The price of crude oil today is not made according to any traditional relation of supply to demand. It is controlled by an elaborate financial market system as well as by the four major Anglo-American oil companies. As much as 60% of today’s crude oil price is pure speculation driven by large trader banks and hedge funds. It has nothing to do with the convenient myths of Peak Oil. It has to do with control of oil and its price. How?
Source: Asia Times Online, William Engdahl
The skyrocketing price of oil on the world market has prompted many Barbadians to finally express an interest about how the price of oil is determined. The local media seems happy to encapsulate the complex pricing mechanism used in the oil business to increasing demand from India and China, and some other bland explanations which are not note worthy. Alternatively readers to BU must be familiar by now with the theory of Peak Oil and the role of the speculators.
Although there is no economist in the BU household here is our simple analysis of a highly complex matter.
We 100% agree with William Engdahl, the author of the article quoted above. The article is very long, but we will attempt to summarize the key points towards understanding the mystery behind how some very powerful people and corporations are ‘fixing’ the price of oil. The article confirms what some pundits have been trying to communicate to mainstream media, who continue to ignore the truth which cloaks this issue. The New York Stock Exchange (Nymex) based in New York and the Intercontinental Exchange (ICE) located across the pond in London are two of the main players responsible for ‘manipulating’ the price of oil.
Source: Asia Online Times
How are they doing it you ask?
There is a financial transaction which is used by Nymex, ICE and other trading markets to trade commodities and currencies known in the business as futures. A simple example of a futures contract at work: Fuel is a key input in the Airline business. The volatility in the oil market which has driven prices upwards would have encouraged that industry to hedge by buying futures. British Airways can contract to purchase fuel three months from today at a price in the future. By doing so they hope to efficiently manage their operation by contracting the fuel at a future price to ensure good business planning . The Nymex and ICE trading markets have been identified as the culprits who sit in executive offices in New York and London and hold the world to ransom by fixing oil prices based on a very complex financial operation.
But how today’s oil prices are really determined is done by a process so opaque only a handful of major oil trading banks, such as Goldman Sachs or Morgan Stanley, have any idea who is buying and who is selling oil futures or derivative contracts that set physical oil prices in this strange new world of “paper oil” – Asian Times Online
We will not irritate the BU family with many of the details but will conclude the blog by focusing a little on the players who William Engdahl fingered as being responsible for the mess the world now finds itself. According to William, in 2006 a US Senate subcommittee acknowledged that market speculation in the oil market had caused oil prices to rise significantly. The trading in ‘paper oil’ by dealing in complicated futures contracts was contrary to the edict of the US Senate. Here is what the US Commodity Exchange Act (CEA) states:
Excessive speculation in any commodity under contracts of sale of such commodity for future delivery … causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity – Asian Online Times
The CEA having identified the concern created a regulated framework to trade energy futures which according to the CEA “were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud.” Since 2006 however there has been an upsurge in “futures look alike” which are being traded in the unregulated markets e.g. ICE. It is interesting that the now collapsed Enron and other large interest in the energy sector lobbied Congress to allow the trading of futures contracts in energy commodities to take place on unregulated markets like ICE. This has had the affect of removing ‘futures look alike’ from under the oversight of the US Commodity Futures Trading Commission (CFTC). To make a long story short: traders on the Nymex market are required to keep logs of all trades which encourages the CFTC to scope the level of speculation and “to detect, prevent and prosecute price manipulation”. The ‘futures look alike’ transacted in the unregulated markets like ICE, record keeping is not a requirement.
The caveat to this interesting story is that in 2006 the CFTC permitted ICE Exchange in London to install trading terminals in the USA to trade oil futures (ICE Futures) on the ICE Exchange in London. Remember this all happened under the George W Bush administration whose affiliation with the oil industry is well known. Members of the BU family should note this is when oil prices started to climb at a sharp rate.
The author of the article Speculators knock Opec off oil-price perch by William Engdahl focuses on the obvious manipulation of the global trading system to benefit a few speculators. He makes the amazing declaration that 60% of the current oil price is as a result of speculation. The role of the speculator has usurped the traditional market bahaviour which was regulated by supply and demand. The world’s mainstream media and others sit idle as we are being squeezed by the ‘curlies’. In case you have forgotten, the speculators who have created some of the most complex mathematical models to drive the futures contracts market are in it to make money, the economic havoc which is being caused to global economies maybe of passing interest to this group.
The truth is when the market collaspes and there is financial chaos, the speculators will move on to their next project.
Barbados Underground 
Many have pointed to the fact that since about 2005, the crude-oil market has been in a state called” contango,” by traders and financial economists. Contango essentially means that futures contracts for a given product are priced higher than that same good for near-term delivery. For example, if the price of oil to be delivered four months from now is priced $15 more than oil to be delivered next month then the market is in contango.
