One of the themes from the Republicans is the need to allow more domestic exploration and (hopefully) production, even in so-called environmentally sensitive areas. This makes a great deal of sense, because the economic cost of subsidizing overseas energy producers, especially in the Middle East and Latin America, is far higher than it would appear, even given the vast sums being transferred directly. The hidden costs are the political strengthening of distasteful or hostile regimes, such as the Iranian government. The swaggering of these regimes lead directly to military and security expenditures, to say nothing of the human costs of casualties.

The price of these excessive environmental sensitivities is way too high. There is no reason, given investment which is well justified (pun intentional) at today’s prices, that the US cannot become self-sufficient in energy. Yes, adjustments will be needed, especially to supply the water and gas for exploitation of the oil shale and oil sands. But there is ample material in the ground to buy more than enough time to transition to non-fossil energy sources. This does not mean trashing the environment, it is perfectly possible to preserve the environment while making use of the resources. We do need a national commitment to do it, and if that means riding roughshod over a few vocal environmentalists who fear the worst, then so be it. Ms. Pelosi claims that she is “saving the planet.” What a heap. She is pandering to a well-funded and vocal environmental lobby at the expense of national security and the economic well-being of Americans.

Tyler Cowen estimates the net economic benefits of drilling in the ANWR alone at over $600 billion. Drill, baby, drill.

Panic buying this morning, as the price of oil collapsed over the weekend in the absence of any obvious damage from Hurricane Gustav. However, as Bloomberg points out, valuations are, to say the least, extended.

Wall Street forecasters, who were too optimistic about earnings for the past four quarters, predict income at America’s biggest companies will grow by a record 62 percent in the final three months of 2008, according to data compiled by S&P.

Oil (and commodity) prices are collapsing because the runup, or at least the terminal stage of the runup, was a bubble. As was pointed out here and as can clearly be seen from the “pop.” Stock prices, I expect, are the second last bubble. T-Bond (bill, note) prices will be the last.

Probably the most powerful meme in the market today, held by both bulls and bears alike, is the belief that the Fed can inflate at will. Of course, to some extent it is always true. The Fed can print physical currency in vast quantities, which leads to the pictures of people buying their groceries with wheelbarrows (Weimar Germany) or backpacks (Zimbabwe) full of bank notes of staggering denominations.

However, it is my opinion that, despite his words, Mr Bernanke doesn’t want to be associated with Mr Mugabe’s economic theories and so he will not resort to physical currency printing on that scale. Therefore, if he is to inflate the “electronic money” supply, he needs to work through the banking system, because the “electronic money” supply is credit - bank credit. Just as a reference point, M2 is about $7.7 trillion, and the currency supply is about $0.77 trillion, so the “electronic money” supply, at least basis M2, is about nine times as large as the currency supply. Arguably, there are many other liquid assets that fill the role of money but the essential point is that any expansion of the “electronic money” supply depends upon an expansion of bank balance sheets. Which depends, in turn, on an expansion of the banking system’s capital base. With 60% or more of their collective assets dependent on real estate-related lending, the banking system is losing capital, not expanding. This is exactly what happened in Japan. The BoJ flooded the banking system with reserves, but banks crippled by loan losses could not expand their lending and deflation lingers to this day. In the end, the Japanese government took steps to recognize the losses with a program very similar to the RTC which cleaned up the Texas S&L massacre, and re-established a healthy - but smaller - banking system. It is worth noting, by the way, that M2 has essentially stopped growing since March of this year, and M3 has begun to fall.

But, you say, the price of just about everything, especially food and energy, is going through the roof. True enough. But that’s not inflation. “Inflation is always and everywhere a monetary phenomenon” said Milton Friedman, and they gave him a Nobel Myrdal prize, so he must have been correct. And even price inflation is about the “general” price level. While the prices of corn and crude oil have been going up, the prices of houses have been falling - about 15% in the last year, according to the S&P Case-Shiller index released this morning. Housing constitutes 23 percent of the CPI, but is measured with a ludicrous and arbitrary measure called “Owner’s Equivalent Rent“. If the CPI were calculated with a proper measure of housing costs, core price inflation would probably be negative, although food and energy price increases would have kept the headline number higher.

But the food and energy price increases are probably transitory, because they are primarily a result of speculative activity. Yes, China and the rest of the developing world have increased their consumption of resources, but the price signals have been doing their work and Americans have been reducing their consumption by, for example, reducing their driving by more than 5% over the last year. The inflation meme has led a lot of people to want to hedge their assets against inflation, leading to the creation of “real asset” or commodity index funds which simply stay long various commodities, usually by rolling huge futures positions. These funds of course have driven up prices, because the commodity supply couldn’t increase fast enough to absorb the influx of money into these funds. Then of course the folks who put money into these funds thought they were incredibly smart as they caused the inflation that they set out to hedge against. There couldn’t be a better example of George Soros’ reflexivity idea:

The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.

It is ironic that this whole idea of real asset funds was started by Jim Rogers, who was Soros’ right hand man for many years. But I digress. Price signals in commodities adjust both demand and supply. Energy is probably one of the slowest to respond, but it is well established that supply responds to price signals with a two to five year lag and five years ago, crude oil was under $40. This is not to say that we don’t have a long term supply issue with oil, we do, but for the time being I expect to see energy prices continue to fall. This will bring price inflation more in line with monetary inflation - moving from disinflation to outright deflation.

The true threat to the economy is not the Fed printing currency, it is the slow collapse of the financial system, starving consumers and businesses of the credit that has been the fuel of growth, bringing about an economic dark age. It is, however, the Fed that caused the collapse of the financial system, by encouraging it to over-extend itself. 

There are strong deflationary pressures out there:

• Rising unemployment
• Slowing consumer spending
• A credit crunch and associated deleveraging
• Falling real estate prices

It seems these are now being joined by falling commodity prices. This most recent bubble seems to have kept things going despite the other pressures. Is there another waiting in the wings, or do we finally get to the big D for deflation? Or are we going to see the last bubble in stocks, as in 1929?

Don Coxe has always said that the news that is worth trading is on page 16, not the front page. Today’s page 16 news that could have serious consequences is the outbreak of fighting between Russia and Georgia. The Belfast Telegraph:

A convoy of Russian tanks and troops is reportedly moving toward South Ossetia’s capital as Russian Prime Minister Vladimir Putin declares ‘the war has started’.

Tech stocks are being jammed today, well, because they can be. Ostensibly, because the price of oil is falling. I suppose it is dumb to point out that tech stocks have rallied anyway since oil broke out above 100 in March. However, this kind of violent action has a tendency to feed on itself, as over-leveraged players blow up or are forced to liquidate positions by margin calls. Watch out, as usual.

My suspicion is that the collapse of commodities is the beginning of the end. It shows that the liquidity crunch and economic slowdown have gone global.