How Zimbabwe’s Experience May Apply To The US

The basic difference between the US and Zimbabwe is one of capital structure or its stages of production. Zimbabwe has a primitive capital structure while the US has a more complex capital structure.

To understand the concept of capital structure, we excerpt Ludwig M. Lachmann in his book Capital And Its Structure

``All capital goods derive their economic significance from their mode of use, or rather, from their actual and potential modes of use…We realize that a heterogeneous capital concept compels us to seek the 'common denominator' of these heterogeneous resources, the common criterion of their capital quality, in their 'designed complementarity', their mode of use within the framework of a plan. Each plan is a logical structure in which means and ends are coordinated by a directing and controlling mind. In the functional variety which is of the very essence of capital utilization plans capital resources exhibit those structural relationships we shall have to study.

``All capital goods are, directly or indirectly, instruments of production. Not all of them are man-made (e.g. mineral resources are not) but all of them are man-used. It is indeed characteristic of such 'natural' capital resources that but for the existence of man-made capital designed to be employed in conjunction with them, they would not even be economic goods. The theory of capital is thus primarily a theory of the material instruments of production. It must have something to say about the role of capital goods in production plans, about the mode of their combined use. In other words, production plans are the primary object of the theory of capital.” (highlight mine)

Roger Garrison: Capital or Structure of Production

For a good account of the production process of a pencil see this article, "I, Pencil: My Family Tree as told to Leonard E. Read" (hat tip: Robert Murphy)

But failed policies can undermine a country's capital structure such as in Zimbabwe’s case -Mugabe's confiscation of farms as part of the controversial land reform, Zimbabwe’s intervention in the Democratic Republic of Congo (DRC)’s war in 1998; the parliamentary (2000/2005) and presidential (2002) elections and the introduction of senators in 2005 (at least 66 posts) as part of ‘widening the think tank base’ and the international payments obligations as discussed in Will Debt Deflation Lead To A Deflationary Environment?

Courtesy of Indexmundi.com

The detrimental impact of policy failures has resulted to the economic deterioration (see above) and the shortening or reduction of its economy's capital structure, which has prompted the Mugabe government to become exceedingly dependent on its printing press than from its taxpayer’s capacity to finance or from its impaired ability to borrow from funding abroad. With 85% unemployment government has virtually dominated the economy.

And so, the hyperinflation depression.

Nonetheless, while the US may have a complex capital structure today, a major string of policy failures which may result to the deepening of economic losses and increasing size and influence of its government can increase the risks of reducing its capital structure, thereby giving the same conditions with that of Zimbabwe of having limited ability to tap its taxpayer for funding and the diminishing prospects of accessing foreign taxpayer funds to support the role of its rapidly expanding leviathan.

This also translates to greater reliance on the printing press to sustain the government’s political objectives.

Hence, the risk of a Mises Moment endgame.

Will Debt Deflation Lead To A Deflationary Environment?

``Let's get to the bottom line. A deleveraging process is under way. It can happen against a background of bankruptcy, deflation, declining cash flows and bank bankruptcy or in a slower way against a background of inflation. Both reduce the debt burden, but one is socially jarring and led in the past to mass unemployment and arguably WWII. Democracies will choose the inflationary approach. This is not evident today, but it will be more evident soon enough as the BoJ, ECB, BoE and others realise that their current monetary policy is driving them not to slower growth and lower inflation but to deflationary calamity. Today, you can see the calamity of the deflationary disease but what will you see tomorrow, or the day after, if the monetary cure pours from the medicine jars of the global central banks?”-Russell Napier of CLSA (courtesy of fullermoney.com)

Not if you ask, Dr. Frank Shostak, ``We however, maintain that it is not the size of the debt that determines the severity of a recession, but rather the aggressiveness of the loose monetary policies of the central bank. It is loose monetary policies of the central bank that cause the misallocation of resources and the depletion of the pool of funding and in turn can be manifested in over-indebtedness. So to put the blame on the size of the debt as the key factor in causing depression is no different to blaming the thermometer for causing the high temperature.” (underscore mine)

Or Joseph Salerno in Austrian Taxation of Deflation, ``Bank credit deflation represents just such a benign and purgative market adjustment process.”

Many have cited the Great Depression as a prospective model of today’s deteriorating environment as having a deflationary character. Yet, the reason debt deflation transformed into the Great depression wasn’t due to the deleveraging process itself, instead it was debt deflation aggravated by economic policies which crushed profit incentives.

Again Mr. Salerno (highlight mine), ``Unfortunately such benign episodes of property retrieval have been forgotten in the wake of the Great Depression. Despite the fact that the bank credit deflation that occurred from 1929 to 1933 was roughly proportional in its impact on the nominal money supply to that of 1839-1843, the rigidity of prices and wage rates induced by the “stabilization” policies of the Hoover and early Roosevelt Administrations prevented the deflationary adjustment process from operating to effect the reallocation of resources demanded by property owners.”

Myths of Liquidity Trap and Pushing On A String

Deflation proponents have further used the Keynesian concepts of “liquidity trap” and or “pushing on a string” to advance their Armageddon theory.

