Relevant and even prescient commentary on news, politics and the economy.

Wealth vs Income

Usually my articles present facts and data and try to drive down to a conclusion. This time, I’m going to drive down to a couple of questions.

Recently, Noah Smith had a post on the subject of economic models titled Filling a hole or priming the pump?  It did quite a bit to restore my lack of faith in the pseudoscience of Economics, but that is more or less beside the point.  Roger Farmer, cited in the post, left a long comment that Noah hoisted up the main page.  Farmer concludes:

My reading of the evidence is that consumption depends primarily on wealth rather than income. That was the lesson of work by Ando and Modigliani, Modigliani, and Friedman in the 1950s. It is for that reason that I support interventions in the asset markets that try to jump-start the economy and reduce unemployment by boosting private wealth. That, in my view, is what quantitative easing has done.

Ok – I’m taking on decades of economic research here, but my first question relates to: “My reading of the evidence is that consumption depends primarily on wealth rather than income.”

First, let’s remember that wealth distribution is on the order of the top 1% owning 40% of the wealth, and the bottom 80% owning 7% of the wealth. And that 7% is not evenly distributed.  There are significant fractions of the population who have a) no wealth at all, or b) negative net worth. Either way, they are living hand to mouth.  This suggests that 1) they have unmet needs, and 2) will spend the next available dollar trying to satisfy one of them. 

So far, this is just a thought experiment.  Let’s take a look at how personal consumption expenditures track disposable income.  Here is percent change from previous year:

Both in the grand sweep and in the year-to-year detail, the curves are pretty much in lock-step.

 Here is the data on a Log Scale:

That’s coordination about as close as you could ever hope to see in real world data.

And if wealth – or it’s perception – were the determinant, wouldn’t you expect some sort of a consumption bump during the housing bubble, when people felt wealthier than their incomes justified?  Let’s look at consumption expenditures per capita.

Here, there is a slope increase, mid last decade, but it’s not great, and it’s no greater than the slope of the late 90’s.  I suppose the tech boom must have had some people feeling wealthy then, as well.  But they weren’t that bottom 80%.  Note that the first graph indicates the personal disposable income was up in those periods as well.  In fact, they were the only up periods since about 1980.

There was also relatively low unemployment in those times, and thus more people with incomes.

Also, it just seems counter-intuitive in a world where, if real people think about money at all, it’s in a personal cash flow context, not in terms of wealth aggregates.  Consuption decision reasoning, to the the extent that it even occurs, is along the lines of: “If I buy this thing, can I still afford to feed my cat?”

So, here is question number 1:

Since to most people “wealth” is miniscule, non-existant, or worse, and given empirical data that closely links consumption to income, how can consumption depend “primarily on wealth rather than income?”

Now let’s look at Excess Reserves of Depository Institutions.

There’s 1.6 trillion QE dollars.  Any left-overs have gone to leveraged speculation causing commodity inflation.

But Farmer says: “I support interventions in the asset markets that try to jump-start the economy and reduce unemployment by boosting private wealth. That, in my view, is what quantitative easing has done.”

If any wealth has been boosted here, it is in the upper reaches of the already wealthy, not among the working stiffs who are highly inclined to spend the next dollar rather than hide it away in Luxombourg or the Cayman Islands.

So, here is question number 2:

How can QE money help the economy when it is either sitting idle or inflating commodity prices?

I have nothing in particular against Roger Farmer, about whom I know nothing, but I am also prompted to ask economists in general:

What in the hell is the matter with you?

So maybe my lack of faith in Economics is the point, after all.

Cross-posted at Retirement Blues.

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Where Has All The Money Gone, Part II – Finance Sector

In Part I we saw that labor’s earnings have lagged far behind GDP growth.  (More on earnings stagnation here) Meanwhile, corporate profits have grown at a rate that, until recently, increased over time, and they are now at a historically high fraction of GDP.
Here is a specific look at the Finance Sector. The graph shows finance sector profits as a percentage of total corporate profits – all after tax.

 
That’s a pretty impressive sweep up over time. I threw some best fit curves through the whole data set, and also though the peaks and valleys. Curves through the extremes are exponential.

Along with the increased percentage we get a dramatic increase in the data spread.

When lines jump around a lot, you can sometimes get clarification by looking at a long average. I tried that here with a 13 year average.

A long average filters out the hash, and reveals the underlying trend. Or, I should say, trends, since there are two, with a sharp break at the beginning of 1986. A best-fit least squares trend line on the data through ’85 is a near-perfect match to the average line, which barely even wiggles. We see a bit more action in the post-85 segment, but the new trend is still very clear, indeed. The earlier trend line in green is now the lower channel support line.

The finance sector has captured an increasing fraction of corporate profits, which have been growing at an increasing rate since WWII.  And the growth rates are greatest when the economy is doing the worst.  Take another look at the first graph.  The correlation of finance sector profit peaks with recessions is close to perfect.  Peaks are in Q2-1949, Q3-1952, Q4-1953, Q1-1958, Q1-1961, Q4-1970,  Q1-1986, Q1-1991, Q4-2001.  The peak in 1986 is the only one that does not correspond to a recession.

The finance sector provides a vital function.  It is there to facilitate and enable the wheels of industry to turn.  But policy matters.  What has happened in the age of deregulation and lax taxation is that the finance sector has come to dominate the economy.  This is madness. And here is your Great Stagnation, folks.

Beyond the point of supplying necessary financing for businesses and mortgages, financial manoeuvrings – speculation in particular, and most especially so with sophisticated derivatives that nobody knows how to rationally evaluate – become rent seeking.  This is a massive misallocation of resources, diverting capital from real investment into totally non-value-added financial tail chasing.

And I’m not the only who thinks so.  Here, Paul Krugman calling the whole operation A Giant Scam, quotes Andrew Haldane, Executive Director, Financial Stability, Bank of England:

In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance. Instead, it was a traverse up the high-wire of risk and return. This hire-wire act involved, on the asset side, rapid credit expansion, often through the development of poorly understood financial instruments. On the liability side, this ballooning balance sheet was financed using risky leverage, often at short maturities.

In what sense is increased risk-taking by banks a value-added service for the economy at large? In short, it is not.

Haldane’s article was reposted at Naked Capitalism. What he is getting at is the derivatives market, the unregulated darling of the World of High Finance.  Estimates vary, since there is no good way to get a handle on it, but the highly leveraged derivatives market has a notional value somewhere between 10 and 25 times the aggregate value of global GDP.  In the wake of Phil Graham’s undoing of Glass-Steagal came a sea change in the way the Finance Sector does business, and along with this came a shift from risk management to risk-making.  As Haldane put it: “If risk-making were a value-adding activity, Russian roulette players would contribute disproportionately to global welfare.”

Since none of this activity does anything to create real wealth, it is nothing but rent-seeking.  That is bad, in and of itself.  Worse, still, in Krugman’s words: “Wall Street and the City were con artists extracting huge rents from an unwary public (and eventually dumping much of the cost, when things went bad, on taxpayers).”   What is perhaps worst of all is that the money locked up in these ventures is diverted from real investment.

So, here is the picture.  While the average earnings of working stiffs has been stagnant, at best, corporate profits have grown at an increasing rate.  Further, the percentage of those profits going to the Finance sector has also grown at an increasing rate.  Total profit growth is above exponential, and Finance Sector profit growth is super-exponential.

To summarize:
1) Over the last 30 years banking has devolved from a necessary financial function involved in the allocation of resources and management of risk to essentially non-value-added rent-seeking activities implemented through high risk practices.
2) When the whole house of cards came tumbling down, the losses were socialized, while the criminals who perpetrated the underlying fraud walked off not only scot-free, but with huge bonuses.

There might be some way to justify this if it were leading to greater GDP growth or a rising tide that lifted all the boats.  But the opposite has happened.  GDP growth has been in decline for decades, and the tsunami of profits floating the yachts in the Finance Sector has swamped all the dinghies.

