The Economist: Pump Priming-Dear oil and subsidised petrol are hurting Asia's economies

Pump priming
Sep 30th 2004 BANGKOK AND JAKARTA

From The Economist print edition

Dear oil and subsidised petrol are hurting Asia's economies

THE high price of oil is taking a serious toll on Asia, in more ways than you might think. Inflation is already ticking up, from Mumbai to Manila. Interest rates are beginning to follow. Increased energy costs, the United Nations reckons, will shave a percentage point off the region's economic growth this year. The Asian Development Bank has just cut its growth forecasts for next year too. In some cases, the prognosis is truly dire: prices of $50 a barrel, if sustained throughout next year, will slash four percentage points off Thailand's growth rate, according to the bank's projections. Yet many Asian governments, including Thailand's, are making a bad situation worse by subsidising fuel prices.

The economies of Asia, like those of most developing countries, are oil-intensive. In other words, Asians consume more oil per unit of output than Europeans or even gas-guzzling Americans. Thailand and China, for example, use more than twice the rich-country average, while India burns through almost three times as much, according to the International Energy Agency. So they naturally suffer more when the oil price rises.

One reason Asian countries get through so much oil is that many of them subsidise it in one way or another. Since the beginning of the year, the Thai government has fixed the retail price of diesel at below market rates, at its own expense. Indonesia has long done the same for all types of petrol. In August, the Indian government cut excise and import taxes on oil, to add to the direct subsidies it already pays on liquefied petroleum gas (LPG) and kerosene. Malaysia, too, keeps petrol prices low through direct subsidies and tax breaks. The government of China sets discounted prices, but leaves it to refiners and distributors, which are largely state-owned, to absorb the shortfall.

Needless to say, all this costs a fortune. The Indonesian government originally planned to spend 14 trillion rupiah ($1.5 billion) on fuel subsidies this year. But as the oil price has risen, the bill has more than quadrupled, to 63 trillion rupiah. That is almost as much as Indonesia's total budget for development. In Malaysia, fuel subsidies and forgone taxes account for roughly half this year's budget deficit of 20 billion ringgit ($5.3 billion). Rating agencies have been muttering about the government's persistent deficits, yet it left the fuel subsidy intact in next year's budget too. India, another compulsive borrower, is spending $1.4 billion this year to subsidise kerosene and LPG alone. The government is also forgoing $540m in tax revenues on various fuels, while state-owned refiners and distributors must also have absorbed considerable costs that do not feature on the government's balance sheet.

Taxpayers, of course, will eventually foot all these bills. Meanwhile, growing public debt puts upward pressure on interest rates and reduces the capital available to more productive borrowers. In the long run, that could cause far more damage than high oil prices.

To make matters worse, artificially low prices encourage waste, along with all the concomitant costs in terms of pollution, traffic congestion and misallocated capital. Thaksin Shinawatra, Thailand's prime minister, claims he is determined to reduce his country's energy bills. To save electricity, he has asked shops to close early and that big buildings should switch off their flood-lights. Yet since January, he has capped the price of diesel—on which most Thai vehicles run—at about three-quarters of the market rate. Motorists, naturally enough, are buying more. Thailand's oil imports have duly surged in volume, as well as just price.

Higher import bills, in turn, have sent Thailand's trade balance into the red. That has depressed the baht, making imported fuel more expensive still, and feeding the inflation the subsidies are supposed to curb. Most Asian nations import at least some of their oil; of all the countries mentioned, only Malaysia is a net exporter. Indeed, Asia as a whole (excluding the Middle East, but including Central Asia) produces only 11% of the world's oil, but consumes about 21%. Oil alone accounts for almost a third of India's imports, for example. Admittedly, a healthy balance of payments and huge foreign-exchange reserves will allow most Asian countries to finance expensive oil imports for a long time to come. But there is no sense in increasing the burden unnecessarily.

Furthermore, most oil subsidies do not go to the people in whose name they are paid: the poor. Cheap petrol, for example, benefits most those who drive the biggest, most inefficient cars, namely the rich. The poorest have no motor vehicles at all. Indonesia effectively subsidises its richer neighbours, thanks to a roaring trade in smuggled petrol. Singapore does not allow locally registered vehicles to leave the country with less than three-quarters of a tank of gas, to prevent them from taking undue advantage of the subsidised stuff across the border in Malaysia. Even targeted subsidies can end up in the wrong hands. Many countries subsidise kerosene, since the poor often cook with it. But so do lots of well-to-do restaurateurs.

The biggest beneficiaries of oil subsidies are the politicians who use them as a crude vote-buying technique. Mr Thaksin has declared that diesel subsidies will remain in place until February, which also happens to be the month by which an election must be held. The previous Indian government did not allow any fuel price rises for five months prior to elections in April. The outgoing Indonesian government, too, put off planned price hikes this year. How unlucky, then, that a record year for oil prices also happened to be a record year for elections in Asia.

Economist Paul Kasriel and Asha Banglore of Northern Trust: Has America Achieved Economic Paradise On Earth?

Has America Achieved Economic Paradise On Earth?

Paul Kasriel and Asha Banglore

Northern Trust

The conventional wisdom is that the Chinese economy has a near infinite capacity to produce goods and services because of its abundant population. The conventional wisdom is that this abundant Chinese population wants to work – i.e., produce goods and services – but has little desire to consume the fruits of its labor. Therefore, China must export if its population is to be employed. The conventional wisdom is that because the Chinese people already own so many U.S. Treasury securities as a result of their central bank’s purchases, they would not dare do anything to bring about a fall in the value of those securities. Therefore, the Chinese central bank will buy any amount of U.S. government securities necessary to preserve the value of the outstandings and to keep the yuan from appreciating. If the conventional wisdom is correct, Americans have achieved an economic heaven on earth. We can now have as many guns and as much butter as we want, thanks to those automatons, the Chinese. Instead of fretting about U.S. government spending and borrowing, we should be encouraging even more of it, if the conventional wisdom is correct. We should be building up our defense systems to the max, issuing government debt to pay for it. After all, the Chinese will buy the debt to keep the yuan from appreciating against the greenback. Heck, we won’t even have to use any of our land, labor or capital to produce these defense systems. The Chinese will be happy to produce them for us and take IOUs in exchange. I know manufactured housing has bad reputation, but I bet those Chinese could turn out some modular models that look like McMansions. So, the U.S. government could buy these kits from China, again giving the Chinese IOUs, and distribute them to Americans. The only constraint would be the amount of vacant land in the U.S. and the labor to assemble the kits. But would not Americans be put out of work by all this? Of course. But so what? The government would write all of us slackers a check for whatever amount we want so that we could purchase all of our desired goods from China. Again, the Chinese people, who evidently only live to work, would gladly exchange the goods they produce for dollar-denominated IOUs. Man, I can hardly wait to take delivery of that 45-foot sailboat I have always wanted! So, if the conventional wisdom is correct, stop worrying about the fact that the U.S. is the world’s largest net debtor economy and start enjoying it. Don’t bother to reflect on the fact that the conventional wisdom is often incorrect.

Eric Fry of the Rude Awakening: Nuthin' To Drill

Nuthin' To Drill

Eric Fry

The Rude Awakening

Crude oil jumped to another all-time record yesterday, in the process increasing the already-considerable wealth of T. Boone Pickens...

"Better late than never" would seem to be a fitting description of Mr. Pickens' financial fortunes. The one-time corporate raider didn't do too badly for himself during the 1980s, when, as president of Mesa Oil, he reaped hundreds of millions of dollars for his shareholders by attempting hostile takeovers of companies like Phillips Petroleum and Cities Services.

But raiding, says Pickens, was never as profitable as simply riding the energy bull market of the last few years. The oil maverick's Dallas-based hedge fund, BP Capital Energy Commodity Fund, has soared 283% so far this year and has racked up profits of more than $1.3 billion since the start of 2000.

"I really needed to win," the 76-year old Pickens explains to Bloomberg News. And win he did! This senior citizen of the oil patch has increased his wealth by more than 3,000% since 1997, finally nosing into the 389th slot on Forbes' list of America's 400 wealthiest people. Pickens says he has paid 75 percent of his lifetime's income taxes since he turned 70.

"He just got lucky," gripes one oil industry consultant. Maybe so, but luck of this magnitude has a mysterious way of repeating itself...which is why we are intrigued by Mr. Pickens' particular brand of luck. He owes most of his good fortune to some extremely prescient - or lucky - calls on the price of natural gas and crude oil. To cut to the conclusion of this tale, T. Boone Pickens believes oil and gas prices are headed higher still...

But first a little history.

In the late 1990s, Pickens launched a tiny hedge fund dedicated to making leveraged bets on oil and gas prices. His fledgling BP Capital Energy Commodity Fund had barely flown the nest before it encountered life-threatening difficulties. The fund suffered large losses in its first two years, 1997 and 1998, trimming Pickens' personal wealth to $24 million from $35 million. But the fund turned the corner in 1999, when it squeaked out a $900,000 profit. BP Capital has been profitable every year since...immensely so. Pickens has seen his personal fortune rise to about $760 million.

"He understands the industry and business like no one else," says billionaire Harold Simmons, one of the BP Capital Energy Commodity Fund's original investors. In 1997 Simmons kicked $5 million into Pickens' hedge fund, only to see the investment shrivel to $400,000 in 1998. "I thought we were going to lose the whole thing," says Simmons.

