Currency Union or Disunion?

The difficulties surrounding the euro were not difficult to foresee. In fact, they have been so since the euro was first conceived. The key question is whether there should be a single currency or multiple currencies. To find the answer, we must delve into the fate of nation-states: will they form a regional union or will each state splinter?

The fate of nation-states themselves is downright precarious. Like a humongous mammal, a modern nation-state consumes massive resources to keep it going. Only the wealth generated by the four technology waves that began with the Industrial Revolution has made the proliferation of nation-states possible. If we meticulously study the wave pattern, we would realise that there's only one more wave left before the world's wealth generating engine turns off. Even now, the rate of wealth generation has slowed down.

The time for tinkering with the political structure is now ripe. However political leaders faced with the loss of their raison d'etre will pull out all the stops to retain the status quo. This struggle against the tide of political and social transformation certainly makes for an interesting spectacle (and writing) if only we could be bystander spectators to this upheaval. Alas, this is not meant to be. To prepare ourselves, we need to look for signs of the impending collapse. They usually start off in the field of economics, not politics, though. Political and social turmoils are always preceded by economic troubles and the extent of the political collapse depends on how severe the economic troubles are.

We have seen how this has unfolded in the Middle East and is spreading to the sub-Saharan African countries. Soon the whole world will be engulfed in this calamity. The direction is clear: the fracturing of nation-states. The latest casualty is Sudan. As for Libya, the solution to its predicament is to split the state into two. Even if NATO and the rebels manage to defeat Muammar Gaddafi, there is no certainty that the rebel leadership can hold the country together. The real problem in all the troubled countries does not lie with the authoritarian leaderships but with the growing young populations that could not be kept economically occupied. Their seething anger was wholly directed at the long reigning autocratic leaders who were made convenient scapegoats for their hardship. The new leaderships of Tunisia and Egypt would in time face the same predicament that brought down their predecessors.

The lack of economic growth marks the later half of any Kondratieff Wave which in its fourth reincarnation is expected to last till 2020. In the second half of the fourth wave which started around 1990, the productive capacity of the global economy exceeds its consumptive capacity. Remember the monopoly board game. If you play long enough, there'll be only one winner and many losers at the end. It's not that people cannot consume, it's just that they cannot do so at the right price because money is stuck with the winners. A new wave which will usher in cheap energy and materials based on biotechnology and nanotechnology will unlock the wealth retained by the current winners but that won't be due before 2020, even then the initial progress may not be fast enough.

Most countries are blaming Ben Bernanke for unleashing inflation but they'd better look at their own selves in the mirror. As I've said earlier, Ben Bernanke's quantitative easing (QE) is impotent. Look at the total credit figure in the US. For the first three quarters of 2010, it was negative throughout. Only in the fourth quarter 2010 did it grow, even then a measly 0.7 percent. With the potential budget impasse looming, the credit growth (and hence the money supply) in the US will again revert to negative territory, dragging Obama's popularity down with it. Bernanke's QE is not going to create new credit but merely exchanging credit (US treasury bonds) ownership. The treasuries held by other countries and the private sector are now being held by the US Federal Reserve. No wonder inflation in the US is low. The one suffered by the emerging countries is due to their unleashing of bank lending - more bank loans, more money supply. That's the reason for their pumped-up property and commodity prices. But this is a temporary phenomenon. When those properties begin their price drops once the banks stop lending, which one day they have to, we'll see the start of the deflation cycle. Money supply would quickly run out as loans get written off. Then everyone knows what a deflationary depression really is.

Each country has its own peculiar way of lunging into depression. The US is already into it though Obama's three consecutive fiscal years (2009-2011) of more than a trillion dollar deficits each have delayed, but not averted, the day of reckoning. The EU is stuck in limbo as the well-off states of Germany, France, and the UK seem lost in how to handle the impending collapse of the PIGS quartet of Portugal, Ireland, Greece and Spain. Should they withdraw their loan assistance, the PIGS sovereign debts will redound on the banks in Germany, France and the UK which have combined exposure to the PIGS of more than $1 trillion. If they continue, the sovereign debts get bigger making the eventual collapse more catastrophic. The PIGS economies are all uncompetitive because of the euro's high value. Their only salvation is through a debt relief AND exit from the EU so that each country can resurrect their old currencies.

The BRIC emerging nations of Brazil, Russia, India and China, and a string of other small nations are all waiting for their highly exposed banks to drop like a hot brick. As for the oil producing countries, actually oil prices are supposed to drop. What's been holding them back is the massive liquidity created by the bank lending and the speculation unleashed by Bernanke's release of capital that used to be tied up in treasury bonds. This liquidity will disappear when the loans are written off. The money used in commodity speculation will also vaporise once the commodity prices plunge.

