Marshall Auerback, born July 27, 1959 in Toronto, Canada, is familiar with the international scenery of finance firsthand. After graduating “magna cum laude” in English and Philosophy from Queen’s University in 1981 and receiving a law degree from Corpus Christi College, Oxford University, two years later, he was from 1983-1987 an investment manager at GT Management Ltd. in Hong-Kong. From 1988-91, Mr. Auerback was based in Tokyo, where his Pacific Rim expertise was broadened to include the Japanese stock market. In 1992 he went to New York to ran an emerging markets hedge fund for the Tiedemann Investment Group until 1995. The next four years he worked as an international economics strategist for Veneroso Associates, which provided macroeconomic strategy to a number of leading institutional investors. From 1999-2002, he managed the Prudent Global Fixed Income Fund for David W. Tice & Associates, a global investment management firm, and assisted with the management of the Prudent Bear Fund. Since 2003 he is serving as a global portfolio strategist for RAB Capital Plc, a UK-based fund management group with $2 billion under management. He is also co-manager of the RAB Gold Fund and an independent economic consultant for PIMCO, the world’s largest bond fund management group. Moreover, he is a fellow of the Economists for Peace & Security (www.epsusa.org) and of the Japan Policy Research Institute in California (www.jpri.org). As Braintruster of the Franklin and Eleanor Roosevelt Institute, he is a frequent commentator at “New Deal 2.0” (www.newdeal20.org) – proving that he is “a brilliant economist who dares to see the world whole”.[1]  Mr. Auerback lives in Denver, U.S.A.

Mr. Auerback, while the vast majority of financial and economic experts were caught on the wrong foot by the financial crisis, you have warned about it for years. Given that “Cassandra”-like record, I think it is only apt to ask you at the beginning of this interview two simple questions: why are we in a global recession right now? And: could it have been avoided?

Yes, it could have been avoided, if we had not stupidly embraced many of the tenets of the so-called “Washington Consensus”, particularly the notion that financial deregulation in and of itself was a good thing.  What was the main cause, in my opinion? There are different kinds of leverage, and we used all of them. Income was leveraged by households and firms to take on more and more debt. As scholars at the Levy Institute have been warning for a dozen years, the private sector went on a practically unbroken deficit spending spree since 1996. The result was massive debt to income ratios, as we discuss in the next section. Financial institutions leveraged equity, with many using highly complex proprietary models to assess risk in order to calculate maximum permissible expansion of their balance sheets given Basle II capital requirements. They also leveraged safe, liquid assets (such as reserves and treasuries)—increasing the proportion of their balance sheets comprised of riskier assets. Banks moved assets off balance sheet onto “special” investment vehicles so they could ignore capital requirements. The financial system as a whole increased leverage, creating a mountain of debt relative to the productive capacity of the economy, and relative to the prospective income flows of the nation as a whole. In other words, financial sector “layering” increased as the nominal value of financial assets and liabilities grew very much faster than GDP. Indeed, financial institution debt grew much faster than other private sector debt. 

We could even say that the “FIRE” (finance, insurance and real estate) sector “leveraged” the rest of the economy as its employment and profits grew at a faster pace (it received 40% of the nation’s profits before the bust). Indeed, recent revisions made to our national accounts show that Americans now spend more on financial services and insurance (8.2% of personal consumption, $832 billion annually) than they do on food and beverages to be consumed at home (7.9%). Back in 1995 that was reversed, with spending on food and beverages at 9% of consumption and financial services at 7.2%. We don’t want to get into a sterile argument about “productive” versus “unproductive” labor but it certainly appears in retrospect that the FIRE sector has played an outsized role in recent years, like a tail that wagged the economy’s dog. The “market” is now trying to downsize the FIRE sector, but Larry and Timmy only let market forces work their “magic” in the bubble, not when it bursts. Hence, all the efforts are aimed at keeping leverage high as the Fed and Treasury try to get banks to lend again as if another debt bubble is the cure for what ails the economy.

As Hyman Minsky argued, banking is an unusual profit-seeking business in that it is based on very high leverage ratios. Further, banks serve an important public purpose and thus are rewarded with access to the lender of last resort and to government guarantees. Those government guarantees provide cheap and virtually unlimited credit to banks in the form of insured deposits. Because these bank creditors (depositors) will not lose should the bank fail, they do not need to closely supervise bank activities—even if they had the expertise and access to information that would be required to do so. Ignoring other types of creditors for a moment, there is no “market discipline” that such creditors will impose on bank management for the simple reason that depositors get paid off no matter what bankers do. The bank, in turn, can increase its profits on equity by raising the return on assets given a capital ratio, and by reducing the ratio of capital to assets (i.e., raising leverage). Each of these actions will increase the riskiness of banks—but can dramatically raise profitability for owners without increasing their capital at risk. Instead, it is the government insurer that absorbs any losses once the bank’s equity is destroyed by losses on bad assets. 

