Globalisation and the costs of international trade from 1870 to the present - Vox EU

Summary:
Many analysts suggest that rising oil prices will sharply reduce international trade. This paper argues to the contrary, noting that transport costs constitute a limited share of trade costs (about 1/3rd). Instead of transportation costs, the biggest reversal of international trade in recent history is linked to large increases in protectionist measures. Moreover, evidence from the first wave of globalisation suggests that higher shipping costs are unlikely to significantly dampen international commerce – only protectionism would seriously threaten trade. Compared with historical patterns, the level of bilateral trade costs is still high for many country pairs, especially for those that are far away from each other. This means that there is scope for trade costs to fall further. Unless there is a backlash in the form of rising protectionism, world trade has the potential to keep growing strongly over the coming decades. (Published: 16/08/08)

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The Dangerous Myth of Energy Independence - Informed Comment

Summary:
Robin M. Mills argues that the world is not running out of oil, that the current high energy prices are the result of a long period of low prices and under-investment, as well as irrational hostility between suppliers and consumers. Ideas about forestalling an oil crisis by ‘energy independence’, or by military action, are mistaken. The proper energy policy should be energy security, not energy independence. Objective profoundly harmed by climate, with elements of paranoia, racism and Islamophobia. Energy security is achieved when suppliers find markets, and markets find supply, at prices permitting both of them economic stability and growth, which requires a complex web of inter-relationships between producers and consumers. Policies to encourage US domestic production, increase efficiency and introduce alternative energy sources are desirable, often for environmental rather than energy security reason, but they have to be pursued with vigour and resolution. Promises to ‘jawbone’ OPEC into supplying more oil sit very oddly with the US’s uniquely comprehensive moratoria on offshore oil and gas production. Need a rational and balanced dialogue about how to co-operate on bringing that abundant energy to consumers. (Published: 02/09/08)

Comment:

• current high energy prices emerge from a long period of low prices and under-investment
• fruit of the breakdown of international energy relationships in the oil crises of 1973-4 and 1978-80
• high prices are not due to a lack of resources in the ground
• remains vast potential around the world for increasing recovery from
  
• existing fields,
  
• discovering new oil, e.g. recently deepwater Brazil
• largely untouched US offshore
• ‘unconventional’ sources such as Canada’s famous ‘oil sands’
• biofuels
• synthetic fuels from natural gas and coal, and others
• ideas about forestalling an oil crisis by ‘energy independence’, or by military action, are therefore mistaken
• such ‘solutions’ are likely to create the crisis they seek to mitigate
• proper objective of energy policy: not independence, but security
• objective profoundly harmed by climate, with elements of paranoia, racism and Islamophobia
• energy security is achieved when suppliers find markets, and markets find supply, at prices permitting both of them economic stability and growth
• requires a complex web of inter-relationships between producers and consumers
• attempts by a major nation to achieve energy self-sufficiency are very distorting to economic competitiveness
• even worse when bad relations with major energy suppliers, and conflicting messages about future energy policy, discourage much-needed investment
• if one side believes they are buying oil from terrorists, and the other thinks they are selling to neo-imperialists, it is not surprising that
  
• oil prices are high
• investment is lacking and
  
• most of world oil reserves are monopolised by state companies
• the Middle Eastern nations have generally been very reliable suppliers, and use of a mythical ‘oil weapon’ is very unlikely
• any régime would be reliant on its oil earnings to sustain the economy
• while strategic reserves in the industrialised countries give some ‘staying power’ to outlast an embargo
• policies to encourage US domestic production, increase efficiency and introduce alternative energy sources are desirable
• often for environmental rather than energy security reasons
• but: they have to be pursued with vigour and resolution
• US energy policy has been more erratic and hostile to increasing output than most of the Middle Eastern countries
• ‘pork barrel’ subsidies and the interminable, inconclusive debates over whether to open new exploration areas, build new pipelines and terminals for clean natural gas, extend support for renewable energy and increase mileage standards
• promises to ‘jawbone’ OPEC into supplying more oil sit very oddly with the US’s uniquely comprehensive moratoria on offshore oil and gas production
• military ‘control’ of oil is not achievable or cost-effective
• expenditure on such wars vastly exceeds the value of any oil ‘secured’
• while production can struggle along in war-torn areas, it is impossible to develop major new fields
• ‘Police actions’ to deal with specific threats are entirely reasonable
• as long as they are multi-lateral and proportional to the danger posed
• and carried out competently
• grandiose military adventures destroy the co-operation which is essential for global energy trade
• ‘Energy independence’ is a chimera, expensive, unachievable, and swimming against the tide of greater global economic integration
• world is not running out of oil
• we need a rational and balanced dialogue about how to co-operate on bringing that abundant energy to consumers
• if the profound misunderstanding of, and hostility towards, the Middle East, continues, the house of energy security is being built on sand

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Oil refining byproduct becomes a hydrogen goldmine - R&D Magazine

Summary:
A commercial-scale process to extract and reuse pure hydrogen from the hydrogen sulfide that naturally contaminates unrefined oil, including oil sands, has been developed by a collaboration between the U.S. Dept. of Energy's Argonne National Laboratory and Kingston Process Metallurgy Inc. (KPM) of Kingston, Ontario. It is less energy- and capital-intensive that existing processes, such as the Claus process. The reactions between the hydrogen sulfide and copper and the copper sulfide and air release energy that helps to heat the system. It produces sulfuric acid as a byproduct and is resistant to contaminants such as ammonia and various hydrocarbons, converting them to their elemental state instead. Thus far this process has only been demonstrated in the lab. A pilot scale reactor will be developed next. (Published: 03/09/08)

Notes:

• hydrogen sulfide present in crude oil and raw natural gas
• conventionally removed using Claus process, invented more than 100 years ago
• energy- and capital-intensive
• limited in terms of the other types of impurities it can handle
• costly energy-intensive modules that scrub other contaminants, such as ammonia, methane and carbon dioxide from raw oil and natural gas must be separately attached to Claus processing facilities
• loses the hydrogen in the process
• gets converted into water
• Argonne and KPM method
• centered around a molten copper reactor
• innovative process technology that is more energy-efficient than existing methods
• in the reactor, hydrogen sulfide gas is first separated from the crude oil stock, using technology already in place
• this gas is then bubbled though molten copper
• releases pure hydrogen
• the hydrogen is then captured for use as a valued product
• as the sulfur reacts with the copper, the copper is gradually turned into copper sulfide
• in addition the process creates concentrated sulfuric acid
• used widely in the chemical industry and which has become a valued agricultural commodity
• the concentrated sulfuric acid is created when copper sulfide is reacted with air to recover the pure copper
• releases a concentrated stream of sulfur dioxide which is then reacted with water
• the copper is then reused in the process with negligible losses
• the reactions between the hydrogen sulfide and copper and the copper sulfide and air release energy that helps to heat the system
• enables the products to be efficiently harvested
• system operates at a temperature of about 1,200 degrees Celsius
• contaminants such as ammonia and various hydrocarbons are reformed to their elemental constituents
• demonstrated in lab
• next step is to develop a pilot scale reactor
• Companies will be able to retrofit their facilities with the process technology or construct new plants that incorporate it

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Quote of the Day

"A lot of people in the car industry - and this is a seachange since the 1990s - have come to see dependence on gasoline as the growth bottleneck in the industry's future. They think that the real constraint on the ability to grow the car market will be dependence on a fuel that causes global warming, that puts money in the pockets of dictators, that has enormous price volatility and so forth. So they want to get off gasoline, because they now see it as a limit to their future prospects." - Jonathan Rauch, in an interview with Russ Roberts on EconTalk discussing the Chevy Volt

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Finding the Mess Behind the Mess - The New York Times