What will be the currency of choice if nation-states cease to exist. The answer lies in the European Middle Ages. Back then, they were using gold, silver and copper. Now we do not use specie not because paper money lends itself easily to unrestrained printing by the powers that be. The uncontrolled printing of paper money is an afterthought exploited by unscrupulous leaders. The real reason is that the supply of precious metals could not keep up with the tremendous supply of goods and services unleashed since the advent of the Industrial Revolution. Had we used precious metals, we would have been suffering from frequent shortages of money. But if the economic growth is stagnant, which would be the case after the fifth Kondratieff Wave, then precious metals would be the answer to our currency needs. By then paper currency would have been useless because most states would have fractured to nothingness to be replaced by small communities of towns and villages.

Indeed currency union is an anachronism that has no relevance in a fast changing world. It is fitting to remind ourselves of the insightful observation of Benjamin Disraeli, the British Prime Minister in the 19th century: "Our gold standard is not the cause, but the consequence of our commercial prosperity." Substitute the euro or free trade or even democracy for the gold standard, and you will find that his statement would be valid for all of them. Hard to believe? Watch the world unfold in the coming years.

A massacre . . . in London

We are witnessing the unfolding of the economic meltdown exactly according to script. It's not all the way downhill. There will be ups and downs but the future ones will be worse than the preceding ones. We'll wait for the script to be played out and come back to economic issues whenever any major episode is reached. Meantime we'll go in search of patterns in other fields.

This time it is about a grisly event that took place surprisingly not in Baghdad or Kabul but of all places, in London. The massacre occurred over a period of several years beginning spring 1925 on Monkey Hill, London, an area of about 33m by 20m. The 100 residents had originally been separated from each other in their own individual ‘tenements’. One day, the administrators thought that it was more ‘humane’ if they were given a bigger partly open space where everyone could roam freely and mix with one another. The open environment had a total population, initial and subsequent additions, of 99 males and 36 females.

By late 1931, 64% of the male residents and 92% of the female had died. Of the 33 dead females, 30 died in fights in which they were the prizes fought for by the males. Fortunately, or unfortunately, depending on your perspective, the perpetrators and victims were not humans but hamadryas baboons. The humans acted only as the catalyst.

This story was recounted by the late Carl Sagan and his wife in their book, Shadows of Forgotten Ancestors. The event would have ominous significance more than 70 years later in Baghdad and Kabul, this time with humans taking up all the roles.

Why did this unmitigated carnage happen? After all, the administrators were doing what any sane white man would have done - give the baboons freedom. Unfortunately, that was the spark that triggered the slaughter; the very failure that the white man of the 1920s failed to appreciate in their handling of the baboons. They attempted to anthropomorphise human ideals onto the baboons.

And tragically, in the present moment, not only the white man but also the black, brown and yellow men cling to the dangerous idea that freedom is the ultimate aspiration of every human being. Now they try to impose the Western ideals onto Eastern peoples who have been brought up in cultures that have stood the test of time that actually has spanned thousands of years. Thousands of lives have been sacrificed in this mindless pursuit with no end in sight.

To correct this false belief, we can unravel the history of mankind to understand how the quest for individual freedom came about. But for this post, we'll stick to animal patterns and hamadryas baboons turn out to be a perfect example of patriarchal and patrilineal tribal living in which the male parent lineage dominates the social system, one that also prevails among the Arabs and Afghan Pashtuns. They also happen to live in a harsh semi-desert environment where food is scarce and a lack of hiding places exposes them to predation. In such an environment, organising oneself into a hierarchical structure is a good defence strategy.

In their natural world, hamadryas baboons maintain their harmony through a complex social structure. It's based on a four level hierarchy which at the lowest level is the one male family unit (OMU) or harem comprising a dominant male controlling about ten females. Several units organise themselves into clans. Several clans can form a band. Finally several bands make up a troop which can consist of more than one hundred individuals. A troop forms for the purpose of sharing a vertical rock/cliff for sleeping. Troops and even bands can combat one another over access to resources. They are the only nonhuman primates in which two groups have been observed to gang up on a third. The Arab, or sometimes referred to as the Afghan, proverb, "I against my brother; I and my brother against my cousin; I and my brother and my cousin against the world", defines in a nutshell the inter-relationships among the hamadryas that also prevail in both the Arab and Pashtun societies.

Bachelor hamadryas males whose job is to protect the females from interloping males can be affiliated to a family unit led by a related male. In return they are rewarded with the occasional sex with the females. The unaffiliated solitary males have no access to females. They can form their own harems by persuading females to join them in the new groups or by stealing females from other troops whenever they go into battle. Within a harem, the leading male's position is safe unless he's injured or enfeebled whereupon his harem may be taken over by another male.

