Saturday, March 19, 2011
A couple of revealing charts from the Fed’s Flow of Funds data. Both show net flows into Treasuries by creditor type and the Federal Government’s borrowing during each quarter. Note, the quarterly data is annualized.
The first chart illustrates how QE2 flushed domestics out of Treasuries and effectively funded 63 percent of the budget deficit in Q4. The Treasury is prohibited from directly selling bonds to the central bank, but effectively finances the government through POMO.
Given that a large portion of the Rest of World category are central banks recycling BOP surpluses, it’s likely that 90 percent of the U.S. budget deficit in Q4 was funded by central banks. You think this may have anything to do with what’s happening in the commodity markets? That is, the central banks’ printing presses providing the fuel for speculators?
Furthermore, we ask: who is going to finance the U.S. budget deficit when QE2 ends, especially at a sub 3.50 percent 10-year Treasury rate? Bill Gross knows!
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 7.5 percentage points to 28.5% in the latest AAII Sentiment Survey. This is the lowest optimism has been since August 26, 2010. It is also the fourth consecutive week that bullish sentiment has been below its historical average of 39%.
Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, edged down 0.3 percentage points to 31.4%. This is the second consecutive week that neutral sentiment has been slightly above its historical average of 31%.
Bearish sentiment, expectations that stock prices will fall over the next six months, jumped 7.8 percentage points to 40.1%. This is the highest pessimism has been since September 2, 2010. Bearish sentiment has now been above its historical average of 30% for four consecutive weeks.
The continued volatility in the markets is clearly taking a toll on individual investors’ attitudes, as can be seen by today’s numbers. Neither bullish nor bearish sentiment are at levels that would be considered contrarian, however, based on the survey’s historical results. Nonetheless, if the S&P 500 is in the midst of a correction, it is likely we could continue to see elevated levels bearish sentiment until a short-term floor for stock prices is found.
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Let's review today's volatility in the S&P 500. The first chart features an overlay of the index and the CBOE Volatility Index (VIX) since 2007. Today the VIX rose to 29.34, a gain of 20.6% over the previous close.
As the chart above illustrates, the correlation between the S&P 500 and the VIX is inverse but imperfectly so. The lower low in the summer of 2008, when the index nearly dipped to 1200, came with a lower VIX in the upper 20s. More significantly, the unprecedented surges in the VIX above 80 in late 2008 predated the actual index low by over three months.
A key to understanding the VIX is to realize that it is far more volatile than the index to which it is attached. The next chart inverts the VIX values, which helps us see more clearly the greater degree volatility and the fact that the VIX tends to lead the S&P 500.
The spike in the VIX today is a bit worrisome, especially because it is approaching the 30 level associated with high volatility. The triangles at the bottom of both charts identify days on which the VIX spiked by more than 20%, something that's happened 12 times since the March 2009 low. In particular, we can see the increase in volatility associated with the 16% correction that began in April 2010 and ended in early July.
For a look at the VIX and S&P 500 since 1990, click here.
Note: For anyone needing a VIX refresher, Investopedia provides a handy overview: VIX: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".... VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.
Prices in 11 of the 20 markets included in the index sank to postbust lows: Atlanta; Charlotte, North Carolina, Chicago; Detroit; Las Vegas; Miami; New York; Phoenix; Portland, Oregon, Seattle; and Tampa, Florida.
"There's just way too many homes out there relative to demand and we're not going to see that change anytime soon," said Joshua Shapiro, chief US economist for MFR, Inc.
Robert Shiller thinks price declines have another 15 to 25 percent to go, due to all the empty houses with no buyers, proposals to reduce the mortgage-interest tax deduction being floated, the uncertain futures of Fannie Mae and Freddie Mac, and Middle East unrest.
The whole idea that every American should own a home just isn't working out. And that is the seed of the housing boom: a government agenda to make everyone an owner of their own cozy home-sweet-home. A seed planted by Herbert Hoover back in the 1920s when he was an ambitious secretary of commerce. Not many authors writing about the housing boom and bust have chased the story back this far. Alyssa Katz does so in her book Our Lot: How Real Estate Came to Own Us.
Katz gets to the nub of it beautifully on page 3:
Owning homes would serve as a force to better the world — to build stronger families, more pleasant communities, financial security, a sharing of wealth through generations. That idea has been embedded in the national psyche, not through any innate aspiration in the human spirit but by dint of methodical, deliberate salesmanship and an array of incentives seemingly too powerful to refuse.
