases supply can not. The oil field follows a set pattern, one of decline (see age of growth post for graph pattern). It doesn't matter how hard you pump, extra drilling, it will always never yield the same daily return.

We will just transition nicely onto the alternatives

Did we prepare for when Western Oil production peaked in the early seventies? Only a crisis brings about change within human society. Then we get onto the question of what alternatives? If there are more economical alternatives then wouldn't we be using them already? The bottom line is that oil is still dirt cheep and convenient compared with all other energy sources we know of and can exploit. It comes back to energy expended during extraction, compared with energy returned.

So what about hydrogen fuel cell technology thats in the news? When someone starts to go through the practicalities it becomes laughable. First you have to make the hydrogen, which is not like drilling oil that naturally occurs. It's an expensive operation using techniques such as electrolysis. Then you have to compress the gas in order to try allow it to be delivered to the refueling stations, yet it will still not contain any where near the same amount of energy as a tanker of oil would contain (in fact it barely becomes economical after the distribution network has expended energy in delivering the tanker). Then you need to unload it at the refueling stations, a highly explosive gas when combined with air (Hindenburg), into a high pressure container. Then the car would need to be fitted with a high pressure tank with high pressure connectors to put the pressurised gas into the car - a feat just to engineer all this. After which the user would be able to drive around in a car of highly flammable gas at which the piping system could burst in a crash or even just leak due to Hydrogen's corrosive properties over time. And the fuel making all this possible is of course fossil fuels which produces the hydrogen in the first place as things currently stand.

That leaves electric which is just not as energy dense as oil. First you have to make the electricity. Then you have to charge your battery powered car for hours, not like oil where it takes a few minutes to refill a tank. Then when fully charged the electric car still gives no where near the same mileage as oil. What are lorry drivers going to do that deliver goods over long distances (plus you are going to need some serious batteries). You could have an electric car running on an electric grid based road, but this is not going to happen overnight. Plus western government finances are already in a mess - do you really think they have money to retrofit our roads.

Hybrid is the other car being discussed, but again it still uses oil and merely dampens demand and the car itself is expensive for the majority of people. Renewables such as solar, wind and hydroelectric etc will never be able to meet our high energy demanding economies and our transportation network. Plus what do you think makes these viable at the moment? Again its Oil, Gas and Coal that are used to build and deploy the equipment. We could burn ethanol just at a time when the there will be huge demands on corn as the globe is becoming more affluent, aggravating global hunger (plus the energy yields again on ethanol are poor). Nuclear fusion is just a pipe dream along with lots of other futuristic technologies leaving just fission as the proven alternative. In the coming years political sensitivity will be ignored for the sake of increasing energy demands and narrowing alternatives.

Our whole transport infrastructure is based on Oil

It's not just cars that rely on oil. Its agriculture machinery, ships and lorries that transport goods, building equipment, mining trucks etc. If oil is becoming more expensive then guess what, your food will be more expensive as the tractors become more expensive to keep running. If the food you import is from overseas then the ship or aeroplane trip becomes more expensive. The supermarket van that delivers the goods near to where you live becomes more expensive. More of your income, your economic productive surplus gets consumed by higher energy costs leaving you less money to spend on other goods in the economy, thus starting the feedback process in reverse from the advent of the industrial revolution. Jobs become less specialised, reversing Adam Smiths theory's of increasing job specialisation (look at the back of a £20 note). The division of labour goes into reverse as you can no longer afford all your shopping so decide to grow your own vegetables leaving you less time to go to that gym you pay £30 a month for, to name one of many plausible permutations. It's the division of labour that has drove economic growth at such a rapid rate in the past two hundred years which has been accelerated abundant supplies of cheap energy and a technological ability to exploit it. Society has in fact been living off an invisible form of slave labour, machines powered by oil have done jobs and tasks that were typically done by many. There may be some wonderful future power source which may be much more convenient, efficient and cheaper than oil however they are just ideas or theories and I like to look at the current situation we face now. Claims of future scientific and engineering brilliance doesn't answer the current problem we have.

