The Spanish Empire spent a fortune waging wars, acquiring territory, subjugating civilizations, spreading its religion and buying stuff. Spain paid for its empire by ridding North and South America of its silver. The Spanish elites racked up quite a bit of debt consuming goods from foreign lands. Merchants were more than happy to sell stuff for Spanish silver.
A very large, very wealthy empire. Wealth would be part of the empire's undoing. Image taken from Wikipedia.
The empire nearly spent itself into oblivion. The prices on goods rose at a pace faster than wages - otherwise known as inflation. The resulting inflation due to circulating Spanish silver is known as the Price Revolution. Spanish silver was the first post-Renaissance reserve currency, and up until the 1850s it was legal tender in the United States. Unfortunately, the silver mines eventually began to produce less silver and so the Spanish became less wealthy.
...The More Things Stay the Same
Here we are, more than 500 years since Spain began its conquest, and look at the situation Spain is in. Once again, Spain is mired in debt; they've sent their money to foreign lands with no way to encourage it to come back. This time it is not a consequence of gutting the silver mines of the Americas and outspending everyone in the conspicuous purchases department. This time it was a consequence of converging interest rates. The jig is up for Spain: no silver, no easy credit, no service.
The 1970s oil price shocks were supply driven. OPEC, in demonstration of a Middle Eastern war, embargoed countries from their exports. The price of oil was increased by using the withdraw of supply to justify the price increase. In the late-1970s as Iran revolted agains the Shah, oil production declined - another supply shock. The 1970s price increases and the 1980s oil price collapse were supply driven events.
From the late-1990s to the late-2000s, oil prices increased from around $10 to almost $150. Unlike previous sharp increases in oil prices, this price increase was driven by demand. The money to bid up the price of oil came from what Ben Bernanke called a "global savings glut". The US ran a large trade deficit, allowing surplus nations, with their dollar reserves, to purchase oil and invest in dollar denominated assets - dollar recycling.
A
third of humanity doesn't want to ride bikes anymore. That has profound
geopolitical implications. Anne Korin (referring to China and India)
From 1971 to 2011
Each year, China and India and other emerging economies consume a greater share of the world's available oil while the United States and other developed economies consume a lesser share. Over the past 40 years, Asia and Middle East consumption has increased as a percent of world consumption while Africa and South America have stayed flat, and North America has Europe have decreased as a percent of world consumption.
Here are the countries included in the regional areas (not a pure analytical collection):
Countries in each region listed below in the pie charts.
The changing trends in consumption growth:
1971 oil consumption by region; Europe and North America make up the largest consumers.
From 1971 to 1991, Asian oil consumption as a percent of world consumption grew by over 30%.
In 2011, Asia was the world's leading consumer.
To put the change into perspective, let's look at major consuming countries and regions:
Consumption amongst major consumers. China:US and India:US ratios show relative consumption trends between the two countries. At the current rate, China will consume as much oil as the US in about 15 years.
The rapid increase in consumption amongst China and India, and rising prices, stands in odd contrast to price-related 2008 drop in production and exports:
Oil exports declined amid credit contraction in 2008 and are slow to recover to previous levels.
The Shift
Two nations, China and India, have been bidding up the price of a commodity that has come in short supply over the past few years. Because of the decrease in supply (production and exports) amid the credit crisis there are elements of supply influencing today's prices, but prices were bid up to their current levels on a surge in demand. Countries of the Middle East, many of them members of OPEC, are increasing their share of consumption.
Nostalgia: The 1990s
In the mid- to late-1990s, the price of oil stayed within a stable range but mostly remained below its early-1980s levels. As financial crises ensued in Southeast Asia and Russia, the price of oil plunged toward $10. US stock markets saw a sharp increase starting in 1995 with momentum continuing until 2000 despite significant changes in the tax code in 1993 and 1997. The historic 5-year run brought back discussion of the historic Mississippi Company and its ill-gotten gains.
Fueled by an emerging online retail enterprise, the flight to capital and a diminishing offering of US government debt, the SP&500 hit an all-time high relative to the price of oil in the late-1990s. The large increase in consumption from Asia was stagnated during the Asian financial crisis as South Korea, Indonesia and Southeast Asian nations experienced sovereign debt crises and rapid changes in foreign exchange rates. The contagion would eventual spread to other countries, such as Brazil, but was eclipsed by Russia's sovereign debt default which wiped out Long Term Capital Management.
SP&500/Oil divisor frm the 1980s oil price collapse to present.
