Nobel Winner Jean Tirole’s Faulty Views on Monopoly

This guest post by Frank Shostak explains that Nobel Prize-winning economist Jean Tirole comes from that school of economists who consider when reality doesn’t fit their faulty models of the economic system, they demand laws written to change the reality.

Frenchman Jean Tirole of the University of Toulouse won the 2014 Nobel Prize in Economic Sciences for devising methods to improve regulation of industries dominated by a few large firms. According to Tirole, large firms undermine the efficient functioning of the market economy by being able to influence the prices and the quantity of products.

Consequently, in the game according to Tirole, the well-being of individuals in the economy is undermined.

On this way of thinking the alleged inefficiency emerges as a result of the deviation from the “ideal state” of the market as depicted by mainstream economics’ idealised model of“perfect competition.”

The “Perfect Competition” Model

In the idealised world of “perfect competition” so idolised by the mainstream, a market is characterised by the following features:

• There are a perfectly infinite number of buyers and sellers in the market (or, at least, so many that none can affect outcomes)
• Products traded are all homogeneous – that is, they are all perfectly alike
• Buyers and sellers are all perfectly informed
• Obstacles or barriers to enter the market are all perfectly non-existent.

This describes an economic system that never was, ignoring everything that makes economics an actual system.

(Bonus) quotes of the day: On currency depreciation

“The so-called improved competitiveness resulting from currency
depreciation in fact amounts to economic impoverishment. The
"improved competitiveness" means that the citizens of a country are
now getting fewer real imports for a given amount of real exports.
While the country is getting rich in terms of foreign currency, it is
getting poor in terms of real wealth — i.e., in terms of the goods and
services required for maintaining people's lives and well-being.”
- Frank Shostak, ‘Will Currency Devaluation Fix the Eurozone?’

“[F]lexible exchange rates preclude an efficient allocation of resources
on an international level, as they immediately hinder and distort real
flows of consumption and investment. Moreover, they make it inevitable t
hat the necessary real downward adjustments in costs take place…in a chaotic environment of competitive devaluations, credit expansion, and inflation…
    “I do not believe we shall regain a system of international stability without
returning to a system of fixed exchange rates, which imposes on the national
central banks the restraint essential for successfully resisting the pressure of the
advocates of inflation in their countries — usually including ministers of finance.”
- F.A. Hayek, quoted in ‘An Austrian Defense of the Euro’ by Jesus Huerta de Soto
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Risk, Moral Hazard, and the Moochers of South Canterbury Finance

“Worry is a sign of health. If you’re not worried, you’re not risking enough.”
- attrib. to Gnomes of Zurich

THE FRAUD TRIAL OF South Canterbury Finance directors brings the question of moral hazard back into the headlines once more, moral hazard being the situation in which governments invite businesses to privatise profits and socialise their losses, and then fall around in wonder when they do.

Such was the case in 2008 when Michael Cullen, with John Key’s explicit support, introduced the Retail Deposit Guarantee Scheme – putting up taxpayers’ assets as backing for the risks taken by NZ bankers.

I said here when the govt’s Retail Deposit Guarantee Scheme was announced that it created a problem of moral hazard—that it would simply encourage finance company to take more risks to make their high interest payouts, and encourage more “investors” to seek out these higher interest rates knowing you and I would bail them out when there was a problem.

Right on cue, as it turns out, a mid-level Timaru finance company with a modest book decided it would allow taxpayers to bear the risk of it making a play to make it big.

Cronyism and the Transcontinental Railroads

Anyone promoting or considering the merits of so-called public-private partnerships (PPPs)– a collusion between public force and private profits that is simply an invitation to cronyism, corruption and worse – should examine the tainted history of American railroading in the Gilded Age.
Why? Because it’s precisely what PPPs will produce again today.
In 1962 Ayn Rand gave a lecture titled “America’s Persecuted Minority: Big Business” in which she identified two types of businessmen, later called “economic and political businessmen,”—the first were self-made men who earned their wealth through hard work and free trade, and the second were men with political connections who made their fortunes through special privileges from government.
It is the second type, the moochers, that public-private partnerships encourage, as this short case-study by Ryan W. McMaken of classic Gilded-Age cronyism helps demonstrate…

Skousen celebrates new non-destructive growth measurement

As I mentioned the other day, mainstream economists are talking up New Zealand as a “rock star” economy on the basis both of expectations of greater demand from China for our milk products, but also because of greater consumption spending.

The latter can only figure as “growth” if the way you measure growth is based on consumption rather than production, which is exactly what so-called Gross Domestic Product measures – measuring spending on retail goods or by government (which is all consumption spending) as production, but ignoring most of the production that makes this spending possible.

It’s like judging a rock star’s success not by how many great records he’s produced and sold, but by how many lines of coke he puts up his nose.

It’s this sort of nonsense that allows unthinking alleged economists to utter nonsense suggesting consumer spending drives more than two-thirds of the overall economy, and giving vote-buying governments the cover to issue shopping subsidies and central bankers to talk about dropping helicopter-loads of money whenever they see spending fall.

This is not just nonsense, it’s dangerous nonsense.

Mark Skousen is one of the few economists clear-eyed enough to understand this, and for years has been arguing that production figures should measure all production – not just beer sales to consumers, for example, but all the hops, barley, malted barley and yeast production that go into beer, not to mention the packaging, warehousing and transporting of the stuff around the country.

And it looks like Skousen will finally be rewarded, in the US at least, because as he writes …

Starting in spring 2014, the Bureau of Economic Analysis will release a breakthrough new economic statistic on a quarterly basis.  It’s called Gross Output, a measure of total sales volume at all stages of production. GO is almost twice the size of GDP, the standard yardstick for measuring final goods and services produced in a year.
    This is the first new economic aggregate since Gross Domestic Product (GDP) was introduced over fifty years ago.
    It’s about time. Starting with my work The Structure of Production in 1990 [highly recommended, by the way] and Economics on Trial in 1991, I have made the case that we needed a new statistic beyond GDP that measures spending throughout the entire production process, not just final output.  GO is a move in that direction – a personal triumph 25 years in the making.

This might sound trivial, but it’s really big news because, while Gross Output is still not perfect, it is “a better indicator of the business cycle, and most consistent with economic growth theory” than so called Gross Domestic Production – which we could more accurately call Net Domestic Consumption. Or in Skousen’s words:

GO is a measure of the “make” economy, while GDP represents the “use” economy… I believe that Gross Output fills in a big piece of the macroeconomic puzzle.  It establishes the proper balance between production and consumption, between the “make” and the “use” economy, and it is more consistent with growth theory.

Most importantly, measuring the “make” economy tells us much more about what happens when things go wrong – and tells us much earlier when they might be heading that way. In other words, it offers more enlightenment for those who try to avoid economic disasters, and fewer excuses for those who cause and prolong them.

In short, by focusing only on final output, GDP underestimates the money spent and economic activity generated at earlier stages in the production process. It’s as though the manufacturers and shippers and designers aren’t fully acknowledged in their contribution to overall growth or decline.

Gross Output exposes these misconceptions.  In my own research, I’ve discovered many benefits of GO statistics.  First, Gross Output provides a more accurate picture of what drives the economy.  Using GO as a more comprehensive measure of economic activity, spending by consumers turns out to represent around 40% of total yearly sales, not 70% as commonly reported. Spending by business (private investment plus intermediate inputs) is substantially bigger, representing over 50% of economic activity.  That’s more consistent with economic growth theory, which emphasizes productive saving and investment in technology on the producer side as the drivers of economic growth.  Consumer spending is largely the effect, not the cause, of prosperity.