Physically, because the males are almost twice the size of the females, males are naturally adapted to having many females. For humans, the body size difference is small which means males paired with more than one female is natural though the number would not approach that of the hamadryas.

Band-and-village or traditional human societies are not necessarily tribal. Some are egalitarian like the !Kung of Namibia and Semang of Malaysia. Even the tribal ones can be categorised into two: those with plentiful supply of food and those with meager food resources. Like the egalitarian the latter tribal group had to cope with food scarcity but in addition it had to fend off predators. To deal with these two conditions, its hierarchy must be modular like that of the hamadryas; in search for food the hamadryas break into harems or clans while in defending or securing a safe sleeping place, they group into bands or troops.

In tribal societies, everyone has a rank. Each would know his place. Lack of switching in ranking makes for peaceful living as the insecurity of the continual jostling for positions is absent. You only fight to take over the position of the leading male and that is fortunately an infrequent event. Occasionally tribes or sub-tribes may raid one another but that usually happens to be in conditions of extreme scarcity where killing is one way to maintain a sustainable population or where the population has exceeded the environment's carrying capacity.

In a human tribal society, maintaining cohesiveness of the society demands the dispensing of rewards from the tribal leader. He could do this if his own members as well as the other tribes recognise him as such whereupon his actions and decisions carry authority which thus can influence the viability of his tribe. The ability of any tribe members to bring in rewards directly can challenge his authority and lead to an organisational breakdown.

Saddam Hussein when he ruled Iraq understood this to a T. He was in fact a tribal leader in chief, certainly relatively more powerful in his country than a US president as commander in chief in his. He didn't have to distribute the oil wealth to every Iraqi but only to the Sunni and Shiite tribal chiefs. As for the Kurds, he unleashed his killing apparatus on a vast scale. Through these means, he kept a tight rein on Iraq.

When the US invaded Iraq in March 2003 in what is known as Operation Iraqi Freedom, the ensuing chaos led to a breakdown in the tribal arrangement that Saddam had painstakingly nurtured. Likewise when the zoo attendants allowed the free mixing of the hamadryas baboons, they were unknown to each other. In trying to establish a dominance hierarchy among themselves, they brawled to their deaths. The number of females which was very much less than the males in contrast to the situation in the wild, made the fight all the more violent. The Iraqi violence subsided only when the US resumed the bribe money to the Sunni tribal sheiks and thus restore the tribal structure.

The coming economic conditions of increasing scarcity call for a new social and political arrangement in order for mankind to reach some sort of stability in the inter-relationships among its members. It can opt for either the egalitarian or the Arab tribal way. The egalitarian is tougher to attain because the society members have a duty to share resources equally. No one needs to feel obliged to another for receiving benefit nor should he expect gratitude for giving. It's an obligation that is demanded of all members. Moreover egalitarian societies live in environments in which they don't prey upon their own kind. A hierarchical structure is thus not needed for organised offence and defence.

That leaves the Arab or the hamadryas tribal way as the only choice left for us. The starting point is the formation of modular groups that can agglomerate and dissipate depending on needs. In this arrangement, there is no room for individual freedom. To be sure, individual freedom is an excellent idea which should be left at that, to wit, as an idea. Being independent in the future economic and political landscape leaves you vulnerable to the predations of organised groups.

As we survey the political landscape of the world, the fragmentation of the nation-state structure hastens with the global economic collapse. However the next technology wave driven by biotechnology and nanotechnology will partially stem it. Ironically, that wave will cheapen the production of weapons of violence and destruction much like the internet weakens the control of minds and ideas in the current wave. Political leaders still stuck to the old paradigm will use all the tools at their disposal to check this disintegration but it is a lost cause noted only as one evolving phase in the long history of mankind.

Gone with the gearing

Below are three comments about the banking industry made by three individuals. Identify the one that is most prescient and the individual who is the least famous, if not totally unknown, among the three.

Comment 1
“I believe that the tools available to the banking agencies, including the ability to require adequate capital and an effective banking receivership process, are sufficient to allow the agencies to minimize the systemic risk associated with large banks. Moreover, the agencies have made clear that no bank is too big to fail. So that bank management, shareholders, and uninsured debt holders understand that they will not escape the consequences of excessive risk taking. In short, although vigilance is necessary, I believe the systemic risk inherent in the banking system is well managed and well controlled.”

Ben Bernanke, Federal Reserve Chairman and a former Princeton University professor
In an answer to a Senate Banking Commitee question on his first confirmation hearing in 2005

Comment 2
"[G]iven 1990 levels of capital, both Fannie Mae and Freddie Mac had sufficient capital to survive." even when tested against "the financial and economic conditions of the Great Depression." And "on the basis of historical experience, the risk to the government from a potential default on GSE debt is effectively zero."