Recessionary Trends
Counting the early-1980s recessions as a single recession, all five major post-fiat recessions have either been caused by or coincided with rising oil prices; three out of five have been caused by or coincided with a deflating housing price index. Can it be that recessions have become predictable or even manageable?
A highly modified housing price index (average sale price divided by personal income per number of workers of working age) used to illustrate house index (blue) and oil price (red) relationship between each other and relationship to recessions.
Carry Trade Finance
Carry trade finance conducted by the Federal Reserve, a type of positive carry, has become more pronounced over the past 20 years. Positive carry occurs when a bank's cash inflows can pay its cash out flows - when the the interest earned on investment loans can pay the interest on savings accounts. When a bank cannot pay interest earned on accounts with interest earned through investment loans (as happened with the S&L industry at various times in the 1970s and 1980s) a bank is said to have negative carry, and is therefore technically insolvent.
Overview of carry trade finance - contraction and expansion of the spread between short-term and long-term interest rates coinciding with recessions. The current spread due to the late-2000s recession has been quite large and lasted longer than the previous cases.
To address any credit impairment as a result of a recession, the Federal Reserve conducts a policy of increasing, or expanding, the spread between short-term and long-term interest rates. They do this by changing their target interest rate - the Fed Funds rate. This encourages the sudden increase in government debt (normally acquired in recessions) to be passed on to short-term treasuries. The accrued interest can be passed on to long-term treasuries.
Mid-1970s recession showing S&P500/Oil divisor and interest rates. Shortly before and during the recession, the 1-year treasury (purple) was paying higher interest than longer-term treasuries, but was not so after the recession.
Early-1980s recession, just as in the mid-1970s recession, 1-year treasury was paying more than the longer-term treasuries before and during the recession. Afterwards, the 1-year was paying less interest until shortly before the recession starting in 1990. Oil prices were not affected by interest rates.
The modern era recessions in which carry trade finance became more obvious. Also, the relationship between interest rates and the stock market became closer.
In 1995, the stock market took off just as interest rates peaked. 1994 marked the CMO (collateralized-mortgage obligation) bond market collapse, due to the higher interest rates - an inverse relationship? As new government debt issues began to shrink (government surpluses) money was driven into the stock market, and conversely money was driven out of the stock market and into hard assets like real-estate.
Some correlation between interest rates and oil prices prior to the early-2000s recession and since then. Oil price is monthly WTI (West Texas Intermediate).
Recessionary Policy and Oil
While oil prices do seem to affect recessions, and affect government and Federal Reserve policy as a result; oil prices do not appear affected by most recessions or any government policy. Stock markets started to show some corollary trends with interest rates starting in the 1990s. However, not until after the most recent recession have oil prices shown their now tight (inelastic) relationship in which index/price movements follow a similar range.
Answering the Question So Far
Why is their now a tight, inelastic relationship with oil and stock markets? The most recent recession was marked by a freeze in the credit markets. Wary investors are now reluctant to make dedicated long-term bets like they were prior to the recession. Cash has been stockpiled in bank accounts either worried about volatility in the credit market or waiting for rates to go up (likely to happen in 2015) or for a market boom to happen.
While my modified housing price index does not show a clear trend amongst oil and housing markets, when I combine data from British Petroleum's 2012 Statistical Review and Robert Shiller's housing market index (from the 2nd edition of his book Irrational Exuberance), there appears to be some kind of a recent 30-year trend. I don't think it is of much relevance except for the relationship between the most recent housing boom and increase in oil prices.
I indexed oil prices in 2011 dollars from BP's 2012 Statistical Review and graphed in Robert Shiller's housing market index graph (from Irrational Exuberance 2nd edition).
I was compelled to do this after seeing this post at Illusion of Prosperity. Sometimes I see a graph and I feel compelled to build upon it, but no graph here just a ledger:
Federal Reserve balance of various US treasuries by maturity along with US treasuries outstanding. I hope my accounting methods are satisfactory, I did not include non-marketable and TIPS into the calculation.
The Federal Reserve currently has 16.4% of the US's outstanding non-TIPS marketable debt on its balance sheet. I suspect the Federal Reserve is going to shed all treasuries with 5 years or less to maturity off its balance sheet - building up the 5+ years to maturity as a reserve for when they test their target rate in 2015.
On the Federal Reserve's Dole
The Federal Reserve also has $852 billion of GSE (Fannie, Freddie, Ginnie) mortgage backed securities on its balance sheet. Prior to the conservatorship in 2009, agency and GSE mortgage-backed pools totaled $5.37 trillion. I suspect the Fed's MBS balance will grow by $1 trillion.
