Marshall Auerback, born July 27, 1959 in Toronto, Canada, is familiar with the internationalscenery of finance firsthand. After graduating “magna cum laude” in English andPhilosophy from Queen’s University in 1981 and receiving a law degree fromCorpus Christi College, Oxford University, two years later, he was from 1983-1987an investment manager at GT Management Ltd. in Hong-Kong. From 1988-91, Mr.Auerback was based in Tokyo,where his PacificRimexpertise was broadened to include the Japanese stock market. In 1992 he wentto NewYork to ran an emerging markets hedge fund for the Tiedemann InvestmentGroup until 1995. The next four years he worked as an international economicsstrategist for Veneroso Associates, which provided macroeconomic strategy to anumber of leading institutional investors. From 1999-2002, he managed thePrudent Global Fixed Income Fund for David W. Tice & Associates, a global investmentmanagement firm, and assisted with the management of the Prudent Bear Fund.Since 2003 he is serving as a global portfolio strategist for RAB Capital Plc,a UK-based fund management group with $2 billion under management. He is alsoco-manager of the RAB Gold Fund and an independent economic consultant for PIMCO,the world’s largest bond fund management group. Moreover, he is a fellow of theEconomists for Peace & Security (www.epsusa.org) and of the Japan Policy Research Institute in California (www.jpri.org). As Braintruster of the Franklin and EleanorRoosevelt Institute, he is a frequent commentator at “New Deal 2.0” (www.newdeal20.org) – proving that he is “abrilliant economist who dares to see the world whole”.[1] Mr. Auerback lives in Denver, U.S.A.

Mr. Auerback, whilethe vast majority of financial and economic experts were caught on the wrongfoot by the financial crisis, you have warned about it for years. Given that “Cassandra”-likerecord, I think it is only apt to ask you at the beginning of this interviewtwo simple questions: why are we in a global recession right now? And: could ithave been avoided?

Yes, it could have been avoided, if we had notstupidly embraced many of the tenets of the so-called “Washington Consensus”,particularly the notion that financial deregulation in and of itself was a goodthing.  What was the main cause, in myopinion? There are different kinds of leverage, andwe used all of them. Income was leveraged by households and firms to take on moreand more debt. As scholars at the Levy Institute have been warning for a dozenyears, the private sector went on a practically unbroken deficit spending spreesince 1996. The result was massive debt to income ratios, as we discuss in thenext section. Financial institutions leveraged equity, with many using highlycomplex proprietary models to assess risk in order to calculate maximumpermissible expansion of their balance sheets given Basle II capitalrequirements. They also leveraged safe, liquid assets (such as reserves andtreasuries)—increasing the proportion of their balance sheets comprised ofriskier assets. Banks moved assets off balance sheet onto “special” investmentvehicles so they could ignore capital requirements. The financial system as a wholeincreased leverage, creating a mountain of debt relative to the productivecapacity of the economy, and relative to the prospective income flows of thenation as a whole. In other words, financial sector “layering” increased as thenominal value of financial assets and liabilities grew very much faster thanGDP. Indeed, financial institution debt grew much faster than other privatesector debt. 

We could even say that the “FIRE”(finance, insurance and real estate) sector “leveraged” the rest of the economyas its employment and profits grew at a faster pace (it received 40% of thenation’s profits before the bust). Indeed, recent revisions made to ournational accounts show that Americans now spend more on financial services andinsurance (8.2% of personal consumption, $832 billion annually) than they do onfood and beverages to be consumed at home (7.9%). Back in 1995 that wasreversed, with spending on food and beverages at 9% of consumption andfinancial services at 7.2%. We don’t want to get into a sterile argument about“productive” versus “unproductive” labor but it certainly appears in retrospectthat the FIRE sector has played an outsized role in recent years, like a tailthat wagged the economy’s dog. The “market” is now trying to downsize the FIREsector, but Larry and Timmy only let market forces work their “magic” in thebubble, not when it bursts. Hence, all the efforts are aimed at keepingleverage high as the Fed and Treasury try to get banks to lend again as ifanother debt bubble is the cure for what ails the economy.

As Hyman Minsky argued,banking is an unusual profit-seeking business in that it is based on very highleverage ratios. Further, banks serve an important public purpose and thus arerewarded with access to the lender of last resort and to government guarantees.Those government guarantees provide cheap and virtually unlimited credit tobanks in the form of insured deposits. Because these bank creditors(depositors) will not lose should the bank fail, they do not need to closelysupervise bank activities—even if they had the expertise and access toinformation that would be required to do so. Ignoring other types of creditorsfor a moment, there is no “market discipline” that such creditors will imposeon bank management for the simple reason that depositors get paid off no matterwhat bankers do. The bank, in turn, can increase its profits on equity byraising the return on assets given a capital ratio, and by reducing the ratioof capital to assets (i.e., raising leverage). Each of these actions willincrease the riskiness of banks—but can dramatically raise profitability forowners without increasing their capital at risk. Instead, it is the governmentinsurer that absorbs any losses once the bank’s equity is destroyed by losseson bad assets. 

