Producer Prices Up Sharply Even Using The Government's Own Statistics

Even the government's own ridiculously skewed statistics are beginning to reflect inflation. Producer prices (even excluding food and energy) were up .4% this month. That translates into a 5% rate of inflation.

Higher oil prices ultimately drive up the cost of a wide variety of goods and services. Add to this the fact that money supply growth of late has been robust and you have the ingredients for higher inflation.

If reported inflation is at 5% you can be sure that actual inflation is above 8%. How does the government distort the inflation figures? The two most important ways are geometric weighting and "hedonic adjustments" (sounds like something you would get at the chiropractor!)

Geometric weighting changes the basket of goods to reflect price changes. If meat prices go up, people will (it is assumed) buy more chicken and less meat. So the government reduces the weight of meat prices (and whatever else goes up more than the average) in the basket of goods. The problem is that while people may actually buy more chicken if meat prices rise, the fact that they do so does nothing to alter the fact that prices have risen by a certain amount.

It is highly deceptive to report inflation in this manner. Just think about it. Consider a basket of two goods that are partial substitutes for one another. Each costs $1 per unit. Sally Consumer purchases these goods in equal quantities at current prices. Assume the price of Good A goes up 10% to $1.10 and the price of Good B goes down 10% to 90 cents. Sally is in the same position that she was before in that the total cost of what she purchases has not changed. Inflation in this scenario is zero. Absolute price levels have not changed; it is just that A costs a little more while B costs a little less.

Government statisticians, however, look at this scenario and assert that now Sally will buy more of B and less of A (this may or may not be true). The total price that Sally has to pay is now lower. Hence, prices are dropping: deflation.

But this is ridiculous. Prices are not dropping, they're just moving around like they always do. Some things are going up in price while others are going down.

Much attention has been given to the role of "hedonic" adjustments in the government's inflation data. In my view, not enough attention has been devoted to the issue of geometric weighting.

The fact is that inflation is significantly higher than the government asserts, and as the price of oil continues to rise the rate of inflation will only increase.

Are the Proposed OPEC Production Cuts an Admission that Peak Oil is Here?

OPEC recently decided to maintain production at current levels. There was talk, however, of a cut in production at the next meeting in March. With prices currently in the 60's and rising, why should OPEC be talking about production cuts? Maybe it is because production is falling anyway and an OPEC "cut" would maintain an illusion that OPEC is actually in control of the situation.

While there is some excess capacity for heavy sour crude for which there is a shortage of specialized refining capacity, the light sweet crudes are past peak and in decline.

OPEC's calls for production cuts really seem to be an admission that lower production levels are coming, like it or not. And if OPEC is past peak, there is a 99% probability that the world is past peak.

Near Term Top in Gold

I'm going to call a near term top in the gold market at $560. Everyone is just way too bullish on gold; the run up from $420 has been tremendous and the market action is not looking as strong as it has over the past few months. While I see gold above $600 by year end, I think that in the near term we will see a correction to $490, maybe lower.

Now would probably be a good time to take some profits in gold. Try to get back in around $500 if you can.

Poised for a breakout: natural gas, the Euro, the Yen, short the S&P 500 index.

I, Greenspan

Bill Bonner is a genius:

I, GREENSPAN
by Bill Bonner

I, Alan Aurifericus Nefarious Greenspan, Chairman of the Federal Reserve Bank, holder of the Medal of Freedom, Knight of the British Empire, member of the French Legion of Honor, known to my peers as the “greatest central banker who ever lived,” (I will not trouble you with all my titles. I will not mention, for example, that I was the winner of the prestigious Enron Prize for distinguished public service, awarded on November 1, 2001, just days after Enron began to collapse in a heap of corruption charges) am about to give you the strange history of my later years.

For I will dispense with childhood…even with young adulthood, and those dreary sessions with that terminally dreary woman, Ayn Rand, who couldn’t write a compelling sentence if her life depended on it. [Correct!] I’ll also dispense with my own dreary years at the Council of Economic Advisors, and pass directly to the time I spent as the most powerful man in the world. For here are my real titles: Emperor of the world’s most powerful money, despot of the world’s largest and most dynamic economy, and architect of the most audacious financial system this sorry globe has ever seen.

