Bonds Liquidity Threat Is Revealed in Derivatives Explosion

The boom in fixed-income derivatives trading is exposing a hidden risk in debt markets around the world: the inability of investors to buy and sell bonds.

While futures trading of 10-year Treasuries is close to an all-time high, bond-market volume for some maturities has fallen a third in the past year. In Japan’s $9.6 trillion debt market, the benchmark note didn’t trade until midday on two days last week. As a lack of liquidity in Italy caused transaction costs in the world’s third-largest sovereign bond market to jump last month, Lombard Odier Asset Management helped propel an eightfold surge in Italian futures by relying more on derivatives.

The shift reflects an unintended consequence wrought by central banks, which have dropped interest rates close to zero and implemented policies such as buying debt to restore demand in economies crippled by the financial crisis. Inefficiencies in the $100 trillion market for bonds may make investors more vulnerable to losses when yields rise from historical lows.

“Liquidity is becoming a serious issue,” Grant Peterkin, a money manager at Lombard Odier, which oversees $48 billion, said in a June 11 telephone interview from Geneva. The worry is that when investors try to exit their positions, “there may be some kind of squeeze.”

That concern has caused investors to pour into derivatives, which are contracts based on underlying assets that can provide the same exposure without tying up as much capital.

Market Shift

As bond trading has slumped, the notional value of over-the-counter contracts soared fivefold in the past decade to a record $710 trillion, based on the latest data from the Bank for International Settlements compiled by Deutsche Bank AG.

The disparity has become more pronounced as at least two dozen nations dropped benchmark rates to 1 percent or less since the financial crisis, while the Federal Reserve, Bank of Japan and Bank of England sapped supply by purchasing trillions of dollars of debt in unprecedented stimulus programs.

It has also depressed yields and deprived traders of the volatility they need to profit from buying and selling bonds.

Yields globally have dropped by more than half in the past five years to an average 1.78 percent, while a gauge of implied yield fluctuations using options on Treasuries is now within 0.1 percentage point of an all-time low, according to index data compiled by Bank of America Corp.

At the same time, regulations designed to curb financial risk-taking such as the Volcker Rule and Basel III are limiting the flexibility banks have to facilitate trades for clients.

‘Least Welcome’

Dealers globally have slashed their bond inventories 75 percent since 2007. Five of the six biggest Wall Street firms reported declines in fixed-income trading revenue last quarter.

“That has to bite and prevent dealers from supplying the balance sheet they did in the old days,” Gregory Whiteley, who manages government debt at Los Angeles-based DoubleLine Capital LP, which oversees about $50 billion, said by telephone June 10. “It’s the sort of thing that rears its ugly head when it is least welcome -- when it’s the greatest problem.”

Some cracks emerged in Europe last month, when investors dumped Italian, Spanish and Greek debt on speculation political parties opposed to the European Union would gain seats in parliamentary elections and derail the euro area’s recovery.

As the selloff intensified and liquidity decreased, the disparity in yields of 10-year Italian bonds between buyers and sellers based on bids and offers doubled to 6 basis points, or 0.06 percentage point, on May 23, the highest this year.

Superficial Liquidity

To avoid being ensnared as transaction costs increased and trading shriveled, Lombard Odier’s Peterkin used futures contracts to wager on Italian notes rather than buying or selling the actual securities. He’s not alone.

Volume on Italian futures, which give buyers the right to purchase the nation’s debt at a future date and price, has soared more than 800 percent since trading of the contracts began in 2009, data compiled by Bloomberg show. By contrast, average daily trading in Italy’s $2.43 trillion market for government bonds, Europe’s largest, has tumbled 57 percent in the past decade, according to the Ministry of Finance.

Exchanges are seeking to capture the trend. NYSE Liffe, which was bought by Intercontinental Exchange Inc. in November, introduced new European government bond futures today including contracts for German, Italian, Spanish and Swiss debt.

No Trades

“During times of uncertainty, investors may find it harder to trade large orders when they want to,” Carl Norrey, the London-based head of non-liquid European government bond trading at JPMorgan Chase & Co., said by telephone on June 12. “Some of this liquidity may be more superficial than really deep.”

Trading in Japan, the world’s second-largest bond market, has virtually ground to a halt as the central bank gobbles up about 70 percent of the interest-bearing debt sold each month. On four days last week, the benchmark 10-year note opened late.

Bank of Japan Governor Haruhiko Kuroda said in parliament last month in response to a lawmaker’s question that while he isn’t concerned that trading is drying up in the Japanese government bond market, the central bank “will continue to watch developments in the market closely to keep it stable.”

There were no trades at all on April 14, the first time that happened since 2000. Since the end of January, yields on the bonds haven’t risen above 0.654 percent or dropped below 0.561 percent -- a band of less than 0.1 percentage point.

Even in the U.S., the world’s deepest and most-liquid government debt market with more than $12 trillion outstanding, buying and selling has decreased as derivatives have surged.

‘Global Phenomenon’

For 10-year note futures, a total of 140.4 million contracts have traded in the first five months of the year, approaching last year’s total of 149.8 million, the most on a year-to-date basis going back to 2007, according to CME Group Inc. Weekly trading of Treasuries with maturities between seven years and 11 years has fallen to $96.3 billion, a 32 percent drop from a year ago, data compiled by the New York Fed show.

“This is a global phenomenon,” Yvette Klevan, a fixed-income manager at Lazard Asset Management, which oversees about $170 billion, said by telephone on June 11.

The decline in liquidity will lead to greater stability as more investors buy and hold rather than focusing on short-term trading, said John Serocold, a London-based senior director for market practice and regulatory policy at the International Capital Market Association, an industry lobbying group.

Welcome Patience

“Bonds are increasingly owned by people who are explicitly more patient,” he said. “Isn’t that what governments said they want to achieve -- more long-term investors?”

The risk of any sharp selloff may also be tempered as the European Central Bank introduced a package of stimulus measures this month and Fed Chair Janet Yellen said in May that there will be “considerable time” before the bank raises rates.

Investors still have reasons to hedge their bets. Any sudden move, such as when 10-year yields soared almost 1.5 percentage points in eight months last year, risks magnifying losses as a drop in dealer liquidity makes it harder to exit, said Andrew Richman, the West Palm Beach, Florida-based director of fixed-income at SunTrust Bank’s private-wealth management unit, which advises on more than $100 billion in assets.