Minsky (2008) provided asimple example. Consider a bank with $25 billion in assets, $1.25 billion incapital, and $187.5 million in profits after taxes and allowance for loanlosses. Its asset to capital ratio (or leverage ratio) is 20 and its return onassets is 0.75% so its profit on equity is 15% (20*0.75). Assume its rival alsohas $25 million in assets and earns the same $187.5 million in profits, but itsequity is $2.085 billion—for a leverage ratio of only 12. While it earns thesame return on assets, its owners only earn 9% on equity. The rival canincrease its profitability either by earning more on assets (all else equal,that means taking on riskier assets) or by increasing its leverage ratio(buying more assets against its relatively larger capital base). Note that thedisparity in profitability due to differences in leverage ratios is dramatic:if the second bank increases its leverage to 20, it will expand its assets to$41.7 billion and its profits to $312.75 million as it increases its profitrate to the 15% enjoyed by the first bank. With the same amount of capital, thebank increases its loans and deposits by $16.7 billion. The bank owners’ totalexposure to losses remains $2.085 billion, but the government insurer’s exposureincreases by the full $16.7 billion.

Further, as Minskynoted, simple arithmetic shows that banks with higher leverage and higherprofit rates must grow faster to maintain their profitability (this is all themore true when shareholders impose a specific target to meet in terms of returnon equity). Assuming a dividend payout ratio of one-third, banks earning a 15%profit rate will accumulate capital at a growth rate of 10% per year. Tomaintain leverage ratios at 20, bank assets and deposit liabilities will haveto increase each year by twenty times the increase of capital. Assets will haveto grow even faster if the return on assets grows, given a leverage ratio, orif banks decide to increase leverage ratios. Both of these events are likely ina boom. This is why an otherwise unconstrained financial system will tendtoward explosive growth. Indeed, a recent paper by FRB-NY economists shows thatleverage in the financial system is highly procyclical, caused by expansion ofassets relative to equity in a boom (and deleveraging in a bust). (Adrian andShin 2009) The notion that legislated capital requirements (such as thosepromulgated by Basle II) can tightly constrain growth and risk is flawed. 

What if the bank thatincreased its leverage ratio discovers that a lot of its new loans are goingbad? Assume that about one out of eight turns out to be toxic waste, so owner’sequity has disappeared (and leverage has approached infinity!). One strategy isto patiently rebuild capital through retained earnings (assuming the otherassets remain profitable). A more aggressive strategy would be to “bet thebank” by making riskier loans and hoping to recoup losses. Which option will bechosen depends on management incentive structures as well as regulatory and supervisorypractices and the general expectational environment. If management’sperformance is closely scrutinized, and its pay is closely tied to short-termperformance, it is likely that it will choose to hide losses and pursue ahigher risk/return path. Strict capital requirements combined with laxoversight makes this even more probable as management will try to rebuildcapital before regulatory agencies discover losses and close the institution.We know that this is how the thrift industry reacted to insolvency in the1980s—indeed, the Reagan Administration’s regulators encouraged them to do justthat (Black 2005).

This is why formerTreasury Secretary Hank Paulson’s argument (parroted by Timothy Geithner) thatgovernment had to inject capital and get bad assets off the books of banks inorder to encourage them to lend again was so nonsensical. First, loan lossesand lack of capital (unless it is discovered and sanctioned by authoritiesthrough prompt corrective actions and other means, something that mostAdministrations have failed to encourage) is not a barrier to lending, indeed,can encourage rapid growth of risky loans. The owners had little to lose oncecapital ratios declined toward some minimum (zero in the case of an institutionsubject only to market discipline, or some positive number set by governmentsupervisors as the point at which they take-over the institution), so wouldseek the maximum, risky, return permitted by supervisors. Second, more lendingis not a solution to a situation of excessive leverage and debt!

Right now there’sagain a remarkable difference between you and a lot of other experts in thefield of finance and economics. While the recipient of mainstream media is toldthat “things are getting better”, “the worst seems over” and “we see greenshoots take root”,  you are saying thatwe are rather heading towards a “Great Depression 2.0”. 

I wouldn’t characterise my view as signalling“Great Depression 2.0”. It is more accurate to describe my view as akin to Japan’s lost decade. With employment numbers dropping rapidly, the finances ofstate governments, households and businesses continuously worsening, and highlyleveraged financial institutions overwhelmed by a mountain of “legacy” assets,the Obama Administration has had a lot to deal with in its first few months inoffice.

Unfortunately, like the BushAdministration before it, the Obama Administration appears to be trying torecreate the bubbly financial conditions that led to disaster. It is pouringgood money after bad in the banking system, much like Japan. This is not likely tosucceed, and is displacing policies that might actually prevent recurrence ofanother great depression. Even if the $23.7 billion the federal government hasso far allocated in the form of spending, lending, and guarantees does preservethe status quo, we believe it will just set the stage foranother—bigger—financial crisis a few years down the road. This is why werecommend an abrupt change of course, to pursue a more radical policy agenda. 

So far, instead of trying to revivethe productive economy, most of the recovery effort has consisted ofcardio-pulmonary-resuscitation for Wall Street. Fearing what it might find ifit actually examined the books of financial institutions in detail, the administrationput a chosen handful of them through a wimpy “stress test” after announcingthat none would fail. Rather than closing massively insolvent institutions,Washington continues to allow them to operate “business as usual” and to cookthe books to show profits so that they can pay out big bonuses to the geniuseswho created the toxic waste that brought on the crisis.

In short, under the guidance ofLarry Summers and Timmy Geithner, policy serves to preserve the interests ofbig financial companies, rather than implementing government programs that directly sustain employment and restorestates’ finances. To make matters worse, the Obama Administration is alreadypreoccupied with “paying for” additional spending through tax hikes or spendingcuts elsewhere. It does not appear to be willing to let the fiscal position ofthe federal budget grow as needed to meet current challenges. So the fiscalautomatic stabilisers will probably do enough to ensure that we don’t fall into“Great Depression 2.0”, but insufficient to offset the impact of private sectordeleveraging. Hence, many years of economic stagnation lie ahead of us.

