Monday, August 27, 2012

Will Greece Blow Up Before Election Day?

Samaras now has two to three weeks left to put together an austerity package worth about €14 billion ($17.5 billion) for the next two years. But politicians in Berlin and Brussels doubt whether his new course will produce results quickly enough.
The troika will spend the entire month of September auditing the books in Athens. Meanwhile, staff at the European Council in Brussels are assuming that the summit of European Union leaders on Oct. 18-19 will be a showdown over Greece.
The IMF is taking a particularly hard line in the negotiations. The fund's envoys feel that Greece's debts are not sustainable and are threatening to withdraw from the aid program altogether. The only alternative is for the public creditors, in particular the European Central Bank (ECB), to write off a portion of Greece's debt.
The German government faces a dilemma. Chancellor Angela Merkel had made IMF participation a condition of any Greek bailout, but if public-sector creditors agreed to a debt haircut, it would cost Germany many billions of euros.
For Merkel, that is out of the question, as is a third aid package or extending the current program by two years, as Samaras has requested. Both of the latter two options would cost additional money, and that, the chancellor fears, is something members of her own party and its coalition partners would refuse to support in the Bundestag. The scenario of a Greek withdrawal from the euro is looming.
--Der Spiegel, Aug. 27th, 2012

Once again, we are invited to witness another Greek cliff-hanger: Will Athens be bailed out (again), or will she default? The financial media are filled with speculation that, this time, Greece will be cut off. This is understandable, given that Greece has failed to implement any of the austerity or reform measures that she has repeatedly agreed to.

Germany's economy minister has rejected calls for Greece to get more time to implement economic reforms, saying that Athens needs to respect the bailout deal reached with its international creditors. "What the Greeks have asked for, half a year or two years, that's not doable," said Roesler, who is also the vice chancellor in Angela Merkel's coalition government. He added that "time is always money" and all parties had agreed that additional funds for Greece weren't up for debate. (AP, 8/27/12)

There is a lot of pressure on Merkel to toss the Greeks out. The Dutch and Finns are angry and making dire noises. Elements of Merkel’s coalition are hostile to rewarding Greek defiance. Merkel’s own finance minister said last week:
"More time generally means more money, and that very soon means a new bailout programme. That would not be the right way to solve the fundamental problems of the euro zone." 

The Finns, Dutch and Germans are all saying no more money for Greece. They appear to be trying to psych themselves up for giving Greece the old sayonara.

But I will make a bold prediction: Greece will be bailed out and won’t get thrown out of the eurozone in October. This is because I can’t imagine that Europe will want to have to deal with a Greek crisis in the middle of the Spanish crisis. And also, as I have said before, because the potential ramifications of a Greek default are unknown, Grexit is still a potential catastrophe. To let Greece go now would be very risky. The cost of keeping Greece on life support would be cheaper and safer.

But, assuming I am right,  how can Europe manage to reposition Greece’s total failure as a success story? That is what Merkel and Hollande must have on their minds right now.

The party line right now is that Europe will decide nothing until the Troika makes its report in October and the ruling circles have a chance to look at what the Troika says.

So, if Europe wants to prevent (postpone) a Greek explosion, at what point in the process should it intervene in order to ensure the right outcome?  The obvious thing to do would be to fix the Troika and ensure that its report will say that Greece is making progress and will succeed if given more time and money (don’t laugh). That might solve the problem, but can they fix the Troika?

The Troika consists of the European Commission, the ECB and the IMF. The fix will be in at EC and the ECB and they will happily go along. But the IMF is harder to influence and is by no means a European stooge. The French head of the IMF will want to play ball, but can she control her team? She can certainly send signals, but it would be risky to leave any fingerprints.

In March, Lagarde said:
“The combination of ambitious and broad policy efforts by Greece, and substantial and long-term financial contributions by the official and private sectors, will create the space needed to secure improvements in debt sustainability and competitiveness. These actions, together with a significant strengthening of the financial sector, will pave the way for a gradual resumption of economic growth.”
So I think we know where she stands, but we don’t know if she can control her team.