In such a situation it creates an incentive for refiners and other oil-market players to buy and hold oil now to sell it down the road.
Some argue that making such a trading opportunity possible requires a huge volume of new buyers on the other side of the futures contracts. The argument is that those persons on the other side of the futures contracts are a new source of “demand” influencing the oil price even though they do not actually buy any oil.
Estimates suggest that these new buyers had put more than $60 billion into U.S. crude-oil futures since 2004.
When the market is in contango, “you tend to operate at the top of your tanks. Estimates suggest that in the U.S., the difference between the industry operating at full tanks and at minimum operating levels amounts to as much as 75 million barrels of oil, or about three days of supply.
I do not share the view that speculation should be thought of as a separate force from supply and demand contributing to the price of oil. An investment fund that today buys a September 2006 futures contract for $75 ($3 above the current spot price of $72) will only make a profit if the spot price of oil in September turns out to be above $75 a barrel. If such speculators prove to be correct and the spot price does rise from its current $72 to, say, $80 a barrel by September, that price hike would be a further factor depressing September demand and potentially increasing September supply. Why would the September spot price be even higher than the current spot price, if users of oil in September will be buying less oil than they are now? According to the speculation theory, we’d have to see even more investment dollars flowing into the market in September than we are currently, causing an even bigger addition to stockpiles (that is, the rate at which oil is added to storage must itself go up at an ever-increasing rate) in order to compensate for the lost demand that $80 oil would choke off as well as to justify an even higher price than at present. And that additional money, in turn, would supposedly be going into February 2007 contracts for $83 oil, in hopes that the February 2007 spot price would be even higher, say $85. All this only makes sense if one believes that investment funds will continue to pour ever-increasing sums into oil futures and an ever-increasing volume of oil gets added to inventory each month. Since the total investment funds and physical facilities for storage are inherently finite, someone in this chain is going to find that they have irrationally thrown their money away. I would argue that this someone is in fact the joker at square 1 who thought you could make money with a September 2006 futures contract betting against the fundamentals.
To me, a much more natural way to try to interpret this phenomenon is that the investment funds are betting not on a bigger fool to bail them out in September, but rather are trying to evaluate the September fundamentals for supply and demand. First, let’s look at the upside. There is currently very little spare capacity in global oil production, meaning that a supply disruption of just a few million barrels a day could easily result in a pretty impressive spike up in the spot price of oil in September. Where might such a supply disruption come from? Oh, maybe Nigeria, or Iran, or Iraq, or Saudi Arabia, or Venezuela, or Russia, to name a few. Even if the probability of such an event is low, the large payoff if it occurs could give an attractive expected rate of return– play such a gamble over a long enough time period, and you could make out quite well, even if everything remains calm over this particular coming six months.
And what about the downside? Certainly a global economic slowdown could bring oil demand and the September spot price down considerably. But my reading is that the economic news of the last two months has led investors to place a lower probability on a global downturn than they would have assessed at the start of this year. Another development that would lower oil prices is if we finally started to see big changes in how oil gets used (for example, a significant change in the fuel efficiency of the outstanding stock of vehicles). But again, the most recent evidence is that this doesn’t seem to be happening yet. And finally, big supply increases from new oil fields were expected by some to have been making a contribution by now, and again the news is that, so far at least, they haven’t.
So, it seems to me that speculators, weighing these ups against the downs, might quite rationally have decided that market supply-demand fundamentals justify a higher futures price than seemed appropriate a few months back.
I would further add that, if these speculators turn out to be right and earn themselves a tidy profit, they will have done us all a favor. By bidding up the price of oil today and filling the storage facilities to the brim, they will have caused consumers to conserve today in order to have more oil available in the event that we do run into a big shortfall in production before September. On the other hand, if the speculators turn out to be wrong, they bought high and sold low. That would be destabilizing, forcing us all through some current pain, which, if we somehow could predict the future with certainty, will turn out to have been unnecessary. Our only consolation would be that the speculators will undoubtedly feel our pain, and then some, as their multibillion dollar bets flew into the wastebasket.
So, the only reason I see to be concerned about the contribution of speculation is if you think that the speculators are in danger of making huge losses. But if that’s your concern, I have a simple cure– just put yourself on the selling side of some of those futures contracts– let their pain be your personal gain.
Not sure you want to take the other side of that bet? Then maybe you’re not so sure that the speculators are wrong in their assessment of the possibilities for September fundamentals.There are demand and supply issues though:
Demand driven by growth in China, India and Brazil.
