The Case for Fed Tapering Sooner Rather Than Later

Better to engineer a mini-crisis while you're still in control than let a crisis you can't control run away from you.

One of the most widespread misconceptions about the Federal Reserve is that its policies are based solely on economic data and models. This misconception is not accidental but the result of carefully managed public relations: The Fed fosters a public image of dispassionate experts working econometric magic that mere mortals (i.e. non-PhDs in Economics) cannot possibly understand.

(Insert joke about one-armed economists being unable to say "on the other hand" here.)

The reality is the Fed is as much a political and PR machine as it is a financial institution. Behind the carefully nurtured facade of experts poring over data and complex financial models is a leadership that spends an inordinate amount of time on PR and perception management (care to count the number of Fed-staged speaking engagements and press conferences this year?).

The Fed is an intrinsically political entity, and its leadership is by necessity thoroughly political. In public, the Fed leadership plays the part of dutiful technocrats to perfection, but behind this mask they are keenly aware that the elected leadership of the nation has relied on the Fed's easy money to enable stupendous deficit spending.

The Fed's mass money-creation and bond buying programs have allowed the elected leadership (the Executive branch and Congress) to avoid any tough decisions; being able to borrow trillions of dollars at near-zero real rates of interest means never having to face difficult spending choices: need another trillion to fund politically powerful cartels? No problem, just borrow it. The Fed has our back.

The Fed has a dual mandate, and no, it's not stable prices and employment. The Fed's real dual mandate is:

1) Preserve and protect the banking sector's power and share of the national income

2) Preserve and protect the Fed's political and institutional power.

The second mandate requires a complex dance with the elected leadership of the nation. The Fed needs to be needed, and so funding the political Elites' borrowing gives the Fed abundant political power. The political class cannot afford to alienate the Fed leadership when they depend on cheap money and trillion-dollar bond buying to sustain their own power.

But the political class's abject failure to deal with the fiscal morass is pushing the Fed into a corner it cannot afford to be trapped in. The longer the Fed prints $1 trillion a year to make things easy for the elected toadies and apparatchiks, the greater the risk that the financial system destabilizes again and the Fed will shoulder the blame.

The political class plans to be on the sidelines during the next financial crisis, innocently tsk-tsking while the Fed absorbs the blame for the fiasco. The Fed is desperate to pass the ticking time-bomb back to the elected leadership before it blows, and there is only one way to do this: taper off the money-printing and bond buying, and accept a mini-meltdown in stocks as the cost of forcing responsibility back on on the elected leadership.

Fed Chairman Bernanke has telegraphed the Fed leadership's concern about the free pass the elected leadership has been given on the fiscal side, and now that his term is ending, Bernanke is aware that the clock is ticking not just on his legacy but on the critical task of handing the responsibility for fiscal management back to the elected leadership.

While doing nothing will let him leave the stage in December with the appearance that everything is in good order, he knows that he's handing the next Fed chair--and more importantly, the Fed itself--a no-win situation: if the global financial system destabilizes, the Fed will have few (if any) options available to save it that don't trigger risky unintended consequences.

Should the financial system slip into crisis again, the Fed's opportunity to force responsibility back on the elected leadership will have passed.

Politically, it's now or never for the Fed, and Bernanke is keenly aware of this. From the point of view of the Fed, it has patiently given the elected leadership four long years to get its house in order, and the political class has chosen the easy way out: do nothing of any substance and borrow $7 trillion to fund every politically powerful cartel and constituency.

Bernanke is also aware that he needs to give the Fed (and the next chairperson) some policy leeway: if the quantitative easing machine's throttle is already maxed on 10, the Fed leadership will have precious little maneuvering room left in the next crisis.

To preserve its political power and avoid taking the fall during the next crisis, the Fed has to taper off its money-creation and bond buying well in advance of December. The majority of commentators in the financial media see the stock and bond markets as not just the most important metrics but the only metrics. This reflects their self-absorption and political naivete; the markets are ultimately theater and PR leverage for the real power plays.

The best way to (ahem) get the attention of the political class is to taper now, trigger a stock market decline and speak directly to the elected leadership's need to put the fiscal house in order.

This is the only way the Fed can escape taking the bullet during the next financial crisis. "We told you so" is much better than "we did everything we could and it still fell apart." Better to engineer a mini-crisis while you're still in control than let a crisis you can't control run away from you, and better to pass the ticking time-bomb to the elected leadership while you still can. 

