Monday, November 30, 2009

Managing the Mother of all Minsky Moments

During the 2008 Canadian federal election, I had the opportunity to be a political commentator for a cable television program. One thing that struck me during the campaign is that when the markets plunged, losing more than 30% of their value, the political class was at a loss to explain the events.

Remember the talk of how our economic fundamentals were sound, that a carbon tax would move us into a recession, and that there was no need to worry about returning to budgetary deficits? Well looking back, it now appears that our politicians really had no idea what was happening although they tried their best to grapple with the extraordinary events.

Certainly, from the perspective of those who believe in the efficient-market hypothesis, the market crash and the subsequent great global recession could not be foreseen. Fortunately, the failure to anticipate and account for economic events of this magnitude forced economists to look for other explanatory models. Much attention was then given to the work of Hyman Minsky and his Financial Instability hypothesis.

In short, Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. He claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

In other words, during the last federal election the economy passed through what is called a Minsky moment. Greed gave way to fear amongst lenders and borrowers, setting off a daisy chain of reduced expectations, credit contraction, asset liquidation, bankruptcies, layoffs, and reduced economic activity. Throughout the OECD, national governments were forced to intercede with massive injections of public funds in order to prevent a collapse of the financial and economic systems.

To that end, national governments turned to budgetary deficits in order to continue furnishing the governmental goods they provide while at the same time experiencing a significant drop in tax revenues due to the decrease in economic activity. Essentially, the infusion of public funds halted the economic decline. From the perspective of the financial industry and government fiscal policy, it is devoutly to be wished that the credit crisis will play itself out and economic growth returns so that the deficits are eliminated and the accumulated debt can be reduced.

However, there now appears the real possibility of passing through a Minsky moment of a much greater scale. Specifically, this moment entails the widespread realization that we have moved from a period of resource abundance to resource scarcity, and the resource in question is conventional oil.

Economic growth is fueled by the availability of cheap conventional oil. Despite our best efforts and brightest minds, there is no alternative energy source that comes close to producing an energy return on the energy invested to extract or produce conventional oil. It is by far the source of energy that has the highest energy density relative to its productions costs. Switching to alternative sources of energy, although desirable from an environmental view, carries the economic cost of reducing energy consumption and economic growth.

It is simply a question of physics. Less energy available means that less work can be done. Other energy sources will replace oil consumption but at a much higher cost, which reduces the amount of work that can be performed. From an economic point of view, this means an inevitable contraction of the global economy that will be qualitatively different. This contraction will not be short-lived, a part of the normal business cycle predicted by economic historians drawing upon Minsky’s work. It will be structural and will require a complete re-conception of the economic and financial systems.

Recently, global financial markets destabilized when it became apparent that the latest round of debt-fueled economic growth had played itself out. Without economic growth, companies become unable to pay back the interest on their debt. To make good on their financial obligations, assets must be sold, but in a market in which asset values are declining rapidly. Thereafter, a vicious circle develops where declining asset values further reduce the availability of credit and the capacity to service debt, which in turn causes bankruptcies, layoffs, reduced consumer spending, business investment, thereby leading to economic recession. Eventually, perceptions change when a critical mass of investors believe that the bust portion of the cycle has bottomed out and assets are then put back into more productive use, thereby generating higher profits, which in turn re-initiates the extension of credit, the appreciation of assets, hiring, consumer spending, and in turn economic growth.

This oscillation between boom and bust is sustainable as long as economic growth is sustainable over the long-term. However, the bust turns into a full-blown collapse if economic growth does not return. Having jettisoned the gold standard in favor of fiat currencies (money is created out of thin air upon the contracting of a debt obligation), the global financial system functions on the belief of continued economic growth. Without growth, the interest on acquired debt cannot be paid.

Debt relief can be obtained if it is believed that a recession will be short-lived, but if the contraction becomes structural, as would be the case once we begin to travel downwards from peak conventional oil production, defaults on debt obligations accompanied by massive asset liquidation will increase exponentially. In other words, the Great Global Recession turns into the Great Global Depression.