The concept of “pushing on a string” suggests that US Federal Reserve policies will be rendered ineffective or impotent and won’t jumpstart the economy by stimulating lending.

While the US Federal Reserve have the boundless powers to add into bank reserves by purchasing assets (usually government liabilities), commercial banks might not lend money to take advantage of this. It’s like leading a horse to a pool of water, but doing so won’t guarantee that the horse will drink from it.

A liquidity trap environment is seen almost similar to the “pushing on a string” concept, but here, as interest rates nears or is at the zero regime, traditional policy tools might also be unsuccessful to spur lending (again!).

So should we fear these as media and Keynesian experts paint them to be?

We doubt so.

Why?

First is to understand how Central banks operate, according to Murray Rothbard in Man Economy and State (emphasis mine), ``The central bank can increase the reserves of a country’s banks in three ways: (a) by simply lending them reserves; (b) by pur­chasing their assets, thereby adding directly to the banks’ deposit accounts with the central bank; or (c) by purchasing the I.O.U.’s of the public, which will then deposit the drafts on the central bank in the various banks that serve the public directly, thereby enabling them to use the credits on the central bank to add to their own reserves. The second process is known as discounting; the latter as open market purchase. A lapse in discounts as the loans mature will lower reserves, as will open market sales.”

Next, Murray Rothbard in Making Economic Sense tells us why deflation isn’t likely to occur given the innumerable powers of Central Banks, ``What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.”

Figure 4: Dshort.com: US Monthly Inflation Chart

A dainty chart from dshort.com shows of the historical bouts of deflation in US history. Most of the incidences of deflation came on a post war basis after a massive expansion in money supply and artificial demand from a war economy resulted to massive adjustments during in the post war economy.

Since the gold has come off the monetary standard in 1971, despite the strings of crisis during the period (Savings and Loans, Black Monday 1987, LTCM, & dot.com bust), there has been no incidence of deflation.

The Nuclear Option: Currency Devaluation

Another, US Federal Reserve Chairman Ben Bernanke in 2001 spelled out his unorthodox “helicopter” means of avoiding a deflationary recession.

The Fed has always the luxury to use its printing presses, this from Mr. Bernanke’s speech Deflation: Making Sure “It” Doesn’t Happen Here, ``To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”

Or even consider massive devaluation as its nuclear option (emphasis mine), ``Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”

About fifty years ago, in his magnum opus the Human Action, Mr. Ludwig von Mises presciently elucidated of the endgame option available to central banks wishing to escape a credit bubble bust, ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Our Mises moment.

In short, a government single-mindedly determined to inflate the system won’t actually need a functioning private credit system to do so. As we previously said, it only needs the bureaucracy and 24/7 operational printing presses, or it can simply invoke massive devaluation as its nuclear option.

Proof?

Zimbabwe should be the best living testament of such government driven tenacity.

From Albert Makochekanwa, Department of Economics, University of Pretoria, South Africa “Zimbabwe’s Hyperinflation Money Demand Model”

``Borrowing from Keynes (1920) suggestions, namely that ‘even the weakest government can enforce inflation when it can enforce nothing else’; evidence indicates that Zimbabwean government has been good at using the money machine print. Coorey et al (2007:8) point out that ‘Accelerating inflation in Zimbabwe has been fueled by high rates of money growth reflecting rising fiscal and quasi-fiscal deficits’. As a result of that, the very high inflationary trend that the country has been experiencing in the recent years is a direct result of, among other factors, massive money printing to finance government expenditures and government deficits. For instance, the unbudgeted government expenditure of 1997 (to pay the war veterans gratuities); the publicly condemned and unjustifiable Zimbabwe’s intervention in the Democratic Republic of Congo (DRC)’s war in 1998; the expenses of the controversial land reform (beginning 2000), the parliamentary (2000/2005) and presidential (2002) elections, introduction of senators in 2005 (at least 66 posts) as part of ‘widening the think tank base’ and the international payments obligations, especially since 2004, all resulted in massive money printing by the government. Above these highlighted and topical expenditure issues, the printing machines has also been the government’s ‘Messiah’ for such expenses as civil servants’ salaries.”

As you can see, no consumer or industrial or any sorts of borrowing-spending Keynesian framework. It's plain vanilla print and distribute, where money supply exponentially outgrows the supply of goods and services, hence hyperinflation.

So even as US government policy tools have seemingly been unsuccessful to stoke up on its much desired rekindling of the inflationary environment after coughing up about $4.28 trillion of taxpayers money (see The US Mortgage Crisis Taxpayer Tab: $4.28 TRILLION and counting…), to quote Asha Banglore of Northern Trust, ``The lowering of the Federal funds rate, the Fed’s innovative programs to provide liquidity to financial institutions – PDCF, TSLF, and other programs – and more lenient rules for borrowing through the discount window appear to have exhausted the gamut of possibilities routed through monetary policy changes to influence aggregate demand. The provisions of the Emergency Economic Stabilization Act of 2008 allow for recapitalization of banks. The FDIC is working on obtaining an approval for the anti-foreclosure plan to address the housing market issues that are central to the current crisis. In conclusion, the probability of a hefty fiscal stimulus package with the Fed buying these securities is growing everyday,” the nuclear option or our Mises Moment endgame seem likely a looming reality as the day goes by.