Joseph Stiglitz, former Chief Economist of the World Bank and a Columbia University professor
In a paper written in 2002 titled "Implications of the New Fannie Mae and Freddie Mac Risk-Based Capital Standard."

Comment 3
"Running a bank is like piloting a warplane. If you alter the steering even a little bit, you end up in a completely different position."

Coskun Ulusoy, a former banker and the CEO of OYAK, Turkey's Armed Forces Pension Fund
On the rationale for selling OYAK's own bank to ING for USD2.7b in 2007

In terms of grey matter, academic credentials and widespread recognition, Bernanke and Stiglitz are far ahead of Ulusoy. But Ulusoy has one essential trait ― the ability to correctly size up the situation and then to use it to discern the key underlying patterns ― that separates those who can rise above the trivia and see the obvious from those blinded by the mass of details. In this, Ulusoy is one of the brilliant few that possess such insight. Certainly getting out of the global banking mess in the nick of time is one thing but to offload a future muck onto ING at a good price deserves acclaim.

While Bernanke and Stiglitz are muddling through one step at a time with the apparent solution at each step being overwhelmed by unintended side-effects, Ulusoy has already leaped five steps ahead knowing fully well the adverse consequences of the slow plodding. Bernanke and Stiglitz do conduct serious analyses and researches but these are all done to confirm their already firmly held beliefs, not to challenge them. This is the fundamental flaw of smart people ― a refusal to admit that they could go wrong.

The whole banking industry has a basic failing which is only evident during a depression ― its high gearing. This weakness is unique only to the banking industry. Practically all bankers except the enlightened few, such as Ulusoy still believe that it's their asset quality that matters. However, in a depression characterised by deflating prices, asset prices will definitely collapse. No amount of money printing can stave off this collapse because such money will be sucked by the black hole of loan write-offs and bank deleveraging. Money printing works only to stem a panic, not to avoid a decreasing money supply which should be allowed to take its natural course.

How does a bank's gearing choke the bank to death? Let's start with the bank's balance sheet. A bank's capital is typically about 8 to 10 percent of its total assets which comprise loans issued out to borrowers. To support the huge asset base, a bank raises the other 90 percent externally in the form of outside liabilities. These consist of money from depositors and inter-bank borrowings. Banks are classic cases of an entrepreneur's dream – use of other people's money (OPM) – that are extremely dangerous in tight liquidity situations. In a depression, asset prices can fall by more than 30 percent and at the extreme can surpass 50 percent whereas the liabilities remain fixed.

How are property prices holding up in the US? For commercial properties, prices have fallen by 44 percent from their peak in October 2007, a fate similarly shared by those in the UK. The median existing house price for the US has fallen by 25 percent from its peak in the 4th Quarter, 2005 with another 10 percent fall forecast for 2010. The Case-Shiller index covering houses in 20 cities in the US reveals a decrease of 33 percent from its peak in July 2006 to its trough in April 2009. Prices then rose for the next five months because of the Obama stimulus before stalling in October 2009. Karl Case, the eponymous co-founder of the index has predicted that prices will fall by another 15 percent. All in all, it won't be surprising if the price collapse exceeds 50 percent, posing fatal threats to the banks' existence.

Because of a bank's gearing, typically from 10:1 to 12:1, it takes only a 10 percent fall in its asset values to compeletely wipe clean the bank's capital. The bank's assets comprising mostly loans are secured against collaterals which can be real properties or other assets, such as machinery financed by those loans. In a deflation, the values of these collaterals will be dragged down with the falling economy. It doesn't take a mathematical genius to figure out that even with loans amounting to only 80 percent of the collateral values, it needs only a 30 percent fall in the collateral values to drag the bank's assets down by 10 percent. The actual situation is much worse because at the peak of the subprime mania in 2006, the loan-to-value (LTV) ratio even exceeded 95 percent. With their collaterals worth less than their loans, the borrowers will simply walk away from their obligations leaving the bank, devoid of capital, holding on to fast depreciating assets.

The severity of such a scenario can only be felt by looking at the impact of the Great Depression in the 1930s. In 1921, the number of banks in the US peaked at 30,456. Thenceforth, the number gradually diminished but the rapid decline occurred between 1929 and 1933, in the midst of the Great Depression, in which 43 percent or about 10,800 of the banks went bust. Even the relatively mild Savings and Loan crisis of the late 1980s and early 1990s led to the closure of more than 1,600 Savings and Loan institutions.

How do the current bank closures stack up against those of the Great Depression? Actually, we haven't scratched the surface. From 2000 to 2008, the US had only 53 bank closures, including two years, 2005 and 2006, the only time in the history of US banking without any closure. In 2009, the pace started picking up with 140 closures. The US now has about 8,000 odd commercial banks. The coming depression which I call the Grand Depression is definitely many orders of magnitude worse than the Great Depression. The credit expansion was many times bigger and, in a regression to the mean, the credit contraction would need to be equally huge. We can expect more than 3,000 banks to shutter for good within the next few years. These zombie banks are still walking because of the foreclosure moratorium which puts on hold the writedowns of their toxic assets to market value.

Would Islamic banking and sukuk bonds be immune to this catastrophe as bragged about by their proponents? In truth, there's no difference between Islamic and conventional banking. They share the same chink in their armour – high gearing. An economic depression doesn't differentiate between Muslims and non-Muslims. Even any other businesses with high gearing will incur the wrath of the depression. And this crisis in banking won't be restricted to the US; it is spreading globally in line with falling commodity and real estate prices. We only have to wait for the other shoe to drop in the US banking crisis to trigger a chain of falling dominoes in other countries.

Clutching at the recovery straws

"A specialty of martial arts is to see that which is far away closely and to see that which is nearby from a distance." wrote Miyamoto Musashi in The Book of Five Rings. That statement aptly applies to fields as distant from martial arts as economics and politics. More so now that we are enmeshed in conflicting signals about the global economy so much so we can't make head or tail about which way the economy is heading. The confusion stems from the absence of a guiding pattern as reflected in our anxiety for any indicative news on the economy. There's no way to strategise when your only beacon is the unfolding news.

A typical confusion is exemplified by none other than two well known professors, both having divergent views on how the economy will turn out. In one corner is Niall Ferguson, an economic historian at Harvard whose contention is that the money printing by Bernanke will lead to rampant inflation and consequently high interest rates. In the other is Paul Krugman, an economics professor at Princeton and a Nobel Prize winner to boot. Krugman believes that Obama's deficit will lead to recovery and any rise in interest rates is an indication of funds moving to stocks and investments.

How these two icons of erudition in economics could go wrong is easy to see. They both rely on analytical inquiry; with one or two steps you can plausibly argue out your position. Instead, we should use a different approach, that is, pattern recognition. This approach takes five or more steps in one thinking cycle. For example, using the investment clock as a pattern (see Ticking towards midnight), it's safe to predict that cash will be precious in this depression because of its scarcity. The likelihood of high nominal interest rates is low but because of falling general prices, real rates will be high. We will see major debt write-offs and financial sector deleveraging (loans being called in as banks' capitals get eroded from debt write-offs). Now it appears that cash is aplenty with Bernanke furiously printing money. But don't be so sure that this can continue indefinitely.

We first need to understand the reasons for the temporary growth spurt and why this is just an aberration in a secular downsliding global economy. The refrain about the coming recovery stems from the actions of three men: Bernanke, Obama and Hu Jintao. I will tackle each in turn and debunk their claims to reversing the depression. But first, an overview of the common structural weakness of their actions.

Their failing lies in their inability to perceive the cause of the depression as more than just a liquidity crisis. If it were so, it would have been easily solved by Ben Bernanke's money printing. The fact that it hasn't proves that it's more than merely a liquidity issue.

In my earlier post, I've argued that this depression is actually a capacity crisis (see It's capacity, not liquidity, stupid). Actually, it's more than that; to find out, we need to take a step back. The real reason is the absence of a new growth driver, not only to propel growth but also to creatively destruct the present growth engine. The alternative is annihilative destruction as exemplified by Hitler's WW2 legacies in Europe. The mind can't even contemplate such a nightmare scenario.

The term 'creative destruction' was coined by Joseph Schumpeter of the Austrian school of economics. This school has been disdained by mainstream economists because of the Austrian school's eschewal of mathematical models. The Austrian school has a valid reason since human behaviours are too complex to avail themselves to modelling.

The purpose of creative destruction is to keep the wealth moving from those who have succeeded under the present growth paradigm to those who will succeed under the new growth paradigm. Without this changeover, whatever deficits and money printed will benefit only those who prosper under the existing growth paradigm. Within the context of the global economy, the higher the budget deficits of the US government, the more will be the US current account deficits as China and the oil exporting countries siphon off the surpluses. And for any national economy, the sizes and debts of almost all governments keep burgeoning to meet the demands of their populace until they collapse under their own and their debts' weights. Take Japan, while its public debt has exceeded 200 percent of GDP (second only to Zimbabwe), its household financial assets amount to US$16 trillion (second only to the US).

Ancient societies had ways of dealing with this imbalance through debt cancellation in times of crisis and famine. Our inability to recognise this unsustainable imbalance condemns us to tackling the symptoms while the real problem remains misunderstood. It seems despite our technological advances, we are way behind the ancients in the understanding of social and economic issues.