Instead, as luck would have it, Pickens' fund handed Simmons about $150 million in profits over the ensuing four years. Let's take a closer peak at the DNA of Pickens' good luck...

In late April of 2003, T. Boone Pickens kicked off the Grant's Spring Conference here in Manhattan by declaring, "I don't believe I'll ever see natural gas below $4.50 again." Inventories are extremely low, he explained, supply is falling and demand is holding steady - a potentially explosive situation for gas prices. "If we get another cold winter next year," Pickens predicted, "the gas price could go to $10 an mcf or more...the gas price could do anything, and I mean anything!"

Sure as shucks, the gas price soared above $7.00 later that year, and has only "kissed" $4.50 a couple of times since then. More to the point, the gas price has averaged about $5.60 since Pickens' declaration and topped $7.00 again yesterday.

Fresh from his dead-on prediction for natural gas prices, Pickens issued a second Delphic forecast last May - this time about crude oil prices. "I think you'll see $50 before you see $30 again," said Pickens. At the time, crude oil was changing hands for $41.50, and had averaged only about $36 for the year-to-date. But as we all know now, the price profile of the crude oil market has changed dramatically since then. Crude decisively scaled the $50-mark yesterday and planted its flag at $51.29 before settling in for the night at $51.09.

Pickens continues to up his forecasts. On September 27, he said in a radio interview with Bloomberg News that he expects the price of crude to surge to $60 before it returns to $40. Should we trust his judgment?

Many of the attendees of the May 2003 Grant's conference wondered the same thing, when Pickens' predicted a new era of permanently higher natural gas prices. One skeptical attendee asked the oilman, "If high, and rising, natural gas prices seem so probable, why aren't the exploration and production companies working feverishly to increase their drilling activity?"

The answer, according to Pickens, was that "there's nuthin' to drill." The oil and gas industry keeps poking holes, of course, but they aren't finding very much oil or gas to suck out of those holes. About 1,243 drilling rigs are currently operating on U.S. soil and in contiguous waters, according to Baker Hughes - that's about 12% more than this time last year, and about 40% more than two years ago. Even so, domestic production of crude oil and natural gas has tumbled 5% since 2001.

Proven reserves of U.S. crude oil are close to a 29-year low after falling 3.5% last year. Meanwhile, demand charges ahead. Worldwide oil demand will average 82.2 million barrels a day this year and jump by another 1.8 million barrels next year.

T. Boone Pickens is fallible, of course. But he seems to have a knack for putting himself in luck's path. All else being equal, we'd rather align ourselves with a consistently lucky soul than a consistently unlucky one.

Morgan Stanley's Daniel Lian: Sino Hollow

Sino Hollow
Daniel Lian (Singapore)

The Three Scenarios of the Sino Hollow Thesis

The Sino Hollow thesis – that the rise of China’s competitive manufacturing sector will crowd out that of its key competitor, i.e., Southeast Asia – has been in existence for quite some time now. China’s rise has become a global economic phenomenon in the decade stretching over the last few years of the 20th century and the first few years of the 21st century. China last devalued in 1994, and global MNCs and capital started aggressively embracing the Middle Kingdom again from 1993-94. Following the Asian Crisis of 1997-98, China’s rise became even more assured as global MNCs, FDI and capital abandoned or reduced exposure to Southeast Asia in favor of China.

While the rise of China is not the subject of dispute, there seem to be three competing scenarios, each implying a different fate of Southeast Asia.

First is a complete hollowing out of manufacturing in Southeast Asia, with little proactive response in terms of reforms of the political economy or shifts in economic development strategy. Under this scenario, China’s inroads into global manufacturing are unstoppable, as its manufacturing industry stretches across the whole value-chain, leaving no breathing space for Southeast Asian manufacturers. China’s rise hits Southeast Asia the hardest as the latter was previously the preferred manufacturing outsourcing and production region for global MNCs. The decline of Southeast Asia is real and rapid as a total dismantling of its manufacturing industry cannot be offset by economic growth in other sectors. This is the worst-case scenario for Southeast Asia, whereby China prospers but Southeast Asia is poor.

Second is a massive manufacturing hollowing out met by some degree of reform of the political economy and some shift in economic development strategy. Under this scenario, the fundamental economic relationship between China and Southeast Asia evolves from one of manufacturing competition to a complementary service and resource demand/supply relationship. Southeast Asia’s ability to grow this complementary role, together with its pricing power on service and resource exports, determines its economic well-being. This scenario suggests an ambiguous outcome where China prospers and Southeast Asia’s economic well-being hinges on whether its policy responses bear enough economic fruit to offset the loss resulting from the massive destruction of its manufacturing potential.

Third is a partial hollowing out cushioned by a proactive and successful reform of the political economy and a shift in economic development strategy responses. Under this scenario, global MNCs diversify to avoid over-dependence on China and geopolitical considerations. Moreover, a probable rise in China’s wage bill and the operation of other supply constraints and wage-cost restraints in Southeast Asia contribute further to the incomplete hollowing out. In consequence, Southeast Asia loses some, but not the bulk, of its manufacturing potential. This, coupled with Southeast Asia’s new emphasis on alternative growth areas in services and resources, enables the region to supplement its economic livelihood and made good or better its losses in manufacturing. This is the best possible outcome for Southeast Asia, in my view, whereby China and Southeast Asia prosper together.

Pessimists and Complacent Asian Policy-Makers

There is plenty of evidence that Southeast Asia is now either responding or contemplating responses to the rise of China. Hence, I believe the investment community should assign little weight to the first scenario. Over the past four years, I have analyzed structural economic policy shifts and their progress in Singapore, Thailand and Malaysia. These policy shifts include Singapore’s new three-pronged growth strategy (Twin Trouble, but Different Destiny, August 4, 2004), Thailand’s well established dual track development strategy (Mr. Thaksin Has A Plan, September 21, 2004) and Malaysia’s move towards a more balanced economic platform (Policy Intent Is Key, November 14, 2003). There are also signs that both Indonesia and the Philippines are also contemplating changes. In my view, this constitutes firm evidence that the region is capable of responding to China’s challenge.

However, simply responding is one thing – succeeding in that response is another. Many members of the investment community remain structurally pessimistic about Southeast Asia. They believe that China is destined to become the world’s factory and that Southeast Asia’s decline will be severe and protracted.

I think I am a ‘constructive’ pessimist when it comes to the Sino hollowing arena (see Tycoon versus Labourer, June 7, 2001; Short-Term Breathing Space, November 6, 2001; and Crowded House, May 23, 2002). While I believe there will be proactive responses from Southeast Asia, I have serious doubts over the region’s ability to create high-value-added alternatives to manufacturing as it has chronically underinvested in services and resources. Thus, I subscribe to the more pessimistic aspects of the second scenario. In my view, becoming a low-value service provider and generic resource supplier to China and the world may not prevent a decline in living standards for Southeast Asians.

On the other hand, Asian policy-makers appear to me to be subscribing to the more optimistic part of the second scenario – i.e., successful development of a complementary relationship – as well as the most optimistic third scenario whereby China and Southeast Asia prosper together through shared manufacturing potential and a complementary service and resource demand/supply relationship. I disagree as I think that the Sino-Southeast Asia ‘complementary’ theory is far too complacent and that China will continue to ‘crowd out’ Southeast Asia’s growth potential.

Examining Hard Data a Decade After China’s Ascent

Examining hard economic data 10 years after the start of China’s rapid rise reveals some interesting economic trends.

1. Manufacturing remains very important to Southeast Asia. Most investors would have expected Southeast Asia’s manufacturing output and export shares to have shrunk following a decade of massive build-out in China. However, the ASEAN five actually raised their manufacturing output share as a proportion of GDP from 25% in 1994 to 30% in 2003. Concomitantly, their manufactured export share as a proportion of merchandise exports increased from 73% to 75% over the same period. While the intensity of manufacturing in ASEAN pales net to that in China (where manufacturing output as a proportion of GDP increased from below 40% to 45% and manufactured exports accounted for 88% of merchandise exports at the end of 2003), there is no evidence that China is forcing Southeast Asia to reduce its dependence on manufacturing.

2. China is indeed rapidly expanding its manufacturing potential. In terms of net FDI, the ASEAN five accumulated only US$147 billion (Singapore alone accounted for more than half, at US$82 billion) for the decade 1994-2003, whereas China picked up some US$392 billion. Furthermore, at the beginning of 1994 China’s combined manufacturing output was less than twice that of ASEAN; at the end of 2003, it was more than three times that of ASEAN (US$640 billion versus US$200 billion).

ASEAN’s manufactured exports have also registered far inferior growth compared with those of Greater China (China, Taiwan and Hong Kong). It makes sense to track Greater China as Taiwan and Hong Kong manufactured exports are linked to China’s manufacturing capacity. ASEAN’s manufactured exports grew from US$188 billion to US$326 billion from 1994 to 2003, whereas Greater China’s grew from US$344 billion to US$741 billion. Southeast Asia’s manufactured exports rose 73% over the 10-year period, versus 115% for Greater China.

3. ASEAN and China’s other two major competitors (South Korea and Mexico) have not lost their global share of manufactured exports. It seems that other countries/regions are bearing the brunt of China’s rise. The disaggregated shares of manufactured exports in global merchandise and manufactured exports show ASEAN manufacturing holding its ground despite the rise of China. ASEAN’s share of the global merchandise export shrank from 6.2% to 5.7% over the decade, a figure that is often cited by analysts – but we think this is comparing apples with oranges. In our view, a more accurate comparison is to track the manufactured export shares of global merchandise exports. Here the numbers reveal that ASEAN’s share remained constant, at 4.4%, whereas the shares of China and Greater China leapt from 2.2% to 5.3% and from 8.1% to 10.1%, respectively, implying gains of 3.1% and 2%.

