Wednesday, February 20, 2008



Can you comment on the recent surge in oil prices? I saw a note in the USA Today that a contributing factor is the low value of the dollar. Since oil is exchanged for dollars, a weak dollar requires more of them to buy oil. Why are we allowing the value of the dollar to fall so much?

Also, I heard someone say that this recession is different than recent recessions. The recession in the early 80's and 90's were caused by the Feds raising interest rates to moderate the economies. This person said the current recession is caused more by fundamental issues such as the credit crunch, oil, etc. Therefore it will take longer to get out of it. What do you think about that?


First of all, the dollar is the ready and handy excuse for all sorts of ills. In truth the dollar is only a medium of exchange, just a convenient tool to facilitate the exchange of goods. The dollar is a commodity, no different than a barrel of oil or a bushel of corn. The price is set by supply and demand. Short term traders constantly bet on the future price of a bushel of corn, a barrel of oil and a quantity of dollars. In the short run, the price of a bushel of corn might jump up or fall down for any number of reasons but the real variables that make for significant moves are how much corn is planted and how much is demanded. The price is also greatly influenced by the availability of substitutes. If the price of farm land gets too high in the corn belt of the Midwest, driving up the price of sweet corn syrup, more sugar beets and sugar cane will be grown in southern locals. The substitution effect is more powerful than is commonly understood. In the same way, the Japanese may decide to build an auto manufacturing plant in the USA if the value of the Japanese Yen is high relative to the price of the dollar.

In the old days, a gold dollar was a gold dollar and that was all. The value of that gold might go up or down relative to the value of a bushel of corn or a barrel of oil but the dollar was never anything more than $1. This concept is simple enough but it created huge problems, both before and after a "standard price" was set for an ounce of gold. The following is a list of some of the panics and depressions of the past:

the panic of 1819,
the panic and depression of 1832,
the panic of 1837,
the panic and 6 year depression of 1837-1843,
the panic of 1857,
the panic of 1873,
the world wide panic of 1893,
the presidential papers panic of 1893,
the panic of 1901 part I, part II and the stock market collapse,
the panic of 1907,
the panic and depression of 1929-1933

Speculators made and lost bundles during these volatile times. For example, in the panic of 1907, the average stock price fell by 50%.

There have been 8 or 9 post WWII recessions and the average depth of decline of stock prices and the percentage of people suffering from lost jobs and bankruptcies has been no where near the levels reached in earlier times.

Part of the problem of using gold or silver as the medium of exchange is that there are truly occasional supply shortages. In attempts to eliminate or to dampen the severity of the panics and depressions, governments would set a price at which they would exchange paper currency for gold or silver. When the price of of silver or gold was incorrectly priced by the governments, people would exchange all their paper currency for the one priced too cheap. A lot of "games" were played to try to solve the problems. In at least one incidence, England was forced to make silver coins smaller and smaller in their attempt to avoid running out of this "precious" commodity.

Over time, the fractional banking system took hold. The fractional reserve system developed because it solved a number of problems. Instead of charging a customer a fee to store his gold, the bank was able to lend a portion of each customers gold to others, earn an interest return and still have enough gold to pay off any one customer who asked. When central banks developed, which were operated by governments, the fractional system became the way a government could in effect grant itself its own "line of credit".

Today, dollars are "printed" as a result of purchases of government bonds issued by federal governments but they are also "printed" as the result of the process of lending and depositing by bank customers. To make the math simple, we can use a 10% reserve requirement. A bank with $1,000 on deposit and operating on a 20% reserve requirement, as dictated by the central bank, could grant a loan to a customer equal to $800. No matter how the $00 was spent, it would sooner or later make it back as deposits at banks. These banks might then make new loans equal to 80% of $800 or $640. This process could be repeated time and again such that theoretically the original $1,000 has become about $4,000 worth of loans. Of course, the total amount of money outstanding is influence by how quickly the loans are paid off. The combination of terms and reserve requirements in the USA today leads us to the situation where there is about $5 outstanding for each $1 held in reserves at central banks.

This is where the Archimedes principle kicks-in. Archimedes is the guy who discovered the power of leverage. His famous quote made around 200 BC was that with a long enough lever and a place to stand he could move the world. The leverage of the government is large. A tiny move in the bank reserve requirements can change the potential total money supply by at least 5 times the amount of deposits on hand. The percentage of reserves required is a very blunt and powerful tool, thus, the reserve requirements are not changed often. What is changed fairly regularly is the charge for borrowing reserves from the central bank. When the Federal Funds Rate is decreased, the door is opened for banks to make repetitive, profitable loans. When deposit rates are well below longer term fixed rates, banks have great incentive to lend money, accept more deposits and lend still more money.