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Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart:

1. Debt and financialization
2. Crony capitalism and the elimination of accountability
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economy

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

Kindle edition: $9.95       print edition: $24 on Amazon.com
To receive a 20% discount on the print edition: $19.20 (retail $24), follow the link, open a Createspace account and enter discount code SJRGPLAB. (This is the only way I can offer a discount.)

Thank you, Helen S.C. ($10), for yet another supremely generous contribution to this site -- I am greatly honored by your steadfast support and readership.

Thank you, Andy O. ($20), for your extremely generous contribution to this site -- I am greatly honored by your support and readership.

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Which Cities will Survive/Thrive?

Here is my semi-random list of potentially decisive urban dynamics.

The bankruptcy of Detroit, though long-anticipated, has unleashed a wave of speculation about the health of other cities in the U.S., and indeed, in the world--for example, China.

The Detroit Syndrome - Coming To A Chinese City Near You Soon(Zero Hedge)

A List of China’s ‘Most Alienating’ Cities Goes Viral

Despite the visible importance of urban centers and cities for thousands of years, it seems our understanding of their dynamics is still incomplete.

I spent the summer of 1968 in Detroit while our stepfather attended summer school at Wayne State University. 

Detroit's auto manufacturing industry was at the apex of its dominance, and I recall an odometer-type billboard proudly displayed the total number of vehicles produced year to date in Detroit.

I doubt that anyone in 1968 predicted Detroit would lose most of its industrial base and half its population over the next 40 years (1970 - 2010). Such a forecast was beyond even the most prescient futurist.

Four decades is not that long a time period, and our inability to predict large-scale trends over that time frame reveals intrinsic limitations in forecasting.

Nonetheless, the dramatic decline of Detroit and other industrial cities makes me wonder if there are dynamics that we can identify that could enable us to predict which cities will thrive and which will decay.

Here is my semi-random list of potentially decisive urban dynamics:

1. Since most people live in cities, global trends that appear abstract from 40,000 feet manifest in cities.

2. Single-industry cities are highly vulnerable to disruption if that one industry declines.

3. Cities that are dependent on highly centralized institutions and industries are more vulnerable to disruption that cities with a broad base of smaller, decentralized employers and sectors.

4. Cities that depend on highly centralized employers attract people seeking to become employees; cities that are not dominated by centralized organizations but foster rapidly growing decentralized sectors are more likely to attract entrepreneurial talent and capital.

5. The cities' primary industries must pull in profits and capital from the nation and world.

6. Highly centralized industries with rigid hierarchies, local political control and vertical supply chains do not foster the same entrepreneurial spirit and ecosystem as decentralized, fragmented industries that are still open financially and politically to competition and cooperation.

7. Rigidly controlled, centralized dominant political and financial organizations cannot foster the complex ecosystem of innovators and risk-takers that generate new wealth.

8. The Ratchet Effect is key: it is easy to expand payrolls, land area, benefits and pensions as the tax base and tax revenues expand; it is essentially politically impossible to shrink payrolls, benefits and pensions as the tax base shrinks and tax revenues decline.

9. Cities with dynamic ecosystems of mobile knowledge workers, innovators, risk-takers and mobile capital will tend to attract these same wealth creators from less dynamic and opportunistic cities and towns, in effect poaching the most potentially productive people and capital from 2nd tier and 3rd tier cities.

Here is a relevant quote from the above article on the poaching of capital and human capital by major cities:

As metropolises such as Beijing, Shanghai, and Guangzhou become black holes for resources, medium and small-sized cites have encountered difficulties in their development. “The most frustrating part about Tianjin [an industrial city an hour southeast of Beijing] is that we don’t own the resources that commonly exist in first-tier cities – good resources are all taken by Beijing."

10. Cities that offer cost-effective good governance are attractive to non-elite productive people; cities that skim wealth via corruption and do not provide efficient services offer disincentives to productive people who have a choice of where they live. 

11. Wealth is not just the financial wealth of the residents or the tax revenues generated by the tax base. Social and human capital, and the networks that enable flows of information, talent and capital are critical types of capital. We can adapt Bob Dylan's line here: "Those cities not busy being born are busy dying." 