In the 1930s, FDR wanted to get housing going and he enlisted the help of two executives, who had formerly sold and financed cars, to put together the FHA-insured mortgage program that gave homeowners comfort that their loan terms were long-term. Just make the payments on time for thirty years and the house with the white picket fence will be all yours! At the same time candidates for office like Charles Percy were on the stump telling voters,
For a man who owns his own home acquires with it a new dignity. He begins to take pride in what is his own, and pride in conserving it and improving it for his children. He becomes a more steadfast and concerned citizen of his community. He becomes more self-confident and self-reliant. The mere act of becoming a homeowner transforms him.
Percy referred to renters as "slaves."
And so it began, the federal government's agenda that Americans not be beholden to greedy landlords but be strong independent owners of property with no one to answer to but God, the local tax authorities, and the mortgage lender (whose investment was guaranteed by FHA). What on earth could possibly go wrong? This is indeed the American way.
From her beginning with the Hoover/FDR agenda, the author then cleverly weaves a number of divergent stories together to form her housing tragedy. You haven't heard of most of the people Katz writes about but all in their own small ways own a piece of the housing-boom-and-bust story.
In her opening chapter, the author pairs Chicago housing activist Gale Cincotta with legendary Salomon Brothers trader Lewis Ranieri, who was immortalized by Michael Lewis in his book Liar's Poker.
Cincotta wanted people in inner-city neighborhoods to have access to credit. She ultimately took her cause to Washington, and in 1991 Congress forced Fannie Mae and Freddie Mac to start buying loans that had been made to poor people.
Meanwhile Ranieri was working on a financial product that would comprise mortgages bundled together, becoming bonds to be sold to investors. At the time, he didn't even have a name for what would become securitizing of mortgages.
Next we meet a nice young couple who buy a home in 1996 with FHA financing. The next thing Spencer and Lisa Kasten know they become a photo op for President Bill Clinton at the Homeownership Summit. In perhaps the book's best chapter, the author chronicles the Clinton agenda to increase the number of homeowners. The Clinton administration was manic: "As someone at HUD calculated it, they would have to add one new homeowner every 24 seconds, 24 hours a day, 7 days a week, 365 days a year," Katz writes.
All the usual constituencies threw themselves behind "The National Homeownership Strategy," a program that emphasized responsibility, right in step with Clinton's welfare reforms. After designating the first National Homeownership Day in 1995, Clinton mentioned homeownership in eight speeches leading up to the 1996 election. He even waxed eloquent about his first house of a thousand square feet, saying he used it to propose to Hillary. "Don't you think you'll have to marry me so I won't have to live there by myself?"
Sunny Orange County California is the back drop for the genesis of subprime lending. Mortgage lenders couldn't figure out how to get the money out the door fast enough with lenders quickly watering down loan-underwriting requirements whenever a competitor seemed to have the upper hand, all in the name of breaking down the barriers to homeownership.
"Our innovative industry has created a great way to expand homeownership by offering loans to those who can make payments, but don't qualify for 'A' paper because of poor credit or bankruptcy," Mortgage Bankers Association former president Ron McCord told the MBA annual convention in 1997.
A decade later home-mortgage debt had ballooned to $11 trillion from just $1.3 trillion back in the early 1980s. America not only had too many houses but too many people peddling loans. There were but 7,000 mortgage brokers in 1987, the author writes, and by 2004 there were more than 44,000 employing 418,000 people. These mortgage brokers originated loans to be sold to the vast new secondary market. A market that couldn't get enough product. The unscrupulous fraudulently worked the system as Katz colorfully narrates in a story about massive loan fraud in a tony subdivision in Atlanta.
The author even works the publicly traded builders into her story, noting that mom-and-pop builders all over the country sold out for top dollar to the Lennars of the world near the height of the boom. But of course all of these builders were just paper contractors. They held but one asset worth buying: land. With stockholder money and cheap financing from Wall Street, these public builders went on a buying spree from sea to shining sea, driving up land prices in all of housing's hot spots.
Alyssa Katz is not an economist or financial analyst. According to the cover-flap bio, she teaches journalism, writes for a variety of publications, and lives in Brooklyn. She neatly brings her story home at the end of the book relating her nightmare of being chased from her rental unit when developers bought her building to convert to condos.
