2/11/06 The Global Speculative Financial System as “Enabler” of America’s Addiction to Oil 1680 words
In his State of the Union address on Jan 31, President Bush supposedly surprised the nation by saying “America is addicted to oil.” What would have been actually surprising is if he had noted the link between America’s oil addiction and the global speculative financial system. Bush also has said that current energy prices are set by the market. Left unsaid is that it is a market in which only one country, the U.S., gets to pay its bills in money it prints (more on energy market distortions shortly).
Perhaps the U.S. would be less addicted to oil, and mountains of other consumer imports (the 2005 trade deficit was just reported at $726 billion), if it actually had to pay for all this stuff in a hard currency that it had to earn through exports. Instead, the U.S. pays in dollars it prints, which is then recycled back into dollar capital markets by OPEC, in the case of oil, and by East Asia, for everything else.
A better functioning global financial system would have incentivized the U.S. to compete to service its current account deficit, which is more than 6% of its GDP and nearly 2% of global GDP. If the U.S. had to run a reasonably balanced current account, like every other nation on earth, the U.S. would export more to pay for the imports it buys using the home equity ATM.
This would have created a shift away from more excessive low-tech McMansion consumption excess, and towards much higher tech-based capital goods for export, as characterized by the much more balanced current accounts of Germany, Japan, and S. Korea, including their account with China. This may have created millions of higher tech U.S. jobs, rather than the much more common Wal-Mart-type service sector jobs that average half the compensation selling all that imported stuff.
Large market distortions affecting the global economy are caused by the current world monetary “system” (a term loosely used), which enables the U.S. to continually run huge current account and fiscal deficits with seemingly very little consequences.
This is because since 1971 the dollar is legally tied to nothing of real value, so that there never has to be actual settling of accounts of the dollar claims held by foreigners. Absent such market discipline, there has also been no “adult supervision” by the Fed in the creation of these dollar claims.
The end result has been predictable. Since the dollar-gold link was severed in 1971, dollar-denominated debt has been growing incredibly faster than actual real GDP, which on a time series graph appears as a huge, seemingly unbridgeable gap opening up between the two lines over the past thirty-five years.
The value of the dollar is currently dependent on the perceived sustainability of the power of the U.S. in the world political/economic system. Because of this power, including over the global oil market, the dollar is the world’s reserve currency used for oil and other international trade.
All other nations have what some economists call the “original sin” of needing to earn foreign exchange to pay their import bills and service their foreign debt. The U.S. alone can simply print more dollars to stimulate its economy, pay its import bills, service its debts, and let other nations, such as China, try to adjust to the global liquidity flood it unleashes as best they can.
The energy market is riddled with other distortions, starting with the supply side dominated by a few major global oil companies and the OPEC cartel, which has regained its role as marginal producer in a market where short-term demand does not decline much even with very large price increases.
On the demand side, U.S. policies in the real estate market, to be discussed in my next article, have resulted in wearying long suburban commutes to work and trips to the mall to fill up huge gas-guzzling SUV's with goodies imported from East Asia, such as big-screen tv’s.
The oil market does not function well due to lack of information. OPEC nations won’t adequately disclose their reserves, including Saudi Arabia, which is being counted upon to supply much of the projected incremental supply over the next fifteen years. Because of this secrecy, despite everything that has been written about “peak oil,” pro or con, no one really knows what the long-term supply picture may look like.
Even short-term demand is not well known. E.g., evidently China says its oil demand actually fell by 0.2% in 2005, after surging by 15% in 2004. While some question this, the lack of viable marginal supply/demand information creates a dysfunctional market environment rife with rampant hedge fund speculation of energy futures.
For many years prior to the rise in oil prices, short-sighted, overly speculative financial markets previously had negatively impacted the spending of energy companies on very long-lead time projects. Political instability, the threat of war, U.S. foreign/military policy, etc. also all affect the energy market. The result of this is huge profits for energy speculators and the oil companies the past few years.
The world may not know if “peak oil” will soon be upon us until enough time has passed to see if these very high profits do indeed call forth increased energy supply, as market price signals are supposed to do. But perhaps by then will be it too late to make the very long lead time investments in the infrastructures of alternative energy.