Summary:
According to Tyler Cowen, the US is unlikely to experience a lost decade as Japan did in the 1990s, but there will still be a long and protracted process of recovery. Number of problems in the real economy are underlying the financial crisis, and will remain once the financial crisis clears up. Problems faced by the US economy: lack of personal savings (people have for years treated rising asset prices as substitute for personal saving); credit crisis stopping banks from investing our savings and making loans; lower consumer spending, need to produce for export; still excess of homes in the market; energy prices. Further fiscal stimulus and excessive banking regulation will make things worse. Solving these problems will be like untangling a bunch wires: need to carefully pull the right wires, in the right sequence. (Published: 23/08/08)

Notes:

• Japanese recession in 1990s
• set off by bursting real estate bubble
• took economy more than a decade to resume steady, noticeable growth
• unlikely to happen in the US
• but will still see protracted process of recovery
  
• may take longer than the usually year or two to climb out of recession
• usually a crisis in the real economy behind every financial crisis
• based in some underlying structural deficiency
• even if financial crisis is bottoming out, sooner or later the real crisis must be faced
• problems in the US economy
  
• fundamental problem in the US economy:
• for years people treated rising asset prices as a substitute for personal savings
• as long as your home's value rose every year, you didn't have to set aside so much from your paycheck
• if your stocks went up, so much the better
• asset prices haven't been rising much lately
• many people will need more savings for their retirement or possible emergencies
• second problem
• US economy enduring a credit crisis
• many banks trying to raise more capital and make fewer loans
• savings are good for the economy when they lead to investment, but there is no guarantee that financial institutions will be allocating capital efficiently
• third problem
• lower consumer spending
  
• will require the US economy to make some shifts
• may mean fewer Starbucks and fewer new homes, but more tractor production for export to foreign markets
• shifting some consumption to investment probably beneficial to the economy in the long run
• in the short term, may mean job losses and costly readjustments
• fourth problem
• still excess homes on the market
• housing prices need to fall further
• such price declines make banks less solvent and thus worsen the credit crisis
• politicians would like to moderate this fall in prices, prolonging the adjustment process
• fifth problem
• energy prices
• high prices will encourage conservation and cleaner energy alternatives
• but: voters want low gasoline prices and winter heating bills
• politicians see lower energy prices as a way to help the economy in the short run, and as a way to win votes
• evolution of energy prices may not follow any kind of desirable logic
• danger that the Fed will view high energy prices as a sign of permanent inflation and tighten the money supply growth prematurely

• what should policy makers do?
• counterproductive path: further fiscal stimulus in form of tax rebates
  
• can raise consumer spending and bolster economy in the short run
• works only by pushing consumers to spend rather than to save
• merely postpones the needed adjustments by providing a grab bag of goodies at exactly the wrong time
• another danger: excessive bank regulation
• regulatory structure for financial institutions has failed in the current crisis,
• change is in order
• but shouldn't reform in a way that will discourage bank lending and weaken the tie between savings and investment
• banks already allergic to very risky mortgages
• we shouldn't overreact by punishing them for past mistakes
• regulatory reform needs to be forward-looking rather than focused on penance
  
• recipe for success likely requires, in ht right combinations and in the right sequences
  
• smooth adjustment into new growth sectors
• more savings from disposable income
• cleaning up the housing mess
• well-functioning energy markets
• more effective financial intermediation
• but: neither the government or the Fed can control this process
• Fed can add regulatory and monetary clarity, but there isn't any magical bullet

• Japanese failed to break out of their recession quickly because they didn't promptly close down or clean up their bank problems
• so far, Fed and other regulators show no signs of making this mistake
• but: not enough to guarantee a successful transition
• American economy will be tested for its deftness
• test will be difficult because there isn't a single enemy to focus on
• undoing a bunch of tangled wires
• if you don't pull on the right wires in the right order, the mess becomes worse
• if you pull too hard, the whole thing can break
• but if your first pulls are good ones, the untangling becomes easier with each move
• like our economy's situation today
• if we expect too much too quickly, we'll make matters worse
• but: there's a way out of the mess, and it lies in our hands

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Our Electric Future - The American

Summary:
Andy Grove calls for a strategy that can deflect our march toward persisting conflict by strengthening our energy resilience. The strategy includes a policy that favors sticky energy (i.e. electricity) with multiple sources and aggressively moving vehicles first toward dual-fuel mode and ultimately to running on just electricity. Focus in the past on energy independence was misguided: talking about “independence” in terms of one product in an otherwise seamless global economy is a contradiction. Energy resilience is what's needed instead, i.e. strengthening our ability to adjust to such changes. Because electricity is the stickiest form of energy (it stays in the land where it is produced), and because it is multi-sourced, it will give us the greatest degree of energy resilience. Shifting to electricity has the added advantage of helping to mitigate a major environmental threat. However, we can't rely on market forces alone: absence of common interests among the industry players is a major obstacle to action. (Published: 01/08/08)

Summary:

• significance of US first a supplier, and later as a consumer of oil has decline
• relative decline as a supplier accelerated in the 70s, after OPEC was formed, and again when it flexed its muscles by precipitating the oil shock
• significance as a customer started to decline in the early 90s as some of the developing Asian economies started to grow at a rapid rate, requiring prodigious amounts of petroleum
• OPEC has enormous control over its customers
• energy is the lifeblood of all economies
• availability of petroleum determines whether an economy grows or declines
• availability of petroleum determines employment levels
• in turn determines national political stability
• Project Indepedence
• kicked of by Nixon in early 70s
• goal
• “At the end of this decade, in the year 1980, the United States will not be dependent on any other country for the energy we need to provide our jobs, to heat our homes, and to keep our transportation moving.”
• dramatically failed to meet that goal
• after Nixon, president after president set similar gboals
• every target was missed
• became more and more dependent on imported petroleum
• net energy imports doubled between 1970 and 1980, and then again by 1990
• goals were unwise
• faulty goals lead to the wrong actions
• problem:
• US became more and more integrated into a global economy
• goods, information, and oil move unimpeded across national boundaries
• oil flows toward the highest bidder, just like all other goods
• talking about “independence” in terms of one product in an otherwise seamless global economy is a contradiction
• correct goal
• to strengthen our energy resilience
• we must protect the U.S. economy from interruptions in the supply of such a critical commodity
• whether those interruptions are related to natural or political causes.
  
• the appropriate aim is to strengthen our ability to adjust to such changes
• how? by increasing our reliance on electricity
• electricity: energy that sticks
• oil
• moves to the highest bidder
• Fleets of tankers carry it across oceans day and night
• natural gas
• can also move around, but with extra difficulties
• on land, it can be transported in pipelines
• to carry it across oceans requires liquefaction and expensive, high-tech ships that can carry this liquid in strong, deeply cooled containers
• electricity
• it is “sticky”:
  
• it can be transported only over land
• i.e. it stays in the continent where it is produced
• it is a multi-sourced form of energy
• petroleum, coal, wind, hydroelectric, nuclear and solar
• if one source suffers a shortage, we can produce electricity from another
• because electricity is the stickiest form of energy, and because it is multi-sourced, it will give us the greatest degree of energy resilience
• nation will be best served if we dedicate ourselves to increasing the amount of our energy that we use in the form of electricity
• transportation: hardest nut to crack
• transportation uses more than half of all the petroleum consumed in this country
• conversion will not be easy
• requires substantial growth in generation capacity as well as in the capacity and reach of the transmission infrastructure
• requires that vehicles be able to run on electric power
• with the size and weight of ordinary automobiles, current technology allows electric cars to run only 100 miles or so before their batteries need to be recharged
• many drivers can live with this limitation most of the time
• but few will find the condition satisfactory all of the time
• new technology
  
• often shows up in this manner: it is not completely satisfactory in the beginning, but good enough to get going
• such approaches are known as “disruptive technologies.”
• starting low and moving up
• waiting game
• automobile industry,
• has been waiting instead for batteries to improve until they can allow electric cars to enter the marketplace with the same driving range as gasoline-fueled cars
• battery developers
• have been waiting for demand from the automobile industry to develop before fully committing the resources required to do the job
• generation and transmission infrastructures
  