Nouriel Roubini fromthe “RGE Monitor” is arguing these days that the United States economy is about to enter a “double dip recession”.[2] What kind of a “double dip recession” is this, and why Mr. Roubini is probably rightwith this observation?

Yes, he’s probably right, for all of thereasons I cited above. Policy is focused on restoring the status quo ante,rather than focusing on restructuring and redesigning today’s convolutedfinancial architecture. The US economy is todaycrushed by massive indebtedness in two sectors of the economy: the financialsector and the household sector. Maintenance of the status quo is not a solution.Administration proposals to relieve debt burdens by encouraging lenders torenegotiate mortgages have failed miserably. Personal income is falling at aterrifying rate. Already 6.5 million have lost their jobs—with June, alone,adding a half million job losses. The administration’s promise that thestimulus package will create 3.5 million jobs over the next two years isunsatisfying in the face of the challenges faced.

We need federal government spendingprograms to provide jobs and incomes that will restore the creditworthiness ofborrowers and the profitability of for-profit firms. We need a swift anddetailed investigation of financial institution balance sheets and resolutionof those found to be insolvent. We need to downsize “too big to fail” financialinstitutions, while putting in place new regulations and supervisory practicesto attenuate the tendency to produce a fragile financial system as the economyrecovers. We need to investigate fraud and to jail the crooks. We need apackage of policies to relieve households of intolerable debt burdens. Inaddition, given that the current crisis was fueled in part by a housing boom,we need to find a way to deal with the oversupply of houses that is devastatingfor communities left with vacancies that drive down real estate values whileincreasing social costs. And we’ve got to reign-in the money managers that seemto be dictating policy.

Due to the financialcrisis the monetary system itself comes into focus. What is your stance on it?

Well, I tend to be a"chartalist" when it comes to money, and tend to follow the teachingsof Abba Lerner.3 I think the reasonboth theory and policy get money “wrong” is because economists and policymakersfail to recognize that money is a public monopoly. Conventional wisdom holdsthat money is a private invention of some clever Robinson Crusoe who tired ofthe inconveniencies of bartering fish with a short shelf-life for desiredcoconuts hoarded by Friday. Self-seeking globules of desire continually reducedtransactions costs, guided by an invisible hand that selected the commoditywith the best characteristics to function as the most efficient medium ofexchange. Self-regulating markets maintained a perpetually maximum state ofbliss, producing an equilibrium vector of relative prices for all tradables,including the money commodity that serves as a veiling numeraire.

All was fine anddandy until the evil government came interfered, first by reaping seignioragefrom monopolized coinage, next by printing too much money to chase the too fewgoods extant, and finally by efficiency-killing regulation of private financialinstitutions. Especially in the US,misguided laws and regulations simultaneously led to far too many financialintermediaries but far too little financial intermediation. Chairman Volckerdelivered the first blow to restore efficiency by throwing the entire Savingsand Loan sector into insolvency, and then freeing thrifts to do anything theydamn well pleased. Deregulation, which actually dates to the Nixon years andeven before, morphed into a self-regulation movement in the 1990s on theunassailable logic that rational self-interest would restrain financialinstitutions from doing anything foolish. This was all codified in the Basle IIagreement that spread Anglo-Saxon anything goes financial practices around theglobe. The final nail in the government’s coffin would be to tie monetarypolicy-maker’s hands to inflation targeting, and fiscal policy-maker’s hands tobalanced budgets to preserve the value of money. All of this would lead to theera of the “great moderation”, with financial stability and rising wealth tocreate the “ownership society” in which all worthy individuals could share inthe bounty of self-regulated, small government, capitalism.

We know how thatstory turned out. In all important respects we managed to recreate the exactsame conditions of 1929 and history repeated itself with the exact sameresults. Take John Kenneth Galbraith’s The Great Crash, change the datesand some of the names and you’ve got the post mortem for our currentcalamity.4

The primary purposeof the monetary monopoly is to mobilize resources for the public purpose. Thereis no reason why private, for-profit institutions cannot play a role in thisendeavor. But there is also no reason to believe that self-regulated privateundertakers will pursue the public purpose. Indeed, as institutionalists weprobably would go farther and assert that both theory and experience tell usprecisely the opposite: the best strategy for a profit-seeking firm with marketpower never coincides with the best policy from the public interestperspective. And in the case of money, it is even worse because privatefinancial institutions compete with one another in a manner that is financiallydestabilizing: by increasing leverage, lowering underwriting standards,increasing risk, and driving asset price bubbles.

I would also like totalk with you about another topic related to the current recession – the oilprice spike of last year. In order to do so, I want to quote a statementpublished in April 2001 by James Baker and the Council on Foreign Relationsentitled “Strategic Energy Policy Challenges forthe 21st Century“.In that paper there’s this statement to be found:

“Oil price spikes since the1940s have always been followed by a recession.”5

Again first of all arather simple question: is this statement in tune with the historical truth –or in other words: does it reflect an “eternal law” of the past, present andfuture one can count on?

I don’t know if Baker’s statement reflects an “eternaltruth”, but oil is undoubtedly a very important component of the global economyand energy (along with food) is a key non-discretionary essential without whichwe couldn’t sustain our current standard of living.  Unlike Europe, the US is still addicted to cheap oil, sothe impact of price spikes tends to be felt much more acutely here than it doesin the EU or UK. Add to that the massive personalindebtedness of the private sector, the fact that historically consumption hascomprised 70% of GDP in the US, and obviously, a rising oil pricecreates another headwind which precludes a significant pick-up in growth.

