Not So Dismal

Making Economics a Little Easier to Understand

Posts Tagged ‘Liquidity

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.

Written by caseyayers

22 October, 2008 at 3:38 pm

The Pie is Bigger Than it Looks

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So how do runs on the bank work, anyway? To understand how bank runs create a self-fulfilling prophecy, it’s important to understand how banks keep and loan money.

Banks don’t keep all of their deposits on tap. Rather, only a portion of these are kept around at any time. Under normal circumstances, this is fine, because it’s very unlikely that everyone will suddenly ask for their money at the same time. Therefore, just keeping a small percentage on hand is enough for the daily traffic at any branch. Why don’t they keep all of the money on tap at any particular moment? That question strikes to the heart of how banks stay in business at all.

Keeping just a portion of the money on hand, a practice known as having a fractional reserve system, means that the bank can use most of their funds to make loans to other people, to businesses, and to other banks. This also leads to an expansion of money behind the scenes. The Federal Reserve sets the reserve requirement; we’ll say it’s 10% for this example:

You deposit $1,000 at your bank. The bank is required to keep $100 of that on hand as its reserve, but is free to loan out the other $900. So they do: your bank also issues credit cards, and I walk into Home Depot with their card to purchase a washer and drier that cost $1,400 together. I put $900 on my card, which means that Home Depot will receive this money. However, the store offers a special no-interest deal for the remaining $500. They can afford to lend this credit, ironically, in part because of the other $900 that I just gave them. Home Depot only uses part of that money, though, and also takes out a loan at a favorable rate to help cover the financing. They do this by drawing on someone else’s savings.

Confused yet? That’s what makes the current situation difficult to understand: everybody owes everybody else somehow, and it all started with just a few green pictures of Ben Franklin.

An economist would tell you that a 10% reserve requirement on $1,000 means there’s actually $10,000 out there. The math is simple: either divide $1,000 by 10%, or carry it out all the way. Everyone has to hold onto 10%, meaning $1,000 creates a new loan of $900, and then another of $810, and then another of $729, and so on until the difference is negligible. But this isn’t really how it works. As in the example, sometimes money “sticks” before it has reached its terminal point. Home Depot pockets the majority of the cash from that $900 I put on my credit card. When that happened, the possibility of that money being loaned out again quickly to somebody else decreases significantly.

So that’s the first cause of the current “liquidity” crunch: money gets stuck along the way. In a period of uncertainty like today, this money leaves the economy and goes underneath a mattress somewhere. But this money has been taken out of the system somewhere halfway through. The real trouble starts when the money is taken out from the origin point: your checking or savings account.

Bank runs happen because people are afraid that they won’t be able to get their money back. This could be due to fears over national security, the global economy, or just poor management of a local bank. In any case, a mad rush of withdrawals can quickly wipe out a bank’s “current liquidity”, otherwise known as the 10% they kept on hand from your savings and those of everyone else. And when this happens, the bank quickly becomes broke. They have to tap into money they’d otherwise use to make loans in order to meet withdrawal requests and, piece by piece, have to take apart all of the different, longer-term instruments like bonds or mortgages that they owned as they keep running out of cash.

Welcome to the current situation. The reason why so many mortgages, and we’ll talk about how they’re wrapped up in packages some other time, appear to be worthless now is because a couple banks that were particularly reckless had to dump out of them for pennies on the dollar just so that they could have a little more cash on hand. The mark-to-market rules I keep harping on means that other banks have to pretend like their securities are just as worthless as those sold at firesale, making it appear like they took huge losses when in fact they have plenty of cash left.

The prophecy is fulfilled when people become worried about these banks’ health and withdraw all of their money. Since our economy is based on a monetary system that boils down to little more than keeping tabs on a scoreboard, when the lifeblood of the system is taken out the whole thing breaks quickly. That’s what we’re seeing now.

Written by caseyayers

2 October, 2008 at 7:47 pm