Ron Cooke: The Perfect (Economic) Storm

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10 Aug 2008
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Introduction

When two or more storm cells come together and then form a larger and more violent storm, the event is often called a "Perfect Storm". The reference is to the increased ferocity of the combined cells as drenching rain, high winds and rolling gray clouds cover the landscape. It is an event fit for neither man nor beast.

That reference came to mind when I wrote the scenarios for Oil, Jihad and Destiny. "What is the worst case scenario?", I wondered. "What is the probability it could happen?" Although the "Perfect Storm" scenario is discussed in my book, I did not publish the results of my analysis. I could not bring myself to believe an economic catastrophe of that magnitude was probable.

No more. All of the elements are in place. This storm has begun.

Storm Cell One: Higher Oil Prices

During a presentation on energy and economics last fall, someone asked me if we were headed for a recession. "Yes," I replied, "we should be in a recession right now."

My response, of course, was based on a previous analysis of the link between oil consumption and the price of oil, versus the occurrence of past recessions1. In theory, the American economy should have been reacting to higher oil prices the way it had in several past recessions. But according to the Bureau Of Economic Analysis in Washington, America’s economy was still growing – however poorly.

Puzzled by that discrepancy, I did the research and analysis for three other essays on Gross Domestic Product (GDP), the Consumer Price Index (CPI) and unemployment2. My conclusion is that the Federal Government’s methodology overstates GDP, understates the CPI, and takes a very "optimistic" view of unemployment.

Recent events suggest America is experiencing declining rates of GDP, higher rates of inflation and increased unemployment3. One of the key drivers is the price and availability of oil, not only because of oil’s value to American commerce, but also because of the accompanying impact oil has on the price and availability of all our energy resources. Sales of coal and natural gas increase because they are an alternative to expensive oil. Wind and solar power become competitive energy options. Given the long term volatility of production and pricing, these realities of the world oil market are unlikely to change - ever.

There is a relationship between oil consumption, expenditures and recessions. Significant increases in the amount of money America spends on oil (1973, 1979, 1990 and 2000) were followed by a recession. Yes. Other factors contributed to the decline in GDP that characterized these recessions. However, one can not escape a nagging fear that sharp increases in oil expenditures may cause a subsequent recession. World oil prices have increased by over 350% since 2002. If oil price and consumption history is any predictor of future events, our economy is in big trouble.

Storm Cell Two: A Decimated Financial System

Let’s not mince words. America’s financial system is a mess.

Private Debt. We have gorged ourselves on unlimited private and public credit. With the complicity of a dysfunctional Congress, and a deficient regulatory system, Wall Street has been able to create multiple financial instruments of dubious integrity. Billions and billions of dollars are now tied to devalued assets and financial documents that have the value of wet toilet paper. We have not experienced the full impact of this brutal devaluation. Last year I estimated international financial institution losses would exceed $700 billion. Current thinking exceeds $1 trillion. Fannie Mae and Freddie Mac teeter on the brink of disaster. The financial strength of many regional banks has been compromised.

Public Debt. The federal budget deficit is projected to more than double in size to $482 billion in the 2009 budget year (which ends on September 30, 2009). Add to this the cost of wars in Iraq and Afghanistan, the costs of the mortgage rescue measure, a likely restructuring of Fannie May and Freddie Mac, the escalating costs of Medicare, as well as underfunded Social Security and Government pension obligations – and it should be obvious America is pushing its ability to fund federal operations. Although Congress has increased the national debt limit to $10.615 trillion, the ability of the United States to pay its debts will increase public debt loan costs and will eventually restrict the issue of additional public debt obligations. Now add these costs to the more than $2.2 trillion in State and Local debt the United States is carrying on its books, and one begins to wonder if public debt payer solvency will become an issue.

Business Credit. Thanks to America’s debt crisis, our banking system has been forced to restrict the availability of business credit. Hardest hit are the retail, travel, transportation, and automotive industries which are dealing with declining credit availability, higher costs, lower revenues and troublesome profit margins. Although some very big corporate names will take a hit, small and medium sized businesses will suffer the most damage. Without easy credit, they will be forced to restrict their activity. It is possible that over a million businesses and more than three million jobs will be lost before the end of 2009. By then, over 3.5 million of America’s self-employed individuals will also be unable to find adequate employment.

Household Credit. Household debt service payments exceed 14% of disposable personal income. Total debt, which includes $2.6 Trillion of consumer credit obligations, is approaching a total of $14 Trillion. Revolving credit appears to be increasing a rate of 7 percent per year. Because consumers have less (or negative) home equity to fund additional loan obligations, they have increased their credit card exposure to fund current purchases. Struggling to regain its health, our financial system has been forced to decrease the availability and size of revolving credit account balances. This will reduce potential consumer spending.

And of course, we live in a global economy. America’s financial crisis is the world’s financial mess. Few nations will be immune to the deterioration of the world’s financial markets. Change a few names and numbers, and one could write an essay like this for many of America’s trading partners.

Storm Cell Three: Iran

Let’s add a little thunder and lightning. The Middle East. Endemic hatred, deadly civil confrontation, uncompromising theology, and the smoldering embers of war threaten to erupt into a devastating political crisis. Into this arena come the leaders of Iran. These people have a definite agenda. Increased political and economic power. Sanctimonious beliefs justify aggression. They firmly believe they will win.

The opposition is uncertain. Poorly organized. And plenty worried. From weakness comes tragedy. Desperation makes poor decisions. The American elections add to the potential for disaster. Another struggle for political power. Domination. The imposition of self-righteous political theology. Here are a few thoughts. Will President Bush attack Iran before he leaves office? Would that be his way of giving Nancy Pelosi the "bird". Do the leaders of Israel believe they must neutralize Iran’s nuclear threat before Bush leaves office? Will Iran move to block oil shipments through the straits of Hermuz?

However this all plays out, any prolonged disruption of oil shipments would have a devastating impact on the world’s economy. When Iran deposed the Shah in 1979, the resulting turmoil reduced Iranian oil production by almost 40%. The price of oil jumped by 125%. American inflation notched up to 11.26%. The subsequent 1980 – 1988 confrontation between Iran and Iraq devastated oil production in both nations. American inflation was 13.52% in 1980, 10.37% in 1981 and 6.13% in 1982. Our GDP, adjusted for inflation, was -4.72% in 1980, 1.83% in 1981 and -2.13% in 1982. During 1982, unemployment reached 9.7%.

Storm Cell Four: Political Theology

No storm would be complete without gale force winds. It’s election time and the Democrats are pandering to pop culture theology. "If we can’t drill our way out of oil shortages", goes the mantra, "then let’s not drill at all".

Few have asked a key question:
how does Congressional failure to develop a comprehensive energy plan impact our economy?

If the Democrats continue to block oil exploration and the development of a comprehensive energy program, then this storm will last forever. Many reason that higher gasoline and diesel prices are good. It does not matter if fuel oil and propane become unaffordable. Why? Because higher prices force us to consume less oil, and that reduces the production of carbon dioxide.

Clean air. No matter what the human cost. How many families will not be able to afford heating oil or propane during the long cold winters that lie ahead? How many men and women will be thrown out of work by a very sick economy?

Ominous Clouds

So. What are the odds of a Perfect Economic Storm? In the Internet era, financial change can be as powerful as a hurricane and as spectacular as lightning. Just ask Bear Sterns.

Higher oil prices? Done deal.

Along with higher prices for gasoline, diesel, propane and heating oil fuels, as well as food, cosmetics, pharmaceuticals, and just about everything else you buy.

Higher rates of current expense inflation? Under way.

The Consumer Price Index for All Urban Consumers (CPI-U) rose 1.1 percent in June, 2008. Although that’s a run rate of 13.2% per year, I expect the average rate of inflation for 2008 to be closer to 8%.

Financial system contraction? Happening.

In order to get their balance sheets back into shape, banks are setting higher standards for loans, and scrambling for cash. These moves decrease the availability (and increase the cost) of commercial and personal credit.

Devaluation of fixed assets? In process.

It would appear my previous projection of a 30% residential housing devaluation is on track. Commercial real estate and business property are also taking a beating.

Credit market collapse? Current events.

As discussed in the above text, only divine intervention will prevent a further deterioration of world credit markets. Somehow, I do not think that will happen. Volatility, disruptions, deteriorating credit performance, and bankruptcy lie ahead.

Consumer spending? Austerity is a virtue.

Although we can expect consumers to push the limits of their credit resources, a contraction is inevitable as they maximize their credit options.

Positive political leadership? Missing.

Will America ever have a constructive, positive and well managed energy policy? Does Congress have the will, organization, leadership and business competence needed to create one? Or will current proposals lead us to a politically correct document laced with theology, corruption, over-regulation, and confusion 4? You decide.

Stock Market? High downside risk.

The American stock markets have entered "Bear" territory with 52 week declines of 20% or more. If economic growth is down and inflation is up, profits will suffer at most companies for the next several quarters. Add in higher interest rates (along with a dose of consumer "blahs") and it is hard to see how we will escape the downside risk.

Iran.

Only the addition of an Iranian confrontation remains uncertain. You tell me. What are the odds of adding war and oil shortages to our torrent of bad news?

A Perfect Storm Scenario

Can we project the outcome? To find out I fired up my trusty spread sheet, made several key assumptions about the factors described above, added a dose of historical data going back to 1929, and ran the numbers. If past economic performance in times of economic stress and higher oil prices is any indicator of future performance, then it is likely 2009 will not be a good year. Thanks to a decimated financial system, irresponsible political theology, and a lack of constructive leadership, our economic malaise could last for years. Depending on the data you chose to use, and the assumptions you make, the results of the Perfect Economic Storm scenario can be described in many ways.

Here are two graphs our political leaders should memorize
because they will come back to haunt them.

The following chart graphs the Rate Of Change calculation for North American oil consumption (includes Canada, the United States and Mexico), and American GDP adjusted for inflation. The chart shows actual historical data from 1970 through 2007, and then graphs my projections through 2030. Since 1970, the rate of change in oil consumption has closely matched the rate of change of adjusted U. S. GDP. The sharp decline in oil consumption and GDP shown for 1973/1974, 1979/1982 and 1991 were primarily due to the effect of oil production shortfalls in the Middle East. America was forced to use less oil. Less oil means less commerce. Less commerce means a lower GDP. These are the facts of economics.

As you view this graph, please note: I have assumed a gradual increase in the use of alternative mobile fuels, as well as electricity, as the automotive force for public and personal transportation. This assumption increases the gap between oil consumption and GDP by 2030. Also please note: the findings of this scenario are consistent with past economic events from 1970 through 2007. Given the assumptions used to construct this scenario, a deep recession is likely. The projected trends through 2030 are consistent with the projected production, consumption, availability and price of oil.

Unless we find salvation, net inflation adjusted GDP will continue to deteriorate though 2030. American GDP per capita will decline, placing additional stress on consumer spending. Low and middle income Americans will see a continuing decrease in their standard of living.

In the second chart, I have graphed actual inflation and unemployment data from 1970 through 2007, and then charted the results of my analysis from 2008 through 2030. Please note: given the economic circumstances described above, these projections are entirely consistent with prior history.

Inflation is a tough call. Asset devaluation and unemployment act to push down the rate of inflation. Higher oil prices lead to higher product transportation costs. Fixed asset deflation versus current expense inflation. Although my model suggests higher inflation lies ahead, a rapid decline in asset values is entirely possible. When the financial markets collapsed in 1929, the CPI fell by 26.3% from 1929 through 1933. On the other hand, the oil crisis of 1973 set off a wave of inflation that lasted until 1982. The worst period was 1979 through 1981, when the net increase in the CPI exceeded 35%. Either scenario is possible.

In this scenario, unemployment could easily exceed 9% for the better part of three years, 2011 - 2013. Under-employment will increase to more than 16%. That means at least 25% or the American work force will be unhappy. Furthermore, average annual unemployment rates will be higher than we want through 2030.

A word to the wise. My estimates of bad news are typically understated. For example I thought last year that financial system losses from the global credit crisis would exceed $700B. Current estimates from other sources run from $1.5 to $2.0T. One could construct a perfectly logical scenario that shows far higher rates of unemployment and inflation.

But wait. Could things really be worse? Sure. This scenario assumes relative stability in the Middle East and elsewhere. If there is a prolonged disruption in the flow of oil, then the recession will be deeper and last longer. Remember. There are no quick fixes. It will take from 15 to 20 years to restructure how America uses its energy resources5. The longer Congress piddles around, the worse the lingering devastation of a perfect economic storm.

Of course we need to transition our nation to alternative forms of energy. And most Americans want to sustain the cleanest possible environment for human habitation. But as a cultural economist, my key issue is:

how do we get from here to there without totally screwing up our economy?

It is impossible to run a complex and sophisticated economy without adequate resources of energy. That enduring fact is true for all nations. But in the United States, current political theology ignores the human consequences of a dysfunctional energy policy. A recessive economy increases personal misery. It is that simple. Although we can (and must) increase the efficiency with which we consume energy, Congressional failure to enable greater access to all forms of energy is an act of criminal neglect. The result? Millions of Americans will endure the deprivation of a failed economy.