So the oil price spike of last year was the coup de grace to the US economy?

Yes, I think it was the straw thatbroke the camel's back, or the "icing on the cake". But I thinkit would be more accurate to say that  the oil price spike catalysedthe subsequent collapse. However, recessionary pressures werealready "baked in the cake" well before the oil price spike. Ifanything, I would say that the oil price spike (largely a product ofspeculation, not final demand) provided a perfect illustration of thedysfunction of our financial system, something Doug Noland has been particularlystrong in illustrating.

Couldyou explain that?

Simply a demonstration that ourfinancial system has become hooked on cheap financing for the purposes ofspeculation. To me, it is no coincidence that when Bernanke began to reducerates in response to the 2007 sub-prime meltdown, he simply incited anotherspeculative bubble in commodities via the leveraged speculating community.

Let’sreturn to the inter-relation of the oil price spike of last year and thecurrent recession. Can you tell us about your reading of last years oil pricespike?

Let mebegin my answer to that question with the observation that economists were almostuniversally opposed to the idea that speculation was playing much of a role inthe oil price spike. A Wall Street Journal survey found that 89%, as close asyou ever come to unanimity in most polls, saw the increase in commodity prices,including oil, as the result of fundamental forces. 6 Nobel prize winner Paul Krugman arguedthe case forcefully in a series of New York Times op-eds and blog posts withtitles like “The Oil Non-Bubble,” “Fuel on the Hill,” and “SpeculativeNonsense, Once Again.”7

I think too little attention hasbeen paid to the role of speculation in last year's oil market rally. Part of this is a usual blind spot amongst economists.  Paul Krugman’spresence in this camp lent credibility to the “oil prices are warranted” view.The Princeton economist had been a Cassandra on the housing mania and had alsocorrectly anticipated that the deregulation of energy prices in California could lead tomanipulation. So Krugman, sensitive to the notion that speculation can distortprices, nevertheless fell in with the argument that oil prices were simplyreflecting supply and demand. 

Yet that belief was spectacularlyincorrect. Oil peaked at $147 a barrel in July and fell even more dramaticallythan it had risen. By October, prices had fallen to $64 a barrel. Bloombergcolumnist Caroline Baum described the world as “drowning in oil.”8 A report by the Commodities FuturesExchange Commission attributed the large swings in oil prices tospeculation. CFTC Commissioner Bart Chilton said that earlier studies thatfound that the moves were the result of supply and demand relied on “deeplyflawed data.”9

Why were economists unable to read theinformation correctly, and so inclined to dismiss the views of experts andparticipants in the energy markets who were saying that prices were out ofwhack with what they saw on the ground.

The short answer is that they hadundue faith in their models. Modeling has come to be a defining characteristicof modern economics. Practitioners will argue, correctly, that economicphenomena are so complex that some abstraction is necessary to come to gripswith the underlying phenomenon, to sort out persistent behaviours from merenoise in the system.

Good models filter the “noise” out ofa messy situation and distil the underlying dynamics to provide betterinsight.  The implications of a mathematical model can be developed in adeliberate, explicit fashion, rather than left to intuition. Models forceinvestigators to contend with loose ends and expose inconsistencies in hisreasoning that need either to be resolved or diagnosed as inconsequential. Theyalso make it easier for the researchers to communicate with each other- 

Any model, be it a spreadsheet, amenu, a clay mock up, a dressmaker’s pattern, of necessity entails the loss ofinformation.  Economists admit this is a potential danger. But thisinherent feature is precisely what makes laypeople and even some insidersuncomfortable, because what was discarded to make the problem manageablemay have been essential.

Worse, someone who has become adeptat using a particular framework is almost certain to be the last to see itsshortcomings. A model-user is easily seduced by his creation and starts to seereality through it. Users wind up trusting the results because they follow fromthe axioms, irrespective of their initial understanding. Practitioners canbecome hostage to them, exhibiting a peculiar sort of selective blindness. Catsform their visual synapses when their eyes open, when they are two to threedays old, and if they do not get certain inputs, the brain circuits never getmade. A kitten who sees only horizontal lines at this age will bump into tablelegs the rest of its life.

If we would discuss the speculation aspect oflast years oil price spike, would it be wrong to take a closer look at"Government Sachs" – the artist formerly known as Goldman Sachs?

As far as Goldman Sachs itself goes,yes, they had a significant role in this speculation, but there were a lot ofother factors. Mike Masters, who really knows this area well, is a ManagingMember of Masters Capital Management, LLC. He demonstrated during lastyear's oil boom that large financial institutions, such as investment banks andhedge funds, which were “hedging” their off exchange futures transactions onenergy and agricultural prices on U.S. regulated exchanges, were being treatedby NYMEX, for example, and the CFTC as “commercial interests,” rather than asthe speculators they clearly are. By lumping large financial institutionswith traditional commercial oil dealers (or farmers) even fully regulated U.S. exchanges are notapplying traditional speculation limits to the transactions engaged in by thesespeculative interests.  Masters demonstrated that a significantpercentage of the trades in WTI futures, for example, were controlled bynon-commercial interests.  These exemptions from speculation limits forlarge financial institutions hedging off-exchange “swaps” transactions emanatefrom a CFTC letter issued on October 8, 1991 and they have continued to presentday (Brooksley Born wasn't even aware of this letter until much later).Interestingly enough, the CFTC puts position limits on most commodities, BUTNOT ENERGY. Masters’ testimony, aided by a widely discussed cover story in theMarch 31, 2008 issue of Barron’s, has made clear that the categorizationof swaps dealers outside of speculative controls even on U.S. regulated contract marketshas been a cause of great volatility in food prices, as well as in the energymarkets.

