Chronicling for Posterity

Doug Nolan
Janet Yellen’s Wednesday news conference was her final as Fed chair. Dr. Yellen has a long and distinguished career as an economist and public servant. Her four-year term at the helm of the Federal Reserve is almost universally acclaimed. History will surely treat her less kindly. Yellen has been a central figure in inflationist dogma and a fateful global experiment in radical monetary stimulus. In her four years at the helm, the Yellen Fed failed to tighten financial conditions despite asset inflation and speculative excess beckoning for policy normalization.

Ben Bernanke has referred to the understanding of the forces behind the Great Depression as “the holy grail of economics.” When today’s historic global Bubble bursts, the “grail” quest will shift to recent decades. Yellen’s comments are worthy of chronicling for posterity.

CNBC’s Steve Liesman: “Every day it seems we look at the stock market, it goes up triple digits in the Dow Jones. To what extent are there concerns at the Federal Reserve about current market valuations? And do they now or should they, do you think, if we keep going on the trajectory, should that animate monetary policy?"

Chair Yellen:
“OK, so let me start, Steve, with the stock market generally. I mean, of course, the stock market has gone up a great deal this year. And we have in recent months characterized the general level of asset valuations as elevated. What that reflects is simply the assessment that looking at price-earnings ratios and comparable metrics for other assets other than equities, we see ratios that are in the high end of historical ranges. And so that’s worth pointing out.

But economists are not great at knowing what appropriate valuations are; we don’t have a terrific record. And the fact that those valuations are high doesn’t mean that they’re necessarily overvalued. We are in a -- I mentioned this in my opening statement and we've talked about this repeatedly - likely a low interest rate environment lower than we’ve had in past decades. And if that turns out to be the case, that’s a factor that supports higher valuations, where enjoying solid economic growth with low inflation and the risks in the global economy look more balanced than they have in many years.

So, I think what we need to and are trying to think through is if there were an adjustment in asset valuations, the stock market, what impact would that have on the economy? And would it provoke financial stability concerns? And I think when we look at other indicators of financial stability risks, there’s nothing flashing red there or possibly even orange. We have a much more resilient, stronger banking system. And we’re not seeing some worrisome buildup in leverage or credit growth at excessive levels. So, this is something that the FOMC pays attention to. But if you ask me is this a significant factor shaping monetary policy now, well it’s on the list of risks. It’s not a major factor.”

Reuter’s Howard Schneider: “So you mentioned in response to Steve's question that asset valuations, you didn't think, were on the, sort of, high-priority risk list right now. So I’m wondering what do you think is on that risk list? And more broadly, what have you left undone? You’ve gotten high marks for bringing the economy back towards its goals, but are there things that are going to nag you when you walk out of here in February, and say, ‘Really, I wish I’d seen this to completion’? I mean, we’re not doing negative interest rates. We’re not doing inflation framework. What’s at the top of the to-do list that you are not getting to see to bring to ground here?”

Yellen: “
So you asked about the risk list. There are always risks that affect the outlook. We tend to focus, in our own evaluation, on economic risks. And we’ve characterized them as balanced, and I think they are balanced. I can always give you a list of, you know, potential troubles, international developments that could result in downside economic risk.

But look, at the moment the U.S. economy is performing well. The growth that we’re seeing it’s not based on, for example, an unsustainable buildup of debt, as we had in the run-up to the financial crisis. The global economy is doing well. We’re in a synchronized expansion. This is the first time in many years that we’ve seen this. Inflation around the world is generally low. So I think the risks are balanced, and there’s less to lose sleep about now than has been true for quite some time. So I feel good about the economic outlook…

As I mentioned, I think the financial system is on much sounder footing, and that we have done a great deal to put in place greater capital, liquidity, and so forth that make it less crisis-prone, and that has been an important objective. What’s on my undone list, you ask? We have a 2% symmetric inflation objective, and for a number of years now, inflation has been running under 2%, and I consider it an important priority to make sure that inflation doesn’t chronically undershoot our 2% objective. And I want to see it move up to 2%. So most of my colleagues and I do believe that it’s being held down by transitory factors, but there’s work undone there in the sense we need to see it move up in line with our objective.”

Bloomberg’s Mike McKee: “…Do you think that there is any Fed blame or complicity in the flattening of the yield curve, and are you worried that there might be some sort of policy mistake built into that that could slow the economy?”

Yellen: “The yield curve has flattened some as we’ve raised short rates. The flattening curve mainly reflects higher short-term rates. The yield curve is not currently inverted, and I would say that the current slope is well within its historical range. Now there is a strong correlation historically between yield curve inversions and recessions. But let me emphasize that correlation is not causation. And I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed. One reason for that is that long-term interest rates generally embody two factors: One is the expected average value of short rates over, say, ten years. And the second piece of it is a so-called term premium that often reflects things like inflation and inflation risk. Typically, the term premium historically has been positive. So when the yield curve has inverted historically, it meant that short-term rates were well above average expected short rates over the longer run – so with a positive term premium that’s what it means. And typically that means that monetary policy is restrictive – sometimes quite restrictive. And some of those recessions were situations in which the Fed was consciously tightening monetary policy because inflation was high and trying to slow the economy. Well, right now the term premium is estimated to be quite low – close to zero. And that means that structurally – and this could be true going forward – that the yield curve is likely to be flatter than it’s been in the past. And so it could more easily invert if the Fed were to even to move to a slightly restrictive policy stance – could see an inversion with a zero term premium. So, I think the fact the term premium is so low and the yield curve is generally flatter is an important factor to consider.” 

The yield curve has become, once again, a critical Bubble issue. Recall Alan Greenspan’s “conundrum.” The Greenspan Fed raised short-term rates 350 bps (June ’04 to January ’06) yet 10-year Treasury yields barely budged (around 4.5%). After trading as high as 273 bps in 2003, the spread between two-year and 10-year Treasuries ended 2004 at 115 bps and 2005 at about flat. The yield curve inverted as much as 18 bps in November 2016.

Keep in mind that system Credit was expanding by record amounts, fueled by years of compounding double-digit annual mortgage Credit growth. Annual Total Non-Financial Debt (NFD) growth averaged $760 billion during the decade of the nineties. By 2002, NFD was up to $1.346 TN and accelerating rapidly. NFD expanded $1.654 TN in 2003, $2.115 TN in 2004, $2.291 TN in 2005, $2.416 TN in 2006 and $2.509 TN in 2007. Clearly, a flat or inverting yield curve was not explained by restrictive monetary policies.

The fundamental issue was not so much that market yields were not rising in response to Fed “tightening” measures. Rather, why were borrowing rates not increasing in the face of unprecedented demand for Credit? How had the price of finance become completely disconnected from underlying demand? And, critically, why was the Credit system not self-adjusting and correcting, but instead fueling a runaway mortgage finance Bubble?