• have not been built up to service the potentially explosive demand from transportation
• our exposure to the vagaries of oil supply is growing by the month
• must accelerate conversion to electricity in a major way
• U.S. government should lead the way by requiring that a growing percentage of new cars be built with dual-fuel capability
• dual fuels
• dual-fuel cars would have both an electric engine and an auxiliary gasoline engine to augment it
• dual capabilities are often built into machines to help with technology transitions
• e.g. laptops with both wired and wireless connection
• forces of disruptive technology would eventually bring about improvements in battery technology, ultimately allowing the production of an all-electric car with satisfactory driving range
• process won’t happen quickly enough on its own
• no matter how fast the production of dual-fuel cars is ramped, replacing the bulk of the approximately 250 million cars on the roads in the United States with new cars will take a decade or more
• retro-fitting
  
• need to retro-fit the low-mileage part of the fleet first
• estimates show that converting these vehicles to dual-fuel operation, even with electricity providing no more than 50 miles of driving range between daily recharging, could cut petroleum imports by 50 to 60 percent
• a stunning opportunity
• task requires major effort and investment
• may need to apply tax incentives to offset the cost of the retrofit and couple them with deep discounts on the cost of electricity used by the vehicle over some initial period, such as one to two year
• environment
• shifting to electricity has the added advantage of helping to mitigate a major environmental threat
• shift from petroleum-based vehicles to electricity-based ones would move the locus for addressing carbon emissions from millions of individual vehicles to far fewer centralized electricity-generating plants
• controlling emissions thus becomes an industrial task, easier technologically.
• estimates indicate a potential reduction of carbon emissions of around 50 percent through such a shift
• can't rely on market forces
• automobile manufacturing, battery production, and the generation and transmission of electricity are all represented by different industries
• each with its own financial aims
• absence of common interests is a major obstacle to action
• requires the coordinated commitment of several industries
• startups and new ventures, not limited by the economic rules of established industries, can break the gridlock in time
• but: we don’t have the time
• Condi Rice: “The politics of energy is warping diplomacy in certain parts of the world”
• oil has been a major factor in many wars, and it could be again
• Kissinger: “Today’s relationship between China and the United States is very similar to that of Germany, a rising country at the turn of the 20th century, and Britain, an established one. Their conflict over resources eventually led to war.”
  
• We are in a period of time in the world today where there is a shortage of resources.
• we will face “an era of persisting conflict.”
• need for a strategy that can deflect our march toward this “persisting conflict” by strengthening our energy resilience
• policy that favors sticky energy with multiple sources and that aggressively moves vehicles first toward dual-fuel mode and ultimately to running on just electricity provides the answer.

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33% of China's Carbon Footprint Blamed on Exports - abc News

Summary:
A Carnegie Mellon study finds that one third of China's carbon dioxide emissions are a direct result of the manufacture of goods destined primarily for developed countries. These "export goods emissions" account for 6% of the global emissions. International policy at the moment tends to penalise the country which produces goods rather than the one that consumes them. China has a point arguing that the US and Europe should bear the burden of responsibility for the emissions as they demand and consume the products. How to fairly apportion the liability for China's exported emissions is the million-dollar question. (Published: 29/07/08)

Notes:

• scale of China's emissions
  
• hot topic since it was forecast that they could surpass US emissions as the world's leader in 2007
• may have already happened

• Carnegie Mellon study:
  
• 2005: one-third of China's carbon dioxide emissions are pumped into the atmosphere in order to manufacture exported goods
• many of them "advanced" electronics goods destined for developed countries
• i.e. developed countries import many of the products that contribute to China's greenhouse gas emissions
• "export goods emissions" account for 1.7 billion tonnes of China's carbon dioxide
• represents 6% of total global emissions
  
• equivalent of Germany, France and the UK's combined emissions
• compare 1987: exports accounted for just 230 million tonnes
• 12% of China's total emissions
• China very aware that much of its carbon footprint is export emissions
• has used this as an argument against adopting Kyoto-Protocol-like emissions caps
• argues that other major emitters, including the US and Europe, should bear the burden of responsibility for the emissions as they demand and consume the products
• International policy at the moment tends to penalise the country which produces goods rather than the one that consumes them
• How to fairly apportion the liability for China's exported emissions "is the million-dollar question"
• Benito Müller of the Oxford Institute for Energy Studies, UK
• "It's just like narcotics," says Müller. "Who is responsible, the drug baron or the junkies?

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A silver lining to high oil prices - FT.com

Summary:
Arnoud de Meyer and Matthias Holweg anticipate a trend of "back-sourcing" due to rising energy and commodity costs: manufacturing will increasingly move to where the markets are, including back to the UK. Few companies that have gone global have so far achieved the full cost efficiencies they had envisaged, and this will get worse. Two common mistakes that companies make when deciding to source components from abroad are: they tend to only calculate the static costs of a supply chain, and they assume that costs will remain stable. Furthermore, global supply lines might be cost-competitive but they certainly are not carbon-competitive, which is gaining in importance. As a result, narrowly defined production costs will become less important in deciding where to locate manufacturing. This presents an opportunity for Western manufacturing, provided the skills and tacit knowledge that is needed for manufacturing are preserved. Companies may also have to learn how to efficiently operate smaller flexible units that produce the customised products for the local market. (Published: 30/07/08)

Notes:

• Increased transport costs resulting from higher energy prices and carbon taxes
  
• may create an opportunity for a revival in western manufacturing
• Most strategic decisions in companies are influenced by new "paradigms"
• path-breaking new concepts
• globalisation was certainly the paradigm of the past decade
• application of such paradigms tends to behave like a pendulum
• swinging towards one extreme, and eventually swinging back
• Is it possible that the pendulum may swing back for global manufacturing?
• premise of global sourcing and exploiting lower labour costs for manufacturing in eastern Europe and the Bric countries
  
• largely built on the cost of transport
• dropped by a third between 1960 and the turn of the millennium
• result of introduction of containers and the rise of third-party logistics providers
  
• shipping goods reliably from one end of the world to the other without owning any of the transport assets in between
• with further help from
• trade liberalisation and agreements
• stable currencies that reduced the risks in establishing global supply lines
• research shows that few companies that have gone global achieved the full cost efficiencies they had envisaged
• some even found that "offshoring" their operations was more expensive than sourcing or manufacturing locally
• subsequently returned to their home country
• cost of logistics may be a lot more important than originally estimated
• others found that product cost was indeed much lower, yet this cost reduction was traded off with much reduced quality
• e.g. recent highly publicised product recalls
• companies commit two common mistakes when deciding to source components from abroad
• tend to only calculate the "static" cost of a supply chain
• basically adds the unit cost ex-supplier factory and the transport cost together
• lower labour cost reduces the unit cost of the product
• generally offsets the higher transport cost of bringing it into the UK from China
• other costs are often not considered or underestimated
• e.g. the additional cost for buffer stocks
• supply chain becomes inherently less able to respond to swings in demand or changes in technology
• e.g. risk of obsolescence or running out of stock
  
• drastically increases, yet often is not factored into the calculation.
  
• e.g. cost of quality defects
  
• rises tremendously when a defect is discovered in a shipped batch arriving in Europe and costly air freight has to be used to refill the supply line
• e.g. co-ordination cost of working over long distances
  
• often taken for granted
• tend to assume that costs remain stable, not account for "dynamic" costs
• perception is that countries in eastern Europe, China and India have inexhaustible labour pools that one can tap into at low cost
• and that all these workers are trained to the needed level
• recent experiences
• Eastern Europe
  
• car manufacturers find that local labour pools of trained workers have been virtually exhausted
• inflation in the cost of trained labour is in double-digits as manufacturers are competing for labour
• India
• trained staff will change jobs several times per year if they see the prospect of higher salaries elsewhere
• annual turnover of 20 per cent being normal
  
• labour cost inflation rising to 25 per cent a year in some regions, such as Bangalore or Pune.
  
