Not So Dismal

Making Economics a Little Easier to Understand

Posts Tagged ‘Inflation

Why Oil Is Tanking

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It’s all about what I call Illusory Perceived Demand. At least that’s what the run-up was all about. The reality is that oil is much closer to its true price. Part of the reason that it has fallen is also attributable to the dollar, which has been remarkably strong given the Treasury’s efforts to completely discredit it as a legitimate currency as of late. But we’ll talk about the incredible inflationary cycle that we’re about to undergo another time.

For now, let’s focus on oil, which was fallen as of today to under $70/barrel, from a high of around $150 as recently as this summer. In the past month alone, the value of crude has fallen by more than thirty percent. So why is oil falling so quickly?

It’s easy to blame the Hedgies, day-traders and speculators, and to say that because they have now been forced out of the market, prices are swiftly falling back to “real” values. But speculators did not cause this, or at least not the type of speculator you have in mind. Rather, actual consumers of oil, the type that purchase these contracts on futures markets, drove up the prices in a bit of a panic. Speculation-in-earnest, not greedy speculation, is the issue here.

The mentality on the futures market has been, until recently, that a massive, amorphous being called CHINA would absorb each and every drop of oil in the world unless Western companies could thwart them by consistently raising the stakes. Because “China” would pay almost anything to continue its stunning growth trend fueled largely by oil, American companies perceived that there was a massive and unquenchable demand afoot that forced them to pay ever-higher premiums to receive the oil they needed to operate. So they accepted rapidly rising oil prices as a geopolitical absolute, and continued to suck down as much of the stuff as they could possibly afford (to the economics student, right up to where marginal cost equals marginal revenue, most especially in the airline industry).

But the reality that is now prevailing in the commodities market is that China is not, indeed, insatiable. Furthermore, their economic system, although difficult for many to understand, doesn’t result in an unlimited supply of wealth with which to buy energy. Further still, their growth is not a phenomenon that will continue to gain speed no matter what. Just as America and Europe are undergoing a recessionary period at this point thanks to the recent liquidity crisis, China is facing a rocky road. Perhaps China is even worse off than America, for instance, since China is so dependent upon Western consumption to maintain its level of growth.

So the boggart has been put back in the armoire, and appropriately so: by enough people standing up to declare the current situation to be ridiculous. The market is soaked in oil, with new production coming out of every spigot at this point. Even the largest nightmares are eventually wiped away as the rational thinkers in the market begin to wake up and question exactly what makes oil almost thrice as valuable as it was just a couple years ago. China is, in fact, a normal player on the world stage, following the same rules of consumption that the rest of us follow. And oil is not in such dire low supply as to be gone within a decade. Even worse for the naysayers, watching oil prices fly so high resulted in many new fields and techniques being discussed anew for where additional oil may reside but be too expensive presently to drill out.

This isn’t to say “Drill Here Drill Now” is the end-all solution to long-term energy needs for this country or the world. Gas will not be, though, obsolete by this time next year. The decision to move to new sources of energy en masse will be made either politically, where citizens decide that they prefer short-term economic inefficiencies for purposes of national security or environmental wellfare, or it will be made economically, when oil supplies truly are outstripped by demand in the long-run.

Unfortunately, the huge run-up and present crash of oil prices is not that dissimilar from the scenario we’ll see when all of this unabsorbed liquidity catches up with the markets. The idea that credit is unavailable is almost absurd. Rather, bankers are claiming that the liquidity flowing out of the fire hydrants is poisoned. When the market quits thrashing about in hysterics and sets to the task of absorbing these funds, they will find money laying about in true excess. This will lead to massive inflation, unless the Fed can perfectly thread a needle that’s almost impossible to read. But we’ll cover that later.

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Written by caseyayers

22 October, 2008 at 3:38 pm

Bailout 2.0

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From today’s Politico Arena question, which is “Bailout II: Does the New Plan Sound Better Than the Old? What else must happen?”

It’s “better”, but only insofar as it’s shoving open the credit markets.