We would make two observations here: first, while the rise in China manufacturing is real, as it has taken an additional 3.1% of the global merchandise export pie, it has taken share away from other manufacturing exporters, not from Southeast Asia. Second, the other usual assumed ‘victims’ of China’s rise – South Korea, Brazil and Mexico – have also avoided significant manufacturing declines. In fact, South Korea and Mexico saw their shares rise from 2.1% to 2.5% and from 1.2% to 1.9%, respectively (note, however, that stagnation in Mexico is evident, as its global share has dropped from a peak of 2.6% in recent years). Brazil lost only 0.1% of global share, declining from 0.8% to 0.7%.

4. Which other countries have lost manufacturing to China? Limited data preclude me from drawing a precise conclusion. However, since Southeast Asia, South Korea, Mexico and Brazil have not lost their global shares, it would seem that some other emerging and/or advanced economies must be the real ‘victims’ of Chinese ascendancy. Given what I see as the absence of other emerging economies with sufficiently sizeable manufactured exports to incur such a big loss of share, I conclude that advanced industrialized countries are the economies losing manufacturing share to China. This is a somewhat unconventional conclusion.
Southeast AsiaShould Avoid the Worst-Case Scenario

It is too early, based on the simple economic data and analysis above, to assert with confidence which of the three potential scenarios will materialize. My views are as follows.

1. There is indeed some ‘relative’ crowding out of Southeast Asian manufacturing by China/Greater China as the latter’s much faster growth rate has led to stagnancy in Southeast Asia’s global share. However, Southeast Asia continues to grow its exports and has not borne the brunt of the impact from China. Even if one uses merchandise exports as the barometer, the hit is minor, with Southeast Asia losing just 0.5% of global share. If the past decade marked China’s most aggressive incursion, then the economic data rule out the worst-case scenario and propel Southeast Asia towards the more favorable ‘partial hollowing out’ scenario.

2. The decade 1994-2003 saw global MNCs aggressively reconstructing their global production and supply chains away from Southeast Asia in favor of China. As a result, FDI flows over the past decade do not augur well for any improvement in, or even maintenance of, Southeast Asian manufacturing potential (the exception being Singapore, which continues to attract significant FDI). Hence, it is plausible that the next decade could well see continued aggressive hollowing. Still, if one assumes such hollowing out by Chinese producers in the coming decade, simple arithmetic suggests that Southeast Asia should not lose much of its manufacturing output and its global share in exports – its manufacturing base is quite large, and it would take a long time for the region to shed its US$200 billion worth of manufacturing output and 4.4% share of global merchandise exports (given that, despite aggressive inroads over the last decade, China has not taken share from Southeast Asia). This again pushes Southeast Asia away from the worst-case scenario and towards the more optimistic ‘partial hollowing’ scenario.

3. Southeast Asia needs political-economy reforms, as well as a shift in economic strategy, to avoid the worst-case scenario. There is ample evidence, albeit in varying stages of development and formulation, that Southeast Asia has embarked on changes to its political economy and economic strategy landscape. Singapore, Malaysia and Thailand thus far are the more proactive countries in this respect. Leaving aside political-economy reforms, just from an economic strategy perspective the efforts thus far include: diversifying and shifting manufacturing to higher-value-added activities (Singapore and Malaysia), creating and strengthening service exports (Singapore, Malaysia, Thailand) and developing sustained domestic demand through second track activities in agricultural, grassroots and SME sectors (Malaysia and Thailand). There are also clear signals from policy-makers in Indonesia and the Philippines that they are seriously contemplating both economic strategy changes and political economy reform. While it is too early to call all of these efforts ‘proactive’ and ‘successful’, the responses thus far certainly suggest to me that Southeast Asia is heading away from the worst-case scenario and towards either the second or third scenario.

Based on the above three points, I submit that Southeast Asia should avoid the worst-case scenario and that there is a chance it will also avoid the ambiguous second scenario.

Bottom Line: Southeast Asia Has Breathing Space

The Sino-Hollow thesis postulates China will make rapid and sustained inroads into global manufacturing and Southeast Asia will be its primary victim as the region used to be the dominant winner of global FDI by manufacturing MNCs.

While the rise of China is not the subject of dispute, there seem to be three competing scenarios, each implying a different fate of Southeast Asia. First is a complete hollowing out of manufacturing with no proactive policy response from Southeast Asia. This is the worst-case scenario for Southeast Asia. Second is a massive manufacturing hollowing out met by some degree of reform of the political economy and a shift in economic development strategy responses from Southeast Asia. This is an ambiguous scenario as the new economic initiatives and better political economy may not offset the loss incurred in manufacturing potential. Third is a partial hollowing out of manufacturing with proactive and successful reform of the political economy and a shift in economic development strategy, whereby Southeast Asia could well retain or even improve its standard of living. This appears the best-case scenario for the region.

Data over the past decade indicate that Southeast Asia’s global share of manufactured exports remains stagnant, at 4.4%, whereas that of China and Greater China has risen from 2.2% to 5.3% and from 8.1 to 10.1%, respectively. Other assumed ‘traditional victims’ of China’s rise – i.e., the manufacturing sectors of South Korea, Mexico and Brazil – were also not hollowed out by China. I think China may, in fact, have gained global manufacturing shares from advanced industrialized countries, as there are no other large manufacturing-intensive emerging economies to be hollowed out.

It is too early to arrive at the right scenario. However, based on the hard evidence of the past decade, policy responses (both political economy reforms and economic strategy shifts) by Southeast Asia, and economic projections based on simple arithmetic, I submit that Southeast Asia should avoid the worst-case scenario. I also see a chance that it can also avoid the ambiguous second scenario and head for the best-case scenario.

Mises.org: Raiders of the Taxpayer's Money by Grant Nulle

Raiders of the Taxpayer's Money
by Grant M. Nülle

October 8, 2004

Misis.org (Ludwig Von Misis Institute)

For a government as vast and powerful as America's, $60 billion is hardly a substantial amount of money, considering it boasts a large populace and economy to plunder; such a sum is a mere three-fifths of what the U.S. Army alone requested for fiscal year 2005.

In the case of the Philippines, an erstwhile vassal of America, $60bn is an exorbitant total that also happens to approximate the country's sovereign debt. Staring acute financial hardship in the face, government officials are imploring the nation, particularly Filipino taxpayers, to bail them out of a crisis of their own making.

Mountains of Debt

Despite prior foreign investment bank prognostications and concerns, economists at the University of the Philippines (UP)—a state institution—ironically brought the country's impending fiscal crunch into sharp relief. Eleven academics, many of them senior economic officials in previous Philippine presidential administrations, collaborated to identify the causes of the country's rapid accumulation of sovereign debt[i]and predicted that if left unchecked, a genuine fiscal crisis would soon befall the country.

They found that between 1997 and 2003 approximately 2.01 trillion pesos ($36.4bn) were added to the national debt, which is almost 1.5 times the debt burden –1.35 trillion pesos ($25.4bn) that existed in 1997. The outstanding government debt is at a level well above what bond rating agencies consider as the median load for similarly rated sovereigns. Divided roughly half and half between domestically and externally-held financial instruments, government servicing of these obligations could become impossible to manage if global interest rates continue to rise and recurring budget deficits cannot be attenuated.

Indeed, since 1998, the Philippines' budget balance has gone south, posting sizable budget deficits annually. The unmitigated deterioration of the government finances comes in spite of modest economic growth in the aftermath of the East Asian Financial Crisis of 1997 and 1998. Like other nations in the region, the Philippine currency suffered speculative attack, precipitating a rise in domestic interest rates by the Philippine Central Bank and a subsequent slowdown in the financial sector and wider economy.

Notwithstanding a rise in unemployment, currency depreciation and an attendant spike in inflation, the Philippine economy, relative to other East Asia countries like Indonesia, Malaysia and Thailand, rebounded rather quickly. Wide-ranging structural reforms initiated at the beginning of the 1990s, including opening an exceedingly protected economy to foreign trade, provided the country the flexibility necessary to rebound from a recession.

However, the government also resorted to public spending to stimulate growth, tapping international capital markets to plug the resultant deficit. In fact Manila's March 1999 sale of a 350m-euro bond was Asia's first debt float in the new European currency.[ii] What differentiates the period of modest economic growth in the Philippines between 1993 and the Asian Crisis and the period afterwards is an erosion of the government's finances, bulging budget deficits and burgeoning debt in the latter period.

As the UP economists enumerate, 43% of the increase in the national debt can be attributed to a surfeit of government expenditures over tax take, 19% to adverse currency movements and 37% to assumed liabilities and subsidization of state corporations.

Leaving aside the currency factor, Government Owned or Controlled Corporations (GOCCs) and the government's budget deficit merit closer examination. Beginning with the former, chronic loss-making state corporations pose an additional budgetary onus upon the government's coffers. Although its debts are not de jure obligations of the government, state enterprises can expect an implicit state bailout should it encounter financial difficulties, thus pushing the public sector debt load (as opposed to the national government) to 135.6% of GDP.

Chief among the beneficiaries of state largesse is the National Power Corporation (Napocor), a notoriously inefficient firm that lost $2.06bn last year and has had nearly $818m of debt absorbed by Manila over the past five years.

