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Monday, April 28, 2008


Bad Money - Reckless Finance, Failed Politics, and the Global Crisis of American Capitlism -- Kevin Phillips, 209 pages ( 239 with notes and index)

Kevin Phillips has written a series of books about the intersection of energy, religion and financial interests and their impact on the long term American economy, most recently American Theocracy in 2006. (#1) American Theocracy analyzed the relationship between these components over roughly 150 years, from the origins of the oil business in America to the present. In Bad Money, Phillips elaborates on the oil and finance themes of American Theocracy and raises new concerns based upon events since 2006. American's financial position has obviously not improved since 2006 and Phillips makes it clear neither political party has conveyed the true danger America faces, much less proposed anything remotely effective at improving our long term direction.

For people who have read American Theocracy, some of Bad Money will seem repetitive, with references to Dutch and English history as covered in the 2006 book and discussions of the American dollar as a world reserve currency and its de facto role as an "oil standard". However, most of Bad Money stays focused on the past thirty four years, from 1974 to 2008. Because it has more recent, dramatic evidence, the new book also focuses more closely on the dangers posed by the interdependence between American energy policy and misguided financial sector favoritism that is compounding the danger each poses to the country.

The Oil Standard and its Effects

1974 is a key date in Phillips' analysis because of a crucial agreement brokered by Henry Kissinger between the United States and Saudi Arabia in which America committed to protect West-leaning OPEC countries and sell weapons systems to them in exchange for OPEC agreeing to price all international sales of petroleum in US dollars and having oil revenues invested in US Treasuries and securities. This interrelationship is referenced throughout the book but there are three key points that seem to nearly SCREAM at you after finishing the entire book.

First, pricing all oil contracts in dollars stimulates demand for US dollars to use in executing oil sales. In 1974, this was thought to be beneficial because it helped support a strong dollar otherwise under threat from inflation left over from deficit spending on the Vietnam War and Great Society programs. Due to the sheer amount of oil sold worldwide, this had the effect of putting the entire world on an "oil standard" while generating huge demand for US dollars.

How much demand? Many Americans may be aware (enraged?) that ExxonMobil made $40 billion in profits for 2007. Far fewer know that $40 billion was earned on revenues of $377 billion. What most Americans don't know is that Exxon Mobil is essentially a bit player in worldwide oil production -- 3 percent according to their own web site. (#2) Revenues for the publicly traded global oil firms for 2007 -- Exxon Mobil ($377) , Royal Dutch Shell ($355B), BP ($284B), Chevron ($208B), ConocoPhillips ($178B) -- add up to $1,402 billion. However, they only amount to about 20 percent of worldwide production. Average crude production in 2007 was about 84.32 million barrels per day or 30,776.8 million for the year. (#3) Assuming an average price during 2007 of $86/barrel, that’s $2.65 trillion in total crude sales worldwide. That's 2.65 trillion U.S. dollars that any buyer of crude on the international market has to find to purchase oil. That's 2.65 trillion U.S dollars sitting in the coffers of the companies or countries selling that oil. Every year.

The second key point about the oil standard's impact involves the nature of the parties controlling the other 80 percent of worldwide production. Those players are nationalized firms in Brazil, Venezuela, Saudi Arabia, China, Iran, Russia and Malaysia. Most of them are not terribly friendly with the United States. Since all oil is being sold in US dollar denominated contracts, all of these other countries are accepting hundreds of billions of US dollars as payment and then have to find somewhere to invest that money. Over the past 20-30 years, they've done what OPEC countries have done and have invested it in US treasuries or directly in US businesses or held it in their central banks ("reserve currency"). However, the recent drop in the value of the dollar has created huge losses on those dollar denominated assets. To grasp the impact of this hit on these parties, imagine a world in which all US food exports had to be sold using Russian rubles, producing an environment where US farmers and agribusinesses held trillions of rubles. Now imagine the ruble losing 27 percent of its value in three years. That would mean a 27 percent loss to American farmers and agribusiness firms. That's exactly what's happened to oil producers over the past three years as the American dollar has fallen. (#4)