You also had theexpanding role of the Dubai Merc, which has minimal reporting requirements. There is also this report from the US Senate (I wrote an analysis of thisbefore which is below the US Senate report - feel free to pass on).

“Untilrecently, US energy futures were traded exclusively on regulated exchangeswithin the United States, like the NYMEX, whichare subject to extensive oversight by the CFTC, including ongoing monitoring todetect and prevent price manipulation or fraud. In recent years, however, therehas been a tremendous growth in the trading of contracts that look and arestructured just like futures contracts, but which are traded on unregulated OTCelectronic markets. Because of their similarity to futures contracts they areoften called “futures look-alikes.”

The only practical difference between futures look-alike contracts andfutures contracts is that the look-alikes are traded in unregulated marketswhereas futures are traded on regulated exchanges. The trading of energycommodities by large firms on OTC electronic exchanges was exempted from CFTCoversight by a provision inserted at the behest of Enron and other large energytraders into the Commodity Futures Modernization Act of 2000 in the waninghours of the 106th Congress.

The impact on market oversight has been substantial. NYMEX traders, forexample, are required to keep records of all trades and report large trades tothe CFTC. These Large Trader Reports, together with daily trading dataproviding price and volume information, are the CFTC’s primary tools to gaugethe extent of speculation in the markets and to detect, prevent, and prosecuteprice manipulation. CFTC Chairman Reuben Jeffrey recently stated: “TheCommission’s Large Trader information system is one of the cornerstones of oursurveillance program and enables detection of concentrated and coordinatedpositions that might be used by  one or more traders to attemptmanipulation.

In contrast to trades conducted on the NYMEX, traders on unregulated OTCelectronic exchanges are not required to keep records or file Large TraderReports with the CFTC, and these trades are exempt from routine CFTC oversight.In contrast to trades conducted on regulated futures exchanges, there is nolimit on the number of contracts a speculator may hold on an unregulated OTCelectronic exchange, no monitoring of trading by the exchange itself, and noreporting of the amount of outstanding contracts (“open interest”) at the endof each day.”

Then,apparently to make sure the way was opened really wide to potential market oilprice manipulation, in January 2006, the Bush Administration’s CFTC permittedthe Intercontinental Exchange (ICE), the leading operator of electronic energyexchanges, to use its trading terminals in the United States for the trading ofUS crude oil futures on the ICE futures exchange in London – called “ICEFutures.”

Previously,the ICE Futures exchange in London had traded only in European energycommodities – Brent crude oil and United Kingdom natural gas. As a United Kingdom futures market, the ICEFutures exchange is regulated solely by the UK Financial Services Authority. In1999, the London exchange obtained the CFTC’s permission to install computer terminalsin the United States to permit traders in New York and other US cities to tradeEuropean energy commodities through the ICE exchange. 

Then,in January 2006, ICE Futures in London began trading a futurescontract for West Texas Intermediate (WTI) crude oil, a type of crude oil thatis produced and delivered in the United States. ICE Futures alsonotified the CFTC that it would be permitting traders in the United States to use ICE terminals inthe United States to trade its new WTIcontract on the ICE Futures London exchange. ICE Futures as well allowedtraders in the United States to trade US gasoline and heatingoil futures on the ICE Futures exchange in London.

Despitethe use by US traders of trading terminals within the United States to trade USoil, gasoline, and heating oil futures contracts, the CFTC has until today refused to assert any jurisdiction over thetrading of these contracts.

Personswithin the United States seeking to trade key US energy commodities – US crude oil, gasoline,and heating oil futures – are able to avoid all US market oversight orreporting requirements by routing their trades through the ICE Futures exchangein London instead of the NYMEX inNew York.

Isthat not elegant? The US Government energy futures regulator, CFTC, opened theway to the present unregulated and highly opaque oil futures speculation. Itmay just be coincidence that the present CEO of NYMEX, James Newsome, who alsosits on the Dubai Exchange, is a former chairman of the US CFTC. In Washington doors revolve quitesmoothly between private and public posts. 

Aglance at the price for Brent and WTI futures prices since January 2006indicates the remarkable correlation between skyrocketing oil prices and theunregulated trade in ICE oil futures in US markets. Keep in mind that ICEFutures in London is owned and controlled by a USA company based in Atlanta Georgia.

InJanuary 2006 when the CFTC allowed the ICE Futures the gaping exception, oilprices were trading in the range of $59-60 a barrel. Today some two years laterwe see prices tapping $120 and trend upwards. This is not an OPEC problem, itis a US Government regulatory problem of malign neglect.

Bynot requiring the ICE to file daily reports of large trades of energycommodities, it is not able to detect and deter price manipulation. As theSenate report noted, “The CFTC's ability to detect and deter energy pricemanipulation is suffering from critical information gaps, because traders onOTC electronic exchanges and the London ICE Futures are currently exempt fromCFTC reporting requirements. Large trader reporting is also essential toanalyze the effect of speculation on energy prices.”

Thereport added, “ICE's filings with theSecurities and Exchange Commission and other evidence indicate that itsover-the-counter electronic exchange performs a price discovery function -- andthereby affects US energy prices -- in the cash market for the energycommodities traded on that exchange.”