Minsky (2008) provided a simple example. Consider a bank with $25 billion in assets, $1.25 billion in capital, and $187.5 million in profits after taxes and allowance for loan losses. Its asset to capital ratio (or leverage ratio) is 20 and its return on assets is 0.75% so its profit on equity is 15% (20*0.75). Assume its rival also has $25 million in assets and earns the same $187.5 million in profits, but its equity is $2.085 billion—for a leverage ratio of only 12. While it earns the same return on assets, its owners only earn 9% on equity. The rival can increase its profitability either by earning more on assets (all else equal, that means taking on riskier assets) or by increasing its leverage ratio (buying more assets against its relatively larger capital base). Note that the disparity in profitability due to differences in leverage ratios is dramatic: if the second bank increases its leverage to 20, it will expand its assets to $41.7 billion and its profits to $312.75 million as it increases its profit rate to the 15% enjoyed by the first bank. With the same amount of capital, the bank increases its loans and deposits by $16.7 billion. The bank owners’ total exposure to losses remains $2.085 billion, but the government insurer’s exposure increases by the full $16.7 billion.

Further, as Minsky noted, simple arithmetic shows that banks with higher leverage and higher profit rates must grow faster to maintain their profitability (this is all the more true when shareholders impose a specific target to meet in terms of return on equity). Assuming a dividend payout ratio of one-third, banks earning a 15% profit rate will accumulate capital at a growth rate of 10% per year. To maintain leverage ratios at 20, bank assets and deposit liabilities will have to increase each year by twenty times the increase of capital. Assets will have to grow even faster if the return on assets grows, given a leverage ratio, or if banks decide to increase leverage ratios. Both of these events are likely in a boom. This is why an otherwise unconstrained financial system will tend toward explosive growth. Indeed, a recent paper by FRB-NY economists shows that leverage in the financial system is highly procyclical, caused by expansion of assets relative to equity in a boom (and deleveraging in a bust). (Adrian and Shin 2009) The notion that legislated capital requirements (such as those promulgated by Basle II) can tightly constrain growth and risk is flawed. 

What if the bank that increased its leverage ratio discovers that a lot of its new loans are going bad? Assume that about one out of eight turns out to be toxic waste, so owner’s equity has disappeared (and leverage has approached infinity!). One strategy is to patiently rebuild capital through retained earnings (assuming the other assets remain profitable). A more aggressive strategy would be to “bet the bank” by making riskier loans and hoping to recoup losses. Which option will be chosen depends on management incentive structures as well as regulatory and supervisory practices and the general expectational environment. If management’s performance is closely scrutinized, and its pay is closely tied to short-term performance, it is likely that it will choose to hide losses and pursue a higher risk/return path. Strict capital requirements combined with lax oversight makes this even more probable as management will try to rebuild capital before regulatory agencies discover losses and close the institution. We know that this is how the thrift industry reacted to insolvency in the 1980s—indeed, the Reagan Administration’s regulators encouraged them to do just that (Black 2005).

This is why former Treasury Secretary Hank Paulson’s argument (parroted by Timothy Geithner) that government had to inject capital and get bad assets off the books of banks in order to encourage them to lend again was so nonsensical. First, loan losses and lack of capital (unless it is discovered and sanctioned by authorities through prompt corrective actions and other means, something that most Administrations have failed to encourage) is not a barrier to lending, indeed, can encourage rapid growth of risky loans. The owners had little to lose once capital ratios declined toward some minimum (zero in the case of an institution subject only to market discipline, or some positive number set by government supervisors as the point at which they take-over the institution), so would seek the maximum, risky, return permitted by supervisors. Second, more lending is not a solution to a situation of excessive leverage and debt!

Right now there’s again a remarkable difference between you and a lot of other experts in the field of finance and economics. While the recipient of mainstream media is told that “things are getting better”, “the worst seems over” and “we see green shoots take root”,  you are saying that we are rather heading towards a “Great Depression 2.0”. 

I wouldn’t characterise my view as signalling “Great Depression 2.0”. It is more accurate to describe my view as akin to Japan’s lost decade. With employment numbers dropping rapidly, the finances of state governments, households and businesses continuously worsening, and highly leveraged financial institutions overwhelmed by a mountain of “legacy” assets, the Obama Administration has had a lot to deal with in its first few months in office.

Unfortunately, like the Bush Administration before it, the Obama Administration appears to be trying to recreate the bubbly financial conditions that led to disaster. It is pouring good money after bad in the banking system, much like Japan. This is not likely to succeed, and is displacing policies that might actually prevent recurrence of another great depression. Even if the $23.7 billion the federal government has so far allocated in the form of spending, lending, and guarantees does preserve the status quo, we believe it will just set the stage for another—bigger—financial crisis a few years down the road. This is why we recommend an abrupt change of course, to pursue a more radical policy agenda. 

So far, instead of trying to revive the productive economy, most of the recovery effort has consisted of cardio-pulmonary-resuscitation for Wall Street. Fearing what it might find if it actually examined the books of financial institutions in detail, the administration put a chosen handful of them through a wimpy “stress test” after announcing that none would fail. Rather than closing massively insolvent institutions, Washington continues to allow them to operate “business as usual” and to cook the books to show profits so that they can pay out big bonuses to the geniuses who created the toxic waste that brought on the crisis.

