Mainstream Crap-o-nomics and Milton Friedman

An article published on Bloomberg.com yesterday by Noah Smith (Milton Friedman's Cherished Theory is Laid to Rest) brought back memories of my early endeavor and research in economics. Smith discusses some recent research on consumption theory that "proves" Milton Friedman's theory was wrong.  If these people who live in ivory towers simply read some of the real world heterodox research, it wouldn't have taken this long to figure it out!

One of the reasons I was attracted to what we call heterodox economics was because I found too many instances where traditional, or mainstream, economics seemed so unrealistic.  My original area of research was on US wealth distribution and related theories used to explain household consumption and saving, the source of wealth.  Mainstream theory was dominated by Milton Friedman's Permanent Income Hypothesis (PIH) and Franco Modigliani's (and Brumberg) Life-Cycle Hypothesis.  Both of these theories argued that we base our consumption (and therefore savings) on our permanent or life-time income.  That is, we are so smart that we base our consumption today on what our income will be over our lifetimes.

As a champion of limited government, Friedman's theory conveniently suggested that temporary government policies used to stimulate the economy during recessions will have no additional impact (the multiplier is zero) because we consumers will view the income as temporary, not permanent. According to Friedman, since the income generated from a stimulus would be viewed as temporary, most of it would be saved; and, therefore, there would be no impact from expansionary fiscal policy.

Having grown up in a middle class household and worked in the hotel industry for some six years, I couldn't think of anyone who acted this way.  The people I hung out with, middle class and poor, spent most of their income--and it certainly didn't matter if it came from our weekly paychecks or winning $500 in the Super Bowl pool!

In studying heterodox economics I was introduced to alternative explanations.  For example, Ed Wolff, probably the premier researcher on US wealth inequality, showed that the consumption-income relation depended on what income or wealth class one belonged to.  Using data on US wealth distribution, he suggested four "class types": the richest 1% (who own 35-40% of all wealth), whose consumption was more closely tied to changes in the value of their wealth rather than changes in income; a professional class (doctors, lawyers, college professors, et al) who followed the PIH/Life-Cycle model because their income was more certain and stable; the working class who spent most of their income; and an underclass, dependent on government programs, who tended to spend even more than any income they earned or were provided.

The policy conclusion is straight-forward: if your aim is to provide a stimulus to the economy by raising consumption demand, then increased spending or tax cuts should be targeted at the bottom two classes (representing approximately the lower 80% of the income distribution) because they will spend almost all of the increase in income, whether or not you call it permanent or temporary.  While this may be obvious to those who live in the real world, it's astonishing and frustrating that it has taken so long for the mainstream economics discipline to reject the PIH theory.

One of the lessons to learn from this is there are many in the economics discipline who claim to be objective but, in fact, have an ideological bias.  Friedman's theory was constructed to support his personal/political bias against government intervention.  In his original article he provided "supporting" evidence, but he had to fudge the data to get that support.  He did so by assuming spending on consumer durables--refrigerators, microwave ovens, and color TVs--was not consumption, rather it was a form of savings.  In other words, once he took out that big chunk of consumption spending (and counted it as savings), then--voila!--he "found statistical support" for his theory.

So, next time you are lucky enough to win a few hundred bucks from a football pool or lottery and you use it to buy a new iPad or Sous Vide, comfort yourself knowing you are not engaging in frivolous spending, rather you are padding your savings account...

It's been awhile....

I have been distracted lately by a major change on the home front, literally.  In July, we decided we were tired of the hustle and bustle of the city and made a move to a quieter neighborhood.  We're finally settled in....

A lot has happened.  The electoral college has chosen a new path for US, and I may add a few cents about that in the near future.  However, I wanted to provide a little update on what I've seen in the commodity sector.  First, a little reminder from my first major post last February describing how financialization of commodities helped fuel a series of commodity bubbles from about 2002 to 2012:

Wall Street’s attempt to hype commodities over this extended period (2003 to 2011) helped create a debt-financed monster that has come home to roost.  While most of the fear is focused on the shale oil boom and bust, the entire commodity sector is experiencing what Irving Fisher (America’s preeminent economist 100 years earlier) called the debt-deflation process.   

The deflationary spiral is not limited to oil, it’s hitting all commodities.  While the value of energy stocks has tumbled by some 50%, mining stocks are down over 70%, and prices for globally traded food commodities have also collapsed.  Over the past eight years billions of dollars were invested in US farmland by private equity, hedge funds, and pension funds at a time when prices of wheat, corn, and soy were 50% higher than they are today.  In 2014, the value of farmland experienced its first decline since 1986.  As grain prices have continued to decline, so too will farmland values, and when Wall Street investors try to unload these very illiquid assets, things will get very ugly in the farm sector as well.  