Supply: Sources of cheap oil are on the decline. The lack of refining capacity in the USA.
Nice post,Doc.
It needed a JR to make some sense out of the oil industry’s sometimes irrational performance.
A couple of points are still puzzling to me.
Why has KSA reduced output by 800,00o bpd when compared to 2005?
Is it their proven reserve figure is a sham?
Is there a bigger game in town, that US has not invaded Iraq to get oil out of the ground, but on the contrary to keep it in there to manipulate a shortage while frantically filling its own strategic reserve from near empty to 97% full, in the last 6 months.
Finally, thank you for debunking the theory that speculators are seperate from the market, they are the market and their activities are subject to supply and demand and risk factors, except when your bank happens to own the Fed and then all market forces are suspended and your losses are transferred to the general public, as in Bear Sterns case.
I for one did not support the fed bailing out bear sterns. Investment bankers and bankers generally are supposed to be experts in risk assessment. When they take risks and make profits they keep them. When they take risks and make losses why should the tax payer foot the bill?
Not just the tax-payer but everyone who uses the devalued US dollar as a store of wealth, (and that includes people whose currency is tied to the US$….you and me!).
JR said:
I remember after the first oil crisis in the 70’s (when OPEC banded together to block oil sales to the US to protest US foreign policy on Israel), when oil became plentiful again thanks to the new oil fields in Alaska and the North Sea coming on stream and OPEC’s embargo coming to an end, what was the result? Most of the attempts that were being made at the time to encourage energy conservation and to further research into renewables was abandoned because it no longer made “economic sense” since oil was once again cheap and available and the alternates in the short term would be more expensive.
I remember as the 1980’s came and went, and I saw more and more new cars and SUVs with large engines on the road and in the glossy magazine ads thinking to myself, whatever happened to the energy crisis? Didn’t they tell us back in the 1970’s we needed to conserve energy and reduce the use of oil? I naively thought (without really bothering to do any research into the matter), that they must have found lots of new oil since the 1970’s, because no one seemed to worry about an energy crisis any more.
The fact is they didn’t find lots of new oil since the 70’s. In fact new oil discoveries peaked in the 1960’s and we were burning several times more oil each year than we were discovering. Now suppose the influence of oil traders and speculators were to be taken out of the equation today and, assuming the analysis in the initial BU post was correct, oil was to drop back to around $40 per barrel. Would the automobile manufacturers (who make way more per vehicle on SUVs and large cars than on small cars) cut down the production runs of SUV’s to make more small cars. Would the salespeople at car dealers stop pushing SUV sales in favour of selling subcompacts and econoboxes with their lower sales commissions? Would the average Joes and Janes, apparently easily swayed by the car manufacturers advertising campaigns, going to reject the latest status symbol SUV for a sub compact econobox once they figure gassing it up at the pumps will not put too large a crimp in their wallet? Will the auto manufacturers still continue to produce or research hybrid cars and electric cars and consumers pay the extra bucks to buy them when we have “cheap” gasoline once again? Will commuters (aside from a few oddballs or enviro-nuts) decide that they really should give up driving alone in a 3 ton metal box on wheels to and from work every day and instead take the bus or subway so they can do their part to help the environment?
As humans unfortunately we seem to engage in short term thinking when it comes to these types of matters and it could be a blessing in disguise if high oil pries today force us to confront the issues surrounding peak oil and energy availability that we have almost totally ignored since the first warnings of the early 1970s. See example below:
You might say, “Oh, we’ve learned our lesson THIS time. Please God, just give us back our low oil prices and this time we promise we won’t fritter away the opportunity and we really, really will work on converting the world from reliance on fossil fuels to alternative energy sources (while we continue our current energy hogging lifestyles as long as possible).” My advice to God would be don’t take that bet. It is not a sure thing.
Hedge fund managers are among the wealthiest working people. Please see the link below.
It’s a disgrace.
How does that old joke go – When I owe the bank $10o,000 dollars and can’t pay, I have a problem. When I owe the bank $100,000,000 and can’t pay, the bank has a problem (or something along those lines).
great post green monkey.
Economists tend to overstate the argument somewhat. But my general point is that we can too easily focus on the role of speculators and lose sight of a basic point. Oil is a finite resource and we have been consuming it at an unbelievable rate.
“Oil is a finite resource”
Not according to David’s man, Engdahl.
He’s a believer in self replenishing abiotic oil, in company with some fringe Russian scientists.