A similar ineptitude afflicts our three key decision makers. I have written an earlier post on Bernanke (see Bernanke vs The Market), so what's described here are additional comments on his perverted beliefs. Ben Bernanke has earned the nickname Helicopter Ben for his remark that he would drop dollar notes from a helicopter in order to keep the economy going. If only it were that easy. Ben is in need more of a helicopter view to overcome his myopic sight than a helicopter ride. Actually, he has to call upon Obama and Congress to drop money because only they can authorise the spending budget. What Bernanke or the Fed can do is to swap the printed money with existing debts, not willy nilly throwing away money.

Most of his swaps (or purchases, to be exact) comprise treasury bills and mortgage backed securities (MBS). There are limits to both. In the case of T-bills, his holding has exceeded US$700 billion. Any further increase depends on the US government getting deeper into deficits or the holders of existing T-bills continue selling to the Fed. The first is getting tougher as Obama has come under increasing pressure to balance the US government budget. The latter option can only be made at increasing prices as supply of T-bills gets scarcer with greater Fed purchases.

As for the MBS, for which the Fed now holds more than US$800 billion, more purchases of it exposes the Fed to higher risks as following the law of diminishing returns, incremental debts tend to carry greater risks of default, more so in times of deflating prices.

Bernanke's artificial suppressing of interest rates through his flooding of liquidity is not helping the economy either. The sloshing liquidity is sending wrong signals, such as higher commodity prices. Commodity producers are encouraged to increase capacity at a time when the commodity prices are going to collapse as they eventually will when their supplies overwhelm the shrinking demand. The only time when the money floodgate should be opened is during a panic and that moment passed in March 2009. Now is the time to allow the liquidity to gradually decline.

The next decision maker, Pres. Barack Obama is facing many critical issues: economic depression, unemployment, health care, global warming, Afghan and Iraq; all of which offer no easy solutions. To tackle them he must first acknowledge that the US is no longer a hegemon especially when the survival of the nation-state itself is precarious. His priority is to the American voters. He can thus safely ignore global warming, Afghan and Iraq.

Global warming, even if it really is caused by carbon emissions, cannot be solved by government edicts and regulations. Only technology can address it. Furthermore, in a severe depression, it will eventually be relegated to the back burner. Iraq is a goner when oil prices crash. The reason the Iraq surge succeeded was because it was accompanied by cash bribes to the Sunni tribal chiefs who then rallied the Sunni tribes against Al-Qaeda. This lesson has been lost on the American generals who still believe that it was the surge alone that turned the tide. American intelligence in preventing attacks in its homeland has improved tremendously that the US doesn't need to be present in Afghanistan. It should allow Taliban to rule Afghanistan and use the threat of the missiles to get them to put on their best behaviour. Israel's experience with Hamas after Hamas's rule of Gaza is instructive. For invisible enemies, the key is to make them visible so that they can be contained.

Health care, the last pocket of inefficiencies in the private sector, is a secondary issue in a downturn. The way health care is administered now, with practitioners operating autonomously within a hospital, engenders perverse incentives and is predatory on the consumers. The US should look into certain revolutionary health care practices, especially in India where salaried doctors using factory line style procedures focusing on volumes, have improved quality and lowered costs.

The economic depression is a given as the moment Obama reduces the US deficits, if not balances its budget, the global economy will keel over once again. That leaves unemployment as the critical issue that Obama should redirect his attention to. To solve this, he must first institute trade barriers and capital controls. It's no point incurring massive deficits if the money eventually flows out. Of course, these measures are economically inefficient.

But look at the factory floor, you can only be very efficient in only one area of your choosing; it's either labour, machine or space. Similarly, if you want cheap quality goods, you must tolerate continual deficits and high unemployment. It's Linear Programming 101: you can only maximise efficiency in only one area, but subject to the constraints or minimum thresholds that you have specified for the others. In the case of the US economy, it's maximising goods production efficiency without regard to any constraints on the level of unemployment nor on the deficits.

Finally, Hu Jintao who is the President of China, a country living on borrowed time. China is probably the last in a series of countries ranging from Japan to the East Asians and South East Asians that have been or about to be humbled by the deflationary plague. The Tibetan and Uighur riots in 2008 and 2009 were just mild foretastes of worse things to come. The riots were easily quelled because they were initiated by minorities. When the turn of the Han Chinese comes, not even the biggest army in the world can subdue it. Even Suharto, politically once the strongest man in Asia had to shamefully step down in 1998 after 30 years of iron rule when the whole region was steeped in economic turmoil.