The President, Treasurer and Chairman of the FOMC must politically always hold to the line that they support a strong dollar. In reality there are advantages to having a weak dollar. As a result, our government, under republican and democratic administrations have practiced policies that cause the dollar to decline in value. This is a complicated topic but the old saying that if it walks like a duck and quakes like a duck, it must be a duck. The value of the US dollar has declined for hundreds of years. We talk about the falling dollar all the time when we talk about inflation.

Over the past 50 years, the government has paid an average of 5.4% on the 90 day treasury bills it issues. The government has paid an average of 5.4% on the money it borrowed in this fashion, or did it? During this 50 years, the average inflation rate has been 4.1%. The government paid 5.4% interest but paid back with dollars that had depreciated by 4.1%. The cost to the government of the borrowed money was 5.4% minus 4.1% or 1.2%, or was it? The government levied taxes on the 5.4% at an average rate of 18%. Thus the governments net cost was 5.4% times .82 minus 4.1% or .3%, or was it?

The reality is that the government actually makes money off seinorage, which is the difference between the value of money and the cost to produce it. If it cost a nickel to make a $100 bill, the difference between cost and value is 95 cents. If that hundred dollar bill is lost, burned up or worn out in a remote region of Siberia, the government has printed a piece of paper and sold it for $100. Even for dollars that are not destroyed, the government issued a peace of paper in exchange for canceled debt in the amount of $100 and the government pays no interest on that $100 for as long as it floats along. Since the dollar has just kept on declining in value for the past 50 years, one of these dollars kept in a piggy bank for 50 years will now buy 13 cents worth of goods.

All of the above amounts to saying that the dollar falls because the government wants it to fall. One of the "beneficial effects" of the falling dollar is that it serves to speed up the redistribution of stagnant wealth.


In the past 30 years or so, the world has enjoyed more than just a technological revolution. It has also enjoyed a financial revolution. The revolution is similar to the development of the fractional banking system. People around the world have come to realize that owning a fully paid for house is similar to the days when "money in the bank" literally meant gold on deposit. The gold paid no interest and yielded no profit. The value of gold over time only keeps up with inflation. In the example of the $1 in the piggy bank now buying only 13 cents worth of goods is the same thing as saying that a $1 worth of gold in the piggy bank 50 years ago would buy a dollars worth of goods today. Money tied up in real estate is money that could be put to more productive use. As you can appreciate, I am writing this statement at the worst of times. It takes people variable lengths of time to learn how to properly use credit and some never learn. There will always be people who borrow too much and there will always be skilled borrowers who hit tough and unpredictable situations. Still, we don't throw away our kitchen knife or skill saw because they have the potential to cut our fingers off.

The tough thing to learn is that the bankers, insurance companies, brokers and other "commercial borrowers" are in competition against you. This means that the best time to borrow is when it is toughest to do so. Banks do not want to loan money when there are mortgage pools selling for 30 cents on the dollar. The bank that buys a pool of mortgages for 30 cents and sees the repayment of 95 cents plus the full interest due on the 95 cents, makes a lot more money that loaning you money at 6% to buy a house. The fact that you might buy the house at a discount of 30% of next years value gives the bank no great joy.

Over the years, it has been interesting to watch insurance companies dramatically jack up the price of insurance on beach condos near the bottom of the market bottom. The excuse is always placed on a storm like Katrina that happened way back in 2005. The fact is that it is easier to accumulate large quantities of real estate at cheap prices if insurance rates are high during the worst of times.


In cycle after cycle the phrase is repeated that this time is different. Indeed, history does not really repeat it self but history does rhyme with itself. The readers friend says that the recessions of the 80's and 90's were the result of the Fed raising interest rates to moderate the economy. He went on to say that this recession is a result of fundamental issues such as the credit crunch, high oil prices, etc. I would like for your friend to show me another time in history where the FOMC held sort term interest rates higher than long term rates for 19 months in a row!

Central bankers and investment bankers cooperated to cause the credit crunch. Mixing weak loans with strong was done in a way to poison the whole barrel of loans in the short run. The US government went along with the strategies employed by investment bankers to sell polluted barrels of mortgages to any and all comers. Then, after the FOMC put the hammer down on interest rates over a period of 19 months and dried up pools of excess liquidity, the government rules dictated that the entire barrels of mortgages be treated as toxic waste. The great majority of paper in these barrels is "money good paper". Most of these mortgages will be paid in full along with the stipulated interest payments. Yes, this is "different" than last time. In 1989 the government put the hammer down and put a lot of banks and savings and loans out of business. The government established the Resolution Trust Corporation of America to buy up the "bad loans" and foreclosed properties. Those who bought properties at the depressed prices of that day made out like bandits.