I read the article and the comments. I posted on the Keltruth blog that OPEC controls the price. Here is the simple reason why. OPEC controls the LOWEST PRICE that will be paid for oil. Speculators control the HIGHEST PRICE that will be paid for oil. in the seventies, those same HIGHLY REGULATED speculators drove up the price of oil on FEARS. Even though speculators are greedy, if there is a IMMEDIATE surplus of oil, then fears go away. There is a “surplus” of oil capacity. Saudi Arabia could almost, at maximum capacity, supply all the world’s oil by itself. Venezuela and Nigeria could almost do the same thing. Saudi Arabia has ten years PROVEN oil reserves at MAXIMUM capacity. The problem is not the amount of oil. The problem is not the speculators. The problem is that the large oil companies, after driving the oil price DOWN to get the small companies out of business, colluded together again to drive it back up. Check who is who in large oil companies and those who CONTROL the speculators. There are a few powerful (and not famous) persons who have absolute control over where the oil price is. To get rid of oil will require more than just renewable energy. We will have to replace plastics, totally reinvent all our propulsion systems and redefine how we produce all our steel, chemicals and other high energy industrial processes like our concrete plant, which use fuel directly. You need a complete shift. Most people don’t want that.
While this argument about speculation is partly correct it does not tackle the source of the problem….The easy monetary policy of the US FED of the last 2 decades which has created so much money out of thin air without requisite growth in goods/ and genuine services…..leading to a world awash in US$$. The subsequent creation of bubbles in housing and equities (among others) which have been deflating over the past year or so has caused problems for all that money and liquidity which is still being created (now at a faster rate) and needs an investment vehicle to earn a reasonable return. Hence commodities are it for the time being (probably over the next few years as inflation gets worse). If this trend remain in tact we will probably see oil at US$200 by early next year as the Arab states are now refusing to accept the same level of depreciating US$ for their barrels of oil. As you can see for the moment, the oil price is closely correlating (negatively) with the movement of the value of the US$. This is also posited as a reason why they are refusing to increase the supply for oil as well. A few of the OPEC members have stop selling oil in US$. A few of the Arab states have broken their currency pegs to the US$ and other are now considering dropping their peg to the US dollar.
This will have significant implications for goods priced in US$$$$ over the next few years….if this trend continues….
All this comes at a time when demand from China and India is steadily growing and no major new oil finds have occurred in the past few years to come online soon
Green Monkey // May 6, 2008 at 9:39 am
When they take risks and make profits they keep them. When they take risks and make losses why should the tax payer foot the bill?
How does that old joke go – When I owe the bank $10o,000 dollars and canāt pay, I have a problem. When I owe the bank $100,000,000 and canāt pay, the bank has a problem (or something along those lines).
=================================
GM this is so true. Last week i read that a high number of foreclosures in America are from persons who did not have any previous difficulty in payiny their mortgage. One person who mailed in his keys and “walked away” from his home said, “it oocurred to him that his 100 % finance mortgage althought not at sub-prime was nothing more than paying rent. He did not have any money in the property and it was losing value at an alarming rate.” Guess who now has a house that they did not want? š
…..However in light of our financial systems, it made sense for the Feds to bail out Bears and Stern. What i have problem with is the reluctance of the republicans to do more to assit those persons who are willing to hold unto to their homes but cannot meet the adjusted monthly payments.
Straight talk // May 6, 2008 at 10:13 am
āOil is a finite resourceā
Not according to Davidās man, Engdahl.
Heās a believer in self replenishing abiotic oil, in company with some fringe Russian scientists.
================================
was it not the Russians that first made diamonds in a lab? I don’t believe um either, but i am not prepared to say it is impossible.
KH:
“Saudi could supply the whole global demand”
Really, who says so?
Proven reserves, even if they exist, are not available at the turn of a tap.
I believe they are currently pumping at max, and with the recent 12 month delay in bringing their new field on-line their exports will continue to dwindle.
We’ve been able to make oil in the lab for years it just costs more than digging out of the ground. I f anybody has been researching it I can’t find any evidence. Does anybody know? Who knows, oil companies may someday roll out “artificial oil” just like the artificial diamonds you can now buy.
Adrian Hinds // May 6, 2008 at 10:29 am
Straight talk // May 6, 2008 at 10:13 am
āOil is a finite resourceā
Not according to Davidās man, Engdahl.
Heās a believer in self replenishing abiotic oil, in company with some fringe Russian scientists.
================================
was it not the Russians that first made diamonds in a lab? I donāt believe um either, but i am not prepared to say it is impossible.
+++++++++++++++++++++++++++
… or indeed how long it takes to replenish itself!!
