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# Oil consumption and extraction/refining have met at 85m bpd - and perhaps extraction/refining rates cannot be increased from here
# In the developed world, GDP is growing in the US, Europe and now even Japan
# In the developing world, India and China are rocketing along
# So, demand for oil continues to rise in the developed world+ and even faster in the developing world
# However, the US is running the largest deficit on external account in its history and the largest in the world++, which
brings with it the threat of a US dollar collapse, imported inflation and a rapid deceleration in the US economy followed by the world economy
# So, on the one hand, there is potential for the demand for oil to collide with an extraction/refining ceiling and for prices to explode
# On the other hand, a significant deterioration in the world economy could cause demand to soften and allow oil supply to comfortably match demand
# If the former happens, then the effects of peak oil are likely to be felt reasonably soon
# If the latter happens, then the effect will be deferred
# Additionally, even with a significant softening in demand, supply side shocks (problems with Nigeria, Venezuala or Iran or the discovery that either Ghawar or Cantarell or both have hit a precipitous rate of backside production decline) could still mean substantially higher push prices in the near future
# Moreover, even if we just assume away the oil problem, we have looming shortages of natural gas and water together with relentlessly increasing soil degredation around the corner...
+ From 1990 to 2003 there is a 99.5% correlation between US GDP (independent variable) and US oil consumption (dependent variable). I think this offers a fair opening point to anyone wanting to argue that increases in GDP simply measure the rate of increase in our usage of fossil fuels...
++ As well as having the largest budget deficit in its history and a property bubble
As Westexas points out, the house is full of elephants but the "real world" is currently focused on swelling oil inventories.
But look on the bright side: we're probably mad :-))
China obviously is directly connected to our economy and would take a big hit; and, if they redirected some of their dollar holdings to Euros, of course, our hit gets worse.
But that arguably would ease oil prices enough elsewhere that Japan, the Asian tigers, and Europe all might have relatively lesser recessions.
The Fed also has a strong anti-inflation bias. There seems to be an overwhelming consensus that it is inflation we should be concerned about. It seems to me that Bernanke mentioned dropping money from helicopters merely as a means of dismissing concerns over deflation out of hand, not because he did in fact have any intention of printing money. I suspect he believes, as you suggest, that deflation can be easily avoided. The implication is that he sees inflation as the real enemy, as did the power-that-be on the eve of the (deflationary) Great Depression.
I agree with you that changing perceptions and expectations would drive up interest rates, but I see this as compounding deflation (and increasing the chances of a liquidity crunch) rather than as a result of inflation. I agree with your forecasts for the the DJIA and the NASDAQ by the way, probably within ten years and likely within five.
Premise: Congress created the Fed and Congress can destroy the Fed or take away its power.
Premise: All Fed members know and fully appreciate the above premise.
Premise: Because of political pressure, the fed will have no choice but to monetize the debt. (Note: This has happened before and will happen again. How else did we get from a 100 cent dollar in 1913 to approximately a 4 cent dollar today?)
Premise: To stave off a rerun of deflation and the Great Depression the Fed will not only use its Open Market Operations magic wand (with which they legally create bank reserves and hence [potentially] money but also its Ultimate Magic Wand (UMW, not to be confused with United Mine Workers;-) of lending however much they feel like to pretty much whomever they feel like. Through the use of these two Magic Wands, the Fed will not have to ask the Treasury to directly print money.
However, under (if I recall correctly) Civil War legislation the U.S. Treasury has the legal authority to print as much currency as it feels like doing. Us oldsters can remember "U.S. Treasury" $5 bills; you youngsters cannot.
Note that it will not only be Congress putting pressure on the Fed to inflate, it will also be the Treasury Department. How else will they be able to finance a deficit of three or four or five trillion dollars per year?
Final observation: The Supreme Court has no power to stop any of this, because the laws giving the Fed and the Treasury its powers have been tested in the courts and have stood up to every challenge.
Note that I make no predictions. I do not know what will happen.
Now here is a query: In the opinion of the readers of this column, does the new Fed chairman have steel balls? Volker did. Most Fed chairman have not had these. Greenspan? Brass balls.
If I had to propose a potential course of events, I would suggest that Bernanke is likely to raise interest rates initially in order to establish his anti-inflationary credibility. With the housing market teetering on the brink, this could be enough to precipitate a housing market crash. Bernanke would already be trying to ride a tiger by this point, which could come relatively early in his tenure.
