False Signals and Unrealistic Hopes
We were missing that old fraudster, Alan Greenspan. What had become of him, we were wondering. The wisest, wiliest, most powerful human being on the planet seemed to have gone dark after he left his post at the Fed. We thought we’d never hear from him again.
The Daily Reckoning PRESENTS: Where finance is concerned, the basic implication of peak oil is pretty stark: an end to industrial expansion. If there is no longer any hope of increased wealth in the world, then all those tradable paper markers become losers. Their value unwinds and imagined piles of wealth evaporate into thin air. James Howard Kunstler explores…
FALSE SIGNALS AND UNREALISTIC HOPES
Against the background of everything else happening in the financial markets is the apparent circumstance of peak oil. Even The New York Times joined the chorus in a Sunday editorial, saying:
“Our demand for petroleum products strains the limits of the global capacity to supply them. In past decades, if a pipeline broke in Nigeria, Saudi Arabia might compensate by setting workers to pumping more oil. Now, with little additional capacity, rising prices are necessary to balance out supply and demand.”
No more increasing capacity = peak oil.
It’s as simple as that. We now have nine and a half months of “rearview mirror” action to look back and see that world oil production has retreated from its all-time high of just over 85 million barrels a day (m/b/d) achieved in December 2005 (just as geologist Kenneth Deffeyes of Princeton had predicted). For 2006, production has remained in the 84 m/b/d range every month reported so far, while demand has exceeded that.
Texas oil man Jeffrey Brown, a commentator at TheOilDrum.com, the outstanding oil discussion group on the Internet, makes the point that Saudi Arabia is at the same point statistically (in terms of ultimate recoverable reserves) that Texas was at in 1972 when production there peaked. The world’s four greatest oil fields are in depletion (Burgan [Kuwait], Daqing [China], Cantarell [Mexico], and Ghawar [Saudi Arabia]) and these have accounted for over 14 percent of the world’s oil production. (Ghawar alone accounts for over 60 percent of Saudi Arabia’s production.) The North Sea has peaked and production there is “crashing.”
Venezuela has peaked and its oil is low-quality heavy crude. Indonesia (an OPEC member) has peaked and is now a net oil importer. Nigeria’s political chaos is making production increasingly difficult-to-impossible. Production in the Canadian tar sands is not making up for losses elsewhere. The United States is down to about a four-year supply of conventional crude and condensates while we import 70 percent of the oil we consume. Discovery of new oil (including Chevron’s largely hypothetical deepwater “Jack” finds) is barely covering a fraction of the world’s consumption. So it goes….
Where finance is concerned, the basic implication of peak oil is pretty stark: an end to industrial expansion (i.e. “growth”). All the alternatives to oil will not keep the industrial economies expanding – they can only slow down a contraction, and only marginally so. The trouble with this picture is that finance is a system that uses paper markers to represent the hope and expectation for the expansion of wealth. These markers are currencies, stocks, bonds, option contracts, derivatives plays, and other certificates that are traded in open markets. If there is no longer any hope of increased wealth in the world, then all those tradable paper markers become losers. Their value unwinds and imagined piles of wealth evaporate into thin air.
The unwinding process depends on the psychology of the people who own these certificates. If they do not understand the global oil situation and its implications, then they will continue to hope for and expect expanded wealth, and thus continue to regard their paper certificates as credible markers of value. And that is largely the case at the moment, since most of the playas in the financial markets are not paying attention to the peak oil story, or don’t believe it is for real.
Two special and transient circumstances are now propping up the financial markets. One is that for practical purposes the world is virtually at peak, meaning this is an extra-special time of strange behavior (like the point in the apogee of a steep sub orbital flight in which passengers become momentarily weightless). Supply and demand for oil are only beginning to go out of whack (that is, demand just barely exceeding supply). Even at this early stage, the oil markets themselves are showing stress, as hoarding behavior sets in and induces wider swings of price volatility. But these swings in oil prices – such as the one we’re in right now, where prices have crashed 20 percent since the panic buying (hoarding) of June and July – send false signals to the financial playas. The main false signal is that all is well on the global oil scene…there’s no real supply problem…and hence no threat to the continuing expansion of industrial production and its associated wealth-generating activities. This signal just tells the playas to buy more paper markers. Thus, the stock market goes up.