Yields on just about everything -- from sovereign bonds to junk-rated company debt -- are at or close to record lows and forecasters predict they will rise as the U.S. economy regains momentum and the Fed moves to end its bond purchases.

Based on the median response in a Bloomberg survey of 75 economists and strategists, yields on 10-year notes, the benchmark for trillions of dollars of debt worldwide, will end the year at 3.07 percent from 2.6 percent at 10:09 a.m. in New York today.

“There is risk that people won’t be prepared,” Richman said by telephone June 9. “The move in yield could be quicker and more dramatic than it has in the past. That’s something we are on the lookout for.”

Source 

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Yahoo Shock: Markets Are Rigged, Yet Can Be Profitable

The stock market is rigged and here's how individuals can play it ... The stock market is rigged and always has been says Heidi Moore, the U.S. economics and finance editor at The Guardian. That's why many investors are staying clear of stocks even though U.S. markets are trading at all-time highs. An April Bankrate.com survey found that 73% of investors are "not more inclined to invest in stocks" -- the third consecutive year of negative investor sentiment. "Once you wake up to how screwed up the stock market really is, the financial industry knows you're likely to get very nervous and take your money out," Moore writes in a recent column. "It's time to break down the polite fiction that investing in the stock market is something that sane, rational, sensible people do. It is a high-risk contact sport for your money. If you know that, you're ahead of the game." – Yahoo Finance

Dominant Social Theme: Wall Street is one tough game.

Free-Market Analysis: This article makes points that we have made in the past about the "Wall Street Party" and how equity markets have been positioned for higher-highs.

Specifically, this article refers to "high-frequency trading," but in fact, market rigging is an ancient tale. Modern stock market manipulation took root after the Civil War when various kinds of federal centralizations became more feasible.

We've covered that history many times and offered various investment solutions. The article, too, has a solution:

Hope is not completely lost; Moore says last week's Senate hearings on high-frequency trading suggest that Congress may pursue legislation that curbs the advantages these computers have. In the meantime, it's best for investors to have a small footprint in the market, she argues.

"Regular investors should not believe the market is a store of value," she explains. "It's not a bank. It can bring you great returns if you're in something safe like an index fund. Just don't trade stocks day by day."

Actually, there are two solutions here: 1. Be cautious about allocations to equities and 2. invest in something "safe" like an index fund.

Well ... we're not sure about that.

Ask people how "safe" the market was in 2009 when – in the US anyway – equities lost up to half their value or more. Now, that may have been a "black swan" event, destined not to happen again for quite awhile but, in fact, that would NOT be our position. We do believe, based on many events enumerated here in the past, that markets are indeed being pushed up and are going to move down hard once the support is no longer sustainable.

In the past, our viewpoint would have been called a "conspiracy theory" but today, as it is with so much else, the mainstream media is catching up with our perspectives. Yes, of course, the "US stock market is rigged."

But as usual, the Guardian only gets it half right ... or less. The idea is that most of the "rigging" comes from high-speed trading and therefore if one legislates against high-speed trading the "rigging" will be reduced.

In fact, legislation is not the answer to stock market rigging. Legislation, regulation, laws generally are a form of price-fixing. This is hard for a lawyer to understand, steeped in the history of law and judicial promulgations. But in fact, economics and law are increasingly at loggerheads.

What economics shows us to be true, the law ignores, even though reality illustrates the predictive nature of free-market economics. And now we see as before that the US Congress is contemplating more regulation to counteract the effects of previous efforts.

It is market centralization itself that has opened up the market to abuses, and yet this centralization has been encouraged no end by powerful players. Shadowy elites understand well that centralized order flow is their friend. There are many ways to "skin" this order flow if one is wealthy enough, adept enough and powerful enough.

In the past we've suggested that insider trading, among other regulations, is pernicious because its putative enforcement gives people the idea that authorities are working to make the market "fair." But the modern equity market cannot be fair. And in this Age of Technology the unfairness must grow even greater.

Much better to acknowledge what is going on than to give people a false impression that fairness can be enforced by proper market organization and penalties. Still, Congress is contemplating legislation that will ban certain kinds of technology.

We predicted exactly this over a year ago in an article entitled, "The Dialectic of a Universal Transaction Tax." 

The powers-that-be are pushing a transaction tax once again. For those who want to rule the world, a transaction tax is ideal. Everyone from the largest to the smallest would likely be under an affirmative obligation to keep some sort of log of trades and transactions.

This follows as surely as night follows day. Either a log would be kept for them or they would keep a log. Either way, the record-keeping would be compulsory. In the beginning perhaps the records would be anonymous. But the idea will be to keep records: painstaking records.

This will open up a bonanza of new crimes and criminals, in our view. First of all, as times goes on, trade data could be matched by powerful computers to detect patterns of "insider trading." But sooner or later other crimes would be discovered as well.

One could come up with a whole category of market manipulation crimes once trade data is extensively tabulated. There could be volume crimes in which trades overwhelm the market, moving certain investments instruments up or down.

Or how about exotic front-running crimes in which markets are primed for front-running by manipulative trades. The trades push securities up into unstable valuations. Then someone triggers a selling program and the instruments begin to fall.

To counteract these newly discovered crimes, an international agency to fight market manipulation and insider trading would have to be set up. It would be a huge, global agency that would be funded by an ever-steepening transaction tax.

Soon, every large firm would have electronic market manipulation police. Certain firms would be identified as "going rogue." These firms might be black-listed once they received unsavory reputations. People's reputations would be blackened if they associated with facilities that did a good deal of trading.

Eventually, firms that did a good deal of proprietary trading would begin to be ostracized. Proprietary trading would come to be seen as a criminal indicator or tag, a dangerous practice. Finally, governments might set up "white lists" of good-guy traders.

This is all fairly predictable, as are the remedies. We are not quite there yet but eventually the absurdities will be piled so high that markets will cease to effectively function. This happened after the repeated crashes of the 1930s. People were so distrustful of equity markets in particular in the 1940s that the New York Stock Exchange actually mounted roadshows all around the country to try to get people to invest again.