Second, GO is significantly more sensitive to the business cycle.  During the 2008-09 Great Recession, nominal GDP fell only 2% (due largely to countercyclical increases in government), but GO collapsed by over 7%, and intermediate inputs by 10%.  Since 2009, nominal GDP has increased 3-4% a year, but GO has climbed more than 5% a year.   GO acts like the end of a waving fan.  (See chart at right.) …
    In my own research [says Skousen], I find it interesting that GO and GDE are far more volatile than GDP during the business cycle.  As noted in the chart above, sales/revenues rise faster than GDP during an expansion, and collapse during a contraction (wholesale trade fell 20% in 2009; retail trade dropped over 7%).
    Economists need to explore the meaning of this cyclical behaviour in order to make accurate forecasts and policy recommendations…
    In conclusion, GO or GDE should be the starting point for measuring aggregate spending in the economy, as it measures both the “make” economy (intermediate production), and the “use” economy (final output).  It complements GDP and can easily be incorporated in standard national income accounting and macroeconomic analysis.

Let’s hope some forward-thinking soul in the NZ Treasury or elsewhere takes up the initiative here.

READ: Beyond GDP: get ready for a new way to measure the economy – Mark Skousen, COBDEN CENTRE

RELATED READING:

• Schiff explains the GDP delusion – NOT PC
• Consumers don't drive the economy, stupid – NOT PC
• Sustaining the moochers – NOT PC
• Your basic 2025 no-brainer: Govt spending is unsustainable – NOT PC
• Recession & Recovery: Six Fundamental Errors of the Current Orthodoxy – Robert Higgs
• What is up with the GDP? – Frank Shostak
• Beyond GDP: A Breakthrough in National Income Accounting [pdf] – Mark Skousen
• Today’s Gross Product is Nett Product [pdf] – George Reisman

The myth of Colin’s deregulation disasters

“One of the methods used by statists to destroy capitalism
consists in establishing controls that tie a given industry hand
and foot, making it unable to solve its problems, then declaring
that freedom has failed and stronger controls are necessary…”
“Ayn Rand on Today’s Crisis”

Colin Espiner is the latest clown on point.  “In the wake of the Fonterra debacle,” says a Colin Espiner jumping Bernard Hickey’s shark into the pool of pro-regulation tadpoles, it’s “become obvious … light-handed regulation has … been an unmitigated disaster.”

Poor Colin. Turns out overnight that the “Fonterra debacle” on which he hangs his hat for the perils of light-handed regulation was “a false alarm,” the result not of private disaster but of government fuck-up. Don’t just take my word for it, listen to the voice of the Labour Party…

Revelations today that no botulism was found in Fonterra's whey protein is "a complete systems failure by the Ministry for Primary Industries," says Labour's Primary Industries spokesperson Damien O'Connor… Our failure to ensure the highest standards of testing, monitoring and auditing means the damage has been done to New Zealand’s international reputation.

“A complete systems failure by the Ministry for Primary Industries.” A failure by government inspectors. How does that fit with Colin's newly-discovered thesis that Ministries never fail?

I point this out not just to poke Colin’s thesis in the eye with a sharp stick, but to raise the important point that government departments fail too—and when they do the “complete systems failure” they cause can be catastrophic.  The department’s “complete systems failure” in this case means “damage has been done”—big damage—to New Zealand’s international reputation.”

To be fair to Colin, he cites more than just this debacle to make his argument against his new-found foe.

Colin argues that this country fell into a dangerous free-market hole in the 1980s and 1990s through the buzzwords "deregulation", followed by "light-handed regulation" and its kissing cousin "self-regulation.”

Why employ big expensive government departments full of people who have to check everything [says Colin] when you can replace them with slimmed-down ministries that set policies and then tick off the completed forms sent back to them by employers?
    Get rid [says Colin] of the people who check planes, mines, workplace safety, food safety, telecommunications and other infrastructure, weights, measures, building standards, and everything else. And then make everyone do it themselves… The idea was simple, if crazy with the benefit of hindsight….
    It's taken a good 20 years for the sheer magnitude of the stupidity of those "reforms" … to become obvious [says Colin].

The result of these “reforms,” says Colin, was “the meltdown of our finance companies, the fleecing of thousands of investors of their retirement savings, a $6 billion leaky homes fiasco, the worst and least competitive telephone service in the western world, some of the highest electricity prices, the deaths of 29 miners at Pike River and most recently, the severe shock to our dairy industry.  Light-handed regulation has, in short, been an unmitigated disaster.”

For Colin, the “Fonterra debacle” was his last straw in this drive he identifies to getting rid of “big government departments” that check weights, measures, building standards, and everything else.

• So what was that big government department doing testing Fonterra’s whey when according to Colin it doesn’t even exist? 
• Where did all the dismemberment of Telecom come from, and what does the forced dismemberment say about who has more power in NZ today—politicians or businessmen and -women? (Q: How do you get a nice small business?  A: Take a large one, and make David Cunliffe the minister in charge.) And while that dismemberment was happening, telecoms companies weren’t inventing in big telecoms? No wonder. As I've said over and over again, "No one but an idiot or a cabinet minister would expect to see businessmen or women making a long-term investment in infrastructure when theft of such an investment is imminent, or the breakup of that investment is on the cards."
• What are all those building inspectors doing crawling all over buildings checking to see if we’ve followed the rules set out in the welter of regulations that kept coming ever since that non-existent deregulation? What is that government department doing checking out all building materials to decide whether or not we’re allowed to use them? And check out the complete systems failure they caused when the materials they said were okay weren’t.
• What did the government’s Reserve Bank (the biggest big-government department on The Terrace, so Colin surely can’t miss it) think would happen when they opened up their credit spigot and tipped out all that counterfeit capital? What was the government’s Reserve Bank doing shovelling out money so cheaply finance companies could rent it out not-quite-so-cheaply and think they had a business model going instead of a paper pyramid? And what was the moral hazard created by the govt’s Retail Deposit Guarantee Scheme really and truly going to encourage?¹

And what about Colin’s shroud-waving over the death of 29 men in the disaster in Pike River? I could point to the big government department that nixed the company’s preference to open-cast the mine instead of creating a bomb with one exit. I could point out the mining disasters in the parts of the world who follow Colin’s prescription today—Australia (Moura and Beaconsfield), Chile (Copiapó), Poland (Halemba), Russia (Ulyanovskaya), Canada (Westray), United States (Quecreek and Upper Big Branch) and South Africa (too many to mention)--not to mention the wholesale disasters of the past in the Soviet Union and China.

And I could point out the 181 people killed in NZ in coal mine disasters long before this mythical age of deregulation (the last before Pike River being the 19 miners killed in the Strongman mine in 1967).

But perhaps the most important point to make is about risk and why people take it—and why they take more of it when they think someone (especially a government) has their back covered. That’s why many finance companies thought they were safe enough to take risks—they  had the government’s guarantee to protect them. That’s why builders, architects and home-buyers thought they were safe and weren’t taking risks—they had the Building Act, the Building Industry Authority, the Department of Building and Housing, the New Zealand Building Code, the Building Research Association of NZ and the consent processes and inspections of Territorial Authorities to protect them. That’s why so many banks thought they were safe to be pumping out all that counterfeit capital to keep the housing bubble going—because the govt’s Reserve Bank and credit-rating agencies with govt-granted monopolies told them all was well, al was safe, all was under control, when it wasn’t.

In short, the more government regulation there was, the less folk thought they needed to regulate themselves—because if Big Brother is doing it as swimmingly as Big Brother says he is, why need we do so ourselves?  So roll on that short-term thinking that causes disasters. 

Mark Thornton observes about the phenomenon:

The public is told that regulators do not cause problems; they prevent them. They police the economy. They are the watchmen that have been endowed with the wisdom, ability, and selfless devotion to the public good.
    There are indeed many people who work as government regulators that are very smart and well-trained that have public spirit and the public good in their hearts. There are also plenty of cads and knuckleheads that work as regulators [some of them now scurrying for their lives in the Ministry for Primary Industries].
    The problem with government regulation is that you cannot fine-tune the regulations: nor can you perfect the regulatory work force in such a way to make regulation work in anything but a superficial way. The truth is that regulation instills confidence in the public so that they let down their guard and makes them less cautious while at the same time distorting the competitive nature of firms in the marketplace.
    After every economic crisis there are calls for new regulations, more funding, and more controls. Economic wisdom dictates that we be ready to contest those calls when the next crisis of the interventionist state occurs.

