The Great Game

For those of us who work in the financial industry, these are interesting times. But even those who have nothing to do with Wall Street have a stake in what's happening below the surface of our economy. This is particularly true in light of the government's response to Katrina, which will impact all of us. This post will focus primarily on oil. As I'll explain, I believe oil is the most important issue facing us right now, but not for commonly accepted reasons. This is a long post, but I don't think you can fully understand major geopolitical issues including Iraq, Iran, and China without also understanding some seemingly unrelated issues that are coming to a head right now. I'll try to keep the wonkishness to a minimum and make this accessible to most readers.

First, we need to dispense with some of the myths about oil that have gained acceptance recently through sheer repetition. One of these is that the relentless rise in the price of oil "acts like a tax on the consumer." This is nonsense. Taxes, as painful as they are, at least have some domestic benefit for those who pay them. Taxes build roads, maintain the military, and pay for public education. The majority of money we fork over at the gas pump simply leaves the country. It builds roads in Riyadh, Tehran, and Caracas. Another chestnut is that "oil is doing the Federal Reserve's job for it", which I heard yesterday on a business news show -- the implication being that Alan Greenspan and the Fed don't need to raise interest rates since higher oil acts to slow the economy just as higher rates do. More nonsense. Oil does not do the Fed's job; it reflects the job the Fed is doing. All else being equal, the more money the government prints, the higher oil goes. And indeed, over the past year all else has been equal. Despite the constant media hype about Chinese demand, last week Morgan Stanley analyst Andy Xie noted that oil's demand-supply relationship has not changed this year -- but oil prices are up about 70%.

You can thank easy money. Although the Fed continues to raise interest rates at a snail's pace from historic lows, the financial system is flush with liquidity. In real terms, monetary policy is easier now than at any time since the early 1970's when the U.S. was paying off the debts from another expensive war, and Federal Reserve chief Arthur Burns kept rates too low to help Nixon get re-elected. (By the way, you can listen to Nixon and Burns on the Oval Office tapes secretly discussing manipulating the economy and government statistics to boost Nixon's 1972 re-election chances at this link. It's a must-listen for anyone who naively believes the Federal Reserve is immune from political pressure as it is supposed to be. It's also relevant, as records indicate that current Fed chairman Alan Greenspan has been visiting the White House far more often than any of his predecessors.) This leads to another oft-spoken absurdity about oil: even though it's near an all-time high, "it's still well below its inflation-adjusted high" of the 1970's. In other words, the price of oil is rising due to inflation, but we've printed so much money over the past 25 years that we've made oil cheap! So goes that line of reasoning, which is cognitive dissonance, denial, and circular logic all wrapped into one. Want a good prediction on where oil will be trading a year from now? Tell me exactly what the Fed's monetary policy will be and how much liquidity will be created or drained over the next twelve months, and I'll give you a pretty good guess on where oil will be trading.

Of course, one doesn't need commodities like oil and gold (the latter hit a new 18-year high this week, by the way) to understand how much money the government is printing. Our wallets are good indicators. The price we pay for gas at the pump is only one manifestation of oil prices. Oil is reflected in the vast majority of our purchases including clothing, food, furniture, heating and air conditioning, and building materials. The government understates actual inflation by a variety of methods, one of which is stripping out the cost of food and energy to arrive at a "core consumer price index." But it's impossible to strip out inflation's unsettling and dangerous social consequences.

The rich and the poor both suffer during inflation. But on a relative basis, the rich do far better. Those who are hurt the most are middle and lower-income workers whose only source of income is a fixed salary, and senior citizens living off a retirement income that does not change while the cost of life's daily necessities inexorably climbs. Staying ahead of inflation takes capital; money must be leveraged and invested in hard assets to keep pace with the constant and ever-increasing debasement of the currency. All that Fed-created money flows through intermediaries including banks and brokers. That's one reason why the stocks of companies like Goldman Sachs, Lehman Brothers, and Bear Stearns are trading at or near all-time highs right now. Of course, insiders at those firms and others (such as the homebuilders) with a seat at the money-creation parade have done extremely well for themselves recently. Everyone else's inflation is their booming economy.

There are not many recent historical examples of an advanced industrialized nation relying on the fuel of debt and money creation to the extent the U.S. has done so during the past few years. Argentina is one, as well as Germany during the 1920's. The latter was a fascinating period. As Germany struggled to pay the debts and reparations from World War I, it resorted to epic printing of money. This impacted and disrupted German society on every level. Restaurant prices changed while customers ate. Workers immediately ran to buy something -- anything -- after receiving their paychecks, because prices rose by the hour. The wheelbarrows used to cart piles of money to the supermarket to buy food were worth far more than the paper money itself. In one account I remember reading, a Berliner came across an expensive bag left on the street and immediately discarded all the contents -- including the stack of worthless cash it contained -- and kept the bag to sell a few hours later.

But parts of German society did quite well during this chaos, particularly those with access to the river of money creation. This included the staid banker class, as well as leveraged stock and real estate speculators -- in other words, today's investment bankers, hedge fund managers, corporate insiders, and real estate flippers. At the height of its inflation during the early 1920's, Germany's stock market began a stunning climb that masked and defied the underlying economic chaos. This happened because people were desperate for any type of return on their money in order to meet their ever-increasing daily living expenses. Twenty-five year old stock traders got rich, while prudent savers and middle class pensioners lost everything to inflation. It is impossible to overstate the impact this had on traditionally conservative and ordered German society. The nation was turned upside down, and people were both fascinated with and enraged by the chaos that defined their daily lives. The public's reaction to this paved the way for the rise of Hitler, who railed against the "greedy money changers" who had benefited from the economic insanity. Importantly, Hitler's appeal increased exponentially after the great credit collapse of the early 1930's, when the inflation and debt creation of the previous decade unwound quickly. We know what happened after that.

Make no mistake: Weimar Germany was an extreme historical example of monetary policy gone bad. We ain't there yet. But the fact remains that our current level of debt and reliance on fiat money creation has very few historical parallels, and that is one of them. It would be foolish to disregard it simply because so much about Germany in the 1920's and 1930's is easily dismissed for its madness. Think about recent news reports like this:

One cab driver says he watched in amazement as a New York gas station billboard price was changed from $2.91 a gallon to $3.49 even as he filled his tank on Wednesday night.

Or this:

Jim Jundt was so determined to rein in his spending on gasoline that he got out of bed early and rode his 14-year-old quarterhorse mare to work.

Jundt lives 15 miles south of Minot and works as a mechanic at Goodyear Tire & Auto Service in the city.

He said he and his co-workers had been talking about rising fuel prices, and he joked that he would ride his horse to work if gasoline ever hit $3 a gallon.

Or this:

Amtrak announced Friday it will raise fares nationally to counter higher energy costs, with Northeast Corridor commuters holding monthly rail passes seeing a fare hike of about 50 percent. Amtrak said fuel costs have risen nearly 40 percent over a year ago and are expected to remain high.

Prices changing while customers wait on line, rising costs forcing people to alter daily behavior, the cost of basic public transportation skyrocketing to reflect ever-increasing energy prices, real assets like property and gold surging, hedge fund managers and real estate speculators profiled and praised constantly in the media -- while prudent savers and those living on fixed incomes fall farther behind every day, and rising inflation contributes to the bankruptcy of companies like Delta, Northwest Airlines and many others. Remind you of any similar historical examples?

As Germany proved in the 1920's, rising asset prices can occur despite deadly underlying weakness. I can't count the number of times I've heard financial pundits assert that all is well because real estate is strong and the Dow is only a few percentage points off an all-time high. Indeed, it "appears" everything is fine. And that's crucial. There is a huge amount at stake. This administration's fiscal program must work, or at least appear to work. If it does not, the entire strategy of encouraging consumer spending and priming the economic pump via tax cuts for the upper class will be discredited for a generation or longer. As a result, the pressure to take extraordinary measures is overwhelming. After 9/11, the Federal Reserve decided that it was never a good time for a recession or any type of economic weakness, including in stocks. That's incredibly dangerous. Recessions are needed to cleanse malinvestment and overcapacity. When government believes it has the ability to repeal the natural business cycle, bad things eventually happen; one truism of the financial markets is that there is no free lunch.

To maintain the facade that all is well in a system built on debt, policymakers must try to ameliorate the undesirable side effects of both inflation and rising rates. And that's exactly what the Fed has been doing for the past few years. Despite slowly raising rates, the Fed has been hurling liquidity at the stock market in an attempt to buoy prices. Remember, the Dow Jones is composed of only a handful of stocks, but it's the most important barometer of public psychology in this country. The behavior of that small group of stocks can paper over a lot of distress under the surface. Intervention in the stock market can occur in several ways. Ample liquidity is overt and indirect; the Fed tells everyone what it's doing, and liquidity flows through various intermediaries and eventually into stocks, bonds, and other assets. There's also another method: covert, direct intervention. This has been the subject of much debate in the financial community for many years. Some veterans of Wall Street believe that the government -- meaning either the Federal Reserve, the Treasury, or a proxy party working on their behalf -- has intervened in the past to directly prop up the stock market. Among those who believe this, the main question is how often it occurs. Based on my experience and various things I've seen and heard, I'm in the "often" camp. Last week, a respected investment house put out a report on this, which you can read here. It's interesting, and I recommend reading it. I believe the time has come for a national debate about this. If government-sanctioned intervention in the equity market is indeed taking place (as it has openly in Japan for many years, by the way) it has serious implications. These include the use of public money to buy stocks while corporate insiders are selling, select Wall Street trading desks profiting from knowledge of the intervention, and the ability to intentionally boost the market prior to an election or other event. Remember, much can be justified when a nation is "at war."

All this is important because it creates an atmosphere of moral hazard. Reckless risk taking is encouraged, because the public sees the government give a wink and a nod that it will be there as a backstop should problems occur. Often it's far more than a wink and a nod. President Bush just announced that the government is going to throw hundreds of billions of dollars into rebuilding the Gulf coast states after the hurricane. If you knew the government would pay for your temporary relocation, rebuild your house, give you a job, and send you a nice check after a natural disaster, would you buy insurance? Would you live in a place less vulnerable to a natural disaster? Would you evaluate your overall risk profile rationally and take appropriate measures to protect yourself? And importantly, what incentive does government have to live up to its own responsibility to prepare for disasters if the printing press is always available as a salve when something happens?

This national atmosphere of moral hazard has important implications. Don't think for a minute other nations do not see it. That might not matter in a less interdependent world. But since U.S. dollars are the planet's de facto reserve currency, the nations we send our paper money to have a keen interest in its real value. There are unmistakable signs of increasing tension about this. One is the declining value of the dollar relative to other currencies. Accompanying this has been the diversification into gold by foreign central banks, including China, Russia, Argentina, Venezuela, India and nations in the Middle East; gold closed this week at its highest level since 1987. Another more ominous sign of skittishness about the dollar is the increasing sentiment among nations in the Middle East, led by Iran, to trade oil in euros instead of dollars. Iran is taking this a step further and planning its own oil bourse to rival those in London and New York, the only two markets where oil trades internationally. This would mark an important shift in the oil and currency markets. (As a sidenote, in late 2000 Saddam Hussein made a big huff about accepting euros instead of dollars as payment for Iraq's oil.) Since oil is currently priced globally in dollars, using a different currency for both pricing and transactions would remove the only way outside of direct military action the U.S. exerts control over a critical natural resource it does not own. This poses a direct threat to dollar hegemony and thus the system of debt creation upon which we rely.

The relationship between oil and the dollar is paramount, because oil is the Achilles heel of the United States. If we owned all the oil on the planet, a major constraint on our fiscal and monetary policies would not exist. In other words, we could essentially print all the money we needed to pay off our debts with far fewer consequences, since we would not have to pay other nations for a critical natural resource. Unpleasant and politically inconvenient downturns in the natural business cycle could be avoided, the government could print money to support the stock and real estate markets endlessly, interest rates could stay low permanently, and there would be no limit on the ability of the nanny state to respond to every natural or man-made disaster with hundreds of billions of dollars in freshly-printed handouts. But this is not the case, and our efforts to make it so have us on a collision course with reality. To illustrate this, think about how you would react in the following hypothetical scenario.

Assume everyone in your town requires an ever-increasing number of widgets every day to live. You are in an enviable position: You are the only widget maker in town, and you have a widget-producing machine in your backyard. However, your machine is old and past its peak, and you're having trouble meeting the town's demand.

For a long time, you've had an informal arrangement with your neighbor. He has a stable, longtime business that produces simple pieces of paper embossed with the phrase "Good For One Widget". Unlike your machine, however, his never breaks down and runs flawlessly 24 hours a day. He has the ability to build as many of these machines as he desires. The arrangement you've had with your neighbor has generally been acceptable to the townsfolk; they like the way the "Good For One Widget" pieces of paper look, and they get their widgets when they need them.

Over the past few years, your neighbor has married, started a family, remodeled his house, and grown fond of taking expensive vacations. To pay for all this as well as his own need for an ever-increasing daily number of widgets, your neighbor builds several more "Good For One Widget" machines which he proceeds to run at full capacity around the clock.

You've also started a family, and have responsibilities and desires similar to your neighbor's. You wish your machine ran as well as his, and you're beginning to get worried about what will happen when your machine stops running completely and you still have a family to support.

One day your neighbor calls you, complains that the unreliability of your widget production is affecting him, and demands that you get your creaky machine running better to meet the exponentially-increasing production of his machine. You slam the phone down, frustrated that you were not blessed with a flawless machine. You realize you have an important choice to make: Work hard night and day trying to squeeze as many widgets as possible out of the remaining life of your machine, or let the price of your widgets rise to earn as much as you can while you still have the ability to produce them at all.

If you were the widget maker, what decision would you make?

Now assume you own the "Good For One Widget" machine, and your name is Alan Greenspan. Your widget-making neighbor's name is Abdullah. Does that change your answer?

This is where the rubber meets the road in the great game. It's where the media cheerleading, manipulated economic statistics, deficit spending, off-balance sheet liabilities, and statist central bank intervention is all called to account. Everything about Washington -- monetary policy, fiscal policy, and politics in general -- is the art of the possible; whatever can be done is done, until it can be done no more. But we cannot print oil. And to the extent we've entered a period in which the majority of wars will be fought not over religion or ethnicity but over natural resources, that has extremely dire implications -- as much for those who own the oil as for us.