• China
• trained middle manager in the car sector, fluent in English and Mandarin, will earn more in Shanghai than in Wolfsburg or Birmingham
• carbon footprint gaining in importance
• global supply lines might be cost-competitive but they certainly are not carbon-competitive
• rising consumer conscience about the impact of patterns of consumption
• manufacturers with offshored operations will find it increasingly hard to justify sending products half-way around the globe if they can be made as easily close by
• recovery of competitiveness in the manufacturing sector
• long been dismissed as an obsolete part of a "service economy"
• "backshoring" trend
  
• manufacturing will increasingly come back to where the markets are
• does not mean that all of it will come back
• emerging countries are also enormous markets and local production will serve local consumption there
• but: companies will have to think increasingly in terms of networks or portfolios of plants
• narrowly defined production costs will become less important in deciding where to locate manufacturing
• developing the opportunity
• UK will need to preserve the skills and the tacit knowledge that is needed for manufacturing
• may have to learn how to efficiently operate smaller flexible units that produce the customised products for the local market
  

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America must not act rashly over inflation - FT.com

Summary:
Mark Gertler warns against Fed targeting of headline inflation. Points out that core inflation has remained steady and low. Rapid increases in the relative prices of energy and food cannot go on indefinitely. Once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it. Fed has adjusted monetary policy to sustain the core measure at a steady, low rate, and headline inflation is still well below that of stagflationary 70s. Impact of increasing inflation expectations, despite moving upwards, has yet to show up in the behaviour of core prices and wages. There are signs that forces that have pushed headline above core inflation are beginning to reverse due to laws of supply and demand. Funneling core inflation through a tight oscillating path even over the medium term is beyond a central bank's capability and may wreak havoc on the real economy. Monetary tightening is needed, however, in many emerging economies. A policy response from the Fed is needed that recognises the complexities of the inflationary process. Learn lesson from Japan. (Published: 28/07/08)

Notes:

• startling jump in US consumer price inflation over past several months
• entering inflationary spiral like in 70s?
• careful inspection of underlying mechanics shows that
• almost all the increase in headline CPI inflation is due to rocketing energy and food prices
• inflation excluding energy and food is significantly lower
• core CPI was just 2.4% over past year
• just over Fed's comfort zone of 1-2%
• uptick last month due to feeding through of food and energy costs to core prices
• but: over coming year, below-capacity output growth and softening oil and commodity prices are likely to push core inflation back towards comfort zone
  

• distinction between headline and core inflation important
• sustained move of headline inflation to levels of 70s is unlikely without an accompanying increase in core component
• reason: although they can be highly persistent, rapid increases in the relative prices of energy and food cannot go on indefinitely
• once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it
• e.g. late 1960s to late 1970s
• Fed lost control over core inflation
• increased nearly in lock-step with overall inflation
  
• this decade
• Fed has adjusted monetary policy to sustain the core measure at a steady, low rate
• despite prolonged periods of departure of headline inflation from core
• but gaps typically under 100 basis points annually
• headline inflation indeed uncomfortably in 3-4% range recently
• but: is well below that of the stagflationary 70s

• signs that forces that have pushed headline above core inflation are beginning to reverse
• oil prices declined >10% over past several weeks
• commodity prices have softened also
• laws of supply and demand suggest this may not be a transitory phenomenon
• root cause of increase in energy and food prices was most probably rising global demand
• global economic activity expected to slow down considerably
• demand for oil and commodities is likely to weaken along with it
• will place downward pressure on relative prices of these goods

• targeting headline inflation directly will not help
  
• in environment of gyrating energy and food prices inflation, targeting headline inflation requires the central bank to engineer offsetting changes in the path of core inflation
• but: prices of most core items adjust only sluggishly
• funneling core inflation through a tight oscillating path even over the medium term beyond a central bank's capability
• simply too much uncertainty over both the timing and the overall impact of its interest rates moves on core inflation to believe that a central bank could smoothly accomplish this task
• sharp interest rate adjustments likely to accompany this attempted fine-tuning exercise could wreak havoc on the real economy

• is high headline inflation unmooring inflation expectations?
• would lead us back to the 70s
• some measures of inflation expectations are edging upwards
• needs to be taken seriously
• but: impact of increasing inflation expectations has yet to show up in the behaviour of core prices and wages
• core inflation has remained stable
• growth in nominal unit labour costs also remains benign
• is what most pricing of core items is based on
• Fed's reputation for keeping core inflation stable may have kept the expectation relevant for price- and wage-setting in line
• also: to date, wage-setters appear to understand that, however unfortunate, the relative increase in energy and food prices is something beyond the central bank's control
• something they must live with

• many emerging countries: picture different
  
• above-capacity output growth has pushed core inflation up along with headline
• also: high output growth among these economies has been an important factor in the global commodity price boom
• here monetary policy needs tightening

• inflation is a real concern
• but: policy response is needed that recognises the complexities of the inflationary process
• including its global nature
• not simple knee-jerk reaction!
• lesson from Japan
• a fractured credit system can induce prolonged stagnation, even in an advanced economy
• given uncertain conditions of the US financial and real sectors, goal should be to achieve price stability in a way that continues to keep low the possibility that this economy could suffer a similar fate
  

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How to fix a broken venture capital model - EETimes

Summary:
Interview with Matthew Nordan about why the current VC model is broken, especially in the case of materials, energy and environment sector investing. The linear path from angel to VC to IPO no longer works due to greater costs, longer gestation times, greater technological uncertainty and ill-defined problems. This is a time of great experimentation and visible discomfort. New type of VC machine needed. Smartest venture firms cultivate relationships with the buyers of technologies. Nordan also has four rules for venture companies: Make non-obvious matches of technologies and solutions; be suspicious of exponential growth; maximize options to avoid surprises from left field; and avoid focusing on an ideal technology to such an extent that you fail to see a "good enough" technology in its wake. (Published: 22/07/08)

Notes:

• Matthew Nordan, Lux Research, President
• ideas on how to make startup financing work again
  
• old machine
• linear path
• angel funding -> VC financing -> (some cases growth equity/PE) -> public markets
• works really well for IT
• don't need tremendous amount of money; pretty capital efficient investments
  
• also for life sciences
• because there's a rule book that you can follow by using the FDA and EMEA approval cycles as a way of determining how far the company is
• none of those rules exist in the materials, energy and environment world
• and you need more money over longer periods of time (gestation times in excess of a decade)
  
• frequently break 10 year close-ended fund cycles that VCs as a rule have
• with greater levels of technology risks further down the cycle, down into the land where you have 10s of millions of dollars of investment being made by PE and growth equity funds
• machine doesn't work; need a new machine
• new machine
• some innovations promising; but you don't know what works till folks have seen a 25% IRR on doing it in a new way
• interesting: fund that raises small amounts of money to be able to go out and seed companies to get them to a stage that they are ready for a venture fund
• cut of that first part of the technology development cycle and get it to fit into a 10-year close-ended structure
• interesting: project financiers beginning to construct joint venture vehicles where there may be a carve-out slice of equity for the venture financiers that may get them some returns (some meat to take home to the cave for the LPs) before the company is able to achieve the liquidity of it
  
• particularly for water and waste technologies
• venture funds have responded by specializing
• Rockport and Kleiner Perkins Caufield & Byers
  
• invest in early-stage technology
• Riverstone and FourWinds
  
• invest in deployment of semi-mature technologies
• only a few funds like Vantage Point try to span the gamut of development and deployment
• new model of "clear-cutting" VCs
• exemplified by Khosla Ventures
• represent funders of last resort
• ultimately this a time of great experimentation and visible discomfort
• will be 5 to 10 years before we know which of any of those ingredients are going to work out
• bringing in the growth equity partner between VC and IPO
• growth equity is coming back
• VCs are not prepared to extend funding into the hundreds of millions of dollars
• smartest venture firms cultivate relationships with the buyers of technologies
• smart venture firms talk to the customers of potential startups to say what problems do you need solved five years down the line?
• ranging from OEMs in the semiconductor field to utility companies in the energy field
• then build a startup based on the wish-lists of those customers
• business plans get ripped apart five times over before the company ultimately decides what it is that it's supposed to be doing
• difference from an energy environment perspective is that the problems are generally less well defined; lack of definition
  
