classical economics
for analysis,  forecasting
and policy design

Taking Stock
Oil, Economy, Fed, Treasury and More

By Wayne Jett
© December 5, 2008

    On April 3, 2008, The Supply Side Guide stated Americans rightly viewed prices of crude oil, gasoline and diesel fuel as obscene; and, on June 25, added: “This is reality: crude oil at $137 per barrel will wreck the U. S. economy in the near term unless promptly corrected, … If ever it could, the Fed can no longer mask the fact that neither the U. S. economy nor other economies around the world can maintain production, much less expand, with oil at or near $137. Unless the oil price collapses, and soon, the economy will.”
    These points are reiterated now, not as “… told you so” self-congratulation, but to emphasize the lesson that classical economic analysis worked then and works now. U. S. and global economies collapsed first, and the price of crude oil is collapsing as a consequence. During November, 533,000 jobs in the U. S. were eliminated, the highest rate since 1974, when OPEC increased the price of crude oil to adjust for dollar devaluation. When price of a product as ubiquitous and substantial as energy is doubled, trebled or quadrupled, consequent increases in product costs and prices undercut demand. Capital and resources flowing from the U. S. to oil producers at the rate of $700 billion annually no longer flow because buyers ran out of money. Then demand and price fell, in that order.
    If manipulation of prices in U. S. crude oil futures trading had been stopped by Congress passing laws prohibiting it, energy prices would have collapsed sooner and economic damage would have been less. The oil price is likely to fall much further, below $20 per barrel, as the overhang of artificial demand descends on the market. The process will damage investment for future exploration and production, thereby laying foundation for future energy shortages and price spikes due to shortage of supply. Wise leadership would act now to prohibit future manipulation, and to detect and punish past manipulation, so this outrageous crime is never repeated.
Federal Reserve Penury
    Chairman Ben S. Bernanke has brought the Federal Reserve System to the place former chairman Alan Greenspan said it had arrived during his tenure: “uncharted waters.” The Fed’s balance sheet is degraded beyond recognition in terms of size and risk level. True, the Fed may profit from its heavy “investments” in private debt now exceeding $1.6 trillion. But the Fed is exposed to risk of major loss. This is significant inhibition of policy discretion at the most important central bank in the world. Never has the Fed been in this position. Why has the Fed done this?
    Never have the major financial institutions of Wall Street required rescue from near-fatal errors as occurred in 2008. Since its creation in 1913, the Fed encountered failures of banks across the country, most of them small, some relatively large, but none of the major Wall Street firms. Never was the Fed so merciful to a failing bank as to put interests of Wall Street banks at risk (through the Fed) to assist a failing bank. That principle was violated at every turn in 2008, beginning with its Bear Stearns gift to J. P. Morgan Chase in March.
    Bernanke threw out the “Fed first” principle because the Fed operates as the tool and for the interests of the big Wall Street banks. This has been demonstrated continuously by Fed policy actions, which always seek to deliver upside for those major sponsors. This year, those sponsors were caught by such grievous errors their rescue is coming at great expense to the Federal Reserve System (meaning all U. S. banks) and to the U. S. Treasury.
Treasury Settlement Fails
    Euromoney reports that primary dealers in U. S. Treasury securities have disclosed disturbing volumes of settlement fails in trading amid signs the settlement system in Treasuries is breaking down. The 17 primary dealers in Treasuries around the world were deemed so important during July they were protected against naked short selling by the SEC emergency order that also covered Fannie and Freddie. With that protection expired, Fannie and Freddie were seized by Treasury’s Paulson September 6 and primary dealer Lehman Bros. filed bankruptcy September 14. During the next two weeks, the value of settlement fails rose to $2 trillion. Potential investors stand aside rather than commit funds, concerned sellers of Treasuries may not deliver the securities purchased.
    This scenario in Treasury markets mirrors effects of unsettled trades due to naked short selling in U. S. stock markets. One expert observer, Susanne Trimbath, says the settlement fails in Treasuries are occurring because primary dealers and other investors are selling Treasuries they don’t own and are not required to deliver on time. The tactic netted the perpetrators about $2 trillion in September for use as “float,” which portends a profit for them. However, for investors who have paid money but received only an “IOU” in exchange, the transaction involves much more risk than envisioned in purchasing Treasury securities.
    Settlement fails in Treasuries threaten to seize that market, inhibiting fund raising operations of the U. S. government, in addition to raising interest rates and cost of funds for debt involved. Four primary dealers account for more than half of all trading in Treasuries and a majority of all settlement fails. The four are Goldman Sachs, Morgan Stanley, J. P. Morgan Chase and Citigroup. The relevant advisory group of the New York Fed has proposed those dealers should voluntarily adopt a “best practices” standard including a money penalty on the party causing a settlement fail, but the proposal appears to presume the fail is caused by the buyer failing to pay rather than the seller failing to deliver securities. Action is encouraged by January 5. With New York Fed president Timothy Geithner scheduled to move to Treasury secretary in January, perhaps he may then view the concern as more serious and urgent.
Aussies to the Front
    On a brighter note, the Australian parliament passed a new law completely banning naked short selling and requiring disclosure of all covered short positions. Americans would gain by political leadership of the same quality Australians are experiencing, and ought not to be denied it. Members of G20 nations who met in Washington, D.C., during November delicately brought to the table the urgent necessity of regulatory control over manipulation of financial markets, allowing U. S. leaders to save face by speaking as if the problem is global rather than primarily U. S. International task forces are at work and will report in early 2009, but implementation will still require effective action by the SEC and Congress. ~