Oil Shale, Oil Sands and Synthetic Oil

With the recent discoveries of the oil sands and shale in Canada there has been great belief that this will flood the market with oil. However this is not conventional crude oil of the liquid type. First it has to be processed which is a very energy intensive process. Then there are all the environmental costs as a lot of toxic waste is produced that will be opposed by many environmental groups (which will probably be ignored when demand for oil becomes so desperate). All this extra processing means that for every 3 barrels of oil you produce, you use 2 barrels of energy to extract it. Sure there may be technological improvements and innovations but there are limits, specifically the laws of thermodynamics and it will never be as easy as it has been in the twentieth century.

You can create a synthetic oil from coal. Germany used the process during Hitlers time in power, as Germany had no oil reserves of their own. Again though there are costs, specifically the processing of it hence why Hitler still wanted access to the conventional liquid oil. It was out of necessity that they were processing oil from coal. People have made claims that it can be done as long as the price of oil is around $50 a barrel. I'm yet to see these huge coal synthetic processing plants, as oil long ago went beyond $50 a barrel.

Coal and Gas

The other two fossil fuels are Gas and Coal. We are told we have hundreds of years of coal but yet if we dig a bit deeper the practicalities remain to be seen. We have already used the best burning, high energy and easily accessible coal. We are already using lower quality grades of coal that do not yield the same energy performances as coal did 50 years ago. There's also the practicalities of getting it. We are having to dig deeper and further, expending more energy in order to extract it. If we believe the estimates that say we have hundreds of years of coal remaining, do you know that these estimates include certain grades of rocks. Gas is similar to oil in that it will be exhausted within the century. The problem with Gas fields is that unlike Oil where it slowly declines, gas just suddenly drops off when fields become empty giving little warning. With North Sea Gas in decline the UK is having to rely on the pipelines from Russia for the delivery of its energy needs, last in the western European chain except for Ireland. Can we really trust Russia? A nation that is still suffering from decades of internal decline with a corrupt political system.

Where from here?

It will be interesting that is for sure. Our leaders are still in denial and will still not face up to the realities of a transition occurring in human history. If history is any guide US peak discoveries occured in 1930, with peak production occuring in 1970, 40 years later. Worldwide discoveries peaked in 1965, so have we passed peak? We will only know in hindsight. All I do know is that our society is ill prepared for a world with ever increasing demand for a finite resource that is critical to our economy and the modern lives we lead. This could well be the biggest challenge we face in the near term future. We currently have an economic system that demands growth. We are so obsessed with growth that when our economies contract we call it negative growth. There are some people that believe China will never be able to fully industrialise and they arrived just as the party was ending. Our financial system has been stretched to its limits, our ageing population is due to retire, we have record levels of debts that are becoming more expensive to service, savings are at record lows thus we have no store of capital to pay for investments, just future promises to pay other nations. All this would be a big enough challenge as history I have looked at has no parellels, however our main source of energy that has powered all of the above to historic highs is now running out. The credit crunch could evolve to become the energy crunch.

This is why I'm such a beliver in higher commodity prices over the comming decade. Oil is used in all parts of bringing products to the market, agriculture is dependant on it, mining of base metals is dependant on it and so on. If materials and basic staples such as food increases then this leads to more inflation. In another 5-10 years if you want to add value to your house you won't be adding a conservatory or granite worktops in the kitchen, you will be adding solar panels or wind turbines (in fact you will be knocking down the conservatory). That is what will happen. The UK has been too caught up in the hysteria of North Sea Oil and Gas, and failed when it had the chance to invest in its decaying public transport infrastructure which will inhibit mobility in the future. The US experiment with suburbia will come to an end and with it the billions (more likely trillons) of dollars that was put into the unsustainable American dream.

I am a believer in technology and the ingenuity of people. I studied Physics, Computing and Mathematics during my A-levels. But I also studied history, and for all humanties brilliance there are always times of sheer stupidity. We could be ushering in a new dark age, a collapse of order, governments falling and widespread anarchy. If the world leaders allow peak to pass, there is no going back and we will be racing against the clock to find alternatives while our oil infrastructure is expossed for its reliance on a finite resource and how dependant we have all become on it. The world will become smaller once again. There will be no one left to turn up the pumps.