Virtually all of the elements of her story serve to drive up the price of New York real estate: cheap money, easy loans, and demand from high-salaried Wall Streeters who were packaging mortgage securities. However, the primary culprit in the author's view is the erosion of rent control. She writes, "the movement to minimize government's role in the economy was throwing renters into free-fall." Renters have been played by the free-marketers, she claims. Thirty years ago, one in ten cities controlled rents. No more.
With landlords able to drive up rents with impunity, renters had to become owners out of self-defense. "[I]t's impossible to make a blanket case for or against rent control," Katz writes, "any more than it's possible to say that police are always a force for good." The author believes any problems with rent control can be worked out with the right political finesse requiring "mechanisms to let landlords increase rents to cover their costs: otherwise, rent controls create slums."
Katz doesn't mention the distortions to property uses that rent control creates or the political corruption it manifests. She doesn't realize that rent control essentially takes housing stock off the market, decreasing supply and thus, with the same demand, driving up rental rates for unregulated apartments as well as the prices of for-sale units.
What the author does understand is that "every intervention [to rescue the housing market] Congress has cooked up so far is doomed to make the problem worse" and that government is doing everything it can to prop housing prices up consigning "future generations to the same trap, huffing on a treadmill of debt, or alternately to a cure of inflation that hikes the price of everything else."
But the real-estate market is a hard mistress for the government to master as the Case-Schiller numbers point out. The author runs a slight thread of argument through Our Lot that blames Reagan's free-market ideology for Americans being weighed down by $13.2 trillion in mortgage debt and millions being bankrupted by the whole mess.
At the same time, Katz clearly fingers the government for its "mind-blowingly naïve" housing scheme that has, using her analogy, turned us all into so many rats being rewarded cocaine for pushing the real-estate lever.
The answer is let the Fannies and Freddies fail, allowing underwater mortgages to be repriced in the bankruptcy auction marketplace. The new debt holders will eagerly make new deals with mortgage payers, just as Selene Residential Mortgage Opportunity Fund, run by none other than Lewis Ranieri, does.
Only the free market can set homeowners free.
The music stopped. And things got, well, complicated.
Today, the world is dancing to a new song with a potentially devastating ending, says Vikram Mansharamani, an equity investor, Yale lecturer, and author of the book Boombustology. That song is called "Commodities."
Many metal futures, like copper, are at record highs, up more than 40% since 2010. The stocks of global mining companies like Rio Tinto have doubled in the last year. The economies of metal-rich nations in South America are booming. And why shouldn't they? Supply for commodities is still tight, and demand for metals is still high, thanks to fast-charging developing countries, such as India and China. There's absolutely, 100%, no way the market for commodities dries up any time in the near future, right?
"I'm a China bear," Mansharamani says. "China is exhibiting all the signs you would expect from an unsustainable boom." He first points to the housing market, where investment hit the inauspicious market of 6% of GDP -- the same mark the U.S. hit in 2006 as the bubble was bursting. What's more, outstanding loans for developers and residential mortgages in China have increased by a factor of FIVE in the last decade. Loan balances have nearly doubled in the last three years alone.
Even worse, Mansharamani says, the Chinese government has spent lavishly to create demand that never materialized. He points to ghost towns like Qungbashi, in Inner Mongolia, a city designed for 1.5 million residents, but drew only 20,000 -- hardly one percent. He points to the New South China Mall, not far from Guangzhou, which was built to handle 1,500 tenants. Instead, it houses a few dozen -- hardly one percent. This sort of one-percent success rate creates ludicrous overcapacity that is eerily reminiscent of the empty homes and strip malls lining recession ghost exurbs in Arizona and Nevada. Mansharamani sees it as the prelude to a dramatic slowdown in government spending on buildings and infrastructure.
AS CHINA GOES, COMMODITIES GO
Well, so what? you ask. What do small towns and empty malls in Nowhere, China, matter to the world economy? The answer is that one engine of the global economy in the last few years has been commodities -- metals like steel and copper and aluminium used to build cities, malls and infrastructure. Countries with commodities, like Brazil and Australia, have thrived. So have US companies that specialize in unearthing commodities, like Bucyrus and Caterpillar.
