So, if we follow the money, where does that lead us? Everyone wants to know the answer to that question. I think that it will be difficult for capital inflows to gain traction in the US, essentially the same problem left in the wake of the 2001 recession. Lacking that traction, the money seems to be flowing into commodities. To halt the rise in commodity prices, I suspect that either global monetary policymakers needs to tighten meaningfully or, what I think the Fed is hoping for, the money will spontaneously shift to another, less inconvenient direction, optimally some real, productivity enhancing form of investment. Until we see one of those outcomes, I tend to fall back on that old Wall Street truism: The Trend is Your Friend.
Friday, July 4, 2008
Follow the money
Tim Duy has written another (and more accessible) post about why the commodity price spike makes sense in the context of global capital flows.
Cross currents on speculation
So, I was never completely convinced by the argument many propose as a way to justify the fundamental nature of $140 per barrel oil -- namely, the purely financial nature of the futures market and the lack of inventories. Lots of people have made this argument, which does make sense, and is essential to consider. I do think that a lot of people don't follow up very thoroughly on the argument however. It's one thing to observe that the index funds are buying futures and not storing physical oil, and it's another to jump to the conclusion that the futures market has no impact on the spot market and hence there can be no speculation. The link between the two markets is indirect, but real, and can come from hidden inventories (kept in the ground), or from intertemporal calculations by refiners, or from fuel subsidies and very inelastic demand curves, or, as this post suggests, from the mechanics of the way contracts are priced.
Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by a system known as "formula pricing". In this system, the price of delivered crude is set by adding a premium to, or subtracting a discount from, certain benchmark or marker crudes, namely: West Texas Intermediate (WTI), Brent and Dubai-Oman. Generally, WTI is used as the benchmark for oil sold to North America, Brent for oil sold to Europe and Africa, and Dubai-Oman for Gulf crude sold in the Asia-Pacific market (Source1, Source2)."JD then provides a description of how the spot market became increasingly subject to manipulation, which led oil exporters to turn to the futures market, which was more liquid and hence less subject to games-playing, as the basis for contract pricing. JD cites a paper by Bassam Fattouh of the Oxford Institute for Energy Studies:"
[T]he futures market has grown to become not only a market that allows producers and refiners to hedge their risks and speculators to take positions, but is also at the heart of the current oil-pricing regime. Thus, instead of using dated Brent as the basis of pricing crude exports to Europe, several major oil-producing countries such as Saudi Arabia, Kuwait and Iran rely on the IPE Brent Weighted Average (BWAVE).11...This is not to argue along with so many politicians that "it's all speculation". At this point I've formulated what I think is a reasonable view on this stuff -- the price increases from 2001-mid 2007 were by and large fundamentally based, despite the gradual shifting of money into futures indexes. When the credit crisis started and real interest rates went negative, speculation started to become an important factor, and occurred through a variety of channels, not all of which would actually fit the definition of speculation most people have (it's actually a damned slippery term when you try to apply it to a cyclical market like commodities). So oil and other commodities are in a bubble, if by this you mean that they may suffer sharp declines -- but they are not going to mean revert to their 2001 price, and there really is a fundamental supply and demand problem that needs to get solved one way or another (historically its been solved by a combination of recession/depression and supply growth/conservation). Right now things are just overshooting, and the greatest danger is in taking the easy road out by scapegoating the evil speculators and ignoring why the speculation got started in the first place.
[11] The BWAVE is the weighted average of all futures price quotations that arise for a given contract of the futures exchange (IPE) during a trading day. The weights are the shares of the relevant volume of transactions on that day. Specifically, this change places the futures market, which is a market for financial contracts, at the heart of the current pricing system.
Thursday, July 3, 2008
And another thing ...
The interdependence of macro variables is so complicated that I have no idea how to keep all of it in your head at once. Tim Duy has some interesting reflections on the current imbalances.
On the other hand, in order to finally control inflation, they might raise rates and let their currency depreciate. It would have to be a sudden depreciation of course (say 20% in one go), to avoid people speculating on the currency. This destroys their competitiveness immediately, but does at least halt some of the speculation. It makes their pile of dollars worth a lot less, and the knock-on effects of that may be worse for the US, given that such an obvious policy failure might be accompanied by a remedy that makes it even worse -- namely diversifying out of dollars, or simply not adding so many new ones to the hoard. This should drive up US rates, and would probably tip the whole world into recession/depression.