"Through our inattention, we have wasted the years that we might have used to prepare for lessened oil supplies. The next ten years are critical."
Kenneth S. Deffeyes, Author of Beyond Oil: The View from Hubbert's Peak

"Oil depletion and climate change will create an entirely new context in which political struggles will be played out. Within that context, it is not just freedom, democracy, and equality that are at stake, but the survival of billions of humans and of whole ecosystems."
Richard Heinberg, Powerdown

Sunday, 21 September 2008

It must be bad if Greenspan says so

I saw a video of Alan Greenspan recently come out and say the current crisis is the worst he has seen in his lifetime.

View Video

Now if Greenpan is comming out and saying this it must be bad. I mean he was one of the prime causes for the mess we are in, blowing bubble after bubble, until it ended up in the current real estate bubble, which was just beginning to show signs of distress when he left the FED in 2006. How he can sit there all serious in TV appearances, I don't know. Within the past 12 months we have seen him say, the US may get a recession, to its 50/50, to we are in a recession, to only a few months ago saying the US hit a housing bottom, to now it is the worst financial crisis we have had in a 100 years. He knew all along it was going to be the worst financial crisis we had seen. However I don't think he will stop there. He may even admit in his next statement in another 3-6 months time, that irreversible damage is done and all Americans will have declining living standards for the forseeable future and so on. We could even see the end of the Federal Reserve itself over the next decade or so? Will this be his next claim?

Saturday, 20 September 2008

Short Selling - Another mistake of History Repeated

Well the FSA and American authorities have decided to ban short selling. Again if we look back to what occurred during the Great Depression and take a look at Murray Rothbards book:

"As early as mid-July, Hoover returned to a favorite theme: attacking short-selling, this time the wheat market. The short-selling speculators were denounced for depressing prices and destroying confidence; their unpatriotic “intent is to take a profit from the losses of other people” - a curious charge, since for every short seller there is necessarily a long buyer speculating on a rise. When the crisis came in the fall, the Stock Exchange authorities, undoubtedly influenced by Hoover’s long-standing campaign against such sales, restricted short selling. These restrictions helped drive stock prices lower than they would have been otherwise, since the short-seller’s profit-taking is one of the main supports for stock prices during a decline."

"Short-selling was - and usually is - the chief object of attack by demagogues who believed that short sales were somehow fundamentally responsible for falling stock prices, thereby forgetting that for every short seller there must necessarily be a buyer, and also that short-selling accelerates the necessary depression - adjustment in stock prices. Senator Smith Brookbart of Iowa had, as early as January, 1930, introduced a bill to prohibit all short selling."

Again Murray Rothbard is spot on, as short selling helps shake out unhealthy business models from the system at an earlier stage thus helping the bust. He also states that investment firms make money from short selling to cover their long losses. I think an explanation of short selling is required.

Short selling is the process where by an individual looks at a company and thinks it is overvalued, thus borrows the stock from someone who is holding the shares in a long position. They usually use leverage as this increases the amount of money they can make typically putting down say 10% of the total stocks value they have borrowed. They then sell the stock at the current prices and wait for the stock to fall. For simplicity say they buy £100 worth of stock at £10 each. They put down £10 to borrow them and they fall by 50% or are now worth £50 at which point the short seller decides to buy them back and give them back to the long position they borrowed them from. That would be £40 profit or in percentage terms 400% profit, which shows how much money can be made from this however, what happens if the stock goes up? Well this is where it can be very painful. If the stock goes up 50% you may get a margin call from your broker asking for a further £5 to ensure at least 10% down. If you can't cover that amount, and the stock keeps going up you are effectively in real trouble. If the stock never falls you have to buy those stocks back at the new price of £150 meaning a loss of 500% from the original amount (as the £10 is included in the £100 original total that was borrowed). A lot of Investors did this for Freddie and Fannie, Northern Rock and other financial firms during the end of 2006, the start of 2007, as they looked at the balance sheets and saw, well a train wreck in motion, and profited from it a lot. The reason I mention leverage is most people who do short selling are hedge funds, pension funds, investment banks etc, the very banks this new law is supposed to be protecting. Yesterday the finance stocks shot up 50% - 70% - however much I didn't really look at the specifics, but they shot up. Now the law said short positions had to be closed out, which means that those investment banks could have lost a lot of money yesterday as they would have had to buy the stocks back at a higher price in order to hand back to the long seller. This is one of the reasons the financial stocks rallied a huge amount. Of course some of the short positions could have been from months ago, even last year, however I imagine a lot of them would have been put on quite recently after the collapse of Lehman etc. So the law that was brought in for financial stability has in fact in all reality inflicted more damage on the banks balance sheets, all to give the stock market a boost and to have artificial stock prices. Its another government and regulatory blunder and in the long run will lead to more stock falls further down the line.