Conclusion: Preparing For The Mises Moment

Finally, as shown above deflationary fears under a Paper money standard seems unwarranted and is not a likely scenario, given the unrestricted powers of the central bank to either use the printing press or its nuclear option- massive debasement of its currency.

Debt deflation in itself is a salutary process which involves the cleansing of malinvestments or the excesses of “exchange of nothing for something” dynamics.

The Great Depression was a product not of debt deflation dynamics only, but was exacerbated by the adaptation of rigid economic policies by the incumbent leadership that crushed business profits and the economic system’s ability to adjust.

Governments determined to inflate don’t need a functioning private banking or credit system as the Zimbabwe experience shows. All it needs is a printing press and an expanding bureaucracy.

Once the inflation process starts to gain ground be prepare for the next bout of inflation!

Reflexivity Theory And $60 Oil: Fairy Tales or Great Depression?

``Oil prices are coming down for all the wrong reasons: low economic growth and low demand. What we are not seeing is oil prices coming down because there is new supply coming on to the market or because the world has got more efficient.” Tony Hayward, BP chief executive

Allow me to disinterest you with a prosaic discourse on market psychology. Why? Because psychology drives the markets more than anything else. Said differently, economies and or markets are driven by people’s incentives to act for a particular goal. And present activities seem to reflect emerging signs of inconsistencies enough to make us discern that some prices haven’t been reflecting “reality”, but of “perceptions” of reality.

Since we will dwell much of successful speculator George Soros’ “reflexivity theory”, this also means we will be having a quote-fest from Mr. Soros.

Understanding George Soros’ Reflexivity Theory

Let me begin with Mr. Soros’ fundamental explanation of the Reflexivity theory [The Alchemy of Finance p. 318]

``The structure of events that have no thinking participants is simple: one fact follows another ending in an unending casual chain. The presence of thinking participants complicates the structure of events enormously: the participants thinking affects the course of action and the course of action affects the participants thinking. To make matters worst, participants influence and affect each other. If the participants’ thinking bore some determinate relationship to the facts there would be no problem: the scientific observer could ignore the participants’ thinking and focus on the facts. But the relationship cannot be accurately determined for the simple reason that the participants’ thinking does not relate to facts; it relates to events in which they participate, and these events become facts only after the participants’ thinking has made its impact on them. Thus the causal chain does not lead directly from fact to fact, but from fact to perception and from perception to fact with all kinds of additional connections between participants that are not reflected fully in the facts.

``How does this complex structure affect the ability of an observer to make valid statements about the course of events? His statements must also be more complex. In particular, they must allow for a fundamental difference between past and future: past events are a matter of record, while the future is inherently unpredictable. Explanation becomes easier than prediction.” (all emphasize mine)

Essentially, there are three variables that shape the reflexivity theory: facts, events and perception.

Let me cite a hypothetical situation:

Fact: Falling Prices or bear market

Event: Official Recession is declared

Perceptions:

1) Concerns about recession prompt for falling prices.

2) Falling prices impels the perception of an economic recession.

The dilemma: This becomes a chicken and egg problem of having to ascertain which among the two comes first or which causes which?

In the same plane, we ask “does the causal chain equate to events (recession) reinforcing the facts (falling prices) or has the facts (falling prices) been shaping events (recession)?”

Facts or events are always seen from the privilege of hindsight or ex-post. But since people don’t exactly know the future, it is always easier to explain away as predictions by the convenience of associations, buttressed by additional connections, the past activities. Essentially, such predicament represents as feedback loop transmission which predominate the thinking process operating in the marketplace.

And where such feedback loop gets bolstered-both falling prices and economic weakness are increasingly being felt and validated-the tendency is to draw enough “following” or “crowd” to shape the growing conviction into a major trend or into a socially accepted and popularly entrenched view or belief.

A vivid empirical example, a non-financial or non-market practitioner neighbor whom I recently bumped into at the local “sari-sari” store confidently insisted to me that the Philippines will experience an “economic recession” in 2009! Wow. Obviously his pronouncements had either been influenced by the headlines from the broadsheet or from news broadcasted by the media airwaves.

Now going back to the feed back loop mechanism of falling prices and recession, such chain of linear “cause-and-effect” thinking leads to the point where the denouement extrapolates to our perdition, or said differently, the ultimate outcome from such induction process is that prices will fall to zero and or society will stop functioning-which is nothing but plain balderdash.

If the US is now in the “eye” of the recession storm, it means that many parts of its “complex” or highly structured economy, which has been unduly boosted by tremendous doses of debt driven malinvestments, are presently enduring from a painful but necessary adjustment process which involves the clearing out of such excesses.