This time the "roadshow" are markets' ever-escalating averages. And if one believes that these averages are due to be pushed even higher over the next year or two, this might be seen as an opportune time for legitimate – if careful – speculation. In fact, it is not index funds that will provide the best opportunities but perhaps entrepreneurial opportunities, start-ups and certain IPOs.

One must, of course, enter the ongoing Wall Street Party with the requisite level of cynicism and alertness. Since it is hard to time the market, one must also be willing to take profits aggressively so as to minimize chances of capital loss. But perhaps it can be done, and certainly there are those that are doing it.

Conclusion

In fact, this Yahoo article we've analyzed has provided the same conclusions that we've been offering: The market is indeed unfair but there are ways to approach it that may be profitable.

Source

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Stone Cold Proof That Government Economic Numbers Are Being Highly Manipulated

How in the world does the government expect us to trust the economic numbers that they give us anymore?  For a long time, many have suspected that they were being manipulated, and as you will see below we now have stone cold proof that this is indeed the case.  But first, let's talk about the revised GDP number for the first quarter of 2014 that was just released.  Initially, they told us that the U.S. economy only shrank by 0.1 percent in Q1.  Then that was revised down to a 1.0 percent contraction, and now we are being informed that the economy actually contracted by a whopping 2.9 percent during the first quarter.  So what are we actually supposed to believe?  Sometimes I almost get the feeling that government bureaucrats are just throwing darts at a dartboard in order to get these numbers.  Of course that is not actually true, but how do we know that we can actually trust the numbers that they give to us?

Over at shadowstats.com, John Williams publishes alternative economic statistics that he believes are much more realistic than the government numbers.  According to his figures, the U.S. economy has actually been continually contracting since 2005.  That would mean that we have been in a recession for the last nine years.

Could it be possible that he is right and the bureaucrats in Washington D.C. are wrong?

Before you answer that question, read the rest of this article.

It just might change your thinking a bit.

Another number that many have accused of being highly manipulated is the inflation rate.

But we don't have to sit around and wonder if that figure is being manipulated.  The truth is that even those that work inside the Federal Reserve admit that it is being manipulated.

As Robert Wenzel recently pointed out, Mike Bryan, a vice president and senior economist in the Atlanta Fed's research department, has been very open about the fact that the way inflation is calculated has been changed almost every month at times...

The Economist retells a conversation with Stephen Roach, who in the 1970s worked for the Federal Reserve under Chairman Arthur Burns. Roach remembers that when oil prices surged around 1973, Burns asked Federal Reserve Board economists to strip those prices out of the CPI "to get a less distorted measure. When food prices then rose sharply, they stripped those out too—followed by used cars, children's toys, jewellery, housing and so on, until around half of the CPI basket was excluded because it was supposedly 'distorted'" by forces outside the control of the central bank. The story goes on to say that, at least in part because of these actions, the Fed failed to spot the breadth of the inflationary threat of the 1970s. 

I have a similar story. I remember a morning in 1991 at a meeting of the Federal Reserve Bank of Cleveland's board of directors. I was welcomed to the lectern with, "Now it's time to see what Mike is going to throw out of the CPI this month." It was an uncomfortable moment for me that had a lasting influence. It was my motivation for constructing the Cleveland Fed's median CPI. 

I am a reasonably skilled reader of a monthly CPI release. And since I approached each monthly report with a pretty clear idea of what the actual rate of inflation was, it was always pretty easy for me to look across the items in the CPI market basket and identify any offending—or "distorted"—price change. Stripping these items from the price statistic revealed the truth—and confirmed that I was right all along about the actual rate of inflation.

Right now, the Federal Reserve tells us that the inflation rate is sitting at about 2 percent.

But according to John Williams, if the inflation rate was calculated the same way that it was in 1990 it would be nearly 6 percent.

And if the inflation rate was calculated the same way that it was in 1980 it would be nearly 10 percent.

So which number are we supposed to believe?

The one that makes us feel the best?

And without a doubt, "2 percent inflation" sounds a whole lot better than "10 percent inflation" does.

But anyone that does any grocery shopping knows that we are definitely not in a low inflation environment.  

For much more on this, please see my previous article entitled "Inflation? Only If You Look At Food, Water, Gas, Electricity And Everything Else".

Of course the unemployment rate is being manipulated as well.  Just consider the following excerpt from a recent New York Post article...

In case you are just joining this ongoing drama, the Labor Department pays Census to conduct the monthly Household Survey that produces the national unemployment rate, which despite numerous failings is — inexplicably — still very important to the Federal Reserve and others. 

One of the problems with the report is that Census field representatives — the folks who knock on doors to conduct the surveys — and their supervisors have, according to my sources, been shortcutting the interview process. 

Rather than collect fresh data each month as they are supposed to do, Census workers have been filling in the blanks with past months’ data. This helps them meet the strict quota of successful interviews set by Labor. 

That’s just one of the ways the surveys are falsified. 

The Federal Reserve would have us believe that the unemployment rate in the U.S. has fallen from a peak of 10.0 percent during the recession all the way down to 6.3 percent now.

But according to shadowstats.com, the broadest measure of unemployment is well over 20 percent and has kept rising since the end of the last recession.

And according to the Federal Reserve's own numbers, the percentage of working age Americans with a job has barely increased over the past four years...

The chart above looks like a long-term employment decline to me.

But that is not the story that the government bureaucrats are selling to us.

So where does the truth lie?

What numbers are we actually supposed to believe?

Please feel free to share your thoughts by posting a comment below...

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Obama’s Latest Betrayal in Favor of the Big Banks: TISA

Wikileaks has done the world a great service again by publishing a leak of an April 2014 (partial) draft of the Trade in Services Agreement (TISA).

Professor Jane Kelsey of the Faculty of Law, University of Auckland prepared an analysis of the leak that I recommend that everyone read. She, appropriately, emphasizes that any analysis must be tentative because we have only a partial, stale draft through the whistleblower(s).

My analysis is more limited in scope but is consistent with the thrust of her concerns.

Three TISA Paradoxes

Financial Deregulation is Criminogenic

The three “de’s” – deregulation, desupervision, and de facto decriminalization – has been critical to the three modern U.S. financial crises. The combination is intensely criminogenic and produces the fraud epidemics that drive our crises…..