• as opposed to software: explicit problem that they're trying to solve upfront
• e.g. Green Fuel Technologies Corp., algae company
  
• intended to use algae to process wastes from natural gas plants and ferment biomass fuels
• turns out that you can get a lot more revenue from the same unit of algae, not by fermenting it to make biofuels, but by selling it as fish feed, or as an additive
  
• the desiccated algae itself are more valuable than the biofuels that you can make from them
• at least in the current state; may change over time

• four rules for venture companies
1. make non-obvious matches of technologies and solutions;
   
2. be suspicious of exponential growth;
   
3. maximize options to avoid surprises from left field and to be aware of unexpected breakthroughs;
   
• e.g. emerging "solar antenna" that can tune in to 800-900 nm waves, thus obsoleting several small-scale solar technologies
• also involves carefully quantifying all externalities
• e.g. the water-use requirements for ethanol and biodiesel make so-called clean energies look dirty when total inputs are taken into account.
4. avoid focusing on an ideal technology to such an extent that you fail to see a "good enough" technology in its wake

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Utilities say grid can handle rechargeable cars - MSN Money

Summary:
Energy industry officials believe they will be able to cope with the increased electric demand when rechargeable cars become a reality. Industry has already dealt with increased electric demand from millions of plasma TVs (cars consume 4x more electricity). Changeover from ICE to electric is likely to be gradual (still lot of issues with batteries to be solved). Will thus be able to handle it in same way as they handled plasma TVs. Most electric cars will likely be charged during off-peak electric use times, utilities should have no problem generating enough electricity. Potentials problems: rise in oil price causes transition to be very rapid; stress on distribution system in certain areas; electric vehicles getting larger and requiring far more electricity for recharging; and demands from people that their vehicles be recharged quickly, drawing more electricity during peak times. (Published: 23/07/08)

Notes:

• cars vs. plasma TVS
  
• rechargeable cars consume about four times the electricity as plasma TVs
• but: industry already has dealt with increased electric demand from the millions of plasma TVs sold in recent years
• experience will help them deal with the vehicle fleet changeover
• Mark Duvall, program manager for electric transportation, power delivery and distribution for the Electric Power Research Institute
• Plug-In 2008 conference
• "So as long as the changeover from internal combustion engines to electric vehicles is somewhat gradual, they should be able to handle it in the same way"
• "We've already added to the grid the equivalent of several years' production of plug-in hybrids."
• "The utilities, they stuck with it. They said, 'All right, that's what's happening. This is where the loads are going, and we're going to do this.'"
• Automakers are planning to bring rechargeable vehicles to the market as early as 2010
• but will take much longer for them to arrive in mass numbers, due in part to a current lack of large-battery manufacturing capacity
• auto and battery companies still are working on the lithium-ion battery technology needed for the cars, and on how to link the battery packs to the vehicles
• Efrain Ornelas, environmental technical supervisor with Pacific Gas and Electric Co. in San Francisco
• "We see the vehicle penetration levels coming at a rate that's manageable. It's not like tomorrow the flood gates are going to open and 100,000 vehicles are going to come into San Francisco or something like that."
• PG&E will be able to track their charging patterns and plan accordingly for the future
• current demand
• utility officials say they already are coping with increased demand
• especially during peak-use periods in the afternoon and early evening
• rest of the day, most utilities have excess generating capacity that could be used to recharge cars
• most electric cars will likely be charged during off-peak electric use times, utilities should have no problem generating enough electricity
• the preparation doesn't mean electric vehicles will be accommodated without problems and good planning
• since people with the means to buy electric cars likely will live in the same areas, utilities worry about stress on their distribution systems
• if high gasoline prices could push sales of rechargeable electric vehicles well into the millions by 2020, that could stress the system
• other possible problems include
  
• electric vehicles getting larger and requiring far more electricity for recharging
• demands from people that their vehicles be recharged quickly, drawing more electricity during peak times
• choice for consumers
• consumers will face a lot of choices about when and where they charge up their cars and how much they want to pay for the electricity
• utilities likely will raise rates to charge cars during peak use times, generally from around noon to 8 p.m., and lower them for charging during low-use hours
• e.g. PG&E charges 30 cents per kilowatt hour to charge an electric vehicle during peak hours, he said, but charges only 5 cents from midnight to 7 p.m
• talk of the cars storing electricity and sending it back to the power companies during peak times
• officials say that's a long way off

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“Scorched Earth Economy” May be the Most Accurate Description the Current Economy - DailyReckoning

Summary:
According to David Galland, the markets are heading toward what might be he terms a Scorched Earth Phase (rather than stagflation, due to severity of both sides of the equation). The cause is the coincidence of a tumbling collapse in the largest component of the stock market (the financial sector); a tumbling collapse in the largest component of people's net worth, their homes; an energy, which increases the cost of everything, especially food; and, most importantly of all, a collapsing fiat monetary system. $6 to $7 trillion dollars is now held by foreign holders, which is unprecedented. If the Fed reduces rates or prints money, in an attempt to placate voters and/or reduce the size of the foreign debt, this will trigger a massive dollar sell-off, reducing its value to zero. There is no doubt a serious economic crisis is on its way, most likely with very high inflation. (Published: 11/07/08)

Notes:

• tumbling collapse in the largest component of the stock market, coinciding with a tumbling collapse in the largest component of people's net worth, their homes:
  
• US financial firms: single largest component of S&P500
• losses so far approaching half a trillion dollars
• quickly running out of rope in attempts to shore up balance sheets
• e.g. Morgan Stanley: saw its investment banking fees fall by half and fixed income sales and trading revenue collapse by over 85%
• SWF to the rescue?
• not anymore
• those that initially rushed in were seriously burned and many are now on record as staying on the sidelines
• housing meltdown
• will continue for at least another year or two
• unless government decides to "do something"
• in which case downturn could last 5 to 10 years
• what markets need most right now is for house prices to fall as quickly as possible to market-clearing price
• but nobody knows where the bottom is (10, 20, 30%?)
• "doing nothing" is not a concept that politicians in an election year are very comfortable with
• energy crisis
• Mexico, 3rd largest source of imported oil for the US, will stop exporting within 4 to 6 years
• no emergency initiatives to open up new energy sources
• on the contrary: perfect world mentality
• ensures that the cost of what energy is available will on get greater
• energy is required in the production of everything, so the cost of everything will go up
• e.g. food
• collapsing fiat monetary system: biggest threat
  
• system that helped create the recent series of bubbles in the first place
• in a fiat monetary system the only tangible barriers to money creation are provided by a loss in stakeholder confidence
• not the average American, unaware of this system let alone consequences
  
• but: the foreign holders of an unprecedented $6 to $7 trillion dollars
• going into the jaws of a vicious economic/dollar crisis those foreign dollar holdings become akin to playing toss with a lit stick of dynamite
• he who holds the dollars when the fuse meets the powder is in for a very, very bad day
• as a result, the foreign holders are watching the moves of the Fed very closely
• if the Fed raises rates to prevent a sell off in dollars, they’ll crush the highly indebted and already struggling populace and, in so doing, unleash a serious economic crisis
• if the Fed keeps rates where they are, or even lowers them, they’ll trigger a dollar sell-off and unleash a serious economic crisis
• most likely scenario, for two reasons:
• depreciating dollar means a reduction in the trillions of dollars in obligations now owed by the US government
• foreign holders don't vote
  
• serious economic crisis either way
• with high inflation
  

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The Next Bubble: Priming the markets for tomorrow’s big crash - Harper's Magazine