But as China goes, commodities go. China's share of world demand for leading metals like aluminium, copper, zinc, lead, nickel, and crude steel is about 40 percent, according to research obtained from Goldman Sachs. For steel, China commands nearly half the global market. (In 2000, its share of global demand for those metals was between 6 and 16%.)
Even these numbers understate the breadth of China's impact. "Think how much steel is sold to Caterpillar or John Deere for capital goods that are sent to China," Mansharamani says. "Or how much is sent to Brazil to mine iron for China. Think of the countries that get dragged down with a commodities slow-down -- South Africa, Brazil, Peru. The world shipping sector."
If China slows down even to 5% growth a year, that will take a booming commodities market down with it.
THE NEXT FEW MONTHS
In the short term, Mansharamani told me in a follow-up interview, the commodities story could hold together longer thanks to new demand out of Japan to rebuild after the quake and tsunami. If a spending binge in Japan increases real demand for metals, it could justify ongoing speculation in metals prices.
But like a balloon batted in the air one last time, this might serve to only make the fall more dramatic, Mansharamani says. "This will temporarily hide the unsustainability of the Chinese investment boom," he wrote to me in an email. "It will embolden mining companies to expand more rapidly. This will likely make the eventual correction more extreme than if the excesses were revealed today."
The general public today knows little about the FED. Prior to Ron Paul’s Presidential run in 2007-8, far fewer people understood it.
I have been asked: “How could we get rid of the Federal Reserve? What will replace it?” The answer: either the free market or Congress.
People who think of themselves as free market people often are not. The tax-funded public schools and the state-regulated and accredited university faculties have taught that the modern system of intrusive civil government is necessary for an orderly society. People cannot imagine a market-based society.
There is an old saying, “You can’t beat something with nothing.” But the free market social order is not nothing. It is expanding around the world, which is why the world is getting richer.
At the Federal level, a free market social order in banking existed prior to 1914. That was back when the dollar was worth over 20 times what it is worth today. (On this point, see the inflation calculator of the Bureau of Labor Statistics.)
We can go back to that system. We will go back to it. The question is: When? The other question is: At what price?
Ending the Fed By Law
Ron Paul could introduce a bill to end the Federal Reserve System. He could call it: “The Monetary Liberty Act.” It would get known as the “End the Fed Act.” Here is what the text might say:
The Federal Reserve Act of 1913 is hereby repealed. So are all subsequent acts based on the Federal Reserve Act of 1913.
All authority of the Federal Reserve System to act in the name of the United States government is hereby revoked.
The assets of the Board of Governors of the Federal Reserve System, which are already the property of the United States Government, are hereby transferred to the Department of the Treasury. This includes all of the assets listed on the balance sheet of the Federal Reserve System.
The twelve (12) privately owned Federal Reserve Banks will return all assets held in trust for the United States government within thirty (30) calendar days of the signing of this bill into law.
The gold reserves of the United States government that are held in storage by the Federal Reserve Bank of New York will be transferred to the Government’s depository at Ft. Knox, Kentucky, within one calendar year after this bill becomes law. The Government Accountability Office will conduct an inventory of the gold held in storage by the Federal Reserve Bank of New York before and after this transfer.
The Board of Governors will vacate the premises of the Federal Reserve building within thirty (30) calendar days of the signing of this bill into law.
Any pension fund assets of the employees of the various Federal Reserve Banks will remain under the control of those banks. All pension obligations under the authority of the Board of Governors of the Federal Reserve System are hereby transferred to the Department of the Treasury, to be administered under the retirement program of the Department of the Treasury.
This is simple. The Board of Governors of the Federal Reserve System is a government agency. Its authority would be transferred to the U.S. Treasury.
The dozen Federal Reserve Banks are privately owned. All authority of these 12 banks that derives from their connection to the Board of Governors will cease. If they can make a profit, fine. If not, equally fine. The free market will determine which will survive and which will not.
Is this radical? Not at all. There are two historical precedents: the refusal of Congress to renew the charter of the Bank of the United States in 1811, and the refusal of Congress to renew the charter of the Second Bank of the United States in 1836. Both of them went bust.
The standard response is that there must be independence between the Federal Reserve System and the U.S. government. Let us apply this to other agencies:
- The Department of Defense
- The Department of the Treasury
- The Department of State
- The Department of Education
I could go on, one by one, to list all of the thousands of agencies that are funded by Federal taxes and which operate by means of the authority of the U.S. government. Only one government agency is defended by publicists, both on and off the payroll of the Federal Reserve System, as deserving to be independent of the government that has transferred authority to it: the Board of Governors of the Federal Reserve System.