12. Cities are ultimately constructed not just of infrastructure and political policy but of incentives and disincentives and individuals who respond to those inputs. In this view, the infrastructure of transit, parks, libraries, etc. and non-material policies and cultural-economic zeitgeist create the incentives and disincentives that people respond to.

Cities that offer incentives--most importantly, a healthy ecosystem of like-minded people--to innovators, risk-takers and mobile capital to fund new enterprises will generate a self-reinforcing feedback loop that attracts more productive people and wealth. Those cities that centralize cartels and political elites who naturally suppress competition as a threat to their control are vulnerable to systemic decay as the disincentives to the most productive overwhelm the self-liquidating incentives of rigid, sclerotic, centralized hierarchies.

The one thing we can safely predict is that technological and social innovations will continue to arise and disrupt the Status Quo. If cities are like ecosystems, then we can see that cities that are static monocultures are much more prone to decay and collapse than cities that encourage a complex wealth of competing and cooperating enterprises and networks.

Perhaps these dynamics apply not just to cities but to entire nations.

This essay was drawn from Musings Report 30. The Musings Reports are emailed weekly to subscribers and major contributors to oftwominds.com.

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Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart: 

1. Debt and financialization
2. Crony capitalism and the elimination of accountability
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economy

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

Kindle edition: $9.95       print edition: $24 on Amazon.com
To receive a 20% discount on the print edition: $19.20 (retail $24), follow the link, open a Createspace account and enter discount code SJRGPLAB. (This is the only way I can offer a discount.)

Thank you, David W. ($30), for your supremely generous contribution to this site -- I am greatly honored by your support and readership.

Thank you, Daniel E. ($3), for your much-appreciated contribution to this site -- I am greatly honored by your support and readership.

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What's Cooking at our House: Peach Pies

Enjoying the bounty of summer.

The peach tree is yielding a bumper crop this year, necessitating the baking of peach pies.

The tree, which is about 20 years old. I had to prop up the branches to keep the tree from self-pruning via branches broken by the weight of the fruit.

The peaches and the flour for the crusts:

The fruit mixture:

One of the pies, ready for the oven:

One of the finished pies. We baked nine small pies and shared eight with friends and neighbors. We enjoyed the ninth, and I think it was one of our best efforts.

---

Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart:

1. Debt and financialization
2. Crony capitalism and the elimination of accountability
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economyComplex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).
We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

Kindle edition: $9.95       print edition: $24 on Amazon.com
To receive a 20% discount on the print edition: $19.20 (retail $24), follow the link, open a Createspace account and enter discount code SJRGPLAB. (This is the only way I can offer a discount.)

Read more...

The Fed Doesn't Control as Much as You Think It Does

The trick to wielding power is convincing people you are powerful. The Federal Reserve is a master at this persuasion.

The Fed's control of the real economy boils down to persuading us that it is omniscient and holds the levers of real power. Neither is true. The only sustainable engine of real wealth creation is innovation, and the Fed has essentially nothing to do with innovation, other than creating massive incentives for carry trades and financier speculation, i.e. the acme not of wealth creation but of rentier wealth skimming.

Those who follow the mainstream media’s “all Federal Reserve, all the time” coverage of financial news naturally conclude that Senator Chuck Schumer neatly summarized reality last year when he declared that the Federal Reserve “is the only game in town.”

This obsessive focus on Federal Reserve policies and pronouncements has several causes, including

1. laziness; i.e., publishing press releases and official spin as “news”
2. willful ignorance
3. craven desire to tout the party line, lest the plumage of someone higher up become ruffled and the messengers be sent to the career guillotine
4. adolescent faith in an all-powerful financial Deity (the Federal Reserve) being far less troubling than skepticism, and
5. all the other lemmings are persuasively running in that direction, so it must be right

This lemming-like belief in the power of the Federal Reserve generates its own psychological force field, of course; the actual power of the Fed is superseded by the belief in its power.  The widespread belief in the Fed’s omnipotence is the source of the Fed’s power to move markets.

We can thus anticipate widespread disbelief at the discovery that the Fed is either irrelevant or an impediment to the non-asset-bubble parts of the economy.

Once ensconced in the comfort of the Fed Cargo Cult, it’s easy to believe that the Fed-inflated asset bubbles in stocks, bonds, and real estate are either the most important sectors of the economy, or they accurately reflect the real economy.

But if we emerge from the dark hut of the Fed Cargo Cult into the bright sun of reality, we find that everything that really matters in the real (i.e., non-Wall-Street) economy is outside the control of the Fed.

What the Fed Does Control

For context, let’s recall what the Fed actually does control:

1. The Fed controls the Fed Funds Rate; i.e., the lending rate between banks.
    
2. The Fed can influence interest rates in the real economy by buying and selling Treasury bonds and other securities; i.e., increasing or decreasing liquidity/money supply.
    
3. The Fed can make funds available to the financial sector. During the 2008 Global Financial Crisis, the Fed loaned over $16 trillion to large global banks. This is roughly equal to the entire gross domestic product (GDP) of the U.S.; all residential mortgages in the U.S. total about $9.4 trillion.
4. 
5. The Fed can invoke the public-relations magic created by belief in its power to issue grandiose pronouncements; for example, “we’ll keep interest rates low essentially forever.”

That this is, strictly speaking, not completely within the Fed’s power is left unsaid, lest the magic dissipate.

So the godlike powers of the Fed boil down to three monetary levers.

What the Fed Doesn't Control

Here’s what the Fed cannot do:

1. It cannot force any enterprise or person to borrow more money.
    
2. It cannot differentiate between productive investments and financial speculation/malinvestments.
    
3. It cannot distribute money to households by dropping cash from helicopters; all it can do is make money available to banks.

Since it can’t do any of these, its powers in the real economy are severely limited.

In actuality, the Fed has little control or influence over the things that really matter in the real economy.

Innovation and the Fed

Innovation is often a meaningless buzzword (think “financial innovation”), but it is also the key driver of wealth creation in the real economy.

The Federal Reserve could be shut down and all its asset bubbles could pop, and innovations in energy, agriculture, transportation, education, media, medicine, etc. would continue to impact the availability and abundance of what really matters in the real world:  energy, knowledge, water, food, and opportunity, to name a few off the top of a long list.

It is rather striking, isn’t it? The supposedly omnipotent Fed has virtually no positive role in the key driver of wealth creation.  On the contrary, the Fed’s policies have had an actively negative influence, as its monetary manipulations have distorted the investment landscape so drastically that capital pours into unproductive speculative bubbles rather than into productive innovation because the return on Fed-backed speculation is higher and the risk is lower (recall the Fed’s $16 trillion bailout of banks; including guarantees, the total aid extended by the Fed exceeded $23 trillion; the landscape looks different when the Fed has your back).

Profits from speculative gambling in malinvestments are yours to keep, while losses are either transferred to the public or buried in the Fed’s balance sheet. Why bother seeking real-world returns earned from real innovations?

Apologists within the Fed Cargo Cult’s gloomy hut (repetitive chanting can be heard through the thin walls—humba, humba, aggregate demand!) claim that the Fed’s financial repression of interest rates boosts innovation by making money cheap for innovators to borrow.

But this is precisely backward: cheap money fuels unproductive speculative bubbles and siphons resources away from innovation, while high interest rates reward innovation and punish malinvestments and financial gambling.

Two thought experiments illustrate the dynamics:

The Free Lunch

Let’s say J.Q. Public has the opportunity to borrow $1 billion at 0% interest rate from the Federal Reserve.  It costs absolutely nothing to keep the $1 billion. How careful will J.Q. be with the $1 billion? There’s a casino open; why not bet a few thousand dollars at roulette? Actually, why not bet a couple of million? If J.Q. loses the entire $1 billion, there’s no recourse for the lender, while J.Q. gets to keep the winnings (if any).

With essentially free money, there is little incentive to seek out long-term real-world investments that might pay off in the future, and every incentive to seek financial carry trades that generate short-term profits with little risk. In other words, if you can borrow money at 1%, then shifting the funds around the world to lend at 4% generates a 3% return with modest risk.  Since 3% guaranteed return beats the uncertain return of investing in innovative real-world companies, the carry trade is the compellingly superior choice.

The Square Meal

If we can only borrow money at an annual rate of 10%, there aren’t many carry trades available, and those that are available are very high-risk. At 10%, we have to sharpen our pencils and select the very best investments that offer the highest returns for the risk.   

Let’s say you’re an entrepreneur and it costs 10% per annum to borrow money to pursue a business opportunity. The only investments that make sense at this rate are the ones with outstanding risk-return characteristics.

In other words, cheap money doesn’t incentivize risky investments in high-return innovation; it incentivizes carry trades and financial speculation, which actively siphon off talent and capital that could have been applied to real-world enterprises.  High real interest rates force entrepreneurs to choose the best investments, a process that favors high-risk, high-return innovations.

Avoiding the Bill

The Fed isn’t supporting innovation in the real economy; rather, it is actively widening the moat that protects the banking sector from disruptive innovation.

Thanks to innovations in technology, it is now possible to bypass borrowing entirely and raise money for innovative ventures with crowdsourcing. It doesn’t take much insight to look ahead and see that the crowdsourcing model could expand to the point that the economy no longer needs Too Big to Fail Banks at all: Virtually all lending, from commercial paper to home mortgages, could be crowdsourced, managed, and exchanged online.

This sort of real financial innovation is anathema to the Federal Reserve, of course, as its primary task (beneath the PR about maintaining stable prices and employment) is enriching and empowering the banks.

There are only two ways to deal with innovation: either dig a wider regulatory moat to protect your cartel, monopoly, or fiefdom from disruptive innovation, or get on the right side of innovation and evolve amidst the inevitable disruption.

Unfortunately for centralized institutions like the Fed, innovation always jumps the moat and disrupts the Status Quo, despite its frantic efforts to protect the perquisites of those skimming cartel-rentier profits as a droit de seigneur.

In Part II: How You Can Limit Your Exposure to the Fed's Financial Interference, we look more deeply at critical dynamics of the economy that the Fed can and cannot influence –and more importantly, what we can do to protect ourselves from the implications of the Fed's efforts.

There is much we, as individuals, can do to ignore the Emperor's clothes (or lack thereof) and focus on how to pursue our own prosperity and happiness irrespective of the meddling of central planners. The real power is in our hands, should we choose to believe it.

Click here to read Part II of this report (free executive summary; enrollment at PeakProsperity.com required for full access).

This essay was first published on Peak Prosperity under the title The Fed Matters Much Less Than You Think. 

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Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart:

1. Debt and financialization
2. Crony capitalism and the elimination of accountability
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economy

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

Kindle edition: $9.95       print edition: $24 on Amazon.com
To receive a 20% discount on the print edition: $19.20 (retail $24), follow the link, open a Createspace account and enter discount code SJRGPLAB. (This is the only way I can offer a discount.)

Thank you, Jay B. ($100), for your outrageously generous contribution to this site -- I am greatly honored by your support and readership.

Thank you, Quentin V.T. ($5/month), for your splendidly generous re-subscription to this site -- I am greatly honored by your steadfast support and readership.

Read more...

Why Oil Could Move Higher--Much Higher

Commodities could rise even as global demand sags.

The conventional wisdom of the moment is that a weakening global economy will push the cost of commodities such as oil down as demand stagnates. This makes perfect sense in terms of physical supply and demand, but this ignores the consequences of financial demand and capital flows. 

I wrote this essay for Peak Prosperity about three weeks ago, before the revelations of investment bank speculation in commodities became news. In my view, these revelations only confirm the basic story I describe here, of capital moving from asset bubbles nearing exhaustion to the open territory of commodities. I see this move as secular, i.e. not limited to a handful of big investment banks; they are the lead players in a much broader shift of capital.

On the Nature of Conspiracies

The human mind seeks a narrative explanation of events, a story that makes sense of the swirl of life’s interactions.

The simpler the story, the easier it is to understand. Thus the simple stories are the most attractive to us.

This is one reason behind the explanatory appeal of conspiracies: 'Event X' occurred because a secret group planned and executed it.

Power groups may indeed have both the motivation and means to influence or control events. Certainly many price-fixing cases that go to trial uncover just such shadowy groups and conspiracies.

Even the Executive branch of government is, in essence, a series of private meetings in which policy makers craft plans to influence or control a series of events. And so we find the Internet a-buzz these days with rumors of grand designs of Orwellian-style populace control.

But conspiracies and power groups do not always provide comprehensive explanations for what we observe.

Multifactorial Causation

Life is messy, and situations with many participants and interactions – for example, markets – tend to be driven by amorphous forces, such as the herd instinct; and emotions, such as the infamous 'fear and greed'.

We have to question the ability of power groups to influence trends shaped by millions of participants and transactions.

For example, if we believe that the stock market is controlled by a power Elite, then we have to accept that this group engineers crashes and recessions along with Bull markets. Various explanations have been offered on how the Elite gains from crashes and crises (for example, Naomi Klein’s Shock Doctrine), but accounts from insiders suggest the 2008 financial crisis was not planned by the conventional power Elites. Rather, it left them scrambling to keep the system from melting down.

In other words, relying entirely on the machinations of power groups to explain a complex non-linear system veers into oversimplification. This leads to implausible claims such as “the Vietnam War was engineered by banks to profit from rising Federal deficits.”  There is exhaustive documentation of the many factors at work in the Vietnam War, and domestic banks’ profiteering from rising Federal deficits simply doesn’t make the cut as a dominant force.

The "Big Idea" Fallacy

Another category of simple, powerful narratives is “the big idea.” These include inflation, deflation, the conflict between labor and capital, and various aspects of systems analysis, for example, feedback loops.

But when simple stories and concepts fail to accurately account for events and fail to project reasonably accurate predictions, then we need to seek more nuanced and complex causal narratives.

Let’s take oil as an example. The global market appears to have ample supply, yet the price of oil keeps drifting higher.

The big idea that many believe drives the price of commodities such as oil is inflation/deflation: In inflationary eras, the expansion of money supply drives commodities higher as prices rise from increased demand and monetary inflation. In deflationary eras, slackening demand and contraction of credit/money supply causes commodities to decline.

The other primary narrative is supply and demand: Commodities rise when demand exceeds supply, and prices decline when supply exceeds demand.

Since the global economy is visibly slowing, demand for many commodities is declining. Though central banks are adding to money supply, this money is not flowing into the real economy, as credit and money velocity are stagnant.

These two factors are deflationary, and so the conventional expectation is for commodities like oil to decline. Oil’s price rise runs counter to both of these narratives.

Is there a conspiracy/power group engineering oil’s rise?

Various power groups – for example, the OPEC oil-producing cartel – clearly have both motivation and influence on the supply side of the equation, and government policy makers have strong incentives to control or influence both supply and demand.

Conspiracy narratives tend to overlook the conflicting incentives and agendas of competing Elites. Some power groups may benefit from rising oil prices, for instance, while others use their influence to lower oil prices. Competing Elites muddy the explanatory power of conspiracies.

Why is oil rising?  The conventional narratives fail to account for this trend. They also lack predictive value, as repeated calls for oil to reverse have been mooted by oil’s uptrend. For reasons I will explain in the next section, it is entirely plausible that oil could continue to rise, despite slackening end-user demand and deflationary stagnation in the global economy.

Such a continued rise in the price of oil would eventually push all commodities higher, even in the face of slackening demand, as producers would have to pass higher production/transport costs on to end buyers. This is why spikes in oil prices correlate to recession. As costs rise while wages remain stagnant, households and enterprises have less discretionary income to spend and invest.

With producer prices up 2.5% over the past year, the trend of higher oil costs leading to higher production costs already seems evident.

Since the conventional narratives fail to account for oil’s price advance, we must seek a new narrative.

Oil: The Super-Commodity

Oil is the Super-Commodity because it underpins the entire industrial economy. Coal and natural gas are used to generate electricity, but transport and the petrochemical industry are still largely fueled by oil.

As the cost of oil rises, the cost of producing and transporting goods also rises across the entire commodity spectrum. Higher oil costs make it more expensive to grow, harvest, and transport agricultural commodities and mine, refine, and transport metals.

This is the basic reason why recessions follow spikes in oil prices. When oil costs rise, costs increase throughout the economy without offering any additional value for the higher prices. Higher oil costs act as a tax that transfers wealth from consumers to oil producers. Since consumers pay more for goods and services, they have less disposable income to spend and invest. This contraction triggers recession.

One key feature of technical analysis is that it is detached from explanatory narratives. The technical analyst doesn’t really care if the rise in price is caused by a cartel, inflation, expanding demand, or geopolitical tensions; he just sees a trend or a reversal of trend.

You have probably seen multiple versions of this chart of oil (WTIC); everyone sees the same wedge and the same technical breakout to the upside.

Every analyst also sees the rising MACD (moving average convergence/divergence) and RSI (relative strength) indicators that confirm the breakout.

This rise in the price of oil in U.S. dollars has flummoxed everyone who expected oil to decline as global demand weakened. Rising prices don’t align with stories of a world awash in oil; clearly, the conventional supply-demand narrative isn’t capturing the key dynamics.

You have probably read the same explanations I have for higher oil prices. These include:

• Inflationary monetary policies will push prices of something higher, and that something is oil.
• Shale oil is costly to extract and the wells deplete rapidly.
• Oil supply is actually tighter than is generally realized.
• Geopolitical tensions are a factor, specifically the coup in Egypt.
• Stronger U.S. growth will drive increased demand.
• Oil-producing nations need oil above $100/barrel to fund their domestic welfare programs.
• Oil-producing nations’ own domestic consumption is rising rapidly, leaving less oil to export.

There is nothing new here to speak of; it has long been recognized that the energy required to extract increasingly marginal sources of oil (i.e., EROEI, energy returned on energy invested) is rising, and this naturally drives the end-cost higher. It has also long been recognized that oil exports are vulnerable to political turmoil and conflict, as oil (like all commodities) is sensitive to small increases in demand or contractions in supply.

A more intriguing dynamic has been presented by Financial Times reporter Izabella Kaminska (The Fed, QE and Commodities) over the past year: Financiers are buying oil as collateral for various speculations. Kaminska sees this financial hoarding of oil (i.e., reduction of supply) as inducing “scarcity amidst plenty.”  Simply put, financial demand is equivalent to end-user demand.

In broad terms, I would characterize this as one aspect of the financialization of commodities.

Again in broad terms, the financialization of commodities is driven by several macro factors:

1. The scarcity of non-phantom, easily tradable collateral in a financial system that is increasingly dependent on phantom collateral.
2. A scarcity of sound investment opportunities.

What is phantom collateral?  I will offer two of many possible examples.

A sovereign bond issued by an essentially insolvent government that is propped up by the intervention of a central bank (for example, the European Central Bank (ECB) buying Spanish bonds). The bond is presented as solid collateral, but the collateral is entirely phantom. Should policy change and the ECB stop buying the bonds or even sell them, the true market value of the bond would quickly be discovered. Much of the bond’s supposed value as collateral would immediately vanish.

Consider a mortgage-backed security (MBS) held on a bank’s balance sheet at full value. Now consider what a marked-to-market valuation of the underlying mortgages would discover: Much of the value of the MBS would be revealed as phantom.

Conclusion

That real estate, stocks, and bonds are in varying stages of bubble-type tops is generally accepted as obvious, at least when the microphone is turned off. “Chasing yield” at the top of asset bubbles is a very risky game. Thus “smart money” seeks lower risk opportunities, either the classic “buy low, sell high” variety or low-risk carry-type trades. 

The total financial wealth sloshing around the world is approximately $160 trillion. If some relatively modest percentage of this money enters the commodity sector (and more specifically, oil) as a low-risk opportunity, this flow would drive the price of oil higher on its own, regardless of end-user demand and deflationary forces.

If we grasp that financial demand is equivalent to end-user demand, we understand why oil could climb to $125/barrel or even higher despite a physical surplus.

In Part II: Understanding the Secular Shift of Capital into Commodities, we examine the impact of this financialization of oil on other commodities. With oil's recent breakout, the prices of many essential commodities (e.g., natural gas, wheat, copper, coffee) are bottoming or already entering new uptrends.

Such a financially driven rise in oil could spark a self-reinforcing feedback as others note the rise and jump into the trade. If trillions of dollars in hot money exit bonds, stocks, and overheated real-estate markets, a small percentage of that money chasing oil and other commodities would have an outsized impact on prices, which are always set on the margins.

This is how oil and other commodities could continue climbing in price even as the global physical demand slumps and more economies slip into recession as oil costs rise.

Click here to read Part II of this report (free executive summary; enrollment  atPeakProsperity.com required for full access).

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Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart:

1. Debt and financialization
2. Crony capitalism and the elimination of accountability
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economy

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

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Thank you, Michael M. ($50), for your superbly generous contribution to this site -- I am greatly honored by your steadfast support and readership.

Thank you, Stephen T. ($50), for your extraordinarily generous contribution to this site -- I am greatly honored by your support and readership.

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