Interestingly enough, as George Monbiot noted, last week two whistleblowers from the International Energy Agency (IEA) alleged that it has deliberately upgraded its estimate of the world's oil supplies in order not to frighten the markets. Three days later, a paper published by researchers at Uppsala University in Sweden showed that the IEA's forecasts must be wrong, because it assumes a rate of extraction that appears to be impossible. In fact, almost every year the Agency has been forced to downgrade its forecast for the daily supply of oil in 2030: from 123m barrels in 2004, to 120m in 2005, 116m in 2007, 106m in 2008 and 103m this year. But according to one of the whistleblowers, even today's number is much higher than can be justified, and the International Energy Agency knows this.

Given the current levels of national debt, it would appear that borrowing from future generations to alleviate financial and economic crisis has reached its limits. Inevitably, the delivery of government goods will be reduced in order to bring some financial stability to government expenditures. However, another financial shock, much larger than the latest round, will create economic conditions beyond the capacity of governments to react. Laden with debt, national governments won’t be able to intervene in any meaningful way unless they reduce the systemic risk that their economies are now exposed to.

Two measures must be taken in the immediate future if we are to stave off economic collapse. The first is to increase the reserves that banks must maintain in order to make loans. Fractional-reserve banking within global financial markets amplifies systemic risk exponentially. To avoid a complete freeze of credit markets within a shrinking global economy, banks must be legislated to hold in reserve funds equivalent of at least 25% of their loan portfolios. Second, a financial transaction tax, similar in kind to the Tobin tax but applicable to all financial transactions, must be implemented. Funds generated from this tax should go towards either building up financial reserves or paying down the national debt.

To stay within the business as usual, good times are just around the corner, lets continue with the status quo is an invitation to simply wait for a Force 5 Hurricane to pass over, believing that will we simply be able to pick up the pieces and return to our previous lives with only minimal discomfort.

Saturday, November 7, 2009

How to Kill the Zombie Economy

To kill a zombie, you must destroy its brain. To kill the zombie economy, we must exorcise its unrelenting pursuit of economic growth and its insatiable lust for capital gains.

Zombies eat live humans to continue their existence. In the zombie economy, the speculative economy cannibalizes the real economy to enrich the lost souls who have given themselves to Mammon.

The realm of the living is much different from the realm of the undead. In the real world, ordinary people are loosing their jobs; they are loosing their homes; they are loosing their pensions; and they are loosing hope. In the realm of the undead, the US economy grew by over 3% in the third quarter. Bankers and fund managers celebrated and welcomed the return of their million dollar bonuses.

Clearly, good fortune is not being ferried from one realm to the other. On one side, the undead relish the great wealth that has been amassed; on the other, real people are having their life-blood sucked out of them and are facing the prospect of having their children enslaved to pay down the debt brought on by the pillaging of the public purse.

How is it that the ghoulish speculators have made off with the so much of the common wealth and left such misery behind amongst the real folk?

We were fooled. We were seduced by our own desires to have more than our fair share, and we allowed the undead to take control of the helm.

We believed the ghouls of finance who told us we could become rich by producing less and by trading more. So we flipped our houses and hollowed-out our companies (paying a handsome fee for each transaction) and placed huge bets on the outcomes of games we did not understand.

All the while, we took comfort in being told that the economy was still growing. We believed that the zombie pulse of the nation, the GDP, indicated continued health and prosperity.

But, we were wrong. We could not distinguish between the sound of our collective heartbeat and the sound of the drum egging us on to place more and more of our wealth in the hands of those who run the zombie economy.

When we had spent all that we could spend, we were then told that our world would come to an end unless we agreed to hand over a large part of our future earnings to keep the system in place. Apparently, even the zombies can’t help laughing amongst themselves that we fell for this one.

So, now we toil longer for less, under conditions much less favourable, and the zombies continue to tell us stories, hoping to entice us to return to the gaming tables of financial speculation.