In short, under the guidance of Larry Summers and Timmy Geithner, policy serves to preserve the interests of big financial companies, rather than implementing government programs that directly sustain employment and restore states’ finances. To make matters worse, the Obama Administration is already preoccupied with “paying for” additional spending through tax hikes or spending cuts elsewhere. It does not appear to be willing to let the fiscal position of the federal budget grow as needed to meet current challenges. So the fiscal automatic stabilisers will probably do enough to ensure that we don’t fall into “Great Depression 2.0”, but insufficient to offset the impact of private sector deleveraging. Hence, many years of economic stagnation lie ahead of us.

Nouriel Roubini from the “RGE Monitor” is arguing these days that the United States economy is about to enter a “double dip recession”.[2] What kind of a “double dip recession” is this, and why Mr. Roubini is probably right with this observation?

Yes, he’s probably right, for all of the reasons I cited above. Policy is focused on restoring the status quo ante, rather than focusing on restructuring and redesigning today’s convoluted financial architecture. The US economy is today crushed by massive indebtedness in two sectors of the economy: the financial sector and the household sector. Maintenance of the status quo is not a solution. Administration proposals to relieve debt burdens by encouraging lenders to renegotiate mortgages have failed miserably. Personal income is falling at a terrifying rate. Already 6.5 million have lost their jobs—with June, alone, adding a half million job losses. The administration’s promise that the stimulus package will create 3.5 million jobs over the next two years is unsatisfying in the face of the challenges faced.

We need federal government spending programs to provide jobs and incomes that will restore the creditworthiness of borrowers and the profitability of for-profit firms. We need a swift and detailed investigation of financial institution balance sheets and resolution of those found to be insolvent. We need to downsize “too big to fail” financial institutions, while putting in place new regulations and supervisory practices to attenuate the tendency to produce a fragile financial system as the economy recovers. We need to investigate fraud and to jail the crooks. We need a package of policies to relieve households of intolerable debt burdens. In addition, given that the current crisis was fueled in part by a housing boom, we need to find a way to deal with the oversupply of houses that is devastating for communities left with vacancies that drive down real estate values while increasing social costs. And we’ve got to reign-in the money managers that seem to be dictating policy.

Due to the financial crisis the monetary system itself comes into focus. What is your stance on it?

Well, I tend to be a "chartalist" when it comes to money, and tend to follow the teachings of Abba Lerner.3 I think the reason both theory and policy get money “wrong” is because economists and policymakers fail to recognize that money is a public monopoly. Conventional wisdom holds that money is a private invention of some clever Robinson Crusoe who tired of the inconveniencies of bartering fish with a short shelf-life for desired coconuts hoarded by Friday. Self-seeking globules of desire continually reduced transactions costs, guided by an invisible hand that selected the commodity with the best characteristics to function as the most efficient medium of exchange. Self-regulating markets maintained a perpetually maximum state of bliss, producing an equilibrium vector of relative prices for all tradables, including the money commodity that serves as a veiling numeraire.

All was fine and dandy until the evil government came interfered, first by reaping seigniorage from monopolized coinage, next by printing too much money to chase the too few goods extant, and finally by efficiency-killing regulation of private financial institutions. Especially in the US, misguided laws and regulations simultaneously led to far too many financial intermediaries but far too little financial intermediation. Chairman Volcker delivered the first blow to restore efficiency by throwing the entire Savings and Loan sector into insolvency, and then freeing thrifts to do anything they damn well pleased. Deregulation, which actually dates to the Nixon years and even before, morphed into a self-regulation movement in the 1990s on the unassailable logic that rational self-interest would restrain financial institutions from doing anything foolish. This was all codified in the Basle II agreement that spread Anglo-Saxon anything goes financial practices around the globe. The final nail in the government’s coffin would be to tie monetary policy-maker’s hands to inflation targeting, and fiscal policy-maker’s hands to balanced budgets to preserve the value of money. All of this would lead to the era of the “great moderation”, with financial stability and rising wealth to create the “ownership society” in which all worthy individuals could share in the bounty of self-regulated, small government, capitalism.

We know how that story turned out. In all important respects we managed to recreate the exact same conditions of 1929 and history repeated itself with the exact same results. Take John Kenneth Galbraith’s The Great Crash, change the dates and some of the names and you’ve got the post mortem for our current calamity.4

The primary purpose of the monetary monopoly is to mobilize resources for the public purpose. There is no reason why private, for-profit institutions cannot play a role in this endeavor. But there is also no reason to believe that self-regulated private undertakers will pursue the public purpose. Indeed, as institutionalists we probably would go farther and assert that both theory and experience tell us precisely the opposite: the best strategy for a profit-seeking firm with market power never coincides with the best policy from the public interest perspective. And in the case of money, it is even worse because private financial institutions compete with one another in a manner that is financially destabilizing: by increasing leverage, lowering underwriting standards, increasing risk, and driving asset price bubbles.

