Revenge of the Real Economy

SUBHEAD:The markets are completely distorted, both by purchaser preference and risk - but also blatant manipulation. By Steve Ludlum on 3 January 2011 in Economic Undertow - ( Image above: Detail of "The Tornado Man" by Mark Bryan, 2004. From ( Happy New Year everyone! There is a lot of talk about inflation since energy costs have risen dramatically since early last summer, taking along prices for food and other goods. Whatever is for sale includes petroleum either in the manufacture, processing, packaging and transport. Basically all goods are forms of petroleum, all services require petroleum to enable them. Rising prices of goods in and of themselves are not indicative of inflation which is a change in the value relationship between money and the business that money leverages. Valuable business means less valuable money: when money is given a 'negative' value by trade in the markets that is inflation. Business lends into existence what funds it needs to insure success. More money in circulation and more credit means a greater money supply and an equivalent decline in unit purchasing power. It also means an equivalent increase in debt. Both of these are benign which is what Fed Chairman Bernanke acknowledges when he proclaims his desire for a 'modest' 2% rate of inflation. Only business expansion creates more credit/money in this way along with the benign inflation. Attempting to add more funds into bank reserves cannot increase business activity, neither can pitching horseshoes. Only the possibility of returns on time, skill and hard work can increase business activity. Because or in spite of Bernanke's efforts, the returns on increased reserves and added debt have vanished. High input prices make fuel- using enterprises unacceptably risky. This being so, what remains is finance and other Ponzi forms of outright gambling/speculation. Finance as a consequence has found itself in grave difficulty. Finance cannot create value so it is an absolute dependency upon the real economy which is relied upon to produce useful, valuable goods and services. The productive economy fell alongside finance. Ironically, finance was rescued. What story can this tell other than to acknowledge that the real economy cannot produce any more and saving it is useless. Too bad the Establishment cannot imagine a 'Plan B' economy that isn't machine/fuel dependent. Sovereign bailouts of finance allocate resources away from the returns from work in exactly the same manner as do increasing fuel prices. The analog is government- sponsored 'War on Work' very much like the failed but destructive Wars on Drugs and Terror. At some point debt increases to a point where it cannot be serviced by business cash flow. Debt then must either be repaid or liquidated. This process is integral to the business cycle. Instead of restructuring, the Establishment has been making an all-out effort to hold-harmless lenders while refusing to allow credit from being wiped out.
It is doing this by replacing questionable private credit with the public version. Doing so does two things. One is to degrade sovereign credit is the one becomes the proxy of the other. Swapping bad private loans for 'better' public versions strip mines the sovereigns' creditworthiness which effects their ability to borrow cheaply.
Not only is the endeavor futile, the effort cannot create the desired (hyper)inflation: credit destruction is irresistible. Even when the sovereign can keep up with credit destruction for a short period it commits itself to doing so endlessly. At some point the sovereign runs out of resources, its creditworthiness is dissolved. Debt becomes too great for the 'virtual cash flow' or monetization efforts of the central banks to service adequately. The failed Establishment becomes irrelevant and useless. Debt destruction commences as before until debts fall to a level that is serviceable by the new (and far lower) cash flows of those businesses which remain. The cycle of money/credit expansion begins again. Inflation is not to be confused with hyperinflation, which is the purposeful expansion of the supply of money and credit into circulation by banking authorities. This effect is taking place right now in China where the authorities are bent on stealing what value remains to the country's bank depositors and working classes. In both inflation (and the hyper version) price increases are accompanied by an increase in demand or in wages and worker earnings. Analysts in the US suggest many important goods such as food, medical care, education, staples and fuel are becoming more costly. They ignore declining wages and house prices. Wages enable workers to pay the high prices. Without wage increases or employment it is hard to see how any company raising prices will be able to stay in business. This was the end of the real estate bubble; pundits said, "there are more people all the time and they aren't making any more land!" "They aren't making any more people with money!" This has been the shortage since oil prices went barometric in 2004: nobody is making any more people with money. People cannot earn, they