But now, for the sake of the unborn, we must break the zombie spell. Even the zombies know that no real thing can grow forever. Eventually, growth slows and comes to rest. We must learn to ignore the shrieks from the zombies that would have us take any action, at any price, to keep their zombie world from contracting.

There are those who know what measures need to be taken. Let us heed their counsel and stop our ears to the sirens song of unsustainable wealth.

Monday, November 2, 2009

Can’t See the Forest for the Trees

The head of the international group leading the fight against climate change has accused countries of pushing science aside in favor of self-serving "political myopia" ahead of the vital Copenhagen summit.

Rajendra Pachauri, head of the Intergovernmental Panel on Climate Change, was quoted in the Guardian as saying: science has been moved aside and the space has been filled up with political myopia with every country now trying to protect its own narrow short-term interests. They are afraid to have negotiations go any further because they would have to compromise on those interests.

Political myopia pretty well sums the Canadian Government’s response to a landmark study published last week that details how Canada can reduce its green house gas emissions by 20% of the 1990 levels by 2020.

Federal Environment Minister Jim Prentice said there is no way Western Canadians could absorb the deep economic hit projected by the report's environmentalist authors – the David Suzuki Foundation and the Pembina Institute. Mr. Prentice, in an interview with The Globe and Mail from Kingston, said Canadians will not accept the report's advocacy of emission targets for 2020 that would reduce Canada's gross domestic product by 3 per cent nationally and 12 per cent in Alberta from business-as-usual estimates.

Well Minister Prentice have you calculated the potential economic cost of dust bowl conditions in Alberta and Saskatchewan that would result as the planet continues to heat up? Look at what’s happening in Australia and the American Southwest, never mind equatorial east Africa. What’s the projected loss of GDP in a worst case scenario where there are successive years of massive crop failures? Why would Western Canadians accept a return to the dirty thirties landscape on the prairies?

Moreover, slowing the rate of extraction of fossil fuels in the West actually makes a lot of sense from a long-term intergenerational economic perspective. The oil and gas locked in the ground will not suddenly evaporate. In fact, once the extraction of conventional oil and gas supplies begins to wane as we move downward from peak oil production, the market value of the reserves in Western Canada will increase substantially. It’s as if you would have us believe that all Western Canadians are intent to piss away their natural inheritance in one generation.

Other than the loony fringe of the Christian fundamentalist movement, where the apocalypse cannot arrive soon enough, and the shareholders of the major corporations racing to extract as much as they can as quickly as they can – they have cornered the market on asbestos suitcases – most Western Canadians have the common sense to realize that extracting non-renewable resources at full throttle is not in their long-term self-interest.

One thing that is most striking in the political myopia of our political class is that almost no serious thought has been given to the economic potential of extracting financial wealth from the real and speculative economy to preserve the carbon sequestration capabilities of Canada’s boreal forest.

A report by the International Boreal Conservation Campaign said the forests, with their rich mix of trees, wetlands, peat and tundra, were a far bigger carbon store than scientists had realized, soaking up 22% of the total carbon stored on the earth's land surface.

If you look across Canada one of [the boreal forest's] great values to us globally is its carbon storage value, said Steve Kallick, director of the Pew Environment Group's International Boreal Conservation Campaign. There is so much carbon sequestered in it already that if it escaped it would pose a whole new, very grave threat.

Canada's cold temperatures slow decomposition, allowing the build-up of organic soil and peat. The forest floors beneath its evergreens hold twice as much carbon per acre as tropical forests, such as the Amazon.

Canada has approximately 1.3 billion acres of boreal forest. Each acre can absorb on average between one and two metric tons of CO2 per year. Do the math at $30 a ton and then at $100 a ton. Evidently, the forests are worth much more as carbon reservoirs than for their lumber.

Unfortunately, the Canadian political class doesn’t seem to have a clue that we should be negotiating hard to have carbon credits for old growth forests included in the post-Kyoto accord. Talk about a missed opportunity. If we can pay Canadians for not growing wheat, we should be paying those in the forestry sector for managing the forests in an ecological manner.