One of the weapons that has helped most in the past few days is one that is hardly being mentioned: FASB, an accounting standards organization, released changes regarding mark-to-market accounting for illiquid assets, suggesting that it might be okay to value mortgage packages and other securities that simply aren’t being traded at their cash value, rather than at the bidding price. This is important because the bidding price is far below both the actual hold-to-maturity value of these securities and even discounted prices many companies might accept to simply get rid of them. If the change is enough to allow auditors the latitude to sign off on less paranoid financial statements, then we may see that many companies on the cusp of problems are, in fact, doing okay from a cash flow perspective.

But the crush of new money bursting through the gates remains a big part of this, to be sure. And that’s what should be most concerning: this money may be useful to break open the clogged pipes, but now the fear should be focused on when they burst. In other words, having hundreds of billions of new dollars in the market that aren’t really needed will lead to massive inflation, and sooner than many people think.

Written by caseyayers

14 October, 2008 at 8:34 am

Government’s Role in Stability

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My answer to today’s Politico Arena question, “What can government do right now to stabilize markets or reassure the public? Bonus question: How low will the Dow go?”

The best thing government can do to stabilize the market is to declare fully, and with the greatest finality possible for such a tenuous situation, the level to which they intend to continue meddling in the markets. The reason we keep seeing day after day of multi-hundred swings this way and that is that noone can price the market. There are too many shadowy variables for traders to really get their hands around this thing.

Protect all deposits to an unlimited value. This should help to stop any runs on banks in their tracks. Provide short-term liquidity to businesses that prove both creditworthy under normal circumstances and unable to obtain credit in these troubled times. Don’t buy stakes in banks, don’t keep throwing money blindly at the sector. Doing this does very little to truly help break the credit logjam; rather, the money is simply being brought in by the truckload to any destination that might have given the slightest hint of illiquidity. This will lead to massive inflation later when we finally figure out that smaller, far more targeted sets of money, such as those the Fed auctions using its term lending facilities, were the smarter solution.

The Dow will go as low as fear can take it. But salvation here lies in greed: already valuations on some companies are absurdly low. Many companies with no exposure whatsoever to housing and with more than enough cash on hand to survive any credit freeze have been trashed. Somewhere between 7000 and 7500, the bargains will become too great to ignore for the savvy investors.

Written by caseyayers

10 October, 2008 at 8:48 am

Stop the Bailout Train

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In response to today’s Politico Arena question, “Does McCain’s ‘Homeowner Resurgence Plan’ announced at the debate make sense?” (Text of plan from the campaign’s website can be found here.)

The problem with the McCain campaign’s proposal is that it favors certain types of investment (namely, housing and real estate) and does so with taxpayer money. What compensation is to be given to those that own Apple or Google stock, with both companies’ market capitalization nearly sliced in half in the past year? Will there be a bailout for stock market investors that were “misled” into buying at prices that make the investment seem unpalatable today?

Government assistance in guaranteeing low interest rates is still an affront to the free market, but a more necessary and less harmful one. It is true that many homeowners were misled into accepting deceptive mortgage terms, and many families may be willing to continue to pay down the original principal of the loan if their payments at the very least do not go up from here.

Free market adjustment of mortgage values should be encouraged, too. Homeowners have every right to simply walk away from the mortgage they signed. The banks that hold these loans will often be very willing to rewrite mortgages to lower values on their own accord, rather than assume the responsibility of the property and be left with a house they may not resell for a long time.

Involving the federal government in yet another facet of a problem that, at its origin, is the result of artificially low interest rates will only serve to increase the national debt, lower the dollar’s prestige, and accelerate the rate of inflation, only further penalizing those that continue to pay their mortgages or invested in assets other than real estate.