The Troika’s most recent statement on Greece (Aug. 5th) was somewhat noncommittal, but not negative:

Staff teams from the European Commission (EC), European Central Bank (ECB) and International Monetary Fund (IMF) concluded today a visit to Greece to discuss with the new authorities the economic policies needed to restore growth and competitiveness, secure a sustainable fiscal position, and underpin confidence in the financial system in line with the objectives of the economic adjustment program that is being supported by the three institutions. The discussions on the implementation of the program were productive and there was overall agreement on the need to strengthen policy efforts to achieve its objectives. The Greek authorities are committed to proceeding with determination in their work over the next month, and the EC/ECB/IMF staff teams expect to return to Athens in early September to continue the discussions.

I predict that we will see similar meaningless mush from the Troika in October. It will issue a “balanced” statement, expressing dissatisfaction with Greece’s progress, but leaving open the option of providing Greece with more time, which is what Europe wants to hear.*

If the Troika report is negative and can’t be persuaded otherwise, then its report would have to be buried or misread, but that would be awkward and undesirable. Remember also that the IMF has to look over its shoulder at its largest shareholder, the U.S. Congress, which loathes the IMF and seeks to prevent more European bailouts.
Since October is the American campaign season, and because Obama certainly doesn’t want a Greek crisis before the election, I think that the fudge will go through. Greece will be given more time, along with more faux-serious “benchmarks” which will also have to be fudged in due course. The objective is not to fix Greece, but to postpone it.

If my prediction turns out to be wrong, then I would reiterate that a Greek exit is a Black Swan, and not to be taken lightly. If Greece exits before election day, bad news for Obama. But I just don’t see it happening.

Wash. Post, 10 Sept.:

By some estimates, Greece needs another €20 to €30 billion to stay afloat (at least for now). So how could the troika rationalize giving Greece even more aid? By massaging a few key numbers:
The troika could thus certify that the Greeks have made progress. According to this scenario, the inevitable financing gaps would be downplayed as a regrettable but merely temporary departure from the plan — and one that must be coped with as part of the current second rescue program. After all, the shortfalls cannot be too great, or a third rescue program might be necessary.
Christine Lagarde, head of the IMF, has already signaled some willingness to be flexible. “The IMF never leaves the negotiating table,” she said last month, adding that Greek efforts to curb deficits since 2009 were “impressive.” Now it sounds like Merkel, too, is ready to be a bit more accommodating. The tricky part, for Merkel, is selling this to German voters.

Saturday, August 25, 2012

Gold: The Republican Death Wish

The libertarian (Ron Paul) wing of the Republican party desires a complete rethink of US monetary policy, and has succeeded in having a monetary commission added to the GOP platform. It is worthwhile examining their policy proposals on the remote chance that they could get some traction.

Among their monetary wish list are:
1. Abolition of the central bank.
2. An end to fiat money and a return to a metallic monetary standard.
3. Liberalization and privatization of currency issuance.

It should be noted that these are not wild and crazy ideas from outer space. The US functioned under similar systems at various times in history:
1. The US was on the gold standard, in various forms and with occasional interruptions, from 1789 until 1971.
2. The US abolished its central bank in 1836 and did not revive it until 1914.
3. Any licensed bank was able to print paper currency (redeemable in specie) from 1789 until 1862.

This shows that these “wild-eyed” ideas have been tried before with reasonable success. The US did exceedingly well under these pre-modern monetary arrangements, experiencing rapid growth with no inflation (that’s right: the price level did not rise from 1789 until 1933). On the other hand, the US experienced wild swings in the business cycle with depressions occurring in every decade. Some of these depressions were as bad as the Great Depression, which was itself caused by the gold standard.

Maybe these periodic depressions of the 19th and 20th centuries were a healthy form of creative destruction. Maybe foreclosed farms and mass unemployment are more efficient than modern socialism and “full employment” policies. That could be. But such periodic depressions were politically unpopular then, and are likely to be now. Americans today think that 10% unemployment is intolerable; they may lack the fortitude to accept 25% unemployment for a few years.