I would also like to talk with you about another topic related to the current recession – the oil price spike of last year. In order to do so, I want to quote a statement published in April 2001 by James Baker and the Council on Foreign Relations entitled “Strategic Energy Policy Challenges for the 21st Century“. In that paper there’s this statement to be found:

“Oil price spikes since the 1940s have always been followed by a recession.”5

Again first of all a rather simple question: is this statement in tune with the historical truth – or in other words: does it reflect an “eternal law” of the past, present and future one can count on?

I don’t know if Baker’s statement reflects an “eternal truth”, but oil is undoubtedly a very important component of the global economy and energy (along with food) is a key non-discretionary essential without which we couldn’t sustain our current standard of living.  Unlike Europe, the US is still addicted to cheap oil, so the impact of price spikes tends to be felt much more acutely here than it does in the EU or UK. Add to that the massive personal indebtedness of the private sector, the fact that historically consumption has comprised 70% of GDP in the US, and obviously, a rising oil price creates another headwind which precludes a significant pick-up in growth.

So the oil price spike of last year was the coup de grace to the US economy?

Yes, I think it was the straw that broke the camel's back, or the "icing on the cake". But I think it would be more accurate to say that  the oil price spike catalysed the subsequent collapse. However, recessionary pressures were already "baked in the cake" well before the oil price spike. If anything, I would say that the oil price spike (largely a product of speculation, not final demand) provided a perfect illustration of the dysfunction of our financial system, something Doug Noland has been particularly strong in illustrating.

Could you explain that?

Simply a demonstration that our financial system has become hooked on cheap financing for the purposes of speculation. To me, it is no coincidence that when Bernanke began to reduce rates in response to the 2007 sub-prime meltdown, he simply incited another speculative bubble in commodities via the leveraged speculating community.

Let’s return to the inter-relation of the oil price spike of last year and the current recession. Can you tell us about your reading of last years oil price spike?

Let me begin my answer to that question with the observation that economists were almost universally opposed to the idea that speculation was playing much of a role in the oil price spike. A Wall Street Journal survey found that 89%, as close as you ever come to unanimity in most polls, saw the increase in commodity prices, including oil, as the result of fundamental forces. 6 Nobel prize winner Paul Krugman argued the case forcefully in a series of New York Times op-eds and blog posts with titles like “The Oil Non-Bubble,” “Fuel on the Hill,” and “Speculative Nonsense, Once Again.”7

I think too little attention has been paid to the role of speculation in last year's oil market rally.  Part of this is a usual blind spot amongst economists.  Paul Krugman’s presence in this camp lent credibility to the “oil prices are warranted” view. The Princeton economist had been a Cassandra on the housing mania and had also correctly anticipated that the deregulation of energy prices in California could lead to manipulation. So Krugman, sensitive to the notion that speculation can distort prices, nevertheless fell in with the argument that oil prices were simply reflecting supply and demand. 

Yet that belief was spectacularly incorrect. Oil peaked at $147 a barrel in July and fell even more dramatically than it had risen. By October, prices had fallen to $64 a barrel. Bloomberg columnist Caroline Baum described the world as “drowning in oil.”8 A report by the Commodities Futures Exchange Commission attributed the large swings in oil prices to speculation. CFTC Commissioner Bart Chilton said that earlier studies that found that the moves were the result of supply and demand relied on “deeply flawed data.”9

Why were economists unable to read the information correctly, and so inclined to dismiss the views of experts and participants in the energy markets who were saying that prices were out of whack with what they saw on the ground.

The short answer is that they had undue faith in their models. Modeling has come to be a defining characteristic of modern economics. Practitioners will argue, correctly, that economic phenomena are so complex that some abstraction is necessary to come to grips with the underlying phenomenon, to sort out persistent behaviours from mere noise in the system.

Good models filter the “noise” out of a messy situation and distil the underlying dynamics to provide better insight.  The implications of a mathematical model can be developed in a deliberate, explicit fashion, rather than left to intuition. Models force investigators to contend with loose ends and expose inconsistencies in his reasoning that need either to be resolved or diagnosed as inconsequential. They also make it easier for the researchers to communicate with each other- 

Any model, be it a spreadsheet, a menu, a clay mock up, a dressmaker’s pattern, of necessity entails the loss of information.  Economists admit this is a potential danger. But this inherent feature is precisely what makes laypeople and even some insiders uncomfortable, because what was discarded to make the problem manageable may have been essential.

Worse, someone who has become adept at using a particular framework is almost certain to be the last to see its shortcomings. A model-user is easily seduced by his creation and starts to see reality through it. Users wind up trusting the results because they follow from the axioms, irrespective of their initial understanding. Practitioners can become hostage to them, exhibiting a peculiar sort of selective blindness. Cats form their visual synapses when their eyes open, when they are two to three days old, and if they do not get certain inputs, the brain circuits never get made. A kitten who sees only horizontal lines at this age will bump into table legs the rest of its life.

If we would discuss the speculation aspect of last years oil price spike, would it be wrong to take a closer look at "Government Sachs" – the artist formerly known as Goldman Sachs?