The phrase, “the independence of the Federal Reserve System,” is a code phrase for “the independence of the four largest U.S. banks from the threat of losses.” A growing number of voters has figured this out since the fall of 2008. This is why the Federal Reserve System is facing public criticism for the first time since 1914. This criticism will grow.
All of this may seem Utopian. Ron Paul could not get Congress to audit the FED, which by law possesses this authority. The Congress has been in the hip pocket of the FED for almost a century. The Congress lets the FED run the nation’s economy.
But as criticism spreads, there will be more voters who figure out what the FED is and has always been: a government-created cartel of the banks. It operates for the benefit of the largest banks.
Will Ron Paul get such a law passed by Congress and signed into law? No. Does this mean that the FED is forever untouchable? No.
We need the following:
- A wave of price inflation caused by the FED
- A subsequent recession caused by the FED
- A depression caused by the FED
- A wave of outage in response to the FED
- An endless series of criticisms of the FED
This will result, ultimately, in the abolition of the FED. Whatever replaces it will decide the economic fate of Americans: Congress (hyperinflation) or the free market (economic stability).
But could the free market replace the FED without a catastrophe following? Yes. We are already seeing this in another sector of the economy.
“You’ve Got Almost No Mail!”
From the days of America’s most famous postmaster, Benjamin Franklin, two decades before the American Revolution, residents of North America have thought that the country could not do without a government-funded postal system. In the past 15 years, this faith has quietly died. The United States Postal Service now delivers mostly subsidized opportunity mail. (I hate the work “junk mail,” for I built my business on opportunity mail. But I have not used it for 15 years.) With email, UPS, FedEx, and text messaging, the first class letter is an anachronism. Historians will not be able to trace much after 1998 based on copies of letters.
With no fanfare, the postal system has become optional. The public does not go to the local Post Office often. If it were not for Netflix, a lot of people would not check their mailboxes daily.
All of this has happened without any new legislation. The once unbreakable monopoly of the Post Office is a rusted-out shell, staffed by union-protected workers who probably know their jobs are peripheral. Its volume declined by over 12% in 2010. This is expected to continue. That would cut volume by 50% by 2017. About 40,000 employees were fired in 2010. Saturday delivery will be dropped soon. There is another rate hike scheduled. Yet the outfit will lose $10 billion this year.
All this has happened without any enabling legislation. It has happened quietly. Market competition has reduced the USPS to an anachronism. It is a leftover shell of a bygone era.
In an essay about his youth, sociologist Robert Nisbet remarked that in the year he was born, 1913, the only contact that most Americans had with the Federal government was the Post Office. Later that year, the Federal Reserve Act was passed in a late session, just before Christmas break. Also in that year, the income tax came into effect. The expansion of the Federal government has been relentless ever since.
Nevertheless, the Post Office is slowly dying. No one planned this. The free market has replaced it, despite its official monopoly.
This offers hope. It means that free market solutions can come into existence before a government entity is shut down by law. The Post Office officially is a monopoly, yet its monopoly status has been eroded over the last four decades. It has been almost entirely replaced over the last two decades.
I think of a TV commercial that did not directly attack the Post Office. It was targeted at UPS. But UPS responded much faster than the Post Office could.
While critics of the postal monopoly had for decades tried to get Congress to revoke the Post Office’s monopoly, all attempts failed. They were associated with the fringe. Yet, year by year, the Post Office fell behind. It is irrelevant in American life today.
This was not planned by any political group. It was the result of new technologies. People made decisions, day by day, to bypass the Post Office.
An End Run Around the Fed
I do not expect Congress to revoke the Federal Reserve Act of 1913 in this decade. The powers that be who run this country do so by means of the Federal Reserve System more than by any other semi-private institution. It is at the center of control, because the monetary system is at the center of the economy.
But the central bank faces a problem. To maintain the boom, the FED must inflate. To cease inflating would allow the credit bubble to implode on a scale far more devastating than what happened in 2008. The FED has placed us all on the back of the tiger.