The libertarian philosophy is at heart anti-statist, and does not accept the idea that the monetary system should be or needs to be controlled by the state. Libertarians believe that central banks manipulate prices, cause swings in the business cycle and manufacture inflation, all of which they believe could be resolved by a return to a metallic standard. Also, if the currency is understood in terms of its value in gold, there is no reason why private enterprises could not issue gold coins or paper money backed by bullion. The government would get out of the money business entirely.

As I have observed previously, all the world’s problems can be attributed to hard money policies, and gold is the hardest policy of them all. The libertarian monetary proposals are a prescription for disaster on a scale that we can’t even imagine. I also believe that such policies would do to the GOP what they did to the GOP eighty years ago, and as a God-fearing Republican, I don’t want another twenty years in the wilderness.

History shows that Man learns from experience. The American people have paid a heavy price to learn the following:
1. Soft money is more conducive to economic stability than hard money.
2. The gold standard is inherently unstable and is constantly tested by speculators and foreign central banks.
3. Hard money requires periodic depressions to remain “credible”.
4. The money supply should be controlled by a wise and independent central bank with the dual mandates of low inflation and maximum employment.
5. Wildcat currency printing leads to currency chaos. (Do we really have to relearn that particular chestnut?)
6. Hard money requires flexible nominal wages and incomes, which only exist in Fantasyland and Hong Kong.

However, instead of a lengthy examination of each of the libertarian proposals, let’s examine their central desire: the gold standard.

An ounce of gold is currently worth roughly $1700. To go on gold, Congress would have to pass a law which fixes that price in perpetuity, and provides that no other objectives are to be considered by the monetary authority.

To maintain that fixed price, the Fed/Treasury would have to:
1. Acquire enough gold to credibly “back” the currency (at least 40% of notes in circulation, but probably a lot more). This would be expensive and would add to the national debt.
2. Stand ready at the gold window to exchange gold for money and money for gold at the fixed price in unlimited quantities at any time.
3. Be prepared to stem a run on the dollar (a “gold drain”) by raising dollar interest rates and reducing the dollar money supply until market actors are induced to buy dollars with gold at the fixed price, even if that requires a major and prolonged deflation/depression.
4. In emergencies, be prepared to borrow in foreign currency in order to buy gold to meet the market’s demands for redemption in gold. (With fiat money, the US never has to borrow in foreign currency.)
5. Subordinate (i.e., completely ignore) all other monetary objectives except the gold price; no more employment mandate.

By adopting the gold standard, the US would surrender monetary sovereignty and would lose all control over monetary policy. It wouldn’t matter who was the Fed chairman, or who sat on the FOMC, since they would have no discretion. The only monetary matters to be discussed would be the techniques to be used to maintain the $1700 price. The foreign exchange value of the dollar would be almost completely outside of the government’s control; only the price of gold would be stable. Politicians would no longer be able to criticize the Fed or its policies, because they would be set by law. The president would have little reason to talk to the Fed chairman since there would be nothing to talk about, even if there were 25% unemployment, because the US was on the gold standard by law.

The gold standard cannot operate if it is not 100% credible. Imagine that Zimbabwe declared tomorrow that henceforth the value of the Z$ would be fixed at one ounce of gold, and that the Reserve Bank of Zimbabwe stood ready to exchange gold at that price for unlimited quantities of Z$. If I gave you a suitcase with Z$10 million, would you keep it in your safe, or jump onto the next flight to Harare to exchange it for 10 million ounces of gold before they run out?

If a country’s gold price is believed to be immovable, markets will know better than to speculate against it, because the speculator will always lose. To build the standard’s credibility, the country must be able to demonstrate that it won’t cut and run at the first sign of distress. An example of this is the HKMA which has pegged the HK$ to the US$ for the past thirty years. No one has ever made a penny speculating against the peg, even when the HK economy was under considerable stress. The HKMA can impose periodic deflations because HK is not a democracy.