Just Like a Stock Market Crash
Remember, from its peak in Q4 2005 to its bottom in Q4 2008, home owner's equity fell $7.27 trillion. I just don't think there is a quick fix to restore the economy - or to restore all that equity - and I don't think I want one. It's been 5 years since the credit crunch of 2007 and we are still at 8% U3 unemployment and 15% U6 unemployment.
Home Equity Loans divided by Home Owner's Equity (blue), and for good measure I turned it into a random gold (red) graph - can't have enough of those.
Looking Into the Crystal Ball
Honestly, I believe the recession was caused by overleveraged households - too much debt, and bad debt at that. Financially speaking, it was a run on the repo, and what we are now experiencing appears to be a crisis of the repo stemming from systemic risk. Households cannot effectively take on debt at the pace they did from the late-1990s to the mid-2000s.
What is the Federal Reserve's ultimate plan? Beats me, but it looks like they are building leverage for when they raise interest rates. There is an inverse relationship between interest rates and asset prices. I think everyone realized that back in 2004-2007, same with the 1994 CMO bond market collapse, and same with the Latin American Debt Crisis. For all those home owners with a mortgage tied into LIBOR (and ultimately the Fed Funds rate), good luck.
Looking Into a Different Crystal Ball
Household debt (blue) and household debt percent change from year ago (red). So it never had a negative year over year change since 1951?
So, I was reading through Robert Shiller's The Subprime Solution (2008) and came across a very, very interesting passage. This passage was in context to when, in 2005, Shiller was updating his book Irrational Exuberance (2000) and wanted to add a chapter about historical housing market statistics. His reaction when he asked around about available long-term data:
To
my surprise, everyone I asked said that there were no data on the long-term performance of home prices – not for
the United States, nor for any country.Stop and think about that.If the
housing boom is such a spectacular economic event, wouldn’t you imagine that
someone would care if this kind of thing happened before, and what the outcome
had been?But, amazingly, nobody seemed
interested in what had happened more than thirty or so years ago.This is at once a lesson in human behavior
and a reminder that human attention is capricious.Clearly no
one was carefully evaluating the real estate market and its potential for
speculative excess.
The S&P500/Oil divisor used in the first part of this series runs only from 1986 to present. Using WTI (West Texas Intermediate) prices, the divisor can be tracked from 1957 to the present (because that is as far back as data goes back at FRED). Brent prices were used earlier because the recent mid-American oil bottleneck has lead to a significant price spread over the past two years.
SP500/Oil divisor from 1957 to present using WTI (West Texas Intermediate). Mean=22.20. Median=19.75
Saudi Arabia - Game Changer
Oil prices increased throughout the 1970s after the 1973 OPEC oil embargo and again later, due to the Iranian Revolution. Iranian oil production picked up toward pre-revolution levels in the early-1980s, to fund normal government functions and itss war with Iraq. Oil prices declined from their $40 peak in 1980 to $30 by 1985.
S&P500/Oil divisor from the embargo to the 1986 price collapse. The divisor bottoms out during the Iranian Revolution and begins to climb back up starting in 1982 (the beginning of a two decade long secular bull market).
In 1986, Saudi Arabia flooded the market with oil - causing prices to collapse. The collapse in prices put further downward pressure on American real-estate prices in the oil states (which had already experienced considerable unemployed in the early-1980s) which facilitated and accelerated the 1980s S&L crisis. The move by Saudi Arabia had a few other world changing consequences.
Cluttered explanation of oil and stock market relationship in a scatter plot. Data is taken quarterly from Q1 1957 to Q3 2012. Black line connects the dots from one quarter to the next.
The Changing World Order
On July 15, 1971, Richard Nixon announced his decision to visit China. One month later, on August 15, Richard Nixon signed the 1971 Economic Stabilization Act which ended the old era gold standard. Think about that for a moment. Within one month's time, the president had announced the direction for a new US economic model - trade with China using a new fiat currency.
Within 18 months after the end of the gold standard, Nixon visited China and ended the Vietnam War. The 1971 Economic Stabilization Act also created rent, wage and price controls. Besides all of that, Nixon helped create the EPA, signed into law supplemental and cost-of-living adjustments (COLA) for Social Security, and, in his 1974 state of the union, stated that it is the goal of the government to create a system to provide affordable healtchare to every American. Not bad for a once staunch anti-communist - or as they say "Only Nixon could go to China".