But it doesn’t mean that ALL of the US economy is suffering, because people’s lifestyle fine tune under dynamic operating conditions. The fact that the world’s largest publicly listed company (money.con.com) and retail behemoth Walmart reported a 10% rise in profits (Reuters) amidst the third quarter squall suggest of the societal response to income elasticity of demand, where changes of income prompts for a change in consumption pattern. The truism is that people will continue to live or society will continue to exist, even at more financially or economically difficult environment, but some sectors are likely to benefit from such adjustments.

The other obvious point is that the present “prevailing bias” dynamics (of falling prices-deleveraging/recession feedback loop) will eventually outlive its usefulness, whose popular convictions will extend to the extremes and morph into a false premise.

To quote Mr. Soros anew, ``Economic history is a never-ending series of episodes based on falsehoods and lies. The object is to recognize the trend whose premise is false, ride the trend, then step off before the premise is discredited." (highlight mine)

Reflexivity and Oil Prices: Spotting False Premises?

In recognition of a trend whose premises could seemingly false, where prices don’t square with economics, oil prices could be an embodiment.

The fact: Prices for oil as measured by the WTIC (West Texas Intermediate Crude) have been in a bear market. To date, prices have lost some 60% from its peak last July.

The event: Pronouncements from energy authorities that demand growth could become negative.

This excerpt from Wall Street Journal (highlight mine): ``The International Energy Agency warned Thursday that world oil-demand growth this year is on the cusp of falling into negative territory for the first time in 25 years, as global economic problems hammer away at energy consumption.

``In a new twist from past months, the agency also substantially lowered its forecast for oil demand in China and other emerging markets, where much of the growth in energy consumption is coming from. The IEA cut its expectations for demand in 2009 in these nations by 260,000 barrels a day.

``The IEA, in its monthly oil market report, said world oil demand will grow by 0.1% in 2008, down from a previous growth projection of 0.5% and far below the 1.1% growth in 2007. Globally, consumers and businesses will use on average 86.2 million barrels a day, 330,000 barrels lower than IEA's previous report.”

The popular perception: Falling demand have sparked a fall in oil prices. Falling oil prices reflect oil demand deterioration. So a feedback loop between falling demand and falling oil prices have fundamentally been reinforcing each other.

In our latest outlook, Demystifying the US Dollar’s Vitality we noted how OIL prices peaked at the same time the US dollar bottomed. We equally pointed out that the rapid pace of acceleration in the surge of the US dollar (as measured by the US dollar index basket) mirrored the sharp degree of descent by oil prices where we opined that the carry trade of being “short the US dollar- long commodities” have basically been unwinding.

We also posited that the all important driver that has virtually been encompassing the divergent global markets- such as the surge in the US dollar, the downside volatilities in the ex-US dollar currencies (except the Yen), the crash of the oil, commodities, emerging markets, the widening of various credit spreads, the collapse of asset backed markets, commercial paper markets, globally stock markets, surfacing of various crisis in different nations (such as Iceland, Hungary, Pakistan, South Korea etc.) and the disruptions in trade finance-have been the ongoing debt deflation or “deleveraging” dynamics.

The recent seizure of the credit markets and the ensuing gridlock in the US banking system has fundamentally impaired the flow of financing enough to have a substantial spillover impact to the global economy.

Thus, the prevailing bias or perception has been one of decelerating global economic dynamics prompting for the selling pressure in oil prices as indicated by the above by the Wall Street report.

And amidst falling oil prices and empirical evidences of deteriorating global economic growth, the feedback loop transmission of falling prices and falling demand has now been fostered into a conventional theme.

So where does this race to the bottom all stop?

With such linear based thinking, some questions pop into our mind: will oil fall below $50 to $10 per barrel or even to zero? Will people shun traveling? Will commerce stop? Will our lives grind to a complete halt?

The world is evidently so consumed with the Keynesian brand of economics, where almost everything seems centered on demand aggregates such that the mainstream appears to have forgotten the supply side variables.

It’s Not All About Demand, Supply Matters Too

Here is where we part with the consensus.

Figure 1: IEA World Production By Source In The Reference Scenario

As Figure 1 from IEA world energy outlook 2008 shows how conventional oil fields (dark blue) are expected to rapidly deteriorate following a “peak” by 2010.

And even without the popular political rhetoric of “energy independence” (an issue we will discuss in the future), such a gap would need to be filled by new oil fields or non-conventional oil or natural gas liquids.

According to the IEA fact sheet, ``The world’s endowment of oil is large enough to support the projected rise in output, but rising oilfield decline rates will push up investment needs. Proven reserves of close to 1.3 trillion barrels equal more than 40 years of output at current rates; remaining recoverable resources of conventional oil alone are almost twice as big. But there can be no guarantee that those resources will be exploited quickly enough to meet the level of demand projected in our Reference Scenario. Decline rates – the rate at which individual oilfields decline annually – are set to accelerate in the long term in each major world region. The average observed decline rate worldwide is currently 6.7% for fields that have passed their production peak. This rate rises to 8.6% in 2030.” (underscore mine)

This means that massive investments are needed to cover such deficits.