I also noticed the FTSE and Dow rallied by huge amounts, with the FTSE gaining 431 points. This happens in markets, Bear or Bull. Its goes down 600, goes up 400, down 400, up 250 etc. Of course if we get inflation over the coming years which I suspect the stock market may go up, but whats the point if inflation is just pushing the price up. Its like having a savings account giving interest of 2% while inflation is 4% - a net loss. If we wish to keep the comparison with the great depression have a look of how the Dow performed.

As I said in my Next Great Depression post, the stock market fell but kept rallying. What point do you think we are at? Number 8 ... 16? However I would be surprised if the above was to be repeated as the Central Banks have already been priming the printing presses. It's going to get interesting that's for sure.

Friday, 12 September 2008

The Next Great Depression?

A great deal can be learnt through history. In a practical sense its completely useless, as it merely just documents past events, but past events can help explain current and possible future events. If you can never get to grips with a subject matter it is best to look at history to try and to identify possible similarities. I have taken some quotes from a historical book and I think a lot of the quotes below could be said of the current situation we find ourselves in.

"If the Federal Reserve had an inflationist attitude during the boom, it was just as ready to try to cure the depression by inflating further. It stepped in immediately to expand credit and bolster shaky financial positions. In an act unprecedented in its history, the Federal Reserve moved in during the week of the crash—the final week of October—and in that brief period added almost $300 million to the reserves of the nation’s banks. During that week, the Federal Reserve doubled its holdings of government securities, adding over $150 million to reserves, and it discounted about $200 million more for member banks. Instead of going through a healthy and rapid liquidation of unsound positions, the economy was fated to be continually bolstered by governmental measures that could only prolong its diseased state."

"The Federal Reserve also promptly and sharply lowered its rediscount rate, from 6 percent at the beginning of the crash to 4.5 percent by mid-November. Acceptance rates were also reduced considerably. This enormous expansion was generated to prevent liquidation on the stock market and to permit the New York City banks to take over the brokers’ loans that the “other,” non-bank, lenders were liquidating."

"Dr. Anderson records that, at the end of December, 1929, the leading Federal Reserve officials wanted to pursue a laissez-faire policy: “the disposition was to let the money market ‘sweat it out’ and reach monetary ease by the wholesome process of liquidation.” The Federal Reserve was prepared to let the money market find its own level, without providing artificial stimuli that could only prolong the crisis. But early in 1930, the government instituted a massive easy money program. Rediscount rates of the New York Fed fell from 4.5 percent in February to 2 percent by the end of the year."

"During 1930, the Federal Reserve had steadily lowered its rediscount rates: from 4.2 percent at the beginning of the year, to 2 percent at the end, and finally down to 1.2 percent in mid-1931."

"President Hoover was proud of his experiment in cheap money, and in his speech to the business conference on December 5, he hailed the nation’s good fortune in possessing the splendid Federal Reserve System, which had succeeded in saving shaky banks, had restored confidence, and had made capital more abundant by reducing interest rates. Hoover had done his part to spur the expansion by personally urging the banks to rediscount more extensively at the Federal Reserve Banks. Secretary Mellon issued one of his by now traditionally optimistic pronouncements that there was “plenty of credit available.” And William Green issued a series of optimistic statements, commending the Federal Reserve’s success in ending the depression. On November 22, Green said: All the factors which make for a quick and speedy industrial and economic recovery are present and evident. The Federal Reserve System is operating, serving as a barrier against financial demoralization. Within a few months industrial conditions will become normal, confidence and stabilization in industry and finance will be

"By early 1930, people were generally convinced that there was little to worry about. Hoover’s decisive actions on so many fronts—wages, construction, public works, farm supports, etc., indicated to the public that this time swift national planning would turn the tide quickly. Farm prices then seemed to be recovering, and unemployment had not yet reached catastrophic proportions, averaging less than 9 percent of the labor force in 1930."