Consider that the current account deficit will need to correct by some mixture of import compression and export expansion. The weaker Dollar encourages that correction, but Dollar-pegs prevent the full adjustment. But where currency adjustment fails, commodity price adjustment steps in as, for example, higher transportation costs support import competing industries. Indeed, we are learning that cheap oil, not just cheap wages abroad, was the critical force supporting offshoring of US production.It's interesting to think about the effect of higher oil prices as a national rebalancing mechanism. It both cuts into your real consumption, and at the same time, by making imports that have to cross an ocean more expensive, shifts the mix of the consumption towards domestic producers. He continues on to the punch line:
I have long maintained that this adjustment should be characterized by weak consumption growth but better-than-expected business activity overall, particularly in export and import-competing industries. Effectively, the US is offshoring some of its weakness. The combination should be something that consumers clearly associate with recession, but with better than expected output, especially when policy stimulus is added to the mix. This is very much like the current environment, a recession that still lacks a single quarter of negative GDP growth. But the level of stimulus is starting to look excessive, and supporting a more inflationary environment than anticipated.
How long can this process continue? As long as global policymakers are willing to support it. Indeed, it is almost of a game of chicken, with US and emerging market policy makers on a collision course, neither wanting to accept the adjustment, a greater reliance on internal balance, necessitated by excessive US consumption.
Thinking about this, it seems to me that the Chinese are seriously fucked. They get caught on both ends of this bargain, as they too have to fork over more for oil and food, at exactly the same time as their exports become less competitive -- and they don't have any domestic demand to fall back on like the US. They can either continue to try to export, pile up dollars, let new direct investment come in (remember, they are accumulating reserves even faster than they can export) and simply accept the inflation this causes -- or they can revalue. Right now they are choosing option A (most of the world is choosing option A actually, not just the Chinese) -- exporting, putting up with the speculative inflows, recycling these into dollars as best they can, and just swallowing the resulting inflation. The fact that they're willing to do this is what is keeping the US afloat, but China must be paying the price for it in terms of bubble-like mis-allocations of these inflows. The whole thing looks like a positive feedback loop between Chinese fixed investment and commodity prices, with US monetary policy intervening in the middle and providing the juju to keep it going. If the fall of the Chinese property and stock markets, and the rise in inflation are any indication, we are at the last stages of this bubble.
On the other hand, in order to finally control inflation, they might raise rates and let their currency depreciate. It would have to be a sudden depreciation of course (say 20% in one go), to avoid people speculating on the currency. This destroys their competitiveness immediately, but does at least halt some of the speculation. It makes their pile of dollars worth a lot less, and the knock-on effects of that may be worse for the US, given that such an obvious policy failure might be accompanied by a remedy that makes it even worse -- namely diversifying out of dollars, or simply not adding so many new ones to the hoard. This should drive up US rates, and would probably tip the whole world into recession/depression.
Global monetary conditions
Naked Capitalism has a post putting together some stuff on the inflation-deflation debate and defending the Fed rate cuts in the face of the ECB. This would be related to my post of the other day where the PIMCO guy also defended the Fed, and suggested that there wasn't much danger of inflation in the US, given the weak position of labor, and that the problem with lower rates really stemmed from the currency pegs in the dollar block.
The crux of the problem seems to be what you do with the money supply when you experience a commodity price spike (if you are a commodity importer). To me, the logic of letting the money supply expand to deal with that shock, and thus balancing the pain of it between capital and labor, is pretty compelling. That seems especially true when the real wages of consumers are already tremendously fragile, and forcing them to bear all the burden would almost certainly tip us into a deep recession.
It seems to me that the normal consequence of this easing into negative real rates would be a fall in the dollar, as the US is essentially inflating away its obligations to the rest of the world (eve if domestic inflation remains fairly contained). The dollar would fall, the US would rebuild its manufacturing, and gradually we would save more and spend less and things would return to balance. In the middle US growth would be slow of necessity because 75% of GDP is consumption, which by hypothesis here has to fall relative to production.
The problem here is that the rest of the world isn't buying, and that in fact they're saving up all their dollars and refusing to let that currency adjustment happen. From their perspective this makes sense because letting their currencies appreciate makes all the dollar reserves they've built up over the years worth a whole lot less, and incidentally, reveals them as suckers once again in the game of global finance -- the insurance they bought by saving after the last round of problems in 98-99 turns out to be worthless.
The crux of the problem seems to be what you do with the money supply when you experience a commodity price spike (if you are a commodity importer). To me, the logic of letting the money supply expand to deal with that shock, and thus balancing the pain of it between capital and labor, is pretty compelling. That seems especially true when the real wages of consumers are already tremendously fragile, and forcing them to bear all the burden would almost certainly tip us into a deep recession.
It seems to me that the normal consequence of this easing into negative real rates would be a fall in the dollar, as the US is essentially inflating away its obligations to the rest of the world (eve if domestic inflation remains fairly contained). The dollar would fall, the US would rebuild its manufacturing, and gradually we would save more and spend less and things would return to balance. In the middle US growth would be slow of necessity because 75% of GDP is consumption, which by hypothesis here has to fall relative to production.