Yet if it does not reverse its policy, it must produce hyperinflation at some point. That will destroy the FED’s ability to guide the economy. Hyperinflation will lead to alternative currencies. Digital technology is now international. If buying and selling digital U.S. dollars is no longer profitable, because long-term contracts are not possible under hyperinflation, then the citizens of the United States will do what citizens of Zimbabwe did. They will use other currencies.
If the FED produces a Third World economy through hyperinflation, then people will do what Third World citizens do: find reliable currencies elsewhere. This can be done on-line nearly for free. The Internet has reduced the transaction costs of using rival currencies.
The FED economists know this. They know that transaction costs for using other currencies are low. If the FED’s policies undermine long-term contracts, the citizens are not helpless. They can switch.
It will not take legislation to end the FED. All it will take is the FED. If the FED continues to inflate, it will destroy its base: the monetary system based on the FED. But if it ceases to inflate, by ceasing to buy Treasury debt, it will create Great Depression 2.
Bernanke can get away with QE2 today only because commercial banks are not lending. If they start lending, M1 will rise, the M1 money multiplier will rise, and price inflation will return.
He has bought time with QE2, but he has not bought a way out of the credit bubble that Greenspan created and he created.
He can play hide and go seek with Ron Paul, refusing to show up at the hearings of the Monetary Policy Subcommittee. Congress cooperates. But he cannot play hide and go seek with the business cycle. Greenspan did, but he got out in 2006. He passed on the Old Maid to Bernanke.
The Federal Reserve System bases its power on its ability to control the monetary base. It swapped T-bills for toxic assets to save the big banks, but to replenish its supply of swappable liquid assets, it has to inflate, as it is now doing. QE2 is replenishing the supply of Treasury debt to swap with large banks.
The FED did not bail out any small banks in 2008. It never has. Its unofficial mandate is to bail out the largest commercial banks. This it has done.
I think Bernanke sees another banking crisis coming. This is why he has pushed QE2. Only Hoenig has voted against it. Bernanke has his way with the other members of the Board of Governors and the Federal Open Market Committee. He has not said why this massive increase in the monetary base is mandatory for the economy. To talk about this would create doubts. He does not want to rock the boat. So, he gets away with another $600 billion in monetary base creation.
This is working for now. But the results are unavoidable: either price inflation or continued high unemployment and stagnation, because commercial banks thwart the stimulation. He is on the tiger’s back. So are we.
The Post Office looked unbeatable for over 250 years. Technology has made it peripheral. The same will happen to the Federal Reserve System. It looks unbeatable. But the Internet can beat it. There are ways out of the FED’s trap.
A lot of people will pay a heavy price for Bernanke’s policies. That will be the price of persuading those people with the bulk of their assets in digital dollars to sell those assets and replace them with other digits.
This is why I do not think the FED will resort to hyperinflation. The economists know that the FED’s victims can escape. The FED will risk mass inflation, but at some point it must say: “We will buy no more Treasury debt.” That will be the moment of truth. That will be the day it climbs off the back of the tiger.
So will we all.Regards,
The Prime Minister of Japan recently stated that his nation was facing its worst crisis since World War II. While most of the world is focused on tragic images of floodwater and rubble, and fixated on radiation levels, there is a bigger picture to be examined – one that also includes energy, coal and the Strait of Hormuz.
Human nature draws our focus to the present. We look for immediate repercussions to a devastating world event. But the real advantage lies in understanding the broader perspective. In order to get this deeper understanding, you could choose to spend endless hours scouring global new sources day and night, constantly questioning their legitimacy and bias. Or you could take a better approach and hire a team of geopolitical experts and uber-intelligent analysts.
I use STRATFOR, a geopolitical intelligence firm, to keep me aware of the why and what comes next of situations I know will, in some form or fashion, affect me and my investments. For those of you currently experiencing full STRATFOR access via their 3-month free trial earlier this year (exclusively for Outside the Box readers), you know what I mean. For those new to this e-newsletter or if you've been hesitant to take the plunge into the thought-changing world of geopolitics - these guys are hard to beat.
In today's Outside the Box I'm including this week's edition of their Geopolitical Weekly report, which fully explains the Japanese PM's concerns and puts the recent major world events, from the Middle East to the Far East, in a context we all can understand. Give it a read, and if you like what you see, << join their mailing list>> to receive free reports like this directly to your inbox every week.