This time is different in that the decline in real estate values has really not been much. Sure, there are pockets of misery but in more than half the cities of America the average home went up in value over the past 12 months.


The story of the high oil price is the opposite of the rest of this story. The primary reason the price of oil is so high is because of tremendous world wide economic growth. The price of oil has gone up because even at $100 per barrel there is still demand for oil. The fact that the dollar has fallen has made the price of oil go up less in terms of other currencies but even so the price of oil has gone up.

It is not unusual for it to take time for price to cure price. The demand for oil is inelastic (not flexible) in the short run. The guy that owns a new V-8 SUV is not willing to sell at a loss to reduce his demand for oil. However, given a little time, high oil prices cause aggressive exploration and aggressive conservation.

The second reason the price of oil has stayed high is political. Misguided souls have fought to "save the environment". The result has been that the cheapest available sources of new energy have been put off limits. The USA owns a trillion equivalent barrels of oil or so that is just off the coast. This oil could be accessed with no real long term environmental damage. By the same token, nuclear power plants could be built that would reduce our oil needs. Instead, trillions of tons of dirty coal are being mined. The railroads are having to add the second set of rails to the great coal fields of America. Another angle to the problem is that energy investors have had to build in the risk that they will be "assaulted" by the policies favored by Hillary and other democrats. Exxon Mobile just paid $30 Billion to the US treasury in taxes but Hillary wants more. If you are an XOM shareholder, do you want the company to spend 6 Billion on a new refinery that will need 30 years of profitable operation to make sense, if Hillary is prepared to change the rules after the plant is built?

The third reason oil prices are high is because of political risk in the producing countries. This risk is more perceive than real but the perceived risk has added as much as $20 to the price per barrel. The reason the risk is only a perceived risk is because the producers would be hurt badly by any disruption in production. It is in no ones long term interest to stop the flow. Chavez has threatened to shut down supplies but the country is already suffering through a "food crisis". Iran's official unemployment rate is 11% but, the real rate is probably at least 20%. Still as long as people believe the risk is high, they will respond accordingly.


There is a lot of good news brewing for oil consumers. The timing of most of the good news is uncertain. Elephant oil discoveries that should have come on line by now have been delayed. The Caspian Sea has turned out to a tough environment for bringing a monster field on line. The super monster fields discovered in Brazil will take several more years to come on line, but in the mean time the total size of the find continues to be assessed and estimates of total size continue to be raised.

More immediate help will come from "a little more from here and a little more from there". Angola, Newfoundland, Ghana and a long list of other places will add production this year. Economics ultimately wins battles and the plan being hatched by Iran and Iraq to jointly develop fields along their borders shows the power of the profit dollar. It makes sense to jointly develop fields rather than to fight to suck out the most the fastest. The science of oil recovery requires pressures to be maintained. A new well in Iran might destroy the investment made in a well in Iraq and vice versa.

As long as people believe oil prices are going up, they will hoard supplies. However, over time, the belief that prices are going to go up will be the straw that allows us to get over the camels hump.

This time is different in that global economic growth has not slowed as much as one would expect by the time of the mid cycle turn. China has raised rate and increased reserve requirements again and again but it just reported an inflation rate of 7.1%. The government is allowing the Yuan to float up more quickly and the numbers are showing up in the US trade accounts. The US has seen extraordinary strength in exports of manufactured goods.

Yes, our dollar is now so cheap that our industrial production is strong even during a time of recession in housing and autos! In the old days, recessions in housing and in autos at the same time meant the rest of the economy was in sad shape.


For me, the more important question is when will the stock market soar? The stock market will appreciate well before the bottom of the economic cycle. Indeed, the US is still likely to avoid going into a full blown recession because the steep drop in interest rates has already started to work its magic. Problems are already being "solved". Another shoe could fall but the evidence suggests that old shoes are getting repaired. I believe it was AMBAC that just raised $2 Billion dollars. The big investment bankers have made deals with sovereign investment funds to give them the strength to hold and buy more of the deeply discounted mortgage pools. The big drop in rates means has taken 300 basis points off rate resets. Suddenly a number of homeowners who were expecting rate increases will see rate decreases.

As I have pointed out, the four legs to the investment stool all support higher stock prices. The answer to when the recession will end (if there is a recession) is that it will end about 3 months after the stock market soars.