The second special and transient circumstance is that so much wealth has already accumulated along the way to peak, that financial markets take on a life of their own – as existing wealth “invests” itself in more paper markers hoping and expecting to “grow” into even more wealth. The problem here is that existing wealth is actually being squandered, since the paper markers will only lose value as the hopes and expectations vested in them dissolve in disappointment. But we haven’t quite reached that point yet.
In simply bidding the markets up, the system has spun off even more gobs of presumed wealth. Some of this “liquidity” – say, in the checking accounts of people who work for Goldman Sachs – has found its way into Manhattan condominiums, or Aspen McMansions, and filtered through the system to everyone from the lawyers who write up the pre-nuptial agreements to the guys who sell the furniture to the people who drive the delivery trucks that bring it to the door, to the men laying tiles in the new bathrooms.
The basic insanity of a system that presumes vastly increased wealth where none will occur, has led to further distortions in finance. The most obvious one is the so-called housing bubble. The misplaced extreme expectation in the ever-increasing value of paper wealth, led to the hijacking of mortgages by financial playas who bundled them into odd lots of tradable debt (promises to pay) and used them to leverage abstruse bets (hedges) on the behavior of other kinds of paper markers (currencies, interest rate differentials, commodity prices) – very profitably as long as all playas believed that industrial societies that run all oil would continue to grow, to produce more wealth. The level of abstraction in these rackets – their distance from the reality of productive activity – is self-evident.
But they were so successful that the profligate creation of ever more mortgages became an increasingly reckless and irresponsible enterprise. Contracts were made with house-buyers who had no record of credit worthiness and often no real proof of income. Contracts were made on terms (interest payments) that were deceptive, even ruinously false, for the house-buyers. The reckless reassignment of lending risk into ever more abstract layers of deferred obligation, and the ease of credit that ensued, allowed millions of ordinary people to acquire real property on unrealistic terms, which had the affect of bidding up the price of houses that these owners will eventually have to surrender for nonpayment.
That process is now underway. The reckless creation of mortgages had the further effect of stealing demand for house-building from the future. So many new houses were built and then sold to people who will probably have to surrender them, and then so many more beyond that were built in the expectation and hope that reckless mortgage creation would continue forever, that there is now a massive over-supply of total existing houses while the pool of suckers for new ruinous mortgages has shrunk to zero.
Similar excesses in all the other lending and debt sectors, including “non-performing” credit card obligations and government deficits, will also unwind and thunder through the system.
Meanwhile, the false signal from the oil markets that has been broadcasting for eight weeks will come offline and a new signal will come on as prices go back up. The pause in bidding for future oil induced by the panic over-buying of the summer will end. The heating season is here. It’s 40 degrees out in upstate New York this morning and the furnace is cranking. The Chinese and the Indians and even the people in France have not stopped using oil, even if Americans have put their Winnebagos up on blocks for the season.
As the price of oil goes back up, the financial markets will get a new signal that running industrial societies has just gotten more expensive again. That will dampen hopes and expectations for increased wealth from these societies. Meanwhile, the air will be coming out of millions of mortgages, and the loss of value will spread among playas holding these bundles of mortgage debt (i.e. promises that money spent on houses is being paid back, which it won’t be). At the same time the houses themselves will lose value as the pool of potential buyers shrinks to nothing. That is, the inflated value (high price) of these assets will deflate.
As this occurs, there will be far fewer wage earners putting up additional houses, fewer furniture sales, fewer trips by delivery truck drivers and fewer tile-jobs in the McBathrooms.
This is why I view the fall melt-up of the stock markets as a swan dive. We’re at the apogee now, just as the world is at the apogee of its oil production. I confess, I thought the reality of our economic predicament would be recognized by the playas and their markets sooner than it has. It turns out the chief luxury of the final cheap oil blowout has been the artificial support of unrealistic hopes and expectations.
James Howard Kunstler
for The Daily Reckoning
October 10, 2006
Editor’s Note: James Kunstler has worked as a reporter and feature writer for a number of newspapers, and finally as a staff writer for Rolling Stone Magazine. In 1975, he dropped out to write books on a full-time basis.