Inthe most recent sustained run-up in energy prices, large financialinstitutions, hedge funds, pension funds, and other investors have been pouringbillions of dollars into the energy commodities markets to try to takeadvantage of price changes or hedge against them. Most of this additionalinvestment has not come from producers or consumers of these commodities, butfrom speculators seeking to take advantage of these price changes. The CFTCdefines a speculator as a person who “does not produce or use the commodity,but risks his or her own capital trading futures in that commodity in hopes ofmaking a profit on price changes.”

Thelarge purchases of crude oil futures contracts by speculators have, in effect,created an additional demand for oil, driving up the price of oil for futuredelivery in the same manner that additional demand for contracts for thedelivery of a physical barrel today drives up the price for oil on the spotmarket. As far as the market is concerned, the demand for a barrel of oil thatresults from the purchase of a futures contract by a speculator is just as realas the demand for a barrel that results from the purchase of a futures contractby a refiner or other user of petroleum.

In 2008, Goldman Sachs and MorganStanley were the two leading energy trading firms in the United States. Citigroup and JPMorgan Chase were also major players and fund numerous hedge funds as wellwho speculate.

InJune 2006, oil traded in futures markets at some $60 a barrel and the Senateinvestigation estimated that some $25 of that was due to pure financialspeculation. One analyst estimated in August 2005 that US oil inventory levelssuggested WTI crude prices should be around $25 a barrel, and not $60.

Thatwould mean today that at least $50 to $60 or more of today’s $115 a barrelprice is due to pure hedge fund and financial institution speculation. However,given the unchanged equilibrium in global oil supply and demand over recentmonths amid the explosive rise in oil futures prices traded on NYMEX and ICEexchanges in New York and London, it is more likely thatas much as 60% of the today oil price is pure speculation. No one knowsofficially except the tiny handful of energy trading banks in New York and London and they certainlyaren’t talking.

Bypurchasing large numbers of futures contracts, and thereby pushing up futuresprices to even higher levels than current prices, speculators have provided afinancial incentive for oil companies to buy even more oil and place it instorage. A refiner will purchase extra oil today, even if it costs $115 perbarrel, if the futures price is even higher.

Asa result, over the past two years crude oil inventories have been steadilygrowing, resulting in US crude oil inventories that are now higher than at anytime in the previous eight years. The large influx of speculative investmentinto oil futures has led to a situation where we have both high supplies ofcrude oil and high crude oil prices.

Compellingevidence also suggests that the oft-cited geopolitical, economic, and natural factorsdo not explain the recent rise in energy prices can be seen in the actual dataon crude oil supply and demand. Although demand has significantly increasedover the past few years, so have supplies.

Well, nowthat we have entered the territory of recession, the pundits talk about “theRoad to Recovery”. In order to travel that road one would need oil, especiallycheap oil, because it does provide a good amount of our energy-basis. Here setsin a quite tricky part of the overall picture, that Mike Ruppert, the formerpublisher of “From the Wilderness”, expressed in an exclusive interview withMMNews this way: 

a) The current global economic paradigm --governed by fractional reserve banking, fiat currency, and compound interest(debtbased growth) -- is inherently and by definition a pyramid scheme. Moneyis useless without energy. One cannot eat a dollar bill or crumble it up andthrow it in his gas tank. Each of the trillions of dollars created out of thinair since the fall of 2008 is a commitment to expend energy that cannot andwill not ever be there.

b) Therecan be no "recovery", no return to growth (which is what the economicparadigm demands), without energy. 10
 

Why this is an observation worth contemplating with regard to Peak Oil? 

I don't really know if I haveanything to add here. To the degree that money is not a store of value butsimply a means to completing a commercial transaction, Mike Ruppert'sobservations can apply to food as well as energy. 

The monetary system, itself, wasinvented to mobilize resources to serve what government perceived to be thepublic purpose. Of course, it is only in a democracy that the public’s purposeand the government’s purpose have much chance of alignment. In any case, thepoint is that we cannot imagine a separation of the economic from thepolitical—and any attempt to separate money from politics is, itself,political. Adopting a gold standard, or a foreign currency standard(“dollarization”), or a Friedmanian money growth rule, or an inflation targetis a political act that serves the interests of some privileged group. There isno “natural” separation of a government from its money. The gold standard waslegislated, just as the Federal Reserve Act of 1913 legislated the separationof Treasury and Central Bank functions, and the Balance Budget Act of 1987legislated the ex ante matching of federal government spending andrevenue over a period determined by the heavenly movement of a celestialobject. Ditto the myth of the supposed independence of the modern centralbank—this is but a smokescreen to hide the fact that monetary policy is run forthe benefit of Wall Street. 

Money was created to givegovernment command over socially created resources. Skip forward ten thousandyears to the present. We can think of money as the currency of taxation, withthe money of account denominating one’s social liability. Often, it is the taxthat monetizes an activity—that puts a money value on it for the purpose ofdetermining the share to render unto Caesar. The sovereign government nameswhat money-denominated thing can be delivered in redemption against one’ssocial obligation or duty to pay taxes. It can then issue the money thing inits own payments. That government money thing is, like all money things, aliability denominated in the state’s money of account. And like all moneythings, it must be redeemed, that is, accepted by its issuer. As Hyman Minskyalways said, anyone can create money (things), the problem lies in getting themaccepted. Only the sovereign can impose tax liabilities to ensure its moneythings will be accepted. But power is always a continuum and we should notimagine that acceptance of non-sovereign money things is necessarily voluntary.We are admonished to be neither a creditor nor a debtor, but all of us arealways simultaneously debtors and creditors. Maybe that is what makes usHuman—or at least Chimpanzees, who apparently keep careful mental records ofliabilities, and refuse to cooperate with those who don’t pay off debts—what iscalled reciprocal altruism: if I help you to beat Chimp A senseless, you hadbetter repay your debt when Chimp B attacks me. 