The less credible the gold peg, the more the nation must be prepared to suffer to demonstrate the peg’s credibility. When the UK pegged sterling to the DM in 1992, all it took was for George Soros to appear on the horizon for the government to panic and devalue. When the UK was forced off gold in 1931, the betrayal of a sacred compact with millions of people, many people felt that it was the end of civilization. That’s how hard a peg has to be; almost if not literally a constitutional amendment.

So, it’s 2018, Romney is still president, and the US is irrevocably on gold at $1700 by law and by constitutional amendment. The Balanced Budget Amendment is in force, and unemployment has risen to 14%. The US has asked for a “gentlemen’s agreement” that foreign central banks won’t present dollars for gold, but the ECB insists on redeeming $100B in gold because it is “rebalancing its international reserves”. By surrendering $100B worth of bullion, the dollar’s gold cover falls below its statutory minimum and the US experiences a “gold crisis”.

Despite the high unemployment rate, the Fed raises the funds rate to 17%, hoping to attract gold. However, at that moment, Vice President Ryan off-handedly questions the gold standard in a TV interview, causing a global dollar run. The Fed must now act decisively to stem the run and to prove its credibility and fortitude. The funds rate is raised to 21% with guidance indicating that it is expected to remain at that level for one year. GM and Ford go bankrupt and liquidate; GE requires an emergency loan from the Federal Recovery Board; and unemployment hits 19%. President Romney declares a Temporary National Emergency, and announces a “Voluntary Wage Reduction Plan”,  calling on employers to reduce wages in lieu of layoffs. Federal salaries are cut by 15%.

I don’t need to go on, because we’ve been there before, under President Hoover. The above scenario ends with the next (Democratic) president raising the price of gold by executive order and “suspending” convertibility for an indefinite period.

My point is that a successful gold standard requires either a dictatorship or Finnish-like national cohesion, both of which America lacks. The American people have never taken kindly to a depression, and depression has always caused political and social turmoil (and a big lurch to the left).

The gold standard is not an experiment we need to try because we’ve already tried it. And it’s always been the Republicans who have tried it, and the Democrats who have fought against it (e.g., W.J. Bryan, FDR, Krugman). Just for the sake of the preservation of capitalism and free enterprise in one country, let’s not drive the bus over that cliff again!

An advantage of the gold standard is that, by removing the risk of inflation, it lowers the Treasury's borrowing cost to a level analogous to TIPS. However, to make such a promise credible, contractual gold clauses would have to be added to Treasuries such that they would be payable in gold. This means that overnight our $15 trillion of debt would be redenominated into gold. It could never be inflated away unless the gold clauses was broken (as they were in 1933). This would suggest that highly indebted countries should stick to fiat money unless they are prepared to repay their debts in blood (see: Greece).

Thursday, August 23, 2012

Europe's Problem Is A "Loss Of International Status"

The euro-zone crisis is eroding Europe's geopolitical influence and compromising the European Union's negotiating position in international circles, European Commissioner for Economic and Monetary Affairs Olli Rehn said.
"In political decision-making involving global economic matters, such as in the G-20 and the IMF, we have constantly been on the receiving end because of the debt crisis," Mr. Rehn told a gathering of Finnish ambassadors in Helsinki on Wednesday. "At this rate, Europe's status in the global economy is weakening ominously."
The European economic crisis is mostly a crisis of confidence, he said, and the region can regain the confidence of the global community by acting as a team. "We can best reinforce confidence by giving the picture of a united European team," Mr. Rehn said. "European decision-making should be a confidence-building team sport, otherwise it will not accomplish anything, nor will it bear fruit."
--WSJ, Aug. 23rd, 2012

So, Europe’s big problem at the moment is that its emissaries are not being treated with adequate respect at international meetings, and representing Europe abroad is becoming a bit embarrassing. The solution: Show more team spirit.