The problem here is that the rest of the world isn't buying, and that in fact they're saving up all their dollars and refusing to let that currency adjustment happen. From their perspective this makes sense because letting their currencies appreciate makes all the dollar reserves they've built up over the years worth a whole lot less, and incidentally, reveals them as suckers once again in the game of global finance -- the insurance they bought by saving after the last round of problems in 98-99 turns out to be worthless.
Wednesday, July 2, 2008
Geopolitics of China
Fascinating post on the geopolitical situation of China. Really, go read about how geography plus demography equals destiny. Don't take the posts conclusion that China will always and forever be a export led manufacturing economy though. Eventually, China may develop a thriving middle class that sells all kinds of stuff to one another, even if it always has to have some exports available to pay for the food it will import.
The merits of inflation
An interesting speech by one of the PIMCO directors. The basic argument is that the US, as an oil importer is experiencing a negative terms of trade shock -- namely, higher oil prices -- and that the Fed shouldn't raise rates to deal with the inflation this causes because it makes labor pay the full cost of the shock, rather than sharing it between capital and labor.
Let me see if I can rehearse the idea. First, the price of oil goes up. In real terms, this means that you have to work more to buy a barrel of oil. Your real wage, as a nation, has decreased. The nation is composed of two groups -- those who labor, and those who hold capital. Let's assume for a second that holding capital means holding cash or T-bills or short-term assets in general. Now, if you raise interest rates to deal with this inflation, you can maintain the purchasing power of that cash. The Fed raises rates in the face of an inflationary shock in order to maintain stable real interest rates. Unfortunately, higher rates also make it less profitable to invest in real businesses, so they imply a slowing economy. This means that more people end up out of work, and those that remain employed see no wage increases. Therefore, the real wage declines, and has to account for all of the necessary adjustment to the decline in purchasing power of the nation. Labor suffers while capital (cash) skates.
If, however, the Fed leaves rates where they are, the real rate of return on short-term capital declines as the price of oil rises. This may even result in negative real interest rates. But this simply means that now some of the burden of the fall in purchasing power is partly absorbed by capital, and should protect labor from an economic decline. The lower rates should cut into economic growth less, meaning that fewer people lose their jobs and those that stay don't need to accept a reduction in (nominal) wages. So the purchasing power of capital is eroded along with labor if you keep rates low.
The problem is in dealing with the knock-on effects of negative real interest rates.
Let me see if I can rehearse the idea. First, the price of oil goes up. In real terms, this means that you have to work more to buy a barrel of oil. Your real wage, as a nation, has decreased. The nation is composed of two groups -- those who labor, and those who hold capital. Let's assume for a second that holding capital means holding cash or T-bills or short-term assets in general. Now, if you raise interest rates to deal with this inflation, you can maintain the purchasing power of that cash. The Fed raises rates in the face of an inflationary shock in order to maintain stable real interest rates. Unfortunately, higher rates also make it less profitable to invest in real businesses, so they imply a slowing economy. This means that more people end up out of work, and those that remain employed see no wage increases. Therefore, the real wage declines, and has to account for all of the necessary adjustment to the decline in purchasing power of the nation. Labor suffers while capital (cash) skates.
If, however, the Fed leaves rates where they are, the real rate of return on short-term capital declines as the price of oil rises. This may even result in negative real interest rates. But this simply means that now some of the burden of the fall in purchasing power is partly absorbed by capital, and should protect labor from an economic decline. The lower rates should cut into economic growth less, meaning that fewer people lose their jobs and those that stay don't need to accept a reduction in (nominal) wages. So the purchasing power of capital is eroded along with labor if you keep rates low.
The problem is in dealing with the knock-on effects of negative real interest rates.
The "VC Crisis"
I really know jack-diddly about venture capital, but a post at peHub today resonates with other things I've read and what Christof has mentioned to me in the past.
I offer five forces that underly the observable change in modern venture capital:
- The technology industry has matured to the extent that startups are viewed as outsourced R&D by big companies.
- The consolidation of technology verticals via either winner-take-all competition or multi-billion dollar acquisitions has decreased the number of would-be customers and acquirers for focused technology offerings.
- The over-availability of growth capital promotes competition among startups for scarce resources such as technical employees and early-adopter customers and raises development costs accordingly.
- Attractive investments may be increasingly found through creative deal sourcing and structuring rather than sexy technologies, big markets or “hot” entrepreneurs. Similarly for successful exits.
- Successful firms have formalized their succession planning to preserve their virtuous cycle, making specialization an increasingly attractive strategy for first time funds.
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