Colin is speaking in good faith about the effect of all these disasters, and in good faith he thinks he sees both the cause and the solution, but his failure to clearly analyse their causes and his proposed solution is a disaster for someone who sells his commentary as professional analysis.

Perhaps the clearest point illustrating his obvious ignorance is his invocation of poor old Adam Smith as the man responsible for all this. The “one lesson” Colin thinks we should all draw is “that pure market theory, Adam Smith's Invisible Hand … is bunk.”

Poor old Adam Smith and his little-understood metaphor, invoked by so many to prove their arguments that are otherwise so lacking.  Colin just joins a long list of folk who berate the metaphor while never learning what Adam meant by it.

"It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own self-interest," said Old Adam. The butcher, the brewer and the iPod-maker "direct [their] industry in such a manner as [their] produce may be of the greatest value," and we are the beneficiaries of their labours and their trade -- each intends only his own gain, but by the blessing of trade he is, said old Adam, "led as if by an invisible hand to promote an end which was no part of his intention."

The “invisible hand” of Colin Espiner’s nightmares is simply a metaphor for the process in which people voluntarily buy and sell, in which process is discovered who values what the most—who is prepared to put their money where their values are, how much that makes resources worth, and what (therefore) producers should produce more of.

And contra Espiner, that is the only real place and process in which to discover exactly how much (or maybe how little) people value what we go out every day to produce. The more government regulation there is in the way of that process, the less coordination there is between brewer and baker, and the less do those values get reflected—and the more does self-regulation get thrown out the window.

Not to mention the extent to which, as Adam Smith most famously recognised, the extent to which the brewer and baker and building materials suppliers will embrace with enthusiasm the rent-seeking and monopoly grants available to them by regulatory capture.  (“To widen the market and to narrow the competition, is always the interest of the dealers,” he obseved.)

And these are the real risks of Mr Espiner’s new-found paradise on earth. Far more real than the myth of deregulation he’s digested from those who know (or should know) better.

* * * *

NOTES:

1. The Myth of Deregulation is so all-fired powerful that even hard-bitten journalists who think they’re immune to such things have bought the myth wholesale. Despite the obvious evidence right in front of their eyes, they’ve bought the idea, especially, that for the last decades we have had “completely free markets and capital flows.”  Free markets! What are they smoking! These hot-shot economics reporters are apparently blind to the fact that in the markets of the last decades there has been virtually no price or profit relationship left untouched. You think the age of Muldoonist price controls and interference with profits are dead?  In the last few decades the “orthodoxy” worldwide has overseen:

• interest rates controlled by an economic dictator with powers Muldoon would have killed for;
• specific interest rates, such as home mortgages, manipulated through subsidies as well as price controls;
• indirect currency controls virtually everywhere;
• direct government manipulation of the gold market by both world govts and the IMF;
• asset price floors—in addition to the ‘Greenspan put,’ we’ve had money printed and “toxic” assets bought, anything to keep asset values raised ;
• wage floors, essentially a guarantee of widespread unemployment in a downturn;
• wage ceilings, especially for executives;
• direct price controls, especially in medicine and education;
• good old-fashioned protectionism—not just currency manipulation, but outright tariff and non-tariff barriers;
• the dismissal of business bankruptcy and liquidation as “old-fashioned”;
• pumping up illusory profits by inflating the money supply, creating an inflationary illusion of profitability and prosperity;
• the grant of virtual monopoly powers to the very credit agencies that didn’t know a bad thing even when it was held right under their nose.*

These are just a few of the means by which govts ran price controls and interference with profits in recent decades—and still are.  But Colin Espiner, Bernard Hickey, Fran O’Sullivan and hundred of thousands of others trained to view all this as part of a “free market” are too braindead to see them for what they are, and  with the failure of this system of control they call instead for the controls to be tightened!

They have the frankly braindead notion that somehow the people in govt responsible for creating, overseeing and extending this economic disaster need to “take back” the reins they never gave up.  They have apparently either lost the brains they once had, or have now reached the point (as it has with most educated in mainstream economics) where the real world has outstripped their learning, so have resorted to the siren cry of the braindead everywhere: “Bring me more big government! Now!!”

The Illusion of Wealth: Ludwig von Mises on the Business Cycle

Just as the economic bust we’re now enduring is the inevitable flipside of the earlier (credit-induced) boom, so too is Cyprus-style bank theft the inevitable flipside of the debts built up by governments during and after the credit boom--inevitable because, as their spending continues to increase even while the bust refuses to go away, governments are increasingly desperate to find money (by any means necessary!) with which to pay back that debt.

Both bust and theft are inevitable results of the earlier boom, that illusion of wealth created by the unlimited credit expansion produced by banks licenced to turn debt into currency.

Can we stop this never-ending cycle? Are the boom and bust of the business cycle inevitable? Economist Ludwig Von Mises reckons not.  Here’s a quick “twelve-minute” summary of his argument as it appears in the new book The Illusion of Wealth: Ludwig von Mises on the Business Cycle, edited by Robert P. Murphy:

Ludwig von Mises: Real vs. Paper Wealth
Ludwig von Mises (1881–1973) is the economic theorist who did more than
anyone to sweep away the mystical view that business cycles just happen
to us, like bad weather and aging. He brought scientific logic to bear on the
problem. He drew on the fields of money, interest, capital theory, and international
capital flows to map out a general theory of what causes business
cycles, the parameters of how they play out in the real world, and how they
might be ended.

With an economy addicted to credit expansion and absurdly low interest rates
(not even Mises could have foreseen zero or negative rates!), we all wonder
what is real and what is not. The book gives us the tools to make that discerning
judgment.

Mises’s general idea is that cycles begin with loose credit provided by a banking
system that is protected from facing the economic consequences of unsound
lending by the existence of the central bank. The boom turns to bust when the
resources to sustain it go missing.

In a market, banks want to lend; they are restrained by risk. Government guarantees
encourage risky lending. Artificially low interest rates — always cheered
by indebted governments — signal to borrowers that there are more savings in
the system than really exist. Business in particular expands production in a way
that is unsustainable. This loose money policy creates a boom — the illusion of
wealth — that is not justified by economic fundamentals. The correction takes
place when the illusion of wealth is revealed in the course of time, kicked off by
tightening credit or when the boom times are tested by reality.

In the 1920s and the first half of the 1930s, Mises’s view came to be almost
commonplace in the English-speaking world, mentioned and discussed by
the mainstream as the top contender. After World War II, the theory ended up
being stamped out by the newfound faith in macroeconomic planning, with
John Maynard Keynes as its leading profit.

Today, that faith in macroeconomic management is now at another low point,
but the baseline assumption that business cycles have a psychological origin
is still with us. As Robert Murphy explains in the introduction, the goal of this
book is to provide the most coherent possible explanation of the entire theory
from its roots to its conclusions.

Mises begins with a discussion of money. It is not neutral to every transaction,
affecting all prices in all places the same way. Changes in purchasing power of
money are a feature of normal market activity. There is no such thing as perfect
stabilization. Prices changes as human valuations change. Money is nothing
but a medium of this interpersonal exchange. Prices are objective, but value is
subjective, an expression of people’s eagerness to acquire goods and services.

Money makes possible economic calculation. This is the ability to assess and truly measure the economic merit and viability of anything. All the technology, all the discoveries, all the laboratories and manufacturing in the world are useless without the ability to calculate profit and loss. The capacity to calculate and assess the relative merits of various production paths is the key to unlocking every innovation and making it real. Without the ability to calculate, society itself would crash and burn. This is the social function of prices. Nothing can substitute for them (not central planning or engineering or intuition). Prices are building blocks
of civilization and require private property and markets for their emergence.

Increasing the amount of money in an economy does nothing to brush away the problem of economic scarcity. Money is merely a tool for calculation. Producing more of it only changes its purchasing power and distorts decision-making. It does nothing to make speculation or
entrepreneurship more or less successful.

Appearances to the contrary (“This whole generation is great at investing!”), the
seeming prosperity is illusory and indicates a false boom. New money only ends
up hiding incompetency and delaying the day that it is revealed. The only vehicle
for authentic economic progress is the accumulation of additional capital goods
through saving and improvement in technological methods of production.