As far as Goldman Sachs itself goes, yes, they had a significant role in this speculation, but there were a lot of other factors. Mike Masters, who really knows this area well, is a Managing Member of Masters Capital Management, LLC. He demonstrated during last year's oil boom that large financial institutions, such as investment banks and hedge funds, which were “hedging” their off exchange futures transactions on energy and agricultural prices on U.S. regulated exchanges, were being treated by NYMEX, for example, and the CFTC as “commercial interests,” rather than as the speculators they clearly are. By lumping large financial institutions with traditional commercial oil dealers (or farmers) even fully regulated U.S. exchanges are not applying traditional speculation limits to the transactions engaged in by these speculative interests.  Masters demonstrated that a significant percentage of the trades in WTI futures, for example, were controlled by non-commercial interests.  These exemptions from speculation limits for large financial institutions hedging off-exchange “swaps” transactions emanate from a CFTC letter issued on October 8, 1991 and they have continued to present day (Brooksley Born wasn't even aware of this letter until much later). Interestingly enough, the CFTC puts position limits on most commodities, BUT NOT ENERGY. Masters’ testimony, aided by a widely discussed cover story in the March 31, 2008 issue of Barron’s, has made clear that the categorization of swaps dealers outside of speculative controls even on U.S. regulated contract markets has been a cause of great volatility in food prices, as well as in the energy markets.

You also had the expanding role of the Dubai Merc, which has minimal reporting requirements.  There is also this report from the US Senate (I wrote an analysis of this before which is below the US Senate report - feel free to pass on).

“Until recently, US energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud. In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. Because of their similarity to futures contracts they are often called “futures look-alikes.”

The only practical difference between futures look-alike contracts and futures contracts is that the look-alikes are traded in unregulated markets whereas futures are traded on regulated exchanges. The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron and other large energy traders into the Commodity Futures Modernization Act of 2000 in the waning hours of the 106th Congress.

The impact on market oversight has been substantial. NYMEX traders, for example, are required to keep records of all trades and report large trades to the CFTC. These Large Trader Reports, together with daily trading data providing price and volume information, are the CFTC’s primary tools to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. CFTC Chairman Reuben Jeffrey recently stated: “The Commission’s Large Trader information system is one of the cornerstones of our surveillance program and enables detection of concentrated and coordinated positions that might be used by  one or more traders to attempt manipulation.

In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight. In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (“open interest”) at the end of each day.”

Then, apparently to make sure the way was opened really wide to potential market oil price manipulation, in January 2006, the Bush Administration’s CFTC permitted the Intercontinental Exchange (ICE), the leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of US crude oil futures on the ICE futures exchange in London – called “ICE Futures.”

Previously, the ICE Futures exchange in London had traded only in European energy commodities – Brent crude oil and United Kingdom natural gas. As a United Kingdom futures market, the ICE Futures exchange is regulated solely by the UK Financial Services Authority. In 1999, the London exchange obtained the CFTC’s permission to install computer terminals in the United States to permit traders in New York and other US cities to trade European energy commodities through the ICE exchange. 

Then, in January 2006, ICE Futures in London began trading a futures contract for West Texas Intermediate (WTI) crude oil, a type of crude oil that is produced and delivered in the United States. ICE Futures also notified the CFTC that it would be permitting traders in the United States to use ICE terminals in the United States to trade its new WTI contract on the ICE Futures London exchange. ICE Futures as well allowed traders in the United States to trade US gasoline and heating oil futures on the ICE Futures exchange in London.

Despite the use by US traders of trading terminals within the United States to trade US oil, gasoline, and heating oil futures contracts, the CFTC has until today refused to assert any jurisdiction over the trading of these contracts.

Persons within the United States seeking to trade key US energy commodities – US crude oil, gasoline, and heating oil futures – are able to avoid all US market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.

Is that not elegant? The US Government energy futures regulator, CFTC, opened the way to the present unregulated and highly opaque oil futures speculation. It may just be coincidence that the present CEO of NYMEX, James Newsome, who also sits on the Dubai Exchange, is a former chairman of the US CFTC. In Washington doors revolve quite smoothly between private and public posts. 

A glance at the price for Brent and WTI futures prices since January 2006 indicates the remarkable correlation between skyrocketing oil prices and the unregulated trade in ICE oil futures in US markets. Keep in mind that ICE Futures in London is owned and controlled by a USA company based in Atlanta Georgia.

In January 2006 when the CFTC allowed the ICE Futures the gaping exception, oil prices were trading in the range of $59-60 a barrel. Today some two years later we see prices tapping $120 and trend upwards. This is not an OPEC problem, it is a US Government regulatory problem of malign neglect.

By not requiring the ICE to file daily reports of large trades of energy commodities, it is not able to detect and deter price manipulation. As the Senate report noted, “The CFTC's ability to detect and deter energy price manipulation is suffering from critical information gaps, because traders on OTC electronic exchanges and the London ICE Futures are currently exempt from CFTC reporting requirements. Large trader reporting is also essential to analyze the effect of speculation on energy prices.”

The report added, “ICE's filings with the Securities and Exchange Commission and other evidence indicate that its over-the-counter electronic exchange performs a price discovery function -- and thereby affects US energy prices -- in the cash market for the energy commodities traded on that exchange.”