cannot find a place where such earning is possible It costs too much to pay workers and also pay for more expensive inputs at the same time. This is the point the 'high prices' people miss. High prices of primary goods are not inflationary. The allocation effect of the high prices is highly deflationary. High prices force choices between one good at the expense of another. A company will buy fuel to transport imports from China rather than paying higher wages to local workers. Consequently, local demand erodes. Exporting jobs also exports customers. At some point the funds available to purchase goods vanishes and all the businesses fail. This is the dynamic of the early 1930's. Even low prices are to the unemployed and impoverished unaffordably high. High real prices -- either for goods or labor -- are simply a form of business suicide. Right now petro prices are going bananas! How long before the rising prices gut the real economy? Will this effect the finance economy at all? Image above: The weekly Brent Crude chart by TFC Charts. From ( Notice that the open interest currently is much less than during the 2008- 09 period of the Great Oil Price Spike. The institutional long index speculators are so far out of the oil markets. It is likely that China and other large customers are buying crude on the spot markets and avoiding futures altogether. The futures markets follow the spot markets since those 'paper' markets must discount risk. The same thing is taking place in the precious metals markets. A premium is paid to take the good rather than wait so the future price is discounted as a consequence. This is self-reinforcing. Demand for either physical crude or metals is intense. At the same time it is very hard to obtain physical by purchasing the forward contracts and standing for delivery. Rising prices create an incentive to hoard. Commodities are held off markets which creates uncertainty. The markets are becoming untrustworthy as a consequence. This in turn puts more purchasers into the spot markets driving the price higher. This is the reverse of what happened in the fall of '07 and the spring of '08 where funds were piling into futures contracts some eight years out. Longs are biting the bullet and paying the spot premium knowing that the 'cheaper' futures contracts provide less of a guarantee of obtaining delivery. How the exchanges expect to deal with this situation is hard to say but at some point they will suspend delivery altogether. The markets are completely distorted, both by purchaser preference and risk - but also blatant manipulation. Only incompetents insist that the markets reflect a top- line improvement in the real economy. The prices of commodities will rocket upward along with prices for stocks and many currencies. This is all part of the Planet Bernanke strategy to devalue the dollar and make the US economy 'competitive' in a more or less traditional, Keynesian sort of way. I acknowledge Mr Bernanke's brilliance but his efforts are self- defeating. Americans are saturated with debt. Customers are unwilling or unable to borrow any more. Only the government is borrowing while standing in the place of private borrowers. Since the government cannot create wealth or value, it can only recycle funds that already exist and shift them from one place or custody to another. Fiscal policy is a shell game. It only works if people suspend disbelief. Traders are cynically doing so on this day but for how much longer? Being debt saturated means large 'spending' produces diminished or negative returns. Trillion$ have been borrowed and spent to what end? To support + 16% unemployment and a piddling 2% increase in US GDP. Pumping in more trillion$ will likely to have even less effect. As for creating hyperinflation in the US, this is practically impossible. The idea is to repay lenders with funds that are worth much less than the original amount borrowed. Most US debt is of short duration or indexed to inflation. Short duration debt must be refinanced repeatedly as it matures. In the face of inflation lenders command higher yields which defeats the hyperinflation tactic. Indexing of yields has the same effect: the loan has a mechanism that adjusts the rate of interest to reflect higher inflation. In debt markets with short durations or 'interest indexes' there is no shortcut to keeping yields from adjusting themselves to protect lenders' capital. At some point the rising yields become too expensive for the borrower to support: debt deflation follows. Currency devaluation cannot work when Americans consume more fuel per capita than all the other countries' citizens. Any dollar gains in output resulting from currency devaluation are more than canceled out by increases in the fuel price 'tax' paid to oil companies and OPEC. Instead of increasing competitiveness, the price rise puts the oil-soaked US economy in a bear trap. $95 crude is a real problem hitman for an economy that is structured around $20 crude. To pay the fuel bill other goods and services are stiffed. Since 2004 this stiffing process has wreaked havoc on the US and Eurozone economies, this ruin has trickled up toward