The First Order of Business
The OPEC oil embargo not only lead toward higher oil prices but also created a dollar pricing mechanism. The various OPEC nations, during the embargo, agreed to price (and many to sell) their oil exclusively in American dollars. The resulting high oil prices lead to rising inflation and decreasing growth for the rest of the decade - known as stagflation. However, the OPEC-dollar pact meant that oil consuming nations would experience the pain of both higher oil prices and fluctuating US exchange rates.
To combat the rising inflation, happening in the US and Europe, central banks raised interest rates to curb government spending. In the late-1970s, the increase in interest rates helped to contract the US budget deficit as a percent of GDP. However, despite the high interest rates the US budget deficit as a percent of GDP widened from FY (fiscal year) 1980 to 1986 - earning debt holders considerable bucks at the high interest rates. In the late-1980s, the budget deficit as a percent of GDP would again begin to contract.
Interest rates on government debt (blue) and US budget balance as % of GDP (red) from 1957 to present. Low oil prices and large capital gains tax receipts lead toward a rare event: the US budget surplus of the late-1990s.
The Double Dip
The US experienced two recessions in the early-1980s. The first, a large increase in oil prices lead to a surge in inflation and operating costs. The second (the double-dip), despite the Federal Reserve's actions to increase interest rates, inflation continued to rise as oil prices stayed high even though they declined.
To combat each recession, the Federal Reserve halted its policy of increasing interest rates, and reduced interest rates to ease the flow of credit for investment. However, after the double dip recession, unemployment rates fell but plateaued at levels above the pre-recession levels of the late-1970s. The unemployment rate did not decrease to pre-recession levels until 1986 when oil prices collapsed.
S&P500/Oil divisor (green), interest rates (orange) and the unemployment rate (yellow-green).
The Fall of a Giant
The cheap oil of the 1980s was the straw that broke the Soviet Union's back. Heavily dependent on oil sales for government revenue, and engaged in war in Afghanistan, the Soviet Union's government revenue greatly decreased when oil prices collapsed. The Soviets experienced a crisis that was beyond their control.
Iraq and Iran, at war with each other from 1980-1988, were also hard hit by the oil price collapse. Funding for their war had to be scaled back; eventually ending in a truce. Because the Soviet Union was the largest supplier of weapons during the war, they experienced even further decline in government revenue. Later, Iraq would invade Kuwait in protest of war-related debts (denominated in dollars) it could no longer pay.
In all, Saudi Arabia's increased oil production may have indirectly saved tens of thousands of lives, and spared many more people from the misery of war and the oppresion of communism. However, in relation to the American stock markets the effect may have not had an immediate impact. It helped to further put Americans back to work as cheap oil meant cheap transportation fuel - setting the stage for the 1990s' stock market boom.
Shiller PE/Oil divisor (black) - this is Robert Shiller's PE Ratio divided by the price of oil (Shiller does not actually produce such a data set). PE/Oil has not recovered since the embargo. The oil price used here is actually a WTI annual-average, indexed to 2005 (via FRED). Shiller PE data at http://www.econ.yale.edu/~shiller/data.htm
Lately, stock market volatility has been edging up and oil prices falling. Oil prices, since the end of the official late-2000s recession, has closely followed the stock markets' movements. Using the S&P 500 index as a measure of American stock markets and Brent oil as an indicator of world oil prices we can see the close relationship by dividing the index by the price of oil.
The S&P500/Oil divisor. Daily S&P 500 index divided by daily Brent price in dollars ($).
Beginning in 1992 - after the early 1990s recession (and Iraq War) and the collapse of the Soviet Union - annual-average S&P 500 growth began to outpace oil prices. The S&P 500 saw very large annual-average gains but oil prices lagged these gains. The S&P500/Oil Divisor went from 20 in 1992 to 130 by late-1998/early-1999.
This relationship reversed course in 1999 when annual-average oil prices began to outpace the S&P 500. At one point in late-1998 (in the wake of the Asian Financial Crisis and Russian sovereign debt default), oil was trading below $10 per barrel - ten years later in 2008 it would trade around $150 per barrel.
Annual-average changes in Brent Oil (Red), S&P 500 (Black) and the S&P500/Oil Divisor (Green).
Prices Go Up, Prices Go Down
Slow increase or decline in oil prices can coincide with increased S&P 500 volatility.
5-years of oil price (Red) and S&P 500 volatility (Blue).
