Sunday, January 18, 2009


Unintended Consequences in Action
James Quinn January 5th 2009

Cutting Edge Financial Crisis Analyst

Ben Bernanke

Columbia University statistician Andrew Gelman has said, “The law of unintended consequences is what happens when a simple system tries to regulate a complex system. The political system is simple. It operates with limited information (rational ignorance), short time horizons, low feedback, and poor, misaligned incentives. Society in contrast is a complex, evolving, high-feedback, incentive-driven system. When a simple system tries to regulate a complex system you often get unintended consequences.”

Gelman is dead on, if not understated. He states that the political system is simple. I’d go a step further and say that lifetime politicians and entrenched government bureaucrats are “simple.” They show no indication of knowledge or expertise in American history or rational financial theory. The President, Congress, Federal Reserve, and Treasury try mightily to direct our economy. It is an impossible task. With a GDP of $14 trillion, there are thousands of inputs and outputs that feed the system. Their hubris leads them to believe that they are in control and can manipulate the gears of capitalism in a way that will produce their desired outcomes. If a desired outcome occurs, it is simply due to dumb luck. The more likely result of their manipulations of our complex system is a set of bigger problems that never occurred to them.

Congress definitely fits Mr. Gelman’s definition of a simple system. I can’t think of a body of people operating with more ignorance than Congress. The information they act upon, is provided by the 17,000 lobbyists that wine and dine them on a daily basis. Corporate lobbyists, Political Action Committees (PACs), unions, and special interests buy their votes. Their time horizons are less than a few months. They are constantly running for re-election, raising money and handing out goodies to their constituents. The only feedback they care about is their standing in the polls and the amount of money they’ve raised from “donors.” Their incentives are poor and not aligned with the needs of the American people. They are not willing to do what is right for the country because they have no incentive to do so. Their only incentive is to get re-elected by insuring that their district gets as much pork spending as possible. They do this by selling their votes to the highest bidder.

Ignorance, Stupidity, and Hubris

Sociologist Robert K. Merton popularized the concept of unintended consequences in a paper written in 1936. Merton’s five possible causes were ignorance, error, immediate interest, basic values, and self-defeating prophecy. Ignorance, error, and immediate interest sound like a perfect motto for the U.S. Congress, Federal Reserve, and Treasury. When media pundits, pompous economists, self proclaimed “experts”, and corrupted politicians assure you that they have the solutions to all of our problems, they are practicing the most evil form of hubris. The arrogance and self importance of these people is an insult to the intelligence of all Americans. They put their unproven theories into practice by committing trillions of taxpayer funds. They are only concerned about the next election cycle and not about the long-term consequences of their ignorance and ignorance of crucial facts. The accumulation of blunders over the decades by government has led to unintended consequences that could bring down our country. Recent developments will have disturbing consequences for all Americans.

Unintended Consequences of Cheap Oil

When oil reached $147 a barrel in the summer of 2008, panic was setting in among the sages in Congress. Windfall profit taxes on oil companies and government intervention to support alternative energy were the mantra of congressmen and Presidential candidates. Government intervention was going to work its magic. Instead, the markets adjusted rapidly to a worldwide decline in demand and the price plummeted to less than $40 a barrel. This drop has put an additional $200 billion of money back into the pockets of Americans. This was a needed relief in the midst of a grinding recession. The law of supply and demand worked without government intervention. The short-term focus of our politicians and many Americans will likely squander this temporary reprieve.

The pundits concluded that oil reaching $147 a barrel was due to speculators. Once the speculators were forced out, oil prices collapsed. Their view is that this temporary crisis has passed and life will go back to normal. American oil demand declined by 13 percent in September 2008, but Chinese demand grew by 28 percent. Auto financing at 0 percent for five years on SUVs will prevail and all will be well. The ignorance of the true facts by our leaders will lead to a future crisis that will make the current financial crisis seem like a walk in the park. The current economic downturn which has temporarily decreased worldwide demand will end. Oil demand will resume its upward slope, while supply has likely reached its peak.

The facts based on exhaustive research by oil insider Matt Simmons are as follows. Sixty percent of the world’s oil is consumed by 10 percent of the world’s population. America represents 5 percent of the world’s population and consumes 24 percent of the world’s oil. Middle East oil use is growing more rapidly than China’s. China now uses 8 million barrels per day versus 3.5 million barrels per day in 1997. China now consumes 2 barrels per person per year versus 24 barrels per person per year in the U.S. The U.S. has 220 million automobiles for 305 million people. China has 32 million cars for 1.3 billion people. Peak supply of 86 million barrels of oil per day has been reached. Demand will grow to 115 million to 125 million barrels per day in the next 20 years.