Here’s a old link for you on reserves
http://www.arabnews.com/?page=6§ion=0&article=44011&d=29&m=4&y=2004
Here’s one on Saudi Arabia pumping capacity and world capacity (note I said ALMOST).
http://www.rigzone.com/news/article.asp?a_id=60714&rss=true
The figures have changed since I last checked Straight Talk so I concede that I’ll have to add Saudi Arabia Nigeria and Venezuela together. Unfortunately the picture remains the same. Why else would Saudi Arabia be “bullish” about production if there was a lack of supply?
But then again read it for yourself.
As humans unfortunately we seem to engage in short term thinking when it comes to these types of matters and it could be a blessing in disguise if high oil pries today force us to confront the issues surrounding peak oil and energy availability that we have almost totally ignored since the first warnings of the early 1970s.
=================================
I think you are correct. Americans recorded their best saving years at a time when they did not have any choice.
——–
“There has been only one time in our history where the average person has saved at that rate. That was during World War II.
During that time, every capable person was either working or in the military. You could only buy necessities, and often precious few of those were available because of rationed gas, meat, butter and sugar. People grew their own food in “victory” gardens.
You couldn’t buy automobiles, radios or even silk or nylon stockings because those industries were supporting the troops with tanks, communication equipment, silk parachutes and nylon for tires.
There wasn’t any way to spend much money, so you saved. Besides, it was popular to support the war effort by buying savings bonds. Children would buy 25-cent savings stamps and paste them in a book until they had enough to get an $18.50 savings bond.
That’s the kind of environment it took to save 23 percent of disposable income per capita. ”
http://www.bankrate.com/nydn/news/retirement/20080218_investing_consumerism_a3.asp
Comment moderation means that the links I posted for Straight Talk have to be moderated first. As I said there, I concede that I would have to add Saudi Arabia Nigeria and Venezuela together to meet world demand. But as the article I hope you get to see shows, Saudi Arabia thinks demand for it’s oil output will FALL.
Adrian, I wondered if artificial diamonds would come to be, but they’re here. I’m posting a second post with a link which, because of comment moderation, make take a while to come up
Artificial diamond article
http://www.wired.com/wired/archive/11.09/diamond.html
Thanks Keith: I think we would make more headway in getting Barbadians to conserve and save more, if it is done via education, and by real incentives “whats in it for me”. I conserve and save becuase it puts more money in my pocket; fear, or concern about destroying the envoirnment does not factor that much.
……To further the point i made earlier about “mortgage walkers” The question i had and did not have an answer for, was, “How will these “walkers” fear in the future with damage credit ratings. I suggested that the number of such persons would be so large that Bankers and other credit issuers will not be able to ignore them for too long. While i was satisfied with this answer i could not add any detail on why this would be the case, but thanks to GM for pointing us to the “CASH as DEBT” video, I got my answer.
The inverse relationship between the dollar and the oil price is a much reported on phenomena in the media today.
The conventional view is that due to the fact that oil transactions are all conducted in dollars, the price of oil rises to compensate traders, or more precisely sellers of oil, for loss in purchasing power.
using the tools of economic analysis the answer is not so clear. A number of statistical studies suggest that there is no statistically significant relationship between the change in the price of oil and the change in the value of the dollar.
From a conceptual viewpoint, even if there was a relationship, the tools of economic analysis raise questions about the direction of any causality.
For example, if a country is net importer of oil, an increase in the real price oil may well lead to a decline in the value of the currency.
We have not really seen an oil price this high and the dollar this low for any length of time making firm conclusions difficult to make.
Conventional may be correct but the statistical studies done to date does not support it.
Adrian I think you meant the Money As Debt video, available to view on Google Video at: http://video.google.com/videoplay?docid=5352106773770802849
Another good video you can watch on line that explains the history and development of today’s monetary and banking systems over the centuries is <The Money Masters. It is somewhat longer than Money As Debt as it runs about 3hrs, but you’ll probably be quite surprised at some of the historical details surrounding the role that banks and bankers played in world history that are not discussed in school or even college level history text books.
If you have a high speed connection, you can watch the video here: http://www.heyokamagazine.com/HEYOKA.12.%20MoneyMasters.htm
The latest online issue of the economist magazine has an interesting article on an investigation into price fixing among supermarkets in Britain.
http://www.economist.com/displaystory.cfm?story_id=11289136
I know David has raised the question as to whether my views on the cost of living have changed since the earlier article. My answer is no.
I have been surprised by the scale of the increases globally. However, I still argue that prices began to rise from a particular level. Vigorous competition policy is needed to make sure that level is a fair one.
