A couple of notes following up on previous posts.

I spent some bits criticizing Paul Krugman of the New York Times for his assertion that the futures market doesn’t influence the price of crude oil. In addition to the arguments that I set out, what I didn’t know was that many OPEC countries actually use the futures market prices as a benchmark to set the contract prices at which most oil is actually sold. Apparently this is done because the spot market is too thin, and therefore too easily manipulated. This excellent post, with supporting references, sets it out. The same kind of speculative money also appears to be driving up grain prices (Edit: although one imagines that burning food isn’t helping). I think that we can safely discount any notion that the futures market does not affect actual selling prices.

Edit: This is probably all Jim Rogers’ fault, by the way. While there have been commodity funds and commodity pools for a long time, I think Jim was the first to start a mutual fund whose asset value per unit tracked a commodity index. Jim developed his own index, more broadly based than others such as the GSCI, and then (circa 1998) started a fund, the Rogers Raw Materials Fund, whose return was based on the change in the index. There has since been an avalanche of new money chasing this idea. I’m not sure what the state of the fund is currently, I think it got caught up in the Refco bankruptcy for which the CEO just got sent to jail. If you want to see the effect of these index tracking funds, check out what happened when Goldman Sachs unexpectedly reduced the weighting of gasoline in the GSCI in August 2006, from 8.75 percent  to just 2.3 percent. This change caused indexers to unload gasoline futures in a hurry; wholesale gasoline fell 82 cents over four weeks, an unprecedented drop; and crude oil, which in July 2006 had traded over $79 -  a record -  fell to around $56 by January 2007.

The government action eliminating the tax on forgiven or cancelled debt resulting from a short sale or foreclosure seems to be accelerating the “walk-aways,” where borrowers simply decide that their house was a bad trade and cut their losses. Jim the Realtor posts a comment made on his blog which typifies the “just a business decision” attitude. Edit: In the Sac Bee,

Walking away is embarrassing, Fatius, a pipefitter and welder, admits. But staying is “stupid,” he says.

The lenders and the housing market are in deep, deep trouble.

I have somewhat been assuming that, in the intermediate and longer term, that the deflationary pressure in the US would more than overcome the pressures weakening the US dollar. I’m now coming to doubt that assumption.

We’ll see what happens in the morning (a policy announcement is due), but it sure seems that the ECB is prepared to do what is necessary to keep Eurozone price inflation under control. I don’t think the Bernanke Fed, with its dual mission of monetary stability and economic growth, is prepared to do the same. I did not expect the price increases in food and energy, although in retrospect it was predictable that the newly enriched developing countries (China, India, Vietnam,…) would spend at least some of their dollars on these essentials. These price increases are going to further weaken the dollar, as the US is no longer self-sufficient in either food or energy. (Yes, I know the US is the largest exporter of grains but on balance it is now a net importer of food).

I think I’m going to increase my foreign currency exposure.

Edit: The ECB did, in fact, raise rates by 0.25%.

The program pumpers are able to move the market, as always, but as soon as they stop it sags. The problem is the banks. The banking index ($BKX) and the regional bank HOLDRs (RKH) are well below their March lows. People are starting to realize how widespread the problems are. The problem assets of the big money center banks like Citi are well known, as are the mortgage problems of the S&Ls like WaMu. But also coming to light are the developer and builder loans. These are especially poisonous because, like neg-am mortgages, the banks often add the interest to the loan (called an interest reserve) during its life. This means everything looks good until the project is finished, but unsold. All of a sudden the developer needs to start paying down the loan, but he can’t. Something like 60-70% of the assets of the smaller banks are real estate related.

Even without actual defaults, these banks are going to have their balance sheets loaded with loans just sitting there waiting for something good to happen. And that means their capacity to make new loans will be impaired. Given that this economy depends on perpetually increasing debt, this is a huge problem and the semi-smart money is starting to figure this out. (The smart money is long gone, or short; the dumb money is buying “beaten-down values” from the semi-smart money).

And the TICK skyrockets as yet another jam job program runs. In the meantime, members of Congress are leaning on the CFTC to find evidence of “speculation” in the oil market. Morons. What do they expect? They let the Fed run the dollar into the ground, and then get all surprised when people put money into something they think will keep its value

The PCE statistics were released this morning, including a claim that PCE inflation for April was 0.2%. Including food and energy. All I can say is that the government inflation figures are becoming more and more unrealistic in the face of rapidly rising prices.

Obviously it is in the government’s interest in many ways to keep reported inflation low. And in my view, they’ve moved beyond statistical games to outright falsification.

The University of Michigan consumer survey this morning reported that inflation expectations were the “highest in 20+ years.” I guess the consumers aren’t fooled.

For a good read on the actual effects of energy price inflation, Desmond Lachlan:

Past experience suggests that if the recent run-up in oil prices is sustained, it alone will subtract more than a full percentage point from U.S. GDP growth in 2008. That experience also suggests that, over the longer haul, the recent doubling in oil prices will subtract another full percentage point from U.S. GDP growth beyond 2008. Since these oil price increases have occurred in the context of a housing bust and a credit crunch, one must assume that the U.S. economy is facing the real risk of a recession that is both deeper and more protracted than the postwar average. And if the recent spike in oil prices threatens to tip the U.S. economy into recession, just imagine what a further run-up in prices—say, to the $150 to $200 a barrel range—would do.

I certainly spend a fair quantity of bits criticizing conventional economics and economists. However, there are always exceptions who question authority and see what is really going on. Paul Kasriel of Northern Trust is notable, but here’s another, Richard Alford. He is interviewed by Institutional Risk Analytics.

If the US consumer were to go back to savings rates of the 1996 period, then you are talking about savings going from essentially zero today to approximately 8% of disposable income. Since US GDP is about 70% consumption, that implies a decline in demand of about 5 to 5.5%. That would be a very dramatic effect.

No kidding. Because of course the decline in demand would reduce employment, which would further reduce income in a vicious circle. That is why Ben is moving heaven and earth to avoid an increase in savings.

Politically and economically, there is no painless solution to the imbalances in the US. For US policymakers, it seems that even short-term pain is intolerable. Nobody in Washington wants to bite the bullet and explain the full dimension of the required change to the US electorate, so we muddle. Going back to the early 1990s, US politicians have bought support from the voters by keeping consumption on an ever rising trajectory. For at least 12 years, we’ve had debt induced increases in consumption and the political class optimized their behavior to maintaining that illusion of rising consumption even as the economic fundamentals worsened.
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The US population is not ready to hear that their real levels of income, assets prices and other indicia of national well being may be falling or relatively stagnant for the foreseeable future. This is just politically not acceptable. So our politicians will attempt to maintain the appearance of growth, but not address the underlying causes.