This is what occurs when politicians who do not understand economics confront economic problems. Jimmy Carter blamed his gasoline shortages on motorists driving too much; Gerald Ford fought inflationary monetary policies with a publicity campaign; Richard Nixon dealt with the oil embargo by declaring that his quest for energy independence was the “moral equivalent of war”.

Europe finds itself on the edge of a deflationary catastrophe;  might the solution be massive monetary reflation? No, the solution is confidence-building exercises and, of course, “more solidarity”, which will convince foreigners that Europe is on the ball and ready to roll, or something.

So we see before us the utter intellectual bankruptcy of Europe’s leadership. They are rain dancers who believe that, if they dance harder and more sincerely, it will surely rain. They don’t know which economic lever to pull.

Depressions are not caused by poor team spirit or by inadequate “solidarity”. Nor are they caused by economists who are skeptical of European monetary union. I was amused to read a recent article by an Irishman with impeccable European credentials which stated that: “A certain model of financial capitalism perceives the euro as a threat, and its adherents will do everything they can to bring about its demise.” What is this “certain model of finance capitalism”, who are its villainous  “adherents”, and what exactly are they doing to bring about the euro’s demise? I have no idea. The best way to bring about the euro’s demise is to tell the Europeans to keep on doing whatever they’ve been doing.

Right now, there are two schools of thought in Europe: the northern school, which preaches fiscal contraction and self-help; and the southern school, which preaches fiscal contraction and debt mutualization. Both schools are completely wrong. The former will quickly lead to breakup, default and chaos, while the latter will shrink the economic base while piling debt upon debt,  leading to a Japanese-style fiscal crisis.

The only solution left for the eurozone is to dissolve the debt mountain by inflating the size of the economy. How did Italy manage to stay afloat for the past sixty years? By printing enough lire to make sure that nominal GDP kept up with government debt; it wasn’t rocket science, and it worked.

When one listens for the voice of economic reason in Europe, there is silence.
Instead, Europe gets 1% nominal growth and 0% real growth, a recipe for disaster that no amount of team-building exercises can fix.

Wednesday, August 22, 2012

Europe Flinches At A Greek Default

ATHENS, Aug 22 (Reuters) - Eurogroup chief Jean-Claude Juncker kept alive Greek hopes of winning more time to push through austerity cuts but warned the country was staring at its "last chance" to avoid bankruptcy.
Mired in a fifth year of recession, Greece has been lobbying for two more years to hit budget targets promised under its second, 130-billion euro bailout from the European Union and International Monetary Fund.

Juncker said a decision to grant more time would depend on the findings of a review by EU and IMF lenders on the country's progress in fulfilling its pledges. He accompanied that with a warning to Greece to shore up its dire finances, saying the country's next tranche of aid would depend on it producing a credible strategy for austerity cuts. "As far as the immediate future is concerned the ball is in the Greek court," Juncker said. "In fact this is the last chance and Greek citizens have to know this."

Right now, two members of Club Med are calling Europe’s bluff.

Spain is refusing to apply for aid until it is told what conditions it will have to meet and how much aid it will get. Europe wants to offer loans from the EFSF and limited bond-buying by the ECB. Spain demands unlimited bond-buying in order to bring down its bond yields.

Because Spain is about as TBTF as you can get, Europe cannot allow her to default and Spain knows that. By threatening to default, Spain has leverage with Europe. Since ex ante we know that Spain is TBTF, we know that she won’t default and something will be worked out. Spain may even get what she is demanding.

Similarly, Greece continues to defy Europe in an in-your-face manner. Her long-standing negotiating strategy has been to agree to everything and then do nothing. This has expedited negotiations: the Troika presents its list of demands, Greece agrees, gets her money, and goes back to protesting austerity and calling the Germans nazis.
One might think that this game would run out, and that Europe would realize that Greece has not implemented any of the agreements to which she has agreed, in writing. (It’s touching the way the Germans think that having the Greeks sign the agreement makes it more binding.)