The obvious question is why, since we know from repeated waves of the three “de’s” how disastrously this ends, we fail to “learn from experience” and finally follow the advice of effective financial regulators, white-collar criminologists, and top economists? The even more pointed question is why President Obama cannot “learn from experience.” It was his appointees to the FCIC who unanimously warned that the three “de’s” played a critical role in causing the crisis.

TISA is designed to replicate, indeed, optimize the criminogenic environment that made fraudulent financial CEOs wealthy by “looting” “their” banks. The (effective) “regulators in the field” figured this out by 1983 – over 30 years ago. We wrote up our findings in great detail. Top economists and top white-collar criminologists studying those findings a decade later (1993) agreed with the findings. Since the original findings in 1983, we have the (prevented) “liar’s” loans crisis of 1991 when federal S&L regulators based in California drove what were then a brand new product called “low doc” loans out of the regulated industry. That “second front” – while the S&L regulators were containing the S&L debacle – was dealt with so effectively that there was no resultant financial crisis. Indeed, it is only with the benefit of the current crisis that we can understand that the containment of the overall S&L debacle (driven primarily by fraudulent commercial real estate loans and investments) and the incipient crisis is liar’s loans prevented a crisis that would have become similar in scope to the current crisis. The S&L debacle was contained before it caused even a minor national recession.

In sum, we know not only that the three “de’s” are disastrous, but also that effective reregulation, resupervision, and restoration of effective prosecutions can be exceptionally effective and save tens of trillions of dollars in costs and 10 million American jobs by preventing the most destructive financial crises and resultant Great Recession. (Those savings would have been dramatically greater in the eurozone where one-third of the population is suffering from Great Depression levels of unemployment.)

The EU and Obama, therefore, should have several key areas of complete agreement in drafting TISA:

1. It is essential, and urgent, to end the global financial regulatory race to the bottom
2. It is essential, and urgent, to end the existing regulatory structure’s continuing hostility to effective regulation, supervision, and prosecution
3. The systemically dangerous institutions (SDIs) (the so-called “too big to fail” banks) pose an intolerable global risk of financial crisis and should have been forced to shrink to a size where they no longer endanger the world’s economies and democracies
4. It is essential, and urgent, to remove the perverse incentives created by modern executive and professional compensation
5. Rehabilitate private discipline by requiring “independent” experts providing services to financial institutions to be owned in partnership form with joint and several liability and fully restore the fiduciary duties of loyalty and care that have been eviscerated by legislation and hostile judicial interpretations

I’ll discuss a limited aspect of what the draft TISA provides below, but it is sufficient for this paradox to make four points. First, none of the five vital and urgent reforms is contained in the draft. Second, there is not a single provision designed to make regulation, supervision, enforcement, or prosecution of private bankers and those that aid and abet their violations more effective. Third, virtually every provision is designed to make banking more criminogenic by increasing the three “de’s” and locking in the existing pathetically inadequate system. Fourth, the draft is designed as a one-way ratchet under which nations are only allowed to further loosen their already inadequate regulation, supervision, and prosecution systems.

The first paradox is that Obama, who cannot claim that he does not know better given the unanimous findings of his own FCIC appointees who investigated the causes of the crisis, is trying to recreate those causes, spur a race to the bottom among financial regulators, and make the causes of the past crisis global (rather than primarily limited to the U.S. and the EU). Obama, in the TISA draft, proposes to do everything that his own FCIC experts, white-collar criminologists, the top economists on the subject of criminogenic environments, and effective regulators with a track record of success have been telling Obama not to do for his entire term in office.

Even more insanely, Obama’s draft is designed to make it far more difficult for competent regulators to respond rapidly to a developing crisis and contain it as was done during the S&L debacle and during the surge of “liar’s” loans in 1990-1991 before it cause any crisis. The goal is to prevent a group of regulators from emulating our successful reregulation of the S&L industry and obtaining over 1,000 felony convictions in cases designated as “major” by the Department of Justice (DOJ). To obtain that result we made over 30,000 criminal referrals. In the current crisis, the anti-regulators who de-supervised banks made, at best, a handful of criminal referrals and the result is that six years after the collapse of the financial system not a single senior banker who led the three most destructive financial fraud epidemics in history has been prosecuted by DOJ. Bank CEOs love the three “de’s” because it allows them to become wealthy by “looting” with impunity. Looting, as Akerlof and Romer aptly emphasized, is a “sure thing” for the leaders of a bank.

“Transparency” for Bankers: Maximum Opaqueness for the Public and Congress

The TISA draft (Article X.16) is very clear about the second great paradox: bankers must be told everything that regulators are thinking about adopting and have ample opportunity to influence the regulators’ drafting of the rule. But TISA is an international secret that will remain an international secret for five years after it is adopted. Like the Trans-Pacific Partnership, the drafts are kept secret even from Congress. Indeed, TISA is “classified” so that those who might blow the whistle on the travesty may be prosecuted. The draft’s initial information contains this language:

Declassify on: Five years from entry into force of the TISA agreement….

It must be stored in a locked or secured building, room, or container.

I note this obvious, indefensible hypocrisy because it is illustrative of the entire draft. When the indefensible appears in a document like this it is because the drafters know that there is no one representing the other side and they can afford to be outrageously one-sided. It was clearly drafted by and for lobbyists for the SDIs. Any government officials involved in the drafting are simply scribes who will be rewarded on the other side of the revolving door. There is no pretense that the draft is a reasoned response to differing views. Only one set of views – literally the wish list of the largest, most criminal banks – is presented and it is presented in exceptionally extreme language. There is literally nothing in the draft designed to increase the regulatory protections afforded the public from private banks. There is literally nothing in the draft that increases restrictions on private banks.

As a lawyer I recognize exactly what happened because the draft reads exactly like how we draft a wish list. Obama is a lawyer. Mr. President, read the draft and it will be obvious to you that no one is representing the public. The President of Ecuador, Rafael Correa (an economist), was outraged when he learned of what the bankers were trying to achieve through TISA. Sadly, the U.S. played a disgraceful role in pushing TISA forward over Ecuador’s objections. If Obama were to admit that Ecuador was right, bring the U.S. back to representing the public rather than the looters, and make public the entire disgraceful draft TISA would collapse.