John Mauldin, Editor
Outside the Box
By George Friedman
Over the past week, everything seemed to converge on energy. The unrest in the Persian Gulf raised the specter of the disruption of oil supplies to the rest of the world, and an earthquake in Japan knocked out a string of nuclear reactors with potentially devastating effect. Japan depends on nuclear energy and it depends on the Persian Gulf, which is where it gets most of its oil. It was, therefore, a profoundly bad week for Japan, not only because of the extensive damage and human suffering but also because Japan was being shown that it can’t readily escape the realities of geography.
Japan is the world’s third-largest economy, a bit behind China now. It is also the third-largest industrial economy, behind only the United States and China. Japan’s problem is that its enormous industrial plant is built in a country almost totally devoid of mineral resources. It must import virtually all of the metals and energy that it uses to manufacture industrial products. It maintains stockpiles, but should those stockpiles be depleted and no new imports arrive, Japan stops being an industrial power.
The Geography of Oil
There are multiple sources for many of the metals Japan imports, so that if supplies stop flowing from one place it can get them from other places. The geography of oil is more limited. In order to access the amount of oil Japan needs, the only place to get it is the Persian Gulf. There are other places to get some of what Japan needs, but it cannot do without the Persian Gulf for its oil.
This past week, we saw that this was a potentially vulnerable source. The unrest that swept the western littoral of the Arabian Peninsula and the ongoing tension between the Saudis and Iranians, as well as the tension between Iran and the United States, raised the possibility of disruptions. The geography of the Persian Gulf is extraordinary. It is a narrow body of water opening into a narrow channel through the Strait of Hormuz. Any diminution of the flow from any source in the region, let alone the complete closure of the Strait of Hormuz, would have profound implications for the global economy.
For Japan it could mean more than higher prices. It could mean being unable to secure the amount of oil needed at any price. The movement of tankers, the limits on port facilities and long-term contracts that commit oil to other places could make it impossible for Japan to physically secure the oil it needs to run its industrial plant. On an extended basis, this would draw down reserves and constrain Japan’s economy dramatically. And, obviously, when the world’s third-largest industrial plant drastically slows, the impact on the global supply chain is both dramatic and complex.
In 1973, the Arab countries imposed an oil embargo on the world. Japan, entirely dependent on imported oil, was hit not only by high prices but also by the fact that it could not obtain enough fuel to keep going. While the embargo lasted only five months, the oil shock, as the Japanese called it, threatened Japan’s industrial capability and shocked it into remembering its vulnerability. Japan relied on the United States to guarantee its oil supplies. The realization that the United States couldn’t guarantee those supplies created a political crisis parallel to the economic one. It is one reason the Japanese are hypersensitive to events in the Persian Gulf and to the security of the supply lines running out of the region.
Regardless of other supplies, Japan will always import nearly 100 percent of its oil from other countries. If it cuts its consumption by 90 percent, it still imports nearly 100 percent of its oil. And to the extent that the Japanese economy requires oil — which it does — it is highly vulnerable to events in the Persian Gulf.
It is to mitigate the risk of oil dependency — which cannot be eliminated altogether by any means — that Japan employs two alternative fuels: It is the world’s largest importer of seaborne coal, and it has become the third-largest producer of electricity from nuclear reactors, ranking after the United States and France in total amount produced. One-third of its electricity production comes from nuclear power plants. Nuclear power was critical to both Japan’s industrial and national security strategy. It did not make Japan self-sufficient, since it needed to import coal and nuclear fuel, but access to these resources made it dependent on countries like Australia, which does not have choke points like Hormuz.
It is in this context that we need to understand the Japanese prime minister’s statement that Japan was facing its worst crisis since World War II. First, the earthquake and the resulting damage to several of Japan’s nuclear reactors created a long-term regional energy shortage in Japan that, along with the other damage caused by the earthquake, would certainly affect the economy. But the events in the Persian Gulf also raised the 1973 nightmare scenario for the Japanese. Depending how events evolved, the Japanese pipeline from the Persian Gulf could be threatened in a way that it had not been since 1973. Combined with the failure of several nuclear reactors, the Japanese economy is at risk.