His latest nonfiction book, “The Long Emergency,” describes the changes that American society faces in the 21st century. Discerning an imminent future of protracted socioeconomic crisis, Kunstler foresees the progressive dilapidation of subdivisions and strip malls, the depopulation of the American Southwest, and, amid a world at war over oil, military invasions of the West Coast; when the convulsion subsides, Americans will live in smaller places and eat locally grown food.
You can get more from James Howard Kunstler – including his artwork, information about his other novels, and his blog – at his Web site:
But yesterday, the man surfaced…like a beluga whale in Canada. Speaking to a private, audience he said that the house price bubble – and incipient bust – were not his fault.
“I don’t think that the boom came from a 1 per cent Fed funds rate or from the Fed’s easing. It came from the collapse of the Berlin Wall,” Mr. Greenspan told his listeners.
The Financial Times reports:
“The former Fed chairman said the collapse of Communism in Eastern Europe and the shift towards more market-based economies in China and other parts of the developing world brought ‘billions of cheap labourers onto the scene.'”
“This,” he said, “brought disinflation and lowered inflation risk premiums and long-term interest rates, creating a decline in real interest rates and equity-risk premiums.” In consequence, “the real market value of assets increased faster than GDP”.
There is undoubtedly some truth to what Greenspan says. But this is one of those occasions for which the word ‘disingenuous’ must have been invented. Yes, global integration probably has reduced inflation expectations, thus permitting lower interest rates and higher asset values. But without the active aiding and abetting of the Fed, which set the Fed Funds rate under 2% – i.e., below inflation – for 35 months, the boom in housing prices would probably never have turned into a bubble. And millions of Americans would still be solvent today. Globalization may have lowered inflation rates…permitting lower interest rates. But globalization didn’t bring with it lending rates below the rate of inflation. Those negative lending rates were not imposed by Mr. Market, but by Mr. Market Manager Greenspan.
A negative lending rate is a marvel. It allows a speculator to borrow, knowing that he can repay less than he was lent. Negative lending is to the financial world what a negative-calorie dessert would be to Sara Lee or a negative-year prison sentence would be to a bank robber. You can imagine, dear reader, what mischief they would cause.
Even at low real rates of interest, a borrower has to be careful. But what kind of care is needed when you are guaranteed to make a profit, merely by borrowing?
The actual effect of the Fed’s sub 2% rate is now history…well, a history that is still being written, one painful page at a time. That it brought about a huge bubble in housing prices is beyond question. It also helped sustain the whole U.S. economy…and, by extension, the economy of the whole world. Goldman Sachs calculates that since 2002, American homeowners have been able to “take out” enough money from their houses to add 2.5% a year to real GDP growth – which was most of it.
And now, it appears that the bubble is deflating. The Fed is no longer giving away money. And the housing market is no longer bestowing big gains on homeowners. The granite countertop business is slowing down…along with the rest of the housing-manufacturing complex.
If Mr. Greenspan were right, investors could expect high asset prices for a long time. Global trade, after all, is not likely to disappear any time soon. Why should house prices go down then? Or stock prices, for that matter?
But now, even the Maestro concedes house prices are going down. Only, he says, it is because houses have become unaffordable. And he guesses that the worst of the housing slump is already behind us.
And who knows? He could be right. But an investor has to play the odds. What are the odds of making serious gains in stocks at today’s record prices? What are the odds of making serious gains in houses? What are the odds that Mr. Greenspan knows better?
We wait to find out.
Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…
“If you look at the U.S. dollar as the ‘stock’ of the U.S., the dollar’s value has corresponded directly to the level of the Current Account…is the dollar not down vs. the euro by almost 50%? And what has the Current Account done since 2002?”
For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig
And more opinions…
*** The real problem, according to Forbes magazine, is not the credit derivatives…it’s the credit swaps:
“If you want to fret over the next financial catastrophes, turn your gaze away from energy futures and focus on something far more obscure: credit default swaps. Hedge funds are neck-deep in these derivatives, and if something goes wrong, the pain will be widespread.
