Rise by the oil, fall by the oil (Part 1)

We've seen how Ronald Reagan benefited from the drop in oil prices (see "Great in debt") to secure a presidential second term. Margaret Thatcher, his political soul mate, also profited from oil but in a contrasting fashion. It's doubtful whether they were aware how their fortunes had been closely tied to swings in oil prices.

Oil's tentacles go beyond deciding the fates of petro-state politics. Even great leaders of the western world survived on the indulgence of oil. Had Reagan been in Carter's shoes, he would have faced the same travails that had plagued Carter with equally limited options of wriggling out. Reagan avoided the fate of Carter because oil prices were trending downwards towards the end of his first term as a result of falling consumption following the long recession from July 1981 to November 1982. The cause was the high contractionary interest rates imposed by Volcker. To his benefit, oil prices stayed low throughout the second term of his administration. This time it was the Saudis who precipitated the price fall by suddenly unleashing output from two million barrels per day (mbpd) to five mbpd.

Reagan's successor George Bush the first might have earned his second term had he not raised taxes and had the Savings and Loan financial institutions not imploded, the implosion itself a consequence of Reagan's deregulation. These two events resulted in a pullback of the money supply growth, effectively scuttling Bush's reelection hopes. The oil price then wasn't a spoiler as its price was still benign except for a short-lived spurt as a result of the first Gulf War.

Thatcher's fortunes however differed. Whereas the US presidents needed cheap oil for economic prosperity, Thatcher depended on expensive oil to sustain Britain which was gradually losing competitiveness on its manufacturing front. Thatcher's predecessor, James Callaghan correctly predicted that the winner of the 1979 election would stay in office for a long time, reaping the benefits of the oil revenues which were about to pour in. He didn't need any clairvoyance as Britain's North Sea oil which had been first discovered in the early 1970s was subject to the usual lead time of 7 to 10 years from discovery to production (see chart above). Thatcher came in at the right time to hold the premiership for more than 11 years.

Now oil has always been subject to great price swings. So were Thatcher's fortunes. The significant drop in oil production and exports in the early 1990s (see left chart) correlated with Thacher's resignation from the premiership on 28 November 1990.

So it appears that Thatcher's great standing rested entirely on oil. How about her economics ideology which initially relied on Milton Friedman's monetarism? She was said to have successfully tamed inflation. Like the oil story, we can set the record straight since most people still think that defeating inflation is a matter of just hiking the interest rates up. Friedman would have recommended restricting the supply of credit rather than manipulating its price, that is, the interest rate, but Friedman's approach would have caused a sudden shock to the credit supply that all developed economies have now abandoned it.

Thatcher, although a novice at economics, was a consummate politician, ever willing to ditch any economic ideologies at the first sign of voters' discontent, particularly nearing an election year. Unfortunately, the British public had to become guinea pigs for her Friedman-influenced monetarist ideas. To suppress inflation, she started off not only by raising interest rates to 17% in 1980 but also drastically reducing public spending in her first budget. The impact was immediate. By the following year manufacturing production fell by 14% and unemployment rose to 2.7 million. British manufacturing capacity shrunk by 25% in 1979-81. Not only that, influenced by Friedman's Chicago liberalism doctrine, she also abolished the controls on capital movement. This is one measure that all countries will come to regret 30 years later with the onset of the Grand Depression.

The austerity measures were driving Britain into bankruptcy. Only the North Sea oil was keeping Britain solvent. Soon Thatcher became the most unpopular Prime Minister in British history. Unemployment hit the Black minorities disproportionately, eventually boiling over into the summer 1981 race riots in several British cities. Thatcher quickly reversed course by ditching Friedman's monetarism temporarily. It is sad to find that politicians, including Britain's very own David Cameron, still believe in austerity measures when history has proven them to be a complete failure.