The 2005 energy bill “funnels billions of dollars to energy companies, including tax breaks and loan guarantees for new nuclear power plants, clean coal technology and wind energy,” according to an AP story.
Besides the usual pork-barrel corporate entitlements, this was an attempt to deal with a fundamental problem of the global speculative financial system, namely that it is extremely heavily skewed in favor of seeking ultra-high short-term “paper” capital gains, usually through quick gimmicks and essentially using private "insider" knowledge, ultimately at the public's expense.
Hedge funds and proprietary trading desks chase huge speculative returns on all sorts of highly leveraged so-called "carry trades" financed by the ultra-cheap liquidity provided by major central banks. Private equity funds look for a big killing on their leveraged debt deals through essentially "flipping" "business fixer uppers," by imposing layoffs, eliminating legal contractual benefits and pensions, often under the threat of outsourcing and/or bankruptcy, etc,. then selling their cosmetically-repaired handiwork back into the less-informed public securities markets.
Global mega-corporations seek a quick boost to growth via m&a, rather than expensive "organic" development of innovative new products and services. Venture capitalists push for the fastest exit/liquidity event strategies, by selling out their companies to the global mega-corporations desperate for growth and, like the private equity firms, to the less-informed public securities markets, which was the essence of the 1990s TMT equity bubble.
I.e., the hedge funds and proprietary trading desks can make huge profits from overly leveraged trades in the explosively growing, very opaque private credit and derivatives markets (the latter now $300-400 trillion in notional value) because they have an implicit public guarantee of insurance via liquidity provision from the central banks should their trading models ever prove wrong.
And the private equity firms, who also use leverage, and venture capitalists essentially arbitrage off their private knowledge as insiders to take advantage of the mispriced valuations in the heavily regulated public securities markets.
Little of the most highly speculative, unrelenting chase after the very big quick buck is ultimately fair and honest, nor is it economically productive and viable, relatively short-term appearances to the contrary.
Rather, it greatly distorts the global market allocation of resources, since it results in the massive under-funding of basic, long-term projects that are the foundation for generating real wealth, but which can’t compete for capital allocation against short-term speculative capital gains offering much higher returns. Speculative finance capital, aka hot money from all sorts of unregulated private funds, is replacing sound productive long-term investments.
These private funds and proprietary traders can get over-leveraged because of the perhaps most well-known way in which the Fed has distorted capital market allocation, the infamous “Greenspan put.” This is the universal belief held for many years in capital markets that large speculators can take excessive risks because Greenspan could always be counted upon to bail them out. Those who still believe in the myth of free capital markets simply are not in touch with the strong speculative incentives created by this “moral hazard.”
The capital markets strongly believe that “Helicopter Ben” Bernanke, Greenspan’s successor, will continue this insurance policy, which of course is why he was appointed. E.g. on a recent television appearance, Paul McCulley of Pimco, the enormous fixed-income investment firm, almost drooled over the magic words, provide liquidity, when he assured the viewers that Bernanke would know what to do in a financial crisis.
Another way in which the Fed distorts market forces, less talked about in polite company than the Greenspan put, is its asymmetrical policy re asset and wage inflation. Greenspan never seemed concerned about the former, claiming that he couldn’t recognize asset bubbles in advance (which obviously seemed strange since he helped create them).
But he never hid the fact that, like a good Wall Street banker, he was vigilant against even the slightest hint that the employment cost index might increase faster than price inflation, i.e. that real wages might actually rise after declining 17% since 1972 (see "2006 Economic Report of the President," Table B-47, pg 338, link), despite huge increases in real GDP per capita, productivity, and profits.
According to Morgan Stanley’s chief economist, Stephen Roach, “Over the 2001-05 interval productivity growth averaged 3.3% in the nonfarm business sector of the US economy -- basically double the 1.6% gains in real hourly compensation over the same five-year period.”
With the exception of Roach, Wall Street simply never even thinks about this discrepancy in policy toward speculative asset inflation and wage increases in line with productivity. It just assumes that the natural order of things is speculative assets going up, good, real earnings of American workers going down, who cares.
I.e., heads I win, tails you lose. This highly rigged game is only surprising to the naively gullible who still believe in a “free market” and think that the Fed is actually a so-called “independent” institution (which in itself would be problematic under our Constitution, let alone given the Bush administration’s constant preaching of global democracy).