Well, Europe is quite aware that Greece has cut nothing, restructured nothing, laid off zero workers, collected no additional taxes, and has sold no state assets. Those things are hard to miss. But Europe, despite all of its confident bluster about a Greek exit being manageable, is afraid of a Greek default. They are worried that a Greek exit would be a black swan that would throw the eurozone into chaos. And so they prefer to paper over Greek defiance and pretend that everything is going according to plan.

Antonis Samaras, the Greek PM, is aware that Europe will tolerate almost anything to avoid a crisis. So, instead of saying “Because you have failed to comply with the agreed fiscal strategy, there will be no more money”, Europe says that the country's next tranche of aid will depend on Greece “producing a credible strategy for austerity cuts”. And then, of course, the big threat: “this is the last chance and Greek citizens have to know this." We first heard this recording played two years ago; we may hear it again in the future.

It is interesting that Dutch and Finnish officials seem much more angry at Greece than the Germans are. My guess is that this is because they are free to say what they really think, while Germany is thinking beyond its understandable anger. Germany knows that the fuse that lights in Athens leads ultimately to Paris.

Sunday, August 19, 2012

A Clinical Diagnosis Of The European Tragedy

Interviewer: We must stand together, because otherwise Europe has little chance against emerging giants like China and India.

Jean-Claude Juncker: We [Europe] are small, we are becoming weaker, we are also demographically weaker, and the only solution for the next 30 years will be that we as Europeans come increasingly closer together. We are few in number; if we stop integration, we will lose economic power, and when we no longer have this common currency, we will have absolutely no political significance. The Europeans are dwarfs. We must show the world something giant, and that’s the euro.
---Jean-Claude Juncker, president of the Euro Group, interview June 8th, 2012 (Luxembourg Government News)

For students of postwar European history, it should not come as a big surprise to learn that the rationale for European monetary union is political and not economic. The economic arguments were invented to justify the grand political scheme: One continent, one currency, one government, one state.

Europe, especially France, did not enjoy the spectacle of America's postwar hegemony, only made more galling by the collapse of the rival superpower. The US (with Britain) created the entire architecture of the postwar world: UN, NATO, IMF, IBRD, GATT/WTO, etc. The governance structure of NATO, the IMF and the World Bank are fashioned such that the US has effective control.

This may have made sense in a world in which the US accounted for half of world GDP, but less so now when the US produces less than 25% of world GDP. America's disproportionate power sticks in Europe's craw.

The European project was conceived as a way to restore Europe to its historical position as a central player in the Concert of Nations. The idea was fraught with political minefields: the power of a unified Germany, the awkward status of the former Soviet Union, the entanglements of NATO, the problems of continental governance, and the simultaneous desire for integration and national sovereignty, to name a few.

The EU is a political solution to a psychological need (France's great-power complex). This is particularly true when one considers that this would-be "world power" lacks an army, navy, air force, strategic weapons and a seat on the Security Council. Some of the EU members have these things, but Europe doesn’t.

Europe is a ill-conceived political organization with an improvised economic structure built around it. As Mr. Juncker said, its goal is to confront the world with something big in order to have political significance. So it is big, it does have a common currency, and yet it still lacks political significance. A regional discussion club which lacks both a foreign policy and a military cannot fulfill its role as a player on the world stage.

There is a second fallacy underlying the European project, and that is the mistaken notion that the larger the economic entity, the more prosperous it will be. “We will lose economic power”--what does that mean in any practical sense?

Some of the most prosperous and successful nations in the world are small, and some of the poorest and least successful countries are very large. Size and prosperity are uncorrelated. Switzerland does not wake up at night worrying about its global economic power.

Not only does membership in the eurozone convey no economic benefits, it comes with a steep economic price. Does anyone believe that Norway, Sweden, Denmark, the UK and Switzerland are disadvantaged by their non-membership in the eurozone? Indeed non-membership is a distinct advantage--and every one of the abstainers is still rated AAA, which is not a coincidence.