In the most recent sustained run-up in energy prices, large financial institutions, hedge funds, pension funds, and other investors have been pouring billions of dollars into the energy commodities markets to try to take advantage of price changes or hedge against them. Most of this additional investment has not come from producers or consumers of these commodities, but from speculators seeking to take advantage of these price changes. The CFTC defines a speculator as a person who “does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes.”

The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel today drives up the price for oil on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.

In 2008, Goldman Sachs and Morgan Stanley were the two leading energy trading firms in the United States. Citigroup and JP Morgan Chase were also major players and fund numerous hedge funds as well who speculate.

In June 2006, oil traded in futures markets at some $60 a barrel and the Senate investigation estimated that some $25 of that was due to pure financial speculation. One analyst estimated in August 2005 that US oil inventory levels suggested WTI crude prices should be around $25 a barrel, and not $60.

That would mean today that at least $50 to $60 or more of today’s $115 a barrel price is due to pure hedge fund and financial institution speculation. However, given the unchanged equilibrium in global oil supply and demand over recent months amid the explosive rise in oil futures prices traded on NYMEX and ICE exchanges in New York and London, it is more likely that as much as 60% of the today oil price is pure speculation. No one knows officially except the tiny handful of energy trading banks in New York and London and they certainly aren’t talking.

By purchasing large numbers of futures contracts, and thereby pushing up futures prices to even higher levels than current prices, speculators have provided a financial incentive for oil companies to buy even more oil and place it in storage. A refiner will purchase extra oil today, even if it costs $115 per barrel, if the futures price is even higher.

As a result, over the past two years crude oil inventories have been steadily growing, resulting in US crude oil inventories that are now higher than at any time in the previous eight years. The large influx of speculative investment into oil futures has led to a situation where we have both high supplies of crude oil and high crude oil prices.

Compelling evidence also suggests that the oft-cited geopolitical, economic, and natural factors do not explain the recent rise in energy prices can be seen in the actual data on crude oil supply and demand. Although demand has significantly increased over the past few years, so have supplies.

Well, now that we have entered the territory of recession, the pundits talk about “the Road to Recovery”. In order to travel that road one would need oil, especially cheap oil, because it does provide a good amount of our energy-basis. Here sets in a quite tricky part of the overall picture, that Mike Ruppert, the former publisher of “From the Wilderness”, expressed in an exclusive interview with MMNews this way: 

a) The current global economic paradigm -- governed by fractional reserve banking, fiat currency, and compound interest (debtbased growth) -- is inherently and by definition a pyramid scheme. Money is useless without energy. One cannot eat a dollar bill or crumble it up and throw it in his gas tank. Each of the trillions of dollars created out of thin air since the fall of 2008 is a commitment to expend energy that cannot and will not ever be there.

b) There can be no "recovery", no return to growth (which is what the economic paradigm demands), without energy. 10
 

Why this is an observation worth contemplating with regard to Peak Oil? 

I don't really know if I have anything to add here. To the degree that money is not a store of value but simply a means to completing a commercial transaction, Mike Ruppert's observations can apply to food as well as energy. 

The monetary system, itself, was invented to mobilize resources to serve what government perceived to be the public purpose. Of course, it is only in a democracy that the public’s purpose and the government’s purpose have much chance of alignment. In any case, the point is that we cannot imagine a separation of the economic from the political—and any attempt to separate money from politics is, itself, political. Adopting a gold standard, or a foreign currency standard (“dollarization”), or a Friedmanian money growth rule, or an inflation target is a political act that serves the interests of some privileged group. There is no “natural” separation of a government from its money. The gold standard was legislated, just as the Federal Reserve Act of 1913 legislated the separation of Treasury and Central Bank functions, and the Balance Budget Act of 1987 legislated the ex ante matching of federal government spending and revenue over a period determined by the heavenly movement of a celestial object. Ditto the myth of the supposed independence of the modern central bank—this is but a smokescreen to hide the fact that monetary policy is run for the benefit of Wall Street. 

Money was created to give government command over socially created resources. Skip forward ten thousand years to the present. We can think of money as the currency of taxation, with the money of account denominating one’s social liability. Often, it is the tax that monetizes an activity—that puts a money value on it for the purpose of determining the share to render unto Caesar. The sovereign government names what money-denominated thing can be delivered in redemption against one’s social obligation or duty to pay taxes. It can then issue the money thing in its own payments. That government money thing is, like all money things, a liability denominated in the state’s money of account. And like all money things, it must be redeemed, that is, accepted by its issuer. As Hyman Minsky always said, anyone can create money (things), the problem lies in getting them accepted. Only the sovereign can impose tax liabilities to ensure its money things will be accepted. But power is always a continuum and we should not imagine that acceptance of non-sovereign money things is necessarily voluntary. We are admonished to be neither a creditor nor a debtor, but all of us are always simultaneously debtors and creditors. Maybe that is what makes us Human—or at least Chimpanzees, who apparently keep careful mental records of liabilities, and refuse to cooperate with those who don’t pay off debts—what is called reciprocal altruism: if I help you to beat Chimp A senseless, you had better repay your debt when Chimp B attacks me. 