But the question is, how will the investments come about and where will the investments come from when access to credit have been severely limited, or if not, the cost of money have been pricier, or oil prices have not been enough to prompt for a revenue stream required to fund or finance future oil projects?

Windfall Profit Taxes and Fairy Tale Oil Prices

Figure 2: Agorafinancial.com: Estimated Cost of Oil Production

Figure 2 shows that at $57 oil, most of the alternatives to the conventional oil have been rendered unfeasible, as present prices appear to be at below the estimated cost of production. This also means at present prices oil companies, whether state owned or privately owned companies are suffering from losses.

Proof?

From Timesonline.co.uk (highlights mine),

``Leading Russian oil producers, including TNK-BP, BP's Russian affiliate, are grappling with a collapse in profits from the export of Siberian oil.

``Heavy export tariffs have almost wiped out the profit margin from selling crude oil outside Russia, forcing Siberian producers to sell at prices as low as $10 a barrel on Russia's domestic market. Fears are mounting that the profits squeeze may speed the decline in Russian oil output, already down 6 per cent this year.

``The profits crunch, caused by the collapse in the worldwide price of crude, is provoking concern within Russia's oil community that capital expenditure budgets will have to be cut if profits from oil sales do not recover. “The tax burden is very tough,” Valeri Nesterov, an oil analyst at Troika Dialog, the Moscow brokerage, said. “The problem is that the future of the oil sector might be jeopardised if the Government doesn't reduce the tax burden.”

As you can see, high taxes and a sharp drop in oil prices pose as double whammies and threaten to curb the immediate supply in the global oil markets as capex are likely to get excised if losses continue to mount.

Besides, high taxes are products of reactionary government policies aimed at attempting to secure more revenues in anticipation of “eternally” high oil prices.

This should also serve as lesson to windfall profit advocates. What has been missed by governments and their social liberal proponents of taxing windfall profits are that

1) Oil is a cyclical commodity

2) Oil prices are never permanent and subject to the balance of demand and supply

3) High taxes tend to compound the miseries of oil companies when prices become unfavorable.

4) Profits are needed to fund or finance future oil or energy supplies.

5) Speculation or “greed” does not drive oil prices as evidenced by the 60% loss from the top.

To quote Steven Landsburg, ``Most of economics can be summarized in just four words: People respond to incentives. The rest is commentary."

More proof?

Figure 3 ntrs.com: Mexico’s Rapidly Declining Crude Production

Mexico, the third largest oil exporter to the US following Canada and Saudi Arabia (EIA) has been encountering a precipitate decline in oil production as shown in figure 2. The Cantarell oil field which accounts for 60% of Mexico’s oil production has been declining at a rate by nearly 20% and could reach 30% (oil drum).

Remember, about 40% of state revenues come from the oil industry which means unless Mexico’s economy diversifies or expand its oil output, the country runs the risk of declining revenues, which given the present conditions of state spending could lead to a debt default.

Yet for years, Mexico has prohibited foreign companies from exploring on its national geography, which has been controlled by state owned monopoly the PEMEX. But recent events have reinforced the political and economic exigency to expand production by accepting foreign investments. Hence, the Mexican government, despite the unpopularity of the measure, has signaled its willingness to subcontract exploration and drilling to foreign companies (time.com).

To quote James Pressler of Northern Trust, ``The only thing that could make this situation worse for Mexican oil production would be an actual storm. The Mexican government, seeing the same warnings we are, has finally passed a much-contested and watered-down energy reform bill to get the sector back in shape by allowing foreign investment – though some fear that it is too little too late. The concern is that the weak legislation is not nearly enough to reverse the strong, downward trends of the oil sector. The justification: Pemex posted a $1.3 billion loss in Q3 as crude production fell almost 10% from a year ago. Clearly, it’s going to take a lot of foreign investment to turn Pemex around, and a lot of time. The real question is, will any private firm invest now that oil has fallen below $60 pb, the credit markets have all but seized up, and Mexican security conditions have worsened?”

And just how much investments are needed to bring supplies on stream to balance with demand?

Mr. Byron King writing in the Rude Awakening from agorafinancial.com gives us a clue,

``According to the IEA, even with massive levels of investment in the oil patch, the best estimate is that the global oil industry can reduce the rate of depletion to perhaps the 6% range. So the world energy industry will have to run faster just to keep from falling too far behind the demand curves.

``Again, you need to keep in mind that current energy prices are just too low to support the level of energy investment that the world needs going forward. (Meanwhile, the U.S. government is spending trillions of dollars just to bail out the banks and bankers, not one of whom runs pump jacks.)

``The IEA estimates that the oil industry will have to invest over $350 billion per year to counter the steep rates of decline in output. And even that will not be sufficient to maintain levels of output for traditional forms of crude oil. Thus, much of the future investment will have to go toward extracting other kinds of hydrocarbon substances. And these "other kinds" tend to be very expensive to develop.”

In addition, capital cost expected for the energy sector is projected at $26.3 trillion going into 2030 with 52% of the total or $13.2 trillion earmarked for the power sector and the balance for upstream oil and gas industry (IEA). Over the present term some of this are at risk.