What does it mean to say that “Europe has little chance against rising giants like China and India”? Little chance to do what? Make things that people want to buy? Enjoy sound economic policies? How do the “emerging giants” threaten Europe, when what really threatens Europe is depression and a looming debt crisis, not some imaginary loss of competitiveness against large poor countries.

The European Project is a wooly-headed idea with no compelling political or economic rationale, which is threatening to condemn half of the continent to penury and intractable indebtedness. The idea that the “loss of political significance” is worse than a depression is not only fallacious, but also elitist. It is better that the people of Southern Europe have jobs and houses, than it is that “Europe” succeeds.

Saturday, August 18, 2012

Is A Big Oil Shock Coming This Fall?

An unnamed “decision-maker” – presumed to be Ehud Barak, the defence minister – told the Haaretz newspaper that Israel could not afford to wait for the US to act. “We need to look at the reality right now with total clarity,” he said. “Israel is strong and Israel is responsible, and Israel will do what it has to do.”
If so, the three months before the US presidential election in November provide the obvious window for an Israeli strike. The impression given is that the world may be a few weeks away from another war. As for the possible consequences, Israel’s outgoing civil defence minister says that any conflict would take place “on a number of fronts”, lasting for 30 days and costing about 500 Israeli lives.
--Daily Telegraph, Aug. 16th, 2012

Since 9/11 and the Lehman crisis, we have been advised to be on the lookout for economic “black swans”, meaning unexpected events of large magnitude*. One particular swan has been flapping around our heads with increasing urgency these days, namely the Israeli government’s hints that it intends to attack Iran this fall.

Without getting into motives and probabilities**, let’s assume that this will happen. Let’s also assume that a Gulf War III will close the Persian Gulf for a considerable period of time. Iran can keep the Gulf closed indefinitely, since marine insurers won’t cover war risks in a war zone. Iran herself can’t export under such a scenario, but that could be a secondary consideration in the eyes of an angry people.

As we know, the short-term demand curve for oil is price-inelastic, because the ratio of stored oil to daily consumption is low. The world economy is designed around the presumption that the oil pumps are on all the time; there are no readily-available inexpensive substitutes in the short-to-medium term. Therefore, in the event of another oil shock, the price mechanism would have to be used to bring oil consumption down by 25% almost immediately. The price of oil will be set at the margin by those who must have it, can’t produce it, and can afford it at any price. Bad news for the emerging markets, and really bad news for Greece.

How high would the oil price have to go to cut consumption by 25% overnight? High enough to force oil-dependent countries to ration electricity and gasoline. We’ve been there twice before in 1973-74 and again in 1979-80. Remember long lines to get gas at the pump?

This would be the world’s third oil shock, and its impact might be similar to the prior ones. In the seventies, central banks sought to cushion the shocks resulting in considerable inflation, then pulled back hard in 1980-82 causing high interest rates and a global recession in 1982-83.

An oil shock, possibly combined with the fiscal cliff or an explosion in the eurozone, would produce a sharp drop in aggregate demand, necessitating QE3 or QE4. The Fed would be hard-pressed to fully compensate for the decline in confidence and consumption. Europe would be hit even harder because it would start from a weaker position and it has a central bank asleep at the switch.

I find it hard to imagine that Gulf War III would be a brief and uneventful exercise. It would almost inevitably be a big event on the scale of the prior Gulf wars, maybe even bigger. These wars tend to escalate, and given the potential involvement of the Gulf states, this one could be the biggest of all. Also, Iran may prove a more formidable opponent than Iraq.

The risk of Gulf War III simply adds another event to the black swan list: (1) eurozone explosion; (2) the fiscal cliff; and now (3) another war. Let’s hope that all three don’t happen at once. If they do, I feel sorry for the guy who wins in November.
* Wikipedia: The black swan theory is a metaphor that describes an event that is a surprise, has a major impact, and after the fact is often inappropriately rationalized with the benefit of hindsight.
The theory was developed by Nassim Nicholas Taleb to explain:

  1. The disproportionate role of high-impact, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance and technology
  2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
  3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs