Meet the next bus that is bearing down on the Gulf Coast. Her name is Wilma. and
She is tropical storm #21 in the Atlantic's northern basin, for the year 2005. And she may be the final blow to Rove's Republic.
When I first started blogging on Atlantic storm information on
July 4th people thought it was unusual, perhaps I am just a storm fan, they thought, "he's an economics geek, not a weather geek." For extreme weather fans, following 2005 has been like following the great home run derby in baseball - records that had been set by Babe Ruth were being shattered by modern players. For extreme weather fans, the golden season was 1933 - which had the most tropical storms on record. But that wasn't the case when I started watching this, it was strictly business.
(This chart is the number of days into the season that a particular storm number formed earlier than the previous earliest storm for that number. So Wilma formed 30 days earlier than storm #21 in 1933.)
I remembered the lesson of Ivan - and of the 1970's - namely that the oil infrastructure of the United States is vulnerable to storms, Ivan shaved about .05% off of US growth last year - and that in a time of a demand shock, it is the supply shock that exposes the problems in the system. The forecasting information which I had, and the equations of Hermann von Schelling, told me that there were a series of probable hurricane paths that swung across the gulf coast. A hurricane is, in effect, a giant exercise in brownian motion.
I reasoned that a major hurricane could shut in production. The total production of the gulf is roughly equal to the total production in Iraq. Between George's little exercise in gun nut diplomacy, and a major storm, there would be zero spare barrels of world capacity. The result, a spike in crude prices. But worse still, the Gulf also has the bulk of our refinery capacity. This would mean a spike in gasoline prices - the place where Americans actually guage the raw price of commodities.
Hence, it became imperative to follow the Atlantic Tropical storm season, and peripherally the Eastern Pacific Basin. I will leave it to meteorologists to explain the details of why this second part is so is so. Suffice it to say, what I saw was mother nature bowling with oil rigs and refiners as the pins, and tropical storms as the ball.
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The reality of Reagonomics and its successors is that they have been a policy, first of burning through savings, then burning through credit, and successively carrying less and less insurance on the whole economy. That is effectively what a liberal government is - a vast insurance company, which converts the national advantage of infinite time arbitrage and recapture transperancy into the ability to spread risk. The government is the buyer, seller, borrower, lender and insurer of last resort. The analogy is similar to the kernel in UN*X - sooner or later, you must talk to a single tasking process that makes decisions about how to balance competing demands for resources.
America, rather than distributing refinery capacity, allowed it to concentrate, this was not a decision that was, in its context, foolish. Allowing more refinery capacity would have lowered the price of gasoline, which would have made it cheaper, and therefore even more people would buy it. Refinery capacity being kept at the knife edge was better for both refiners, and for a government that had to carefully balance the stimulitve effect of low gasoline prices, with the costs of importing petroleum.
Economically, when the marginal profitability of a refinery gets to zero, the market should stop, however, using game theory, one finds that suboptimal numbers of refineries will be built, as competitors try and drive each other out of business. The other point of stability however, given the cost of building refineries, is with somewhat too few refineries. This is because a refinery is expensive and takes time to build. If one competitor tries to build another refinery to get more of the market, the others can start one too - the time that the new refinery will give a competitor an advantage is just about zero, because the "fast followers" can hurry theirs up by spending only a little more money. Hence, no one starts one, it is the business equivalent of a Mexican stand-off. A competitor that could surprise others by building a new refinery could under-cut the others, but it would not be able to do so for long enough to make the refinery worth it. It could not "recapture" the investment.
The government could have changed the situation, but the government had no reason to interfer in this stability. Refiners weren't making huge profits, and the stand off acted as a stealth gas tax, which slightly counter-balanced the massive gas subsidies that are weak environmental laws and the US military.
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Now however, the situation is reverse - the other reason to allow overcapacity in a market, according to typical economic theory - is that it acts as a cushion in case of larger swings in demand. If a shortage is unacceptably expensive, it is worth having too much capacity as insurance against this. This too is an effect the government can encourage - it can subsidize an industry on the belief that in crisis - let's say war time - there would be no interuption of supply. Whether a particular industry - like sugar - is worth this is another question.
The US did not allow over capacity in refining, and in fact, as outlined, allowed a bit of under capacity. This is why economists run around talking about the "core rate of inflation" being the rate without energy and food. These are expected to go through an annual dance, where supply squeezes and demand spikes occur, but can be ignored so long as they don't "pass through". Conservative economic theory believes that it is inflationary expectations that are dangerous - that is, when people and businesses start to act as if there is going to be more and more inflation. Since "disinflation" is the lowering rate of inflation, I will coin the term "proflation" as the rising rate of inflation. Expectations of proflation, based on the work of Prescott are a core part of what makes the "business cycle" occur.
That is, it isn't really the increase in costs that are a problem, it is when people decide that costs are going to increase, and they increase costs to others in expectation of them. That is, people raising prices in response to higher prices doesn't produce problematic levels of inflation - since the market will adjust to these - but instead, the problematic point is when people raise the spread between price pressures on them, and price pressures that they put on others.