I would also like to ask you aboutsome remarks by Matthew Simmons, chairman of “Simmons & CompanyInternational”, from March of this year: 

"Unless oil demand falls by 10or 15 percent per annum, which it is not going to do, then we don't need towait for oil demand to come back before we have a supply crunch," he said.“Within a few months, we are going to realize our visible inventories arereally tight -- squeaky tight -- and what would really be inconvenient is tosee a recovery in the economy."

Mr. Simmons also stated that oilprices eventually exceeding last year's high: 

"Sooner or later we will burstthrough that like a hot knife through butter."11

What is your oppinion about this?

Look, by and large, I accept thePeak Oil thesis, but I tend to shy away from the apocalyptic predictions ofpeople like Matt Simmons.  I think his case for price spikes is very compelling(as is the work done by Colin Campbell), but I think they tend to underestimatethe demand response to a major price spike. Here in America, (in marked contrast toEurope or Japan) there has been verylittle squeezed from energy inefficiencies via conservation, green tech,etc. We could do a lot here, but the price has to get much higher tosustain that kind of change in behaviour to make it happen. I think itwill happen. When prices spiked last summer, and gasoline was almost $5.00a gallon, the roads in southern California were empty. Thatdoes have implications for demand. The marginal trip to the mall or theweekend getaway tends to be reconsidered when you get these kinds of priceshocks. The decision to invest in solar panels for the house becomes a bitmore understandable if the energy bills are exploding.  I tend to thinkthat Simmons and his ilk tend to ignore this dynamic. 

I am sure that we have run out of$50 oil. We're running out of $60-$70 oil. In a few years, we'll runout of $80 oil. The low hanging fruit has been picked, and it will getmore expensive and change the way we live our lives. There's no doubtabout that.

As a fellow of "Economists forPeace & Security" wouldn't you agree that people around the globe whoare concerned about peace should begin to concentrate more and more on theproblems that Peak Oil will usher in? The geopolitical implications of it arecolossal - and I guess the outlook of endless resource-wars isn’t really apromising vision for the future of mankind.

Yes, this is the area that doesconcern me the most. Michael Klare has written some excellent stuff onthis: the prospect of heightened global tension as the competition for secureenergy supplies heats up. I have no doubt that this is a big problem. ThePentagon gradually seems to be expanding its remit to become, in effect, aglobal energy protection racket for the American consumer. Themilitarisation of energy policy is a very troubling development, but clearly astrong by-product of Peak Oil.12 

Some financial experts see a Weimar-stylehyperinflation coming to the United States. Is this your position, too?

I am not sure I agree on that. Thereis only one scenario where I think this could occur, and that is via widespreadtax non-compliance. But most of the conditions of Weimar are not present. Firstoff, it is important to remember that German production capacity was eithersignificantly damaged by WWI, or redirected toward output required by themilitary. The Allied blockade further restricted imports well into 1919, and in1923, French and Belgian troops occupied the Ruhr valley which held a good dealof Germany ’s manufacturing base.All of these measures significantly restricted Germany ’s capacity to produce,fueling the distributional conflict that fed the hyperinflation.

This time around, the real netcapital stock growth in the US has been slow, on the order of 1-2% per year,and the manufacturing sector is currently operating with one third of itscapacity idled. Plant, equipment, and labor have not been physically destroyed– rather, reinvestment rates have remained low. While trade has been inhibitedby credit disruptions and some protectionist responses, import prices arefalling as export driven economies struggle to reverse decliningshipments.  

Second, Weimar Germany faced large foreignclaims from war reparations, as well as exploding budget deficits. By 1919, itis reported the German budget deficit was equal to half of GDP, and by 1921,war reparation payments represented one third of government spending. Projectedfiscal deficits are as high as 12-13% for the US and the UK in 2009, so the scaleof the fiscal responses, though large, is not nearly as large as the undertakenby the Social Democratic Party as they attempted to quell social unrestfollowing the Revolution of 1918 with a variety of social benefit programs.

In the US, while foreigninvestors do hold large Treasury bond positions, the debt service paid by the US government to foreignholders amounted to $ 167b in 2008. While this is up from $ 82b in 2004,interest payments on foreign held Treasury debt are not ballooning, the US budget deficit on ascale similar to the Weimar experience. An interestrate spike could change that, but the current foreign interest payment burdenis clearly not a third of the budget deficit as it was during the Weimar experience.

In addition, the US is still running atrade deficit on the order of $338b in Q1, making the type of distributionalconflict over real output that lies behind hyperinflation episodes harder toaccomplish. More good and services are coming into the US than going out. Thistoo could change if foreign net saving preferences fall, and the US has to run a tradesurplus.

Third, German trade unionmembership quadrupled from 1914 to 1920, and the 1918 revolution ushered in agovernment led by a Social Democratic party that instituted an 8 hour work dayand provided social benefits in order to reduce social unrest. Many unions wereable to negotiate cost of living adjustments in their wage packages after themark fell in 1921, creating an automatic feedback mechanism from priceinflation to wage hikes. Absent such mechanisms, nominal wage and salary growthcannot keep up with rising consumer prices. Real wages fall, householdpurchasing power is undermined, and the volume of output households can claimdiminishes unless consumer credit facilities can fill the gap.