There are times I really hope I am wrong. This is one of them. Maybe we will continue to enjoy the benefits of cheap and readily available oil. Perhaps our economy will prove to be amazingly resilient. Maybe most of the credit crunch is behind us. It’s possible 2009 will be an "OK" year. The Federal Reserve Board’s Federal Open Market Committee, for example, believes inflation will moderate later this year. If so, unemployment should continue below 6.5% and "real" GDP should be slightly positive into 2009.

So.
Who is right? You decide.

References

The following essays may be found on my web site www.tce.name. A detailed explanation of scenarios and how I use them may be found in my book "Oil, Jihad and Destiny."

1. ^ Will High Oil Prices Fuel Inflation? (Ron Cooke, 2006)
Warning: Recession Ahead (Ron Cooke, 2007)

2. ^ Unemployment: What Is The Real Story? (Ron Cooke, 2008)
CPI: Sophisticated Economic Theory, Terrible Ethics (Ron Cooke, 2008)
American GDP: Can We Trust The BEA Data?(Ron Cooke, 2008)

3. ^ Yes Virginia, This Is A Recession (Ron Cooke, 2008)

4. ^ The Energy Policy Act of 2005, Legislative Achievement or Management Fiasco? (Ron Cooke, 2005)
As a point of information, I am qualified by prior experience to develop the kind of energy program America needs.

5. ^ Peaking of World Oil Production: Impacts, Mitigation, and Risk Management, published by the U.S. Department of Energy, National Energy Technology Laboratory, February 2005; Robert L. Hirsch, SAIC, Project Leader, Roger Bezdek, MISI, and Robert Wendling, MISI.
The executive summary of the report warns that "as peaking is approached, liquid fuel prices and price volatility will increase dramatically, and, without timely mitigation, the economic, social, and political costs will be unprecedented. Viable mitigation options exist on both the supply and demand sides, but to have substantial impact, they must be initiated more than a decade in advance of peaking."


Mostly a good piece.  Good

Mostly a good piece.  Good job.  But, (yes, here comes the but...) Mr. Cook would have a bit more credibility if he also had some criticism for the Republicans regarding energy policy.  They are holding us back every bit as much as the Dems.  McCain and teh Repubs don't have it together on energy any more than Obama and the Dems. 

In fact, it should be said regarding this election that party politics on both sides are preventing the country from having the adult conversation about energy that it desperately needs to have. 

And, it's not about clean air versus Americans needing to heat their homes and/or find jobs.  A truly comprehensive energy and climate change plan (which neither party is interested in pursuing) would very much create jobs and help people stay warm.  The low level of political discourse, aided and abetted by the abysmal lack of quality reporting on the part of the media is why few Americans understand this point. 

Perhaps part of the "perfect storm" should be the total disinterest of the mainstream media in providing Americans with the kind of information they really need to understand the problems we are facing and the kind of information that helps keep a democracy healthy. 

Cheers.

 

 

The perfect economic storm

Ron, A good roundup of the economic storm cells. But I believe you may have missed one: Financial provisions for maintenance and renewal of fixed Infrastructure assets. Probably part of storm cell 2, Public debt component.

This would certainly include roads and bridges but probably other categories like water supply, sewage treatment etc. In New Zealand we are obliged by law to account for depreciation of assets like these on an annual accrual basis. This recognises that we are drawing down on the value of the asset from the get go.

We don't wait for a repair or renewal event and then look for the money. As far as I know this accounting approach does not happen in the US. You "use up" the asset each year without providing for repairing the effects of using it (and aging) and you pay for repairs out of cash flows.

To explain: In NZ a fund is created to provide for M&R for any asset throughout its planned lifespan when the thing (say, a bridge) is built and it is progressively credited with actual money (say from tolls or taxes) to represent the decline in the service condition of the asset. This shows the true cost to the public of owning and using the asset.

When you want to return the asset to good standard again, the money is there to do it. This prevents delayed repairs and eventual collapse.

Judging by the debate on the condition of assets like bridges and roads in US, I would say that there is a sizable debt already accumulated there where a credit should be showing - ready to fix or replace things.

As we head into the vulnerable period you describe, these "assets" will be found to be significant liabilities with no easy source of funding. Further, as the DoT has already found, lower sales of gas in the US results in lower tax revenues to fix things on a cash flow basis.

As a result of the anticipated more extreme weather events caused by climate change, and the much higher cost of oil based materials and contruction services, I would say there is trouble brewing in your networks.

But there is a silver lining to this cloud - there may be lots less traffic to be compromised and an opportunity to launch a new "New Deal" to reduce the unemployment in your projections !

Archer