TISA’s drafting consists of a meeting of banking thieves who are successfully demanding a return to what Gramlich correctly described as “no cops on the beat.” If the street robbers of the world demanded that we remove the cops on the beat we would be enraged. Bankers and their neoclassical economist allies, however, regularly lobby for just such a boon to elite white-collar criminals. We have millennia of experience with what happens when we give the elites the power to loot with impunity.

The Paradox of Secrecy and “Prudential” Regulation

The third paradox is that as bad as the draft is I also know as a lawyer exactly how it will be defended. The defense will be simple: the draft will cause no harm because Article X.17 allows allow regulators to adopt rules for “prudential” purposes. Note that it does not require nations to adopt appropriate prudential rules to avoid creating the disastrous race to the bottom. As I explained, the TISA draft does not encourage or require any prudential measure. It does not even contain a vague and unenforceable suggestion that it might be a good thing to look for areas of regulatory or supervisory weakness and fix them.

Article X.17: Prudential Measures

1. Notwithstanding any other provision of the Agreement, a Party shall not be prevented from [PA, EU: taking] [US: adopting or maintaining] measures for prudential reasons, including for:

(a) the protection of investors, depositors, [PA, US financial market users], policy-holders or persons to whom a fiduciary duty is owed by a financial service supplier; or

(b) to ensure the integrity and stability of a Party’s financial system.

2. Where such measures do not conform with the provisions of this Agreement, they shall not be used as a means of avoiding the Party’s commitments or obligations under the Agreement.

The Paradox of Withstanding a “Notwithstanding” Clause

The defense of TISA is obvious. The “notwithstanding” clause means that regardless of “any other provision” of TISA every nation has the absolute right to take financial regulatory and supervisory measures “for prudential reasons.” Further, the examples of such “reasons” are broad. The obvious conclusion is that TISA poses no barrier to important regulatory or supervisory actions.

But there are three non-obvious problems with that interpretation. First, why does Article 17.2 exist?

2. Where such measures do not conform with the provisions of this Agreement, they shall not be used as a means of avoiding the Party’s commitments or obligations under the Agreement.

The “notwithstanding” clause means that “such [prudential] measures” “conform with the provisions of [TISA]” by virtue of that clause. Article 17.2, however, indicates that regulations that the U.S. finds vital to adopt to “ensure the integrity and stability of [our] financial system” can be found invalid by some (as yet unspecified entity) on the grounds that the entity thinks are being used to “avoid [our] commitments or obligations under [TISA].” The unspecified entity is supposed to decide what the motive of those involved in adopting the rule or taking the supervisory action was. Almost any new banking regulation that the U.S. adopted to stem an epidemic of the forms of fraud that drive our financial crises could be interpreted as not “conforming with [TISA]” absent the “notwithstanding” clause. That means that virtually any rule the U.S. found essential to adopt to prevent the imminent collapse of the “stability of [our] financial system” could be declared a breach of TISA under paragraph 2 of Article 17.

What entity will be deciding whether U.S. banking rules were adopted in order to “avoid … commitments … under [TISA]? Article 20 says that a “dispute panel” will consider alleged violations of TISA. If this clause follows recent U.S. practices under Obama, and the bankers are explicitly lobbying to ensure that TISA does so, this means that a group of so-called “arbiters” will decide such disputes. The panel, if it follows current practices, will be subject to no rule of law and no effective right of appeal. They will operate in secret and will be composed primarily of lawyers with glaring conflicts of interest. The same lawyers who bring claims against nations on one day then serve as the “arbiters” on the next day deciding cases brought by their counterparts. These panels have issued orders to sovereign nations demanding that they take unconstitutional actions – and then proposed to fine the nations for refusing to violate their constitutions (and any civilized concept of due process). Remember, any foreign bank can ask such a panel to declare a banking regulation invalid that we have adopted because we have found that the foreign bank has engaged in conduct that poses a grave and imminent threat to the “integrity and stability” of our Nation and even the global financial system. Under TISA, we will lose all control and can be stripped of our sovereign duty to act to protect the American and world economies. A group of fervently anti-American lawyers who are viscerally opposed to banking rules because they became wealthy by representing banks making attacks on banking rules will control our fate. The (faux) arbitral panels claim the power to issue injunctions ordering a sovereign nation not to adopt rules and not to take supervisory actions even against criminal enterprises – and to issue damages against nations that refuse to comply with such orders.

Taken together, subparagraph 2 and the Article 20 “dispute panel” provisions explain the third terrible TISA paradox. The “notwithstanding” clause was inserted to make it appear to the credulous that TISA would have no effect on the ability to regulate banks. But we can see that when read together the protections of Article 17’s “notwithstanding” clause are illusory. TISA can destroy America’s ability to take the reregulatory, supervisory prosecutorial steps essential against the elite frauds that drive our recurrent, intensifying financial crises. The worst fraudulent CEOs controlling foreign banks operating in the U.S. would happily bribe a group of already morally crippled (faux) arbiters to declare U.S. banking rules a violation of TISA and to order the U.S. not to enforce its laws against even the most fraudulent bankers causing a grave crisis.

TISA is awful for honest bankers. Effective financial regulators are the essential “cops on the beat.” Only we have shown the ability to break the “Gresham’s” dynamic (bad ethics drives good ethics out of the markets and professions) that fraudulent CEOs create. When we break that dynamic we make it possible for honest bankers to prevail. TISA is good for only one group – dishonest bank executives.

Conclusion

That brings us back to the reason the bank CEOs have demanded that TISA be “classified” and kept from the public and even Congress. Indeed, the plan is to classify its provisions for five years after TISA is adopted. That delay is meant to make it politically possible for TISA to be adopted and then continue to protect heads of state from being thrown out of office by their enraged constituents.

But the prior discussion raises other questions. What if Article 17’s “notwithstanding” clause really meant what it appeared to say? What if TISA imposed no restrictions on the adoption of banking regulations? U.S. banking rules are entirely prudential. All of our S&L rules, supervisory actions, enforcement actions, and prosecutions were “prudential” under TISA’s definition. If there were no paragraph 2 to Article 17 and no Article 20 “dispute panels” the TISA exercise would be pointless. The U.S. would be able to adopt any financial rule, take any supervisory or enforcement action, and prosecute anyone regardless of any TISA provision.