Written by caseyayers

9 October, 2008 at 8:08 am

Convenience of Money

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An interesting piece by Tim Harford, the author of The Underground Economist, appeared in Slate Magazine last year that discussed price rigidity, using a classic example. The price of a bottle of Coca-Cola remained at a nickel for over Glass Bottles Always Taste Betterseventy years, an incredible fact given the long-term inflation of so many other prices, including those of its main ingredients. Yet Coke was hard-pressed to raise the price in order to stabilize their margins because of the vast leap between a nickel and a dime. Indeed, the next-highest denomination resulted in a full doubling of the price of a bottle of the world’s favorite soft drink. In the 1950s, when a price change was absolutely necessitated, Harford tells us that the, “…boss of Coca-Cola wrote to his friend President Eisenhower in 1953 to suggest, in all seriousness, a 7-and-a-half cent coin.”

This may seem like a bit of a comical notion, but the lack of flexibility in US denominations did adversely hurt Coke, allowing its time-honored competitor Pepsi the chance to use their famous slogan, “Costs a nickel, worth a dime.” A similar situation faces soft drink bottlers and various other vendors today. Across the country, it appears that prices are being pushed past $1.00 for a 20 Oz. bottle and $0.50 for a can en masse. While prices obviously differ from place to place, the new ceiling for cans tends to be around a dollar, indeed a doubling in price.

No Coke, PepsiBut the fact that it costs twice as much isn’t the issue anymore. Indeed, even the poorest among us would rarely be found complaining about the average price of a can of pop/soda/insert-your-regional-slang-here. The problem now is what I call “convenience of money”. While $1.00 is a nice, round figure, bottles are left in an odd predicament. In most cases, $2.00 would be seen as too high of a price, and on an ounces-per-dollar basis would be less of a value than a dollar can. Prices for bottles have fidgeted often around the $1.25 point. Even though this is much more reasonable than $2, I would surmise that Pepsi and Coke’s sales don’t show as large of a difference between $2 and $1 as they show between $1 and $1.25 due to a demand curve bent as if by gravity to the easiest combinations of monetary denominations.

The problem is that blasted quarter. People just don’t carry change like they used to, and while there may be a few $1 bills in their wallets, the likelihood of being able to finish the transaction with a quarter is much smaller. Indeed, in this day and age, it is a $1.25 bill that Coke and Pepsi should request from the US Mint, rather than the 7 1/2 cent piece of old.

Broadly speaking, it might be even better for the soda companies if dollar bills were to simply be taken out of circulation, replaced with dollar coins entirely. The Mint has tried again and again to get people to switch over voluntarily to a higher-denomination coin. Yet the embattled green portrait of George Washington survives with nary a scratch.

Dollar-scanning machines tend to break down more often than their coin-only counterparts and can become an issue when dispensing return funds when more than one dollar bill has been submitted. Vending machines have already mostly been converted to accept dollar coins, whether they are of the Susan B. Anthony, Sacagawea or Presidential variants (all share the same size and weight). Coinage loves company, as well; having dollar coins on hand makes it more likely that smaller coins will again find their way to people’s pockets, making $1.25 not so awkward a price, after all.

Another tactic has been to switch to plastic: more and more machines include credit card swipers on the front, which allow consumers to either swipe their RFID-enabled card or their old-fashioned magnetic strip to purchase some edible goodies. Overseas, cell phones are often used for transactions, with the final tab simply added on to a phone subscriber’s bill at the end of the month. Both methods take the actual money out of the equation, leaving only the true price for customers to consider; having a quarter on hand isn’t a part of this purchasing decision. While these alternatives do carry transaction costs, a price point of, say, $1.35 for credit card purchases vs. $1.25 for cold, hard cash would not scare away many customers looking for a caffeine fix. Or, perhaps, not having to be as concerned about machine break-ins, drivers having to carry around so much coinage and cash and technicians having to fix the mechanical pieces required to process the money would present a large enough savings to vending companies to make the transaction costs a wash.

One caveat is that higher prices still carry a psychological barrier to customers. Especially in these smaller denominations, people have been taught to think in coins. Perhaps $1.35, then, is a larger leap for some people than it honestly should be. Certainly $1 seems like a much better value than $1.15 would be, for example. But alternative payment systems strip away the physical tie to this price psychology and affords companies more flexibility in adding more balance-sheet “bounce to the ounce”.

Written by caseyayers

8 October, 2008 at 4:00 pm