Is M3 Important?

There is interesting discussion on Paul Krugman’s NYT blog today regarding monetary expansion and the Great Depression. For the current crisis, I think you need to look at the divergence of M2 and M3. As institutional money market investors fund commercial paper that funds asset sales by originators, M2 is converted to M3. The money multiplier becomes unlimited as the original reserves used to fund loans are returned in full to the banking system with no new net increase in deposit liabilities. What’s happening right now is the reverse – M3 is liquidating and the monetary base is expanding to, in part, accommodate the conversion. If you look at Institutional Money Market Funds on Z.1 you will see the reductions in this (and, I believe other) components of M3 relating to credit expansion in the modern financial system. I have been waiting for the next Z.1 to confirm these movements.

I believe M3 is important, notwithstanding the Fed’s decision to stop publishing it. I have not concluded that the M3 expansion is the cause of the bubble, but it certainly shows how monetary expansion and, in particular credit expansion, contributed. I plan to post more on this after the holiday weekend.

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Oil and Speculation - Again

OK, more on speculation and oil prices. I have followed Paul Krugman’s reasoning for a while on the oil price/speculation issue. His reasoning is very solid and at first blush seemed unassailable to me. His basic model on spot and future prices can be found here and I think is really worth a read. To give a brief summary, the logic is that if excessive speculation in the futures market was driving prices in the spot market there would be a couple of signatures we could observe. The first signature would be future prices that exceed spot prices (a condition called contango) providing the incentive for producers to withhold product from the market. Why deliver it today for $120/barrel when I can deliver it tomorrow for $125/barrel? Sell it tomorrow at a higher price rather than today at the lower price. (Note that holding current supply from the market would cause spot prices to increase and the aforementioned inventory build.) The other signature is that there should be a build in inventory as oil is held off of the market for delivery in the future. Neither of these signatures is evident in today’s market, however, so the conclusion is that speculation in the futures market is not impacting oil prices. To see this on his graph I have reproduced a modified version here.

The blue lines represent the original graphs (as drawn by me using crude tools). Expected appreciation is the curve on the left graph, and if future prices are expected to exceed spot then expected appreciation is positive (contango). If spot prices exceed future prices we get negative expected appreciation (backwardation). Equilibrium that determines the spot price is the intersection of expected appreciation and carrying costs. Looking at the blue lines, the typical argument that future prices are driving up current prices suggests there is excess supply (the supply being held off of the market). This would be the other signature – inventory build.

This model assumes, however, that supply is fixed. If I want to deliver less oil today, I must store the excess. What if instead producers are making output decisions that are influenced by future prices. Strong future prices at lower volumes of output would suggest less elastic demand, which in turn would suggest lower output for profit maximization. I illustrate this using the red lines. If the supply curve shifts to the left because of distortions caused by strong future demand, current output equals current demand and we are in backwardation at the same time spot prices are impacted by future prices. If strong future demand is impacting the output models of oil producers this model could explain why the signatures we would expect to see are absent. I have no particular experience with the oil industry and don’t know whether they set production based on models or based on maximum capacity. If they use supply and demand models, as I would suspect they do, then strong speculative demand for future delivery, particularly in the physical delivery market, could have a meaningful impact on spot prices through output model distortions. (I note that if in fact producers are setting output at lower levels than they otherwise would the lower level of supply could appear as a peak oil issue.)

All input welcome. I am not an expert on this topic and want to learn!

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Oil and Speculators – Anecdotal Evidence

There has been a lot of debate going on about whether or not speculation is driving up oil prices. I haven’t taken a position one way or the other. I am not an expert in the commodity markets and I have been impressed with the evidence on both sides of the argument. Paul Krugman has done some interesting analysis (see this post and follow-up posts throughout the month of June) on this issue ultimately arguing that speculation is not driving oil prices. He points to the lack of inventory build that would be present in a traditional speculative driven market resulting from owners holding product off the spot market to sell at higher future prices. On the other hand, some very smart investors and former regulators have been arguing that speculation has caused somewhere in the neighborhood of $50/barrel of the price increase in crude. Finally, there is the common sense issue. Financial markets fall apart, stocks and bonds become less attractive investments, the housing bubble bursts, and suddenly there is a sharp increase in the price of a commodity that just happens to be in a market that was partially deregulated several years ago. This last part sounds too familiar to me to be ignored.

Today, I was watching the testimony of Ben Bernanke before Congress when the subject of speculation in the energy markets was raised. It was clear that Congress is serious about passing some regulations to address margin requirements and possibly other issues in this market. Suddenly oil dropped $9.00 a barrel from around $145 to $136. That’s a 6% decline within minutes. Now, whether this price drop was caused by the congressional testimony or not is something I cannot determine. The CNBC commentators are saying the cause of the price drop is banks liquidating their energy positions to meet capital requirements. Isn’t that speculation? And look at this coincidence: the investment banks decided it was a good time to unwind their energy position right at the moment it became clear Congress is going to act on the issue of speculation in the oil markets. Do you believe in coincidences like these?

Rational economic arguments aside, the anecdotal evidence suggests that “speculation” is having a meaningful impact on oil prices.

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A History of The Great Economic Collapse of 2008

Looking back several decades at the economic downturn in the United States that began in the third quarter of 2007 and lasted for the better part of a decade, the causes seem predictable and inevitable. The United States had been consuming more than it produced for many years, running massive trade deficits. At the same time consumers were borrowing from international sources of capital to finance consumption, the United States Government was also running budget deficits, financing its expenditures largely from foreign investors and the retirement funds of the baby boom population – some 75 million Americans. Some of this over-consumption was funded through asset sales, especially after the initial decline in the dollar, as foreign investors thought they were getting bargains purchasing US assets.

The cracks in the system began showing up in earnest in 2007 with the great Subprime Mortgage Meltdown. This crisis in the subprime real estate market ultimately spread to the rest of the market and triggered an exodus of capital from the financial system as investors realized they had been taking on too much risk for the promised returns. Notwithstanding valiant attempts by the Federal Reserve to provide liquidity to the banking system, the risk re-pricing forced historic write-downs of assets on the books of the major banks, both commercial and investment, resulting in capital shortfalls at the major institutions. The first bank to experience a run was the 83-year old investment bank Bear Stearns, which was temporarily kept afloat through emergency loans from the Federal Reserve. This marked the first time such a loan was made since the Great Depression of the prior century. The resulting lack of financing into the economy drove investment to levels not seen in decades and unemployment soared. At the same time as the employment picture soured, many in the baby boom generation were retiring. Unfortunately the insolvency of the Federal Government resulting from tax cuts for the wealthiest Americans and deficit spending required massive cuts in health care and social security as well as large tax increases, further depressing the economy. A massive portion of the population retired into poverty.

In an attempt to fight both the re-pricing of assets and the lack of financing in the economy the Federal Reserve lowered interest rates dramatically, from 5.25% to 1%, at the same time inflation was running up. The interest rate targeted by the Federal Reserve at the time, the Federal Funds Rate, was negative in real terms for the second time in a decade. Unfortunately, these lower rates did not pass through to borrowers because the banks’ lack of capital prevented them from making loans regardless of how low their cost of funds was, and the fear of insolvency prevented banks from lending to one another which was how the system worked at the time. In fact, the monetary easing resulted in a further flight of capital as investors sold dollars to invest elsewhere where returns were better. The resulting fall of the dollar was also historic in nature as it hit all time lows against a basket of currencies week after week. This would have been a bright spot due to its impact on net exports, except that the decline in the US economy spread to the rest of the developed and developing nations reducing demand for exports.

Ultimately the Federal Government had to step in and bail out the financial system that had profited so handsomely for many years prior to the meltdown. The size of the bailout dwarfed the S&L bailout that was still visible in the rear view mirror, enraging much of the population. At the same time, those who had amassed fortunes during the boom years were able to acquire vast holdings of productive assets thereby widening the already large gap between the wealthy and the poor. Despite passing law after law and amending regulation after regulation in favor of the banking lobby for two decades, Congress professed shock at the actions taken by some of the major financial institutions during the ensuing hearings. The conflicts of interest of the rating agencies, the off-balance sheet accounting, the lax capital requirements, and several other issues resurfaced in the public view. Once the population at large learned that all of these issues had been brought to the attention of Congress years before, but ignored at the behest of the finance industry, there was a near revolt in the streets. This resulted in what we now refer to as the Great Political Restructuring.

Between the devaluation of the dollar and the massive infusion of funds to rescue the financial system inflation raged out of control for some time until the collapse progressed, after which deflation took hold as the world economy followed suit and demand for everything fell off globally. The lessons of this era remained strong and bank regulation was revised and strengthened. However, due to advances in technology and other systemic changes, the banking industry is now lobbying Parliament for additional powers such as combining their commercial and investment banking operations and allowing them to export interest rates from their home state to other states. They are also seeking reform to the bankruptcy laws and a declaration of Federal Preemption for protection from state regulators. Some argue that we should honor the lessons of the past and deny these powers to the banks, especially since the banks are ultimately backed by the taxpayers as lender of last resort. The neo-neo-conservatives, however, argue that the free markets will provide better competitive results for all consumers and the bankers, notwithstanding their incentives to take excessive risk, will adequately manage any potential risks to a systemic crisis. Paul Krugman, the sage economist now in his 98th year, declared such proposals outrageous and claimed they will lead the economy on a path to great divergence of wealth and the rebirth of the poverty population. Larry Kudlow, the underground talk show pundit whose age none can ascertain, pronounced this to be a great day for America, the likes of which he has not seen since the Great Political Restructuring. Time will tell which of these elder statesmen is still connected to the political economy and which is simply disconnected.

[Of course, I hope none of this is true and we see a rebound in the second half of 2008 as many predict. I just could not help having a bit of fun with this. I may do a serious analysis if time permits.]

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