The artificial demand for US dollars produced by this "oil standard" has made America over-dependent on an artificially strong dollar and artificially low interest rates to cover not only out of control government borrowing but even more out of control private sector borrowing by consumers and businesses. This is one of the key points Phillips makes in the new book. Those who argue that America's $9.3 trillion dollar national debt and $160 to $250 billion dollar annual deficits "aren't that bad" as a percentage of gross domestic product might be right… They might be right IF the private sector wasn't in even deeper debt -- consumers via home equity loans and businesses via fixating on the manipulation of derivatives of derivatives to make money using highly leveraged bets on changes in asset values rather than actually producing things. In short, domestic mismanagement of our private and government finances has drastically increased our dependence on a financial crutch that foreign countries see growing incentives to remove over doubts about our ability to meet our end of the bargain (providing protection while struggling to fight two simultaneous wars that are destabilizing many of those sellers) and increased costs (financial exposure to falling value of the dollar for their massive dollar holdings) of using the US dollar as a middleman in oil transactions between other parties.

Efficient Market or Rigged Casino?

In Phillips' thinking, government policy makers essentially picked the FIRE (finance, insurance, real estate) sector as the "favorite", cannot fail sector within the US economy in the mid 1980s. Since winning that implicit favored son status within the economy, the FIRE sector has produced a nearly continuous of astronomically expensive meltdowns:

* the failure of over 1000 savings and loans in the late 1980s ($124 billion)
* the Saudi backed bailout of Citibank in the early 90s after bad real estate bets ($550 million)
* a bailout of the Mexican peso to protect Wall Street investments in Mexican bonds ($50 billion)
* a rescue of LTCM coordinated by the New York Fed in 1998 after Russian bond failures exposed bad bets ($3.6 billion)
* injections of liquidity in 1998 to fend off supposed Y2K problems that helped fuel the dot.com bubble
* injections of liquidity to soften the post-dot.com bust and September 11 attacks that fueled the housing bubble ($50.4 billion)
* injections of liquidity to fend off a commercial paper lockup in August 2007 ($62 billion)
* accepting worthless paper from Bear Sterns to avoid a bankruptcy in March 2008 ($29 billion)

Phillips highlights several important points about the circular flaws in the financial engineering that has taken over the American economy that every investor should ponder. The first point is that unlike any other professional discipline, the financial sector seems bent on inventing MORE complicated mechanisms to solve problems when existing, well-documented, well-understood, time-tested solutions already exist. Phillips includes the following quote from another author, Richard Brookstaber, who wrote about hedge funds:

….consider the progress of other products and services over the past century. From the structural design of buildings and bridges, to the operation of oil refineries or power plants, to the safety of automobiles and airplanes, we learned our lessons. In contrast, financial markets have seen a tremendous amount of engineering in the past 30 years, but the result has been more frequent and severe breakdowns… The integration of the financial markets into a global whole, ubiquitous and timely market information, the array of options and other derivative investments -- have exaggerated the pace of activity and the complexity of financial instruments that makes crises inevitable.

Now here's the scary part. All of the above concerns hold true even with perfect information. Unfortunately, there is ample proof of gross, systemic distortions of financial data that has a huge bearing on the inputs fed into these already crisis-prone strategies. Phillips cites two examples. The first is the odd decision by the Federal Reserve to stop reporting statistics on the M3 money supply, curiously at precisely the time when continuing to report those numbers would have shown a huge increase in bank repurchase agreements between the Fed and member banks, reflecting a HUGE spike in liquidity injections and a major inflation risk. A second example illustrated just one flaw in the "hedonic" adjustments to calculations for inflation and gross domestic product figures. To illustrate, consider $1195 spent on an Apple ][ Plus computer in 1979 with a 1MHz CPU and 48k of RAM and one 163k floppy drive. Now, in 2008, for only $1800, you can buy an iMac with a 2.4GHz processor (2400 times faster), 1 GB RAM (21,333 times more memory) and a 320 GB hard drive (over 2 million times more disk space). Sure, the price has gone up nearly 50 percent but look at what you get! So what IS the cost of a "computer"?