How will it end?  Financialization means commodity prices are more volatile because investor bets drive prices.  Assuming no unforeseen changes in markets (like a serious Middle East “event”), the glut in global markets will keep a lid on prices well into 2017, but volatility will reign because there’s no other way to make a quick buck when interest rates are zero and heading negative.  “Smart” investors--those who think they can time markets—will jump back in at the slightest indication of “good news.”  For example, if central banks announce another attempt to save the markets or a group of producers attempt to curtail production, there will be a quick jump back up in prices, only to be brought down by the reality of “pork oil”—the glut in global inventory and supply.  

I'll start with the last paragraph, as there has been another attempt to prop up oil prices through an OPEC-Russia agreement, which caused the price of oil to rise by 15% in one week.  Here's where financialization provides its countervailing force to rising prices over the long term.  An article  from Bloomberg today discusses how shale oil producers have used the jump up in prices, also reflected in the futures price curve, to lock into prices for 2017-20 in the mid $50 range, providing a high enough price to generate profits.  There's an interesting figure in the article that shows how the Shale "sells" (say that 3 times real fast)  have caused the oil price curve to flatten out over the 2018-20 window, even displaying some backwardation.  The UShale guys could help offset production cuts from the cartel guys!  In other words, don't bet on any sustained price increase.

Regarding the second paragraph, I've finally come across a few pieces describing some of the impact in the farm and mining sectors. This article from Mining.com discusses a Moody's report on the sector.  While it states that in its review of mining stocks many were downgraded at the start of this year, but the sector has now stabilized.  While Moody's suggests the sector has stabilized, it also believes the global glut is still weighing heavily over prices:

However, Moody's believes the latest leg up for base metals (bellwether copper is up more than 25% over the last eight weeks) is not sustainable. Carol Cowan, Moody’s Senior Vice President says most metals markets remain in surplus and "supply-demand fundamentals have not improved meaningfully"...All base metals, with the exception of zinc, remains oversupplied and global inventories have also remained stubbornly elevated (again zinc is the exception) according to the report.

Finally, regarding the farm sector, this from a Bloomberg.com article last month:

Betting the farm on record crop, livestock and dairy prices has turned into a losing investment for an expanding share of America’s agricultural heartland. The level of debt to income is the highest in three decades, and growers are increasingly unable to make loan payments. 

Four years after record U.S. crop and farmland values boosted purchases of land and equipment, a global surplus has sent prices tumbling and farm income into the longest slump since 1977. The Federal Reserve says growers are borrowing more to pay bills, repayment rates are plunging, and the number of bankers requesting additional collateral is the highest in 25 years. 

Bankers are getting more bearish about the farm economy. The Rural Mainstreet Index created by Creighton University, based on monthly surveys of lenders across 10 Midwestern states, sank in October to the lowest since April 2009. The banks expect about 22 percent of farmers to suffer negative cash flows in 2016, and some lenders said farm foreclosures will be an increasing challenge.

The commodity boom fueled by global demand and speculation is experiencing a debt-deflation, and the debt-financed increase in production that started it will help keep a lid on prices for a few years longer.  Certainly, there will be some unique situations, but don't bet the farm in the era of "pork" oil, minerals, and grains...

Oil Zombies, living on a prayer (and a little hope)...

Interesting piece on Bloomberg.com today about "zombie oil companies," which are oil producers that have pursued various restructuring strategies with their creditors in hopes they can survive long enough for prices to turnaround.  The companies have engaged in "distressed exchanges":

Such exchanges — defined by Moody's Investors Service as when a troubled company offers its lenders new or restructured debt, securities, cash, or other assets, that amount to a smaller commitment than the original IOU — could have big implications for debt markets as they stretch out the current credit cycle and result in even greater losses for investors.

As noted in the article, in the current down cycle, investors have recovered on average a paltry 21% of the value of assets from bankrupt energy companies (versus an historical average of 59%).

Unfortunately, as the International Energy Agency stated today, they now believe it will take another year before markets balance out.  The future is not bright for these zombies. As I've noted previously, investors and firms are simply cutting off their nose to spite their face."  Extending the life of energy firms through these distressed exchanges means they will continue to pump oil to generate revenues, but this will also extend the low price environment.

Investors should've cut their losses when those assets were more valuable. The (market) force is not with them.  By allowing the zombies to survive a little longer, the supply shakeout is pushed further out; and speculators trying to time the bottom prevents prices from reaching a kill point. Instead, what we have is a bunch of slowly dying zombies living on a prayer for higher prices.  Whenever there is a bit of positive news (a decline in inventories for example), speculators push prices up too fast which gives everyone a little hope, but hope does not a trend make...

Steady Price of Crude

As I mentioned in my last post, I don't see oil prices moving to either extreme price predicted by two forecasters a couple months ago.  An article in Bloomberg here provides some support for my view. From the article:

All but one of 15 senior oil traders and executives interviewed this week at the annual Asia-Pacific Petroleum Conference in Singapore expect crude to remain between $40 and $60 a barrel over the next 12 months. Brent crude has traded in that range for the past five months.

The issue, as I've stated, is that commodity markets dominated by investors do not allow prices to fall low enough to generate the shake out needed to balance the market. Prices also tend to rise quickly enticing new production. So-called "savvy" investors are looking to time the bottom and ride the price rise up.  As one trader stated, the issue is that prices go up too fast, and this happens because of the herd mentality of Wall Street.