The price of oil is now dangerously low. There are large amounts of untapped resources in non-traditional places. These include oil sands in Canada, oil shale in the Western U.S., and deep water oil. At $40 a barrel, the cost to extract oil from these sources is greater than the revenue that can be generated. Therefore, all projects in these areas will be stopped or delayed indefinitely. Drilling rigs are being shut down, employees are being laid off, and all expensive deep water projects are being abandoned. Supply has topped out at 86 million barrels per day. Mature oil fields throughout the world are in decline. Projects can take decades to bring online. Projects not started today will result in supply shortages in the future.

If the U.S. leaders allow today’s low prices to reduce its sense of urgency regarding energy independence, the consequences will be shocking. The existing energy infrastructure is rusting away. The estimates to rebuild the crumbling infrastructure, that is 80 percent beyond its original design life, run as high as $100 trillion. The Cantarell oil field in Mexico is collapsing and will lead to Mexico becoming an oil importer in the next five years. The U.S. currently gets 11.1 percent of our supply from Mexico, almost as much as from Saudi Arabia. Another 30 percent comes from unstable countries such as Venezuela, Iraq, Nigeria, and Russia. We are not in command of our energy future. By doing nothing today, we insure that $147 oil will seem like a bargain in the not too distant future. Converting our country to wind power, natural gas, and nuclear power would decrease our dependence on foreign oil and keep $700 billion in the United States rather than transferring it to the Middle East.

Unintended Consequences of 0 percent Interest Rates

The Gross Domestic Product of the United States is $14.4 trillion. Consumer spending makes up $10.2 trillion or 71 percent of GDP. Government spending makes up $2.9 trillion, or 20 percent of GDP. Domestic investment makes up $2.0 trillion, or 14 percent of GDP. The trade deficit of $700 billion reduces GDP by 5 percent. President Obama has quite a dilemma in trying to revive this economy. The American consumer has borrowed from their homes and credit cards to fuel a colossal spending spree in the last twenty years. The dilemma is that the U.S. economic growth during the entire Bush administration was a debt-induced fraud.

From 1953 through 1983, consumption as a percentage of GDP ranged between 61 percent and 64 percent. Consumers rarely, if ever, borrowed against their houses. Paying off your mortgage was a goal of all families. A normalized level of consumer spending at 65 percent of GDP will require consumers to spend at least $1 trillion less per year. Less consumer spending will also contribute to reducing the trade deficit. The Federal Reserve and politicians running our country see a $1 trillion reduction in consumer spending as a disaster. Their positions of power would be in jeopardy. They will do everything in their power to not allow this to happen. The unintended consequences will commence shortly.

From the time Alan Greenspan took over as Federal Reserve Chairman in 1987, consumption and household debt rose at a faster rate than the economy. The Greenspan Put was a major contributor to these developments. Everyone knew that Greenspan would lower rates and inject liquidity into the system whenever an economic bump in the road came along. Greenspan’s reduction of the discount rate to 1 percent in 2003 led to the greatest debt bubble in history that still threatens to bring down the financial system.

The entrenched politician rulers of our country who are bought and sold by Big Business lobbyists, the Military Industrial Complex, and Big Media want to preserve the status quo. Their power base depends upon it. Prior to the creation of the Federal Reserve in 1913, depressions were violent and short. Prices for goods and wages adjusted rapidly, which allowed businesses and workers to survive. Having the dollar pegged to gold, limited what the government could do. The Federal Reserve artificially inflated the money supply in the 1920s causing a normal depression to become a Great Depression. Government interference with wage and price controls and government made work projects did not allow the system to fix itself. It took a World War to pull our economy out of the Great Depression.

It’s the End of the World As We Know It

What is required to happen and what will happen, in the next year, will have calamitous consequences for the future of our country. Consumers need to cut back dramatically on consuming. Spending as a percentage of GDP needs to decline to 65 percent, or by $1 trillion. This would be approximately $3,000 less spending per household per year. Twenty years of consumer debt accumulation must be unwound. This required deleveraging needs to eliminate $2 trillion of household debt. The result will be thousands of retail store closings, mall closings, restaurant closings, and auto dealership closings. The distinction between needs and wants will reveal itself like a sledgehammer.

The consumer needs to increase their savings rate from 2 percent to 10 percent. This would provide more capital for investment. People who cannot afford the mortgage on their home need to sell or enter foreclosure. When home prices fall far enough, the market will clear the inventory. Lower prices are the only way to eliminate excess supply. Companies that have failed to prepare for this downturn by taking on excessive debt, allowing expenses to soar, and having no clear strategic plan should go bankrupt. Unemployment will reach 9 percent. New businesses will be created and Americans will be hired.The Government should make sure that no one starves to death or has to sleep on the streets. The safety net of food stamps and unemployment insurance should be strengthened.