"During the second half of 1930, production, prices, foreign trade, and employment continued to decline. On July 29, Hoover called for an investigation of bankruptcy laws in order to weaken them and prevent many bankruptcies—thus turning to the ancient device of attempting to revive confidence by injuring creditors and propping up unsound positions."

"As a consequence, while the immigration law had already reduced net immigration into the United States to about 200,000 per year, Hoover’s decree reduced net immigration to 35,000 in 1931, and in 1932 there was a net emigration of 77,000. In addition, Hoover’s Emergency Committee on Employment organized concerted propaganda to urge young people to return to school in the fall, and thus leave the labor market."

"He hailed the Federal Reserve System as the great instrument of promoting stability, and called for an “ample supply of credit at low rates of interest,” as well as public works, as the best methods of ending the depression."

"As 1931 drew to a close and another Congressional session drew near, the country and indeed the world were in the midst of an authentic crisis atmosphere—a crisis of policy and of ideology. The depression, so long in effect, was now rapidly growing worse, in America and throughout the world. The stage was set for the “Hoover New Deal” of 1932."

"During 1929, the Federal government had a huge surplus of $1.2 billion"

"From a modest surplus in 1930, the Federal government thus ran up a huge $2.2 billion deficit in 1931."

"One thing Hoover was not reticent about: launching a huge inflationist program. First, the administration cleared the path for the program by passing the Glass–Steagall Act in February, which (a) greatly broadened the assets eligible for rediscounts with the Fed, and (b) permitted the Federal Reserve to use government bonds as collateral for its notes, in addition to commercial paper"

"Thus, the Hoover administration pursued a giant inflationary policy from March through July 1932, raising controlled reserves by $1 billion through Fed purchase of government securities. If all other factors had remained constant, and banks fully loaned up, the money supply would have risen abruptly and wildly by over $10 billion during that period. Instead, and fortunately, the inflationary policy was reversed and turned into a rout. What defeated it? Foreigners who lost confidence in the dollar, partly as a result of the program, and drew out gold; American citizens who lost confidence in the banks and changed their deposits into Federal Reserve notes; and finally, bankers who refused to endanger themselves any further, and either used the increased resources to repay debt to the Federal Reserve or allowed them to pile up in the vaults. And so, fortunately, inflation by the government was turned into deflation by the policies of the public and the banks, and the money supply dropped by $3.5 billion."

Notice some parallels between the present and the period being described above? The things I find most striking are the fact the FED drastically cut rates from 6% to 1.2%, compared with today in which they cut from 5.25% to 2% at present. Also the fact that at the beginning of the bust the government were running huge budget surpluses, and within a couple of years were running huge deficits, compared with now where the US has persistently for years now been running up huge deficits which will get worse.

Of course the period being described was the Great Depression and the Quotes were taken from Murray Rothbards book, Americas Great Depression. Contrary to what people believe the great depression was not suddenly brought about after the infamous stock market crash in October 1929, it was brought about over a 3-4 year period of excessive monetary inflation in the previous years during the 1920's boom and increasing inflationary policies during the bust along with increased government interference, which made the Depression so great. In fact the stock market also rallied during this time and didn't bottom out till around 1933. Hoover was the creator of the New Deal, Roosevelt just merely carried on with it with even more enthusiasm contary to the myth that Hoover had a no hands approach to the economy. In the end this is where we now stand,

"But here, in the crisis of 1933, the banks could no longer continue as they were. Something had to be done. Essentially, there were two possible routes. One was the course taken by Roosevelt; the destruction of the property rights of bank depositors, the confiscation of gold, the taking away of the people’s monetary rights, and the placing of the Federal Government in control of a vast, managed, engine of inflation. The other route would have been to seize the opportunity to awaken the American people to the true nature of their banking system, and thereby return, at one swoop, to a truly hard and sound money."