Money used to be backed by Gold and Silver but today’s money is backed by debt – your promise to pay back a loan and the government’s promise to back up the currency. Money as Debt: how money is created
āThe mortgage meltdown started with problems with subprime mortgages — those made to people with tarnished credit. However, they have spread to more creditworthy borrowersā. Ben Bernanke
āCalifornia, Florida and parts of Colorado, on the other hand, saw delinquencies rise during a period when unemployment generally decreased but the value of homes declined.ā Ben Bernanke
“A widespread decline in home prices, by contrast, is a relatively novel phenomenon, and lenders and servicers will have to develop new and flexible strategies to deal with this issue,” Ben Bernanke
āThe current housing crises has clobbered some borrowers home prices dropped. That left them with mortgages that are bigger than the value of their home. When that’s the primary problem, Bernanke said the best solution may be reducing the amount that the borrower owes on the loan or some other permanent modification to the loan.ā Ben Bernanke
ā¦..With the rise in the 100% mortgage (no money down no personal risk involved) walking away from such a mortgage is very easy to do. Adrian Hinds
āRising foreclosures add to the glut of unsold homes and that put more downward pressure on prices, aggravating the housing slump, he said. More rapid declines in house prices could have an “adverse impact” on the broader economy and the stability of the financial system.ā Ben Bernanke
It seems that the point which we thought we made in the blog is the extent which the US government and other powerful players are able to create a system which uses the speculators for their own end. It is the dirivatives which the speculators have been trading on the unregulated exchanges away from oversight which has helped to destablized global economies. So we see this issue as bigger than the price of oil.
We stick with our point that the speculators have created contract/options which pander to the confidence sensitive nature of the market and has nothing at all to do with oil.
Yes you made the point, and i agree, but i believe that the speculators are using the money, and credit crunch to make more money on oil. Most people cannot seperate out the two.
This article backs up what you have said, and ties into the GM supplied video on “Money as Debt: How money is created
http://video.google.com/videoplay?docid=-9050474362583451279
……..AMERICA NEEDS URGENT CHANGE IN IT’S HOUSE OF REPRESENTATIVES,…MORE SO THAN IN THE WHITEHOUSE.
“March 21, 2008
Op-Ed Columnist
Partying Like Itās 1929
By PAUL KRUGMAN
If Ben Bernanke manages to save the financial system from collapse, he will ā rightly ā be praised for his heroic efforts.
But what we should be asking is: How did we get here?
Why does the financial system need salvation?
Why do mild-mannered economists have to become superheroes?
The answer, at a fundamental level, is that weāre paying the price for willful amnesia. We chose to forget what happened in the 1930s ā and having refused to learn from history, weāre repeating it.
Contrary to popular belief, the stock market crash of 1929 wasnāt the defining moment of the Great Depression. What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931.
This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure.
As the decades passed, however, that lesson was forgotten ā and now weāre relearning it, the hard way.
To grasp the problem, you need to understand what banks do.
Banks exist because they help reconcile the conflicting desires of savers and borrowers. Savers want freedom ā access to their money on short notice. Borrowers want commitment: they donāt want to risk facing sudden demands for repayment.
Normally, banks satisfy both desires: depositors have access to their funds whenever they want, yet most of the money placed in a bankās care is used to make long-term loans. The reason this works is that withdrawals are usually more or less matched by new deposits, so that a bank only needs a modest cash reserve to make good on its promises.
But sometimes ā often based on nothing more than a rumor ā banks face runs, in which many people try to withdraw their money at the same time. And a bank that faces a run by depositors, lacking the cash to meet their demands, may go bust even if the rumor was false.
Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction. And there can be wider economic effects: as the surviving banks try to raise cash by calling in loans, there can be a vicious circle in which bank runs cause a credit crunch, which leads to more business failures, which leads to more financial troubles at banks, and so on.
That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.
And we all lived happily for a while ā but not for ever after.
Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free ā partly by persuading politicians to relax the rules, but mainly by creating a āshadow banking systemā that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.
For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages ā with nary a regulator in sight.
As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.
In fact, however, we were partying like it was 1929 ā and now itās 1930.
The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People arenāt pulling cash out of banks to put it in their mattresses ā but theyāre doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.
Mr. Bernanke and his colleagues at the Fed are doing all they can to end that vicious circle. We can only hope that they succeed. Otherwise, the next few years will be very unpleasant ā not another Great Depression, hopefully, but surely the worst slump weāve seen in decades.
Even if Mr. Bernanke pulls it off, however, this is no way to run an economy. Itās time to relearn the lessons of the 1930s, and get the financial system back under control. “
David:
You said:
David // May 6, 2008 at 7:25 pm
It seems that the point which we thought we made in the blog is the extent which the US government and other powerful players are able to create a system which uses the speculators for their own end. It is the dirivatives which the speculators have been trading on the unregulated exchanges away from oversight which has helped to destablized global economies. So we see this issue as bigger than the price of oil.