Hedonic adjustments attempt to reflect some of this technological improvement in economic statistics by reducing the net cost required for X amount of "value" in the "basket" of goods used to calculate inflation or by increasing the "value" of goods produced above the dollar value set by the market. Surely any "efficient market" purists would scoff at such adjustments, wouldn't they? After all, if a 2008 iMac was truly "worth" 2400 times a 1979 Apple ][ plus, surely the price set by the market would reflect that, right? Hmmmm. To give a sense of the magnitude of these hedonic adjustments and their distortion of key inflation and economic growth statistics, Phillips cites the adjustments made by the Bureau of Economic Analysis on tech spending between 2Q2000 and 4Q2003. Actual spending jumped from $42 billion to $88 billion but was reported by the government to have grown from $446 billion to $557 billion. That means not only was price inflation for those goods understated for that period but that absolute production was being overstated by over $400 billion dollars PER YEAR, in just one sector of the economy.

These hedonic adjustments were proposed by none other than Alan Greenspan in the mid-1990s as a way to combat growth in Social Security spending without requiring direct changes to payout formulas (political suicide). The Clinton Administration and Congress both accepted the changes without batting an eye. Adjustments like that not only inflated GDP and understated inflation but, by rigging those numbers, those adjustments misled investors about the underlying performance of the economy (we would have had another recession) and true returns on stocks and bonds over that period.

So what level of efficiency and perfection can a market achieve when it is operating on falsified statistics about the money supply, inflation and the nation's productivity? How dangerous are complicated financial trading strategies, already crisis-prone enough with perfect information as inputs, likely to be with falsified inputs? Just go back to the beginning of this section and review the list of meltdowns experienced in the past few years. Notice the dollar amounts are going up -- substantially.

Investment Implications

One idea that struck me while reading Bad Money was that the long term (5-10 year) impacts of a realignment among oil producing countries away from dollar denominated sales and American dependence on that crutch don't seem to have much uncertainty. Crude prices will continue to skyrocket as production plateaus (Phillips cites numerous sources stating it already has -- in 2005 to 2006) and begins dropping and demand continues to grow, producing ever larger windfalls for oil producing nations. As China's economy grows and they become a larger share of the world crude market, producer countries will have less incentive to placate the US by selling in US dollar denominated contracts and relying on US military force for protection. At some point, worldwide demand for US dollars will plummet from current levels, either because

a) producing countries begin cutting the US out in fear of further investment losses from dollar denominated assets,
b) because producing countries simply decide they don't need us in the transactions, or
c) because the current model is followed until the last drop of practical oil is pumped out of the last field in 30-40 years.

Even in that last scenario, if it truly is 30-40 years out, surely the efficient market will realize that endpoint is coming and will begin shifting away from strategies based upon current dollar demand, producing the same result without requiring 30 to 40 years to elapse.

For investors, the eventual removal of the crutch of foreign demand for US dollars will make the dot.com bubble and subsequent collapse look like a picnic in comparison. Most American investors have grown accustomed to the 9.87 percent CAGR in equities (#5) enjoyed for the past 25 years. With that kind of return, many probably figure they can tolerate one or two 15 to 20 percent "corrections" and still come out ahead over a twenty to thirty year horizon. In the climate likely to emerge, investors may easily suffer a 50 percent "correction" then instead land in a climate where US returns are likely to be far lower than past historical averages, making it virtually impossible to "catch up" after a major correction.

Diversification would normally be the prescription but two considerations come in to play with diversification as well. First, news stories have already confirmed the junk produced by American financial firms has already produced massive losses for banks and investors in Australia, Germany, France, Britain and elsewhere. More importantly, regulations in other countries may be no better equipped to deal with the complexities or outright fraud associated with complicated financial products than US markets.