However, because volatility is measured on a 3-month basis, oil prices do not necessarily lead changes in the stock market. During the 2007-2008 financial crisis, the S&P 500 began its decline while oil prices were peaking - which then took a nose dive itself. During the crisis, large investors began hedging risk with positions in gold and oil. This was particularly true after two Bear Stearns hedge funds were liquidated in the summer of 2007 - essentially the beginning of the credit crisis.
S&P 500 (Black) and Oil (Red).
Plotting oil volatility alongside S&P 500 volatility reveals the close relationship.
S&P 500 volatility (blue), oil volatility (purple) and the S&P 500 index (black).
So what explains the current tight (inelastic) relationship between oil and the stock markets? Peak Oil? Slow growth? The wealth effect? Lack of easy credit? Something outside America's control?
Calls for fiscal policy change have arisen in the US - for both spending cuts and tax increases. A so called fiscal cliff will be enacted at the beginning of 2013 whereby some spending is reduced and some tax revenue increased. The recent recession has created a large budget deficit, bringing gross federal debt to $16 trillion with a net federal debt of $11 trillion (non-intragovernmental).
Quarterly yearly change in US federal debt held by the public (blue) and the monthly unemployment rate (red).
During recessions, when GDP growth decreases and unemployment increases, tax revenue decreases and unemployment insurance increase (as well as other welfare spending). The combination of declining revenue and rising spending on such a short time scale can only be funded by issuing debt to the public (investors, foreign governments, etc).
Annual federal budget surplus or deficit (blue) and the monthly unemployment rate (red).
Since the early-1970s, the US has run some very large non-wartime budget deficits. The budget surpluses of the late-1990s almost seem like a fluke - perhaps the culmination of a secular bull market in stocks from 1982 to 2000. Since the end of the secular bull market, we have now gone into a secular bear market. In the late-1990s, an unprecedented increase in housing market prices began; the housing bubble deflated in the mid-2000s, and the government has been running a large deficit since.
Various orders of economic cycles at work. Unemployment data at FRED goes back to 1948; the unemployment rate in 1934 was about 22%.
Spain
The situation in Spain, where a real estate bubble has formed a very large economic imbalance, is experiencing a similar yet harsher situation compared to the US. Spain and other fiscally troubled countries have been told they must cut spending from their budgets. The austerity measures have thus far lead toward sky-rocketing unemployment while the European Debt Racket seeks to impose its will. Spain is stuck in a Catch-22 in which its fiscal policy becomes a type of end-all-be-all solution while in either case (remaining in the Euro or exiting) real estate must go down, employment must increase and real income must grow.
Spain's neighbors think that by adjusting Spain's budget deficit to 5% of GDP somehow everything will be fine again.
No stranger to high-unemployment, Spain's unemployment rate is now rising above 25%, and welfare is now a major transgenerational benefit. The unemployed youth, victims of the post real estate bubble, are relying upon family household wealth and family income to support themselves, often in the form of government welfare. The high unemployment rates Spain felt in the 1990s are now being cast into a greater long-term structural problem - as real estate prices decline so too will household net worth.
The combination of falling real estate prices and high unemployment will have the effect of driving down labor costs in Spain - recently passed by Australia as the 12th largest world economy. This phenomena is happening in other Euro countries. For Germany, the looming prospect of slower-than-expected growth in China and contracted purchasing power in their Euro neighbors has already driven down factory production outlook - a likely indicator of increasing unemployment.
Compare and Contrast
Fiscal restraint is needed in Spain but that can only happen when unemployment rates decline. What needs to unwind in both Spain and the US (and throughout much of the world) is inflation disparity. As real estate prices rise, people are priced out of the market, and they transfer a greater share of their income to pay rent or mortgage. In the long-term, only an increase in income or decline in real estate value can resolve such a disparity.
When inflation lead GDP growth and real estate prices greatly outpace the growth in real income the consumer becomes overleveraged. In order to pay for the deficit, as a result of this imbalance, the US has run a carry trade amongst interest rates. To run the carry trade, short-term rates are lowered relative to long-term rates. Therefore, the short-term debt is rolled over at the expense of passing interest along to the long-term debt (which pays the yield).
The carry trade has been most pronounced since the early-1990s recession.
In Spain, this past summer, interest rates on 2-year and 10-year bonds rose. How much longer can Spain pass along interest payments while unemployment continues to increase?
The great convergence, at the heart of the matter many countries benefited from the "artificially" low interest rates under the one exchange rate mechanism (essentially a currency peg). Since problems in the economy cannot be corrected with exchange rates they must be corrected with taking on unsustainable debt. Germany (blue), France (purple), Euro are (orange), Italy (green) and Spain (red).