Arguing asset price valuations back in the 2004 to 2007 Bubble period was as futile as it is today. It was the yield curve that signaled something was seriously amiss. The so-called “conundrum” needed serious contemplation, not clever self-serving rationalization and justification (i.e. “global savings glut”). Moreover, the anomalous yield curve was providing important corroboration of anomalous Credit growth data.

Finance had been fundamentally altered. Contemporary Credit systems, increasingly dominated by market-based finance, were essentially operating with unlimited supply. Somehow, a rapid doubling of mortgage Credit in just over six years neither stressed the supply of Credit nor evoked higher risk premiums. Instead of self-correction, this new financial apparatus was a self-reinforcing Bubble machine. The system had badly malfunctioned, though the ugly reality remained camouflaged until later in 2008. In the meantime, it flaunted a pretense of being both phenomenal and sustainable.

The yield curve has again flattened significantly in 2017. The two-year to 10-year Treasury spread ended Friday’s session at 51 bps, down from the 125 bps to start the year, to the narrowest spread since the heydays of Bubble excess back in 2007. Short-rates have risen, the economy has gathered momentum and prospects for an uptick in inflation have increased. What’s behind the replay of the “conundrum”?

On one point, I concur with chair Yellen: “I think there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.” But I would posit that this change evolved over recent cycles, as central bankers took an increasingly activist role in the economy and, most importantly, throughout the financial markets.

I would argue that the yield curve flattened in’06 and ’07 specifically because of Bubble Dynamics in mortgage Credit coupled with Bernanke’s previous professing on “helicopter money” and the government printing press. Dr. Bernanke, a radical inflationist, had become a powerful force in Federal Reserve policymaking. Bond markets back then discerned mortgage finance Bubble unsustainability, while deftly anticipating the Federal Reserve’s crisis response. The bursting Bubble saw the formal unveiling of the new central bank modus operandi: slash short rates to at least zero; aggressively inject liquidity into the markets through long-term debt purchases; manipulate long-term market yields much lower while telegraph unwavering liquidity support.

The Fed and conventional thinking are comfortable with the view that today’s flat yield curves (low long-term yields) signal ongoing disinflationary pressures. The talk is of an extraordinarily low “neutral rate” that, conveniently, necessitates ongoing aggressive monetary accommodation. Apparently, financial stability concerns remain undeserving of the Fed’s “risk list”, so long as core consumer prices remain (slightly) below the 2% target.

December 13 – Reuters (John Ruwitch and Winni Zhou): “Financiers keep pouring cash into the shale oil sector, providing producers with a path to keep U.S. output rising through the middle of the next decade. The United States is on track to deliver up to 80% of the world’s oil production gains through 2025, the International Energy Agency estimates, increases fueled in part by easy access to capital. Rising U.S. production is undermining OPEC’s attempts to curb global supply and boost prices, forcing the oil cartel to continue restraining output through the end of 2018. Hedge funds and private equity firms have given producers a range of new and traditional financial levers they can pull as needed to keep shale rigs drilling…”

In so many ways, years of loose finance have spurred over-investment and attendant downward pricing pressures. Shale finance is only one of the more visible examples. Importantly, excess cheap finance and investment have evolved into powerful global phenomena. One has only to point to the runaway Credit boom - and resulting manufacturing overcapacity in China (and Asia more generally) - to come to the rather obvious conclusion that activist monetary management/accommodation can foment downward pricing pressures.

These days, central bankers from around the globe sing from the same hymn sheet. The inflation backdrop demands ongoing stimulus. The yield curve is “within its historical range”. “The financial system is on much sounder footing.” There’s “less to lose sleep about.” “When we look at other indicators of financial stability risks, there’s nothing flashing red there or possibly even orange. We have a much more resilient, stronger banking system. And we’re not seeing some worrisome buildup in leverage or credit growth at excessive levels.” When it comes to mounting risk throughout global securities and derivative markets, it’s hear no evil, see and speak none either. It’s worth highlighting an exchange from Mario Draghi’s Thursday press conference”

Question: “What kind of discussions have been going on within the governing council about possible bubbles in sectors of the market or economy – and how exiting the asset purchase plan could impact those bubbles?”

Mario Draghi: “We always discuss financial stability issues, and we certainly closely monitor the financial stability risks that may emerge from a situation where we had very, very low interest rates for a long period of time; abundant liquidity for a long period of time. So, the ground is fertile for these risks. At the same time, we are not seeing systemically important financial stability risks. We see the local spots where valuations tend to be over-stretched. But also, as soon as you ask this question, one should also ask the question ‘How’s leverage?’ Because a bubble is also the outcome of two components. So how’s leverage behaving? And there, differently from other parts of the world, we don’t see leverage – for the private sector going up, as for the whole of the Eurozone. As a matter of fact, debt to GDP or debt to value of assets – depending on the yardstick – continues to decrease…”

My response: Proclaiming a lack of “private sector” leveraging is disingenuous when the greatest sources of systemic leverage throughout this long cycle have been ballooning central bank and government balance sheets. It recalls how pristine government finance was an important facet of the last cycle’s bull story. Meanwhile, massive leveraging by the private and financial sectors was behind the mirage of responsible fiscal management.

As for Draghi’s “local spots” of “over-stretched” valuations, could he be referring to Italian 10-year yields at 1.80% or Spain at 1.49%? Or perhaps Greece at 3.89%, or Portugal at 1.76%. Or could it be German 10-year yields at 0.29%, or perhaps German two-year yields at negative seven bps. And then there’s French 10-year yields at 0.62%, Switzerland at negative 0.24%, Finland at 0.45%, Ireland at 0.48%, Belgium at 0.49%, Netherlands at 0.40%, Austria at 0.45% or Slovenia at 0.69%.

It’s reminiscent of chairman Greenspan’s declaration that you can’t have a national real estate Bubble because all real estate markets are local. The flaw in the maestro’s thinking was his apparent disregard for the Bubble throughout mortgage finance – very much on a systemic, national basis. Today’s Bubble is in finance on a systemic, global basis – most prominent in government, central bank and securities finance – developed, EM and, importantly, all things China. Leveraging galore – with the associated Bubble finance utterly “fungible.”

December 13 – Bloomberg (Chris Anstey): “European investors have been plowing so much capital abroad they’ve taken up about half the boom in U.S. corporate debt in recent years, but now that liquidity tap is poised to be shut off, according to Oxford Economics. ‘The global debt issuance boom is likely to lose steam, given the extent to which it has relied on the support of European investors,’ Guillermo Tolosa, an economic adviser to Oxford Economics in London who has worked at the International Monetary Fund, wrote… ‘Issuers better seize the opportunities while they last.’ European Central Bank asset purchases took up so great a supply of bonds that it pushed euro area investors into markets abroad, to the tune of 400 billion euros ($473bn) a year over the past three years, Oxford Economics estimates.”

It’s simply difficult to believe that these central bankers fail to recognize what have evolved into deeply systemic risks. They know they’re trapped, but in denial – right? Then again, complacent central bankers have a history of being blindsided. Clearly, they’re determined to cling to flawed doctrine. I’ve always believed conventional thinking has it wrong: The great risk is not deflation but runaway Credit Bubbles. And the very serious problems unfold when the risk of a bursting Bubble ensures that policymakers rationalize, justify - and sit back and do nothing.

December 12 – CNBC (Tae Kim): “Stanley Druckenmiller believes the overly easy monetary policies by global central banks will have disastrous consequences. ‘The way you create deflation is you create an asset bubble. If I was 'Darth Vader' of the financial world and decided I'm going to do this nasty thing and create deflation, I would do exactly what the central banks are doing now,’ he told CNBC's Kelly Evans… ‘Misallocate resources [with low interest rates], create an asset bubble and then deal with the consequences down the road,’ he said. The investor noted how this boom-and-bust cycle has happened time and time again. ‘Deflation just doesn't appear out of nowhere and it doesn't happen because you are near the zero bound. Every serious deflation I've looked at is preceded by an asset bubble and then it bursts,’ he said. ‘Think about the '20s, a big asset bubble that burst, you have the Depression. Think about Japan. Asset bubble in the '80s. It burst. You have the consequences follow. Think about 2008, 2009.’”

Country without a Government

Merkel's Difficult Road to a Coalition

Three months after the election, Germany is as far away from a governing coalition as ever and Social Democrats don't expect an agreement before Easter. Meanwhile, Germany's influence in the EU is on the wane. By DER SPIEGEL Staff

The Chancellery in Berlin
The Chancellery in Berlin

Germany's acting finance minister, Peter Altmaier, is fond of playing the cosmopolitan European diplomat on visits to Brussels. Articulate and multilingual, Altmaier doesn't shy away from speaking a bit of Dutch into the microphone and is perfectly at home chatting with outgoing Eurogroup head Jeroen Dijsselbloem or delivering a withering critique of U.S. President Donald Trump's tax plan.

But once the doors close and his counterparts begin asking him the question that is foremost on their minds -- when is Europe's most important country going to finally assemble a new government? -- Altmaier has no choice but to tell them the sobering truth. The constitutional situation in Germany, he notes, is complicated. Furthermore, if a renewed coalition between Chancellor Angela Merkel's conservatives and the center-left Social Democrats (SPD) -- a pairing known as a "grand coalition" -- does, in fact, take shape, the SPD has said it plans to have the grassroots vote on it. That will take time, Altmaier says, looking into the shocked faces surrounding him.

With its current provisional government, Germany is in the process of gambling away its excellent political reputation in Europe. The country used to be considered a paragon of democracy with a parliamentary system that worked just as reliably as its cars and industrial machinery.

Yet with the German general election, held on Sept. 24, rapidly fading into the rearview mirror and parties like the business-friendly Free Democrats (FDP) and the SPD -- both of which with plenty of experience as members of governing coalitions in Germany -- shying away from joining Merkel's conservatives in a political alliance, many abroad have begun seeing the country in a new light. The growing skepticism started, of course, with Berlin's misadventures in its attempt to build a simple airport and the doubts have gained credence with a series of other mishaps, most recently German rail's inability to get its much-ballyhooed new high-speed line between Munich and Berlin working properly. And now the country can't even seem to assemble a governing coalition. Can't the Germans do anything anymore?

For the time being, the damage done isn't overwhelming. The acting cabinet, in office since October, has been leading the republic with the listless efficiency one might expect. And there are plenty of people out there who approve of a government that focuses exclusively on the day-to-day and is limited in the amount of money it can spend.

But the longer the vacuum continues, the more obvious the disadvantages will become. Important decisions are being delayed, Germany's heft in Europe and the world is eroding and -- perhaps most importantly -- the standstill in Berlin is bolstering populist critiques of the parliamentary system and their claims that the political elite only care about their own parties and not the good of the country as a whole.

'Embarrassing Display'

With the first round of coalition negotiations -- which sought to assemble a government comprised of the conservatives, the FDP and the Greens -- having failed, a clear majority of Germans believe the country to be "in a difficult situation" according to surveys. A poll taken by the Allensbach Institute resulted in replies like: "It is embarrassing to put such disunity on display to the world."

It could get even more embarrassing shortly. With the conservatives and the SPD soon to begin preliminary coalition discussions, doubts about a successful conclusion to those talks are greater than ever. The idea of joining Merkel in another governing coalition is anathema to many in the SPD while some conservatives have been vocal about their preference for a minority government, a position they share with a number of SPD members.

That means that Merkel is faced with fighting a battle on two fronts: One pitting her against the critics in her own camp; and one aimed at convincing the Social Democrats to join her.

Merkel herself hasn't been shy about her affinity for governing together with the SPD. In mid-October, at a time when the first round of coalition talks with the FDP and Greens seemed to be going well, the cabinet of the chancellor's outgoing coalition with the SPD met on the seventh floor of the Chancellery.

Nobody there seriously thought there was a chance that their alliance might continue for another four years. And wine-fueled amicability was in generous supply that evening, with senior politicians from both parties dropping the formality that had characterized their working relationships. Merkel held a brief farewell address in which she sang the praises of the grand coalition. She said that cooperation with the SPD had been outstanding and expressed her doubts that a different coalition could ever work together so harmoniously and smoothly.

Preferences for a Minority Government

The problem, though, is that among her conservatives, enthusiasm for the alliance with the SPD isn't nearly as profound. Indeed, the intransigence has become so unabashed that Horst Seehofer, head of the Christian Social Union (CSU), the Bavarian sister party to Merkel's Christian Democrats (CDU), saw fit to complain.

Last Sunday, he joined Merkel in the Chancellery to bemoan the numerous statements of grand-coalition skepticism coming out of the CDU. He said that he had counted 14 such statements coming from the CDU in recent days. "You have to put a stop to it," Seehofer told Merkel.

Both Seehofer and Merkel would like the talks with the SPD to go as quickly as possible. "The world is waiting for us to be able to engage again," the chancellor said on Monday. Others, though, don't see it that way. The party's economically liberal wing prefers a minority government while Jens Spahn, perhaps Merkel's most dangerous adversary within the CDU, has demanded that the conservatives not abandon a single core position in their talks with the SPD. If they do, he said, he would also be in favor of a minority government.