By autumn 1981, Thatcher started cutting interest rates. In the following year's budget, Thatcher increased public expenditure. With the high number of the unemployed, it was not surprising that inflation remained low. Oil prices were also moving downwards. More importantly, the British economy was increasing its money supply (see chart below from McKinsey). It should also be noted that the previous British governments since the World War II had to contend with high public sector debt. So they resorted to inflation to bring the share of public debt down to manageable level. Thatcher benefited greatly from her predecessors' efforts, enabling her to start pumping credit again, though this time using households and financial institutions to undertake the borrowings. This recovery and the euphoria from the Falklands war victory enabled Thatcher to retain her premiership in the 1983 election.

The impact of the inflation especially in the 1970s helped to whittle down the real value of debt. As seen in the chart below (again from McKinsey), debt or credit has always been on the increase. Any political leaders thinking of crimping the total credit growth are dangerously courting a total social breakdown. Only inflation could ameliorate a debt growth. Consequently, the inexorable rise in UK's total real debt level beginning from the Thatcher's administration can be attributed not in a small way to the low inflation conditions prevailing since then.

Since Thatcher's story has many interesting lessons for our bumbling EU politicians, we'll continue the second part of the story with the conditions leading to her downfall.

Great in debt

It is said that Margaret Thatcher and Ronald Reagan were the two great leaders of the western world in the 1980s, instrumental in ending the Cold War and ushering in a new era of small government, low taxes, free trade, weak union, prosperity and freedom. With the current palpable lack of leadership in the major economies, the public is yearning for the good old days of Reagan and Thatcher.

We don't want to revisit the legacy of both leaders; that would be the job of historians. Indeed they were truly admirable. But were there to be a leader of similar ability, could he or she reach the great heights of global stature especially in these trying times? Or was there something else about Reagan and Thatcher that has yet to be made known to us, the gullible public?

With the benefit of hindsight and a vast treasure trove of information on the web, we can now reexamine the reasons behind their prominence from the perspective of the 4C (see "Reality in 4C"). You should have been aware by now that Reagan secured his second term by paying homage to the credit market. But let's get into the details to debunk the conventional wisdom surrounding Reagan first, to be followed by Thatcher in a future post.

We begin with the tax and spending cuts, two issues frequently cited by the Republicans to justify their calls for similar action by Obama. When Reagan came into office in 1981, he reduced the top marginal tax rate from 70% to 50%, and federal spending by almost 5% of the federal budget. However this step could only last one year as coupled with Volcker's high fed funds rate that topped 19%, the economy was plunged into a recession (see left chart from The New York Times). The fall in inflation rate following Volcker's tight money policy accentuated the fall in the tax intake. So Reagan had to reinstate the tax revenue in 1982 not by reversing course but by transferring the burden onto businesses. Still, his tax cuts were much more than the increases; by the end of his administration the top marginal rate was further reduced to 28%.

The result of the tax cuts was reflected in the ballooning federal deficit, tripling from US$900 billion to $2.7 trillion by the end of his administration (blue column on the left chart). However this deficit actually boosted the economy. It supplied the spending and liquidity that uplifted the incomes of households, businesses and foreign nations. In turn the businesses and households took on higher borrowings of their own, resulting in a spike of total US debt that started from the end of Reagan's first term.

Now, two questions remain a puzzle to most observers of the Reagan administration. First, can't we continue the borrowing binge by all sectors that brought prosperity not only to the US but also to the whole world? Second, why was the inflation subdued when in fact the money supply as reflected in the debt increase during his second term was skyrocketing? Nobody has satisfactorily addressed these issues. Our attempt will demonstrate that Reagan came into office at the most propitious time. Because of that, his mistakes, which would have been calamitous to any other president, were glossed over.

He gained much from the cautious policies of his predecessors. Not only were they conservative with deficit spending but the inflationary conditions that had characterised their presidencies reduced the relative level of the federal debt. For example, Carter increased the federal debt by about 30% but because of the inflationary condition, the debt/GDP ratio actually decreased by 3.3%. Reagan's two terms however marked a new era of debt financing, not only by the government but also by the other sectors: businesses and households. Reagan took advantage of the depressed borrowings of the earlier years to let rip the borrowing and spending spree.

Also, unlike Nixon, Ford and Carter, Reagan didn't have to endure periods of high inflation, commonly known as stagflation because of the stagnating GDP. Milton Friedman used to remark, erroneously in fact, "Inflation is always and everywhere a monetary phenomenon." It should have been a 4C phenomenon instead of only a monetary phenomenon. The other important factor is capacity in which oil plays a very significant role as the driver of virtually all economic activities.

Remember that oil prices started to experience wild swings following the 1973 OPEC oil embargo. In fact, the sudden jump in prices wasn't totally unexpected had the buyers observed the declining spare capacity leading to the embargo (see "Oiled for Turmoil"). But as new oil fields took at least 7 to 10 years from initial exploration to production, it wasn't until the early 1980s that these fields managed to boost the spare capacity. However the 1979 Iranian Revolution followed by the Iran-Iraq War in the following year further scuttled oil production leaving the Carter administration wondering why his increased spending didn't translate into higher economic growth instead of higher inflation.

Only in 1985 did the prices drop to US$26 per barrel and by the following year to as low as US$11. Until the end of Reagan's second term the prices remained favourable, hovering around US$20. So Reagan could have the cake and eat it too, his spending going straight into the consumers' pockets instead of the oil producers'. Production capacity could increase to take care of the spending when previously any increase was constrained by higher input costs.

These two factors explain why no one else can repeat Reagan's feat and why there is so much yearning for Reagan's leadership. Although oil prices will likely go down as vast new fields in North Dakota, Colorado, North Sea, Colombia and Brazil's coastal waters come onstream in the next couple of years, the debt could no longer be increased. It has reached the peak of the S-curve and the only way forward is down. Those who want to spend no longer have the income to afford the debt while those who have the means have no use of further borrowings.

Poor Obama, intelligence alone is not enough to guarantee good leadership. More important is the external environment which in these troubled times can do far more to make or break a leader.

Mugabe to the rescue

Desperate times call for desperate measures, so goes the oft-quoted proverb. The politicians are well aware that the current dire situation has caused them to freeze up like the deer caught in the glare of headlights, not knowing which way to go. This is a result of the democratic checks and balances that are intended to prevent domination by any one of the three governing branches. However in governing, you must be able to switch from democratic to authoritarian methods as the situation demands. But the constitutions of all democratic nation-states do not provide for such a privilege.

Ancient Athens and Rome were more enlightened in this respect. We've seen in the previous post, The 'Greek' hold the answers to the euro crisis, how the ancient Greeks turned to Solon for autocratic leadership in 594 BC though it was probably the only time that the Greeks did so. The ancient Romans were much better; when faced with a major crisis during the time of the republic, they would appoint a dictator known as dictatura rei gerundae causa (dictatorship for getting things done) for a period of six months, enough time to lead the Romans in their wars which were fought only in summer.  The appointment of the temporary dictators occurred between 501 and 202 BC. Rome had other types of dictatorship but these were less common than the rei gerundae causa. Ordinarily the Romans would be governed by two consuls who would decide when a dictator was needed.

In 82 BC, the six-month time limit was breached when Sulla became a dictator for one year to suppress a civil war and amend the constitution. With the precedent set, Julius Caesar subverted the governing privilege when he declared himself a dictator for life in 44 BC though he didn't get to enjoy it for long as he was assassinated in the same year. Upon his death, his adopted son, Augustus, made the change official when he transformed the republic into an empire, though still maintaining a veneer of the old republic in the form of consulship and senate.

Our present dire situation now doesn't involve any war or constitution amendment but it might lead to more worrying conditions if the current crisis is not urgently addressed. The first thing to getting things done is to immediately tackle the debt crisis. Would this solve our real problem, which is the capacity/consumption crisis? No, but it will give us some respite and in a crisis that's many times preferable to stasis. Even with the cancellation of debts, wealth accumulation enjoyed by the affluent will continue unabated as if the cancellation is only a minor pullback. The debt crisis may recur but hopefully the paradigm of the fifth Kondratieff wave will precede it and destroy enough wealth so that mankind can pursue its new wealth accumulation game afresh.

Since no creditors would want to see their debts written off, we would need to explore some creative ways to magically siphon the creditors' financial savings, i.e., debts due them, off their books. For this, we have to call in Mr. Mugabe, a dictator that can get things done, albeit in a negative sort of way. He may not know much about economics but his mastery of money printing anytime thumps that of Ben Bernanke. The problem with the US is that people from the academia, who are too clever by half, are at the helm of the White House and the Fed.

Bernanke's grasp of money printing is flawed. Printed money is not money in the economic sense until it is spent, that is, it doesn't matter a whit to the economy if you print to hoard. To do the spending, Bernanke needs Obama: Bernanke prints and Obama spends. Only then can money supply shoot through the roof. In the case of Zimbabwe during its hyper-inflationary days, Mugabe had full power to execute both, which he did, unfortunately, too well. Mugabe's money printing was not a recent phenomenon, it had been going on since Zimbabwe's independence in 1980. Only in 2008-2009 did it rapidly intensify, the inflation rate, last recorded in July 2008 reaching 231 million percent annually before official inflation statistics stopped being filed.

By April 2009, the Zimbabwean dollar officially ceased being used, replaced instead by the US dollar and the South African rand. However capital flight continues to afflict the country as the country is effectively broke. The country's productive capacity has been severely curtailed with good farmland, expropriated in 2000 and turned over to cronies, being laid to waste. Now its foreign-owned mines, banks and factories are targets for seizure, ensuring further collapse of its capacity. Mugabe is economically dangerous if given a free rein. To benefit from his expertise, not only must his remit be restricted to the cancellation, or rather whittling down to nothingness, of most debts, but also his term be limited to only one month.

What damage has Mugabe wrought on the Zimbabwean dollar (Z$) as to cause its disappearance? In short, his money printing has become too efficient. If only that could be said of his country's productive capacity. To bring on hyperinflation, printing alone is insufficient. You must also add on countless zeroes, followed by a downward redenomination to slash the added zeroes. In the case of Zimbabwe, after three rounds of redenomination, all in all, 25 zeroes have been slashed from the Z$. The highest denomination ever printed was Z$100 trillion. Just imagine if the US dollar were printed in this denomination, a piece of this bill would have been enough to redeem all the world's holding of US treasuries with plenty of change to spare.

Printing money is only one half of the equation. Spending the printed money completes it. Once the bills are printed, they must be spent immediately in a 'shock and awe' way to preempt the holders of the financial savings from switching to gold or commodities. The easiest way is to flood the banks as settlement for all mortgage and other debts owed by individuals and corporations. The public would be happy that the banks as creditors get paid in devalued bills, and the banks shouldn't have any qualms as their problem loans would vanish immediately. All homeowners will get back their previously foreclosed homes. The final step is to erase the trailing zeroes from the bills by redenominating them in new US dollars, say a new US$1 for every old US$1 million. It must also be done quickly; otherwise the goods will disappear from the shelves. Of course, there are losers. China's forex holdings would be worth US$3.2 million. Even Sun Tzu would have marvelled at this money conjuring stratagem. Those holding treasuries and with substantial financial savings will find their wealth disappearing in front of their very own eyes. Not to worry, if they were successful before, their success in accumulating wealth would remain.

Those countries which have been fixated with squirreling forex reserves would now be wary of repeating it. Every country would trade with each other in a responsible manner. But most will wind down their international exchange, producing at home for home consumption. Where things need to be traded, they will be carried out on barter. Anyway, even without this extreme devaluation, trade barriers will go up in an economic depression. Any leaders still enamoured of free trade will be booted out of office in next to no time.

But wait, don't switch your savings to gold yet. This is just wishful dreaming because reality is still Nightmare on Wall Street.