China survives for the moment because of its US$586 billion stimulus and the US$1.2 trillion in additional bank credits. These packages are being used to increase capacity when it is least needed. Soon abandoned factories and real properties will dot China's landscape. The cost in terms of massive bank failures and lost jobs will be closely followed by a social breakdown of immense proportion.

At least Japan were rich when they were hit by the crisis in 1990 while the East Asians and South East Asians were partially saved by the devaluation in 1998. China may be the world's second biggest economy but its per capita GDP is still low. The devaluation option is no longer available as, given its economic impact, all eyes are watching its actions. As the negative forces of unsustainable debts, falling asset prices, rising unemployment and shrinking exports close in on their quarry, China, we can only watch with trepidation the strangulation of a would-be superpower. How fortunes change ― from greatness to wretchedness, from prosperity to calamity, from mastery to misery, from predator to prey, all it takes is a spin of the economic wheel.

Oiled for turmoil

Oil is getting scarcer but demand is increasing at an alarming rate. Peak oil has already been reached, production will soon decline. Ergo the high oil prices. Certainly a grim narrative for oil consumers. Except that it's untrue. The bleak outlook will instead redound on the oil producers.

Actually, the oil business is turning into a sunset industry. New technologies are discovering new vast reserves faster than can be consumed. As for old and plugged fields, they can now be brought back to production with new recovery techniques squeezing more oil that heretofore remains unrecoverable.

Capitalism leaves in its wake a history of broken constraints. In the case of oil, there are two ways in which oil supply constraints can be smashed. Both involve the use of new technologies. One will enhance the prospect of discovering new fields and recovering more oil from the fields, including those that have been long abandoned. The other, part of the final technology wave, will make oil obsolete and redundant.

On the surface, although oil prices appear as the product of supply and demand, things are not that straight forward. Looking back at the history of oil prices since October 1973, when OPEC started flexing its muscles, oil prices have usually been a product of the interplay between global liquidity and the follies of the oil producers. On the way up and down, they move in tandem, continually reinforcing each other. The wild swings in oil prices are the inevitable outcome of the commodity nature of oil. It doesn't take much to tip the scales in favour of either the consumers or producers; the marginal price sets the price for the entire market since the market is not segmented. Worse, both supply and demand are not that elastic over the short term.

In the immediate term, even without factoring the new technologies, the outlook for oil prices is downward. Because bringing new oil fields to production takes time, anywhere from 7 to 10 years, these fields, the planning of which began in 2003 when oil prices inched upwards, will start producing by 2010. Foreign Affairs Nov/Dec 2009, disclosed that Saudi's production capacity would rise from 9.5 million barrels a day in 2002 to 12.5 mbd in 2010, with an extra 1.0 mbd on standby. By then, total OPEC production capacity will grow to 37 mbd, giving a spare capacity of 6 to 7 mbd over current production level. All this is happening in the face of a massive global economic slowdown.

Twice in the past, as narrated by Foreign Affairs Mar/Apr 2002, Saudi used its spare capacity to discipline wayward oil rivals. In 1985/86, Saudi intentionally engineered a price war to regain its market share from interlopers. More than ten years later, in 1998, again it purposely added another 1.0 mbd to its production to punish Venezuela for displacing it as the prime supplier to the US. But the authors of that piece ignored the events leading to the two price collapses that had taken place a few years earlier. The chart shown here from The Economist is enlightening.

Prior to the Arab Israeli War in 1973, the oil spare capacity had been on a secular fall while production - and, by inference, consumption - had been rising, Surely, such opposing trends would have signalled a price increase in the near future. On the other side of the globe, another war had been draining the US of substantial funds that by August 1971, Nixon had to de-peg the US dollar from the gold standard. Free from its leash, the total debt level (money supply) in the US leaped. The 1973-74 oil shock, wrongly attributed by many to the Arab oil embargo, wouldn't have been a shock had the policymakers been aware of the rapidly declining spare capacity as well as the depreciating value of the US dollars. The sudden jump in oil prices from US$3 a barrel to US$12 was an otherwise predictable event. In the 1967 Arab Israeli War, the Arab countries also imposed an embargo but it came to nought. Why? Because spare capacity was still high; even the US then was a net oil exporter.

However at US$12-US$14, there was no much incentive to develop new oil fields. Oil spare capacity was still hovering around 5 percent of production. It needed the Iranian revolution and the subsequent Iran-Iraq war to secure a production fall of more than 3 mbd and thus jolted the prices to US$38 a barrel by end 1979. At this new price, consumption dropped through energy efficiency measures but not in an appreciable manner. More momentous was the spike in spare capacity as all producers ramped it up to capitalise on the high prices. Gradually, the prices dropped to US$26 by 1985. Saudi, being the swing producer had to cut production from 10 mbd to less than 4 mbd in order to stabilise prices. Seeing that others were profiting at its expense, it suddenly surged production to 5 mbd in early 1986. Within a year, prices slumped by more than 50 percent, dropping to as low as US$11.