In a market, entrepreneurs can profit or they can take losses. Errors result
in losses and success results in profits. There is, in a market economy, no
systematic tendency for one tendency to prevail over others. False prices
are checked by competition. Errors are never general and social. They are
specific and cleared away when discovered. “The market process is coherent
and indivisible,” writes Mises. “It is an indissoluble intertwinement of action
and reactions, of moves and countermoves.” But there is no such thing as a
general under-consumption in markets, as Keynesians like to believe.

Conventional economic modelling cannot capture the time horizons of millions
of capitalist investors and producers. The real-world structure of production
includes production plans of one day or 50 years or several generations. What
allows coordination between these many plans are markets with free-floating
prices and interest rates that respond to real savings and the actual plans of
entrepreneurs and capitalists. Interest rates themselves reflect the time horizons
of the public. They fall when people save and rise when people prefer
consumption over saving. The loan markets reflect these varying plans.

When the central bank lowers rates, it creates “forced saving” — the appearance,
but not the reality. Forced saving causes an inflow of resources to capital goods
industries, because investors make longer-term plans. It looks like capital expansion.
It is really what Mises calls “malinvestment” — meaning bad investment in
lines of production that would not otherwise take place.

The reality is that all credit expansion tends toward capital consumption. It falsifies
economic calculation. It produces imaginary or only apparent profits. People
begin to think they are lucky and start spending and enjoying life. They buy large
homes, build new mansions, and patronize the entertainment business. These
activities all amount to capital consumption.

Credit expansion also raises wage rates in a way that is not sustainable. Entrepreneurs become addicted to expansion in order to enlarge the scale of their production. This requires ever more infusions of credit. The boom can last only as long as the system expands credit at an ever-increasing pace. When this
ends, the plans stop too and business starts selling off inventory, wages fall, and the economy begins to fall into recession. Mises describes this as the collapse of an “airy castle” — something beautiful that has no substance.

Artificial credit expansion doesn’t always produce price inflation. When it does happen, inflationary expectations can cause a general tendency to buy as much as can be bought. That can lead to the crackup of the whole of the economy. At the same time, the effects of
inflation can be disguised as rising stock prices or increasing home values.
But it always leads to relative impoverishment.  It always makes people
poorer than they otherwise might be. But Mises specifies something very
important here. It doesn’t mean society will revert exactly to the state
it was in before the boom. The pace of capitalistic expansion is so great
that it has usually outstripped the “synchronous losses” caused by
malinvestment and overconsumption.

10 Takeaways

1. Economic calculation is indispensable to the creation of society and civilization;
   it is what unlocks and applies all-over knowledge discoveries.
2. Prices are true and functioning only in a market economy with private
   property and competitive markets.
3. Production processes take place over time, with each capitalist forming
   a different time horizon and configuring plans based on that.
4. Artificial increases in the money supply, released through the banking
   system, lower the rate of interest. This is akin to forced savings.
5. Forced savings accelerate the pace of economic progress and the improvement
   in technology, but this is unsustainable.
6. Credit expansion makes some people richer and some people poorer, but
   it can never raise the standard of living of the whole of society. It causes
   people overall to be poorer than they would otherwise be.
7. There is nothing wrong with falling prices. That is the natural state of
   the market.
8. The “wavelike movement” of the economy is the unavoidable
   outcome of the attempt to lower the market rate of interest by
   means of credit expansion.
9. All present-day governments are fanatically committed to an easy
   money policy.
10. The moral ravages of credit expansion are worse than the economic ones.
    It creates feelings of envy towards those who receive “first use” of the easy
    credit, despair and frustration among the victims of the crash, and discourages
    people who would otherwise be excellent inventors, workers, and investors.

Why does a good theory of the business cycle matter? Understanding the
process as it unfolds helps reveal the source of the problem, which is not in
our heads or hearts or in some other strange force of history, but more specifically
in the government-protected banking cartel. In short, it is not the market
that deserves the blame, but the interventions in the market. This theory helps
in assessing whether reforms are geared toward fixing the problem or making
more problems. For example, further regulation of the monetary and banking
systems is not likely to do much toward addressing the underlying cause of
the business cycle.

Conclusion
Mises’s theory predicts that a society addicted to artificial credit stimulus would
probably enjoy unusual amounts of technological progress, but relentlessly
declining real income. It would depend on increasing rates of technological
improvement, but this would never be enough to raise incomes and prosperity
over the long term. Mises was writing before the age of the fiat dollar, but
he foresaw precisely what we have today: advances in technology, declines in
standards of living, and endless waves of boom and bust with no increases in
the capital and savings that make long-term prosperity possible.

Ludwig von Mises (1881–1973) was an Austrian economist who enjoyed
enormous fame in Europe before the Great Depression. The rise of the Nazis forced
his emigration, first to Geneva in 1934 and then the U.S. in 1940. His first
decade in the U.S. was spent as an unemployed writer trying to restart
life. He ended up teaching a private seminar at New York University that
taught a new generation. Instead of being the last of a great line of economists,
he sparked a revival of free-market thought. Today, many hundreds
of thousands count themselves among his students and followers.

This summary is part of a new series of 12-Minute Executive Summaries produced for the Laissez Faire Book Club.

Recessions: The Don't Do List

Back in 2008, when even politicians started to notice the economic fertiliser had begun hitting the blade-rotating ventilation device, I suggested there were seven things governments could to to ensure the economic recession was a long one—and predicted they would do them all.
And so they did.
And here we still are.
Those seven things were taken from Murray Rothbard’s excellent book America’s Great Depression. In this Guest Post, John Cochran updates the story.

Listening to a new report on the just-released American GDP numbers while reading Rothbard’s America’s Great Depression made me realize how relevant and important this work is relative to today’s poorly performing economy. The book briefly summarizes Austrian Business Cycle Theory and applies the theory to the period of the Great Depression from 1929–1933. The book is especially relevant in that it provides policy guidance for dealing with an economic crisis, based on both historical evidence and Austrian Business Cycle Theory. The policy recommendations include actions to avoid, as well as positive actions government could undertake to speed recovery. Unfortunately, the official reaction to the present crisis has been a virtual match to Rothbard’s “don’t do” list, while the few positive actions have been conspicuous by their absence in most mainstream policy discussions. Even more important for  future prosperity is the need for monetary reform, the key to preventing future boom-bust cycles and thus avoiding depressions altogether.

Preliminary US GDP numbers for 4th quarter 2012 were just released and, in the words of the Wall Street Journal, indicated that the “[r]ecovery shows a soft spot” with GDP declining 0.1%. As Jeffrey Tucker reports in “The GDP Shock”:

Hardly anyone anticipated this. USA Today and other purportedly reliable venues immediately assured the world that this does not mean recession. Somehow after hanging onto to GDP numbers for three years—recovery is here despite your internal sense that the economy is still in a ditch—now we are told that the GDP figures are really just misleading. Recovery is still here, says the mainstream press.

Jon Hilsenrath in “Unusual Quarter of Contraction Doesn’t Mean Recession” provides a toned-down example of what Tucker is talking about:

A one-quarter contraction of economic output doesn’t mean the economy is formally in recession, but it is unusual for such contractions to happen in the middle of economic expansions.

Austrian economists are keenly aware that “GDP figures are really just misleading.” Inclusion of government spending in any measure of economic production or growth is inherently misleading.  Business cycles are characterized by greater fluctuations in the capital goods industries relative to consumer goods. Malinvestment during the boom is followed by capital restructuring during the depression/recovery. Maintaining a coordinated structure of production is essential for maintaining a given level of prosperity, and lengthening the structure is a necessary condition for an improvement in the material standard of living. When one fully incorporates capital theory into macroeconomic analysis, it becomes clear that consumption is not the “engine of the economy” (see John Papola’s “Think Consumption Is The ‘Engine’ Of Our Economy? Think Again”in Forbes online, or Mark Skousen’s “Gross Domestic Expenditures (GDE): the Need for a New National Aggregate Statistic”). Per Rothbard (Americas Great Depression, pp. 58–59):

Savings, which go into investment, are therefore just as necessary to sustain the structure of production as consumption. Here we tend to be misled because national income accounting deals solely in net terms. Even “gross national product” is not really gross by any means; only gross durable investment is included, while gross inventory purchases are excluded. It is not true, as the underconsumptionists tend to assume, that capital is invested and then pours forth onto the market in the form of production, its work over and done. On the contrary, to sustain a higher standard of living, the production structure—the capital structure—must be permanently “lengthened.” As more and more capital is added and maintained in civilized economies, more and more funds must be used just to maintain and replace the larger structure. This means higher gross savings, savings that must be sustained and invested in each higher stage of production.

