Sunday, June 10, 2012

Everything is bullish (in its own way)

My apologies to Ray Stevens, writer of the 1970s hit "Everything Is Beautiful," the lyrics and title of which I've morphed into the title of this piece. But with that I note the perpetual bullishness of the financial industry in the face of what is really an ongoing debt deflation. Every incident, every turn of events is summarized by the industry as a "bullish development."

If the stock market goes up, that's bullish. If it goes down, that's bullish, too, because the world's central banks are just waiting in the wings to create more liquidity to support a rally. If crude oil goes up, that's bullish because it means the world economy is hitting on all cylinders. If crude oil goes down, that results in a decline in the costs we all pay for energy and that's bullish, too. (Never mind that a decline in energy prices can also mean declining demand and thus a weak economy.)

If the Greek government is getting loans to keep it running for another few months--until things get better, of course--that's bullish. If the Greek economy is about to collapse, if the Spanish banks are about to collapse, if Italian bond rates are about to skyrocket, all of these things are bullish, too, because, of course, the European Central Bank will have to ease in some way or the Germans will have to relent and agree to bail out the Greeks, the Spanish banks or the Italian bond market.

If the U.S. economy is growing that's bullish. If it is weakening, that's bullish, too, because the U.S. Federal Reserve will add more liquidity to help it grow.

But, here is the point. Unprecedented government spending and central bank easing have led to an extremely tepid economic recovery when history would suggest that a strong, vibrant recovery should have occurred. Neither action is solving the underlying problem: too much debt. Now, to most neoclassically trained economists (which is virtually all economists these days), debt is absolutely no problem because, they will tell you, one person's debt is another person's asset. The two cancel each other out. Sounds nice, doesn't it?

But when there is too much debt, it means that people who have that debt are unable to service it, that is, they are unable to pay even the interest payments on it. Of course, not everyone who is indebted is in this situation. But it doesn't take everyone to create an ongoing debt deflation. Here's the simple way to think about it: Every debt must be resolved in one of two ways. Those carrying a debt will either pay it back or default, handing the lender a loss, sometimes partial, sometimes complete. Those who can are generally paying down their debt. Hence the contraction in private debt worldwide since 2008. Those who can't pay their debts are defaulting. This includes individuals, companies and countries.

But the global economy is entirely dependent on the continuous expansion of debt in order to grow spending and consumption. That's just the way we've set things up. And, the only substantial expansion of debt we've seen since 2008 is in government debt. Without it, we would already be in a deep worldwide depression. The expansion of government debt and the purchasing which resulted from it have counterbalanced the shrinkage in private debt so far. But this expansion has not led to a robust economy recovery.

There are two reasons, neither of them bullish, for this result. First, it will take years for private debtors, both household and corporate, to bring down their debt (either by paying debts off or defaulting) to a level that would make them feel comfortable with expanding their debt again. Until they do, the economy will remain sluggish at best. But it will only remain sluggish--instead of falling off a cliff--if huge government spending and central bank easing continues. Governments around the world have probably reached the limit of what they can do without destroying their finances. And, in fact, a few already have destroyed them and more probably will.

As for central bank easing, with short-term interest rates hugging zero in major countries around the world, interest rates cannot go lower. Central banks could continue to buy dodgy collateral such as home mortgages or better quality collateral such as government bonds. This would provide more funds to the financial system meaning more cheap money made available for private borrowers. But few private borrowers see a reason to borrow. Either they are too indebted already and so banks will not lend to them or they are capable of borrowing, but see no reason to borrow. Businesses, for example, see little reason to expand in the face of continuing economic weaknesses, so they borrow very little. Individuals who can borrow are choosing not to because they are concerned about job security in such a weak economy.

Analyst Doug Noland has demonstrated that each fresh round of stimulus and easing has had a palliative effect for a shorter period. The initial stimulus turned the economy around starting in 2009 until mid-2010 when the European sovereign debt crisis exploded. Measures taken then worked until late summer 2011. To quell the second crisis in Europe additional stimulus in the form of $1 trillion in low-interest bank loans was made available that fall. This created a new precarious stability for about six months. We are now in the throes of yet another chapter of the European debt crisis. How long will the measures ultimately taken work this time? Three months? Three weeks? At some point, Noland believes, the market players will realize that these measures are not addressing the heart of the problem and make moves that will crash the system รก la 2008.

The second reason for ongoing economic weakness is high oil prices. I've been wondering when $100 oil prices would finally place enough stress on the world economy to create weakness and even outright contraction. With the recent rapid decline in oil consumption and prices--indicative of economic softness--I think that weakness has finally arrived.

Even if the world's governments and central banks manage to avoid a catastrophe this time, high energy prices and two much debt will continue to bedevil the global economy for years to come. World oil production has been on a plateau since 2005 and shows no signs of growing despite all the hand waving about new tight oil production (often referred to misleadingly as shale oil). Production declines from existing fields continue to equal growth from new fields. Hence the oil production plateau.

Debt levels have much further to fall to reach levels that are manageable for households. And, total credit including government debt continues to be far outside the norm.

While it is conceivable to me that in the next decade the world will achieve marginal gains in petroleum production (as distinct from so-called total liquids which include natural gas liquids and biofuels), I do not believe those gains can return us to an era of cheap oil. That means the path to resolution of our current economic woes rests with debt reduction. The problem could be resolved more quickly if there were a coordinated worldwide debt forgiveness on a very large scale. But rich people own that debt, and they appear to control most of the world's governments. Don't look for them to agree to a debt jubilee. Instead, the economy will likely limp along for another decade or so while people continue to retrench, paying down debt or defaulting when they cannot pay.

The result will be continuing high unemployment, social unrest and wildly gyrating markets. There is a better path. But, we will not take it as long as we are deluded into thinking that we can grow again as we did when oil was cheap and that the key to ending this slump is to add more debt.

Kurt Cobb is the author of the peak-oil-themed thriller, Prelude, and a columnist for the Paris-based science news site Scitizen. His work has also been featured on Energy Bulletin, The Oil Drum, 321energy, Common Dreams, Le Monde Diplomatique, EV World, and many other sites. He maintains a blog called Resource Insights.

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