According to the country's Freedom from Debt Coalition[iii], Napocor's debt has grown from $2.2bn to $25.4bn between 1994 and 2003 and represents more than 40% of the $61.8bn debt. Unable to borrow in global capital markets, the loss-making entity has had the national government purchase its bonds and then obtain financing from foreign lenders in the government's name, including a $400m sovereign bond flotation, part of Napocor's $27.3m borrowing requirement for 2004.

In addition to current or recent government absorption of quasi-public agencies' debts, it has volunteered to service the obligations incurred during the profligate Marcos era. Even the Central Bank required financial assistance, a notion nearly incomprehensible in America or Europe where such institutions are considered omnipotent. Of course, the heroic decision of Philippine officials to assume these excesses will not be paid out of the state's or their own ill-gotten assets, but by squeezing hapless taxpayers.

Show me the money

The discrepancy between government expenditures and the property it can coerce from the populace account for 43% of the upsurge in the nation's sovereign debt. Contrary to countries that have courted fiscal crises due to increased spending, the Philippines has actually experienced a slight decline in spending levels since 1999, attributable to president Gloria Malacañang Arroyo's (GMA) determination (so far marginally successful) to cull the country's budget deficit since assuming power in 2001.

Rather, private property seizures are descending at a gait quicker then spending. The tax take has fallen from around 17% of GDP to 12.5% of GDP between 1997 and 2003. Investment banks estimate the country's rampant tax evasion totals in the billions of dollars per year. Philippine enterprises are thought to pay only 60% of the Valued Added Tax (VAT) that the state demands as tribute, while domestic financial institutions rarely pay levies on interest income commensurate to what they purportedly owe. Corruption within the government, including the Bureau of Internal Revenue (BIR) contributes to disappearing receipts. Not to be outdone, the judiciary is inclined to issue a free pass to tax dodgers. GMA has publicly condemned the endemic tax evasion and has directed the bureaucracy and citizenry to wage a Kulturkampf against it.

As for the Philippine political system, it vindicates columnist H.L. Mencken's characterization of elections as an advance auction of stolen goods. Washington's occupation of the Philippines from 1898 until 1946 imposed the American system of government on its client, complete with a president, bicameral legislature and Supreme Court. The U.S. legacy proved to be a boon to the leading families of a country encompassing thousands of islands and dozens of disparate local languages. Ambitious clans, already fluent in English (an essential in Manila) could establish provincial fiefs in the native tongue as a springboard to either house of congress and even the presidency.

Party affiliation is subordinate to filial ties; about three-fifths of the last Congress had relatives in office[iv] . Legislator loyalty can be bought (with taxpayers' money of course) to assemble majorities on any piece of legislation. What is more, elected representatives find time to grant themselves and connected friends tax exemptions (e.g. in the legal and medical professions) as well as augment their own pay for all of that taxing work. Specifically, Congress managed to almost triple its own budget over the past 15 years. But then again, the 24-member Senate does need the extra funding to discharge the expense of 36 permanent committees and 16 ad hoc oversight committees (by contrast America's upper chamber has only 16 and four permanent and special committees, respectively).

Granted, tax exemptions are always just—no matter who receives them (see Rothbard[v]) especially in the case of people who are forced to contribute to public services they themselves do not use.

Do I smell bacon?

Mounting a successful political campaign is prohibitively expensive, running into the tens of millions of dollars to conduct a serious legislative or presidential bid. In a country where a substantial portion of the population live in abject poverty, the sums expended on political campaigning is staggering. The prize, however, is lucrative: command of discretionary funds, government perks, and the ability to influence legislation and appropriations favorable to congressmen, their families and business associates.

The chief tool of personal aggrandizement at the legislator's disposal is the aptly named pork barrel. A term gleaned from the American occupiers, "pork barrel" dates back to the United States's antebellum period when masters gave African slaves salted pork stored away in barrels. Like congressmen in America, Filipino legislators mob the pork barrel to secure government appropriations for pet projects.

Marcos actually abolished the pork barrel when he disbanded congress and imposed martial law in 1972. Not until a few years after the strongman stepped down did the personal legislative allotments resume and incrementally grow in value from 1990 onward. At present, senators and representatives receive an average pork barrel (officially referred to as the Priority Development Assistance Fund) of $3.7m and $1.2m, respectively.

Nominally earmarked for development projects (roads, schools, hospitals, etc.) of their choice, legislators do deliver the goods to their constituents, although not before enriching themselves. Former Finance Secretary Salvador Enriquez reckoned that up to 45% of the pork barrel is actually lost to so-called commissions, kickbacks or rebates. The stories of Filipino firms that have won pork barrel contracts illustrate the pervasive corruption.

Neophytes quickly learn that representatives are less interested in the sales pitch than the percentage cut in the transaction they will receive. A 40 to 50 percent rebate is an acceptable sum on anything from school supplies to medicines. Payments, made in cash, are usually transferred to the legislator or a designated third party at restaurants, hotels or homes. Despite the hefty discount incurred, contractors can frequently muster a marginal profit by skimping on materials, using inferior substitutes and doing a shoddy job.

Besides retaining considerable sway over the disbursement of government money to the legislative branch, the Philippine presidency commands its own pork barrel. Dwarfing the senators' discretionary allotment by five-fold, the executive's $18.2m allotment is evenly split between a "social fund" and "intelligence fund." Although GMA has managed to keep her hands clean, her predecessor, Joseph Estrada, was impeached (but not convicted) and later ousted from office for accepting kickbacks in an illicit gambling ring and Marcos was thought to have pilfered millions.

In the same vein the civil service is bloated and inefficient; government expenditures on operating expenses and salaries constitute half the budget. Not only are Filipinos compelled to surrender their property to fund the country's bureaucracy, they receive shoddy public services from inept, indebted, and monopolistic state enterprises and government contractors as recompense, not before their "honorable representatives" lop off a portion of the tax receipts for themselves.

Dial "A" for austerity

How then is the Philippine government going to avert a looming fiscal crisis, which has been mounting for years? Of course, taxpayers will have to principally atone for the enormous debts run up by bureaucrats, legislators and managers of GOCCs.

"We are already in the midst of a fiscal crisis and we have to face it squarely wielding our courage, resourcefulness and solidarity as a nation of a people," said GMA when she laid bare the gravity of the situation on August 23, indicating that yet again the government would externalize its mistakes on the populace at large.

The federal government's medium term fiscal plan is designed to obtain solvency over the next six years. It plans to exact revenue (projected take) by implementing a two-step increase in the VAT rate ($362m); tax on telecommunications franchises ($91m); adoption of gross income taxation for corporate and self-employed payers ($305m), indexation of tobacco, alcohol, etc. excises ($127.3m); augment excise on petroleum ($540m); rationalization of fiscal incentives ($91m) and a general tax amnesty. Failing legislative endorsement of these measures the executive has mooted reversing the 1997 income tax exemption granted to the country's 7m citizens working abroad.

Others have pointed out that the best performing (and lightly taxed) sectors of the economy—exports and agriculture—deserve to assume a greater share of the burden. Shame on these people who do not appreciate the connection between low taxes and high growth.

The taxmen have been encouraged to vigorously collect all unpaid interest income withholdings that banks have declined to surrender. The ongoing professionalization of the tax bureaucracy will continue, albeit marred by imbedded corruption in the BIR. Recently some staff refused to collect taxes when one of their superiors tried to proscribe bribery in the ranks.

Moreover, public service user fees—specifically the electricity rate charged by Napocor—will climb. From 26 September onward, the price per kilowatt-hour will provisionally rise by 40%. Not only are Filipinos already forced to defray the debts of this tax-consuming monstrosity, but now are also compelled to devote a higher share of their income to the dismal services provided by this monopolistic entity.

Coupled with its proposals to coercively seize legitimately held property, the Philippine government has plans in the works to employ its stolen goods more efficiently. Administrative changes are to be implemented, requiring cost cutting in the bureaucracy on utilities, travel, supplies, etc. Superfluous offices are to be junked or consolidated and a voluntary trimming of the public payroll is in the works. GOCC creation—an oft-abused presidential prerogative—is to be frozen indefinitely and the 2005 budget proposal envisages reducing pork barrel allocations by 40%; the government is even preparing to privatize Napocor.

Furthermore, the executive is seeking to pass a fiscal responsibility bill, which will impose a debt cap on government borrowing and prohibit new spending without new taxes. Finally, the president will seek legislative authority to revamp executive departments and agencies as well as GOCCs. There is talk of limiting Internal Revenue Allotments (tax revenue transfers) to local governments by as much as 25% ($2.64bn) keeping that money in the federal government's accounts.

Taken together, the government's revenue and expenditure proposals promise by 2010 to balance the budget, increase the tax take, and reduce the public sector debt burden substantially.

Fuzzy math

Despite these ambitious measures, it remains to be seen if the supposedly radical rationalization measures evolve into something more than cosmetic reshuffling. Quite obviously the second element of the fiscal responsibility law is dreadful; the government's ability to tax and spend is at the root of the debt problem.

In the meantime, the government's projected 2005 budget of 907.6bn pesos ($16.5bn)—including $2.45bn in subsidies—is 5.3% higher than the previous year. Somehow an additional $2bn request for unspecified items and cash deficit has been left off the tender. Even GMA's promise to slash travel expenses fail to hold water, as the budget provides an extra $13.3m for this purpose.