Even though GDP is a highly inaccurate measure of economic activity, and regardless of whether or not one quarter of negative growth in real GDP indicates an economy on the verge of a double-dip recession, the number does provide further evidence of an economy struggling to recover from the depression which followed back-to-back Fed induced boom-bust cycles. This is an economy essentially stagnating since the reported end of the “Great Recession” in June 2009, nearly four years ago.

Mainstream economists have given competing explanations of why this is the worst recovery since the Great Depression. Many Keynesians, including Paul Krugman, have argued the recovery is slow, not because the policy response was wrong, but because it was not big enough. The policy response was strong enough to save the economy from a bigger disaster, but despite an $800 billion fiscal stimulus, deficits of over one trillion dollars leading to a public debt of over $16 trillion, and a tripling of the Fed’s balance sheet, the policy response was still too small. Carmen M. Reinhart and Kenneth Rogoff, also defend the policy response, but in This Time is Different, they argue that recoveries from recessions accompanied by a financial crisis have, based on historical evidence, always been slow compared to recessions not accompanied by financial crisis. While fiscal and monetary stimuli have not generated a speedy recovery, these policies did prevent the crisis from being even worse. According to Rana Foroohar in Time, “The Risks of Reviving a Revived Economy”:

Ironically, the stimulus is also a reason the recovery has been so slow and will continue to be for the next three to five years. Harvard economist Ken Rogoff, who, along with his colleague Carmen Reinhart, has been the best rune reader of the past few years, says that historically during financial crises “to the extent that you act to slow the deep, sharp economic pain, you also slow the recovery.”

Contra Rogoff and Reinhart, Michael Bordo has done some excellent work showing that throughout US economic history, recovery has actually been quicker following financial crises. His work has been used by John B. Taylor to bolster his argument that policy activism and the accompanying policy uncertainty, both monetary and fiscal, have impeded business planning and recovery. Much of the debate can be accessed here. Austrian economists like Robert Higgs and myself, and fellow travelers such as Mary L. G. Theroux, have pushed the uncertainty argument even further to include regime uncertainty as the key element retarding recovery.

However, readers of Rothbard’s America’s Great Depression should not have been surprised that the recent bust was not a sharp depression followed quickly by a return to prosperity and sustainable growth, albeit not necessarily to the levels expected by those fooled by the false expectations created by monetary mismanagement due to malinvestments and wealth destruction during the previous two booms (see Salerno’s “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Ravier’s “Rethinking Capital-Based Macroeconomics,” and most recently Shostak’s “Fed’s policies expose mainstream fallacies”). While the first part of Rothbard’s great book is devoted to explaining the Austrian boom-bust theory of the business cycle, defending the theory from critics, and illustrating its applicability to the events leading up to the 1929 crisis/bust, the second part of the book is devoted to examining governmental interventions and policy errors that retarded recovery and turned a “garden variety recession” into a Great Depression.

Rothbard notes two things of significance for both then and now:

1. “[T]he longer the boom goes on the more wasteful the errors committed, and the longer and more severe will be the necessary depression readjustment” (p. 13). The current boom-bust had its roots in the boom during the late 1990s, which resulted in a bust/recession, recovery from which was aborted by aggressive Fed action beginning in 2003, which added new malinvestments and misdirections of production to the unresolved malinvestments left over from the previous boom (see my article “Hayek and the 21st Century Boom-Bust and Recession-Recovery”).

2. Unemployment, if recovery is not impeded by interventions, will be temporary. Per Rothbard (p. 14):

Since factors must shift from the higher to the lower orders of production, there is inevitable “frictional” unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production. In practice, unemployment will be aggravated by the numerous bankruptcies, and the large errors revealed, but it still need only be temporary. The speedier the adjustment, the more fleeting will the unemployment be. Unemployment will progress beyond the “frictional” stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wage rates are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed. The greater the degree of discrepancy, the more severe will the unemployment be.

When the crisis hit in 2007 and 2008, the correct policy would have been the response Rothbard recommended in 1982 in the introduction to the fourth edition (p. xxi) of America’s Great Depression:

The only way out of the current mess is to “slam on the brakes,” to stop the monetary inflation in its tracks. Then, the inevitable recession will be sharp but short and swift[emphasis added], and the free market, allowed its head, will return to a sound recovery in a remarkably brief time.

While, as mentioned above, Rothbard only briefly discusses Austrian Business Cycle Theory (p. xxxviii), “a full elaboration being available in other works,” America’s Great Depression, elaborates on the theory’s implication on government policy: “implications which run flatly counter to prevailing views [both then, 1963, and now].”

What are these implications? First and foremost (p. 19), “don’t interfere with the market’s adjustment process” [emphasis original]. The more government blocks market adjustments, the “longer and more grueling the depression will be, and the more difficult will be the road to complete recovery.” Rothbard argues it is possible to logically list the ways market adjustment could be aborted by government action and such a list would coincide well with the “favorite ‘anti-depression’ arsenal of government policy.” The list almost perfectly matches with policy responses to the crisis during both the Bush (see Thornton’s “Hoover, Bush, and Great Depressions”) and Obama administrations.

Here is Rothbard’s “Don't Do” list (pp. 19–20), with my comments in brackets:

1. Prevent or delay liquidation
“Lend money to shaky businesses, call on banks to lend further, etc.” [Done. Tarp, auto bailouts, and the Fed’s mondustrial policy. See recently John B. Taylor in the Wall Street Journal: “The low rates also make it possible for banks to roll over rather than write off bad loans, locking up unproductive assets.”]

2. Inflate further
“Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government ‘easy money’ policy prevents the market's return to the necessary higher interest rates.” [Done in spades.]

3. Keep wage rates up
“Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.”

4. Keep prices up
“Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.” [3 and 4 are both direct results of current Fed actions, including price inflation targets near 2%.]

5 & 6. Stimulate consumption and discourage saving
“We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further. Government can encourage consumption by ‘food stamp plans’ and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds would have been saved and invested; all of the government funds are consumed. Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.” [The federal government has expanded from a bloated 18–20% of the economy to 23–25% of the economy under the current administration. The Bush fiscal stimulus in 2008 and the majority of the 2009 Obama stimulus supported consumption relative to investment as did the ineffective recently repealed temporary payroll tax cut.]

7. Subsidize unemployment
“Any subsidization of unemployment (via unemployment ‘insurance,’ relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.” [Does anything need added here?]

Rothbard (p. 21) argued these were “time-honored favorites of government policy” and the last part of America’s Great Depression was devoted to showing how these were the policies adopted in 1929–1933. Current policy has followed the same path. We should not be surprised that the result has been similar, if not as yet quite as tragic. It is still not too late to change paths, but unfortunately such action, while possible is not likely to happen. Neither will the positive actions recommended by Rothbard (p. 22) to speed recovery be undertaken. Reducing the relative role of the government in the economy while reducing taxes, especially those that bear most heavily on saving and investment, are also, as I have argued previously in “Thoughts on Capital-Based Macroeconomics” (Part III),the correct actions to address the debt and size-of-government crisis.

We are again undone by the “Crisis of Authority,” the urge to action, the incorrect, but too often, as explained by Pierre Lemieux, unchallenged belief that Somebody in Charge[1] is a solution to recessions. The correct government depression policy is “Nobody in Charge.” Laissez-faire is thus the untried alternative and the preventative of depression. Sound, free market money is the untried alternative to government money. Laissez-faire and sound money would replace the recurring boom-bust, and its attendant needless depression and unemployment, with sustainable growth and relative prosperity.