So unless the world falls into a great depression (version 2.0), which seems unlikely unless global government start erecting barriers that would restrict trade and finance flows, the likelihood is that oil demand trends will continue to be strong over the medium to long term and will pose as hazardous strain to the demand-supply equation.

From the basis of the continuance of present government policies, the IEA also predicts that the “primary demand for oil (excluding biofuels) rises by 1% per year on average, from 85 million barrels per day in 2007 to 106 mb/d in 2030”, where most of these demand would come from non-OECD countries, see figure 4.

Figure 4: IEA Estimated Change in oil Demand by Region

From the IEA, ``These global trends mask big differences across regions. All of the projected increase in world oil demand comes from non-OECD countries. India sees the fastest growth, averaging 3.9% per year over the projection period (to 2030), followed by China, at 3.5%. High as they are, these growth rates are still significantly lower than in the past. Other emerging Asian economies and the Middle East also see rapid growth. In stark contrast, demand in all three OECD regions (North America, Europe and the Pacific) falls, due to declining non-transport demand. The share of OECD countries in global oil demand drops from 57% in 2007 to 43% in 2030.”

Conclusion: Groping For A Guidepost

As you can see based on the above projections, oil below $60 dollars hasn’t been unambiguously reflective of real world economics. To paraphrase Agora’s Byron King, $60 oil seems priced at “Fairy Tale” levels.

Instead, oil at $60 has been a function of indiscriminate selling, triggered by the massive waves of debt deflation or delevaraging dynamics.

This downside overshoot only aggravates the structural imbalances in the supply demand equation over the medium to long term basis that risks an equivalent fierce overshoot to the upside once the present trends inflects or reverses.

This also means that while oil prices can remain at depressed levels as global financial markets attempt to find its footing, from which George Soros once observed ``“When a long-term trend loses momentum, short-term volatility tends to rise, it is easy to see why that should be so: the trend-following crowd is disoriented”, the brewing imbalances are likely incite a sharp recovery perhaps sooner than expected.

Furthermore, this also demonstrates how market psychology works; the public has been anchoring oil prices on the premise of a deep global recession, if not a great depression from a prospective an OECD deflationary environment. The latter idea is something we don’t share unless governments, as we stated earlier, start erecting firewalls.

As in the case of Zimbabwe, we understand that a government determined to inflate don’t need a functioning private credit system in order to inflate.

All it needs is 24/7 full scale operations by the printing presses and an expanding network of bureaucracy (or helicopters). As we noted in Black Swan Problem: Not All Markets Are Down!, its 231,000,000% (hyper) inflation has prompted for a year-to-date return of 960 QUADRILLION % (!!!) in its stock market as people flee its national currency. Why the refuge in stocks? Perhaps because to quote Mr. Soros, ``stock markets is one of the most important repositories of collateral”.

And as global governments combine to adopt a path to Zero Interest Rate Policy and have been flooding the world with “money from thin air” to rescue entities affected by the bubble bust, this equally reflects another reason why oil at $60 seems like a fantasy.

Finally, Mr. Soros tells us that ``People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

Applied to the oil markets, it simply means that once oil prices begin to reverse, the “expert” rationalizations over “deflation and depression” will likely be replaced with stories of “recoveries” and renewed concerns over inflation.

Demystifying the US Dollar’s Vitality

``The Achilles Heel of the United States is the dollar. The reserve status of the US dollar is absolutely critical to the health of the US. If the dollar begins to lose it's reserve status, the US economy will be in shambles.”-Richard Russell

Some have found the recent rise of the US dollar as mystifying while the others have found the surging US dollar as a reason to gloat.

While there are many ways to skin a cat, in the same way there are many ways to interpret the US dollar’s vigorous advance, see figure 3.

Figure 3: stockcharts.com: US Dollar’s Rise Coincided with Market Breakdowns

From our end, we read the action of the US dollar index (geometric weighted average of 6 foreign currencies of major trading partners of the US) by looking at its relationship across different asset markets.

And as we can see, the dramatic surge of the US dollar index coincides with an astounding symmetry-the collapse of the oil market (lowest pane) and the equivalent breakdown of critical support levels (vertical arrows) of stock markets of the US (signified by the S&P 500- pane below center) and Emerging Markets (pane below S&P).

And market actions have fantastically been too powerfully synchronized for us to ignore its interconnectedness or the apparent simultaneous cross market activities.

While we can discuss other possible influence factors such as the shrinking trade deficits which may have contributed to a narrowing current account deficit or an improvement in US terms of trade or the ratio of export prices over import prices, the fact that the US dollar behaved in a spectacular fashion can’t be interpreted as a sudden market epiphany over some unlikely radical improvement in trade fundamentals.

What we understand was that by mid July, cracks over the financial markets began to surface with the US Treasury publicly contemplating to inject funds to support both Fannie Mae and Freddie Mac. From then, the deterioration in the financial markets accelerated which inversely prompted the skyward ascent of the US dollar. Fannie and Freddie were ultimately taken over by the US government in September.

