A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Sunday, February 27, 2011

Transcript: Double, double, oil and bubble, Economies burn, prices' trouble

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“In my view, we’ve got plenty of oil, we’ve got plenty of gasoline, we’ve got plenty of diesel fuel, but if the global oil market stays above $100, and now with the situation of Lybia, which is quites serious, we stay there for quite some time, unfortunately.

“Refining capacity? We have too much. That means we have too much oil, ah, with too much refining capacity, and this is why Sunoco had to last year close down a refinery in my market area, Philadelphia. We had a big refinery in Montreal close. We had another big refinery in Delaware close. All on the East Cost. So here you have the situation: we have too much oil, we have too much refinery capacity to manufacture that oil, and yet, ah, it, ah, I mean, it it’s just amazing, the absolute disconnect and I’ll bet you, if we didn’t have such an active speculator, you have to really wonder if it would really be this distorted.

“I mean you would have on a micro level …, it kind of brings home just how precarious the whole situation is. So gasoline prices, this is going to be probably the ugliest summer since the oil bubble of 2008.”
Today on the podcast, Oil and energy, the absence of relevance in the economic debate these days, and another black swan event, the third in a month, when the Fed and Demand Side actually agree on something. Today we actually agree with Thomas Hoenig.

We led with leading oil analyst Stephen Shork of the Shork Report in an interview, highly edited, from Bloomberg. We had it cued up to display our call of a continuing and growing bubble in oil, not connected to supply and demand. We were favored by a timely note from one of our listeners, Jim, who linked us to the explanation of how futures prices determine physical oil prices.

Paul Krugman, among others, has argued that because futures speculators never take delivery of oil, their activity cannot be connected to the spot price of oil. Perhaps that’s too simplistic. See the link online for the full discussion.


In it, we find that the spot market has become very thin and susceptible to getting cornered with a technique called the “squeeze,” so producers have come to rely on the much deeper and more liquid futures markets. The futures market is the heart of the current oil-pricing regime.

Quoting JD,

“… Krugman and Birger are profoundly confused about the way the international oil markets actually function. Futures aren't a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price literally *is* the price of oil.”
So speculation in futures markets, so kindly assisted by the Fed, does drive up prices. We knew it had to be the case, just from the fact that these markets are much larger and weirder than would be required for legitimate hedging by legitimate business, and there are plenty of anecdotes about people who need them getting priced out, but we thank listener Jim for the tip on the mechanics.

Oil prices are important. One of the worst market tips I ever gave, and one that led me to be very wary of making any more, was that all energy prices are led by oil prices. When oil goes up, natural gas and electricity are sure to follow. That was right before the disconnect between natural gas and oil. So oil no longer leads all energy, but it is still important.

It comprises upward of four percent of household spending. Demand elasticity is low, so when the price goes up, it sucks spending power from other activities and puts a big pinch on the discretionary spending. This means oil prices usually march with consumer sentiment.

More problematic is oil’s influence on perceived inflation. While there is a core CPI which strips out oil prices from the consumer’s basket, it is still true that energy and oil are embedded in all goods and many services, anything that energy to produce or transport. Because this cost is a weak contributor to income of labor, it is a virtual tax. I say virtual, because it corresponds more closely to the reactionary view of taxes: a black hole. With actual taxes, you actually get actual public goods.

Another way to see this is energy as a competitor to labor. Everything is made of labor and energy, primarily. When the price of energy goes up, and prices need to stay the same, the price of labor goes down. Since the price of labor is income, and the major source of demand, when the price of energy goes up, demand tends to be displaced.

So it is a cruel irony that often in the past, the Fed has leapt in at the first sign of energy price, cost-push inflation and attempted to slow the economy. The economy was already being slowed!


The Demand Side View

Does anybody really doubt the following facts:

The Great Recession began with a housing bubble fueled by zero interest rates from the Fed, predatory lending and financial innovation and predation in the financial sector.

The Great Financial Crisis resulted from overleverage by the banking sector and the shadow banking sector.

The central banks of the Western industrial economies kept the financial system from imploding by bailing out the big banks. The Fed and others support and keep solvent almost every financial market with guarantees, low rates and too big to fail insurance.

Unemployment is stalled at a very high level.

The housing market is moribund, prices are still falling, a massive foreclosure epidemic is visiting nearly every community, and households have seen the value of their major investments eviscerated.

Investment and hiring by small business is also stalled at a very low level.

If you doubt any of these facts, please turn off the podcast, visit the appropriate data sites, and return when you have confirmed that we are not making this up.


So, then, Why is the answer to our mess to cut government, neuter unions, roll back entitlements, and cut taxes for the rich?

In what way has the federal debt or state spending on education and social services contributed to the problem?

Has any one of those contributed to the situation in which we find ourselves?