Ask yourself this question: why would the bankers and heads of state have demanded, and received, “classified” treatment of a document that did not have any confidential information (there are no state secrets, no privacy issues, and nothing of proprietary value in the leaked TISA draft) and made no meaningful restriction on regulation and supervision due to the “nowithstanding” clause of Article 17? The demand for classified treatment makes it inescapable that the bankers and government officials involved in drafting TISA are trying to hide something they believe would outrage the public. The paradox is that the bankers’ and politicians’ rabid fear of disclosure to the public and Congress of TISA’s assault on regulation confirms beyond any reasonable doubt that subparagraph 2 of Article 17 and Article 20 combine to make TISA a grave threat to the global economy, workers, and honest bankers by making the financial world even more criminogenic.

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Why Standard Economic Models Don’t Work - Our Economy Is A Network

The story of energy and the economy seems to be an obvious common sense one: some sources of energy are becoming scarce or overly polluting, so we need to develop new ones. The new ones may be more expensive, but the world will adapt. Prices will rise and people will learn to do more with less. Everything will work out in the end. It is only a matter of time and a little faith. In fact, the Financial Times published an article recently called “Looking Past the Death of Peak Oil” that pretty much followed this line of reasoning.

Energy Common Sense Doesn’t Work Because the World is Finite 

The main reason such common sense doesn’t work is because in a finite world, every action we take has many direct and indirect effects. This chain of effects produces connectedness that makes the economy operate as a network. This network behaves differently than most of us would expect. This networked behavior is not reflected in current economic models.

Most people believe that the amount of oil in the ground is the limiting factor for oil extraction. In a finite world, this isn’t true. In a finite world, the limiting factor is feedback loops that lead to inadequate wages, inadequate debt growth, inadequate tax revenue, and ultimately inadequate funds for investment in oil extraction. The behavior of networks may lead to economic collapses of oil exporters, and even to a collapse of the overall economic system.

An issue that is often overlooked in the standard view of oil limits is diminishing returns. With diminishing returns, the cost of extraction eventually rises because the easy-to-obtain resources are extracted first. For a time, the rising cost of extraction can be hidden by advances in technology and increased mechanization, but at some point, the inflation-adjusted cost of oil production starts to rise.

With diminishing returns, the economy is, in effect, becoming less and less efficient, instead of becoming more and more efficient. As this effect feeds through the system, wages tend to fall and the economy tends to shrink rather than grow. Because of the way a networked system “works,” this shrinkage tends to collapse the economy. The usage of  energy products of all kinds is likely to fall, more or less simultaneously.

In some ways current, economic models are the equivalent of flat maps, when we live in s spherical world. These models work pretty well for a while, but eventually, their predictions deviate farther and farther from reality. The reason our models of the future are wrong is because we are not imagining the system correctly.

The Connectedness of a Finite World 

In a finite world, an action a person takes has wide-ranging impacts. The amount of food I eat, or the amount of minerals I extract from the earth, affects what other people (now and in the future) can do, and what other species can do.

To illustrate, let’s look at an exaggerated example. At any given time, there is only so much broccoli that is ready for harvest. If I decide to corner the broccoli market and buy up 50% of the world’s broccoli supply, that means that other people will have less broccoli available to buy. If those growing the broccoli spray the growing crop with pesticides, “broccoli pests” (caterpillars, aphids, and other insects) will die back in number, perhaps contributing to a decline of those species. The pesticides may also affect desirable species, like bees.

Growing the broccoli will also deplete the soil of nutrients. If 50% of the world’s broccoli is shipped to me, the nutrients from the soil will find their way around the world to me. These nutrients are not likely to be replaced in the soil where the broccoli was grown without long-distance transport of nutrients.

To take another example, if I (or the imaginary company I own) extract oil from the ground, the extraction and the selling of that oil will have many far-ranging effects:

•  The oil I extract will most likely be the cheapest, easiest-to-extract oil that I can find. Because of this, the oil that is left will tend to be more expensive to extract. My extraction of oil thus contributes to diminishing returns–that is, the tendency of the cost of oil extraction to rise over time as resources deplete.
• The petroleum I extract from the ground will consist of a mixture of hydrocarbon chains of varying lengths. When I send the petroleum to a refinery, the refinery will separate the petroleum into varying length chains: short chains are gasses, longer chains are liquids, still longer ones are very viscous, and the longest ones are solids, such as asphalt. Different length chains are used for different purposes. The shortest chains are natural gas. Some chains are sold as gasoline, some as diesel, and some as lubricants. Some parts of the petroleum spectrum are used to make plastics, medicines, fabrics, and pesticides. All of these uses will help create jobs in a wide range of industries. Indirectly, these uses are likely to enable higher food production, and thus higher population.
• When I extract the oil from the ground, the process itself will use some oil and natural gas. Refining the oil will also use energy.
• Jobs will be created in the oil industry. People with these jobs will spend their money on goods and services of all sorts, indirectly leading to greater availability of jobs outside the oil industry.
• Oil’s price is important. The lower the price, the more affordable products using oil will be, such as cars.
• In order for consumers to purchase cars that will operate using gasoline, there will likely be a need for debt to buy the cars. Thus, the extraction of oil is tightly tied to the build-up of debt.
• As an oil producer, I will pay taxes of many different types to all levels of governments. (Governments of oil exporting countries tend to get a high percentage of their revenue from taxes on oil. Even in non-exporting countries, taxes on oil tend to be high.) Consumers will also pay taxes, such as gasoline taxes.
• The jobs that are created through the use of oil will lead to more tax revenue, because wage earners pay income taxes.
• The government will need to build more roads, partly for the additional cars that operate on the roads thanks to the use of gasoline and diesel, and partly to repair the damage that is done as trucks travel to oil extraction sites.
• To keep the oil extraction process going, there will likely need to be schools and medical facilities to take care of the workers and their families, and to educate those workers.

Needless to say, there are other effects as well. The existence of my oil in the marketplace will somehow affect the market price of oil. Burning of the oil may affect the climate, and will tend to acidify oceans. It would be possible to go on and on.

The Difficulty of Substituting Away from Oil 

In some sense, the use of oil is very deeply imbedded into the operation of the overall economy. We can talk about electricity replacing oil, but oil’s involvement in the economy is so pervasive, it can’t possibly replace everything. Perhaps electricity might replace gasoline in private passenger automobiles. Such a change would reduce the demand for hydrocarbon chains of a certain length (C₇ to C₁₁), but that only reduces demand for one “slice” of the oil mixture. Both shorter and longer chain hydrocarbons would be unaffected.