We stick with our point that the speculators have created contract/options which pander to the confidence sensitive nature of the market and has nothing at all to do with oil.
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This has been an interesting, and, perhaps useful discussion, that has benefitted from Prof. JR’s contributions. But we need to move on to discuss how what we know should be used to condition our behaviour, both at the national/policy-making, and the individual levels. After all, how does it help us, when we have arrived in hell in a handbasket to know exactly how we got there, but to have done nothing to stop our precipitous descent?
Linchh we read your cynical comment and wish to remind you that this is all part of the process of educating Barbadians. If more people can understand the factors which can impact the business of oil it may help to move the discussion forward.
So now we know, not very much at all.
There are a myriad theories attempting to explain oil prices.
Peak Oil, devalued dollar, market manipulation, shadow government depopulation strategy etc.,
but instead of arguing the causalities let us start looking at the basics and how we can best adapt to the fact that oil has increased in price fourfold since the Saudi Oil minister announced he had sufficient reserves to power the world and maintain prices within the $20-30 bracket, way back in 2004.
We should ignore the agenda driven mouthings of politicians and oil companies and study the raw data.
Something, whatever it is, is driving energy prices upwards so fast that there is barely time for both nations and their people to adjust.
This “something” is so powerful that the world’s leaders are at a loss, or are unwilling, to explain the true ramifications of the end of cheap oil.
Food scarcity is leading to mass starvation.
Nations are forging new alliances, and reneging on old ones, in order to achieve their own oil security.
Resource wars are already being fought in Darfur, Chad, Nigeria and Iraq.
No matter that the Saudis say they are awash in the stuff, the fact is as the price and emerging nations’ demand spirals upwards, whilst production plateaus, we will struggle to afford the new energy costs.
Action now is what is required.
Duty and VAT free status for all renewable energy equipment.
Nett metering at the market rate for our electricity supply.
Preparation and leasing of all unused government arable land to the the people as cooperatives, or allotments to individuals.
Government is too unwieldy for the community action that is necessary, the proposed parish councils should be speedily established to oversee the utilisation of all local resources and the organisation of self sufficient groupings.
The ideas are out there to cope with these changing circumstances it only needs the political will to stop the talking and do what we elected them to do, ….. lead.
Thank you for that post Straight Talk, I completely agree with the actions you suggest. While building solar energy devices (I actually became something of an expert metal bender because of that experience) I met a plumber who had THE most innovative solution I have ever heard to the Holetown flooding problem. The problem was, no-one would listen to him. He has since gone overseas. We will fix our problems when we listen to each other. We can fix them slowly as one person forges ahead against the odds or we can find a way to work together, and fix them quickly. The choice is up to each of us.
People know full well what needs to be done, but have become accustom to their lifestyle of conveniences, and to my mind, it is always difficult for the citizens in a socialist state such as Barbados, to return to the level of self-help, that will be required to weather these cyclical economic down turns.
……I was once in danger of forgetting all those great things my Parents and neighbours did before the post 1960’s Economist, political scientist, Bankers, and Politicians brought to bare on us, their progressive ideas and tinkering. The social construction engineered by these people and our willingness to capitulate, without fully understanding what they were offering and without a willingness to return to the tried and true best practices should these nouveau ideas not pan out, are the core reasons for the mess we find ourselves in today.
…..My advise is to seek out the writings of pre 1960 sociologist, Economist, political scientist, and politicians, and supplement their thoughts with those of the most natural of these disciplines from that era,…your grand parents, village elders, and elder statesmen. If we continue to look to the Peter Wickhams, Mia Mottley, and David Thompson of today for sustainable answers we will most likely be face with best practices in band-aid application to a festering and enlarging open sore.
David // May 7, 2008 at 5:40 am
Linchh we read your cynical comment and wish to remind you that this is all part of the process of educating Barbadians. If more people can understand the factors which can impact the business of oil it may help to move the discussion forward.
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David:
Who told you that my comment was cynical, or did you find that out all by yourself. The problem is that in my other life, I have spent 45 years trying to advise political decision-makers of their options, but leaving it up to them to make their own decisions on how to use their best efforts to promote the interests of the poor people on this benighted Rock.
Now, if you had the time, gumption, and pure intestinal fortitude, and testicular common sense, you would attend the DLP/FLF on May 9, 2008 and hear George Reid speak on the subject: “1991 and all that, or back to the Future: A cautionary tale”.
Found this article on http://www.theoildrum.com today:
I know the link to the “Money As Debt” video has now been posted by myself and AH several times here on BU, but I’ll ask for the indulgence of the BU team if I post it one more time, just in case there are any lurkers or new BU readers who might have just stumbled on this discussion and are curious about the statement in the article above on a Steady State Economy regarding banks “lending at interest money they create out of nothing”.