Spare capacity dropped steadily all the way to 1990. Because of the long lead time in the development of crude oil production, spare capacity cannot jump or slump suddenly. Not however actual oil production . When Iraq sparked the first Gulf War by invading Kuwait on 02 Aug 1990, oil prices bounced back to US$38 but this was shortlived as Saudi jacked up production from 5 mbd to 8 mbd to appease the coalition countries which expelled the Iraqis.

The prices moved within a price band of US$15-US$23 from 1991 to 1997. Spare capacity was subdued at 5 percent. This was a period when supply and demand reached a stable accommodation. From now onwards, the oil producing countries no longer maintained spare capacity as a matter of policy. Any increase in spare capacity will be a result of a consumption slowdown. When the financial crisis hit East Asia in 1997-1998, global oil consumption for 1998 stagnated and spare capacity increased. Venezuela increased its shipments to the US to dethrone Saudi as the biggest OPEC supplier but Saudi retaliated by jacking up production by 1 mbd. Prices collapsed to US$9 by end 1998 and early 1999.

The 2000 dotcom boom pushed prices to over US$30 but they fell back to US$16 the following year with the dotcom crash. The spare capacity yo-yoed from 1998 to 2001 because of these economic crises. Beginning 2002, Greenspan and Bush participated in the biggest US credit creation that ended in 2008. Prices peaked at US$143 by June 2008 but dropped to US$34 by winter. Spare capacity was dangerously low. Obama's public stimulus (the biggest in US history), Bernanke's money printing and Chinese easy credit revived the prices to US$80 by late 2009. These not only benefit oil exporters but also countries, such as Australia, Brazil and Indonesia that depend on other extracted commodities including coal. Their economic growth is by no means a reflection of their management of the economy.

As the world approaches 2010, these band-aid measures will start to wear off. And spare capacity for OPEC itself will exceed 10 percent. In 2008-2009, two years in a row oil consumption fell, the first time since 1982-1983. In 2010, it's likely to fall unless the US institute another trillion dollar budget deficit. The outlook for oil certainly looks very gloomy.

Will oil production drop in order to prevent price collapse? Possible but highly unlikely. The producers are caught in a trap of their own doing. Almost all the major exporters have populace that is dangerously dependent on oil largesse through government jobs and spending. This is a fixed cost that cannot be crimped without severely exposing the governments to social instability and political upheaval. As prices drop, they will rev up production to keep revenue steady. Soon, this vicious circle feeds on itself until the country itself succumbs to economic and political collapse. Although oil will be cheap, it's not oil but blood that will be spilled in the streets.

Remember the Eastern European communism collapse and Soviet withdrawal from Afghanistan in 1989, and Russian financial crisis and Suharto's fall from grace in 1998. Their root causes lay in the oil price collapse. Take Indonesia. Like the other South East Asian countries, it suffered from an overvalued currency then but buffeted at the same time by low oil prices and El Nino-induced rice crop failure, the ensuing carnage was total. Even now the rupiah exchange rate tracks the oil price movement.

As an aside to the main topic, certain commentators, some of whom are economists, have attributed the present recession to the high energy costs, specifically those based on oil. Yet more ridiculous are those who blame the expected declining oil production as a leading cause for the recession. These conjectures reflect a flawed reasoning arising from confusing cause with effect.

If you recall the investment clock (see Ticking towards midnight), high commodity prices immediately precede the deflationary crash. Inferring that A causes B just because A precedes B is a flawed reasoning known as post hoc (after this) reasoning. A fitting analogy is a rooster's crow at the break of dawn which in no way causes the sun to appear. Actually high commodity prices is symptomatic of massive credit creation and when this credit is later written off because the borrowers cannot repay, the whole economy collapses.

As for the declining oil production Chicken Littles, they should read Scientific American October 2009. The magazine describes the new technologies that will extract more oil from the fields. Right now, only 35-40 percent of the oil in the average field is recovered; the rest remains unrecovered. New recovery techniques using heat, chemicals and microbes allow us to go after this buried wealth. Moreover, for new fields, only one third of the world's sedimentary basins - geologic formations that may contain oil reserves - have been thoroughly explored using modern technologies.

A recent example in the natural gas reserves is instructive. Hydraulic fracturing, a new technology that injects water and chemicals at high pressure to break shale rocks that trap natural gas, has been attributed to a 35 percent jump in the US gas reserves in two years. A similar thing is happening to oil reserves. The fact is more oil is still untapped and peak oil is rather more of our psychological fear than of physical reality.