“Like the issue of…’Is it better to have austerity or stimulus?’ Well, the basic problem there is that we’re not having a quality conversation on the subject.” –Ray Dalio, Bridgewater Associates, on the Charlie Rose program, October 20, 2011

Probably no American city better illustrates the trajectory of post-war US growth than Los Angeles. With its ganglion of highways (built when oil cost $14 dollars a barrel) and its never-ending boulevards that, having replaced vast acreages of citrus, now light up the night sky, the City of Angels spent 40 years blowing past its old pre-war borders and filled up an entire geological basin with infrastructure.

The scale of this expansion can be seen in this very helpful satellite photo from NASA, which captures a sweeping view of Los Angeles County. For example, Hollywood, a common reference point for most Americans, is reduced to a small village from this perspective; a mere data point, if you will, as the greater metro region cascades without interruption 100 miles to the east.

Even more awesome to contemplate is that much of this landscape is duplicated to the south, as well, through Orange and San Diego counties. Indeed, nearly 7% of US population lives in the five large counties of southern California, with counties like San Bernardino having exploded from 200,000 people after WW2 to over 2 million today. Unfortunately, what was long accepted as a triumph of growth the past 60 years has now become a rather burdensome and exceedingly expensive system to maintain.

I bring up the case of Los Angeles because there is currently a rather tribal, oppositional, and, of course, very heated debate taking place in the US right now that roughly frames the solution to our problems as a choice between Austerity and Stimulus. For this debate to have meaning, we need to consider how economic policies will actually solve the problems currently endured in a mega-region like Los Angeles. Unemployment, food stamp use, and energy costs have leapt ever higher here since the 2008 crisis. Moreover, the seeds of these trends were already showing up before the infamous Autumn of 2008. How would either a new phase of belt-tightening or reflationary policy actually affect southern California?

When we witness the clash between the Austerity and Stimulus camps, on the surface there is the appearance that a true debate is taking place between diametrically opposed economists. For example, Austerity folks correctly note that our economy has been badly weighted towards consumption for some decades. They want to clear out the excesses, let the malinvestments fail, and elect an overall path of acute economic pain in order to reset the system. Stimulus advocates find such plans completely unnecessary, if not downright masochistic. Armed with a more humanistic approach, Keynesians want the government to run large deficits to help the private sector deleverage, which of course could take years.

A late 2010 article in the FT by Gavyn Davies illustrates this point. From the viewpoint of sectoral balances, government deficits show up as “savings” on the balance sheet of the private sector. Of course, this is a deduced accounting identity and may not actually tell us much at all about whether the private sector is becoming healthier. I will probe further into this data later on in the essay. But first, the Gavyn Davies chart from the Financial Times:The most important graph of the year:

From the standpoint of a global macro economist, this is my nomination for the most important graph of the year. (See the end of this blog if you wish to suggest alternatives.) It explains why the world’s largest economy, the US, has defied the pessimists by mounting a decent recovery in 2010. It also explains the behavior of the government deficit and shows why it has so far been easy to finance this deficit.

This is the essential argument made by Keynesians and adherents to MMT (Modern Monetary Theory). The US is a monopoly issuer of its own currency, and while inflation is a risk, default (per se) is not. While interest rates are low during deleveraging in the developed markets (DM), why not ease social and economic pain through further borrowing? After all, as the chart implies, the private sector will simply use this spending to repair its own balance sheet. Once a tipping point is reached, then the private sector can start taking on new credit, increasing tax revenues to government, and thus knocking down the debt incurred during the recession (or depression). What’s not to like?

Meanwhile, a great example of the austerity argument comes from Ron Paul, who recently released his plan to dismantle several federal government agencies, end the wars, and consequently chop a full trillion out of the annual budget deficit. Those in favor of such fiscal shock and awe are also persuaded by the view that government spending “crowds out” the private sector, and that government misallocation of capital nearly always exceeds the private sector’s similar mistakes.

Frankly, I am sympathetic to the sincere urges on both sides of this debate. Why not conduct reflationary policy indefinitely, at least as a humanitarian exercise? That is the plea I detected in a recent Martin Wolf column, Time to Think the Unthinkable and Start Printing Again. And also, why not end the wars, kill off a number of regulatory agencies, and promote the growth of small business? Is it not clear that the Project of Empire has greatly deprived the US domestic economy of badly need infrastructure, transport, and educational investments?

Internal to this debate, however, are a number of shared assumptions about the free market’s ability to allocate resources—and the economy’s ability to create supply of those resources—given the proper encouragement from both policy and price signals. Namely, both sides are in near-complete agreement their prescription will not only deliver the US economy back to growth, but also to trend growth–an eventual rejoining, if you will, to the pre-2008 trend.

This is partly why this essay kicks off with a recent quote from Ray Dalio, founder of Bridgewater Associates, who correctly identifies that the situation we face is perhaps much more complex than can be solved by an entrenched, oppositional argument. Dalio is known for describing the economy as a machine that operates according to certain realities. I agree. Moreover, Dalio has also suggested repeatedly that once you understand how the machine operates, you no longer have to be so surprised all the time. Indeed, the last three years have been a true marvel, given how many people refuse to accept we are not in a post-war recession, but rather a debt-deflation depression. Do economists know how the economy actually operates?

As tough as I can be on the economics profession, I actually think most economists understand very well how the economy operates. But here is the problem: Their understanding has been rendered increasingly obsolete by the emerging problem of resource scarcity and the resistance of our built environment to an easy or quick energy transition. In other words, economists typically no longer have a solution for Los Angeles, or for Southern California. Or, for that matter, the United States.

It’s quite clear that advocates on both sides of the current debate truly believe that the US can return to a growth path. Equally, they share an assumption that the supply of energy will adhere to a shift in the supply curve, which means simply that more supply or substitutes will be brought to market if the price level is sustained at high enough levels.

As the chart above shows, however, neither the steady advance of energy prices into 2008 nor the ensuing three years brought on new, usable energy sources that could reduce energy expenditures for Americans. But there is no mystery as to why Americans, having to spend more for energy and thus less on consumption and investment, have faced persistently high oil prices. We have a built environment that’s designed for liquid fossil fuels. And the expected shift in the supply curve for oil has not occurred.

Earlier this month in the Harvard Business Review, in our response to Dan Yergin’s faith in future oil supply and healthy, industrial economies, There Will Be Oil, But At What Price?, Chris Nelder and I wrote:

Yergin wants to have it both ways: He wants us to believe that the market will bear the high prices required to keep supply increasing against the backdrop of mature fields — which are declining by 5% per year — while at the same time asserting that prices will remain low enough to engender continued economic growth. This, we submit, is impossible.

A rather serious problem in the ability of Developed Economies to coherently allocate resources started showing up well before the 2008 crisis. This status quo, made in part by policy mistakes, credit creation, and the energy limit, still remains today. Crucially, neither stimulus nor austerity will dislodge this status quo. Unless, of course, by austerity we mean to intentionally collapse the system, or if by stimulus we mean to engender a runaway inflation that will eventually yield the same result.

Even if you agree that the US economy has gotten itself into a badly misaligned place, ripping one trillion dollars out of its center is hardly going to “free up” resources or immediately engage the private sector in replacement activity. Equally, throwing more trillions at the economy in its current condition may serve to heighten, not dampen, inequality. As we have seen already, while stimulus may have put a break on systemic collapse, it has likely perfected the status quo. I agree very much with Paul Brodsky’s remarks earlier this month in his essay On Media Coverage of the Protestors:

For those of you who self-identify as progressives, you should re-think your defense of the current system. Money printing is a terribly regressive tax on the working and middle classes. Those with higher incomes and access to credit remain able to maintain their demand for inelastic goods and services, as well as maintain their ability to service debts, while lower wage earners, those with less access to credit, and those losing jobs as the real economy shrinks, are suffering. For those of you who self-identify as “free-market conservatives”, you should also re-think your support of the current system. “Free markets” are compelled to de-leverage presently, not to re-leverage. A more laissez faire regulatory environment and lower taxes do not address the fundamental problem, which is an abundance of credit that re-distributes wealth from the factors of production to the leveragers.

Precisely.

In Part II: How The Coming Decline Will Play Out, I provide fresh data on California’s economy and skewer the deductive accounting illusion that government deficits are allowing Americans to reduce their debts. I also show that free market failures are already occurring in the US economy. Austerity programs, from our current juncture, would do nothing but remove portions of the system at a time when the economy is not able to organically produce new economic flows. This would only serve to cripple the economy further, forcing it to contend with our crisis from an even lower starting point.

What the system needs instead is a more targeted transition process, not a radical simplification (Joseph Tainter’s term for collapse). Nevertheless, you can expect the sterile debate to continue, with the newest iteration of stimulus advocates now promoting NGDP (nominal GDP) Targeting. There is no question that capital markets, in the short term, absolutely love stimulus, because it allows existing economic flows to extend themselves temporarily. However, underneath this, all of the poor allocation of existing resources continues apace, and this is the central explanation for why the economy cannot create jobs: The connection between needs and actual production is badly broken.

How the Coming Decline Will Play Out

by Gregor Macdonald, contributing editor

Thursday, October 27, 2011

Executive Summary

• Understanding The Economics Driving Energy Transition
• California Is Serving As The Canary in the Coal Mine
• Why The Middle Class is Getting So Squeezed While Corporations Are Flush With Cash
• Why America Won’t Change Course Until The Status Quo Becomes Too Painful Not To
• Predictions on How The Coming Decline Will Play Out (Until We Get Our Act Together)

Part I – The Great American False Dilemma: Austerity vs. Stimulus

If you have not yet read Part I, available free to all readers, please click here to read it first.

Part II – How The Coming Decline with Play Out

Understanding The Economics Driving Energy Transition

Robert Allen of Oxford University has done some of the best work on the Industrial Revolution but he has also helped us understand the historic energy transition from Wood to Coal, in England. Along with the work of Vaclav Smil, Allen has shown that energy transitions are long, drawn out affairs that do not comport with the faith in efficiency that defines contemporary economic theory. This chart of BTU prices shows that natural gas is being offered each day in the bargain bin to the economy, but the economy is so inextricably tied to oil (liquids) that its existing infrastructure cannot take advantage of the opportunity.

Have you heard any economist, from Joseph Stiglitz to Nouriel Roubini, from Greg Mankiw to Robert Barro, or from Robert Reich to Larry Summers, even mention that a million BTU in natural gas can be obtained at a nearly 75% discount to a million BTU in oil? This is precisely the kind of market failure that contemporary economists exhort their students to discount. Faith in price, and the power of price, is thought to be paramount.

As we know, energy costs are part of the basic business proposition for an economy. It is completely understandable that when oil priced at $14 a barrel for nearly 25 years after WW2 (in inflation adjusted terms) a new highway system, built with cheap oil and utilized with cheap oil, returned enormous profit to the economy. California’s embrace of that proposition was a trade in which low margin agriculture was swapped for much higher margin wages in Defense and Aerospace industries. This is what characterized the post-war economy in places like southern California: if you have a very powerful and energy-dense input at your disposal, you will use it ad infinitum to maximize your profit. California’s gargantuan accumulation of wealth, and its rapid build out from 1945-2000, was funded by oil. Now what?

http://www.chrismartenson.com/martensonreport/how-coming-decline-will-play-out

Your faithful information scout,
Chris Martenson

Submitted by Gonzalo Lira

Waiting For Lehman

In Samuel Beckett’s playWaiting for Godot, the four main characters wait in vain—Godot never arrives.

In the financial markets, the same thing is happening now—we are all waiting for Lehman: That sudden bankruptcy-crisis-calamity which sets off a whole series of credit events, which in turn causes massive sell-offs, plunging markets, collapsing confidence, and ultimately—just like the bankruptcy of Lehman Brothers did back in 2008—shoves the entire global financial edifice right up to the very edge of the cliff.

To the edge—and perhaps this time over it.

We have good reason to be waiting for Lehman—our current situation is simple and stark: Sovereign nations and individual citizens are over-indebted—to the point where they cannot pay back what they owe. We all know that this overindebtedness at the sovereign and individual level is going to end, and end badly: Worse than 2008.

So along with everyone else, I’ve been waiting for Lehman—and fruitlessly trying to guess which will be the Lehman-like event this time around. Will it be the bankruptcy of Dexia? BofA? UniCredit or SocGen or one of the Spanish banks? Will it be a war in the Middle East? Bad producer index numbers from China? A fart by a day-trader in Uzbekistan?

When will Lehman arrive!?!?

But lately, my thinking has changed: Like the characters in Godot, I think that we’re waiting in vain. The Lehman-like event will never arrive because it won’t be allowed to arrive. So this miserable slog we are going through will continue—indefinitely. (Yeah, I know: Sucks to be us.)

My thinking is based on two assumptions: One, that the central banks and government financial authorities and regulators around the globe are absolutely terrified of a repeat of a Lehman-type bankruptcy or trigger event. And two, that those self-same central banksters and government drones will do absolutely anything to prevent another Lehman-like credit event from setting off another cascade of consequences.

And when I say “absolutely anything”, I’m not using hyperbole: Fuck principles, fuck the law, fuck legal constraints, fuck even basic long-term economic and fiscal health—or sanity. The clowns running the circus were so freaked out by the effects of the 2008 Lehman bankruptcy and the domino-effect that it triggered, that they will not let it happen again—ever. Come what may.

Hence, this endless Waiting for Lehman: This endless slog of ad hoc solutions and fiscal half-measures that brings us only tension and misery—and erodes our economy even further.

But this certainty that the bureaucrats in Washington and the eurocrats in Brussels and Frankfurt will do absolutely anything to avoid a Lehman-like event adds something key to the equation:

Predictability.

Since we know how the central banks and economic leadership will react—that is, if we start from the assumption that the political/economic leadership will do absolutely anything to prevent a major credit event from taking place—then we can predict what they will do in the three main areas of weakness:

• Sovereign debt and the possibility of default.
• Financial sector weakness and the possibility of insolvency.
• Geopolitical crisis and the possibility of another Oil Shock.

What follows is a discussion of those three areas of weakness—and what the central banks and economic leadership will do about each of them.

A Sovereign Debt Default

We all know the score, insofar as sovereign debt is concerned:

National governments—as well as local ones—went on a spending spree during the good times before 2008. They over-promised entitlements and services, while at the same time cutting taxes—thus placating the electorate with the promise of something for nothing. They financed the inevitable shortfall with cheap sovereign debt. Hence the massive fiscal deficits during boom years.

Now, of course, we’re dealing with the hangover.

Because of the recession and the concomitant high unemployment, tax receipts have dropped—drastically. Hence the hole of the governments’ balance sheets—which was big to begin with—becomes massive during these bad times, requiring even more money—

—thus pushing sovereign nations closer to default and bankruptcy.

The nations most in debt, and therefore most likely to default, are well-known—Greece, Portugal, Spain, Italy. But there is also the issue of local government over-indebtedness and default in the United States, China, the various “strong” European nations, etc. No nation is exempt from this problem—which will come due.

Or will it?

If we assume that the central banks and government regulators will do absolutely anything to prevent a Lehman-like event—in this case a sovereign debt default—then their course of action becomes abundantly clear: They will do for the big economies what the Europeans have been doing for Greece. They will hand out more loans, backed by assets that are less and less trustworthy, in exchange for more promises of austerity and fiscal responsibility that everyone knows will not be kept.

Greece is the poster-child for this pernicious approach: Ever since April of 2010, when the Greek issue first reared its anencephalic head, the European Commission, the IMF and the European Central Bank—the so-called “Troika”—have been struggling to “fix” the Greek situation by giving Greece more debt with which to tide the country over until their situation “turns around”.

But the problem, of course, is that the Greek economy isnot getting any better.

And every fix has failed, because the Greeks fail to live up to their side of the bargain: They fail to implement the austerity measures they promise, they fail to raise the taxes that they say they will (tax avoidance in Greece is on a par with Argentina, or Delaware-based corporations)—

—yet the Troika still tries to fix Greece with more loans! Every time! Even now, this past week, Angela Merkel and Nicolas Sarkozy say they are close to “fixing” Greece. The very epitome of Einstein’s dictum that insanity is doing the same thing over and over, yet expecting a different result—the Troika’s living it in the flesh!

So: Is the Troika crazy, under Einstein’s definition?

No: Because the Troika’s aim is not to fix the Greek situation—the Troika’s aim is to prevent Greece from becoming the Lehman-like event.

This is exactly what the Federal Reserve, the European Central Bank, and the assorted financial bureaucrats will do with every other major sovereign debt that is out there: They will keep on lending it money, so long as it prevents a default.

So what’s the upshot for us small fry?

Here comes the boring money-grubbing stuff, where I discuss what the above policy approach will mean for small investors—which I have thoughtfully edited out for you Gentle Readers uninterested in such mundane affairs. For you Godless materialists, you can read the full version here.

A Major Bank Bankruptcy

The major European and American banks are all exposed to the bad European sovereign debts—the European banks directly by way of actually owning this crap, the American banks indirectly via their sale of credit default swaps on the bad European sovereign debts.

The weak banks seem to be Dexia, Bank of America, UniCredit, Société Générale, BNP Paribas—though nobody really knows.

Why doesn’t anybody know for certain how weak these guys actually are? Because following the 2008 Global Financial Crisis, the financial authorities made the banks’ balance sheets more opaque—that is, less transparent.

In the United States, the suspension of FASB 157—which essentially allowed American banks to mark to make-believe—was just one of the policies implemented to, quote, “shore up the financial sector”. A similar process took place in Europe.

The Orwellian/Absurdist rationale was, “If nobody can see how weak a big bank really is, then it is no longer weak—therefore, it is strong”. (Beckett would have been so proud.)

Hence Bank of America: It is impossible for anyone outside the bank to really say for sure how weak BofA really is—but there are some mighty powerful clues. In the last two months, Warren Buffett lent them $5 billion, at usurious terms—then BofA sold its very lucrative stake in China Construction Bank for $8.3 billion—then BofA announced the lay-off of 30,000 employees, representing a yearly savings of some $5 billion.

All told, Bank of America raised north of $18 billion. Does anybody ever raise that kind of cash just because they feel like it?

No they do not. Likely as not—though this I cannot prove—someone must have told BofA to raise that kind of capital. (Methinks it was Tiny Timmy Geithner, but again, I have no proof, merely a speculative mind.)

On the European front, the Belgians and the French have just finished nationalizing Dexia. They didn’t call it“nationalization”—I would characterize it as “cannibalism”: The French, Belgian and Luxembourger governments essentially bought the local (profitable) pieces of Dexia for a song, and left all the crap in “Dexia”, de facto creating a bad bank carrying all the euro-trash. The bullet-points of the deal are here.

Q.: Was there a Dexia credit event?

A.: No. There was no Dexia bankruptcy—hence no Dexia default—hence no Dexia credit event.

Hence no crisis. The Dexia nationalization/cannibalism wasn’t big on the radar of the American commentariat, but it was important: One of the biggest banks of Europe was broken up over a weekend, with nary a ripple in the global credit markets. Significant? Very. Now that the strong parts of Dexia have been stripped away, and the bad parts are locked into the much small “Bad Dexia”, the unwinding and ultime bankruptcy will not wreak havoc on the French, Belgian or Luxembourger economies. There will be no triggering of American-written credit default swaps.

In short, there will be a big yawn, when “Bad Dexia” finally goes under in a year or two—which is precisely what everyone wants.

Thus these are the twin models of how other teetering banks will be managed: In Europe, their profitable units will be stripped off the cancerous skeleton of the bank, and then grafted onto existing (and State-controlled) local banks, leaving behind the “bad bank” with the name of the failed institution—like Dexia.

In America, the bank will be recapitalised, even as it is shrunk. Insofar as Bank of America is concerned, apart from all the cash they’ve raised through these deals, there is a lot of talk that the Merrill Lynch investment banking unit—which BofA bought at the height of the 2008 crisis—will be spun off and/or sold. My bet is Merrill will indeed be spun off—and right soon.

So once again: What’s the upshot for us small fry?

Once again: Boring stuff about money and contrarian bets. For you rubberneckers, you can go here to read what I wrote about where the money’s at. For everyone else: Move along, nothing to see here folks.

A Geopolitical Crisis

At this time, the most obvious potential crisis is the Middle East—specifically, a possible war with Iran.

At SPG, we already discussed in detail the financial effects of such a war. So I won’t bother going over it again here.

Needless to say, the conclusions were not pretty.

Is there the real possibility of such a war? Well, considering all the noise and trial balloons coming out of Israel, war with Iran seemed at one point inevitable—

—but lately, the tide has most definitely turned. Any notion of “all options on the table” insofar as Iran is concerned is starting to go over like a lead zeppelin.

Take this latest “Iranian plot”—the supposed attempt to assassinate the Saudi ambassador to the U.S. (huh? I mean really, why bother): Some people behind the curve are still growling about attacking Iran, and using this “plot” as an excuse to beat the War-with-Iran drum.

But this latest “Iranian plot” has been met by the American government and Capitol Hill with calls for sanctions and more diplomatic isolation—but not with calls to bomb Tehran. The more plugged in of the American nomenklatura aren’t taking seriously any talk about war with Iran.

Why? Because an American (or Israeli) war with Iran would break Europe. The U.S. doesn’t import Iranian oil, much less depend on it—but Europe does, especially Italy. Recall the oil consumption figures of the SPG Scenario. And anyway, a cut in Iranian oil supply would hit global oil prices equally—disastrously.

An Oil Shock brought about by a war with Iran would hit Europe—which would hit American banks, due to their exposure to Europe. An Oil Shock—as the name implies—would drive up oil prices, further eroding the global economy. An Oil Shock that hits Europe would likely kill the euro, as inflation would skyrocket.

In fact, any hiccough in the Middle East which hits oil prices would be disastrous for the global financial sector, as well as the global economy.

And the Western central banksters and assorted bureaucrats and eurocrats know this.

Therefore (and of course, barring any unforeseen calamity), there will be no war with Iran any time soon. The financial leadership will make sure to quell any such notion of war with Iran.

In fact, now that Gaddafi is dead, not only will there be no war between the West and Iran—the United States and/or Europe will actively help wipe out any Middle Eastern protests that threaten oil production. In other words, the West will try its utmost to end the Arab Spring.

Increasingly—especially as the Libyan rebels show themselves to be less pro-Western than people have fooled themselves into believing—there will be the notion of “better the Devil you know than the Devil you don’t”. And if this approach means siding with bloody dictators and betraying quaint notions of democracy, human rights, etc., in order to shore up the availability of oil, well . . . too bad: The global economy and the banksters’ bonuses are more important than the lives of a few million ragheads.

So once again, and for the third and final time: What’s the upshot for us small fry?

Once again—and for the third and final time—I won’t bore you with the details. It’s just a tedious discussion of oil prices, and where they will likely go in the near-term future. But if you want to bore yourselves silly, read the full post here.

Conclusions

The situation we find ourselves in reminds me of the First World War: The European diplomatic situation back then was tied up among all the nations of the continent by way of a series of pacts, alliances and coalitions of mutual assistance. They were wrapped up so tightly that, when a relatively minor event happened—the assassination of Archduke Franz Ferdinand—it set off a chain reaction of obligations and consequences that eventually led to the whole continent going up in flames.

The same thing is going on today, with regards the global financial markets: Everyone is obligated to everyone else, by way of credit instruments. Therefore, if one of these obligations is broken—that is, a default by one of the European countries, or a cash hole in one of the banks, or a spike in oil prices that creates a hole in someone’s balance sheet—the entire rickety structure is going to go up in flames.

The central banks and the government authorities and regulators have made it clear that they will do absolutelyanything to prevent this outcome: They will prevent a Lehman-like event from taking place, no matter what.

In other words, they have made things predictable for us all.

Insofar as these three areas I have outlined above—sovereign debt, weak banks, geopolitical crisis—there are tremendous opportunities, bought and paid for by way of this predictability.

The fact that the markets will be waiting for Lehman allows people like us—who realize that Lehman will in all likelihood never arrive—to make some bets which could pay off big. The investment strategies I outlined above for each of those cases make it clear how lucrative it could potentially be.

So long, of course, as Lehman never arrives. But caveat emptor: If Lehman does arrive, all bets are off.