Equally mysterious, the $6.26bn of principal payments due in 2005 has been left out of the proposal, which when added would allow the budget total to exceed the 1 trillion peso threshold for the first time ever. One of Asia's most spendthrift states owes $11.81bn in interest and principal repayments next year, an 81% increase since 2002[vi]. The budget deficit is projected to be another $9.31bn, financed by domestic borrowing. Moreover, the current presidential administration—which in only three years was able to borrow more than its two most recent predecessors managed to do over a span of eight years—is preparing to spend more than it pilfers from the populace for the next four years, prompting it to amass further debt.

As appealing as the moratorium on GOCCs and the vague promise to limit government guarantees to these firms may be, it does not adequately address the chief culprit of the Philippines' gaping fiscal deficit and substantial debt: the GOCCs themselves. Records from the country's budget department indicate that state corporations are collectively expected to register at least a $2.4bn loss during Fiscal year 2004. Blithely ignoring their financial drain on the country, many top GOCC administrators have awarded themselves lavish pay packets and discretionary funds (by Philippine standards) and then asked the government for subsidies and bailouts.

In the case of Napocor, the 40% provisional rate increase, with another unspecified rise scheduled in another 6 months, will merely serve to help it pay off interest payments amounting to more than $1bn over the next year. A clutch of company executives were recently paid $218m in retirement and severance pay and then subsequently rehired with a higher salary. After a bout of obfuscation by Napocor's management a government audit of the firm's books in 2003 discovered $2.55bn of accounting irregularities. Quite rightly, the Senate's Ways and Means Committee has deplored the systematic waste at the power provider.

Indeed, Napocor's $2.06bn loss in 2003 far exceeds the $618m per annum (before the 40% reduction in pork barrel) spent on corruption-riddled congressional pork barrel and the legislature's budget. Before Napocor is privatized Philippine taxpayers are poised to assume $9.1bn of its debts.

Perhaps a more politically palatable and positively outlandish method of plugging the budget gap would be a plan floated by President Arroyo in early 2003. She claimed that more than $18bn-worth of gold rests within the island of Mindanao's Mount Diwalwal. The Japanese occupation forces during the Second World War are reputed to have left behind buried treasures all over the country, which have enticed several Filipino presidents (along with Thai and Indonesian authorities in their own countries) to launch abortive, Indiana Jones-like searches for the missing caches. Indeed, Estrada had the garden of a presidential residence overturned in search of loot[vii].

Debt repudiation, not service

The aforementioned UP Economists reckon a debt crisis cannot be avoided for more than three years and that action must be taken within the next year to assuage financial markets. In April 2003, Standard & Poor's S&P lowered the Philippines long-term foreign currency rating (BB+ to BB), followed by Fitch in June 2003 and Moody's (Ba2 to Ba1) in January 2004. On September 8, S&P critisized the Philippine government's willingness to enact reforms and admonished authorities to reverse its negative fiscal trajectory in a fundamental and sustainable manner, lest it court an increasingly onerous debt burden.

Rather than comparing Manila's plight to that of Argentina, which defaulted on its sovereign debts in late 2001, one need look no further than the crunch and contraction that the Philippines suffered between 1983 and 1984. Spearheaded by the licentiousness of GOCCs and abetted by brisk petroleum price rises, the rapid accumulation of government debt during the late 1970s and early 1980s prompted the Marcos regime to default on its foreign obligations in 1983. An acute peso depreciation ensued, and the country plunged into economic and political turmoil for the rest of the decade.

On the heels of GMA's national announcement of impending fiscal difficulties, her subordinates quickly assured international capital markets that debt service would not be interrupted. They stressed that the definition of "fiscal crisis," as accepted by the IMF and credit agencies, is a situation that occurs only when: a country is in default, its deficit is unsustainable and the country does not have access to capital markets. S&P cautioned Philippine authorities that the recent 40% increase and future rise in Napocor's power rate would not save the company, much less the country, and urged authorities to introduce additional tax measures and enhance collection.

The S&P's advice indicates a proper method to resolve the Philippines debt situation, albeit not in the manner the rating agency advocates. Instead of devoting more of their income to Manila's debt problem, the Filipinos should press the government to repudiate all outstanding obligations to multilateral and private lenders alike.

To the casual observer this suggestion is anathema for it violates the sanctity of contracts. However, as Murray Rothbard[viii] correctly explained, there is a fundamental distinction between private and public debt.

In the former case, where a low-time preference creditor lends money to a high-time preference borrower in exchange for repayment plus interest, to repudiate one's debts is tantamount to depriving the lender of his property, which is indefensible. In regard to public debt, governments do not pledge their own assets, but taxpayers' instead, with creditors cognizant that the principle and interest will be paid through the involuntary confiscation of private property—taxation. In effect, both sides are complicit in the violation of property rights of a third party in the future, which scarcely deserves to be acknowledged as a contract.

Beyond the dodgy status of sovereign borrowing, debt repudiation is beneficial in that it immediately alleviates the citizenry of onerous repayments on obligations issued by present and previous governments. Politicians, bureaucrats, and their constituencies that receive succor at the public trough parasitically exist at the expense of productive tax-paying members of society. Why should the latter be made to pay for the former group's livelihood, much less its mistakes?

More importantly, by denying the Philippine government credit, as lenders are wont to do, the state will be compelled to operate within the confines of a balanced budget, certainly an unorthodox but necessary development.

Undoubtedly, the Philippine economy will be buffeted by a severe downturn as the country's private sector incurs the wrath of international capital markets. However, when the citizenry is relieved of massive tax-funded repayments on these obligations and no longer saddled with a credit-worthy government, foreign lending will return to invest in promising private enterprises. Likewise, indigenous capital formation can emerge as the profligate public sector is reined in. Fortunately, the estimated $7bn in annual remittances from Filipino workers abroad can serve as seed money for productive investments.

With respect to private creditors, as shameful as the blatant deprivation of the funds loaned to the Philippines may be, such arrangements clearly infringe third-party property rights and are an affront to liberty. As Rothbard suggested, a government mulling unilateral cancellation of its debts could at least partially allay creditor contempt by selling state assets and channeling the receipts to servicing its obligations. Auctioning off ill-gotten properties would divest the government of its coercion-acquired and maintained ascendancy.

Hopefully, debt repudiation by the Philippines would serve notice to prospective lenders that states, the only entity in society besides criminals that exist at the expense of others, are parasitic and wasteful consumers of capital undeserving of investment.

Grant M. Nülle is a Research Fellow with the Ludwig von Mises Institute. Contact him at grantn007@yahoo.com. Post comments on the blog.

[i] De Dios, Emmanuel S., et al. "The Deepening Crisis: The Real Score on Deficits and the Public Debt." University of the Philippines.
[ii] Milo, Melanie. "Contagion Effects of the Asian Crisis, Policy Responses and Their Social Implications." Philippine Institute for Development Studies. Discussion Paper Series No. 99-32. Dec. 1999.
[iii] "Past and Present Administrations Responsible for State-owned Power Firm's Heavy Loss." Freedom from Debt Coalition. 4 May 2004.
[iv] Democracy as Showbiz." The Economist. 9 July 2004.
[v] Rothbard, Murray N. Power and Market. 1970: 120–21.
[vi] "RP's 'Real' Debt Service Not Indicated in 2005 Budget." Manila Times. 28 August 04.
[vii] "All That Glisters..." The Economist. 16 January 2003.[viii] Rothbard, Murray N. "Repudiating the National Debt." Mises.org. 16 Jan. 2004.

D.R. Barton, Jr. of Trader's U: Joe's Loss Is Your Gain Controlling the Downside

Joe's Loss Is Your Gain: Controlling the Downside
by D.R. Barton, Jr.

President, Trader’s U

"Big losses continue to haunt us; nice profits are soon forgotten." ~ Shakespeare's Julius Caesar (liberally paraphrased by DRB)

I wasn't worried about Joe. He had the money to lose; but I could tell by his tone that the phone call wasn't about the money. There was fear in the voice on the other end of the line.

"How long have you been in the position?" I asked.

"It started out as a day trade in that semiconductor stock, Rambus," Joe replied. "But it dropped big on me that day and I just stayed in overnight, hoping it would come back up the following day. Then it was down the next day, and I just knew it that it would move up again. That was four weeks ago."

$320,000 is a lot of money to lose in four weeks. Fortunately, it was a relatively small chunk of Joe's net worth.

Joe got into the trade on a rumor that the chipmaker was going to make a big announcement. He was thinking about the big bucks he would make by being on the right side of some good news. But the news never came. And when the semiconductor sector took a big hit in early 2001, Joe's stock was cut in half in a matter of weeks.

While Joe had several miscues in this trade, the biggest mistake that he made was getting his priorities backward. He put his zeal for profits ahead of the need to protect his equity.

Let's use the tuition that Joe paid - and learn how you and I can leave the rookie mistakes behind and adopt the mentality of elite traders.

Here's how to make safeguarding our cash the number one concern BEFORE we enter a trade or investment...

Controlling Risk: Every Trader's Top Priority

I've had the pleasure of trading with and learning from some incredible traders. I also get to teach workshops where I hear from traders and investors of all experience and skill levels.

One difference that is always striking to me is between what I hear the pros talk about and what newer traders think.

When an experienced trader looks at any trading opportunity, the first thing he or she asks is, "Where will I get out if I'm wrong?"

In contrast, those new to the game are often lured to trading by the idea of big profits. A typical question asked by a new trader is this, "How much can I make if this works?"