Summary:
Eric Janszen: the only thing worse than another bubble is no bubble. No coincidence that the internet and housing hyperinflations transpired within a periord of ten years. The US can no longer function without them. The bubble cycle has replaced the business cycle. The cause for this transformation lies with the rise of the FIRE economy in the late 70s. Next bubble must be large enough to recover the losses from the housing bubble collapse. Many candidates, only one fits all the criteria: alternative energy. Will be accompanied by boom in infrastructure. Danger: hyperinflations, in the long run, are always destructive. Could have serious consequences, as alternative energy and the improvement of our infrastructure are both necessary for our national well-being. The author estimates estimate of $20 trillion in speculative wealth will be created in the alternative-energy/infrastructure bubble. Unfortunately, this money will inevitably be employed to increase share prices rather than to deliver “energy security.” (Published: February 08)

Notes:

• financial bubble: a market aberration manufactured by government, finance, and industry, a shared speculative hallucination and then a crash, followed by depression
• note: term "bubble" confuses cause with effect
• a better descriptor would be “asset-price hyperinflation”
• the huge spike in asset prices that results from a perverse self-reinforcing belief system, a fog that clouds the judgment of all but the most aware participants in the market
• asset hyperinflation starts at a certain stage of market development under just the right conditions
• the bubble is the result of that financial madness, seen only when the fog rolls away.
• frequency
  
• bubbles were once very rare
• one every hundred years or so
• legislation enacted to prevent subsequent occurrences
• nowadays: barely a pause between such bouts of insanity
• before the dotcom bubble had deflated, housing bubble took off
• no coincidence that the internet and housing hyperinflations transpired within a periord of ten years
• the US can no longer function without them
• there will be many more such boom
  
• the bubble cycle has replaced the business cycle.
• how did this transformation come about?
• following WWI
• Wall Street wrote checks to finance new companies that were trying to turn wartime inventions into consumer products
• e.g. radio, refrigeration
• consumers of rising middle class were ready to buy but lacked funds
• banking system accomodated them with new forms of credit
• e.g. the installment plan
• brief recession in 1921, following which fed accomodated progress by keeping interest rates below rate of inflation
• "new era" of prosperity hailed until Black Tuesday, Oct 29, 1929
• crash, Great Depression and WWII
• brutal education for government, academia, corporate America, Wall Street and the press
• next 60 years, chastened generation managed to keep the fog of false hopes and bad credit at bay
• Keynes: emerged as the pied piper of a new school of economics that promised continuous economic growth without end
• doctrine: when a business cycle peaks and starts its downward slide, one must increase federal spending, cut taxes, and lower short-term interest rates to increase the money supply and expand credit
• the demand stimulated by deficit spending and cheap money will thereby prevent a recession
• aka. reflation
  
• WWII
• brought real recovery as a highly effective, demand-generating, deficit-and-debt-financed public-works project for the US
• war did what a flawed application of Keynes' theories could not
• Bretton Woods
• US succesfully pushed to peg the currencies of member nations to the dollar and to make dollars redeemable in American gold
• Americans could spend as wisely or foolishly as government policy decreed
• regardless of the needs of other nations holding dollars as reserves, as many dollars could be printed as desired
• 1971
• US balance of trade had run up its first deficit: $3.8b (adjusted for inflation)
• worries by Bretton Woods members that US intended to repay the money borrowed to cover its trade gap with depreciated dollars
• de Gaule demanded payment in gold
• Nixon, facing a run on the US gold supply, unilaterally ended the US legal obligation to redeem dollars with gold
• i.e. US defaulted
• decade of economic and financial-market chaos followed
• dollar remained the international currency but traded without an absolute measure of value
• inflation rose, not just in US but around the world
• Fed pushed interest rates into double digits
• set off two global recessions
• new international standards and methods for measuring inflation and floating exchange rates were established to replace the gold standard
• never again a US trade surplus after 1975
• decline of high-value finished-goods-producing industries as steel and automobiles
• new economy belonged to finance, insurance and real estate
• FIRE
• era of FIRE
• is a credit-financed, asset-price-inflation machine organized around one tenet:
• that the value of one’s assets, which used to fluctuate in response to the business cycle and the financial markets, now goes in only one direction, up, with no more than occasional short-term reversals
• free of the international gold standard’s limitations, US now had great flexibility to finance its deficits with its own currency
• massive external debts built up
  
• trade partners to the US balanced their trade surpluses with the purchase of U.S. financial assets
• especially the oil-producing nations and Japan
• process of financing our deficit with private and public foreign funds became self-reinforcing, for two reasons:
  
1. if any of the largest holders of our debt reduced their holdings, the trade value of the dollar would fall
• and with that, the value of their remaining holdings would be decreased
2. if not enough U.S. financial assets were purchased, the United States would be less able to finance its imports
• cfr. old rule about bank debt, applied to international deficit finance:
  
• if you owe the banks $3 billion, the bank owns you. But if you owe the banks $10 trillion, you own the banks.
• 1990s
• banking and securities markets were deregulated
• note: root of the 1920s bubble is believed to have been the conflicts of interest among banks and securities firms
• 1999: Glass-Steagall Act of 1933 repealed
• regulated banks and markets
• a servile federal interest-rate policy helped move things along
• FIRE rose in power
• so did a new generation of politicians, bankers, economists, and journalists willing to invent creative justifications for the system
• as well as for the projects that it financed: ranging from the housing bubble to the Iraq war
• high-water mark: the publication of the Cato Institute report “America’s Record Trade Deficit: A Symbol of Strength.”
  
• Freedom had become slavery; persistent deficits had become economic power.
• the bubble machine
• often starts with a new invention or discovery
• internet bubble
  
• Mosaic, graphical Web browser, released in 1993
• began to transform the Internet into a set of linked pages
• suddenly websites were easy to create and even easier to consume
• industry lobbyists stepped in, pushing for deregulation and special tax incentives
• by 1995, the Internet had been thrown open to the profiteers
  
• four years later a sales-tax moratorium was issued
• opening the floodgates for e-commerce
• such legislation does not cause a bubble, but no bubble has ever occurred in its absence.
• otherwise rational men and women fall under the influence of a fast-flowing and, it was widely believed, risk-free flood of money
• logic and historical precedent pushed aside
• deregulation had built the church, and seed money was needed to grow the flock
• mechanics of financing vary with each bubble
• what matters is that the system be able to support astronomical flows of funds and generate trillions of dollars’ worth of new securities
• internet bubble: seed money came from venture capital
• a few startups like Netscape went public, netting massive returns
• such liquidity events came faster and faster
• loop was formed:
  
• profits from IPO investments poured back into new venture funds, then into new start-ups, then back out again as IPOs, with the original investment multiplied many times over, then finally back into new venture-capital funds.
• public was exposed to constant reiterations of the one true faith
• government stood back
• little incentive for lawmakers to intervene
• Members of Congress, who influence the agencies that oversee market-regulation functions, have never been unfriendly to windfall tax revenues
• the FIRE sector has very deep pockets
• 2000: millions of investors with unrealized gains in mutual funds sold stock to raise enough cash to pay taxes on their capital gains
• the mass selling set off a panic, and the bubble popped.
• fictitious value
• is the delta between historical-trend growth and growth brought on by asset hyperinflation
• “One added to one, by any rules of vulgar arithmetic, will never make three and a half; consequently, all the fictitious value must be a loss to some persons or other, first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost.” (anonymous, South Sea Bubble pamphleteer)
• goes away when market participants lose faith in the religion—when their false beliefs are destroyed as quickly as they had been formed
• Janszen: "Since the early 1980s, the free-market orthodoxy of the Chicago School has driven policy on the upward slope of an economic boom, but we’re all Keynesians on the way down: rate cuts by the Federal Reserve, tax cuts by Congress, deficit spending, and dollar depreciation are deployed in heroic proportions."
• brief national recession in the early part of 2001
• result of layoffs, cutbacks, and the collapsing stock market rippled through the economy
• despite a concerted effort by the Federal Reserve and Congress to avoid it
• despite the technology industry representing only a small fraction of the U.S. economy
• crucial dilemma: how to counter the loss of that $7 trillion in fictitious value built up during the bubble
• housing bubble
• new boom
  
• McMansions on the ground: wood and nails, granite countertops
• as opposed to castles in the sky of electrons and monetized eyeballs
• price-inflation process was traditional:
  
• way too much mortgage money chasing not enough housing
• at the bubble’s peak, $12 trillion in fictitious value had been created, a sum greater even than the national debt
• should have known better: historically, the price of American homes has risen at a rate similar to the annual rate of inflation
• Why, then, did housing prices suddenly begin to hyperinflate?
  