The comparison with World War II was apt since it also began, in a way, with an energy crisis. The Japanese had invaded China, and after the fall of the Netherlands (which controlled today’s Indonesia) and France (which controlled Indochina), Japan was concerned about agreements with France and the Netherlands continuing to be honored. Indochina supplied Japan with tin and rubber, among other raw materials. The Netherlands East Indies supplied oil. When the Japanese invaded Indochina, the United States both cut off oil shipments from the United States and started buying up oil from the Netherlands East Indies to keep Japan from getting it. The Japanese were faced with the collapse of their economy or war with the United States. They chose Pearl Harbor.
Today’s situation is in no way comparable to what happened in 1941 except for the core geopolitical reality. Japan is dependent on imports of raw materials and particularly oil. Anything that interferes with the flow of oil creates a crisis in Japan. Anything that risks a cutoff makes Japan uneasy. Add an earthquake destroying part of its energy-producing plant and you force Japan into a profound internal crisis. However, it is essential to understand what energy has meant to Japan historically — miscalculation about it led to national disaster and access to it remains Japan’s psychological as well as physical pivot.
Japan’s Nuclear Safety Net
Japan is still struggling with the consequences of its economic meltdown in the early 1990s. Rapid growth with low rates of return on capital created a massive financial crisis. Rather than allow a recession to force a wave of bankruptcies and unemployment, the Japanese sought to maintain their tradition of lifetime employment. To do that Japan had to keep interest rates extremely low and accept little or no economic growth. It achieved its goal, relatively low unemployment, but at the cost of a large debt burden and a long-term sluggish economy.
The Japanese were beginning to struggle with the question of what would come after a generation of economic stagnation and full employment. They had clearly not yet defined a path, although there was some recognition that a generation’s economic reality could not sustain itself. The changes that Japan would face were going to be wrenching, and even under the best of circumstances, they would be politically difficult to manage. Suddenly, Japan is not facing the best of circumstances.
It is not yet clear how devastating the nuclear-reactor damage will prove to be, but the situation appears to be worsening. What is clear is that the potential crisis in the Persian Gulf, the loss of nuclear reactors and the rising radiation levels will undermine the confidence of the Japanese. Beyond the human toll, these reactors were Japan’s hedge against an unpredictable world. They gave it control of a substantial amount of its energy production. Even if the Japanese still had to import coal and oil, there at least a part of their energy structure was largely under their own control and secure. Japan’s nuclear power sector seemed invulnerable, which no other part of its energy infrastructure was. For Japan, a country that went to war with the United States over energy in 1941 and was devastated as a result, this was no small thing. Japan had a safety net.
The safety net was psychological as much as anything. The destruction of a series of nuclear reactors not only creates energy shortages and fear of radiation; it also drives home the profound and very real vulnerability underlying all of Japan’s success. Japan does not control the source of its oil, it does not control the sea lanes over which coal and other minerals travel, and it cannot be certain that its nuclear reactors will not suddenly be destroyed. To the extent that economics and politics are psychological, this is a huge blow. Japan lives in constant danger, both from nature and from geopolitics. What the earthquake drove home was just how profound and how dangerous Japan’s world is. It is difficult to imagine another industrial economy as inherently insecure as Japan’s. The earthquake will impose many economic constraints on Japan that will significantly complicate its emergence from its post-boom economy, but one important question is the impa ct on the political system. Since World War II, Japan has coped with its vulnerability by avoiding international entanglements and relying on its relationship with the United States. It sometimes wondered whether the United States, with its sometimes-unpredictable military operations, was more of a danger than a guarantor, but its policy remained intact.
It is not the loss of the reactors that will shake Japan the most but the loss of the certainty that the reactors were their path to some degree of safety, along with the added burden on the economy. The question is how the political system will respond. In dealing with the Persian Gulf, will Japan continue to follow the American lead or will it decide to take a greater degree of control and follow its own path? The likelihood is that a shaken self-confidence will make Japan more cautious and even more vulnerable. But it is interesting to look at Japanese history and realize that sometimes, and not always predictably, Japan takes insecurity as a goad to self-assertion.
This was no ordinary earthquake in magnitude or in the potential impact on Japan’s view of the world. The earthquake shook a lot of pieces loose, not the least of which were in the Japanese psyche. Japan has tried to convince itself that it had provided a measure of security with nuclear plants and an alliance with the United States. Given the earthquake and situation in the Persian Gulf, recalculation is in order. But Japan is a country that has avoided recalculation for a long time. The question now is whether the extraordinary vulnerability exposed by the quake will be powerful enough to shake Japan into recalculating its long-standing political system.
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