Top traders are obsessed with controlling their risk and preserving their capital. This is their TOP PRIORITY.

The single biggest mistake a trader or investor can make is to hold onto a loser and give it a chance to grow beyond your intentions.

We hold onto a day trade loss and it turns into an overnight trade...

The overnight trade turns into a bigger, intermediate-term swing trade loss.

Then the trade that started out as a "little loss that came along one morning" turns into an unintended part of your core portfolio. Oh yeah - this "little addition" carries along with it a loss that is chewing up 10 or 20 percent (or more) of your equity. And it's still growing.

These are the type of trades that destroy accounts and end traders' careers before they even get started. As Shakespeare put it, these trades are "the evil that men [and women] do." And they sure haunt us for a long time.

But there is a better way - and it starts with your mind.

Think About Risk First and Reward Second

Top traders know that this game we call trading and investing is pretty simple, from a statistical viewpoint. Big moves do come along. Our goal, whether we are day trading or making long-term investments, is to be on the right side of those moves. And if we happen to get caught on the wrong side of the move - WE GET OUT! No questions. No hesitation.

Investment U has long been an advocate of using stops when entering trades. This is a great way to think about limiting risk. When you use a 25% trailing stop, you know precisely what your risk is before you enter the trade.

How You Can Use "Risk Control Thinking" In Your Trading

1. Before you decide to use any trading system or newsletter recommendation, make sure that there are explicit price levels that serve as the "get out if we're wrong" point for each trading signal or investment recommendation. If these "stop loss" points are not provided, find another system or advisor.

2. Work on changing your thought process. Everyone gets excited about the potential for big profits. But the folks that stick around for the long term think about "risk control" first and then "size of reward" second. Start to look at every trade or investment opportunity by first asking, "When will I get out if I'm wrong?" This applies equally to day trading, long-term investing, real estate projects or business ventures.

3. Once you know the "worst case" loss level (your stop loss), determine the size of your position. As a rule of thumb, do not risk more than 1% of your equity on any one trading or investing idea. When you are just starting out, trade even smaller size (one-quarter to one-half of a percent). As you gain expertise in a trading or investing strategy, you can increase this amount if the strategy or system is very successful, but not above a maximum of 2% of your equity.

4. Finally, don't forget about the reward side of the trade! Once you know the amount you are going to risk, make a reasonable estimate of the reward you could receive if this trade or investment works our well. DO NOT TAKE THE TRADE if the reward-to-risk ratio is less than 2:1. For most trading time frames that are longer than a few days, look for reward-to-risk ratios that are 3:1 or more.While it will be hard at first, try to set aside that warm feeling you get from thinking about the potential profits from a trade. Think first about managing the risk. Then (and only then) are you ready to look at the reward side of the equation. Dream big dreams, but keep your feet firmly planted on the ground.

Great trading,

D.R.

Dr. Krassimir Petrov: Oil performance in a worldwide depression

Oil performance in a worldwide depression

September 29, 2004

by Dr. Krassimir Petrov

In a previous article called “China’s Great Depression”, I postulated that China must necessarily fall into a depression, probably comparable to the American one from the 1930s, which in turn will spread to become a worldwide depression. In response, many readers asked whether in such a depressionary environment the price of oil would go up or down. The straightforward answer is that in an inflationary bust, the price of oil will go up, and in a deflationary bust—down. Of course, the response is evasive, provides no analysis, and answers an ill-defined question. Therefore, the goal of this article is to explain the importance of the question, to define its scope properly, to answer it with sound economic analysis, and to summarize our results.

Over the next decade, oil fundamentals may be characterized as 10+. Oil supply is at or near its “Hubbard’s” peak, and oil is currently pumped at close to 100% capacity. Therefore, growth of oil supply is rapidly slowing down and is expected to decrease in the coming years. On the other hand, China’s and India’s industrialization will continue to drive oil demand at growth rates higher than the growth rates of oil supply, and as a consequence, the price oil has to go much higher in order to ration the relative scarcity of oil supply. In this environment of strong fundamentals for oil, a booming worldwide economy will guarantee much higher oil prices; however, in a worldwide recession, the issue becomes whether the strong oil fundamentals will nonetheless outweigh a slowdown in oil demand. Precisely this issue motivates our present analysis.

The proper definition of the problem requires investigation of the price of oil (1) relative to the U.S. dollar, (2) relative to strong fiat currencies, (3) relative to gold and silver, and (4) relative to a basket of commodities. Below, we investigate each in turn, although I would like to respectfully acknowledge Marc Faber’s seminal contribution in (1) and (2).

The U.S. dollar is fundamentally unsound. It has been used for decades to monetize U.S. government debts and to pay for trade deficits. As a result, the dollar has been overissued in the U.S. and overaccumulated by foreigners. In a worldwide depressionary environment, two decisive factors will drive the dollar’s value substantially lower. First, the injury to the dollar will come from foreigners decumulating their dollar-denominated investments. In a depression, foreign banks will fall on hard times, and they will have little choice but to shore up their reserves by selling foreign-denominated assets and repatriating their capital home. In addition, foreign governments will attempt to stimulate their economies with lowered interest rates, increased domestic investments, and bigger government spending. All of these will be better accomplished by repatriating foreign investments home rather than by pure monetary stimulus, because the repatriation will actually increase the pool of savings within their economies and provide a sound, sustainable basis for the stimulus, while a pure monetary stimulus will provide a credit-based, unsustainable stimulus that is doomed to failure. Second, to add insult to injury, the dollar will come under additional pressure from the Fed’s own inflationary policy, now fighting the more pronounced deflationary forces. No doubt, “Helicopter” Ben will step up the printing press, and as a result, U.S. money supply will continue to increase, at least for a while, and some of the freshly printed dollars will be sold on the foreign exchange markets for better stores of value. Thus, a depressionary environment will exacerbate the dollar’s problems and the dollar is likely to fall a lot more than oil due to its inherent vulnerability. As a result, in a depression, the price of oil is likely to go up in U.S. dollars.

In terms of strong foreign currencies (e.g. Swiss Franc), I believe that in a depression the price of oil will actually fall. These currencies, by definition of being strong, will hold their value relatively well, and their demand will be relatively stronger than demand for oil, because a flight to safety will increase demand for those currencies, while depressionary forces will reduce oil demand. This, of course, assumes no oil wars, terrorism, local political instability, or other unforeseeable disruptions of oil supplies; given such a disruption, all bets are off, and oil will likely rise in all fiat currencies. Under normal conditions, however, the price of oil is likely to fall in terms of strong currencies.

Gold shines bright in a depressionary environment. It is the ultimate safe haven, and in times of crisis it holds its value better than anything else. In a flight to safety, it has always been the top choice for investors. The reason is that in times of crisis, sinking profits crush stocks, looming defaults pressure bonds, credit-crunch chokes real estate, and escalating monetization devalues fiat currencies. In such an environment, there is simply nowhere to run but gold. Even though demand for gold as a commodity collapses, its demand as the only safe money skyrockets; the latter dramatically overcompensates the former, and total demand for gold increases substantially. As a result, gold (and silver) is likely to rise against all currencies, weak or strong. However vital for human civilization, in a depression, oil is no match for gold, and is certain to fall in terms of gold.

Demand for commodities generally drops in a depressed worldwide economy. We base our argument on the fact that oil demand is very inelastic, even when compared to the elasticity of commodities. Thus, in a strong economy, oil prices generally rise relative to commodity prices, and in a weak economy—fall relative to commodity prices. From an Austrian point of view, oil may be regarded as a higher-order capital good relative to other commodities, and therefore in a bust environment, it follows from Austrian theory, that oil prices will fall relative to commodity prices. However, we must acknowledge that the inelasticity argument is not independent of the higher-order Austrian argument, for the higher-order argument naturally implies relative inelasticity. Therefore, one may expect that in a depression, the oil price will most likely fall in terms of a commodity index, such as the CRB, provided that there are no oil disruptions, as already indicated above. To reiterate, with oil supply disruptions, oil is certain to outperform every single commodity, except gold and silver.

We will note a number of important analytical properties. First, nowhere in our analysis did I assume inflation or deflation. Instead, I relied entirely on demand and supply characteristics of a bust, whether inflationary or deflationary. Second, I was able to resolve the problem in terms of currencies because of their explicit choice: the dollar being inherently weak, and strong currencies, being inherently strong. For currencies in the middle of the “strength” spectrum, the answer is considerably harder and somewhat indeterminate. Third, for gold and silver I applied the “safe-haven” argument. Finally, for commodities I applied the relative inelasticity argument.
To conclude, in a depressionary environment, the price of oil will go up in terms of U.S. dollars, and will fall in terms of strong currencies, gold, silver, and a basket of commodities. It follows that the appropriate investment strategy for investors should involve the accumulation of gold, silver, strong foreign currencies, and government bonds denominated in those currencies.

Dr. Krassimir Petrov is a disciple of the Austrian School of Economics and spent this summer at the Mises Institute of Austrian Economics at Auburn , Alabama

USA TODAY: The looming national benefit crisis

The looming national benefit crisis
By Dennis Cauchon and John Waggoner, USA TODAY

The long-term economic health of the United States is threatened by $53 trillion in government debts and liabilities that start to come due in four years when baby boomers begin to retire. (Related graphic: U.S. economy threatened by aging of America)

The "Greatest Generation" and its baby-boom children have promised themselves benefits unprecedented in size and scope. Many leading economists say that even the world's most prosperous economy cannot fulfill these promises without a crushing increase in taxes — and perhaps not even then.