finance. Since 2004 the $30 fuel-dependent cohort has been eliminated as prices have risen, as prices rise further the businesses that can afford moderately high crude prices are pushed to the edge of the cost abyss. Fuel price rises are squeezing a balloon: clench on one end and the balloon expands elsewhere. High fuel prices make servicing municipalities more expensive. Unlike private companies, states, counties and 'metro areas' cannot ship fire-fighting or police jobs to low-wage countries like Vietnam. High wages, high benefits and leaping fuel/goods' costs are becoming ruinous to the municipalities. Just as these were to US businesses before China bailed them out and took all those unaffordable US manufacturing jobs. Meanwhile, the urge to buy and drive more cars becomes the epitaph for our expiring gestalt. Our policy makers do not have the inner resources to confront the failure of our personal transportation 'choices'. This looks to be a fatal error as auto and other industrial uses of petroleum drive prices higher, bankrupt more individuals and businesses and make a general oil-driven economic crash more likely. Somehow high oil prices and high energy company profits are painted in the business media as an unadulterated good thing: says Bloomberg:
Stocks Rally, Treasuries Tumble on Economic Outlook Stephen Kirkland and Nikolaj Gammeltoft Stocks rallied, sending the Standard & Poor’s 500 Index to its best gain in a month, and oil rose as growth in U.S. and European manufacturing bolstered speculation the economic recovery will strengthen. Treasuries slid. The S&P 500 increased 1.4 percent to 1,274.62 at 11:22 a.m. in New York and the Stoxx Europe 600 Index gained 0.7 percent for its largest advance since Dec. 21. Oil rose to a 27-month high, copper reached a record near $4.50 a pound and silver topped $31 an ounce. The 10-year Treasury note fell, sending the yield seven basis points higher. Markets in London, Shanghai, Tokyo and Sydney were closed for holidays. All 10 industry groups in the S&P 500 advanced today after U.S. manufacturing expanded at the fastest pace in seven months in December, while data later this week is forecast to indicate growth in services and employment. European manufacturing expanded more than initially estimated in December, London-based Markit Economics said. “It’s a happy start for the market to the new year,” said Tom Mangan, who helps oversee $2.4 billion as a money manager at James Investment Research Inc. in Xenia, Ohio. “The stronger manufacturing numbers complete the pattern from the end of last year with strong economic data, reflecting greater confidence in the economy.
Obviously the finance economy is doing just fine, to hell with the real economy. So far, the Federal Reserve has been successful inflating assets with moral hazard and the dollar carry trade. How long can this game be kept up? The money managers must know that higher oil prices will soon effect demand. This is basic business, 101. Meanwhile, squeezing the balloon causes distortion in the housing markets which are beginning to resume their long decline. Real estate during the bubble years was bizarre in many ways. As 'homebuilders' excreted millions more ugly boxes at ever higher prices the demand became insatiable. Were houses 'Giffen goods'? These are items that are more sought after even as the prices rise, defying the laws of supply and demand. How about precious metals, now? Is crude oil a Giffen good? At what price level do the high-priced versions become ordinary good? Seems that a lot of what is taking place in the greater world orbits around opportunity costs and time factors, both of which are fuel/machine doppelgangers. The outcome is a crisis of valuation: what is anything worth if there isn't enough fuel to run things? Conventional analysis obscures the real picture. There are few words about the energy/infrastructure imbalances that 'back' our currencies/debt loads and stands as collateral for everything including our 'money'. Our consumption infrastructure which includes housing, shopping, transport and support and 'moderne' agriculture is unprofitable with higher priced fuels. No profits = no economy. Inputs are too pricey to allow profits. This is our crisis in seven words. We cling to the fuels and jettison everything else: jobs, benefits, senior care, police and other civic services, rational government, and much of our national character. This process is taking place in other countries as well ... What is 'preserved' is the cartoon version of modernity with 'just in time' convenience at a cost that strip mines everything else. It would be nice to see this aspect of our 'policy' appear in the public discussion along side banker care and debt remediation. In fact, economic circumstances will deteriorate until stringent energy conservation becomes the center of the public policy. It's that or conservation will be imposed by events - which is what is taking place right now. We must start taking steps to ready ourselves for the new world that is coming for us whether we are prepared for it or not. .

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