The Government’s purpose is to protect its citizens, enforce the laws and maintain the public infrastructure. Our roads are crumbling, we have 156,000 structurally deficient bridges, millions of miles of pipes under our streets are rusting away, and our power grid is antiquated. The job of Government was to maintain these things. They have failed miserably. Why does anyone think a new government infrastructure plan will work? Bridges to nowhere will be everywhere. Reducing spending dramatically on our military empire would provide funds to support the social safety net that is required during a depression. Congressmen in the pocket of the Defense industry will never allow it to happen.

What needs to occur would inflict too much pain for our politicial leaders to allow. A violent short depression will be traded for a decade long extended depression. A painful deflationary depression will be converted into a hyperinflationary depression that could threaten the very existence of our country. President elect Obama has begun his finely orchestrated marketing plan to spend $775 billion of borrowed taxpayer money. His rationale for the stimulus package is classic Washington politics - "Economists from across the political spectrum agree that if we don't act swiftly and boldly, we could see a much deeper economic downturn. That's why we need an American Recovery and Reinvestment Plan that not only creates jobs in the short-term but spurs economic growth and competitiveness in the long-term."

Not one economist on the face of the earth predicted the events of 2008. None of Obama’s list of blue chip economists saw a crisis coming, and they have no idea how long or deep the current downturn will be. They make weather forecasters look highly accurate in comparison. Most economists are either sellouts (Lawrence Yun), cheerleaders (Larry Kudlow), ideologues, or academic theoreticians. If Barrack Obama is depending on economists to determine our future, all is lost. Alan Greenspan was an economist. If we had done the opposite of everything he recommended in the last 20 years, the country would be on the right track. President Obama, with the overwhelming support of a Democratic Congress, will double down on the trillions already poured down a rat hole by the Bush administration.

The $775 billion plan will grow to at least $1 trillion as Obama will need to buy off various factions within Congress with pork projects. Congress will approve the second $350 billion tranche of TARP funds. Barney Frank and Nancy Pelosi will shovel billions to homeowners who should be foreclosed upon. Billions more will be given to the automakers. GMAC will get more funds from the taxpayer at 8 percent interest so they can then loan it to subprime borrowers at 0 percent. This doesn’t sound profitable, but they’ll make it up on volume.

TARP funds will be given to commercial developers who foolishly overleveraged, overbuilt, and overpaid for properties. Credit card companies that handed out credit like candy for the last 20 years will see their write-offs triple to over 10 percent by 2010. The government will give more of your tax dollars to these incompetent bankers so they can send out another 5 million credit card offers to deadbeats. The Federal Reserve will buy mortgage debt and long-term Treasuries to artificially reduce market interest rates. With money market funds paying .25 percent, senior citizen savers will be forced to take on risk to get a return on their money. Penalizing savers to resuscitate reckless gamblers is the path that Ben Bernanke has chosen. When the Markets decline another 20 percent in 2009, more senior citizens will see their retirements destroyed by Mr. Bernanke.

Citicorp and JP Morgan will require additional enormous injections of capital from the taxpayer due to their looming credit card and commercial loan losses. The top 10 biggest banks are insolvent. They are being kept alive on life support systems provided by the Federal Reserve and Treasury. All the bankers who didn’t bankrupt their banks should be outraged at this misappropriation of taxpayer capital to incompetent, reckless, immoral, politically connected bankers.

Home prices will drop another 15 percent in 2009 and will remain depressed until 2015. The market will adjust to its natural equilibrium level despite all government efforts to keep prices artificially elevated. When you can buy a house and rent it out and generate a positive cash flow, houses will be reasonably priced. Despite the immense spending, zero interest rates, and propping up bankrupt financial institutions, consumers will not spend. Economists, bureaucrats and politicians are so focused on models and theories that they have failed to realize that the social mood of the country has changed forever. The poor economic conditions are being caused by the mood change, not vice versa. A return to frugality, saving, and simpler lives will keep a cap on spending for at least the next decade.

The sum total of all that has been done and all that will be done will eventually lead to a hyperinflationary bust. The money supply is being expanded too rapidly, fiscal stimulus spending will be borrowed from foreigners, the dollar will fall as foreigners refuse to accept 2 percent for 10 years, and the Federal Reserve will react too late, just like they did when this crisis began. This overstimulation of the economy will lead to a panic out of dollars and into real assets. The government will attempt to control the situation by confiscating gold as they did in the 1930s and Americans will be forced to surrender more liberties. In periods of economic and social upheaval - war, revolution, or dictatorship become possibilities. The average American needs to wake up from their materialistic stupor and understand the risks that lie ahead. An educated, concerned citizen is our only defense against tyranny. Orwellian governmental policies will be inflicted upon the populous.

Cutting Edge Financial Crisis Analyst James Quinn is a senior director of strategic planning for a major university. This article reflects his personal views, and does not necessarily represent the views of his employers and is neither sponsored nor endorsed by them.

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