The price of gasoline will drop, (making Chinese buyers happy because more will be able to afford to use motorcycles), but what else will happen? Won’t we still need as much diesel, and as many medicines as before? Refiners can fairly easily break longer-chain molecules into shorter-chain molecules, so they can make diesel or asphalt into gasoline. But going the other direction doesn’t work well at all. Making gasoline into shorter chains would be a huge waste, because gasoline is much more valuable than the resulting gases.

How about replacing all of the taxes directly and indirectly related to the unused gasoline?  Will the price of electricity used in electric-powered vehicles be adjusted to cover the foregone tax revenue?

If a liquid substitute for oil is made, it needs to be low priced, because a high-priced substitute for oil is very different from a low-priced substitute. Part of the problem is that high-priced substitutes do not leave enough “room” for taxes for governments. Another part of the problem is that customers cannot afford high-priced oil products. They cut back on discretionary expenditures, and the economy tends to contract. There are layoffs in the discretionary sectors, and (again) the government finds it difficult to collect enough tax revenue.

The Economy as a Networked System

I think of the world economic system as being a networked system, something like the dome shown in Figure 1. The dome behaves as an object that is different from the many wooden sticks from which it is made. The dome can collapse if sticks are removed.

Figure 1. Dome constructed using Leonardo Sticks

The world economy consists of a network of businesses, consumers, governments, and resources that is bound together with a financial system. It is self-organizing, in the sense that consumers decide what to buy based on what products are available at what prices. New businesses are formed based on the overall environment: potential customers, competition, resource availability, services available from other businesses, and laws. Governments participate in the system as well, building infrastructure, making laws, and charging taxes.

Over time, all of these gradually change. If one business changes, other business and consumers are likely to make changes in response. Even governments may change: make new laws, or build new infrastructure. Over time, the tendency is to build a larger and more complex network. Unused portions of the network tend to wither away–for example, few businesses make buggy whips today. This is why the network is illustrated as hollow. This feature makes it difficult for the network to “go backward.”

The network got its start as a way to deliver food energy to people. Gradually economies expanded to include other goods and services. Because energy is required to “do work,” (such as provide heat, mechanical energy, or electricity), energy is always central to an economy. In fact, the economy might be considered an energy delivery system. This is especially the case if we consider wages to be payment for an important type of energy–human energy.

Because of the way the network has grown over time, there is considerable interdependency among different types of energy. For example, electricity powers oil pipelines and gasoline pumps. Oil is used to maintain the electric grid. Nuclear electric plants depend on electricity from the grid to restart their operations after outages. Thus, if one type of energy “has a problem,” this problem is likely to spread to other types of energy. This is the opposite of the common belief that energy substitution will fix all problems.

Economies are Prone to Collapse

We know the wooden dome in Figure 1 can collapse if “things go wrong.” History shows that many civilizations have collapsed in the past. Research has been done to see why this is the case.

Joseph Tainter’s research indicates that diminishing returns played an important role in the collapse of past civilizations. Diminishing returns would be a problem when adding more workers didn’t add a corresponding amount more output, particularly with respect to food. Such a situation might be reached when population grew too large for a piece of arable land. Degradation of soil fertility might play a role as well.

Today, we are reaching diminishing returns with respect to oil supply, as evidenced by the rising cost of oil extraction. This is occurring because we removed the easy to extract oil, and now must move on to the more expensive to extract oil. In effect, the system is becoming less efficient. More workers and more resources of other types are needed to produce a given barrel of oil. The value of the barrel of oil in terms of what it can do as work (say, how far it can move a car, or how much heat it can produce) is unchanged, so the value each worker is producing is less. This is the opposite of efficiency.

Peter Turchin and Sergey Nefedov have done research on the nature of past collapses, documented in a book called Secular Cycles. An economy would clear a piece of land, or discover an approach to irrigation, or by some other means discover a way to expand the number of people who could live in an area. The resulting economy would grow for well over 100 years, until population started catching up with resource availability. A period of stagflation followed, typically for about 50 or 60 years, as the economy tried to continue to grow, but bumped against increasing obstacles. Wage disparity grew as wages of new workers lagged. Debt also grew.

Eventually collapse occurred, over a period of 20 to 50 years. Often, much of the population died off. An inter-cycle period followed, during which resources regenerated, so that a new civilization could arise.

Figure 2. Shape of typical Secular Cycle, based on work of Peter Turkin and Sergey Nefedov in Secular Cycles.

One of the major issues in past collapses was difficulty in funding government services. Part of the problem was that wages of common workers were low, making it difficult to collect enough taxes. Part of governments’ problems were that their costs went up, as they tried to solve the increasingly complex problems of society. Today these costs might include unemployment insurance and bailing out banks; in ages past they included larger armies to try to conquer new lands with more resources, as their own resources depleted.

Today’s Situation 

Our situation isn’t too different. The economy started growing in the early 1800s, abut the we started using fossil fuels, thanks to technology that allowed us to use them. Oil is the fossil fuel that is depleting most quickly, because it is very valuable in many uses, including transportation, agriculture, construction, mining, and as a raw material to produce many goods we use every day.

Our economy seems to have hit stagflation in the early 1970s, when oil prices first began to spike. Now, some of the symptoms we are seeing are looking distressingly like the symptoms that other civilizations saw prior to the beginning of collapse. Our networked system has many weak points:

• Oil exporters Governments can collapse, as the government of the Former Soviet Union did in 1991, if oil prices are too low. The fact that oil prices have not risen since 2011 is probably contributing to unrest in the Middle East.
• Oil importers Spikes in oil prices lead to recession.
• Governments funding Debt keeps expanding; infrastructure needs fixes but they don’t get done; too many promises for pensions and healthcare.
• Failing financial systems Debt defaults are likely to be a major problem if the economic system starts shrinking. Debt is needed to keep oil prices up.
• Contagion if one energy product is in short supply This happens many ways. For example, nearly all businesses rely on both electricity and oil. If either one of these becomes unavailable (say oil to supply parts and ship goods to customers), then the business will need to close. Because of the business closure, demand for other energy products the business uses, such as electricity and natural gas, will drop at the same time. Direct use of energy products to produce other energy products (mentioned previously) also contributes to this contagion.