We all know what happened in subsequent years. Nixon removed the US from the gold standard, and in effect all western currencies from gold as bretton woods was dissmantled. Now the dollar and world currencies are backed with nothing as we enter another dissasturous chapter in history of fiat currency.

If we wish to draw the parallels to today, roughly in 1928 real estate prices began to fall compared with 2006 in the US. 1929 and stock prices began to fall, compared with 2007 when the Dow was at its all time high. So what does that mean in the next few years if we are only at 1930. Well we have a lot further to go and the governments and Central Banks are doing exactly what history has taught us not to do.

However there are differences, which I believe position the US in a worse position. Back then the US had huge budget surpluses in previous years, exported goods throughout the world and had huge oil reserves (cheep energy reserves which can never be overstated). They also theoretically had the dollar backed by Gold which meant even though the FED tried to inflate they were constrained, where as now it is a complete fiat currency meaning there will be no limits to inflate this time. Ben Bernanke the current head of the FED is supposedly a student of the Great Depression but from what I've seen, he's repeating what was done 75 years ago, and he's doing a pretty good job of fooling everyone. Nationalising Fannie and Freddie Mac, that were created at the end of the Great Depression, is an absolute disaster as I have said before, and is exactly what President Hoover and the FED would have done during the last depression.

I will end on the following note from Murray Rothbard. Maybe we are facing another depression and crisis of the same magnitude? Or worse?

"What was the trouble? Economic theory demonstrates that only governmental inflation can generate a boom-and-bust cycle, and that the depression will be prolonged and aggravated by inflationist and other interventionary measures. In contrast to the myth of laissez-faire, we have shown in this book how government intervention generated the unsound boom of the 1920s, and how Hoover’s new departure aggravated the Great Depression by massive measures of interference. The guilt for the Great Depression must, at long last, be lifted from the shoulders of the free-market economy, and placed where it properly belongs: at the doors of politicians, bureaucrats, and the mass of “enlightened” economists. And in any other depression, past or future, the story will be the same."

Saturday, 6 September 2008

Credit Crunch Part II and Beyond

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."
Fed chairman, Ben Bernanke, Congressional testimony, March, 2007

“When written in Chinese, the word "crisis" is composed of two characters-one represents danger, and the other represents opportunity.”
John Fitzgerald Kennedy, 35th US President

When the credit crunch began last year a lot of people didn't seem to realise the severity of what was happening. People saw stock markets fall and massive liquidity injections, and thought it wouldn't effect them. As soon as I heard the news and saw the footage, I knew this was the beginning of something, a once in a life time experience. The financial institutions realised the music had stopped and now came the consequences of decades of monetary expansion. The Credit Crunch is just the beginning of the start of something much worse. To use an analogy of a car crash, the credit crunch was just the person seeing what was coming and putting the brakes on. The real pain is yet to come.

We are entering the next stage of the crises, Credit Crunch Part II. Central banks have been busily infusing huge amounts of money into the private banks, through the swapping of Treasuries for the banks alphabet soup of deadly cocktails of debt. At what point will Central Banks stop? There has to be a limit, I mean they are effectively taking over the market, a market which is massive. This is the juncture we are at, where the Central Banks will soon begin to slow the liquidity they provide and start getting a lot more selective. British banks have been issued huge amounts of money, and not just from the Bank of England, but from the FED and the ECB due the global connectivity of banks. British Banks are in fact in a terrible state, which doesn't surprise me as I warned the economy was too reliant on finance. This is the part in the chapter where lending begins to get a whole lot tighter.

The media continually report that all these liquidity schemes will soon have banks lending back to the recent decade of reckless standards, however this will not be the case for decades. Libor is still showing great signs of stress, and will continue to do so. We are entering the phase where job losses will really start picking up, losses will keep increasing on debt, governments deficits and debt will keep going up. Worldwide currencies are fluctuating everywhere, the price of gold will begin to rise over the coming years. Incomes are being squeezed. Credit Crunch Part II will be much worse than last year and I can see major problems in the system in October, and definitely once the next president is in office at which point the recent rally in the dollar should resume its decline. Its the beginning of the impact in the car crash analogy, a realisation of the trauma and pain to come.