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Where Has All The Money Gone, Pt I, Corporate Profits

INTRODUCTION

1) Rethug Speaker of the House John Boehner says that as a nation, “we’re broke“; Rethug presidential candidate Ron Paul claims America “should declare bankruptcy.”  I say these two are liars, and at least one of them is crazy.

2) Tyler Cowan says “we are poorer than we think we are,” due to mis-measurement of value, which might be true.  I believe his prescription for recovery is generally very bad, though.

3) In comments to my previous Angry Bear post, Bob McManus directed us to the writings of Michael Hudson, where we find his post Democracy and Debt.  This is must reading.  The relevant point here is that the increasing capture of wealth, as rents, by a creditor class impoverishes society in general, and this eventually leads to severe repression, major social upheaval, or both.  I whole-heartedly agree.

4) Jon Hammond’s guest post at Angry Bear shows that a more-or-less continuous decrease in real investment has occurred during the post WW II era.

In this series of posts, I intend to show that we are a wealthy nation, but that our wealth  has been increasingly captured by elite creditors, who, in my opinion, are strangling the economy by 1) extracting excessive rents and 2) diverting this wealth to financial tail chasing, rather than real investment.

WHERE THE MONEY HASN’T GONE

Here is a look at average hourly earnings, the typical income of a working stiff, presented on a log scale.

Like almost every time series you can imagine, including GDP, it exhibits a break near 1980.   The break is always to lower growth.  But, compared to most other data series, this break is especially sharp.

Hear is the same series compared to GDP, an approximate measure of the income of the nation, on a linear scale.  For this graph, each is normalized to a value of 100 in Q1, 1965.

While earnings have grown less than 8 times in 47 years, GDP has grown more than 20 times.

Clearly, the money has not gone to compensation of the workers whose labor actually creates the wealth of the nation.  That might explain some of the alleged envy.

CORPORATE PROFITS

As a first step in finding where the money has gone, let’s consider the growth of corporate after-tax profits since about 1950.  You can see it in this FRED graph.   It’s on a log scale, so constant growth would be a straight line.  There are lots of wiggles, but I see an increasing slope over time, and it’s not an optical illusion.

There are a lot of ways to parse this.  One is to connect the dip bottoms with straight lines.  I’ve done that with alternating red and blue to show the slope increasing over time.  The problem is selecting which bottoms to connect.  Some alternate choices are indicated in yellow.  The yellow lines define times of above normal profit growth: 1970 to 1980, 1986 to 1998, and 2001 through 2007.  Each of them leads to a correction, indicated by a purple line across the top of the decline.

After I did all that, it occurred to me to let Excel throw an exponential best fit line on the data set, and you can see that as well.

I see now that I could have included another yellow line from 1961 to 1967.  Notice that with each yellow line, the data set advances above the exponential best fit line before a sideways correction takes it below again.  After the correction is complete, profits increase again until the best fit curve is breached.  Or, they did until now.

Remember that on a log scale constant growth rate is represented by a straight line, and that the growth compounds, so that the underlying increase is exponential.  Sooner or later, that has to end.  Nothing in the real word can go to infinity.  Here we see an exponential curve on a log scale.  This demonstrates an increasing growth rate.  Therefore, the underlying increase is greater than exponential.  If exponential growth is unsustainable, what would you say about greater than exponential growth?

In fact, the whole trend might now be falling apart, as the last blue line has a much lower slope.  Also, for the first time following a correction, profits have stayed below the trend line, and the gap is increasing.

To show the extent of national income capture by corporations, here is a graph of corporate profits as a percentage of GDP.   I’ve divided the set into two segments: 1951 to 1979, and 1980 on, and had Excel place a linear trend line on each.  This division is somewhat arbitrary, but almost every economic time series you can find has a break point within a few years of 1980.  Division between ’79 and ’80 is the least favorable to my point that Profits/GDP had no trend in the post WW II Golden Age, but have trended sharply upward during the Great Stagnation period.

Profit/GDP growth was unusually poor from 1980 through 1986.  Then from late 2001 through early 2006 it exhibited the greatest growth ever.  But remember the denominator effect.  Nominal GDP growth increased rapidly following the ’80-’82 double recession; while GDP growth in this century has been generally slow.  The financial melt-down of 2008 caused a dip that was sharp and brief, but the rebound has not gone to a new high.  But even now, in the midst of anemic recovery, profit/GDP is hovering in the 9 to 10% range, far above historical norms.

CONCLUSION

The corporate profit growth picture looks unsustainable, and that is troubling.  What it means for the future is anybody’s guess.  But, what we get from it is the first partial answer to the question, “Where has all the money gone?”

Gone to profits, everyone.

A slightly different version is posted at Retirement Blues.

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GDP Revisions

This is just a short post to illustrate the magnitude of GDP revisions. I downloaded quarterly GDP data from BEA in June 2011. I went back to BEA this morning to update the file. Forgetting about GDP revisions, I thought I’d be adding 2 or three more quarters of data, but discovered that all the numbers since Q2 2003 had been revised. Prior values are unchanged. Plotted below is the difference between the June, 2011 numbers and what I found this morning.

The depth of the trough in Q3 2009 was $194 Billion worse than we thought just a few months ago. I was surprised to see the revisions go back a full 9 years.

Tyler Cowan got one thing right. We are poorer than we think we are.

Cross-posted at Retirement Blues

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Ron Paul Challenges Liberals – or Maybe Not

Matt Stoller, the former Senior Policy Advisor to Rep. Alan Grayson and a fellow at the Roosevelt Institute has a couple of very interesting articles posted at Naked Capitalism,  Why Ron Paul Challenges Liberals, and the follow-up, Naked Capitalism, “A Home for All Sorts of Bircher Nonsense”

These are thought-provoking, in many ways insightful, and strike me as required reading, for a variety of reasons, including some valuable historical insights.  However, one thought they provoke from me is that the main thesis is spectacularly wrong-headed.  Stollar talks about what a great ally Paul’s staff was, when working on certain issues.  I should say, “when working against certain issues” or things, like war and the unfettered evil workings of the Federal Reserve.  The correct vocabulary is worth emphasizing.  Liberals and Libertarians may find common ground in what they are against, but it is quite unlikely that they will ever find anything substantial that they both are for.

Stollar goes on to point out what he calls “a big problem” with liberalism.  This is the mixture of two elements, support for federal power and the anti-war sentiment that arose with Viet Nam and has continued though today.  In the same paragraph, Stollar says, “Liberalism doesn’t really exist much within the Democratic Party so much anymore.”  This is an important thought, but he doesn’t pursue it, and as he goes on seems to conflate Democrats with Liberals, as suits his convenience.  In the final paragraph of the first post he refers to: “a completely hollow liberal intellectual apparatus arguing for increasing the power of corporations through the Federal government to enact their agenda.”  Seriously, WTF?  I have absolutely no idea what the hell that is supposed to mean.

The second article is especially weak, and essentially devoid of any intellectual content.  Stollar decides to “highlight a few of the reactions here without much of a rebuttal.”  Why would anyone do that?  Does he believe the reactions are self-refuting?   Is he too lazy to rebut, or does he simply not have a good rebuttal?

At least he clearly sets forth the thesis of the first article:  “that the same financing structures that are used to finance mass industrial warfare were used to create a liberal national economy and social safety.”   Here is the source of Stollar’s alleged intra-liberal conflict, that Paul is somehow supposed to illuminate and inform.  Though Stollar says: “I’ll be describing in much more detail the shifting of the social contract underlying this failure, which has nothing to do with Ron Paul and would exist with or without him.”  So referencing Paul in the first place was a bit of a red herring.

He then goes on to provide extended quotes from posts by David Atkins, who he describes as “wrestling with what liberalism is” and Digby, who he simply rejects out of hand, though with a lot of words that don’t quite reach the level of snark

What Stollar describes as “contradictions within modern liberalism”  boils down to liberalism needing big government to be interventionist, as Atkins demonstrates, but not imperialistic.  But this is a totally coherent position. The problem lies not with progressive liberalism, but with the practical realities of managing a power system – which is what governemnt is – in a way that advances the common good, while holding the drive for imperialistic and domestic domination in check.  This is going to be a central practical problem with any governing system or political philosophy – at least for one that takes seriously the idea of advancing the common good.  To say it is the problem of liberalism is to ignore human nature, political reality, and the entirety of history.

Thus, a liberal can hold the positions that American involvement in WW II was necessary, but that our involvement in Viet Nam was not.  Ditto Kosovo, vis-a-vis Iraq.   One can also recognize that the only entity with enough heft to balance the power of trans-national mega-corporations is government, but Stollar does not choose to give that any consideration.

Stollar concludes: “As the New Deal era model sheds the last trappings of anything resembling social justice or equity for what used to be called the middle class (a process which Tom Ferguson has been relentlessly documenting since the early 1980s), the breakdown will become impossible to ignore.  You can already see how flimsy the arguments are, from the partisans.

I don’t know how one gets from the systematic dismantling of the New Deal by successive Republican administrations (and you can include both Clinton and Obama in this list) to the New Deal model shedding anything at all.  And, no, I can’t see how flimsy liberal partisan arguments have anything to do with an assault on the middle class that has taken place from the right.

Stollar has constructed a straw man problem.  Which is a shame, since there are real problems to be dealt with.  One is the growth of right wing populism, as exemplified by the Tea Party – at least to the extent that is is real, and not a Fox News fabrication.  Another is to harness the energy of the Occupy Movements, which provide some evidence that there is progressive populism that could be a source of real political strength.  Most critically, though, as things stand now, there is no political left in this country with any actual power. 

Corey Robin describes the central problem of American liberalism in the 21st Century, and closes the loop back to Stollar’s Ron Paul idea like this.

Our problem—and again by “our” I mean a left that’s social democratic (or welfare state liberal or economically progressive or whatever the hell you want to call it) and anti-imperial—is that we don’t really have a vigorous national spokesperson for the issues of war and peace, an end to empire, a challenge to Israel, and so forth, that Paul has in fact been articulating.  The source of Paul’s positions on these issues are not the same as ours (again more reason not to give him our support).  But he is talking about these issues, often in surprisingly blunt and challenging terms. Would that we had someone on our side who could make the case against an American empire, or American supremacy, in such a pungent way.

Digging a level deeper, the reason we don’t have such a spokesperson is that our political system is essentially owned by corporate interests, which is why we get alleged liberals like Clinton and Obama in Democratic leadership, while genuine progressives like Bernie Sanders, Dennis Kucinich, and even Alan Grayson are marginalized.  On top of this, the right has a vigorous and powerful propaganda machine – hence the Tea Party; and the small number of progressive voices in broadcast media is nowhere close to providing a balance.

Money owns politics, and corporate interests, along with a small entrenched elite, own the vast majority of the money.  The key to achieving progressive solutions is to get the money out of politics.  But in the wake of Citizens United, that prospect is a forlorn hope.  That is my “coherent structural critique of the American political order” in one short paragraph.

Cross posted at Retirement Blues

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A Deeper Dive into Oil Pricing

In the previous post, I suggested that speculation is driving oil prices higher than they should be.  In this follow-up, I think I can show that oil prices are not behaving in a completely supply-demand determined way.  We’ll look at price activity, volatility, and an estimate of what rational pricing might be.

First, here is Brent Crude spot price activity since 1987, data from the U.S Energy Information Administration.  I’ve taken a weekly average of daily data, and plotted it as of each Friday (it was just a lot easier than trying to work their data table into a daily data plot.) Also included is a 55 week moving average.

As you can see, the price really took off after 2000.  Coincidentally, the Gramm–Leach–Bliley (Financial Services Modernization) Act of 1999, which undid portions of the Glass-Steagall of 1933, was signed into law on Nov 12 of that year, and the Commodities Futures Modernization Act of 2000 was signed into law on Dec 21 of that year.  These new laws allowed mega-consolidation in the finance industry and prohibited the regulation of certain speculative activities.

Here is the same data, separated into two graphs around the year 2000.  Also shown are the 55 week moving average, and an envelope one standard deviation above and below the average.  St Dev is based on the same 55 data points as the moving average.  The sections of the price line that extend above the {Avg + St Dev} line are highlighted.

The entire data set contains 1166 points.  Of these, 428, or 36.7%, lie more than 1 Standard deviation above the moving average.  For the segment through 1999, 156 of  574 points, or 27.18%, lie above the St Dev envelope.  For the segment 2000 on, 272 of 592 points, or 45.95%,  lie above the St Dev envelope.

For data normally distributed around the mean, about 1/3 of the data points should lie outside the 1 Std Dev envelope, half of them (1/6 of the data set) above and half below.   I’m no statistician, but this is not a well behaved data set.  Clearly, there is a powerful high-side bias.  What could be the cause?  Here are some possibilities.

1) Supply-demand forces in a growing world economy are so skewed to the demand side that this is that natural result.
2) External forces, such as panic due to war and instability in the Middle-East, have irrationally raised prices.
3) Speculative forces with a strong long-side bias have skewed the market away from a supply-demand determined price level.
4) Withheld supply due to OPEC activities, contango (hoarding on leased tankers), and the disruption of Iraqi supply for the last decade have unnaturally skewed the supply component.

My view is that possibilities 2 – 4 are all operating to some degree.

I have no way of evaluating 2 and 4. However, 4 seems reasonable, in view of the classic description of inflation: too many dollars chasing too few goods.  This effect could also spill into into futures speculation, where the amount of oil traded is finite, but the amount of speculative money available appears not to be.

To be clear, I’m not talking about CPI inflation, I’m talking about commodity-specific inflation. I believe that financial tail-chasing has not been limited to oil speculation. There is enormous wealth in the world, and to a large extent, it is not being devoted to legitimate investment. It is being devoted to computer generated program trading that capturess tiny fractional percentage gains millions of times per day, to skim money away from those who use exchanges for valid purposes.

And maybe we can get a handle on speculation.  My hypothesis is that deregulation in the 1999-2000 time frame has enabled and encouraged speculative rent-seeking activities in the oil futures market, which has inflated the price of crude.  One way to go at it is to have a look at volatility.  We already have standard deviation in our hip pocket.  Let’s see what we can do with it.

Here is standard deviation, based on 55 consecutive data points, divided by the average of those data points.  Just for kicks, included are a 55 point moving average of the St Dev in red  (for what it’s worth –  not much, I’d say) and a best fit (least squares) trend line. 

Well – the trend line slopes up a bit, but that’s not really a lot to go on.  On the other hand, the entire 90’s lie below the trend line.  In fact, except for the 1990 price spike, most of the of the St Dev values prior to about 1999 lie below the trend line.  Let have a closer look.

Here, the data are divided into two segments,  up through 1999, and 2000 and beyond.   For the early segment, the St Dev/ Price line is in dark blue and the 55 week average is in red.  For the latter segment, the lines are light blue and yellow, respectively.  Now, the trend lines tell an interesting story.  For the early period, the trend line is essentially flat, with a slight downward slope.  For the latter period, the slope is clearly upward.  Despite the localized gyrations, we can see that prior to deregulation, volatility had no trend.  After deregulation the trend is up.

Up to 1999, St Dev / Price averaged 12.65% (exclusive of the 1990 spike, taken as August, 1990 through January, 1991 the value is 12.01% )  From 2000 until now, the St Dev / Price averaged 15.06%.

So, what we see is that since since deregulation, prices have gone up, volatility has gone up, and upside bias in the data set has gone up.  Let’s resurrect possibility 1) and see if demand pressure can be the cause.  To get a handle on this, I took a closer look at my speculative idea from the previous post, and extrapolated prices forward from 1990, based on hypothetical constant growth rates.  Originally, I took a SWAG at the 1990 average price, and came up with $30 per barrel.  With a growth rate of 4% over 21 years, that would result in a current price of $68.36.  The 4% growth rate came from a generous estimate of World GDP growth over the period, assuming a direct, linear link between GDP growth and demand for petroleum.

Here is a graph based on the data instead of a SWAG.  It shows constant price increase rates of 3, 4 and 5% per year, based on the actual 1990 average price of $23.66.  The first thing to note is that my $30 SWAG was more than $6 too high.  The next thing to notice is that 1990 was the worst possible year to select, given the point I’m trying to make.  Due to the local spike, the 1990 average of $23.66 is almost $5 higher than the 1987 to 1993 average of $18.84.  So, if anything, my estimate of $68.36 is artificially high.

Still, I went with the 1990 average for this chart.  Extrapolations are based on growth rates of 3 (yellow), 4 (red) and 5(green)% from the 1990 average of $23.66.  This gives Mid 2011 price estimates as follows.

At 3%   $43.34
At 4%   $53.02
At 5%   $64.09

I’m not suggesting that this is a fool-proof method.  However, it is gratifying that it is more-or-less consistent with the oil industry estimation of a supply-demand determined price.  Further, these price growth estimates are quite generous, since estimates of petroleum demand growth are in the range of 1.6 to 2.3 %.

My conclusions:
1) The price of oil is far above rational, market-based pricing.
2) While other distortions and manipulations are likely to play a part in an inflated price, it’s not clear how they could contribute to increased volatility.
3) Unregulated, excessive speculation, with a long side bias is indisputably taking place.  I believe this is a major contributor to excessive price inflation, and the sole contributor to excess volatility.

Do you have a better idea?  Let’s hear it.

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Speculation About Oil

Last Spring, some Democrats and liberals (Ed Schultz and Bernie Sanders spring readily to mind) who have somehow resisted the enlightenment of unfettered free markets suggested that high oil prices are due to speculation.

Noah Smith took this subject on, asking the question: “Do speculators cause oil and/or gas prices to rise above their “natural” or fundamental level?” Noah’s take is that speculation is innocent, and he cites some corroborating experimental evidence. I’m a big fan, but this time I think Noah missed the point. First, I’ll state right up front that futures markets play a vital role in allowing the producers and first-line purchasers of various commodities to be able to stabilize their cash flows and construct realistic business plans. So – yes, futures markets are a good thing.

On the other hand, when quizzed by Senator Cantwell on why big, trans-national oil companies should continue to receive multiple billions of dollars in tax breaks, Exxon CEO Rex Tillerson admitted that a good estimate of a supply-demand determined price (considering the price of the next marginal barrel) for crude is in the range of $60 to $70 per barrel.

For reference, here is a chart and data table for Brent crude, going back to 1987.

At the depth of the global recession, on Boxing Day 2008, when the world was coming to an end, the price dipped below $34. Be that as it may, with recent prices back over $100, we’re looking at premiums over a rational value estimate of from 60 to 85%. Let’s just call it 75% for convenience.

Now, back to the point that Noah misses, and that Senator Cantwell suggested. What is the effect of unregulated speculation on the price of oil? The Senator estimates 30% activity by concerned stake-holders, and 70% by profit-seeking (in my view rent-seeking) speculators who are playing the market for a profit. The graph on Pg 5 of this study (18 Pg. pdf) suggests a ratio closer to 45% commercial and 55% non-commercial interest. Also it looks like open interest, which had been relatively flat for years, increased by a factor of 6 or 7. This financial tail chasing, aided and abetted by deregulation, is a direct manifestation of the asset misallocation that, in my view, is the real cause of The Great Stagnation.

A look at the oil price chart shows 10 to 15 years of more-or-less flat line in the range of $20, followed by a classic bubble and post-bubble bounce. As an aside, this is typical Elliott wave behavior. I can easily trace a five wave rise to the peak, and what looks like the recent end of a counter-current B-wave since the Dec. ’08 bottom. If this is anywhere near correct, the price of crude a decade from now will be eye-poppingly low, and fundamentals be damned.

As an example of a classic bubble peak, consider the Dow Jones Industrial Average during and after the 1929 crash.

But let’s look at fundamentals, anyway. Global GDP growth since 1980 has been in the range of 2 to 5%. Let’s generously call it 4%. The price of crude in 1990 varied from about $15 to $41. Let’s generously call it $30, on average.

If we compound $30 at 4% for 21 years we get (are you ready for this) $68.36. And this is based on generous numbers.

Not a rock-solid price algorithm, for sure, but it ought to be in the ball park. Maybe it’s just a coincidence that this number corroborates Rex Tillerson’s off-hand estimate.

Maybe it’s another coincidence that oil prices took off after Phil Graham pushed through legislation (signed by Billy-Bob Clinton at tail end of his battered second term) that exempted some speculative trading from certain regulations dating back to the Commodities Exchange Act of 1936. One of these exemptions was removing this requirement: “Either way, both the buyer and the seller of a futures contract are obligated to fulfill the contract requirements at the end of the contract term” from oil and other energy products. In case this is not crystal clear, it means that back in the bad old days of regulation, a contract had to be closed by executing the opposite transaction from the original prior to expiration, to avoid either supplying or receiving the physical amount of the contract. But after deregulation this requirement was not in force for oil.

Maybe it’s another coincidence that Morgan Stanley became the largest oil company in America. Plus, another point that Noah explicitly missed is that big, speculative finance entities did, in fact engage in physical hoarding. Here is a 20 month old news flash.

Oil traders are taking advantage of a market condition known as contango, in which the price for future delivery is greater than the price for spot (immediate) delivery. If the difference between the two prices is more than the cost of chartering an oil tanker, traders stand to profit. The difference between the price of crude oil for June delivery and the price of crude oil for July delivery is more than $2.00 a barrel; that’s enough to defray the cost of chartering a very large crude carrier (VLCC), which holds about 2 million barrels of oil and, as of April 23, cost $43,876 per day, according to the Baltic Exchange.

How much of an incentive to keep prices artificially high do you suppose is provided by a cost of $43,876 per day? That’s $1.31 million per month.

And that’s why I think Ed Schultz, Bernie Sanders, and Maria Cantwell might actually be on to something.
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An earlier (and to be honest, inferior) version of article was posted on Retirement Blues back in May.

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‘Jazzbumpa’ to write for Angry Bear

Jazzbumpa has been writing about various topics that involve economics for several years now. He maintains several blogs, one of which is Retirement Blues. He is data driven with a sense of humor and will add such to Angry Bear.

Jazzbumpa is retired from a product development career in the auto industry. His education is in chemistry, but he did very little actual chemistry in the real world. The MBA is not worth mentioning. His professional strengths were in trouble-shooting, problem solving and looking askance at management.

So you’re unlikely to get anything from him on IS-LM curves, utility theory, or the hyper-neutrality of money. He also intends to avoid any mention of Social Security and/or FICA. We’ll see how that works out. Ricardian Equivalence and Rational Expectations strike him as the silliest ideas to be believed in by very serious people since chemists gave up on phlogiston. In the early chemists’ defense, though, at that time, they didn’t know any better; and there wasn’t any contrary data.

…With no reason to adhere to any particular brand of economic dogma, he can look at empirical data, and attempt to draw the conclusions that the data actually suggests. He also brings curiosity, skepticism, a smart-ass attitude, and the ability to do simple math.

His main relevant interests are in time-series data of various econ-related phenomena, inquiries into how and why things happened in the ways that they did, and what implications one might expect going forward.

JzB’s publication history includes a chapter in a Materials Handbook and a book review in an obscure and long-defunct science fiction magazine. His non-publication history includes a large stack of rejection letters. His real name was once mentioned on the acknowledgments page of a real novel by a real author.

When not involved in this nonsense, he’s an active (occasionally hyper-active) amateur musician/composer/arranger, occasional poet, loving husband, and devoted fan of 11 smart, beautiful, and talented grandchildren.

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