Well, that's not very helpful, is it? A common critique of this "doomsday" thinking is "Where's the actionable information? If you can't give me a specific recommendation to trade on given this theory, then the theory is just sky-is-falling BS." In a world with an efficient market, perfect information, and a government sitting on the sidelines not picking favorites and protecting them with taxpayer money, I would

* short Ford and GM -- gas will hit $5.00 to $6.00 sooner than they can retool their lines
* short Citigroup -- Citi has gotten in big trouble twice and still hasn't learned a thing in 20 years
* consider converting some US dollar cash holdings to foreign currency
* divest any holding that requires any major debt restructuring in the next 3-5 years

I would also try to find some investments in alternate energy (wind, solar) or in energy saving technologies, though at this point, very few are probably beyond the incubator phase and are thus still highly speculative.

However, read the preceding sections a second time. We already know we don't have an efficient market -- efficient markets wouldn't produce $29 billion dollar mistakes that operate in plain site for years before a simple question like "how can a person making $70,000 qualify for a $500,000 mortgage?" unravels the entire scheme. We already know the market is using flawed information -- the government was making up hundreds of billions of dollars worth of productivity to make it easier to cheat senior citizens out of COLAs. We already know the government and the Fed HAVE picked favorites and continue to bail them out as "indispensible" with public dollars.

Policy Implications

Phillips doesn't provide many specific recommendations within Bad Money but his analysis of the linkage between energy policy and financial stability seem to suggest a few. First, changes to laws affecting the availability of new oil sources (ANWR, etc.) may be up for discussion but active tax subsidies to oil companies for drilling or production is a lost cause. No tax dollars should go towards supporting profits or accelerating domestic production.

Second, gas tax reductions or temporary holidays serve no purpose either. Temporarily or permanently lowering gas taxes simple reduces funds in the treasury that have to be borrowed from abroad anyway, artificially reducing the true cost of energy which artificially sustains demand which lines the pockets of countries who, in the long term, are not aligned with our interests.

Finally, the last thing we need is the federal government trying to pick a new energy winner or technology to replace petroleum. However, given the damage the financial industry has wrought with its favored status, it seems pretty clear the payoffs for the American economy are likely higher plowing billions into university and small company research and development rather than tossing billions in bailouts at financial firms who have already proven their models don't work. Repeatedly. The billions that might bail out financial institutions will go directly to the top earners at those companies. Billions spent at universities and small start-up firms have a much better chance of being spread across the economy to stabilize communities and employment and maybe actually find some solutions to the energy side of the equation.

Political Implications

Phillips cites numerous statistics that indicate the Democratic Party has actually become the top money destination for the financial sector and that Democratic electoral strongholds line up well with major financial centers (Boston, NYC, Connecticut, Philadelphia, Chicago, SF and LA). As a result, Democrats aren't likely to tighten regulation or disclosure requirements on key contributors. Republicans aren't likely to call for tightened regulation based on misguided trust in efficient markets and reduced regulation. That leaves it to the press (yea right) and the public to put these concerns on the political agenda. Getting the public focused on something as technical and mundane as dollar-denominated oil sales is obviously next to impossible without some sort of attention grabber. At least with global warming, a cute polar bear facing extinction can become the face of the movement on the posters and T-shirts. For these problems, maybe the attention grabber is a question: "How would you like to lose half of your retirement savings AND pay $6.00 for gas sometime in the next ten years?"

I think it could happen.


#1) http://watchingtheherd.blogspot.com/2008/02/book-review-american-theocracy.html

#2) http://www.exxonmobil.com/corporate/energy_issues_globaloil.aspx

#3) http://www.theoildrum.com/node/3439

#4) http://www.oanda.com/convert/fxhistory

#5) http://www.moneychimp.com/features/market_cagr.htm from Jan 1983 to Dec 2007