Unfortunately, when it comes to operating an economy, it is Liebig’s Law of the Minimum that rules. In other words, if any required element is missing, the system doesn’t work. If businesses can’t get financing, or can’t pay their employees because banks are closed, businesses may need to close. Workers will get laid off, and the inability to afford energy products (economists would call this “lack of demand”) will be what brings the system down.

Modeling our Current Economy 

Everywhere we look, we see models of how the energy system or the economy can be expected to work. None of the models match our current situation well.

Growth will Continue As in the Past It is pretty clear that this model is inadequate. Every revision to growth estimates seems to be downward. In a finite world, we know that growth at the same rate can’t continue forever–we would run out of resources, and places for people to stand. The networked nature of the system explains how the system really grows, and why this growth can’t continue indefinitely.

Rising Cost of Producing Energy Products Doesn’t Matter In a global world, we compete on the price of goods and services. The cost of producing these goods and services depends on (a) the cost of energy products used in making these goods and services (b) wages paid to workers for producing these services (c) government, healthcare, and other overhead costs, and (d) financing costs.

One part of our problem is that with globalization, we are competing against warm countries–countries that receive more free energy from the sun than we do, so are warmer than the US and Europe. Because of this free energy from the sun, homes do not need to be built as sturdily and less heat is needed in winter. Without these costs, wages do not need to be as high. These countries also tend to have less expensive healthcare systems and lower pensions for the elderly.

Governments can try to fix our non-competitive cost structure compared to these countries by reducing interest rates  as much as possible, but the fact remains–it is very difficult for countries in cold parts of the world to compete with countries in warm parts of the world in making goods. This cost competition problem becomes worse, as the price of energy products rises because we are competing with a cost of $0 for heating requirements. If cold countries add carbon taxes, but do not surcharge goods imported from warm countries, the disparity with warm countries becomes even worse.

In the early years of civilization, warm countries dominated the world economy. As energy prices rise, this situation is likely to again occur.

Price is Not Important  Apart from the warm country–cool country issue, there is another reason that energy cost (in real goods, not just in financial printed money) is important:

The price of the energy used in the economy is important because it is tied to how much must be “given up” to buy the oil or anther energy product (such as food). If energy is cheap, little needs to be given up to obtain the energy. Because of energy’s huge ability to do “work,” the work that is obtained can easily make goods and services that compensate for what has been given up. If energy is expensive, there is much less benefit (or perhaps negative benefit) when what is given up is compared to the work that the energy product provides. As a result, economic growth is held back by high-priced energy products of any kind.

Supply and Demand Leads to Higher Prices and Substitutes  Major obstacles to the standard model working are (a) diminishing returns with respect to oil supply, (b) recession and even government failure of oil importers, when oil prices rise and (c) civil unrest and even government failure in oil exporters, if oil prices don’t keep rising. If there isn’t enough oil supply, oil prices rise, but there are soon so many follow-on effects that oil prices fall back again.

Reserves/ Production This ratio supposedly tells how long we can produce oil (or natural gas or coal) at current extraction rates. This ratio is simply misleading. The real limit is how long the economy can function, given the feedback loops related to diminishing returns. If a person simply looks at investment dollars required, it becomes clear that this model doesn’t work. See my post IEA Investment Report – What is Right; What is Wrong.

IPCC Climate Change Model Estimates of future carbon emissions do not take into the networked nature of the energy system and economy, so tend to be high.  See my post Oil Limits and Climate Change – How They Fit Together.

Energy Payback Period, Energy Return on Energy Invested, and Life Cycle Analysis These approaches look at the efficiency of energy production, comparing energy used in the process to energy produced in the process. In some ways, they work–they show that we are becoming less and less efficient at producing oil, or coal, or natural gas, as we move to more difficult to extract resources. And they can be worthwhile, if a decision is being made as to which of two similar devices to purchase: Wind Turbine A or Wind Turbine B.

Unfortunately, modeling a finite world is virtually impossible. These approaches use narrow boundaries–energy used in pulling oil out of the ground, or making a wind turbine. It doesn’t tell as much as we need to know about new energy generation equipment, together with (a) changes needed elsewhere in the system and (b) whatever financial system is used to pay for the energy generated with that system, will actually work in the economy. To really analyze the situation, broader analyses are needed.

Furthermore, there are the inherent assumptions that (a) we have a long time period to make changes and (b) one energy source can be substituted for another. Neither of these assumptions is really true when we are this close to oil limits.

Where the Peak Oil Model Went Wrong

Part of the Peak Oil story is right: We are reaching oil limits, and those limits are hitting about now. Part of the Peak Oil story is not right, though, at least in  a common version that is prevalent now.  The version that is prevalent is more or less equivalent to the “standard” view of our current situation that I talked about at the beginning of the post. In this standard view, oil supply will not disappear very quickly–approximately 50% of the total amount of oil ever extracted will become available after the peak in oil production. There will be considerable substitution with other fuels, often at higher prices. The financial system may be affected, but it can be replaced, and the economy will continue.

This view is based on writing of M. King Hubbert back in 1957. At that time, it was commonly believed that nuclear energy would provide electricity too cheap to meter. In fact, in a 1962 paper, Hubbert talks about “reversing combustion,” to make liquid fuels. Thus, not only did his story include cheap electricity, it also included cheap liquid fuels, both in huge quantity.

Figure 3. Figure from Hubbert’s 1956 paper, Nuclear Energy and the Fossil Fuels.

In such a situation, growth could continue indefinitely. There would be no need to replace huge numbers of vehicles with electric vehicles. Governments wouldn’t have a problem with funding. There would be no problem with collapse. The supply of oil and other fossil fuels could decline slowly, as suggested in his papers.

But the story of the cheap, rapid nuclear ramp-up didn’t materialize, and we gradually got closer to the time when limits were beginning to hit. Major changes were needed to Hubbert’s story to reflect the fact that we really didn’t have a fix that would keep business as usual going indefinitely. But these changes never took place. Instead the view of how little change was needed to keep the economy going kept getting downgraded more and more. “Standard” economic views filtered into the story, too.

There is a correct version of the oil limits story to tell. It is the story of the failure of networked systems.

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