Tuesday, July 01, 2008

Talk or Progress? History in the Making!

There have been scores of headlines suggesting that it is time to talk to Iran. How uninformed and naive can these "journalist" be? Negotiators have been talking to Iran for 30 years and, besides, if you want to make a deal, you have to offer a price; if you want to buy a car, you do not need to spend a lot of time talking to the dealer about the weather. The size of the deal is not the key. Negotiating a multi-trillion dollar civil and military deal is perhaps more like negotiating a deal between the UAW and GM than to buying a car but in all three cases, talk is cheap. GM and the UAW must each be willing to close up the plants or the one that is not is going to win big. If a car buyer is not willing to buy a different brand or if a union is not willing to strike or if a country is not willing to back up its talk with action, then talk is worthless. If a car buyer comes close but fails to buy, if there is a strike or shut out, if a deal with Iran does not get done, all the parties have lost. The reason to make a deal is because a deal is a win-win for all parties.

For many months, UN negotiators have been "close" to a deal with Iran. We have offered a price, Iran has counter offered, we have counter offered and so on. Progress has been made while trillions of dollars of commerce has been put on hold, pending resolution of the "master agreement". Iran is currently "giving careful consideration" to the latest UN offer. Lives and treasure are being sacrificed by both sides and it is in the best interest of both sides to "make a deal" soon.

In recent weeks, certain Iranian groups, which had been on US and European lists of sanctioned terrorists, have been removed from these lists and frozen assets have been made available to them. These groups desire to overthrow the government of Iran. In recent days, a 2007, $400 million appropriation by the US congress, for US covert operations in Iran has been made public. I am reminded of Charlie Wilson's war, in which an initial small appropriation grew into appropriation of 100's of billions of dollars and the defeat of Russia in Afghanistan. Suddenly, there are reports coming out of Iran in regard to strange explosions. In one instance Iran reported that a gas cylinder facility had exploded but outsiders reported a military installation was bombed. Four hundred million is a small appropriation but perhaps just enough to show Iran that the terrorist tables can be turned. The evidence suggest that the UN negotiators still prefer a deal to regime change. For now, the threat of regime change is just another move to put pressure on Amadinejhad.

Talleyrand, perhaps the greatest diplomat of all time, enjoyed words, women, wine and song. Still, the key to his success was in understanding how to help both sides win. He was famous for making deals so good that all three sides won! The third side being a country estate for himself.

India: With Pakistan and Iran or With the USA, Russia and Europe?

Reports say that India is making final preparations to sign a civilian nuclear power agreement. This agreement will allow India to purchase nuclear fuel and technology from 71 nations but it will require India to allow UN-IAEA inspectors routine access to its peaceful nuclear power facilities. The decision to make this deal has been gut wrenching for the Prime Minister of India because he will possibly face elections as a result.

India is the worlds largest democracy; it maintains the third largest military force and it exerts a powerful influence on its region of the world. When India was granted independence from the British Empire, Pakistan was made a separate country and the two countries have since waged an almost constant battle over disputed territories. Pakistan is predominately Muslim and India is a mixture of Eastern Religions. There is no love lost between the countries and Pakistan is both a US ally against Iran and a sponsor of terror. If you have played the board game Diplomacy, you have gained insight into how many cross currents develop during international negotiations. A tricky business indeed. Americans remember 2001 as the year of attack on the US World Trade Center but Indian's remember 2001 as the year that Pakistani sponsored terrorists bombed Parliament. The USA is in what is called a "star position". We must be friends with Syria, Israel, Pakistan, India, Russia, France and China all at the same time. We must even demonstrate to Iran that we are willing to be their friend as will.

People have lived along the Indu river for over 9,000 years but have enjoyed democracy for only 60 years. One big change for India and the rest of the world is that borders have suddenly become relatively constant. India is a charter member of the UN. When given the choice of going for a lucrative gas pipeline with Iran and Pakistan or joining the USA, Russia, Europe et. al. in trying to make terrorism a thing of the past, the people chose wisely. Despite the frequent headlines that say America is despised by the rest of the world, the facts are that Indians and most other people hold American in high regard.


"Supply Siders" often enjoy attacking Keynesian Economic thought by attacking the Phillips Curve. The Phillips Curve simply says that there is an inverse relationship between employment and inflation. The reason the concept is easily attacked is because an economic contraction often results in a time both high inflation and high unemployment. This totally logical occurrence does not in and of itself refute the Phillips Curve. When a business cuts pack production, it is likely to lay off workers on its most marginal lines of business. The remaining lines are the ones for which the company enjoys pricing power. The way to keep profits as high as possible when volume is declining is to raise prices on goods sold. As Louis Gave points out, the irony is that profits are hard to come by when every business has pricing power. The auto companies currently enjoy great margins on their economy car lines. The price of a small car has gone up dramatically relative to the price of a large truck, but auto company revenues and profits are down. There is deflation in truck prices except for the fact that few are being purchased.

Inflation has always been a problem for the stock market; the cure for inflation is often, in the short run, worst than the disease. Since last summer, the world has been drinking medicine. The FOMC had started the cure in the prior 19 months by holding short rates above long rates. By last summer, the excessive money was not withdrawn by the central bank but by the commercial banks. Banks went from lending 80% of the inflated value of a house with no income verification or 120% of the inflated value to a good credit to not wanting to make mortgage loans to anyone. Once this trend was underway, the FOMC was forced to counter balance with easier money. The net result has been a larger contraction by the banks than the stimulus by the central bank and a spike in the price of oil (and other commodities). To a large extent, the inflation in commodities was offset by deflation in home prices but eventually it was commodities that won the day. Home prices have not fallen as much as perceived and the decline is over in more than half of the markets. The huge declines happened only in the "hottest of markets" but these big declines have gotten most of the press coverage.

Today, while inflation as measured by the PCE is quite modest, those who spend a large percentage of their income on food and energy (commodities) are feeling great pain. This pain can be described as "Jacques Rueff pain". Jacques Rueff was a Keynesian who despised wasteful government spending! It seems that Supply Siders and Keynesian's agree in more ways than they care to admit. Jacques definition of inflation: a policy which substitutes expenditures that give no returns with money that does not exist. As you might guess, my favorite example of this is our governments willingness to print money for the purpose of subsidizing ethanol. The left perceives the war in Iraq as the biggest government boondoggle of all time. The massive expenditures for this war will wind down substantially and quickly upon our success.

Louis Gave is correct to note that in the past several years the world has learned to borrow money denominated in dollars in order to invest aggressively. Since the dollars keep falling in price, payback has been easy. The very process of borrowing to invest can create self fulfilling bubbles. The problem comes when the bubbles burst. The good news is that the next bubble to burst will be the commodities bubble, which will also mark the end of the inflation bubble. The see saw action will be inflation, commodities and interest rates down accompanied by stocks and real estate prices up.

Foreigners who have borrowed US dollars to invest elsewhere will suddenly find that their total interest rate to be extremely high. In addition to paying interest, they will have to pay a growing premium to pay the dollars back. As the dollar appreciates, the incentive to pay back dollar based loans will produce a positive feedback loop that will power the dollar and US stocks higher. A dollar worth of US profit will become a dollar plus appreciation for the foreign investor. In the past six months, the dollar has moved sideways in preparation for its big turn. The turn has taken longer than I thought but George Bush has been on a bigger "international elephant hunt" than I realized. George is inviting the rest of the world to join in promoting peace and the peaceful use of very low cost nuclear power.


General David Petraeus wrote his doctoral thesis on Lessons Learned From Vietnam. It is a shame it could not have been Lessons Learned In Vietnam.

Timesonline.co.uk has posted an excellent article about Petraeus. The man has build an impressive resume. He has assembled a crew of PhD officers who understand how to win a complicated war. The key understanding they have is to use all available resources to kill the bad guys while turning on the lights for the good guys. If Iran cannot be turned, the fight in Iraq will be extended but a successful conclusion to the negotiations in Iran will mean that thousands of troops can come home. The bad guys in the mountains of Pakistan and Afghanistan and in a few other trouble spots will begin to wither on the vine once oil money support is eliminated.


Members of the IEA are required to maintain 90 days of total oil consumption in storage; a lot of oil as a 10% reduction in supply can be offset for 900 days. After hurricane Katrina, oil was released from storage in a number of countries to reduce the supply shock. Since those days in 2005, the amount of oil in storage has grown to no less than 4 billion barrels! While the US has all but capped off its SPR at 700,000 barrels, China was recently adding significant reserves to storage. Should an embargo of all oil from Iran occur, the world has more than 1,600 days of replacement capacity. The situation is a negotiation from strength. The big pressure was not applied to Iran until after the world was ready.

The fear of a closing off the Straight of Hormuz is over done. During the Iraq - Iran war of 1984 to 1987, both countries fired on ships in the channel. The flow of oil was never significantly reduced. This week the US 5th Fleet Commander said that the Straight will be kept open. Like Dennis Gartman, I say that the risk of war with Iran is over blown. Neither side has anything to gain from going to war. Even if it were true that Iran could stop the flow of oil from all the Middle Eastern Countries that use the Straight of Hormuz (and the Saudis operate a pipeline to the Red Sea), then the world still has 250 days of replacement supply!

The market has not yet made its "PE ratio adjustment". When the market is fearful, $1 worth of earnings in a growing company might sell for only $5. When the market is greedy, the same $1 of earnings might sell for $20. In comparative terms, a speculator might pay 4 times as much for a barrel of oil in the right market. When the market believes there is a chance of war, it is willing to pay a similar premium for hard assets such as gold and oil. Once it is clear that the supply is plentiful, the risk premium will go away. The price could easily fall below $70 per barrel.

It is natural for legislators, who are generally lawyers, to understand laws but not markets. The most recent democratic solutions to the energy crisis have been to sue OPEC and to jail speculators. OPEC is busy supplying the rest of the world with energy while investors continue to try to guess which investment will go up or down the most. What would a successful law suit against OPEC do for us? What would be the benefit of decreasing the liquidity of the markets?


We are living during an exciting time; a time when much work is going into making major steps toward world peace; a time when innovation is dramatically reducing the labor required to produce abundance; a time of change, when the marginal cost of new fuel coming on line is dramatically lower than the average cost of fuel; a time when the marginal cost of new food coming on line is dramatically lower than the average cost of food. The results will be a decline in the rate of inflation which means an increase in the value of income from dividends, capital gains, rents and work. There is some risk that these values will be reduced by the imposition of new taxes but these risks are probably overstated. The rest of the word is reducing taxes. The rest of the world is discovering that freedom is of great value.


A drug company entrepreneur who is a regular reader note that the odds of success for the new GIFT treatment offered by WFU is only about 1 in 20. I am sure that he is on the money but I remain hopeful. Even if this method had only a 1% chance of a 100% success rate against cancer, it would be worth giving it a try.

The good life is spreading. One piece of evidence is the explosion of the music business in China. Rich people spend money on the beautiful things, every thing from clean air to ballet.