DEBT DEFLATION Dynamics In Progress

So what could be the forces behind such phenomenon?

``Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation.

``The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”

This according to Irving Fisher is what is known as the DEBT DEFLATION theory dynamics. As you would notice the chain of events leading to the current market meltdown and the precipitate rise in the US dollar have closely shadowed Mr. Fisher’s definition.

How?

Figure 4: Bank of International Settlements: CDS and Foreign Exchange Derivatives Market

One, a significant market of the structured finance-shadow banking system (estimated at $10 trillion) and derivatives ($596 trillion, Credit Default Swap $33.6 trillion down from nearly $60 trillion-left pane- see figure 4) have mostly been denominated in US dollars (foreign currency derivatives also mostly US dollar denominated-right pane), thus deleveraging or debt deflation means the closing and settlement of positions and payment in US dollars.

This also implies whether the counterparty is from Europe or from Asians settlement of such contract means payment in US dollars. Thus, the sudden surge in demand for US dollars can be attributed to the ongoing debt deflation-deleveraging process.

Figure 5: Investment Company Institute: World Mutual Fund

Two, cross currency arbitrage or 'carry trades' have also significant US dollar denominated based exposures.

For instance US mutual funds in 2007 totaled US $12 trillion (see Figure 5 courtesy of ICI) with 14% of the total allocated to International Stock funds or $1.68 trillion.

We may not know exactly how much of these funds flows were borrowed in order to buy into international stock funds, but the idea is, once the margin call came, highly levered funds were compelled to liquidate their positions in order to repay back their loans in US dollars.

Isn't it ironic that the epicenter of the present crisis emanated from the US and yet the debt deflation dynamics prompted a gravitational pull to the US dollar? Had these been something resembling like an Asian crisis then such dynamics would have been understandable.

The US Dollar’s Hegemon and Threats To Its Dominion

Figure 6: Bill Gross: Going Nuclear

Lastly, we have always described the architectural platform of the US dollar standard as pillared upon the cartelized system of US banking network which extends to a syndicate of peripheral banks abroad or global central banks.

PIMCO’s chief Bill Gross in his latest outlook wrote a good analogy of this as a function of nuclear energy see figure 6.

From Mr. Bill Gross (all emphasis mine), ``Uranium-238 has something like 92 electrons circling its nucleus…And, importantly, uranium-238 is metaphorically quite similar to the global financial system of the past half century. At its nucleus was the overnight Fed Funds rate which, when priced low enough, led to an ever-increasing circle of productive financial electrons. The overnight policy rate led to cheap commercial paper borrowing and then leapfrogged outward and across the oceans to become LIBOR. In turn, government notes and bonds as well as markets for corporate obligations were created, leading to their use as collateral (repos), which fostered additional credit and additional growth. The electrons morphed into productive financial futures and derivatives of all kinds benefitting all of the asset classes at the outer edge of the #238 atom – stocks, high yield bonds, private equity, even homes and commodities despite their being tangible as opposed to financial assets.”

``This was how the scientists, the financial wizards with Mensa IQs, visualized the financial system a few years ago: leverageable assets held together by a central bank policy rate at its nucleus with institutional participants playing by the rules of conservative self interest and moderate government regulation. Out of it came exceptionally high returns on assets with minimal risk – the highest returns occurring with the most levered electrons farthest from the nucleus.”

Since financial flows appear to have revolved around the foundations of the US banking system with its core at the US Federal reserve, the recent logjam in US banking sector caused a ripple effect to the peripherals via shortages of the US dollar, a liquidity crunch and a subsequent scramble for US dollars which triggered several crisis among EM countries whose balance sheets have been vulnerable (excessive exposure to foreign denominated debt or currency risks, outsized current account deficits relative to GDP, excessive short term loans or highly levered domestic balance sheets).

Thus, the paucity of US dollars has compelled some nations to bypass the banking system and utilize barter (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?) such as Thailand and Iran over rice and oil. Whereas Russia and China have announced plans to use national currencies for trade similar to the recently established Brazil-Argentina (Local Currency System).

The recent crisis encountered by South Korea (heavily exposed to short term foreign denominated debt) and Russia (corporate sector heavily exposed to foreign debt) seem to be prominent examples of the US dollar squeeze.

Figure 7: finance.yahoo.com: South Korea Won-US dollar

Understanding the present predicament, the US Federal Reserve quickly extended its currency Swap lines to some emerging nations as South Korea, which has so far resulted to some easing of strains in the Korean Won, see figure 7. However, we are yet uncertain about its longer term effects although it is likely that access to the US dollar should demonstrably reduce the liquidity pressures.

The important point to recognize is that some nations have began to acknowledge the risks of total dependence on the US dollar as the world’s reserve currency and/or its banking system. A furtherance of the crisis with the US as epicenter can jeopardize global trading and finance. Hence, some countries have devised means of exchange around the present system or have been mulling over some alternative platform.

Such developments are hardly positive contributory factors that would buttress the value of the US dollar over the long term especially as the US government has been throwing much weight of its taxpayer capacity to resuscitate and bolster the present system.