• formative stage of the bubble:
  
• changes in the reserve requirements of U.S. banks, and the creation in 1994 of special “sweep” accounts, which link commercial checking and investment accounts, allowed banks greater liquidity
• meant that they could offer more credit
• next, 2001 - 2002: hypergrowth
  
• Federal Reserve Funds Rate was reduced from 6 percent to 1.24 percent
• in wake of dotcom crash
  
• led to similar cuts in the LIBOR that banks use to set some adjustable-rate mortgage (ARM) rates
• drastically lowered ARM rates
  
• meant that in the US monthly cost of a mortgage on a $500,000 home fell to roughly the monthly cost of a mortgage on a $250,000 home purchased two years earlier
• demand skyrocketed, though home builders would need years to gear up their production.
• with more credit available than there was housing stock, prices rapidly rose
• supply of new capital needed to sustain hypergrowth: securitized debt
• turned out to be economic poison
• securitization
• to make a new security out of a pool of existing bonds, bringing together similar financial instruments, like loans or mortgages, in order to create something more predictable, less risk-laden, than the sum of its parts
• many such “pass-thru” securities, backed by mortgages, were set up to allow banks to serve almost purely as middlemen
• if a few homeowners defaulted but the rest continued to pay, the bank that sold the security would itself suffer little
• or at least far less than if it held the mortgages directly
• in theory, risks that used to concentrate on a bank’s balance sheet had been safely spread far and wide across the financial markets among well-financed and experienced institutional investors
• happens with most bubbles: a perfectly good idea is taken to an extreme
• in the case of the housing bubble, the new securitized debt product that drove the final stage was the collateralized debt obligation (CDO)
• CDO is a class of instrument called a credit derivative;
  
• specifically, a derivative of a pool of asset-backed securities.
  
• parts of pools of asset-backed securities that were e.g. rated at a moderately high risk of default—junk grade, such as BB—were modeled, packaged into CDOs, and rated at lower risk-investment grades, such as AAA
• these were used to finance the more creative mortgages
• stated-income or “liar loans”
• subprime mortgages were only a sideshow that appeared late, as the housing-bubble credit machine ran out of creditworthy borrowers
• main event was the hyperinflation of home prices
• risks are embedded in price and lurk as defaults
• even after the faith that supported a bubble recedes, false beliefs continue to obscure cause and effect as the crisis unfolds
• compare with chemical industry
• 40 years ago: “the solution to pollution is dilution”
• mixing toxins with vast quantities of air and water was supposed to neutralize them
• big mistake
• modern bankers have carried this mistake into the world of finance
• as more and more loans with a high risk of default were made from the late 1990s to the summer of 2007, the shared level of credit risk increased throughout the global financial system
• ballooning credit risk can be thought of as ecomonic poison
• in theory, those risk pollutants have been diluted in the oceanic vastness of the world’s debt markets
• thanks to the magic of securitization, they are made nontoxic and so pose no systemic risk
• in reality, credit pollutants pose the same kind of threat to our economy as chemical toxins do to our environment
• like their chemical counterparts, they tend to concentrate in the weakest and most vulnerable parts of the financial system
• that’s where the toxic effects show up first
• the subprime mortgage market collapse is essentially the Love Canal of our ongoing risk-pollution disaster
• more and more risk pollution is rising to the surface
• credit continues to contract
• FIRE economy depends on the free flow of credit
• will experience its first near-death experience since the sector rose to power in the early 1980s
• FIRE economy will be in need of $12 trillion by time prices reverted to mean
  
• all asset hyperinflations revert to the mean
• we can expect housing prices to decline roughly 38 percent from their peak as they return to something closer to the historical rate of monetary inflation
• if rate of decline stabilizes at between 6 and 7 percent each year, the correction has about six years to go before things stabilize
• Where will that money be found?
• "Bubbles are to the industries that host them what clear-cutting is to forest management. After several years of recession, the affected industry will eventually grow back, but slowly"
• housing bubble has left us in dire shape
• worse than after the technology-stock bubble
• Federal Reserve Funds Rate was 6 percent
• dollar was at a multi-decade peak
• federal government was running a surplus
• tax rates were relatively high
• made reflation relatively painless
• i.e. interest-rate cuts, dollar depreciation, increased government spending, and tax cuts
• now:
• Funds Rate is only 4.5 percent
• dollar is at multi-decade lows
• federal budget is in deficit
• tax cuts are still in effect
• chronic trade deficit, the sudden depreciation of our currency, and the lack of foreign buyers willing to purchase its debt will require the United States government to print new money simply to fund its own operations and pay its 22 million employees
• economy in serious trouble
• new bubble needed to keep the economy from slipping into a depression
• new bubble
• criteria
  
• the industry in any given bubble must support hundreds or thousands of separate firms
  
• financed by not billions but trillions of dollars in new securities
  
• Wall Street will create and sell those
• this sector of the economy must already be formed and growing even as the previous bubble deflates
• like housing in the late 1990s
• legislation guaranteeing favorable tax treatment for those investing in that sector, along with other protections and advantages for investors, should already be in place or under review
• finally, the industry must be popular, its name on the lips of government policymakers and journalists
• should be familiar to those who watch television news or read newspapers.
• candidates
• number of plausible candidates, but only a few meet all the criteria
• health care
  
• must expand to meet the needs of the aging baby boomers
• but there is as yet no enabling government legislation to make way for a health-care bubble
• pharmaceutical industry
• can hyperinflate only if the Food and Drug Administration was gutted of its power
• second technology boom, under the rubric “Web 2.0”
• based on improvements to existing technology rather than any new discovery.
• biotech
  
• will not inflate, as it requires too much specialized intelligence
• alternative energy: only industry that fits the bill
• is already being branded by the media
  
• Al Gore, joining Kleiner, Perkins, Caulfield & Byers
• "providing a massive dose of Nobel Prize–winning credibility that will be most useful when its first alternative-energy investments are taken public before a credulous mob"
• candidates for the 2008 presidential election invoking “energy security” in their stump speeches and on their websites
• legislation: Energy Policy Act of 2005
• authorizes $200 million annually for clean-coal initiatives, repeals the current 160-acre cap on coal leases, offers subsidies for wind energy and other alternative-energy producers, and promises $50 million annually, over the life of the bill, for a biomass grant program
• loan guarantees for “innovative technologies”
• boom in infrastructure will support alternative-energy bubble
• alternative energy and the improvement of our infrastructure are both necessary for our national well-being
• therein lies the danger: hyperinflations, in the long run, are always destructive
• estimate of $20 trillion in speculative wealth will be created
  
• gross market value of all enterprises needed to develop hydroelectric power, geothermal energy, nuclear energy, wind farms, solar power, and hydrogen-powered fuel-cell technology—and the infrastructure to support it—is somewhere between $2 trillion and $4 trillion
• assuming the bubble can get started, the hyperinflated fictitious value could add another $12 trillion
• In a hyperinflation, infrastructure upgrades will accelerate, with plenty of opportunity for big government contractors fleeing the declining market in Iraq
• thus, we can expect to see the creation of another $8 trillion in fictitious value
• That money that inevitably will be employed to increase share prices rather than to deliver “energy security.”