* * * * *

John P. Cochran is emeritus dean of the Business School and emeritus professor of economics at Metropolitan State University of Denver and coauthor with Fred R. Glahe of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research. He is also a senior scholar for the Mises Institute and serves on the editorial board of theQuarterly Journal of Austrian Economics.
This post first appeared at the Mises Daily.

You don’t get richer by making yourself poorer

A “DEBATE” IS SUPPOSEDLY under way about monetary policy in New Zealand. A “debate” begun by economic ignoramuses calling for the Reserve Bank to redirect its efforts from “stabilising prices” to lowering our exchange rate.

What this amounts to is a call to use the printing press to lower our exchange rate—and hence to lower real wages.

Revealingly, however, none of the politicians promoting this call to lower wages by means of the printing press give this as their method. Instead, they like to use metaphors.

Russel Norman, who has all the economic credentials of an organic termite farm, reckons "you can't be a pacifist in an international currency war."

David Cunliffe, a man never short of a desire for more “tools” in the politician’s toolbox, reckons “a broader range of tools are needed.”

Meanwhile, the bloke whose back Cunliffe has his knife in Cunliffe’s colleague David Parker talks about “pulling the levers” to get the dollar down. How? An explicit answer to that question still eludes him even after his flying trip around the globe to ask a gaggle of famous inflationists which specific levers to pull.

The most any will allow is that “the Reserve Bank should be actively considering selective intervention in currency markets.” Which, given the Reserve Bank’s size, would be roughly equivalent to pissing uphill in an attempt to reverse the flow of Niagara Falls.

It is left to alleged economists like Bernard Hickey and Rod Oram to make their case for them.  “Bernard Hickey wonders why New Zealand is not printing money and thinks we are being severely disadvantaged by not following the crowd,” says the fiscal fool’s own headline. And Oram’s column in the weekend’s Sunday Star Slime was essentially a begging letter to the Reserve Bank’s custodians to take the tarps off the printing presses and let rip.

After all, they both say, everyone else is doing it!

What a fruit loop of fucking fools!*

It appears to have escaped their notice that “doing it” has done nothing at all to effect any recovery. Anywhere.  They’ve been “doing it over there” for five years now, with nothing noticeably positive to report.

Indeed, they might observe that those who have done it--most conspicuously, the US, Britain, Europe and Japan—have only made things worse. Worse for themselves, and worse for everyone around them. (Try and analyse why Japan has now enjoyed two “lost decades” before even beginning to fall for the easy delusion peddled by monetary cranks like Hickey, Oram and Norman.) Will currency devaluation make the Eurozone, the US, Britain or Japan wealthier? Answer: No.  But it will help to impoverish them all.

Every country in the world is printing money at the moment. We are too, just not quite so fast. What all the “debate” amounts to is a demand by the fiscal fools that we catch up.

LET’S CONFRONT RIGHT off the bat here a serious delusion about the desirability of any interventions by the Reserve Bank at all.  They cite the “effectiveness” of the Bank at its job of price stabilisation, without ever bothering to notice that their policy of price stabilisation has depreciated the value of the dollar by around 35% since the policy of stabilisation was begun, and when followed in both the 192os and 2000s the policy was fully responsible for pumping up unsustainable booms that led in both cases directly to economic disaster. This should surely bring into question any demand for any intervention by the Bank at all!

Second, they reckon it should take its eyes off that ball to try having a lash at “fixing” our exchange rate. (How? Somehow. At what level? At whatever level the fools decide—up one day, down the next, sideways presumably the day after.) But even if it were successful at reversing the flow of Niagara, or of printing sufficient amounts of our currency to have an effect without blowing us all up, what would the effect of that intervention actually be?

At the moment, for no good reason other than having interest rates marginally higher than elsewhere and a government borrowing hundreds of millions of foreign currency every week, there is an avalanche of foreign money wanting to be exchanged for our paper.

The net effect has been to raise the value of said paper. And the net effect of that, if you follow the argument through, has been to raise the purchasing power of our dollar. Which means, yes, that the prices exporters get are not translated back into as many local dollars, but it does raise sky-high the ability of businesses here to buy capital goods and supplies needed for production, thus lowering their costs; and it does, when you think about  it further, mean that every worker’s wage goes that little bit further when buying any of the thousands of goods and services whose production is priced in a foreign currency.

Which means that the pleas by Labour and Green politicians to lower our exchange rate amounts to a plea to lower real wages. Yes, to lower real wages—for that is what the call to lower our dollar’s purchasing power amounts to. A ‘round the houses’ means by which one of the chief difficulties created by the rigidity of wages may be overcome. It is a kind of subtle, surreptitious, supercilious beggar-thy-selves mercantilist type of policy explained by Adam Smith more than tw0-hundred years ago, and exploded by Friedrich Hayek less than one-hundred years ago.

You would think that at least the trades union’s economist would recognise this Keynesian subterfuge for what it is. But instead, he applauds it. “Stop talking, just do it,” says CTU economist Bill Rosenberg, oblivious apparently to the fact he is calling for a reduction in his members’ wages by monetary means.

THE SO-CALLED “IMPROVED competitiveness resulting from purposeful currency depreciation is a delusion, explains Australian economist Frank Shostak.

The so-called improved competitiveness resulting from currency depreciation in fact amounts to economic impoverishment. The "improved competitiveness" means that the citizens of a country are now getting fewer real imports for a given amount of real exports. While the country is getting rich in terms of foreign currency, it is getting poor in terms of real wealth — i.e., in terms of the goods and services required for maintaining people's lives and well-being.
    As time goes by, the effects of loose monetary policy filter through a broad spectrum of prices of goods and services and ultimately undermine exporters' profits. A rise in prices puts to an end the illusory attempt to create economic prosperity out of thin air. According to Ludwig von Mises,

The much talked about advantages which devaluation secures in foreign trade and tourism, are entirely due to the fact that the adjustment of domestic prices and wage rates to the state of affairs created by devaluation requires some time. As long as this adjustment process is not yet completed, exporting is encouraged and importing is discouraged. However, this merely means that in this interval the citizens of the devaluating country are getting less for what they are selling abroad and paying more for what they are buying abroad; concomitantly they must restrict their consumption. This effect may appear as a boon in the opinion of those for whom the balance of trade is the yardstick of a nation's welfare. In plain language it is to be described in this way: The British citizen must export more British goods in order to buy that quantity of tea which he received before the devaluation for a smaller quantity of exported British goods.

    Contrast the policy of currency depreciation with a conservative policy where money is not expanding. Under these conditions, when the pool of real wealth is expanding the purchasing power of money will follow suit. This, all other things being equal, leads to currency appreciation. With the expansion in the production of goods and services and the consequent falling prices and declining production costs, local producers can improve their profitability and their competitiveness in overseas markets while the currency is actually appreciating. Note that while within the framework of loose monetary policy exporters' temporary gains are at the expense of other activities in the economy, within the framework of a tight monetary stance gains come not at any one's expense but are just the outcome of the overall real-wealth expansion.
    It must be appreciated that, contrary to popular thinking, both tight fiscal and monetary policies provide support to wealth generators while undermining non-wealth-generating activities. [Hickey, Oran, Norman, Uncle Tom Cunliffe and all], by pleading for looser policies, are in fact asking to strengthen wealth-destructive activities and thereby recommending a prolonged economic slump.

That conclusion should hardly surprise you.

THE FACT IS, WE are still an economy in depression. The fact is, a reduction in costs would help businesses recover, while a reduction in wages would help reduce costs and help produce full employment.

That none of the politicians is honest enough to admit that’s what they’re after, a reduction in wages, tells you all you need to know about either their honesty (if they intend a fall in real wages) or their competence (if they don’t). That neither Oram nor Hickey—nor even Bill Rosenberg—even recognises that’s what’s afoot tells you they’ve never actually read all those Keynesian tracts they claim to be using in their playbooks.