Mr. Ronald Solberg, vice chairman and lead portfolio manager of Armored Wolf, in an article at Asia Times online articulates more on this (emphasis mine),

``According to Goldman Sachs estimates, the US Treasury faces an unprecedented financing need in fiscal year 2009.2 Excluding funding requirements under the Supplemental Financing Program (SFP), they estimate 2009 FY issuance at $2 trillion compared to last year’s $1.12 trillion, which itself was already outsized. This prospective amount is driven by an estimated budget deficit reaching $850 billion, funding TARP purchases of up to $500 billion and the rollover of maturing debt equal to $561 billion.

``On top of these needs, it would not be unreasonable to expect additional SFP funding requirements of $500 billion, the amount already issued to date in FY 2008 used to recapitalize the Fed’s balance sheet. The magnitude of such funding requirements will test the operational efficacy of the Treasury, requiring increased auction size, frequency and expanding maturity buckets on debt issuance, and will likely extend through FY 2009 and into FY 2010, prior to these pressures abating. Perhaps even more ominously, issue size will severely test market demand for such an avalanche of debt.”

Conclusion

All these demonstrate the two basic factors on why US dollar has recently surged.

One, this reflects the US dollar’s principal function as international currency reserve and importantly,

Second, most of the leveraged assets markets had been denominated in US dollars. And in the debt deflation dynamics as defined by Economist Irving Fisher, ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”

Finally, with US government printing up a colossal amount of money within its system (yes that includes all swap lines extended to other countries as de facto central bank of the world), financing issues will be tested based on the (supply) issuance of its debt instruments and the (demand) market’s willingness to fund the present slew of government programs from internal sources (US taxpayers and corresponding rise in savings) and or from external sources (global central banks amidst normalizing current account imbalances).

We don’t buy the idea that US debt deflation will spur hyperinflation abroad which could further bolster the US dollar. Monetary inflation doesn’t necessarily require a private banking system to extend credit and inflate, because the government in itself as a public institution can inflate the system through its web of bureaucracy.

Zimbabwe is an example. Its banking system seems dysfunctional: savers don’t trust banks, the government has been using such institutions to pay for government employee salaries yet have suffered from government takeovers, while some of the banks have engaged in forex accumulation than operate normally.

Basically, Zimbabwe’s inflationary mechanism is done via the expansion of its bureaucracy to a leviathan and the attendant acceleration of the printing press operations.

The Origin of Money and Today's Mackarel and Animal Farm Currencies

Contrary to common perception money originated not from governments but from free markets,

According to Murray N. Rothbard in What Has Government Done to Our Money?, `` Now just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media--in almost all exchanges--and these are called money.”

What ideal place to demonstrate this than in the ultimate government controlled living place-Prison Facilities!

In the US, a Californian prison where the US dollar has been banned to circulate within its premises, inmates have elected by implicit virtue of the above dynamics as their alternative currency of choice-cans of Mackarels!

Wall Street Journal

This interesting article from Wall Street Journal (emphasis mine),

``When Larry Levine helped prepare divorce papers for a client a few years ago, he got paid in mackerel. Once the case ended, he says, "I had a stack of macks."

``Mr. Levine and his client were prisoners in California's Lompoc Federal Correctional Complex. Like other federal inmates around the country, they found a can of mackerel -- the "mack" in prison lingo -- was the standard currency.

``"It's the coin of the realm," says Mark Bailey, who paid Mr. Levine in fish. Mr. Bailey was serving a two-year tax-fraud sentence in connection with a chain of strip clubs he owned. Mr. Levine was serving a nine-year term for drug dealing. Mr. Levine says he used his macks to get his beard trimmed, his clothes pressed and his shoes shined by other prisoners. "A haircut is two macks," he says, as an expected tip for inmates who work in the prison barber shop.

``There's been a mackerel economy in federal prisons since about 2004, former inmates and some prison consultants say. That's when federal prisons prohibited smoking and, by default, the cigarette pack, which was the earlier gold standard.

``Prisoners need a proxy for the dollar because they're not allowed to possess cash. Money they get from prison jobs (which pay a maximum of 40 cents an hour, according to the Federal Bureau of Prisons) or family members goes into commissary accounts that let them buy things such as food and toiletries. After the smokes disappeared, inmates turned to other items on the commissary menu to use as currency.”

Oh well, this is definitely a lot better than for society to utterly eschew government’s mandated legal tender similar to that in Zimbabwe where its 531 BILLION PERCENT hyperinflation (Voanews.com) rate has virtually ravaged or evaporated the purchasing power of its currency, enough for the people to reject it and find an alternative...

Courtesy of Zimbabwean

From “The Zimbabwean” Thomas Ncube, 58, who also lives in Dongamuzi, told IRIN he had exchanged all his goats and had nothing left to barter with. "The people who are selling maize are refusing cash, saying the Zimbabwean dollar loses value fast and they only exchange the grain with livestock, and most villagers have become poor from exchanging their livestock for grain." (highlight mine).

Welcome to the Barter economy!

Lesson: When governments take away or devalue money, people will always find an alternative.