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The Outlook For Inflation and the Likelihood of $60 Oil - Hussman Funds' Weekly Market Comment

Summary:
John P. Hussman believes speculators are behind the rising oil prices, and that the fact that speculators don't take physical delivery for the product is irrelevant. What matters is that the purchase of futures contracts by speculators is crowding out the purchase that a bona-fide hedgers would otherwise be able to make from a producer. In a few months, however, due to broadening economic weakness we may see an unwinding of speculative pressure, resulting in steep declines in commodities prices, including oil. On the topic of inflation, Hussman believes that a combination of weakening demand for most goods and services as a result of consumer restraint, accompanied by a generally firm demand for currency and Treasury securities as safe havens from credit risk will result in disinflation, rather than inflation. Excellent tutorial on the causes of inflation in terms of marginal utility, and how government spending (whether by printing money or issuing bonds) contributes to inflation. Government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities. (Published: 07/07/08)

Notes:

Inflation

• bulk of recent inflation has been restricted to food and energy
• year-over-year change in the CRB commodity index minus food and energy is already negative
• main factors influencing the outlook for broad inflation
• US economy most likely already in a recession
• consumers are unusually strapped because of both mortgage debt and high budget constraints
• international economies are beginning to weaken
• note: China: Shanghai index down by well over half since last year's peak
• stock markets typically don't drop in half without economic repercursions
  
• credit concerns are endemic
• US government spending: relatively stable and not expanding rapidly
• given this context:
• combination of weakening demand for most goods and services as a result of consumer restraint
• accompanied by a generally firm demand for currency and Treasury securities as safe havens from credit risk
• that combination is disinflationary
• likely that we'll observe further downward pressure on inflation outside of the food and energy groups over the coming quarters

Oil prices

• broadening economic weakness and an unwinding of speculative pressure will combine to produce steep declines in commodities prices
• most probably by the end of the summer season
• is the price of oil being driven up by hedge funds, commodity pools and speculators?
• many pundits say no:
• speculators don't take delivery of the physical product
• instead they roll their futures contracts over indefinitely or until they close out their positions
• so they can't drive up prices
• Hussman says yes:
  
• disagrees with opponents:
• argument ignores the zero-sum nature of the futures market
• producers have an interest in selling their output forward to lock in a predictable price
• similarly, bona-fide hedgers (e.g. transportation and industrial companies) have an interest in buying oil forward so they can plan without concern about future fluctuations
• speculation unbalanced on one side: purchase of futures contracts by speculators begins to crowd out the purchase that a hedger would otherwise be able to make from a producer
• doesn't matter that the speculator has no intent to take delivery
• if the speculators are unbalanced on one side, the producers will have satisfied their need to pledge future delivery
• and because they can lock in a high price, they will be inclined to sell more for future delivery than they otherwise would
• meanwhile, bona-fide hedgers will be inclined to buy less on the forward market than they otherwise would
• when it comes time for the speculators to roll the contracts forward, they have to sell their existing contracts either to someone who is willing to take delivery
• or to a producer who sold the oil forward and can now clear that liability without actually producing the stuff
• given relatively high spot demand and tight supply, these rolling transactions have worked fine to this point, without driving prices lower
• problem will emerge few months from now as
1. economic demand softens further
2. planned production hikes actually emerge
3. weakening price momentum encourages speculators to close long positions instead of rolling them forward
• at that point, we can expect the net speculative positions to plunge by 10-15% of open interest
• we'll see a sudden glut on the market for spot delivery
• should not be surprising if this speculative unwinding takes the crude below $60 a barrel by early next year
• geeks rule of thumb:
• "when you have to fit a sixth order polynomial to capture price history because exponential growth is too conservative, you're probably close to a peak"
• doesn't mean that prices can't move even higher over the short term
• once prices go into a vertical spike, very small changes in the date of the final peak imply significant uncertainty about the ultimate high
• but: reasonable to believe that the often extreme cyclicality of commodities has not suddenly become a thing of the past.

• In commodity markets in particular, price trends feed on themselves in both directions, so we see pronounced cyclicality, and much more persistent trends – once set in motion – than we typically do in the equity and bond markets. It may be difficult to identify a peak in oil when it occurs, but most likely, the fallout from that peak will be spectacular.

Primer on inflation

• concept of marginal utility
  
• ice cream: 1st ice cream very enjoyable, 2nd one a little less, ..., 4th one probably indifferent
• as you increase the availability of a good, the "marginal utility" declines
• i.e. the value you place on an additional unit
• same principle holds for economy as a whole
• e.g. economy-wide supply of ice cream and pencils
• marginal utility of ice cream: 6 smileys
• marginal utility of pencils: 2 smileys
• price of an ice cream cone, in terms of pencils = ratio of their marginal utilities = 3 pencils
• money
• dollar in your wallet
• you hold onto it in your wallet, forgoing interest earnings, because that dollar of currency provides certain usefulness in terms of making day-to-day transactions and so forth
• dollar provides certain amount of marginal utility
• as a result, the prices of goods and services in the economy, in terms of dollars, will reflect the ratios of marginal utilities between "stuff" and dollars
• i.e. the dollar price of good X is just the marginal utility of X divided by the marginal utility of a dollar
• how do you get inflation?
  
• either, increase the marginal utility of "stuff"
• happens either if the supply of goods and services becomes more scarce
• or if the demand for goods and services becomes more eager
• or, reduce the marginal utility of dollars
• happens either if the supply of dollars becomes more abundant
• or if the demand to hold dollars becomes weaker
• effect of government spending and fiscal policiy
  
• need to stop thinking in terms of "partial equilibrium"
• ie. supply and demand of one item at a time
• think instead in terms of a full or "general" equilibrium imposed by a government constraint
• government spending
• financed through printing paper
• happens in banana republics
• predictably leads to inflation
• in particularly unproductive economies, it leads to hyperinflation
• financed through issuing government bonds
• tempting to think that issuing bonds means that the government is taking something in return for what it spends
• whereas printing money means an increase in spending power
• but: important to focus on the general equilibrium
• regardless of whether government finances its spending by printing money or issuing bonds, the end result is that the government has appropriated some amount of goods and services, and has issued a piece of paper: a government liability
  
• in return, which has to be held by somebody
• both of those pieces of paper – currency and Treasury securities – compete in the portfolios of individuals as stores of value and means of payment
• values of currency and government securities are not set independently of each other, but in tight competition
• particularly true today, when bank balances are regularly swept into interest earning vehicles as often as every night
• whatever the form of the paper receipts, aggressive government spending results in a relative scarcity of goods and services outside of government control, and a relative abundance of government liabilities
• real goods and services are being appropriated by government in return for an increasing supply of paper receipts
• setting a proper marginal tax policy
• on deflation
• e.g. Great Depression
• the marginal utility of “stuff” dropped, while the marginal utility of money soared
• output declined enormously
• but output fell because of a major reduction in demand
• so the marginal utility of goods and services most likely declined during that period even though production itself was down
• in contrast, despite a rapid increase in the monetary base during the Depression, people were frantic to convert their bank deposits into currency
• even the monetary growth that occurred wasn't nearly enough
• the frantic demand for currency, resulting from credit fears, translated into a major increase in the marginal utility of money
• result was rapid price deflation

• Summary:
• inflation results from an increase in the marginal utility of goods and services, relative to the marginal utility of money
• can reflect:
  
• supply constraints
• unsatisfied demand
• excessive growth of government liabilities
• or a reduction in the willingness of people to hold those liabilities
• inflation typically picks up in late-stage economic booms
• not because the economy is growing too fast, but rather because the economy begins to hit capacity constraints and is therefore not able to grow fast enough
• Fed often attempts to cool down the resulting increase in the marginal utility of goods and services
• by trying to make sure that demand growth doesn't outstrip the increasingly constrained level of supply
• apart from commodity prices, which may take a bit longer to reverse, the pressures on marginal utilities are presently on the disinflationary side

• Milton Friedman is widely known for two phrases
• "inflation is always and everywhere a monetary phenomenon."
  
• only half right because a government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities
• very true that the major hyperinflations in history have been triggered by currency expansion
• but as long as a government appropriates goods and services to itself in return for pieces of paper that compete as stores of value and means of exchange in the portfolios of investors, you'll get inflation
• "The burden of government is not measured by how much it taxes, but by how much it spends."
• completely correct
  

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