The fact is, we have two basic choices regarding exchange rates. We can either work to the exchange rate we have. Or we can tell this irresponsible government presiding over our decline to stop borrowing $300 million of foreign currency a week, and to start living within its means. 

That is really the message given to this irresponsible over-spending government through the price signal of foreign exchange rates.

That is the real fiscal message given through the monetary discipline effected by foreign exchange markets.

That would do more to produce our real exchange rate than all the lunatic pulling on random levers would ever do.

That would help more effectively to bring about the recovery I’m sure we do all want far more successfully than will continuing to borrow and hope.

Good luck ever getting a politician interested only in buying votes to understand that.

* * * * *

* “fruit loop” = the collective noun for fiscal fucking fools.

The Shift to a New Global Currency Alters International Relations

The present economic depression has been going five years, with no sign of abating. We now that in times of worldwide economic depression, one thing to suffer is worldwide free trade—and without being able to freely trade for energy and resources, some nation states will be worse off than others.
Which is why they’re making a grab for resources now…

GUEST POST by Marin Katusa of the Casey Daily Dispatch 

Last week I wrote about how Israel's newfound natural gas wealth is catalyzing a shift in Middle-Eastern relations. It was a topic that generated much discussion in our office - we knew that the Mediterranean Sea resource is highly significant for the Jewish state, which has long struggled with energy insecurity, but the deeper we delved into the issue the more we realized that Israel's new resource is already having wide global implications. In particular, we were very intrigued to realize just how cozy Russia and Israel are becoming - this being the same Russia that usually supports Iran and Syria, Israel's sworn enemies.

The article generated a fair bit of feedback from our readers as well, including several good questions. In answering the questions and in continuing to discuss the issues among ourselves, we placed Russia's advances on Israel as but one part of a shifting global web, wherein old allegiances are being dropped in favor of new friends with benefits. Those benefits are energy resources, and the race to control them is changing the way the world turns.

Dozens of countries are slowly altering their international allegiances because of energy considerations. Here I will shine a light on a few of the more significant transitions and how they might impact US and EU energy security.

Russia's Strategic Steps Toward Israel

I discussed this at some length last week, so rather than repeat myself I will just summarize the situation in order to address some questions that arose following that Dispatch. The gist of it is this: The Middle East has long been informally divided into two camps, with US allies such as Saudi Arabia, Egypt, and Qatar making up the camp that can get along with Israel, while Iran and Syria lead the group that cannot befriend the Jewish state. In a holdover from the Cold War, Russia has long backed the anti-Israel group, providing arms to Syria and support to the increasingly isolated Islamic Republic.

Now Israel, long the oil- and gas-poor brother in the squabbling Middle-Eastern family, has delineated trillions of cubic feet of offshore natural gas. It is hard to overstate the significance of this discovery. Instead of having to rely on a strained peace with Egypt for its natural gas, Israel now has far more natural gas than it can use - the country will be self-sufficient in terms of gas to generate electricity and will be able to fill its coffers with export revenues.

Israel's transition from a nation constantly in need of resources to one that could well play a major role in the global gas trade is earning it new respect. Greece and Cyprus are discussing paths for potential pipelines to Europe. Turkish leaders are likely kicking themselves for having destroyed what was a close friendship with Israel in recent years; now Turkey will have to sit on the sidelines and watch as Israel, Greece, and Cyprus work together to develop these gas riches. Egypt's Islamists, finally in power after decades of having to abide their nation's peace accord with Israel, have been stripped of the opportunity to cut off Israel's gas supplies - the Jewish state doesn't need Egyptian gas anymore. Syria and Lebanon, among others, are considering how to stake their claims on the gas bounty, which sits in waters laced with international boundaries.

And then there's Russia. Vladimir Putin's third official international trip after retaking the Russian presidency in May was to Israel. The two nations now share $3 billion in annual trade and considerable immigration. Arching over all those ties is the fact that, in the wake of the Arab Spring, Russia and Israel share an interest in preventing the rising tide of radical Islam.

The Russia just described sure doesn't sound like a very good friend to Iran, does it? But why the shift - is Russia that concerned about radical Islam? No, Putin has never cared much about religion; his decisions are always far more strategic than that. The reason is simple: Israeli gas.

That brings us to the most common question we were asked following last week's energy Dispatch: Why does Russia, a natural gas giant in its own right, want Israeli gas? To our questioners, you are absolutely right: Russia does not need any more gas for itself. Russia is home to one-quarter of the world's known natural gas resources, roughly 1,600 trillion cubic feet (TCF) according to the EIA. And that doesn't count potential reserves of unconventional gas. We think that all told, Russia may control as much as one-third of the world's natural gas.

Russia has gas. What Putin desperately wants is to maintain his country's stranglehold over European natural gas supplies.

Putin loves using control over resources to enhance Russia's power, and natural gas is a key part of his scheme - we dedicated an entire issue of the Casey Energy Report to this topic recently. It was only a few years ago that Russia cut off gas supplies to Europe for a few days in the middle of winter in order to punish Ukraine for siphoning fuel from Russian lines. Europe relies on Russia for 34% of its natural gas; Putin wants to increase that reliance. To that end, he has spent years building new pipelines to Europe that avoid transiting troublesome countries (i.e., Ukraine). As if controlling Europe weren't enough, Putin is also developing Russia's ability to sell gas to Asia by jumping into the liquefied natural gas (LNG) scene with new facilities in the Far East. And he's several steps ahead of the United States in this LNG game.

How does Israel factor in? Israeli gas could join the world market in two ways: through a pipeline to Europe running under the Mediterranean Sea (with a stopover in Cyprus); and/or as LNG, which would be sold to Europe and beyond. Both would turn the Jewish state into an unexpected competitor in Putin's plan to continue controlling European natural gas supplies. Since he can't prevent Israeli gas from flowing, Putin is trying to control where it flows and siphon off some of the profits.

That control is so important, it seems that Putin is considering coming out as a full-fledged friend of Israel. Such a move would almost certainly sever those long-time ties between Russia and Iran, but when the currency in question is energy then alliances formed over decades can change overnight. If Russia does take that strategic step away from Iran and toward Israel, it will rock the ever-delicate Sunni-Shiite balance in the Middle East... to what end is anyone's guess. As for whether Israel will reciprocate Russia's advances: never forget that Israel is a pragmatist nation, its very survival dependent on making strategic decisions. We would not be surprised to see the Jewish state playing both sides of the ex-Cold War game, if that's what makes sense for them.

Africa's New Best Friend: China

Late last week the news broke that China will lend $20 billion to African governments over the next three years. The funds will be directed at infrastructure and agriculture projects, but to anyone who views the world with an eye out for strategic resource relationships, the growing friendship between China and Africa is all about energy and minerals.

Specifically, China is cultivating the relationship very carefully in order to cement its role as Africa's best friend and top ally. Caring for Africa's needs puts China in a perfect place to negotiate resource deals with countries across the African continent - after all, aren't sharing and caring the first rules of friendship?

This isn't a new tactic - Chinese involvement in Africa has increased dramatically over the past decade. Today annual trade between the African continent and the People's Republic is worth more than $166 billion, a threefold increase since 2006. What is new in the relationship is China's new breadth and depth of caring. Until recently, most Chinese aid to Africa went to projects that were clearly designed to primarily benefit China's extractive industries on the continent, not Africa's people. To boot, Chinese laborers were brought to work on the projects, reducing the number of jobs available for Africans. The result: China was accused - by Africans and by international observers alike - of being dastardly self-serving in its African endeavors.

This has become particularly problematic in Angola, which has received more Chinese money than any other African nation. Angola is rich in oil, diamonds, gold, and copper, but a devastating 27-year civil war destroyed most of the country's infrastructure. China has been helping Angola rebuild by providing infrastructure-related loans in exchange for oil; bilateral trade between the countries topped $25 billion in 2010. But the projects, such as rebuilding the 840-mile Benguela Railway, are all designed to make it faster and easier for China to access Angola's resource wealth, and Chinese laborers are now a common sight in Angola. With jobs and resources ending up in Chinese hands, Angolans in recent years have started questioning whether China has their interests in mind at all.