I would also like to ask you about some remarks by Matthew Simmons, chairman of “Simmons & Company International”, from March of this year: 

"Unless oil demand falls by 10 or 15 percent per annum, which it is not going to do, then we don't need to wait for oil demand to come back before we have a supply crunch," he said. “Within a few months, we are going to realize our visible inventories are really tight -- squeaky tight -- and what would really be inconvenient is to see a recovery in the economy."

Mr. Simmons also stated that oil prices eventually exceeding last year's high: 

"Sooner or later we will burst through that like a hot knife through butter."11

What is your oppinion about this?

Look, by and large, I accept the Peak Oil thesis, but I tend to shy away from the apocalyptic predictions of people like Matt Simmons.  I think his case for price spikes is very compelling (as is the work done by Colin Campbell), but I think they tend to underestimate the demand response to a major price spike. Here in America, (in marked contrast to Europe or Japan) there has been very little squeezed from energy inefficiencies via conservation, green tech, etc. We could do a lot here, but the price has to get much higher to sustain that kind of change in behaviour to make it happen. I think it will happen. When prices spiked last summer, and gasoline was almost $5.00 a gallon, the roads in southern California were empty. That does have implications for demand. The marginal trip to the mall or the weekend getaway tends to be reconsidered when you get these kinds of price shocks. The decision to invest in solar panels for the house becomes a bit more understandable if the energy bills are exploding.  I tend to think that Simmons and his ilk tend to ignore this dynamic. 

I am sure that we have run out of $50 oil. We're running out of $60-$70 oil. In a few years, we'll run out of $80 oil. The low hanging fruit has been picked, and it will get more expensive and change the way we live our lives. There's no doubt about that.

As a fellow of "Economists for Peace & Security" wouldn't you agree that people around the globe who are concerned about peace should begin to concentrate more and more on the problems that Peak Oil will usher in? The geopolitical implications of it are colossal - and I guess the outlook of endless resource-wars isn’t really a promising vision for the future of mankind.

Yes, this is the area that does concern me the most. Michael Klare has written some excellent stuff on this: the prospect of heightened global tension as the competition for secure energy supplies heats up. I have no doubt that this is a big problem. The Pentagon gradually seems to be expanding its remit to become, in effect, a global energy protection racket for the American consumer. The militarisation of energy policy is a very troubling development, but clearly a strong by-product of Peak Oil.12 

Some financial experts see a Weimar-style hyperinflation coming to the United States. Is this your position, too?

I am not sure I agree on that. There is only one scenario where I think this could occur, and that is via widespread tax non-compliance. But most of the conditions of Weimar are not present. First off, it is important to remember that German production capacity was either significantly damaged by WWI, or redirected toward output required by the military. The Allied blockade further restricted imports well into 1919, and in 1923, French and Belgian troops occupied the Ruhr valley which held a good deal of Germany ’s manufacturing base. All of these measures significantly restricted Germany ’s capacity to produce, fueling the distributional conflict that fed the hyperinflation.

This time around, the real net capital stock growth in the US has been slow, on the order of 1-2% per year, and the manufacturing sector is currently operating with one third of its capacity idled. Plant, equipment, and labor have not been physically destroyed – rather, reinvestment rates have remained low. While trade has been inhibited by credit disruptions and some protectionist responses, import prices are falling as export driven economies struggle to reverse declining shipments.  

Second, Weimar Germany faced large foreign claims from war reparations, as well as exploding budget deficits. By 1919, it is reported the German budget deficit was equal to half of GDP, and by 1921, war reparation payments represented one third of government spending. Projected fiscal deficits are as high as 12-13% for the US and the UK in 2009, so the scale of the fiscal responses, though large, is not nearly as large as the undertaken by the Social Democratic Party as they attempted to quell social unrest following the Revolution of 1918 with a variety of social benefit programs.

In the US, while foreign investors do hold large Treasury bond positions, the debt service paid by the US government to foreign holders amounted to $ 167b in 2008. While this is up from $ 82b in 2004, interest payments on foreign held Treasury debt are not ballooning, the US budget deficit on a scale similar to the Weimar experience. An interest rate spike could change that, but the current foreign interest payment burden is clearly not a third of the budget deficit as it was during the Weimar experience.

In addition, the US is still running a trade deficit on the order of $338b in Q1, making the type of distributional conflict over real output that lies behind hyperinflation episodes harder to accomplish. More good and services are coming into the US than going out. This too could change if foreign net saving preferences fall, and the US has to run a trade surplus.

Third, German trade union membership quadrupled from 1914 to 1920, and the 1918 revolution ushered in a government led by a Social Democratic party that instituted an 8 hour work day and provided social benefits in order to reduce social unrest. Many unions were able to negotiate cost of living adjustments in their wage packages after the mark fell in 1921, creating an automatic feedback mechanism from price inflation to wage hikes. Absent such mechanisms, nominal wage and salary growth cannot keep up with rising consumer prices. Real wages fall, household purchasing power is undermined, and the volume of output households can claim diminishes unless consumer credit facilities can fill the gap.