I'm not in agreement with this model, so I won't spin out the implications. Because in this model the current spike in energy prices is unproblematic - until wages and interest rates, the macro-economic drivers - being to reflect them, rather than simply seeing redistribution between demand. The reason people like Larry Kudlow are untroubled by rises in energy prices is that, until very recently, neither wages nor interest rates seemed to reflect rising proflationary expectations on the part of either the labor or bond markets. Hence, until recently inflation seemed tame, until recently. You see, you can only argue that a rate is core, if the parts that bounce around center around that core rate, if energy is going up above "core" inflation for a long time, then it is no longer the core rate of inflation. As of now, energy is the core rate of inflation, and the low rate of increase in manufactured goods represents a large deflationary pressure.
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Instead I am going to argue that there is a mesoeconomic effect which is important. Namely, that there is a structural relationship between the price of energy and the money supply. The money supply is based on the assets we have on the books of banks. A bank can use fractional reserve money to lend out more money if what is is lending to buy is enough to cover the loan, and it has enough currency on hand to meet needs. The Federal Reserve regulates this process by auditing banks, setting the level of reserves required, and by setting the cost of currency to the bank - this is the overnight and discount rate. I will leave aside how these effect the way the bank lends in detail, because they aren't crucial to what is going on here.
Suffice it to say that the more land is worth, the more what is built on that land can be worth. The more of these hard assets there are, the more money can be in the money supply. This, once upon a time, was a major revolution in economic thinking - it effectively made the money supply linked to the market capitalization of tangible assets. This meant the amount of currency could expand to the market value of assets. This was the problem that killed the gold standard - there was, at a certain point, no organic relationship between how much of the dead metal one could pull out of the ground, and the rate at which wealth was created. In the early 1920's several governments tried to unlink the two - the hyper-inflation of the Weimar German Republic, combined with the post-world war I inflation convinced almost everyone that this was the worst idea possible. Thus in the late 1920's, when the disconnect was even more extreme it forced governments to choose between keeping currency linked to the amount of gold, and blocking any expectations that money would buy less and less of it - or allowing currency to increase. Government after government put the screws in to keep gold linked to currency. When the US did, that was the final hammer blow. Money supply contracted dramatically, there was no longer enough currency to float the economy - and a death spiral of deflation began.
Dirt money is now as obsolete, because, like the gold economy of the late 19th and early 20th century, there is a problem. We can build more factories, employ more people and build more things than we can dig oil out of the ground. Now oil still limits the economy in a more direct way than gold did, but it is now out of sync with the rate we can create value. Government after government is now facing a stark choice: it can make it so that money continues to be a constant claim on future energy supply, or it can unhinge the currency. The US tried to unhinge the dollar, and for a while it seemed to work, the dollar devalued, and the only thing that really happened was that US budget deficits ballooned and the price of energy spiked up. But it seemed, as with the first parts of unhinging currency in the 1920's, as if the relationship between money and money basis was not as tight as at first appeared.
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For a diary that led with Wilma, I haven't talked much about storms. Now it is time to turn that corner. The relationship between energy and money supply is this. Energy buys three things: the ability to produce, the ability to maintain, and the ability to expand. The first is very micro-economically elastic. Energy prices go up, and there is an immediate move to find substitutes or save energy. The price of surfactants has gone up with petroleum, and business are quickly using other kinds of oils instead. The second is how we maintain our houses. A television without electricity is not as useful. Increasing energy prices are fairly elastic there too: people drive less, run lights less, use less heating. Higher prices squeeze the fat out of the system.
However there is one place where this is inelastic - the ability to maintain the home or center of business itself. One can lower the thermostat to 68 in the winter, or even 65. But one can't move out of the home itself, or simply shutter the restaurant. One must keep those, even if they are losing money, in order to keep ones place in the economy. Abandonment means facing the barrier to entry costs all over again.
What this means is that if gasoline prices went up, while the US consumer could pull back a little bit, largely he had to pay and pay for higher prices. I call this effect "the black gold window", it is the means by which market players can cash in their dollars, as gold was under Bretton Woods. The neo-Bretton order has linked the dollar to oil, and now large investors are realzing is better to invest in the fall of the dollar, than in the rise of American industry. We don't have proflation, we have, instead, a bet on continued industrial deflation - falling prices for manufactured goods and intellectual capital, which is what the US produces.
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The storms exposed this, with no spare capacity, there is, in effect, no competition. No supplier has any reason to lower his prices by very much, because he can sell all he has at high prices. Profits for energy companies have spiked over the last few years, and now they seem set to go up more. Had the US invested in a more energy dense economy in the 1980's, or had we invested in a more robust energy infrastructure in the 1990's - we wouldn't be here. We'd have other problems, but not these.