Some suspect that Spahn may not be primarily concerned with the party's positions on the issues. Indeed, conservative floor leader Volker Kauder sharply upbraided Spahn and his allies during a recent meeting of CDU leaders: "You are only interested in getting a cabinet seat," he said. And indeed, were the CDU to opt for a minority government, Spahn's chances of receiving a cabinet portfolio would be much greater.

Spahn, of course, has made no secret of his ambitions. Thus far, though, he doesn't have the necessary governing experience to perhaps succeed Merkel one day. He does, however, have plenty of backers within the CDU, which helps explain why many in the party aren't rallying behind Merkel's calls for quick coalition talks with the SPD.

Concerns about a repeat of the grand coalition, though, are much greater within the Social Democrats. After the party's catastrophic results in the Sept. 24 election, the SPD had seemed relieved that it could flee into the opposition. Indeed, even after Merkel proved unable to assemble a coalition with the FDP and the Greens, the SPD continued to play hard-to-get -- until German President Frank-Walter Steinmeier, who has suspended his SPD membership while he is the country's head of state, made it clear he wasn't in favor of holding new elections. But the party clearly isn't eager to join another government. The word coming out of the SPD is that a government before Easter will only be possible if talks go completely smoothly.

What is a KoKo?

Following the preliminary talks, the SPD plans to hold a party congress to decide on whether to enter formal coalition talks. Should those talks then produce an agreement, the final deal would then be voted on by the SPD grassroots.

But there is a fair amount of confusion within the Social Democrats at the moment and it remains completely unclear what exactly party leaders want. Whereas party head Martin Schulz and floor leader Andrea Nahles recently indicated that they are leaning in favor of a grand coalition, senior party member Malu Dreyer, the SPD governor of Rhineland-Palatinate, is more in favor of a minority government.

How exactly a minority government might be beneficial to the SPD isn't entirely clear. Furthermore, Dreyer herself decided against a minority government in her own state in 2016, preferring to cobble together a three-party coalition. Still, her voice is a weighty one in the party.

Then there is a third group, including the party's left wing, that has thrown its support behind an experimental form of government participation. One idea circulating is that of a "Cooperation Coalition," quaintly abbreviated to "KoKo" in German. The idea is that the coalition agreement would only formalize the alliance on a handful of core political projects while the parties would be allowed to work against each other on other issues. KoKo fans within the SPD believe the arrangement would give the party a bit more distance from Merkel and her conservatives. But the concept seems to ignore the fact that the SPD would find it virtually impossible to push proposals through parliament in opposition to the CDU and CSU. Even if the SPD were to have the support of the Greens and the Left Party, they still wouldn't have a majority.

Everybody in SPD leadership is clear that the party must present a more united front at its January congress than it did during its congress from last week. In order to avoid a rupture, leaders must arrive at a clear position supported by all of the top brass: Either in favor of forming a government or opposed. And it seems clear that Schulz will only be given a green light to proceed if he can credibly claim that a renewed alliance with Merkel will lead to far-reaching health care reform, billions of investments in education and progress on other key Social Democrat demands.

Much will depend on the state SPD chapter in North Rhine-Westphalia, which has traditionally been extremely skeptical of an alliance with the Christian Democrats. With the state being Germany's most populous, the SPD chapter there will send 150 delegates to the party congress, roughly a quarter of the total. And it won't be easy to control them. Everybody at SPD headquarters in Berlin knows that if the North Rhine-Westphalia SPD doesn't support a grand coalition, it won't happen.

Signs of Torpor in Berlin

And state SPD leader Michael Groschek is extremely skeptical. "There is much currently being said about the SPD's shared sovereign responsibility," he says. But the SPD's primary responsibility is to "once again become large and strong enough that the people of our country see it as a real alternative when it comes to choosing our country's chancellor," he continues. "If we get used to being the junior partner, we'll end up as lackeys."

Groschek warns the SPD and conservatives against making any quick assumptions about the potential success of renewed grand coalition talks. "Nobody should fall prey to illusions that the grand coalition will become an inevitability just because of a few nice headlines coming out of the preliminary talks," he says. "We're not drawing any red lines, but without concrete improvements in the areas of labor market policy, pensions and health care, it is unthinkable that the party congress will give a green light to further talks."

The consequences aren't difficult to predict. If SPD negotiators want to be able to present concrete agreements to party congress delegates and, later, to grassroots Social Democrats, they will have to wrestle with conservatives over every single detail. And that will make coalition negotiations even more drawn-out.

Meanwhile, the world is not standing still. German Environment Minister Barbara Hendricks was confronted with that fact at COP23, the recent global climate change conference in Bonn. Under the leadership of Canada and Britain, an international alliance was formed for the phase-out of coal -- and Hendricks had to stand by and watch. Until a new government is formed, after all, she is only leading the portfolio in a caretaker capacity.

But it is in Brussels where Germany's absence has been particularly noticeable. Diplomats there emphasize with barely concealed delight that work is continuing on virtually all issues despite the lack of a government in Berlin.

French Prime Minister Édouard Philippe, for example, recently presented an ambitious plan for electromobility. "France plans to end the sale of automobiles with internal combustion engines in the year 2040," Philippe wrote, adding that he hopes other EU countries will emulate the pledge. The letter hasn't yet been published, but it is nothing short of an open challenge to Berlin. And Germany's caretaker government isn't in a position to defend itself. Indeed, the outgoing grand coalition had failed in recent months to agree on a clear policy on electromobility.

Protracted Even Further

Berlin also remains on the sidelines in terms of reforming the EU, likely to be the most important political issue facing Europe in the coming months. European Commission President Jean-Claude Juncker presented his vision for the EU's future a few days ago, an answer to the laundry list of proposals French President Emmanuel Macron delivered two days after the German general election. But it remains unclear what Germany wants. The last meaningful proposal coming from Berlin originated with then-Finance Minister Wolfgang Schäuble, who has been president of the Bundestag, Germany's parliament, since late October.

When Merkel flew to Brussels on Thursday for a meeting of the European Council, she brought along a dossier regarding Juncker's proposals. But the paper ended with the conclusion that little could be done until Germany formed a new government.

Given Germany's traditional role as the most powerful voice when it comes to the direction taken by the EU, the delay is becoming a problem. European Council President Donald Tusk had hoped to come up with an agreement on the way forward by the middle of next year. But thanks to the slow process of assembling a government in Berlin, that timeline is beginning to look unrealistic. And with European elections looming in 2019, the delay could be protracted even further.

Even those who aren't generally known for showing nerves are becoming nervous, people like Gunther Krichbaum, a CDU parliamentarian who is the long-serving chair of the European Affairs Committee in the German parliament. He generally doesn't demand the floor during meetings of the conservative caucus, but when Merkel on Monday evening only briefly mentioned the upcoming European Council meeting ("... and then there's the summit"), he'd had enough. Germany, he called out, has to be careful that it doesn't completely lose its influence in Europe. German interests, he said, are in danger of disappearing under the radar. Günther Oettinger, Germany's representative on the European Commission, likewise complained recently in an interview with DER SPIEGEL that Germany's influence on important issues in Brussels had gone missing.

Like the issue of money, for example. Oettinger, the commissioner for budget and human resources, is currently compiling a draft budget for EU spending from 2021 to 2027. For Germany, billions in agricultural subsidies and regional assistance programs are at stake while Merkel would like to shift large chunks of EU spending to education, refugee policy and technology.

Delayed Decisions

Another controversial issue is how to compensate for the 10 billion euros per year that will be lost once Britain leaves the EU. Many EU member states have a clear idea of who should jump into that gap: namely, Germany.

Berlin's ongoing inability to assemble a stable government is far from being a crisis of state. At first glance, political administration is continuing as it should while in the Bundestag, committees have been formed and debates are being held. But at second glance, things are in fact stalled throughout the political machinery.

It begins with minor formalities: The personnel department in the Justice Ministry, for example, isn't sure what to do because some employee contracts there contain a provision saying that the contractual relationship comes to an end two months after the minister's departure. Now, lawyers are trying to figure out whether a caretaker minister has actually "departed" in a legal sense.

Every office head at the moment must decide for him- or herself how to proceed on important issues and personnel questions: Either delay vital decisions or just charge ahead. Delay is possible, if difficult, in some cases -- such as two senior vacancies in the Justice Ministry caused by retirements. Because acting minister Heiko Maas doesn't know who might be taking over the ministry, or whether he might actually remain in his current position, he doesn't feel able to hire replacements.

But there are certain issues on which decisions must be made immediately. One of those is the diesel problem. In late February, the Federal Administrative Court will render a judgment on whether diesel-fueled vehicles can be banned from the centers of some cities. In an effort to satisfy the court's concerns, Merkel had pledged 1 billion euros in immediate aid for programs aimed at, for example, modifying aging diesel buses. But funding cannot be made available without a budget and a budget cannot be passed without a government.

A Boon for the Populists

Because the clock is ticking ahead of the verdict, the government is trying to divert money to the programs from other existing projects within the Environment Ministry and Transport Ministry that are somehow related to clean air. But it's far from sufficient, leading officials to nab a half-billion euros from the country's climate fund, which is supposed to provide resources to projects combatting climate change.

The winner of the ongoing governmental stalemate in Berlin is likely to be the right-wing populist Alternative for Germany party. Should negotiations for a renewed grand coalition succeed, the AfD would become the largest opposition party. If they don't succeed, the AfD could continue to decry the failures of Germany's big-tent parties. And continue to pose as the true representatives of "the people."

During the first round of coalition negotiations between the conservatives, the FDP and the Greens, the AfD had a "dispatch" delivered to Angela Merkel at the site of the talks. "We are following the exploratory talks with great concern," the missive read. "We have gained the impression that these negotiations are not adequately addressing the problems facing our country."

It seems likely that once preliminary talks begin for a re-run of the grand coalition, leaders from the SPD and CDU can expect to receive a similar message.

By Melanie Amann, Veit Medick, Peter Müller, Ralf Neukirch, Michael Sauga, Christoph Schult and Gerald Traufetter

Here’s What Happened the Last Time Economists Ignored the Yield Curve

By Ben Eisen

An age-old debate is bubbling up again about the value of a bond-market gauge that’s sending warning signs about the U.S. economy, mirroring a discussion that took place before the last recession.

The so-called yield curve, which can be measured by looking at the differential between two-year and 10-year Treasury yields, has been shrinking in recent months, falling to as little as 0.52 percentage point last week. That about half its level from May.

Long-term yields tend to go up and down alongside expectations for growth and inflation, while short-term yields tend to rise when the Federal Reserve raises rates. A low long-term yield, especially at a time of rising short-term rates, is thought to be a sign of caution. And when long-term yields dip below their short-term counterparts in what’s known as an inverted yield curve, it has reliably indicated a coming recession.

10-year and 2-year Treasury note yields are converging, one widely-watched sign of a flattening yield curve

While the yield curve isn’t inverted at the moment, the accelerated pace of flattening recently has unnerved some economists and investors. It’s also emboldened others who say the yield curve’s forecasting power is being obscured by a unique set of factors, including the growing participation of foreign buyers and declining demand for additional compensation to own longer-term debt.

“There is a strong correlation historically between yield curve inversions and recessions,” said Fed Chairwoman Janet Yellen at a press conference Wednesday. “But let me emphasize that correlation is not causation, and I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.”

Compare that to what happened the last time the yield curve sent an ominous signal about a recession in the mid 2000s.

The flattening of the curve, which began in mid-2003, picked up steam a year later as the Federal Reserve started a steady drumbeat of rate increases. Short-term Treasury yields rose along with the central bank’s key policy rate, while long-term rates confounded economists by resisting a move higher. Alan Greenspan, then the Fed chairman, called that development a “conundrum” in early 2005.

The inverted yield curve, a traditional economic warning sign, spurred furious debate about the indicator´s value ahead of the last recession

The yield curve debate continued to intensify throughout that year as it flattened more. With few economic worries on the horizon, many were ready to write off the value of the yield curve as a predictor — including Mr. Greenspan. A Wall Street Journal article from Dec. 2005 laid out the arguments:

“A growing chorus, including Federal Reserve Chairman Alan Greenspan, is challenging the reliability of the yield curve’s forecasting ability. Heavy foreign buying of U.S. bonds drives prices up and keeps long-term yields, which move in the opposite direction of a bond’s price, low. The heavy foreign buying, the argument goes, keeps long-term yields unusually low, which could help the economy, even as short-term rates rise.

“Skeptics say such arguments are reminiscent of the talk of the indestructible New Economy that helped drive the dot-com bubble in the late 1990s.”

A few weeks after that article published, two-year yields popped slightly above 10-year yields, the first instance of the yield curve inversion during that period. A Journal article from Dec. 29 of that year quoted economists continuing to shrug it off. As one put it: “I think the bond market is on drugs… It’s hard to take the yield curve seriously as a recession indicator.”

In February 2006, Ben Bernanke took over as Fed chair from Mr. Greenspan. A month later, in a speech at the Economic Club of New York, Mr. Bernanke gave a speech titled “Reflections on the Yield Curve and Monetary Policy.” He said:

“Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards. Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.”

The yield curve stayed negative for most of 2006, even after the Fed stopped lifting rates in the middle of the year. In 2007, as signs of economic weakness cropped up, the Fed started lowering rates, pushing the spread between the two-year and 10-year yields back into positive territory. But a nasty recession was already approaching that would take a heavy toll on the economy.

It’s tough to tell what a flattening yield curve is signaling this time around — particularly because it hasn’t yet inverted. Plus, the decade-ago experience shows that a recession can lag years behind a yield curve inversion once it does happen. But some say the lesson from the last time around is clear: keep an eye on the yield curve, and take the words of economists–even Fed chairs–with a grain of salt.

America’s Supply-Side Scam


Income tax regulation books

NEW HAVEN – Tax cuts masquerading as tax reform are the best way to describe the thrust of Washington’s latest policy gambit. The case is largely political – namely, the urgency of a Republican Congress to deliver a legislative victory for a Republican president. The consequences, however, are ultimately economic – and, unsurprisingly, likely to be far worse than the politicians are willing to admit.

Taking the lead from President Donald Trump, the political case for tax cuts is that they are essential to “make America great again.” Over-taxed and cheated by bad trade deals, goes the argument, America needs tax relief to revive its competitive prowess.

Notwithstanding the political pandering to hard-pressed middle-class families, corporate America is clearly the focus of these efforts, with proposed legislation aiming to reduce business tax rates from 35% to 20%. Never mind that US companies currently pay a surprisingly low effective corporate tax rate – just 22% – when judged against post-World War II experience.

And pay no attention to the latest tally of international competitiveness by the World Economic Forum, which finds the US back in second place (out of 137 countries). And, of course, don’t draw comfort from the lofty stock-market valuations of the broad constellation of US companies. Forget all that, Republicans insist: cut business taxes, they say, and all that ails America will be cured.

There are times when the politicization of economic arguments becomes dangerous. This is one of those times. The US simply can’t afford the current tax cuts making their way through Congress.

According to the nonpartisan Congressional Budget Office, the cuts will result in a cumulative deficit of about $1.4 trillion over the next decade. The problem arises because America’s chronic saving shortfall has now moved into the danger zone, making it much more difficult to fund multi-year deficits today than was the case when cutting taxes in the past.

The so-called Kennedy tax cuts of 1964 and the Reagan tax cuts of 1981 are important cases in point.

The net national saving rate – the broadest measure of domestic saving, which includes depreciation-adjusted saving of households, businesses, and the government sector – averaged 10.1% during those two years (1964 and 1981). In other words, back then the US could afford to enact major tax cuts.

That is not the case today, with the net domestic saving rate a mere 1.8% of national income.

Even during the two tax cuts that followed – the second installment of Reagan’s fiscal program in 1986, and the initiatives of George W. Bush in 2001 – the net national saving rate averaged 4.2%, more than double the current level.

Both experience and macroeconomic theory indicate what to expect. Saving-short economies simply cannot go on deficit-spending binges without borrowing surplus saving from abroad.

That is what brings the balance-of-payments and trade deficits directly into the debate over fiscal policy.

Significantly, the US current account was in slight surplus during the big tax cuts of 1964 and 1981 – in sharp contrast to today’s deficit of 2.6% of GDP. With fiscal deficits likely to push an already-low domestic saving rate even lower – possibly back into negative territory, as was the case from 2008-11 – there is a great risk of a sharply higher current-account deficit. And a bigger current-account deficit means that the already-large trade deficit will only widen further, violating one of the main tenets of Trumponomics – that making America great again requires closing the trade gap.

It is at this point where the tale goes from fact to fiction. Trump and the congressional Republican majority insist that the proposed tax cuts will be self-financing, because they will spur economic growth, causing revenues to surge. This so-called supply-side argument, first advanced in support of the Reagan-era tax cuts, has been a lightning rod in US fiscal policy debates ever since.

Reality has turned out quite differently than the supply-siders envisioned. Yes, the economy recovered spectacularly from a deep recession in 1981-1982. But that was due largely to an aggressive easing of monetary policy following the Federal Reserve’s successful assault on double-digit US inflation.

By contrast, the fiscal nirvana long promised by supply siders never materialized. Far from vanishing into thin air, federal budget deficits ballooned to 3.8% of GDP during the 1980s, taking public debt from 25% of GDP in 1980 to 41% by 1990.

Not only did the supply siders’ self-funding promises go unfulfilled; they also marked the beginning of the end for America’s balance-of-payments equilibrium. From 1960 to 1982, the current account was basically in balance, with a surplus averaging 0.2% of GDP. On the heels of the budget deficits of Reaganomics and the related plunge in national saving, the current account swung sharply into deficit, averaging -2.4% of GDP from 1983 to 1989. And it has remained in deficit ever since (with the exception of a temporary reprieve in the first two quarters of 1991 due to external funding of the Gulf War).

Far from a recipe for greatness, the Trump fiscal gambit spells serious trouble. Lacking in saving, outsize US budget deficits point to sharp deterioration on the balance-of-payment and trade fronts. Nor will creative supply-side accounting alter that outcome. A “dynamic scoring” by the nonpartisan Tax Policy Center suggests growth windfalls might prune the multiyear deficit from $1.4 trillion to $1.3 trillion over the next decade – hardly enough to finesse America’s intractable funding problem.

George H.W. Bush said it best when he was campaigning for the Republican presidential nomination in April 1980. He rightly criticized the “voodoo economic policy” of his opponent, Ronald Reagan.

For today’s saving-short US economy, déjà vu is a painful understatement of what lies ahead.

Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.

Cutting US Corporate Tax Is Worth the Cost


President Donald Trump makes a statement to the media

CAMBRIDGE – The United States Congress is close to enacting a major tax reform. The plan’s most important provision reduces the corporate tax rate from 35% to 20% – from the highest among all OECD countries to one of the lowest – and allows US companies to repatriate the profits of their foreign subsidiaries without paying additional US taxes. Opponents of the legislation point to the resulting increase in the federal budget deficit, which will add $1.5 trillion to the government debt over the next ten years.

I dislike budget deficits, and I have long warned about their dangerous effects. Nonetheless, I believe that the economic benefits resulting from the corporate tax changes will outweigh the adverse effects of the increased debt.

The lower rate will attract capital to the US corporate sector. American corporations will invest more in the US, because foreign countries will no longer offer lower tax rates, and will repatriate profits earned by their foreign subsidiaries rather than leaving them abroad. They will also bring back some of the previously earned foreign profits that have been left outside the US, estimated by the Treasury to be worth $2.5 trillion. Foreign companies will expand their investments in the US – or even shift their operations there – to take advantage of the lower tax rate. And within the US, capital will flow from agriculture and housing to higher productivity uses in the corporate sector.

Although it is difficult to estimate the total increase in capital in the corporate sector, I think it is reasonable to assume that over the next ten years it will reach at least $5 trillion. The increased flow of capital to the corporate sector will raise productivity and real wages. If that happens, it will raise annual real GDP in 2027 by about $500 billion, equivalent to 1.7% of total 2027 GDP, implying a gain of $4,000 per household in today’s dollars.

These favorable effects are directly relevant to balancing the primary adverse effects usually associated with a fiscal deficit: that government borrowing crowds out private capital formation; that higher interest payments generally require higher taxes or reductions in spending on defense and nondefense programs; that a budget deficit implies an unwanted increase in aggregate demand when the economy is at full employment; and that a higher debt ratio leaves less capacity for increased emergency government spending.

I believe that none of these problems will materialize during the coming decade. Let’s consider them in turn.

Although the $1.5 trillion of government borrowing caused by the tax bill during the next decade could crowd out an equal amount of private borrowing, the capital stock will grow by an even larger amount. The $1.5 trillion corporate tax cut will go directly to US companies, and the stock of corporate capital will grow further because of the inflow of funds from the rest of the world. Even with increased government borrowing, the proposed tax reform can therefore still raise the corporate capital stock by some $5 trillion over the next decade.

Moreover, the $500 billion increase in total annual income by 2027 would increase tax revenue by $100-150 billion a year. That is enough to cover the $60 billion in interest payments on the $1.5 trillion of extra debt, with money left over to increase government spending or reduce personal taxes.

Likewise, concern that an increase in the fiscal deficit would undesirably stimulate aggregate demand is misplaced. In fact, the stimulative effects of the fiscal deficit and increased corporate investment should be welcomed, for two reasons. First, they will offset the contractionary effects of the expected increase in the federal funds rate and the shrinking size of the Federal Reserve’s balance sheet. And, second, after nine years of economic expansion, most experts expect the US to enter recession sometime in the next five years.

Similarly, concern about the ratio of government debt to GDP, which has doubled in the past decade and is now 77%, is exaggerated. The Congressional Budget Office projects that even with no further legislation, the debt ratio will rise to 91.2% by 2027. The direct effect of the $1.5 trillion deficit implied by the tax reform would be to raise that to 97%. A military emergency or an economic downturn would call for additional debt-financed spending or tax reductions. But even a massive spending program like the $900 billion American Recovery and Reinvestment Act of 2009 would add only an additional three percentage points to the debt ratio. It is hard to believe that a debt ratio of 97% would make that more difficult to achieve than a debt ratio of 92%.

So, for all four of these reasons, I believe that the benefits of cutting the corporate tax rate more than offset the adverse effects normally attributed to budget deficits. But, looking ahead, I believe that reducing the fiscal deficit should be a high priority after the 2018 congressional election. A tax on carbon dioxide emissions or a slowdown of spending growth for federal entitlement programs can start to bring the debt ratio back down toward the 50% level that prevailed before the 2008-2009 downturn. But first it is important to enact the proposed tax reform.

Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

Soaring Deficits Force Treasury into Foolish Gamble: Part II

By: Michael Pento 

As mentioned last week in Part I, the U.S. National debt is now at a record $20.5 trillion. And the first month of fiscal 2018 showed a deficit increase of nearly 38% over fiscal 2017. The total amount of Non-Financial Debt is up nearly $15 trillion during the 2007-2017 timeframe. In addition, the Federal Reserve Bank of New York reported that household debt totaled $13 trillion in the third quarter ended September 30th, which is a record high and the 13th straight quarterly increase. And, CNBC recently reported that the debt of nonfinancial corporations has grown by $1 trillion in just the last two years and now totals over $8.7 trillion, which is also a record 45% of GDP.

In order to better handle the mounting National debt, the Treasury Department has announced new plans to ease pressure on long-term interest rates by shifting bond sales to the short term.

This program will increase the shorter-term and reduce the share of longer-term debt issuance, which is a significant departure from the former strategy that favored locking debt service payments at historically-low, long-term rates.

The fear within government is that the tremendous increase in debt supply, if financed on the long end of the yield curve, would significantly push down prices and force yields higher. That rise in long-term yields would negatively influence the borrowing costs for households, businesses and the government. And of course, a rise in long-term rates would slow the economy and de-rail one of Trump’s most self-tweeted “accomplishments”; the rise in the stock market.

But there will very quickly surface a few huge problems and unintended consequences with this new government scheme to garner a lower a debt service cost through the financing of debt at the shorter duration. Problem number one is this will expedite the flattening of the yield curve, currently just 57 basis points, cascading from 266 in December 2013. And, it will soon lead to an inverted yield curve, which has presaged a recession 7 out of 7 times in the past 50 years.

The second problem is that it puts the structure of the National Debt into history’s most pernicious adjustable-rate mortgage. Once the foolish goal of sustainable and rising inflation is achieved by the Fed, interest rates will begin to become unglued. That isn’t such a problem if the government did the correct thing and pushed the refinancing duration far out along the yield curve. In contrast, by going short, even a cyclical period of inflation will force the Treasury to roll over its debt at much higher interest payments and at much shorter intervals.

Perhaps the simple reason for the government’s decision to forgo financing Treasury debt at longer durations is because we just cannot afford it…not even at these historically-low yields.

While the Treasury Department has set the government up for insolvency, the Fed is preparing for the inevitable and fast approaching recession; and devising even more extraordinary ways to achieve its inflation target.

At a recent European Central Bank conference in Frankfurt, Chicago Federal Reserve Bank President Charles Evans was the second Fed official to introduce new plans to handle low inflation in the future. His idea is called price-level targeting, where a central bank counters periods of low inflation by allowing inflation to run very high for a protracted period of time. If taking rates to zero doesn’t get the inflation job done, the Fed, along with the Keynesian cohort of debt lovers in D.C., are contemplating deploying tactics such as; negative interest rates, helicopter money and universal basic income to achieve their inflation goals. But that inflation shock treatment will send interest rates soaring, and its effect on debt service payments will be humongous.

This is the ultimate conundrum facing the Fed and Treasury once this next recession commences: Massive money printing will be called upon once again to cause another rebound in asset prices and to pull the economy out of its tailspin. However, the inflation created this time around should also send interest rates sharply higher; and given the extent of crippling new debt that has infected both the public and private sectors in the past decade, it virtually assures chaos in markets and the economy.