The new US administration doesdisplay a social democratic rhetoric, but so far, redistributive policies haveprimarily benefited financial institutions. Social benefit payments are up 12%versus a year ago on a spike in unemployment benefits, and public health careinsurance proposals are on the table. However, trade unions outside the publicsector have withered, and cost of living adjustment clauses have largelydisappeared since the early ‘80s (although some government benefits like socialsecurity retain them). Average hourly earnings are up only 1.8% annualized overthe three months ending in April, and we would not be surprised to see wagedeflation before the unemployment rate peaks this time around. US householdsare net paying down debt – even credit card debt – and creditors remainreluctant to make new loans, so the odds of a wage/price spiral taking rootlook decidedly low.

Undoubtedly, the Reichsbank had ahand in the Weimar hyperinflation, havingbecome accustomed to “monetizing” German government debt during the WWI aftergold convertibility was severed. However, while price levels quintupled betweenthe armistice and February 1920, currency in circulation only doubled, leadingmany politicians to blithely claim monetary policy could not be blamed forinflation. An increase in money velocity must have played a role, although themonetary arrangements of the Reichsbank became increasingly suspect.

The Reichsbank had pegged thediscount rate at 5%, and accepted private commercial debt for discounting underwhat was known as the real bills doctrine of the time. Money creation tofinance production was not believed to carry an inflationary impulse. Directloans to businesses were ramped up by the central bank after December 1921 whenprivate financial institutions began to withhold credit as inflationaccelerated. The assassination of Foreign Minister Rathenau in 1922 set off aselling spree by foreign investors of German bonds, and the central bank wasonce again forced to offset the run with more purchases of German governmentobligations.

Central bank mayhem aside, thefinal culminating chapter of the Weimar hyperinflation doesappear closely related to the response to reparation demands. The May 1921 socalled London ultimatum required annual installment payments of $2b in gold orforeign currency, in addition to a claim on just over a quarter of the value ofGerman exports. Germany attempted to accumulateforeign exchange by paying with treasury bills and commercial debts denominatedin marks, but the mark simply went into free fall on foreign exchange marketsas this ploy fell flat. The January 1923 occupation of the Ruhr by Belgian and Frenchtroops seeking to secure reparation payments in goods – since the mark wasnearly worthless - was the final straw. German production was lost asworkers employed a passive resistance response, and money was printed by the Weimar government to continueto pay workers despite their production halt. Within months, the Germanmonetary system collapsed.

Today, there can be no questionbroad money growth has surged in many countries around the world. Through Marchend, UK M2 was up 18% against a year ago, China ’s M2 was up 26%, Switzerland ’s M2 was up 30%, Canada ’s M2 was up 14%, andUS M2 was up 9%. There can also be no question that budget deficits as a shareof GDP have equally surged. Behind the US and UK 12-13% budget shares, Spain isdue in at nearly 10%, Russia at 8%,  Japan near 6%, and the Euro area near5.5%. Even Germany ’s Chancellor Merkel,following the sharpest quarterly decline in German growth since 1970, hasinitiated a $111b fiscal stimulus package. In addition, the ECB has moved to a1% policy rate with $81b of covered bond purchases scheduled for their move toquantitative easing.

Against the explosion of moneystock measures and fiscal deficits – of which Weimar must be viewed as asuper-sized version – remains a deceleration in private credit growth, animpairment of financial institutions, a rebuilding of cash reserves, andcollapse of private spending. While the Fed’s balance sheet is still nearly twoand a half times the size it was a year ago, it has shrunk by $102b since theend of 2008. Total assets held by US commercial banks have also shrunk by $50through mid May. Commercial banks are still sitting on $1tr in cash reserves,just as they were at the turn of the year. They have been unwilling to lendthose reserves or invest them in securities like Treasuries. No doubt, banksare bracing for further loan losses from credit cards, commercial real estate,and the continuing home price deflation.

Strictly speaking, the Austrian School defines inflation asmoney creation not backed by real saving (that is, available durable goods,like gold). Price inflation is merely the symptom of such money creation. However,as a practical matter, if money is hoarded in a precautionary fashion, and notspent on goods and services, price inflation is thwarted. Ludwig von Mises,writing in 1936, was able to recognize this practical consideration.

“Once the reversal of the tradecycle sets in following the change in banking policy, it becomes very difficultto obtain loans because of the general restriction of credit…It is a well knownphenomenon, indeed, that in a period of depressions a very low rate ofinterest…does not succeed in stimulating economic activity. The cash reservesof individual and of banks grow, liquid funds accumulate, yet the depressioncontinues...capitalists prefer to hold their funds in a form that permits them,in such a case, to protect their money from losses in an eventualdevaluation…capitalists today are reluctant to tie themselves, throughpermanent investments, to a particular currency. This is why they allow theirbank accounts to grow even though they return only very little interest, andhoard gold, which not only pays no interest, but also involves storageexpenses.”

Mises is describing a situationsimilar to what we see today. Banks, households, and companies are holding onto cash as uncertainty is rife. Job destruction prevails, profit contractioncontinues, and private credit is scarce. Cash cushions are built up onhousehold, business, and bank portfolios despite minimal short term yields toweather the storm. In a hyperinflation like that experienced during the Weimar Republic , no one wants to holdcash – cash is a hot potato, a wasting asset.

Thankyou very much for taking your time, Mr. Auerback! 

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