The inexcusable trade-off, however, was to build an economy which was very dependent on cheap gasoline both to increase the money supply, and contain inflation, and then not protect the supply of gasoline from forseeable spikes in energy prices. Over the course of the 20th century there had been three very large energy price disequilibriums - post-World War I, pre-World War II and in the last phases of the Cold-War. Thus, a prudent planner would realize that an energy supply or demand squeeze occurs roughly every 20 to 35 years, and should be built into the cost of doing business. While the cause isn't forseeable, the results of a prolonged squeeze are unpleasant. Even if there isn't a war, it can knock 1% off of GDP for a decade.
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Which brings us to Katrina, Rita and possibly Wilma. The Gulf of Mexico is the gut of America's petroleum system. These storms have roared straight into it, knocking out current production, refinery capacity - and exploration. The reason our dear President finally got serious about conservation is that while Katrina hit this year - Rita knocked out exploratory rigs, meaning that production is going to be dinged for a longer time. As the above discussion shows, the consumer has to keep paying. This has exacerbated the bloat of petro-dollars, dollars piling up from petroleum profits.
This year was slated to happen eventually. While the Republicans are going to go around blaming the storms, the reality is that they have left a floor filled with bannana peels. This is the year they finally slipped on one.
If Wilma merely reshuts in the capacity that has been brought back on line in the last few weeks, it will mean a spike back over $3/gallon for gasoline prices, even though demand is continuing on its usual fall reduction as Americans stop driving for vacation. It will mean that heating prices will spike, and with them consumer electricity prices, which are based on the trade off between natural gas for heat, and natural gas for electricity.
This will be the final blow for an economy already tottering on recession. The Federal Reserve cannot lower interest rates, because of the rising proflationary expectations they see in the interest rate markets - earlier many of us were talking about a flattened yield curve, and that yield curve has started to unflatten, but that isn't buying Alan any breathing room, instead, it is forcing him to keep raising interest rates.
We could still get lucky, projections this far out are fickle, the Gulf isn't as warm and wet as it was earlier, and the fall regime is settling over upper level winds. But it is possible.
WILMA DROVE SOUTHWARD OVERNIGHT BUT A WESTWARD COMPONENT SEEMS TO
HAVE RETURNED...AND THE INITIAL MOTION IS ESTIMATED TO BE 235/4.
MODEL GUIDANCE HAS BEEN EXTRAORDINARILY INCONSISTENT FROM RUN TO
RUN AND THERE IS PRESENTLY A HUGE SPREAD IN THE GUIDANCE. WHAT IS
MOST PUZZLING IS THAT THE MODELS THAT BEST ANTICIPATED THE
SOUTHWARD MOTION OVERNIGHT...THE GFDL AND THE GFS...ARE WAY OUT
THERE ON THE EASTERN EDGE OF THE GUIDANCE ENVELOPE WITH A TRACK
OVER WESTERN CUBA AND INTO THE EXTREME SOUTHEASTERN GULF OF MEXICO.
THE UKMET...NOGAPS...AND ECMWF TAKE WILMA INTO VARIOUS PARTS OF THE
YUCATAN PENINSULA. THERE ARE IMPORTANT DIFFERENCES IN THE AMOUNT
OF MID-LEVEL RIDGING OVER THE WESTERN GULF OF MEXICO IN THESE
MODELS THAT IS AFFECTING THE ABILITY OF WILMA TO CONNECT WITH THE
WESTERLIES NEAR THE END OF THE FORECAST PERIOD. WHILE IT IS
TEMPTING TO ADJUST THE TRACK TO THE RIGHT BASED ON THE RECENT
CHANGES WITH THE GFS AND GFDL MODELS...THE FACT THAT THE 6Z RUNS OF
BOTH MODELS WERE INITIALIZED A BIT TOO FAR NORTH MAY MEAN THAT THEY
ARE TOO FAST WITH THE RECURVATURE SCENARIO. FOR NOW...I HAVE MADE
LITTLE CHANGE TO THE OFFICIAL FORECAST. CLEARLY...CONFIDENCE AT
THE LONGER RANGES IS UNUSUALLY LOW. WHILE THE SOUTHWARD MOTION
OVERNIGHT NOW REQUIRES A TROPICAL STORM WARNING FOR
HONDURAS...GIVEN THE UNCERTAINTIES IN TRACK AS WELL AS THE SIZE OF
THE CYCLONIC ENVELOPE...IT IS A LITTLE PREMATURE TO LOWER THE WATCH
AND WARNING FOR THE CAYMAN ISLANDS.
Or in otherwords, this storm could splay off in several different directions, and the models have not been good at predicting motion. This is typical early in a tropical cyclone's life span. Which is why alarm should be out, but watchfulness should be in.
And what is more, it is likely. Even if nothing happens, this will lead to a spike in crude and gasoline futures, which will nick the economy one more time. Even if Wilma is just Ivan level trouble, that is straight to the economy's bottom line. This is the year of storms.
The topic for another day is why many of the slogans being tossed around - such as "energy independence" would not do anything about the problems we face at all - in fact, an "energy independent America" would have been more, not less, vulnerable to what has happened with storms.