Why will the government be successful in creating inflation and rising bond yields during its next iteration of extraordinary monetary policies and not just in asset prices, as what occurred in the wake of the 2009 Great Recession? Two reasons. One, if the government resorts to using a Negative Interest Rate Policy, Universal Basic Income and Helicopter money; it will in effect circumvent the private banking system and force both the supply and velocity of broad-based money much higher than ever before. And, the most important reason, is that the credibility of central banks and governments to be able to normalize interest rates and allow markets to function freely will be completely shattered. In other words, it will destroy all faith in the government’s ability to preserve the dollar’s purchasing power.

The government is preparing now for the next market and economic crisis…perhaps you should as well.

Is “Geopolitical Risk” Behind Rising Oil Prices?

By George Friedman and Xander Snyder

Toward the end of October, Brent crude prices crossed $60 per barrel for the first time in two years. They continued their ascent, peaking at around $64. Experts explained the spike with vague references to “geopolitical risk,” without really detailing what those risks entailed. Such explanations are not wrong, but they are careless. A proper geopolitical risk assessment necessitates that we go beyond equivocal wording and develop an understanding of the relevant economic, political, and military factors.

Threats to Supply

For weeks, developments in Saudi Arabia have been cited in commentary on oil markets. It all comes down to the rivalry between Saudi Arabia and Iran—a rivalry that plays out throughout the region, in Yemen, Lebanon, Iraq, Syria, and elsewhere.

In early November, the Houthis, a group of Iranian-backed Shiite militants who have been fighting Saudi Arabia in Yemen, launched a missile at Riyadh. The Saudis accused the Iranians of supplying the missile. Then Riyadh claimed that Lebanon had declared war on Saudi Arabia and forced the Lebanese prime minister, who was in Riyadh at the time, to resign. Lebanese politics are heavily influenced by Hezbollah, a paramilitary group with strong ties to Iran. (Around the same time, the Saudi king and crown prince began arresting potential rivals to the throne.)

Saudi Arabia is trying to keep Iran preoccupied so that it cannot gain too much ground in Syria, where the Islamic State has now lost nearly all of its territory. The Saudis don’t want the Iranians to develop a land bridge to the Mediterranean through Iraq, Syria, and Lebanon. This would not only threaten Saudi Arabia’s security from the north, but it would also give Iran access to the Mediterranean and, therefore, the ability to export more to Europe.

What does this have to do with the price of oil? For one thing, in the course of their quarrel, Iran and Saudi Arabia could destroy infrastructure, affecting the ability of oil producers to get oil to the market. How likely is this? With a great deal of effort, Iran’s proxies could damage a small portion of Saudi Arabia’s infrastructure, but they couldn’t take on Saudi Arabia in an all-out fight. On the flip side, while some Sunni extremists have carried out terrorist attacks in Iran, their ability to damage Iran’s oil infrastructure is limited.

Another event that would restrict oil supply would be if a ground war were to break out between Iran and Saudi Arabia. This is highly unlikely. Iran doesn’t control the territory it would need to supply any sort of war effort in Saudi Arabia, and Saudi forces would struggle mightily to overcome the Zagros Mountains, which shield Iran’s western flank. Modern technology can overcome some geographic barriers, but to control a territory, men and machines must be moved to it, and mountains are hard places to maintain supply lines.

The timing also isn’t good for either side to start a war. Iran is only just beginning to reap the economic benefits of the lifting of UN sanctions in 2015. Saudi Arabia is facing too many problems at home, not to mention the war in Yemen.

Another way these events could restrict oil supply would be if Iran were to blockade or mine the Persian Gulf at the Strait of Hormuz. This, too, is unlikely. It would represent an overt declaration of war, and it would force countries that depend on Saudi oil to take sides in a conflict in which Iran would be seen as the aggressor.

Instead, Iran has resorted to having the Houthis mine the Bab el-Mandeb on the western side of the Arabian Peninsula. This gives Iran a degree of deniability while still impeding, though not stopping, transport vessels from leaving the Gulf of Aden. Nor does it hinder Saudi Arabia’s eastern coast on the Persian Gulf. It would be more difficult for the Houthis to mine the Persian Gulf since they do not have a base in Oman.

These factors need to be considered in constructing a comprehensive picture of geopolitical risk. It’s not enough to vaguely reference geopolitical risk; potential scenarios must be concrete enough to allow for an evaluation of their likelihood. In the Saudi example, once the implications of these developments are seriously considered, the geopolitical risk does not appear substantially altered.
The Business Cycle

But if events surrounding Saudi Arabia don’t substantially increase the threat to the oil supply, what explains the increase in oil prices? For starters, OPEC has recently made supply cuts while demand has remained strong. Though in the long run, US shale production counterbalances the strategy that OPEC has pursued for decades, in the short run there are factors preventing shale drillers from expanding at the clip witnessed over the past few years. 

When oil was above $100 per barrel, shale drillers could focus on expansion, since profit margins were wide enough to sustain the growth. Lending to the industry financed the expansion. Advances in technology increased the yield that each well could produce, bringing the amount of oil that shale drillers could provide to the market even higher. But when prices dipped, shale drillers began to default on their loans and go bankrupt. The ones that have stuck around either purchased locations where drilling had a lower break-even cost per barrel or had more productive drilling processes.

Bankruptcies are continuing, and drillers are being forced to focus on profitability rather than growth. Certain input costs (such as fracking and land acquisition) have increased, further squeezing drillers’ margins. Rising interest rates—which seem increasingly likely given that the Federal Reserve has already begun shrinking its balance sheet—will put even more pressure on companies with variable rate debt. Despite all this, advances in drilling technology continue to raise well yields—putting downward pressure on break-even costs—and higher oil prices still raise the profitability tide for all drillers.

Financing is a cyclical business. Lending expands when profits appear more readily available and constricts when unproductive enterprises find their debts unserviceable. As companies go out of business, oil supply decreases, driving up prices and raising profits for the companies that survive. Eventually, the efficient companies start growing again, seeking more lending and starting the cycle of expansion all over again.  

Rising oil prices, then, cannot be explained solely by events in the Middle East or by OPEC’s cuts. Rather, it’s a combination of OPEC’s cuts and the inability in the near term of shale drillers to significantly expand capacity. These limitations, however, don’t change the fundamental interplay of shale oil drillers and the global oil market. New drilling technology is continuing to lower per-barrel break-even prices, and more shale companies will find their operations profitable when oil prices increase, thereby increasing the amount of oil they supply to the market and driving prices back down.

Benjamin Graham, one of Warren Buffett’s greatest influences, coined the term “Mr. Market” to describe a manic character who buys and sells shares depending on his emotions. He drew a sharp contrast between this type of investor and the company analysis based on fundamentals that his methodology entailed. Just as in business analysis, it’s not enough to acknowledge that world events are driven by more than financial considerations. Real geopolitical risk analysis requires a deeper dive into what drives geopolitical phenomena.