“A credit swap is an insurance policy on a bond, often a junk bond. The fellow selling the swap – writing the policy, that is – collects a premium. If nothing goes wrong, he pockets the premium and looks like a financial genius. But if the bond defaults, the swap seller has to make good. The notional amount – the aggregate of bonds, loans and other debt covered by credit default swaps – is now $26 trillion. This is a staggering sum, twice the annual economic output of the U.S.
“Selling a credit swap is equivalent to buying the corporate bond on margin,” Forbes continues. “If you buy a junk bond with borrowed funds, you collect the high coupon on the bond while paying out a lower amount, presumably not too much more than what the U.S. government pays to borrow money. Either way – with a swap or a margined bond trade – you pocket the spread, unless and until the corporate bond gets into trouble, at which point you’re sitting on a painful capital loss.”
What is going on? We keep gazing over our shoulder and wondering about the big picture. In the late ’90s, people would buy tech stocks with no earnings, no revenue and no future. And they’d lend money to companies with no means of paying them back – at a paltry one or two percentage points over U.S. Treasury yields.
They figured they couldn’t go too far wrong…because interest rates were sinking…and because there was always the “Greenspan Put,” the notion that if things started to slip, ‘Bubbles’ Greenspan would lower the cost of money even further.
Of course, the Greenspan Put didn’t save the tech stocks. But it seemed to save the Dow and the economy. It arrived in the investment markets like a bottle of whisky among teenage boys. It eliminated Fear.
The confidence of the late ’90s was stirred by the rout in the NASDAQ…but it was never entirely shaken. Now, speculators take bigger and bigger risks…. with more and more leverage. Derivatives, loans to Thailand and Goldman. Swaps…there is no sense of fear anywhere in the market.
But fear is alive and well in the political world. Yesterday, news spread that North Korea had exploded a nuclear bomb. While the United States squandered its military forces, fighting the least of our enemies, the greatest of them proceeded to build nuclear weapons. But, when the news exploded on the world financial markets, it turned into a dud. Gold rose a few bucks. Asian markets gasped, briefly. Then it was business as usual.
Business as usual is the way business usually is. But usual changes with the seasons and the cycles. There was a time when people had more appreciation for risk…more reluctance to invest or lend…and great fear that something would go wrong. When that sentiment comes around again – and it will – a lot of swaps, credit derivatives, house prices, mortgages and junk bonds are going to look like very bad investments.
Ask Charlie T. Munger. The vice chairman of Warren Buffett’s Berkshire Hathaway describes how his company lost $404 million unwinding credit, interest-rate and foreign-exchange derivatives positions in its General Re unit:
“When we ran it off, it didn’t run off at anything like book value,” Munger says. “I would bet a lot of money there are some terrible valuations on the books of corporate America.”
We would bet it too.
*** A Dear Reader writes:
“I understand your bewilderment over the Chinese people allowing Mao to destroy them without a peep. I feel exactly the same way about the American people fiddling around while Bush burns America to the ground. Obviously we are dealing with the human psyche here and the power of perception.
“People will believe anything and see or not see anything according to their vision of themselves, their vision of others, and their vision of their country. It really doesn’t matter if the vision is accurate.
“America has a self-image problem. We think we’re the greatest nation on the earth. We think we are always the good guys. Ronald Reagan thought of himself as the heroic small-town sheriff. George W. thinks of himself as a benevolent emperor. Russia was the ‘Evil Empire.’ Iraq, Iran, and N. Korea are the ‘Axis of Evil.’ These are comic book terms and America sees itself in juvenile comic book terms. It’s always clear who the good guys are and who the bad guys are and we like it that way.
“I will cut this short and just say that what is happening in America is that America’s shadow, in Jungian terms, is breaking out and wreaking havoc in the world and at home. Americans have denied their dark side for a long time and now the dark side is in charge of the country. George W. Bush is the perfect person to represent America’s shadow, but in order to see him for what he is, we would have to see ourselves and our own denial and avoidance. We would have to see that we are as stupid as the Chinese under Mao.”
[Ed. Note: As we said in Empire of Debt, people come to believe what they need to believe when they need to believe it. Like our dear reader so aptly pointed out, it doesn’t matter if what they or what they believe is accurate. It’s what helps them sleep at night. Unfortunately, their clouded vision will clear eventually – and they will be in for a nasty surprise. Make sure you aren’t left in the dark…get your copy of Empire of Debt here: