Friday, June 27, 2008

Oil: While Congress Slept, The Value of the Dollar

Michael Hodges is an analyst probably not much loved in Congress. His Grandfather Economic Report Series has been online for quite a while. The writer has found, in checking other sources, government and private, that Hodges is a pretty good reporter.

America has become more a debt 'junkie' - - than ever before
with total debt of $53 Trillion - - and the highest debt ratio in history...That's $175,154 per man, woman and child - - or $700,616 per family of 4, $33,781 more debt per family than last year....Grandfather Economic Report Series: America's Total Debt Report, 2007 edition

He's an old-fashioned analyst and he's older than most of us. He's not fooled by professional jargon or by methodologies that obscure rather than reveal.

Inflation in my adult years increased average prices 1,000% or more - example 1: a postage stamp in the 1950s cost 3 cents; today's cost is 41 cents - 1,266% inflation;
example 2: a gallon of 90 Octane full-service gasoline cost 18 cents before; today (2007) it is $3.39 for self-service - 1,883 % inflation;
example 3: a house in 1959 cost $14,100; today's median price is $213,000 - 1,400% inflation;
example 4: a dental crown used to cost $40; today it's $1,100 - 2,750% inflation;
example 5: an ice cream cone in 1950 cost 5 cents; today its $2.50 - 4,900% inflation;
example 6: monthly government Medicare insurance premiums paid by seniors was $5.30 in 1970; its now $96.40 - 1,889% inflation; (and up 70% past 5 years)
example: several generations ago a person worked 1.4 months per year to pay for government; he now works 5 months.
And in the past, one wage-earner families lived well and built savings with minimal debt, many paying off their home and college-educating children without loans. How about today? Few citizens know that a few years ago government changed how they measure and report inflation, as if that would stop it - - but families know better when they pay their bills for food, medical costs, energy, property taxes, insurance and try to buy a house....Grandfather Economic Report Series: America's Total Debt Report, 2007 edition

These two elements, borrowing and inflation, play in the same sandbox. They interact with each other. Let's look at inflation first, then both together.

What has this inflation done? For essentials, such as housing, medical care, fuel, the dollar is worth less than ten percent of its purchasing value in 1950. As inflation was low until the 1970s, you can say almost the same about the purchasing power of a dollar in 1970 versus its value now. Some things, such as electronic gear (especially computers) etc, are dramatically cheaper, but for essentials the value in nominal dollars, i.e., the dollars you can actually hold, or write a check for, has skyrocketed. So have incomes (see below on the difference between median income in 1970 and 2008). The net effect is that a lot of us have a lot of money that isn't worth very much.

Historical Anecdote: My 7th grade teacher, a Ms. S., a single woman of about 30, made $6,500 in 1962. With this income, she owned a mid-priced car ($2500), a small co-op apartment near the Hudson River ($30,000), kept herself fed and clothed, and traveled to Europe for a few weeks each summer. Today, a 7th grade teacher in the same system makes $72,500. Sounds great, but look closely. What possible way could the teacher in 2008 afford a $30,000 car, and what is now a $900,000 condo, go to Europe for a few weeks each summer, keep herself clothed and fed on that income? You're right. She couldn't unless (drum roll) she borrowed a substantial amount of money. What does that do?

If you borrow money over and above your earnings, that adds more dollars to the system. That means more money chasing goods. And, inflation, simply put, is too much money chasing too few products and services. This is oversimplifying a bit, but the impact of dramatically increased borrowings is to put far more money into the system, which in turn drives prices higher. It's a vicious and relentless circle. And, without rigid indexing of incomes and pricing, which, in a complex economy is impossible to do, a point is reached where prices, earnings and borrowings begin to interact negatively. (Income is your earnings plus your borrowings.) This happened in housing over the last year or two. Result?

A sector, in this case housing, crashes. A bubble bursts. And another vicious cycle begins. As people put their houses on the market, they find that
a) because of widespread defaults and mortgage broker doubts about the sustainability of prices, there's insufficient available credit for buyers, which drives the price down further, and
b) they're paying a mortgage that was based on a price that's no longer supportable. This encourages default. To be blunt, if the cost of abandonment is less than recoverable equity, there's no reason to pay down a mortgage. That gravely threatens the credit markets because they don’t recoup interest or capital.

As Hodges makes abundantly clear in this remarkably detailed report, Americans (and their Congress) have been asleep for a long time regarding the interaction between earnings, credit, and prices. We are so heavily leveraged that a major disturbance in the credit market, as has been happening for six months in the subprime (and in other) mortgage markets, can get serious people awfully scared:

Barclays Capital has advised clients to batten down the hatches for a worldwide financial storm, warning that the US Federal Reserve has allowed the inflation genie out of the bottle and let its credibility fall "below zero"..."We're in a nasty environment," said Tim Bond, the bank's chief equity strategist. "There is an inflation shock underway. This is going to be very negative for financial assets. We are going into tortoise mood and are retreating into our shell. Investors will do well if they can preserve their wealth."...Barclays Capital said in its closely-watched Global Outlook that US headline inflation would hit 5.5pc by August and the Fed will have to raise interest rates six times by the end of next year to prevent a wage-spiral. If it hesitates, the bond markets will take matters into their own hands. "This is the first test for central banks in 30 years and they have fluffed it. They have zero credibility, and the Fed is negative if that's possible. It has lost all credibility," said Mr Bond....Barclays warns of financial storm,, 6/27/08

And just a few days before...

The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks..."A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist...A report by the bank's research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets...Such a slide on world bourses would amount to one of the worst bear markets over the last century....RBS issues global stock and credit crash alert,, 6/18/08

Why the scare? It's no longer just a 7th grade teacher involved here, no longer just America. For almost forty years, dollar credits and deposits have been driving the world economy. If the dollar continues to slide, all of those credits and deposits will have a lot less real value. People won’t want them anymore. Another vicious cycle could start with an effort by the Fed to fix the problem. How?

If the Fed followed the recommendations of Barclays and the Bank of Scotland, and dramatically increased rates, the ability of borrowers to pay back (or qualify for) loans would dramatically decline. The credit crunch wiping out housing values across the United States, and depressing real-estate mutual funds across the world, would get much worse. In a credit crunch, it's not just mortgage-seekers who suffer; everybody does. Pilot to copilot: We are going down.........

What has this got to do with the price of oil? Oil, far more than gold, is a direct reference to value of a given currency, especially in a developed country (US, Europe, China, Japan, Europe). We all need oil to run modern industrial economies. We don't store oil in a bank vault. We burn it and convert it into plastics and other materials. And a conclusion related to what Hodges reports emerges: a dollar that would buy 1/10th of a barrel of oil in 1970 will only buy 1/140th of a barrel of oil in 2008. While speculators and political manipulators have pushed that ratio to probably double what it should be, it's still a dramatic change in value for the dollar.

That's the monster in the living room that nobody wants to talk about. We’d better start because this monster's bite could be fatal.


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