Looking beyond Credit Crunch part II the next decade will be completely different to now. Prices of stocks and property won't reach their 2007 highs until at the earliest around 2022 (unless hyperinflation occurs at which point you won't care what those are worth). This is a huge leveraged boom and the fallout will be very severe, for the world. Old powers will slowly collapse from within, and new powers will rise and replace those who have lost principles of thrift. Currencies will collapse and be replaced by new ones or nations will converge into single currencies. Present future liabilities will be realised as those future debts will now become a reality, staring my generation in the face. Industry will change, to quote,

"During the great bear market in commodities that began in the 1980s and carried into this decade, very few college entrants dreamed of becoming engineers and geologists to work in the commodity sector, but instead poured into finance and technology related degrees. This has created a vacuum in available talent that will only get worse with the retirement of many existing engineers and geologists that received their degrees in the last commodity bull market of the 1970s."

My father is included in the above description, and as global energy and commodities demand increases in the future he may even come out of his coming retirement to take part in the greatest boom since he started in the industry.

It will be an interesting time to live in and I personally can't know for certain the outcome. All I do know is that at this present time, with the facts as they stand, a similar future as described above seems very likely.

Tuesday, 2 September 2008

Panic Intervention

"If you look at this situation, because we've got low inflation we can cut interest rates, because we've had low debt we can afford to keep our public spending programme in line and to borrow at the right time to help the economy come through difficult times."
Gordon Brown 8/4/2008

"The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced, if the nation doesn't want to go bankrupt. People must again learn to work, instead of living on public assistance. "
Cicero, 55 BC

It seems that it is finally dawning on people that the UK is about to enter a recession. With zero growth reported for the last quarter the credit crunch is beginning to show up (as explained before due to statistical manipulation we will actually be in negative growth territory already due to hedonic and substitution manipulation of GDP data). Credit is being destroyed and all the bad loans are only just starting to surface with rising arrears in the UK banks. Job losses are starting to gain momentum and will keep rising over the coming years.

When faced with a deteriorating economy the best thing the government and institutions can do is nothing. Of course this would not be a popular policy with people so politicians always do the exact opposite. This was mentioned in the previous posts and I'm afraid this will prolong the economic misery and draw out the crisis further. America will probably nationalise fannie and freddie mac, huge institutions in the mortgage market across the pond. This is a disaster and the FED seem intent on propping up and monetarise this bad debt (which in the long run will result in further inflation). The UK it seems is now proceeding to carry out similar policies by cutting stamp duty and support bad debt. The Tories suspended stamp duty in the last recession, and they openly admitted after that it had done more harm then good, and cost hundreds of millions of pounds.

Gordon Browns popularity is at record lows in all the polls, and he is constantly being questioned on his leadership so it is no surprise that for his own political goals he wants to try prop up the housing market and be seen to be doing something. This is the politically popular thing to do, however this will be a disaster in the medium to long term for the UK. They have already nationalised Northern Rock, with a lot of bad debts, which again will cause pain for the UK in the long run. By trying to artificially inflate a flagging market, it will take longer for the required adjustments to take place and more pain and monetary inflation for the average person. And why prop up house prices? It diverts money away from productive enterprises into a sector that is priced based on the surplus that the productive economy produces. What we should be doing is letting this bad debt get written off and more importantly letting the banks deal with the handling of this. You don't see the government deciding to subsidise the IT industry when the dot com bubble burst as most businesses that collapsed were running unsustainable business models. Business models where start up IT companies had no earnings. Similar to buy to let landlords who are subsidising rents in the hope of capital gains. A unsustainable model. A free market economy should be left to its own devices.