Yes, I, Alan Greenspan, ruled the financial world. But who ruled Alan Greenspan? Ah…I will come to that, and tell you how, while presiding over the biggest boom ever I became caught in what I may call the “golden predicament” from which I have never since become disentangled.

This is not by any means the first thing I have written. I have written much over the years. But it was all written for a purpose, which only a few were able to discern. Most readers foolishly saw the cluttered mind of a dithering economist or the clumsy, stuttering pen of a professional bureaucrat. Many listening to my wandering speeches and twisting sentences thought that English was not my first language. They thought they detected a faint accent, like that of Henry Kissinger or Michael Caine. They mocked me as “incomprehensible” or “indecipherable.” They watched what they thought was an obsequious bureaucrat squirm. They had no idea what I was really up to and what I can only now reveal.

But they admired me, too. I knew it. Because they saw in me a kind of genius…a Bernoulli of banking…a Newton of numbers…a Leibnitz of lucre…a Copernicus of currency. My mind worked at such a high pitch, they believed, that my thoughts were inaudible to most humans. They counted on me to keep the great empire’s economy trundling forward. Little (actually nothing) did they know of my real thoughts and designs.

But now, all has changed. Now, I can write clearly and speak the truth. For now I am leaving my post. There is no further need for me to dissemble; no further need for me to pretend to kow-tow before Congressional committees; no further need to hide the real facts from my employers and the American people. Now, I swear by the gods, what I write comes from my own hand, and not from some overpaid, anonymous flack.

Some are born in crisis, some create crisis, and others have crisis thrust upon them. [???!!!???]

Let me begin at the beginning. Scarcely had I settled into to the big chair at the Fed when a crisis was thrust upon me. And it is true, I responded in the conventional manner. There is no manual for central bankers, but there is a code of behavior. Faced with a financial crisis of any sort, a central banker’s first duty is to run to the monetary valves and open them. This I did in 1987. I was new to the job and probably didn’t open them enough. The U.S. economy lagged its rivals in Europe for several years. My old boss, George Bush, the elder, lost his bid for re-election in 1992 and blamed it on me. I resolved never to make that mistake again. Faced with a slew of challenges, shocks, uncertainties, crises and elections…ever thereafter, I made sure that every valve, throttle, level, switch and sluice gate was wide open.

But it was on December 5, 1996, that I had my first epiphany. That was the year that I made my celebrated remark about stock prices. I wondered aloud if they did not reflect a kind of “irrational exuberance.” In truth, whether they did or did not, I do not know. But what I came to realize was this: 1) People, especially my employers, actually wanted prices that were irrationally exuberant. And 2) they could become far more irrationally exuberant if we put our minds to it.

I was 70 years old at the time. I had weaseled (why not be honest about it?) my way to the top post by knowing the right people and by making myself generally agreeable, and helpful, and by not saying anything anyone could disagree with. That was the original reason for what the press called “Greenspan speak.” My private thoughts remained mine alone. All the public and the politicians got was gobbledygook, but for good reason.

They would not have wanted to hear what I really thought. So, I did not tell them. For I knew well and good what generally happened when politicians and central bankers got their hands on soft money and a compliant central banker. I was not born yesterday. They use their control of the money to cheat people. It is as simple as that. (I explained this early on in my career; fortunately, no one bothered to read what I wrote. Otherwise, I never would have gotten the job.) If central banking were an honest métier, there would be no reason to have it at all. Private banks could do the job better.

But people are ready to believe anything. Somehow, they think that a collection of rich financiers and power-mad politicians got together to create and run a central bank for the benefit of the people! Well, I’ve got news: it doesn’t work that way. Money is only valuable when it is rare. It is like stock in a company. The shareholder is happy to hold a few shares. But imagine how he would feel if the company issued a few million more shares. His own ownership of the valuable thing is diluted. He would be cheated.

Likewise, an honest banker cannot dilute his depositors’ money. He cannot create real money “out of thin air,” as if he were issuing new share certificates, without cheating his clients. But that is exactly what central bankers do. They issue a certain amount of currency. Then, they issue more and more of it. So, the people who got it and saved it lose a little bit of the value each year. In effect, the value is lost by the savers holders and captured by the people who control the currency. It is really a very simple swindle. Who but an octogenarian Fed chief, on his way out the door, would have the courage to say so?

People today act as if they had invented money themselves. But money, central banking, and currency debasing have been around a long time. In 64 A.D., Nero decreed that the number of aureus coins minted from a pound of gold would increase from 41 to 45 (each coin would be about 10% less valuable). The silver denarius, meanwhile, lost 99.98% in the five centuries before the sacking of Rome. Paper sheds value even faster. The dollar has lost 95% of its purchasing power since the Fed was set up to protect it in 1913.

A successful central banker, in the age of compliant paper money, is one who is able to control the rate of ruin so that the rubes don’t catch on. A little bit of inflation, they believe, is actually healthy. Haven’t the economists told them so? Issuing a little bit more money each year makes people feel richer…so they spend more; they hire more people; they build more houses. Everybody is happy. Everyone feels richer. What an elegant fraud! It’s almost a perfect crime, because no one objects as long as it is done right. (My replacement at the Fed, Ben Bernanke, specializes in controlling the rate at which central bankers can steal from dollar holders without getting caught. He says that if necessary, he’ll “drop money from helicopters” should the currency fail to lose value fast enough. I predict that there will be a lot of people who will want to drop him from a helicopter…for reasons I will explain here.)

I return to my narrative. After I made my remark about “irrational exuberance,” I was called into Congress. The politicians who confronted me were the usual oafs and know-nothings. They made it clear that if I wanted to hold onto my job, I would have to stop worrying whether asset prices were too high; instead, I would need to do all I could to goose them up! It was on that very day, I recall it well, that what I had previously seen only in foggy theory came out into the clear, bright daylight of applied central banking.

No one wants honest money. No one. The politicians, bankers, investors, voters, and householders – anyone with a voice in the matter wants “easy” money. It is just too delicious to resist. (I wondered what kind of a central banker would stand against them; he would need a backbone of titanium like Paul Volcker, and a head as thick and hard as a vault.) Debtors want a little inflation to lighten their burdens and put a wind to their backs. Creditors want inflation to swell their asset values. Politicians want to be re-elected. Businessmen want customers with money to throw around. Is there anyone who doesn’t appreciate a little inflation?

And yet, of course, I always knew the answer. Easy money only works by defrauding people into thinking they have more money than they really do. Easy come; easy go. They get it; they spend it. Before you know it, you have a boom. But people soon adjust their expectations. Prices rise to catch up to new money. Debt levels increase, and with them come heavier debt service costs. The magic fades. What can a central banker do? He can do the right thing. He can “take the punch bowl away,” as my predecessors used to say. But this is where the trouble begins. Take away the punch bowl, and they begin punching you! I recall they burned Paul Volcker in effigy on the Capital steps when he did it. They would have burned him alive if they could have gotten their hands on him.

Why should I, Greenspan, suffer such a fate? No, it was not for me. This was the “golden predicament” I faced. Yes, I knew well that the nation would be better off if the punch bowl were removed, but I knew that I would be removed too, if I did it. And I knew, also, that it would be just a matter of time until the pressure for easy money would overwhelm any resistance a Fed chairman could put up. No pure paper money system has ever lasted. People can never resist the temptation to make the money easier and easier…until it is so wobbly and woozy it falls on its face. It’s better that it falls sooner rather than later. It’s better that the lesson is taught now, rather than 10 years from now. It’s better that the lean times come on the next man’s watch, not on mine! That’s what I owe to old Ayn; she taught me who rules Greenspan - Greenspan! Ayn taught me the number one rule: Look out for Numero Uno.

I remember it so clearly. I was sitting in a House committee hearing room. My tormentors kept asking questions. I kept giving the kind of answers for which I later became famous…answers that didn’t say anything. And I thought to myself: if these lardheads want easy money, I’ll give them easy money. I’ll give them the easiest money the planet has ever seen! I’ll give it to them good and hard!

And so, I did.

Since I joined the Fed, outstanding home-mortgage debt has jumped from $1.8 trillion to $8.2 trillion. Total consumer debt went from $2.7 trillion to $11 trillion. Household debt has quadrupled.

And government debt, too, exploded. The feds owed less than $2 trillion in the second Reagan administration, a figure that had been almost constant for the previous 40 years. But under my direction, the red ink has overflowed like the Nile in flood - to over $7 trillion.

During the two terms of George W. Bush alone, the feds have borrowed more money from foreign governments and banks than all other American administrations put together, from 1776 to 2000. And more debt will be added in the eight Bush years than in the previous two hundred. The trade deficit, too, more than tripled since I’ve been at the Fed, from 150.7 to 756.8 billion, and will reach $830 billion in 2006. When I came to power, the United States was still a creditor. Now, it is a debtor, with more than $11 trillion worth of U.S. assets in foreign hands, a more than 500% increase since 1987.

Who can argue with such a record? Who can compete with it? Who would want to?

But that is the smooth, perverse pleasure a cynical old man takes in his achievements. I have practically ruined the nation, and I know it. If you
distributed the cost of the federal government’s programs, promises, and
pledges to the voters, along with the nation’s private debt, the typical
household, and the nation itself, would be broke. And yet, almost everywhere I go, I am revered as a maestro…saluted as if I were a war hero. It is as if I had won World War II all by myself. The same numbskulls that wanted easy money 10 years ago, now praise me for causing what they call “The Great Moderation,” as if there were anything moderate about America’s borrowing binge.

Others say that my real legacy is that I finally “made central banking work.” Yes, I made it work…just like it’s supposed to work, giving the people enough rope so they could hang themselves. That’s what they’ve done. Now, they dangle from a long rope of mortgages, deficits and credit cards.

And I am delighted. Soon, people will be able to see how central banking really works. And poor Ben Bernanke will get the blame for it. He and his stupid helicopters…he almost deserves it.

Regressive Taxation In America -- Capital Gains and Social Security

David Hackett Fisher in The Great Wave asserts that it is a common feature of the peaks of price cycles that elites have sufficient power to shift the burden of taxation onto the lower classes. See my post here for more discussion of this tremendously important book.

Progressivity has long been a supposed feature of American taxation. This only makes sense. People like Bill Gates really should have to pay a far greater percentage of their income in taxes than your typical single working mom. While hard work certainly have a lot to do with success, much financial success really is the result of luck, being in the right place at the right time: the Bill Gates factor.

But is American income taxation really progressive? I believe that, rather than being progressive, American taxation is actually regressive and that it is becoming dangerously so. This for two main reasons: 1) capital gains tax treatment, 2) social security taxes.

Capital gains taxation treatment is a fantastic loophole for the weathly. Instead of taxing people on the increase in the value of their assets at the end of the year, gains remain untaxed until "realized," i.e. when the asset is sold. As a result of this fantastic loophole, businesses have an incentive to return value to shareholders in the form of capital gains rather than dividends. It is for this reason that so many companies use their cash from operations to buy back their own stock rather than use that cash to increase the dividend paid to shareholders.

Dividends are taxed at the end of the year. Capital gains from an increasing stock price are not taxed until the shares are sold. This allows the gains to compound tax-free, much like an IRA or other tax-advantaged investment vehicle.

Ultimately, shareholders (or their heirs) will pay tax on the gain but only after benefitting from tax-free compounding over the years. And then when they do pay tax it is at lower long-term capital gains tax rates which can be half of the tax paid on ordinary income. Since it is primarily the wealthy who generate a significant percentage of their income via capital gains, this represents a major, well, loophole in the tax code.

The other major problem in the tax code is Social Security and Medicare. The fact is that the government has been using Social Security and Medicare revenues to fund the expenditures of the federal budget for many years now. The government currently owes the Social Security "trust fund" some 4 trillion dollars. Social Security taxes are paid only on the first $90,000 or so of wage income. Interest income is exempt, dividends are exempt, capital gains are exempt. These are taxes paid by wage slaves and no one else. The question is: why are we taxing the working class so heavily to fund general expenditures when the rich get off scot-free for years and then only pay at half the normal rate?

But, you say, Social Security payments are not a tax, they are contributions to a retirement plan of sorts. Contributors will receive benefits comparable to what they have paid in. Sure.

The net return to date of contributions to the Social Security system has been zero. Thus, at the very least we are talking about forcing working class folks to make interest-free loans to Uncle Sam to fund the government budget deficits. But the real question is: will current "contributors" ever receive anything of comparable value in return for the money they are forced to pay? And if they don't, isn't this really a way of funding the government's outrageous expeditures by taxes that fall primarily on those least able to pay them?

Is the government really going to increase taxes on income sufficiently to repay the 4 trillion dollars we owe to people who have paid into Social Security for all these years? Or will they just print the money and hand it out? But, you say, Social Security payments are indexed for inflation. If the government just prints the money, it will increase the payments and recipients will get their fair share.

Yes and no. First of all, the government can manipulate the inflation numbers as it does now to underreport the effects of its dollar printing. Secondly, Social Security payments are only adjusted once a year, and as a result accelerating inflation, if sufficiently great, will escape the effects of indexing.

Of course, this is a recipe for hyper-inflation.

Which is why I say: buy gold. Sell stocks, sell real estate, most of all sell bonds. And buy gold.

Intel and Citigroup Offer "No Guidance" Going Forward -- GE's Profit Plunges

Not only are earnings coming in below expectations as the economy slows down, but companies are now stopping the practice of forecasting earnings and revenues for next quarter and the year ahead. According to Citigroup, it is "not in the business of giving guidance."

Is the business outlook so bad that a fear of lawsuits has major companies afraid to make any earnings forecasts at all? Now that is scary!!

Buried in Citigroup's earnings report: consumer bankruptcies cost the company $600 million. "On a managed basis, net credit losses due to new bankruptcy legislation were approximately $600 million pre-tax." And the bankruptcy wave is just begninning as declining real estate prices remove the one prop that was staving off BK for so many consumers: the cash out refi.

Not surprisingly, the stock market sold off 2% on Friday. More is coming. There has been so much emphasis on interest rates and what the Fed will or won't do, that people have lost sight of the fact that companies need to show sold earnings growth to justify current price to earnings ratios (now close to 20 for the S&P 500!)

Over the past few years companies have been able to use financial manipulation and interest rate plays to juice up earnings. The inversion of the yield curve, however, is making that much more difficult. GE is typical. It's earnings are down 46% compared to last year. While this decline was attributed to the sale of insurance businesses, the real story is that GE's insurance businesses lost a ton of money. So what does GE do? They sell off the unit at a loss and then say, "... earnings from 'continuing operations' are up 10%!"

Sure. If you sell off all your money-losing businesses and just keep those that improved over last year you can always "grow earnings."

GE stock sold off significantly on Friday and the rest of the market sold off with it. With earnings of .29 on the quarter, GE's P to E is around 20. But revenue growth (excluding acquired businesses) is only 8%. Earnings growth is negative. This is a $15 stock, not one that should be trading at $33.

Dow 5000, baby!

The Oil Weapon and Iran -- Every Exporting Nation Is Now An OPEC In Its Own Right

An insightful article in Al-Ahram Weekly from Cairo discusses why the Iranians have decided to go forward with their nuclear program despite the political risks attendant upon international disfavor. According to Al-Ahram conservatives within Iran have made joining the nuclear club the central principle of their dreams of national prestige. Iranian conservatives must move forward on building the nuclear bomb if they are to retain any credibility at home.

It is interesting to note, however, that Iran's "move forward" is coming at a time when oil exporting nations are in a position of tremendous power. Because demand and supply are now so tightly balanced, the Iranians know that sanctions against Iranian oil exports would be suicide for the West, China, Japan and other oil importing regions.

Of those nations on the UN Security Council, only Russia would stand to benefit from $100 oil, and Russia has stated, perhaps a little slyly, that it opposes sanctions.

The present situation is reminiscent of the days before the 1973 oil crisis. As crude oil demand exploded in the early 70's and as America passed its own "peak oil" in 1971-72 and was unable to keep up, power shifted to the oil exporting nations in OPEC. This pricing power over such a vital commodity inspired geopolitical assertiveness, the nationalization of Middle Eastern oil fields and an embargo against the West to punish America for its support for the Israeli military in their war against the Arab nations.

What is fascinating about the current situation is that no country has sufficient excess capacity to replace the exports of any significant oil exporting nation. This makes every oil exporter of any size equivalent to its own OPEC, capable of sending oil prices dramatically higher by removing even so little as a million barrels a day from worldwide production.

As worldwide demand surges ahead, prices are headed higher. A supply interruption would only accelerate the upward move in prices. The Iranians know this, and thus they can (or believe they can) act with impunity. Iraqi oil production declined to negligible levels after the Iraq War began in 2003. A loss of Iran's 2.3 million bpd of exports even for just a few months would be catastrophic.

What will America do? The signs don't look good. Dick Cheney said just a few days ago that even though a price spike is likely over Iran, "$100 oil is better than a nuclear-armed Iran." Yikes!

My concern is that $100 oil is coming without problems in Iran. What we may well get is $150 oil, and that will sound the death knell for the post-real estate bubble economy of this nation.

2006 Predictions, Or the American Jalopy at 150 MPH

It seems everyone in blogistan and in the financial press is making predictions this January. So, after some initial hesitation, I figured I might as well weigh in with the following. Bear in mind. I do have an authentic gift of prophecy.

The vision I see is this: picture an old jalopy, a vehicle bearly hanging together, ready to experience what the doctors call "multiple system failure." Will it be the steering, the brakes, the engine, or the transmission that fails first? Or will the wheels just fall off? Now picture this jalopy, let's call her "America", barreling down the highway at 150 mph.

Who would drive such a vehicle at that speed? George II? the American consumer? As if it matters. We are all driving or at the very least we are in the passenger seat.

So the question for 2006 is: what breaks first? Take your pick: is it the engine (real estate bubble)? The steering (stock market bubble)? The brakes (debt bubble)? Or is it the transmission (peak oil)? Or will the wheels just fall off (globalization and our $800 billion trade deficit)?

My guess is that everything will probably come flying off at the same time. In case you missed it, housing has peaked and is now headed down. Get ready for a 20% drop in housing prices at least in those areas that saw prices double since 2001 (California and the Atlantic Coast). Other areas will see more moderate losses.

The refi boom has also ended, consumer spending is pulling back. Adjustable mortgages are resetting higher. Energy costs continue to rise. A recession is coming, although it will take us until 2007 to admit that we are in one. Expect a 20% drop in the stock market by year end. Small and mid-cap stocks could lose 30-40%. The trade deficit may shrink somewhat, but the dollar will still fall sharply, say 15% on a trade-weighted basis. This would mean roughly 100 Yen to the dollar and the Euro at $1.35.

Oil will spike to $150 and end around $100. Gas will spike to $4.50 and settle in around $3.00 a gallon.

Gold will continue on its manic run as people sense what is in store. Expect gold to close the year significantly above $600 an ounce.

Call me crazy, but this old jalopy is falling apart at the seams and moving way to fast.

So, by year end: Dow 9000, oil $100, California real estate down 15%, gold at $650, the US Dollar at 110 Yen and $1.35 to the Euro.

Don't say I didn't warn you.

China Holds Crude Oil Import Growth to 3.3% in 2005, But What About 2006?

Crude oil prices have been moderate since the Katrina peak of $70. In part this appears to be due to considerable efforts on the part of the Chinese to limit crude oil imports. Import growth in 2005 was only 3.3% despite the fact that the Chinese economy grew at a roughly 9% pace during the year.

According to reports on Oilcast.com (Show #27) this was accomplished by using price controls to create shortages of refined products. But the question remains: how long can the Chinese keep the lid on demand?

The correction in the price of oil bottomed at $55 in November. Now, we are at $67, just $3 shy of the all-time peak. Yet, because there is plenty of refined product in the US market, gas prices are fairly moderate. The public is unaware that crude oil prices are marching steadily upward. Like the frog slowly being boiled, the American consumer has no idea what is happening.

The present run in crude prices should take us to $90 to $105 by summer. The resulting run up in gas prices will take America by surprise. "I thought gas prices would go back down after the Katrina shock, so I went out and bought a new Suburban. They were cheap." It is as if we all have to play our role in this tragedy that is Imperial America. There just isn't any helping it.

The fact that the price spike this summer was accompanied by a hurricaine allowed Americans to file it away as a "one time event." The real estate bubble also prevented people from recognizing the need to reduce consumption. If you are a (bubble) millionaire, what is an extra $40 per week to fill up the tank? But now home prices are falling, and that $40 might be needed to help pay the (adjustable) mortgage that just went from $1800 to $2200.

China is the key: if Chinese imports grow anything close to 9% this year, get ready for an epic run in crude oil prices, perhaps as high as $150 by year's end.

That and $4 gas should get everyone's attention. Ya think?

Price Revolutions and Peak Oil

One of the most profound influences on the history of civilizations is the prices of basic goods (primarily necessities) relative to wages and rents. David Hackett Fisher's brilliant work The Great Wave shows how gradual changes in prices over the course of one or more centuries result in tremendous transformations of society. In the most simple example, if wages decline steadily and the price of food and energy rises steadily for many decades eventually a society enters a crisis caused by the simple fact that people who are unable to feed themselves or their children are prone to revolution (think Paris, 1789).

Fisher shows how periods in which wages are high and prices and rents low alternate with periods during which wages are low and prices high. These periods are of varying length but tend to last from 100 to 200 years. Good times (at least for workers) result in increased child-bearing which results in more workers. More workers means more competition for work, lower wages. More workers also means more demand for food and energy and thus higher prices for food and energy. Ultimately, workers are squeezed to the point where they cannot even feed themselves or their families. Child-bearing drops precipitously and the cycle proceeds until wages increase and prices decrease.

Fisher shows how the crisis periods of European history coincide with peaks of prices for food and energy and troughs of wages. The 14th Century in which famine and plauge reduced Europe's population by 25%, the 16th Century with its incessant strife and religious wars, the late 18th Century with its revoutions and widespread warfare: all these periods occurred at peaks in the price cycle.

Fisher is a liberal economic historian and so equates the periods of high wages and low prices with "good times" and periods of low wages and high prices for food and energy with "bad times." In some respects, it really depends on whether you are a worker or a landowner (or employer), however. For landowners (or employers) periods of low wages and high prices are ideal. Rents are high because there is high demand for farmland. Employing servants or other workers is less burdensome. In general, there is a premium on capital (and land) relative to labor and returns on capital are high while expenditures for and returns to labor are low.

As an American, my own bias is to view the more egalitarian periods in which labor is at a premium and the capitalists are getting squeezed as closer to the ideal, but this is just a political preference and is not relevant to understanding the historical processes at work. What is clear, however, is that the more egalitarian phases are more peaceful politically.

In the 20th century, scarcity of natural resources replaced scarcity of food as a cause of conflict. Feuding classes were replaced by feuding nation states. A burgeoning Germany wanted its share of global resources and two world wars were required to determine whether Britain, France and their new ally America would be forced to share these resources with Germany. The basic pattern, however, was the same: a peaceful period of prosperity (1815 to 1914) results in rising population followed by a disastrous period of conflict over increasingly scarce resources.

So where are we now? The entry of the former Soviet Union, China and India into the capitalistic system has resulted in an extraordinary increase in the pool of skilled labor available to capital. Thus, returns to labor are low and look to be under considerable pressure in the future. Wages are falling in real terms. At the same time, the entry of all these workers into the global economy is increasing demand for food and energy.

Returns to capital have been tremendous with the stock market and real estate generating enormous wealth in a relatively short period of time (1985 to 2005). Large multinationals have benefited from the excess supply of labor by being able outsource factories to low-cost areas and keep domestic wages low by the mere threat of such outsourcing.

Ordinary Americans are getting squeezed as wages stagnate and prices for food and energy rise. This trend can be expected to continue for the forseeable future as China and India are still just beginning to industrialize and the resources available for such industrialization are severly limited.

Peak oil is often presented as a discontinuity with the past, but the cycle is itself very common throughout history. Many times during the past 800 years, Europeans came up against the limits to how much food they could grow in their little corner of Western Asia. The result was typically a die-off (warfare, starvation, and infectious disease killing the malnourished). Politically, it was chaos and mayhem. A similar fate is in store for us. As wealthy westerners we will be able to eat. But the competition for energy will result in significantly reduced standards of living. Inevitably, there will be warfare, chaos and conflict, both at home and abroad.

The cycle is being greatly accelerated by the rapid pace of modern history. Globalization will result in the current cycle being the first that takes place everywhere at once on the entire planet. But make no mistake, this is the same cycle that we have faced for thousands of years.

A poet once wrote: the race is not to the swift or the battle to the strong, but time and chance happen to them all. For all our virtues, for all our technology, time and chance still play their role in determining our fate. Those young among us have been born into a world of too many people, and to few resources, the only question is what can we do to make their world better and more secure.

Cassandra

The China Factor

I found the following comment to a post on Brad Setser's Blog tremendously perceptive and reprint it here in its entirety. The comment was in response to a post in which a Chinese official acknowledges that ultimately the value of all the dollars Asian central banks have accumulated (as part of their currency manipulation to boost exports) will lose much of their value.

"... all east Asian countries have tremendous foreign exchange reserves and they all want to get rid of them, but if you do this then you cause competitive devaluation, not of their own currencies, but of the US dollar. So we should do this in an orderly fashion. If Asian countries moved too fast, everyone would lose..."

To this, JM commented:

The passage from which the above was extracted keeps using the word "if", but there is no "if". When you lend things of value to someone who has no way to repay you, and never will, then your loss dates from the instant that you lend, not from whatever future time at which you finally admit to yourself (or the true owner of what you lent) that you'll never be repaid.

We must all keep in mind that money is a medium of exchange, and has value only to the extent that you can exchange it for something of value.

For what things of value can the Asians exchange their dollars? And what value have those things compared to the value of the things they sent us to get those dollars?

To avoid loss, the Asians would have had to have consistently demanded that if we wanted them to send us things of value we must promptly send them something of equal value in return.

But they didn't, because for that to happen with money as the medium of exchange, they would have had to ensure that exchange rates were always such as to make it worthwhile for Americans to make and send such things (and would also have had to dismantle their myriad non-tariff trade barriers). But that would have led to various privileged elements within their societies losing their positions of privilege. So they didn't.

What is going on here can be properly understood only by viewing it as a variant of the vendor-financing frauds of the telecom bubble years.

By lending their customers the money to buy their products, Nortel, Lucent and others made it appear that they were making lots of money. But they weren't, because there was no way that their customers could ever get the revenues to repay the loans, and indeed the very making of those loans acted to ensure that, by creating telecom capacity far in excess of demand.

Similarly, by lending us the money to buy their products, Asian governments (esp. Japan and China) keep their citizens busy and believing that all is going splendidly. But the very making of those loans ensures America will never be able to repay them, by destroying the only American industries that could create the things we might repay them with.

If this were only a result of true "comparative advantage", there would be no serious problem, as it would just ensure a more optimal allocation of American resources. But prices are the fundamental signalling mechanism through which resource allocations are to be optimized, and exchange rate manipulation systematically falsifies prices.

The trillions in reserves now piled up in Asia represent a massive accounting fraud inflicted on the the people of Asia by their governments, analogous to the frauds inflicted on the shareholders and workers of Nortel and Lucent by their managers. In the case of Nortel and Lucent, there were regulators that could call them to account, and force the losses to be recognized. But in the case of the Asian governments who or what could do that? Can this fraud in fact be sustained forever?

Has the scale of the fraud not already grown so great that none of the Asians can face up to it? Is that not implied between the lines of ...'s remarks? He says, "If Asian countries moved too fast, everyone would lose..." But they've already lost. They have exactly the same problem Enron had with the assets it shoveled out into its "special-purpose entities" -- it wasn't that the assets were such that selling them would drive down prices down below their true value, it was that it would reveal their true value. Any pace the Asian countries may move at, if fast enough to reduce their reserves, will send the dollar down to its true value.

Why are Chinese workers and business owners willing to do 8200 yuan worth of production to get $1000? Because the can exchange that $1000 for more American goods and services than they can get for 8200 yuan? Hell no, 8200 yuan in China buys as much as $5000 in America. At the very instant that they accept payment they have lost $4000.

The only reason Americans can buy 8200 yuan worth of stuff for $1000 is that the Chinese government guarantees its people that it will give them 8200 yuan in exchange for the dollars. Where does the government get the yuan? It prints them. Where does the $4000 dollar loss go? It is spread across the entire economy, so that in effect everyone in China has that much less deferred buying power than they think. But it's not a deferred loss, and it's not a loss they can somehow avoid by selling off the dollars at some measured pace. All that's deferred is the recognition of the loss.

Perhaps there's no real loss anyway. Perhaps had the workers and businessmen been told Americans would pay them only 1640 yuan for the goods, they'd have made them for that anyway. But I think not.

PS: Because a large fraction of the Chinese trade surplus with the US is actually an indirect Japanese trade surplus, you could substitute the Japan for China anywhere above with equal validity (except that the Japanese will only send us about $1500 of stuff for a $1000 dollars).

Written by jm on 2005-12-17 13:37:43