Neither President Bush nor John Kerry is addressing the issue in detail as they campaign for the White House.

A USA TODAY analysis found that the nation's hidden debt — Americans' obligation today as taxpayers — is more than five times the $9.5 trillion they owe on mortgages, car loans, credit cards and other personal debt.

This hidden debt equals $473,456 per household, dwarfing the $84,454 each household owes in personal debt.

The $53 trillion is what federal, state and local governments need immediately — stashed away, earning interest, beyond the $3 trillion in taxes collected last year — to repay debts and honor future benefits promised under Medicare, Social Security and government pensions. And like an unpaid credit card balance accumulating interest, the problem grows by more than $1 trillion every year that action to pay down the debt is delayed.

"As a nation, we may have already made promises to coming generations of retirees that we will be unable to fulfill," Federal Reserve Chairman Alan Greenspan told the House Budget Committee last month. (Related story: Americans' views on the benefit quandary)

Greenspan and economists from both political parties warn that the nation's economy is at risk from these fast-approaching costs. If action isn't taken soon — when baby boomers are still working and contributing payroll taxes— the consequences may be catastrophic, some economists say.

The worst-case scenario is a sudden crisis — perhaps a major terrorist attack or a shutoff of oil from the Middle East — that triggers a loss of confidence by investors in the U.S. economy. Foreign investors refuse to lend more money to the government to finance its deficits; drastic tax increases and benefit cuts occur suddenly; the dollar's value plummets, which raises the cost of imported goods; and a severe recession or depression results from falling incomes.

A softer landing: The USA acts swiftly and becomes more like Europe. Taxes are higher, retirement benefits are less generous but widely distributed; health care costs are controlled; and the economy is sound but less productive.

Big payments on the debt start coming due in 2008, when the first of 78 million baby boomers — the generation born from 1946 to 1964 —qualify at age 62 for early retirement benefits from Social Security. The costs start mushrooming in 2011, when the first boomers turn 65 and qualify for taxpayer-funded Medicare.

Early warning signs

But Americans needn't wait until 2008 or 2011 to see firsthand the escalating costs of these benefit programs. Medicare last month announced the largest premium increase in the program's 39-year history. In 2004 alone, federal spending on Medicare and Social Security will increase $45 billion, to $789 billion. That one-year increase is more than the $28 billion budget of the Department of Homeland Security.

Many economists say a failure to confront the nation's debt promptly will only delay the inevitable.

"The baby boomers and the Greatest Generation are delivering an economic disaster to their children," says Laurence Kotlikoff, a Boston University economist and co-author of The Coming Generational Storm, a book about the national debt. "We should be ashamed of ourselves."

USA TODAY used official government numbers to compute what the burden means to the average American household. To pay the obligations of federal, state and local government:

•All federal taxes would have to double immediately and permanently. A household earning $100,000 a year would see its federal taxes double from an average of about $20,000 to $40,000 a year. All state taxes would have to increase 20% immediately and permanently.

•Or, benefits for Social Security, Medicare and government pensions would have to be slashed in half immediately and permanently. Social Security checks would be cut from an average of $1,500 per month for couples to $750. Military pensions would drop from an average of $1,782 per month to $891. Medicare spending would fall from $7,500 to $3,750 annually per senior. The Medicare prescription-drug benefit enacted last year would be canceled.
•Or, a combination of tax hikes and benefit cuts — such as a 50% increase in taxes and a 25% reduction in benefits — would avoid the extremes but still require painful changes that are outside the scope of today's political debate. Savings also could come in the form of price controls on prescription drugs, raising retirement ages and limiting benefits to the affluent.

Every solution has the potential to damage the economy by reducing disposable income or diverting economic resources.

The estimates computed by USA TODAY are similar to ones by government watchdog agencies such as the Congressional Budget Office and the Government Accountability Office and respected think tanks such as the conservative American Enterprise Institute, the liberal Brookings Institution and the non-partisan Urban Institute.

"Political leaders know this is a big problem," says Glenn Hubbard, chairman of the Council of Economic Advisers for President Bush from 2001 to 2003. "I know the president is keenly aware. But in an election year, it's not easy to talk about. The solutions may be very painful. If he is re-elected, I think he will make this a top priority next year. I hope so."

"Economists agree this cannot go on," says Joseph Stiglitz, President Clinton's chief economic adviser from 1995 to 1997. "We can borrow and borrow, but eventually there will be a day of reckoning."

Economist James Galbraith of the University of Texas in Austin is a rare optimist in this debate. "I'm not at all concerned about Medicare or Social Security," Galbraith says. "Unless the government goes broke, Medicare isn't going to go broke, and the U.S. government isn't going to go broke because it can print money."

Galbraith says the country can handle higher tax rates, as Europeans do, and can save money by cutting spending elsewhere, such as on defense, and by implementing a Canadian-style health care system that uses private doctors and hospitals but has the government set prices and pay the bills.

"We are an enormously rich country," he says. "Providing health care and a modest living for our elderly is certainly something we can afford."

An aging population

Social Security was created in 1935 to help the elderly avoid poverty during the Great Depression. Medicare was established in 1965 to provide health care for the elderly, who were finding it increasingly difficult to afford medical care. But the aging of America and a declining birth rate have put these programs on a collision course with financial reality.

When the government set 65 as the retirement age in the 1930s, most people didn't live that long. But life expectancy for women has increased from 66 to 80 since 1940 and for men from 61 to 75.

Meanwhile, the birth rate has dropped from 25 births per 1,000 residents in the 1950s to just 15 today. The lower birth rate ultimately means fewer workers paying taxes to finance Social Security and Medicare benefits for the rapidly growing population of people 65 and over.

Medicare has had about 3.3 workers paying taxes for every recipient for the past 30 years. Baby boomer retirements will reduce that to just two workers supporting every Medicare recipient in 2040.

Immigration has helped offset some of the decline in birth rates. But immigration rates would have to increase by five or 10 times — above the recent peak of 1.2 million in 2001, legal and illegal — to provide enough workers and their payroll taxes to boost Medicare.

Medicare recipients are growing older and more expensive, too. Annual medical costs for an 85-year-old are double those of a 65-year-old. Federal spending per Medicare recipient will average $7,500 this year. The official projection for 2050: $26,683 per recipient in 2004 dollars.

A problem in plain view

The scope of the problem is no secret in Washington.

Medicare and Social Security trustees report the obvious every year: The system has no way to pay for itself, even under the rosiest scenarios. The Congressional Budget Office regularly updates Congress on the liabilities.

Bush's budget for the fiscal year that began Friday spells out the numbers in detail and concludes, "These long-term budget projections show clearly that the budget is on an unsustainable path."

Comptroller General David Walker, the government's chief accountant, travels the nation warning of the impending crisis. "I am desperately trying to get people to understand the significance of this for our country, our children, our grandchildren," Walker says. "How this is resolved could affect not only our economic security but our national security. We're heading to a future where we'll have to double federal taxes or cut federal spending by 50%."

But documentation of the problem hasn't prompted political action to address it. The $4.2 trillion national debt has generated some debate in Congress and the presidential campaign. But the government's obligations for Medicare and Social Security are 10 times the size of the national debt.

"We have instructed our politicians not to tell us about this problem," says Boston University economist Kotlikoff. "If they even mention cuts to Social Security, we vote them out of office."

Grim financial statement

To bring attention to the problem, USA TODAY prepared a consolidated financial statement for taxpayers, similar to what corporations give shareholders. The newspaper totaled federal, state and local government liabilities, taken from official documents.

Key findings:

•Total hidden debt. Federal, state and local governments today have debts and "unfunded liabilities" of $53 trillion, or $473,456 per household. An unfunded liability is the difference, valued in today's dollars, between what current law requires the government to pay and what current law provides in projected tax revenue.

•Social Security. The retirement program has $12.7 trillion in obligations it cannot meet for current workers and retirees at the current Social Security tax rate.

•Medicare. The health care program has a $30 trillion unfunded liability for people now in the system as workers or beneficiaries. The $30 trillion reflects the value today of the more than $200 trillion in deficits over 75 years to cover current workers and retirees at existing levels of benefits, tax rates and premiums. Medicare's new prescription-drug benefit, which starts in 2006, accounts for $6.9 trillion of the program's financial ill health.

How much is $30 trillion? The gross domestic product, the entire economic output of the USA, was $11 trillion last year.

"These numbers are staggering in their magnitude," says economist Thomas Saving, whom Bush appointed as a public trustee on the Medicare and Social Security board. "But when I testify before Congress, I'm the only one saying, 'We have a funding problem.' Everyone else is testifying for more benefits."

Like a home mortgage

The $53 trillion in liabilities is like a mortgage balance: That's what it would cost to pay off the debt now. The actual cost would be higher because of interest payments. A $100,000 mortgage at 5% interest, for example, actually requires $193,000 in income to repay over 30 years.

Under corporate accounting rules, a corporation would record a $100,000 liability on its books if it promised to pay $193,000 in medical benefits over 30 years. That liability would reduce profits immediately, when the promise was made, although the money would be paid over 30 years. Otherwise, shareholders could be fooled into thinking that the company was better off than it really was.

In fact, the company had committed $193,000 in future revenue — worth $100,000 today — to a retiree and couldn't use the money for shareholder profits.