Bad debt could leave many financial institutions vulnerable, but attempting to bail them out would threaten the role of the dollar as global reserve currency and the continuing influx of foreign capital. International dumping of the dollar could proceed rapidly, although within the US the value of many assets classes could still fall relative to cash in the rush to cash out and cover debts.
I envisage a cascade of bank failures as defaults snowball and savers try, and fail, to reclaim their savings. A liquidity crunch could follow, severely limiting purchasing power and therefore energy consumption, among other things. I very much hope to be wrong, but the power of a positive feedback loop in action can be truly awesome. I have no faith in the ability of one institution to stand in the way of such a chain of events, magic wands notwithstanding.
If I understand you correctly, you are suggesting that all of the Fed's efforts to inject liquidity into the system in order to prevent deflation and bank failures might be insufficient, or that while nominally sufficient, these measures might backfire by causing panic selling of US Treasury notes and a subsequent crash of the dollar relative to other major currencies. So Bernanke could choose inflation as a monetary tool and yet end up triggering deflation anyway.
One thing you said puzzled me though:
"I envisage a cascade of bank failures as defaults snowball and savers try, and fail, to reclaim their savings."
So you are saying that the FDIC would not be able to honor its commitments, causing peoples' savings to just be wiped out? I would think that the Fed and Congress would act to prevent that at all costs because that's the type of thing that could result in a revolution. Think about millions of unemployed mortgageholders who then lose their homes because they can't make their mortgage payments using their savings. That situation would be very ugly.
I am also saying, as you point out, that deposit insurance is not likely to be worth the paper it's written on, as it was never designed to actually bail out a systemic banking crisis. It's existence has lulled savers into a false sense of security IMO. I would expect the Fed and Congress to find themselves overwhelmed by the monumental scale of bad debt in the system, and unable to prevent a liquidity crunch. As you say, the social and political consequences would be severe, especially considering that there may also be energy supply disruptions and price volatility simultaneously courtesy of peak oil and natural gas. Needless to say, I don't think we are looking at a slow squeeze here.
That is indeed a grim picture. Considering your disagreement with "conventional" wisdom (specifically the efficability of the Fed) about how such a financial would unfold, how do you think the holders gold and silver bullion would fare?
I had an uncle, since passed away, who was a "gold bug" and believed the U.S. financial system would eventually melt down. It seems to me that although bullion holder would fare better than the hapless depositors jilted by the FDIC (the bugs still have their store of value), the practical aspects of using that bullion might be problematic. In other words, a clerk in a grocery store would not be able to accept anything that wasn't legal tender. So using it in retail stores for necessities doesn't seem feasible. So you have identify people who have what you want and find out if they will accept gold. Hopefully these are people you already know and trust, otherwise you might just end up trading gold or silver for lead, so to speak.
Interesting times indeed.
Personally, I would look first to getting out of debt, then to hedging your bets with some basic self-sufficiency measures (as economic disruption can lead to inconsistent availability of necessities) and finally to holding some form of liquidity (although this is easier said than done in a liquidity crunch as you might imagine). If you can't afford a house without a mortgage (unless it's a very small one), then I'd rent and let someone else take the house price risk. The equity you extract could serve you well if you can manage to hold on to it. I see money as the lubricant for the economy. Without it, the economy seizes up like a car engine run with the oil light on. That's why a liquidity crunch is so disruptive.
Beware of governments trying to separate you from what wealth you may have managed to preserve. In Russia the government got all the money out from under the beds of the nation by reissuing the currency and then making it very difficult for many people to exchange their old rubles for new ones in time. Many lost their life savings. In Argentina, the government converted dollar savings accounts into Argentine currency then allowed that to devalue drastically as the currency peg fell (debts remained denominated in dollars). They also converted short-term government debt into long-term and then later defaulted on it. There are no risk-free answers.
There really is no other option than attempt a controlled inflation given the current situation, and that is what the Fed will try to do. I don't honestly know how that will play out, though it will take a decade or more if successful. Unfortunately it may get out of control and often runaway inflationary periods end with a nasty bout of deflation.
- Another Great Depression, with falling price, bank failures and all the rest or
- Hyperinflation to wipe out intolerable debt burdens.
Keynes pointed out the superior political influence of the debtor class.Politics rules.