The new US administration does display a social democratic rhetoric, but so far, redistributive policies have primarily benefited financial institutions. Social benefit payments are up 12% versus a year ago on a spike in unemployment benefits, and public health care insurance proposals are on the table. However, trade unions outside the public sector have withered, and cost of living adjustment clauses have largely disappeared since the early ‘80s (although some government benefits like social security retain them). Average hourly earnings are up only 1.8% annualized over the three months ending in April, and we would not be surprised to see wage deflation before the unemployment rate peaks this time around. US households are net paying down debt – even credit card debt – and creditors remain reluctant to make new loans, so the odds of a wage/price spiral taking root look decidedly low.

Undoubtedly, the Reichsbank had a hand in the Weimar hyperinflation, having become accustomed to “monetizing” German government debt during the WWI after gold convertibility was severed. However, while price levels quintupled between the armistice and February 1920, currency in circulation only doubled, leading many politicians to blithely claim monetary policy could not be blamed for inflation. An increase in money velocity must have played a role, although the monetary arrangements of the Reichsbank became increasingly suspect.

The Reichsbank had pegged the discount rate at 5%, and accepted private commercial debt for discounting under what was known as the real bills doctrine of the time. Money creation to finance production was not believed to carry an inflationary impulse. Direct loans to businesses were ramped up by the central bank after December 1921 when private financial institutions began to withhold credit as inflation accelerated. The assassination of Foreign Minister Rathenau in 1922 set off a selling spree by foreign investors of German bonds, and the central bank was once again forced to offset the run with more purchases of German government obligations.

Central bank mayhem aside, the final culminating chapter of the Weimar hyperinflation does appear closely related to the response to reparation demands. The May 1921 so called London ultimatum required annual installment payments of $2b in gold or foreign currency, in addition to a claim on just over a quarter of the value of German exports. Germany attempted to accumulate foreign exchange by paying with treasury bills and commercial debts denominated in marks, but the mark simply went into free fall on foreign exchange markets as this ploy fell flat. The January 1923 occupation of the Ruhr by Belgian and French troops seeking to secure reparation payments in goods – since the mark was nearly worthless - was the final straw. German production was lost as workers employed a passive resistance response, and money was printed by the Weimar government to continue to pay workers despite their production halt. Within months, the German monetary system collapsed.

Today, there can be no question broad money growth has surged in many countries around the world. Through March end, UK M2 was up 18% against a year ago, China ’s M2 was up 26%, Switzerland ’s M2 was up 30%, Canada ’s M2 was up 14%, and US M2 was up 9%. There can also be no question that budget deficits as a share of GDP have equally surged. Behind the US and UK 12-13% budget shares, Spain is due in at nearly 10%, Russia at 8%,  Japan near 6%, and the Euro area near 5.5%. Even Germany ’s Chancellor Merkel, following the sharpest quarterly decline in German growth since 1970, has initiated a $111b fiscal stimulus package. In addition, the ECB has moved to a 1% policy rate with $81b of covered bond purchases scheduled for their move to quantitative easing.

Against the explosion of money stock measures and fiscal deficits – of which Weimar must be viewed as a super-sized version – remains a deceleration in private credit growth, an impairment of financial institutions, a rebuilding of cash reserves, and collapse of private spending. While the Fed’s balance sheet is still nearly two and a half times the size it was a year ago, it has shrunk by $102b since the end of 2008. Total assets held by US commercial banks have also shrunk by $50 through mid May. Commercial banks are still sitting on $1tr in cash reserves, just as they were at the turn of the year. They have been unwilling to lend those reserves or invest them in securities like Treasuries. No doubt, banks are bracing for further loan losses from credit cards, commercial real estate, and the continuing home price deflation.

Strictly speaking, the Austrian School defines inflation as money creation not backed by real saving (that is, available durable goods, like gold). Price inflation is merely the symptom of such money creation. However, as a practical matter, if money is hoarded in a precautionary fashion, and not spent on goods and services, price inflation is thwarted. Ludwig von Mises, writing in 1936, was able to recognize this practical consideration.

“Once the reversal of the trade cycle sets in following the change in banking policy, it becomes very difficult to obtain loans because of the general restriction of credit…It is a well known phenomenon, indeed, that in a period of depressions a very low rate of interest…does not succeed in stimulating economic activity. The cash reserves of individual and of banks grow, liquid funds accumulate, yet the depression continues...capitalists prefer to hold their funds in a form that permits them, in such a case, to protect their money from losses in an eventual devaluation…capitalists today are reluctant to tie themselves, through permanent investments, to a particular currency. This is why they allow their bank accounts to grow even though they return only very little interest, and hoard gold, which not only pays no interest, but also involves storage expenses.”

Mises is describing a situation similar to what we see today. Banks, households, and companies are holding on to cash as uncertainty is rife. Job destruction prevails, profit contraction continues, and private credit is scarce. Cash cushions are built up on household, business, and bank portfolios despite minimal short term yields to weather the storm. In a hyperinflation like that experienced during the Weimar Republic , no one wants to hold cash – cash is a hot potato, a wasting asset.

Thank you very much for taking your time, Mr. Auerback! 

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