Government doesn't follow this accounting rule. If it did, the federal deficit in 2004 would be $8 trillion, not $422 billion. The $8 trillion reflects the value of new financial obligations Congress approved without any way to pay for them,plus the year's operating deficit.

Government accounting rules are more lenient because, unlike a business, Congress can take whatever money it needs through taxes and renege on promises by passing new laws. Theoretically, the president and Congress could end all health care for the elderly tomorrow and cease Social Security payments the next day — or double or triple tax rates to pay the bills.
That's why AARP, a non-partisan lobbying group for people over 50, says the unfunded promises of Medicare and Social Security are less worrisome than they appear.

"The reason we make companies fund their pension liabilities is because it's uncertain they'll be around in the future. That doesn't apply to government," says John Rother, AARP's research director. "The size of the liabilities isn't relevant, nor is how much we put aside today. What matters is how healthy will the economy be in the future."

He agrees that Medicare has a long-term funding problem but says the nation's entire health system is the issue, not Medicare.

Alan Auerbach, director of the Burch Center for Tax Policy and Public Finance at the University of California-Berkeley, says people are understandably skeptical about gloomy predictions. But he says these numbers are not guesses.

"We can't predict major wars or major inventions," he says. "But we do know the baby boomers aren't going to disappear. We know pretty well that health care costs will rise because of new technology. I wish these were worst-case scenarios, but they're rather cautious best guesses. It could be much worse."

A bill coming due

The heart of the problem is that the Greatest Generation and baby boomers have promised themselves retirement benefits so generous — and have contributed so little to financing them — that even the most prosperous economy in history cannot pay the bill.

Consider a married couple who throughout their lives earned the median income — the amount at which half of Americans make more and half make less — and who will retire at age 65 next year. They earned $46,400 in their final year of work.

Mr. and Mrs. Median would get a joint Medicare benefit valued at $283,500, the Urban Institute estimates. That's the present value of the benefit — what it's worth today — not the larger amount the government will actually pay over the years. But the couple would have paid only $43,300 in Medicare taxes (valued in 2004 dollars). Taxpayers lose $240,200 on the deal.

But the Medians' good fortune doesn't end there. They also qualify for $22,900 in annual Social Security benefits, which rise annually with inflation.

Present value of the Social Security benefit: $326,000. Present value of Social Security taxes paid over a lifetime: $198,000.

Net loss to taxpayers: $128,000.

And the situation is worse than that. The federal government didn't save the money that the Medians paid in Medicare and Social Security taxes. It spent that money as it came in on other things — defense, education, past Medicare costs, etc. So the Social Security and Medicare taxes paid by Mr. and Mrs. Median won't help offset the cost of their benefits. The Social Security and Medicare trust funds have no money, only IOUs that other taxpayers must repay.

"These mythical trust funds are a financial oxymoron — they can't be trusted and they aren't funded," says Peter Peterson, a businessman and Commerce secretary under President Nixon who wrote the best seller Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It.

Because the trust funds have been spent, taxpayers must come up with the full $609,500 that Mr. and Mrs. Median are entitled to under Medicare and Social Security. And the Medians are a bargain compared with what their 45-year-old children will cost.

Social Security is structured so that future generations get increasingly large benefits. And Medicare benefits rise with soaring health care costs.

The Medians' children would receive Social Security and Medicare benefits with a present value of $884,000 in 2004 dollars when they turn 65, according to the Urban Institute. That's 45% more than their parents would get.

For Hubbard, now dean of the Columbia Business School in New York, the stakes are clear: "The question is whether the political process will make gradual changes or we'll wait for a crisis."

Contributing: Paul Overberg, Bruce Rosenstein

Elliot Wave's Futures Focus: Getting a Grip on Slippery Logic About Oil

Getting a Grip on Slippery Logic About Oil
10/1/2004 5:30:09 PM

Every day this week, headlines have explained the rise in Crude Oil prices with cause-and-effect logic that only seems plausible. Here's one from today:

Supply Worries Lift Oil Near $50 US (Toronto Star , October 1)

If this sounds right to you, it's probably because you've heard similar stories over and over. The fact is, explanations like this one are misleading, even if they do jibe with conventional wisdom. So what's the best alternative? Try turning this headline around:

Oil Near $50 US Lifts Supply Worries

Just by flipping a few words, the explanation changes completely… for the better. The prevailing perceptions about supply and demand tightness don't cause Crude Oil prices to surge. Rather, fluctuations in the price of Crude actually cause perceptions about Oil supplies to change.

Recent energy news provides more evidence of faulty logic. Citing supply disruptions due to weather, two oil companies solicited and received loans from the U.S. Strategic Petroleum Reserve (SPR) last week. Depending on what a barrel of Crude cost when the papers went to press, journalists reported the same fundamental "cause" as having two opposite effects.

When prices sagged on September 24, many headlines looked like this one:

Oil Dips as U.S. Loans Out Supplies (CNNMoney/Reuters )

But because Crude Oil finished higher that day and opened this week higher still, the news on September 27 offered a starkly different perception of SPR interventions. Here's an example:

"If anything, the market has taken the SPR loan as a bullish factor as it highlights how tight the market is in the U.S. Gulf, brokers said." ( Wall Street Journal Online)

These two stories contradict each other for a simple, yet striking reason: fundamentals like supply concerns don't drive prices, prices drive fundamentals. The news itself reflects what's already happened in the market -- in other words, it is a lagging indicator.

Wall Street Journal: China Is Joining Global Hunt for Oil And Coming Up Dry

China Is Joining Global Hunt for Oil And Coming Up Dry
By PATRICK BARTA
Staff Reporter of THE WALL STREET JOURNAL
September 23, 2004; Page C1

With oil prices still high, some see a new reason to think relief is on the way: China's oil companies are joining the global oil hunt, and they've got big money to burn. There's only one problem. They're not finding a lot of oil.

Instead, as China's oil giants fan out across the globe, they're learning what Big Oil has known for decades: Deep pockets don't always guarantee new discoveries, or even a stake in the world's premier oil fields. The best assets are either already controlled by the West, or they're off-limits to foreign investors – as in the Middle East. And China's oil companies don't have a lot of experience prospecting in hard-to-reach places.

As a result, some Chinese companies are settling for lower-return scraps the Western majors didn't want. In other cases, they're opting to spend on big natural-gas projects or refineries that don't bring more crude oil into the pipeline. The upshot is that China's majors are struggling to keep their reserves from dwindling at a time when their country -- and the world -- needs new oil more than ever. Rapid economic growth and declining domestic production are forcing China, a net oil exporter until the early 1990s, to now import 2.5 million barrels a day. That demand is placing a heavy strain on world supply and pushing prices higher. Unless China's oil companies find a lot more oil soon, Chinese imports are expected to more than double to nearly six million barrels a day by 2015, according to the East-West Center, a research center in Honolulu.

Many Western majors are holding the reins on new spending. But China's largest publicly traded oil and gas producer, PetroChina Co., is expected to invest $10.4 billion in new projects this year, compared with less than $7.5 billion three years ago, according to Deutsche Bank AG's global equity research staff. PetroChina's 2004 total is more than that of ChevronTexaco Corp. and all other large oil companies the bank tracked except for the U.K.'s BP PLC, Royal Dutch/Shell Group, France's Total SA and Exxon Mobil Corp. of the U.S.

Another major Chinese company, China Petroleum & Chemical Corp., or Sinopec, is expected to raise capital spending this year by 16% to $6.1 billion. Cnooc Ltd., China's primary offshore oil company, should boost investment by more than 40% this year to $2.2 billion, Deutsche Bank says.

All that cash is raising China's profile overseas, especially in places like Indonesia. In 2002, for example, Cnooc agreed to buy stakes in five Indonesian oil and gas fields from Spain's Repsol YPF SA for $585 million. That was followed by additional investments in other fields. PetroChina followed by paying $216 million for stakes owned by Devon Energy Corp. of the U.S. Chinese oil companies also have exploration and development projects under way in Venezuela, Canada, Thailand, Azerbaijan, Oman and the Sudan.

But while some of the overseas assets are large, many are in declining regions or are small oil producers by international standards. In some cases, China's companies have failed to get their hands on bigger, newer assets. In one example, Sinopec and Cnooc tried to secure a stake in an enormous field in Kazakhstan in 2003. But the other development partners exercised pre-emptive rights to block entry of the Chinese companies.

China's oil companies are thinking big, but "they haven't been involved in any finds that would make a dent in China's oil requirements," says Norman Valentine, an analyst at Wood Mackenzie, an energy consultant in Edinburgh, Scotland. Indeed, production from China's overseas investments is supplying only between 5% and 10% of its needed imports, says Kang Wu, a research fellow at the East-West Center. "I don't think that will rise," he says.

Even with all their spending, PetroChina and Sinopec both reported a drop in oil reserves last year. Cnooc's reserves have increased, but the company is much smaller, so those changes will have a much less measurable impact on China's needs.

China does have promising investments in the Sudan, where China National Petroleum Corp., PetroChina's state-owned parent, holds a 40% stake in a consortium that is developing sizable fields. But for now, the consortium is only producing about 300,000 barrels a day, with China getting a good deal less, analysts say. That is a drop in the bucket when the world is consuming more than 80 million barrels a day, and China more than six million.

CNPC said no one was available at the company for comment.

PetroChina and Sinopec didn't make executives available for an interview. But Mark Qiu, chief financial officer at Cnooc, says he is not surprised that China isn't securing more big fields overseas. Many proven assets are too expensive, he says, and operating in unfamiliar terrain is risky.