The current commodity deflation is a consequence of the bubble Wall Street promoted from 2002 to 2012, and most prices will be depressed for a long time because of the over-investment that occurred as a reaction to that bubble.  We consumers are getting some needed relief...

Is it $80 or $10?

I've been meaning to write this particular post for awhile, but other priorities have taken up much of my time--finishing up some formal articles--publish or perish!

About a month ago two very different oil price forecasts came out within days of each other.  First, a report by Raymond James financial advisers forecast oil at $80 in 2017, and shortly after that publication Gary Shilling came out with a forecast of $10-$20.  The RJ forecast is based on projections of a "tightening in supply and demand dynamics" over the next year, though more so on supply issues, and you can read a bit more about their forecast in this Bloomberg article.

Shilling's projection is based on a combination of factors: high inventories; producers pumping oil to generate cash flow in order to survive the shakeout, and the Saudis pumping oil to drive them out; a slowing global economy; and the impact from a rise in the value of the dollar as a safe haven in uncertain times.  Shilling's views can be found in his Bloomberg piece here.

It's quite possible that both forecasts are right!  Shilling does not provide a time frame, though it appears he is describing a near term crash in prices, whereas Raymond James' forecast is for sometime in 2017.  Futures prices suggest some movement higher over the next year, as the price of a July 2017 contract is currently $47.07.  However, while the current futures oil price curve is in contango, it is not steep enough to support the oil storage trade.  In his piece, Shilling provides some estimates of storage costs: floating storage is about $1.13/month, rail storage 40 cents, and Cushing oil tanks cost 25 cents/month.  Given the current contango structure, alternative storage facilities (rail and sea) are no longer profitable, so, as contracts mature from trades that were previously profitable, those traders will have to dump oil into the market, putting downward pressure on prices in the short term.

Therefore, my view is somewhere in the middle.  The current market has too much excess crude AND too much excess refined products, as recent reports indicate.  While the fundamentals dictate near term crude weakness, it's difficult to see oil falling to $20 or less because investor/speculators (and they dominate trading in futures markets) will be looking for the bottom and an opportunity to start buying again.   This is what also puts a lid on future prices of crude: since investors dominate price discovery in futures markets, prices will continue to seesaw and make it impossible for producers to adjust to real forces; that is, prices most likely will not reach a low enough price to create the shake out necessary for stronger future prices.

My best guess is prices will not fall below $30 in the short term, and they will not exceed $70 in 2017, assuming no major supply shock event.  Then again, in this topsy turvy world, who would've predicted a guy like Donald Trump would have a shot at becoming president of the United States....

Brexit and Oil Prices

I was going to write a piece to update recent issues with oil prices, and came across this article which essentially includes the point I wanted to make: despite no change in the global physical markets for oil, prices are declining, which is the result of the strengthening US dollar caused by Brexit.  The relevant parts:

Moreover, price movements are also largely dictated by the interaction between global currencies. Since oil is priced in U.S. dollars, any strengthening of the dollar relative to other currencies makes crude more expensive, cutting into demand and pushing prices down. The crash of the British pound over the past two trading days is having this effect. The pound is now down 10 percent from the pre-Bexit vote last week; the euro is down 3 percent. The U.S. dollar index, which measures the currency’s strength against a basket of six major currencies, is up. The dollar jumped by another 1 percent on Monday, to a three-month high.It is no coincidence that oil prices plunged at the same time as the dollar surged. “We all got it wrong,” Michael Lynch, president of Strategic Energy & Economic Research, said in an interview with Bloomberg. “This is strengthening the dollar, which is bad for commodities."

 As I've argued in several pieces, I believe the reasoning that explains the decline is hogwash! A change in the dollar does not cause a rapid change in oil demand; the explanation is that the dollar-oil trade is a favorite of hedge funds and other global investors.

21P

It's a been awhile....

I've been taking a breather after the end of our semester.  I've been planning on an oil market update, and will do so in the next week.  This post is about something a bit on the lighter side, a concert review.  I took my stepson to see 21 Pilots down at Canal Side in Buffalo on Tuesday June 21.   My stepson got me interested in them, and he really wanted to see them.  I've got to say they are very entertaining!

Only two guys in the band, a drummer and the lead singer who plays mainly piano, with a little guitar and ukulele sprinkled in here and there.  They have a hardcore fan base, and it's easy to see why.  They literally interact with the audience, setting up an additional drum set and key board in the middle of us.  The lead singer also climbed into a giant hamster ball and rolled over the top of the audience at one point.  Despite the theatrics, their music is engaging, and the lyrics are thoughtful and philosophical.  They even do a couple of covers for us old folk--Twist and Shout and Can't Help Falling in Love.

I've been to a lot of concerts, and I would give this one a 10 out of 10--my stepson gave it a 20!

If you haven't heard of them, check out my current favorite: Tear in My Heart.