If this statement has you puzzled, you can find out how banks get to simultaneously create new money and lend it out at interest by watching the 47 minute video documentary Money As Debt, which can also be viewed on line at Google Video: http://video.google.com/videoplay?docid=5352106773770802849
Green Monkey quite a decent piece, but the problem with that model is that it has excluded the variable “M” where M is the market. Economic growth theories of the recent past have been feed by ever increasing and identifying new markets. By its very success were the seeds of its failure sown. M is not infinite and by the very SSE of the earth’s numbers, as well as the fact that further new markets are not homogeneous or at the same stage of development, renders the model imperfect. Nice try though Green Monkey. The fact remains that even with bank lending to the n power, there comes the point at which there is no more people to lend to, or that all borrowers will behave in a uniform way. One or two rogue elements and the model again breaks down.The parameters of the hypothesis have been imperfectly framed.
JTB.
Until we’ve moved on from needing crude-oil (we’ve moved on from needing whale-blubber), the price of this limited commodity can but go up. Then it will be worthless, and the change will be rapid.
Unfortunately Luc, whale oil only provided light.
Our whole globalised economic system is predicated on cheap oil.
FYI whale oil did not provide transport fuel, fertilisers, plastics, or natural gas.
10 calories of crude oil is required to produce each single calorie of food in today’s energy intensive agrobusiness..
Many commentators believe if we can manage to downslide the oil deficit cliff successfully, we will be sitting round our tables in an evening watching the flickering oil lamp again.
There has never in the history of the world been such an energy intensive, easily obtainable, fuel as crude oil has been for the last 125 years, and, even though there is no viable alternative at the moment, I sincerely hope the optimists posting here that technology (read someone else) again will provide the answers to save our way of life.
In the meantime, sensible people will also hope for the best………….. but plan for the worst.
The CFTC has a six month investigation going on about the serious speculation in the oil futures commodities market which is believed to be driving price of oil up. For people who understand how the market works and how big it is this will be very difficult to do.
The big question is why has this commission only started to investigate rising oil prices 6 months ago when suspicious speculation in the oil futures market has been happening for almost 6 years now.
David:
The futures market is a zero sum game.
Just before each monthly call day you decide either to sell your option to purchase, or take it up and stick a thousand barrels of oil under the bed.
Don’t see much of the latter going on an a small scale or on the gigantic scale necessary to influence the market.
A cursory glance at any oil price graph will show the 3-10 dollar drop at the end of each month.
That is the speculative froth being blown away by the call day.
This commission is another futile attempt to cast blame on anyone rather than admit that we have sorely abused our most precious ever resource.
We have squandered the most energy intensive liquid ever.
Selling it so cheaply that our whole way of living has become utterly dependent on its increasing availability.
Oil, for the work it does and the byproducts we make from it, is still cheap, its even cheaper than bottled water.
The reason for the price rise is world demand for oil is outstripping producer countries’ export capacity.
The gap will only grow wider as oil supply dwindles as two thirds of mankind strives for “developed nation” status.
Oil will continue on its inexorable rise until it passes its true utility value and demand destruction causes a fall in price asked by those producers who need the cash.
I suspect most producers, after experiencing the economic pain that change will incur, will prefer to leave the stuff in the ground for national use only.
ST it is a zero sum game but why must a narrow band of people benefit at the expense of masses? Isn’t this the reason why regulatory mechanisms are inserted? Bush tea has already made the point that human nature is configured to consume more so that the challenge of mankind is to find economic ways to match human consumption.
David:
You are missing the point.
In a zero sum game there has to be an equal amount of winning and losing speculators.
The masses are not losing they are paying a market price for a commodity in short supply.
Either pay it or do without it, that is the choice with which we have to come to terms.
No amount of blame allocation can affect the basic fundamentals.
ST,
as the “most energy intensive fuel ever”, how does oil compare with Uranium pound for pound?
David,
ST is completely on the ball. The CFTC investigation is a matter of drowning men clutching at straws.
Just use your common sense…
If we had significant crude deposits in Barbados…
would we..
….Sell it cheaply so that others could continue their developed way of life without stress?
…Reduce production to the point where the income met our immediate needs, while leaving as much as possible in the ground to be sold at clearly higher prices in the future?
….seek to extract the highest prices possible in our own interest even if it causes pain in some (smug and arrogant) countries?
You David, would probably do all in your power to meet mankind’s needs, but us other mere mortals would be very focused on our own self interest.
Even if some greedy middle men who look to get their cut in the process are targeted the basic equation remains.
..in short. Cheap energy will be no more.