No. None of these matter. Nor does pent-up inflation, immigration pressure, Obamacare, or any of the other bogeymen concocted by charlatans for their political effect. These are just bogeymen at the window that disappear whenever you look at them directly.

On the other hand, they do matter quite a bit, just because they dominate public discourse and apparently prevent people from looking out that window. And because we are talking about the wrong thing, we are going the wrong direction.

Because if we don’t fix the problem, but fix something that is not the problem, we will have two problems and we will have lost the time and effort and money we had to do something about the first problem. The foundation sank, damaging the structural integrity of the house, so we dug a hole in the front yard and removed the roof.

This is exactly what we have done.

The federal deficit is a product of the free rider tax avoiders on one hand, but it is also a symptom of the Great Recession. How can we have a deficit this big in the midst of a recovery. One, we cut taxes for the rich and prosecuted two foreign wars. Two, we can’t. We have this big of a deficit because we are not in recovery.

New lows in house prices and home sales do not mean a healthy housing market is around the corner. They mean that what we have done so far has not worked.

Big incomes on Wall Street do not mean there is a thriving credit market, nor healthy growth in personal, corporate or public pension plans. It means incentives are still screwed up and the Street is bleeding the real economy dry.

High unemployment does not mean the cash on corporate balance sheets is worth it. It means profits are not connected to US economic well-being. What is good for our corporate oligarchy is NOT good for our economy. Insofar, that is, as that economy has anything to do with people.

ZIRP – Zero Interest Rate Policy – does not mean money is growing or investments are being made. It certainly does not mean employment is increasing.

As former Labor Secretary and author of Supercapitalism, Robert Reich said this week:

“as long as Democrats refuse to talk about the almost unprecedented buildup of income, wealth, and power at the top – and the refusal of the super-rich to pay their fair share of the nation’s bills – Republicans will convince people it’s all about government and unions.”
There is a second set of facts which we would like to propose for your consideration. We’re willing to debate them at any length, but your guests might get bored.

One. Low tax rates killed employment growth. George W. came to Washington, elected by the black vote, Clarence Thomas. He had campaigned on the theme “Cut taxes, after all it’s your money.” But it took a recession to convince enough Democrats to vote in the first tax cut in 2001 and another in 2003. The Fed under Greenspan simultaneously brought the interest rate down to one percent – historically unprecedented. Deficits ballooned when wars in Iraq and Afghanistan were prosecuted on credit. High deficits, low interest rates, falling taxes. What followed? A decade of zero growth in jobs. Had he stayed in office since months longer, W would have been the only president in a century to preside over negative job growth. As it is, he easily beats out his father for worst all-time job producer among US presidents. His economic policy again: cut taxes, cut regulation, sic Greenspan on interest rates.

Everyone agrees with the evidence, but only Demand Side, it seems, is willing to pronounce the verdict. Tax cuts, low interest and coddling the financial sector produced unemployment and stagnation. NOT “accompanied unemployment and stagnation” caused by something else. The results were Y. The policy was X. X led to Y. Bad policy led to bad results.

The counter to this argument is – I did you not – something along the lines of “The disease was worse than we thought, so we need to do more of the same. Give banks more. Cut interest rates further, if we only could. And whatever happens, keep cutting those taxes. A fully funded government might work in Sweden or Germany, but it can’t work here. After all, it’s OUR kids money.”

And that counter is carrying the day.


Let’s end with another in our segment, The Fed Agrees with Us Exclamation Point.

First it was Elizabeth Duke agreeing that money is not created the way the Fed has always said. Then it was Dennis Lockhart saying inflation is a general phenomenon, not a rise in a specific or even a category of prices. Now it is Thomas Hoenig, of the Kansas City Fed, quoting.

“Fifteen years ago, I gave a speech entitled “Rethinking Financial Regulation,” which summarized the major threats facing our financial system. My suggestion then was to take steps to reduce interdependencies among large institutions and to limit them to relatively safe activities if they chose to provide essential banking and payments services and be protected by the federal safety net. I also argued that safety net protection and public assistance should not be extended to large organizations extensively engaged in nontraditional and high-risk activities. A final point of those remarks was that central banks must pursue policies that preserve financial stability. I am going to repeat those suggestions today, and as often as the opportunity allows. History is on my side.

“Today, I am convinced that the existence of too big to fail financial institutions poses the greatest risk to the U.S. economy. The incentives for risk-taking have not changed post-crisis and the regulatory factors that helped create the crisis remain in place. We must make the largest institutions more manageable, more competitive, and more accountable. We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis.”
Thomas Hoenig.

Indeed, there are no economies of scale in banking. There are actually significant drawbacks to depersonalizing a personal business and creating complexity that cannot be unwound. The only economies of scale are that if you are large enough you can capture your regulator, in this case the Fed, and the representatives of the citizenry, in this case the Congress and President.

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