Of course the reason institutions are beginning to prop up companies and monetarise debt, is the credit boom we have just witnessed has been the largest in history and has been allowed to go on for too long and inflate too much. I believe it is that big, that if the printing presses were not to be run then we would witness the collapse of the financial system. The deflation would be immense and there wouldn't be the money in the system to keep pay the existing debt created and the public would find out that the current system we operate in has been allowed to fail. Remember we have had inflation in the past decade, however this has not shown up in consumer goods that we purchase. It has gone into assets - stocks, houses and debt. Now however we have turned a corner and the credit expansion has begun to break down, under the weight of just paying the interest on the current debt. Therefore defaults occur and this debt which is based on future earnings, has to be effectively taken out of the current time frames monetary earnings. This is hugely destructive and why banks are getting Treasury Bills from central banks, to try and replenish the little capital that is available at this current time frame. Asia and places have also absorbed a lot of inflation for us, by buying up dollars and euros etc. However they are now beginning to want to diversify their holdings, interestingly into Gold. Of course they can't dump all their dollars onto the market at once. Take for example China who hold $1.5 trillion dollars, they want to move slowly out of the dollar, but can't immediately as this would cause a collapse in the dollar thus rendering their reserves worthless (also collapsing China's biggest customer). This will be an interesting area in the future, with a lot of pain for westerners. The Russians, Saudis and Japanese also holds huge dollar reserves which is one of the reasons America can have 2% interest rates, while inflation is running at around 4-5% (actually more like 8-9% using real inflation) - other nations are funding Americas consumption.

There has been a downturn in commodities recently as I said this will occur in the short run as there are always consolidations along the way. This will only be a temporary correction, and the prices of "stuff" will increase further in the long run. What will further support high prices is the fact that the FED are determined not to let deflation take hold, which means they prefer inflation for the economy. Ben Bernanke has already stated that under a fiat currency (which all western countries have) Central Banks can always inflate and print infinite amounts of money. Sounds a bit worrying? 1970's again? Stagflation? A prolonged period of deteriorating living standards for people, however a lot of the factors are now in worse shape than they were in seventies. Larger debts, decreasing wages, and the emergence of the BRIC nations (Brazil, Russia, India and China).

There are three options, in my opinion, that Central Banks and governments could choose to handle the current situation:

  • Default on the debts - would lead to currency collapse, and probably starvation and result in 3rd World Living standards as we import most things, so a collapsing currency would render our purchasing power obsolete. This is therefore not an option.

  • Deflation of the Credit Bubble - Leave the system to self correct. Credit would be destroyed, wages would drop but so too would prices of goods therefore offsetting drops in wages thus keeping purchasing power. The problem with this option is the debt of governments and individuals would increase in real terms as wages and government income drops. This is what happened during the Great Depression as money contracted, debt increased even without more debt being created. However the debts we have currently are a larger percentage of GDP then they were around 1932 - well into the Great Depression and after a couple of years of deflation. This will not be an option in my opinion as Western economies generally have huge amounts of external debts to other countries, in particular America (Also liabilities for the ageing of society). The debt would increase as would the interest payments on the debts, therefore could result in the above, default.

  • Inflation - Governments and Central Banks replace the credit being destroyed with new money, in effect trying to re inflate the bubble at all costs, thus causing inflation. This in effect erodes debt and ensures the debt mountain does not increase if the natural course of deflation was to take place (the above situation). Throughout recent history governments have always favoured inflation or known as the stealth inflation tax (as people are always confused as to who to blame for inflation and governments can blame others for monetary inflation) and have always intervened in markets. This option will prolong the crises for some time and cause incomes to be squeezed. The endgame will be deflation when the public become sick of inflation (hyperinflation in the worst case) and demand a return to sound currency and a stable money system. At this point the government have to contract the money supply and to ensure it has value (late 70's, early 80' double digit interest rates). I suggested this scenario in my previous post and all the facts available point to this outcome. However, what happens if the deflationary forces are too powerful? What happens if the central banks can't inflate? If people begin to hoard cash?

There are a lot of issues Western Economies will face over the coming years and the price of homes is not one of them. A return to sane price levels should be welcomed, as money and effort is required in more pressing areas of our country. It is not the job of society to bail out bad loans and irresponsible individuals (and bad government regulation of the fractional reserve banking system). Let businesses fail and prices adjust and then the government and system can be exposed for the flaws it contains and ensure the excesses do not occur during another boom. If it collapsed we could even discuss a possible replacement to the current financial system and replace it with a more stable and robust model that is more beneficial for the majority rather than the informed minority.