Lopsided relationships like this are nothing new for Africa. From colonialism to aid dependency, Africa has been in a lopsided relationship with Europe for decades. However, it seems the continent has learned from the past and now wants to try to craft a deeper relationship with China... one that would hopefully result in a more sustainable partnership.

"Africa's past economic experience with Europe dictates a need to be cautious when entering into partnerships with other economies," said South African President Jacob Zuma at the recent Forum on China-Africa Cooperation in Beijing. He continued to say that China has demonstrated its commitment to Africa with investment and development aid and that Africans are generally pleased that they are treated as "equals" in the relationship. However, he cautioned that the trade balance "... is unsustainable in the long term."

It was seemingly in response to that worry that Chinese President Hu Jintao promised $20 billion in loans aimed at projects specifically not related to mining or oil. Instead, the money is earmarked for agriculture, manufacturing, education, safe drinking water, protected lands, and the development of small businesses.

Has the Chinese leadership suddenly taken to caring for the health, welfare, and economic prospects for the people of Africa? It might be nice to think so, but the truth is much more strategic: China realized that it needs to improve its standing in the hearts and minds of Africans if it wants to continue securing access to African oil, gas, and minerals. And it did so with a bang - the $20 billion pledged for the next three years is twice what China pledged for the last three-year period.

With a show of renewed friendship and caring, China will now go about seeking new resource deals to add to the plethora of extractive deals it has signed with African countries in recent years. In Nigeria, China is spending $23 billion to build three oil refineries and a fuel complex; the two countries are also building one of Africa's largest free-trade zones near Lagos, a $5-billion, 16,000-hectare project. In Sudan, where Darfur-related sanctions bar American companies from investing, China has invested billions in oil ventures and buys 90% of the country's oil exports. A billion dollars in bilateral trade between China and Mauritania revolve around oil; the magnitude of China's investment in the country has carried Sino-Mauritanian relations through two military coups in the last decade. In Botswana the expansion of the Morupule coal-fired power station is being funded through an $825-million Chinese loan, but that is only one of 28 infrastructure projects that China is b acking in the country.

China has money, Africa has resources, and both have tainted views of many other global powers. It's a match made in heaven.

Asia Stakes a Claim on Canada

They came only a month apart: two multibillion-dollar offers from Asian energy giants to buy up Canadian oil and gas companies. The first was in late June, when Malaysian state energy company Petronas offered $5.5 billion in cash for Canadian natural gas producer Progress Energy Resources. The offer represented a 77% premium over Progress' closing price the day before the deal was announced and is the biggest deal to date for Petronas. Why did the Malaysian firm play such a huge hand? Because Progress has 1.9 trillion cubic feet of proved and probable gas reserves in British Columbia's Montney shale region, a massive resource that Petronas hopes to export to Asia asLNG.

News of the second deal broke just yesterday; the dollar size of the deal sent it reeling across business headlines around the world. China National Offshore Oil Company (CNOOC) is buying Canadian oil and gas producer Nexen (T.NXY) for $15 billion in cash. It is the largest investment China has ever made into Canada - its previous Canadian investments total $23 billion - and the offer represents a 66% premium to Nexen's 20-day volume-weighted average share price.

CNOOC wants Nexen for its diverse project portfolio - the company has operations in Colombia, Yemen, the North Sea, and the United States - but it is the company's Canadian projects that hold the vast reserves that China seeks. Nexen is only a mid-sized player in the Canadian oil sands, but it has 900 million barrels in proven oil reserves plus another 5.6 billion barrels of less-certain contingent resources. In addition, Nexen is on the cusp of producing from its significant shale gas reserves in BC. Between those two forays - oil sands and shale gas - Nexen has major exposure to two of the world's most rapidly growing, major energy sources.

New, fast-growing supplies are exactly what Asian energy giants need. In the race to secure oil and gas resources for the future, importers have to look beyond historic suppliers to new frontiers. Big oil reserves in historic producing countries are generally either state-owned and therefore closed to investment - examples include Saudi Arabia, Iran, Mexico, and Venezuela - or have already been staked out and carved up among domestic and international partners who aren't likely to give up an inch of their claim.

That means nations looking to buy up international oil and gas reserves have to look at newer regions - the oil sands, the Arctic, the shale fields of North America, the sub-salt oil riches off Brazil's coast, and the like. The risks and costs may be higher, but at least these regions still offer the opportunity to stake a claim on a massive resource. When it comes to the oil sands and the shale fields of British Columbia and Alberta, the fact that these massive resources are in western Canada - pretty darn close to the Pacific Ocean - makes the opportunity almost picture-perfect.

That is precisely why Asian energy giants are moving on Canadian oil and gas companies... though to be fair, they were invited to do so. Led by Prime Minister Stephen Harper, the Canadian government has been actively courting Asian investment for its energy riches; these two multibillion-dollar deals are the first fruits of that labor.

The growing, energy-based relationship between Asia and Canada represents a seismic shift for Canada, which until now relied on the United States market to buy almost all of its oil and gas. Today, southbound oil pipelines are almost at capacity and political theater is slowing the approval process for new lines to a snail's pace, just as production in the oil sands is set to ramp up. Similarly, shale gas discoveries across western Canada have delineated vast new reserves that are begging for new buyers.

Canada needs to diversify its export list if it wants to capitalize on its unconventional energy resource wealth. Asian nations, led by China, are racing to put down payments on the oil and gas deposits that will fuel their futures. Sure, Canada and Asia are in the honeymoon stage of a new relationship, with multibillion-dollar deals keeping things new and exciting. When CNOOC, Petronas, PetroChina, Mitsubishi, Korea Gas, and the other Asian energy firms pressing Canada to permit oil and gas pipelines to the west coast come up against regulatory roadblocks and popular opposition, the new relationship will get a real test.

For now, however, it looks like the United States is losing a race that it has always led - the competition for Canadian energy resources (it's especially losing out to China, whose purchases of North-American energy resources include a stake in a Texas oil shale project). Interestingly, this is happening a few short years after the army of oil refineries along the Gulf Coast spent billions upgrading their facilities to process heavy oil in preparation for an onslaught of Canadian oil sands bitumen. If Asia beats out the US for access to Canadian oil, US refiners will be left paying a premium for heavy oil from other suppliers - not an ideal situation.

It's also interesting that this is happening just as the US seems to be at risk of finding itself distanced from two of its strongest Middle Eastern energy allies - Egypt under its new Islamist government and Israel, which might move gently away from the US in order to secure strategic ties to Russia. Is a hegemonic outlook still clouding US views on the security of its relationships and energy supplies, leaving the nation complacent while its competitors race to lock up new resources and secure new friends?

It's a very interesting thought, but the details of that discussion are best saved for another day. The point for today is that increasing desperation from resource-needy nations to secure oil and gas for their futures is putting the world's complex web of relations under incredible pressure. Longstanding allegiances are being tested, and any nation that assumes its historic friends and suppliers will simply stay by its side risks losing precious supply streams. Lubricated with money and the potential for future profits, new friendships are being forged that could alter the global balance of power.

Energy security underlies every country's abilities for today and prospects for tomorrow. Without secure access to the resources that power buildings, move vehicles, connect people, and enable growth, a country's economy will stagnate and its global influence dwindle. From that perspective it is easier to understand why Russia is considering a 180-degree shift in its Middle-Eastern relations, why China is willing to spend tens of billions of dollars on schools, wells, and hospitals in Africa, and why Asia is offering fat premiums to take over Canadian energy producers in a down market.

Energy is the new global currency, and its influence is starting to change the rules of the global diplomatic game. China is playing, Russia is working its hand, and countries with resources from the Black Sea to the Horn of Africa are placing their bets. As for the United States, it seems to be a couple of steps behind and had better figure out a game plan before new allegiances solidify and the US finds itself alone.

Marin Katusa is the chief investment strategist, Energy Division, of Casey Research, publishers of the Casey Energy Speculator and Casey Energy Confidential Alert Service.