Think Different About Purchasing Power

The dollar is always losing value. To measure the decline, people turn to the Consumer Price Index (CPI), or various alternative measures such as Shadow Stats or Billion Prices Project. They measure a basket of goods, and we can see how it changes every year.

However, companies are constantly cutting costs. If we see nominal—i.e. dollar—prices rising, it’s despite this relentless increase in efficiency. This graphic illustrates the disparity (I credit Tom Selgas for a brilliant visualization, which I recreated from memory).

Hiden Debasement

CPI measures only the orange zone, the tip of the iceberg. Most people don’t see the gray zone, and that’s a result of the greatest sleight of hand ever.

We need an accurate way to measure monetary debasement. For example, in retirement planning it’s tempting to divide your net worth by the cost of consumer goods. This seems to show your purchasing power. For example, if you have $200,000 and the cost of groceries for a year is $20,000 then you can eat for ten years.

However, this approach is flawed. To see why, let’s briefly consider primitive times when there was no lending or banking. People had to set aside some of their income, to buy a durable good like salt or silver—hoarding. When they could no longer work, they sold a little bit every week to buy food—dishoarding. People accumulated wealth while working, and dissipated it in retirement.

Life got a lot better with the advent of lending, because interest enables people to live on the income generated by their savings. People no longer consumed their principal, worrying about outliving their savings.

Don’t think of capital assets as something to sell in order to eat. An old expression says, if you give a man a fish then he eats for a day, but if you teach a man to fish then he eats for a lifetime. Think of a productive asset like a fishery. It should produce for a lifetime. It should not be consumed as a mere fish.

Capital assets should be valued in terms of how many groceries they can buy, not by liquidation, but by production. Unfortunately, monetary policy is making this increasingly difficult. Interest rates have been falling for over three decades, and now there’s scant yield to be had anywhere. We are regressing to the dark ages of paying for retirement by dishoarding.

CPI understates monetary debasement, because companies are constantly becoming more efficient. Dividing wealth by CPI compounds the error, because asset prices are rising.

We need a different way of looking at monetary debasement. I propose Yield Purchasing Power (YPP).  YPP is the yield on assets divided by the Consumer Price Index (or other index). The idea is to look at the productivity of assets to see what you can really afford.

Let me explain YPP with a simple example. If hamburgers sell for $5 and interest is 10%, then $50 of capital lets you eat one burger per year. Suppose the price of the burger doesn’t change, but the interest rate falls to 0.1%. You now need $5,000 in capital to earn that burger. Unfortunately, if you still only have $50, then you only get one burger every 100 years.

CPI doesn’t show this collapse in purchasing power, but YPP does.

Let’s take a look at YPP since 1962. The graph is inverted, to make the trend easier to see.

YPP

It’s interesting that the drop in purchasing power (rising in this inverted graph) begins around 1984, when the conventional view said inflation was tamed. CPI may have slowed down, but interest was falling too.

YPP shows us a staggering monetary devaluation—a classic parabola. The problem isn’t skyrocketing prices, but collapsing yields.

You need more and more assets to afford the same lifestyle. If your assets don’t keep up, then you have to liquidate your capital.

GE’s Restructuring Pleases Investors and Avoids Other Risks

GE

On April 10, General Electric, which for 123 years has been one of America’s best known and most highly respected companies, announced a radical return to its basic industrial roots. After years of disappointing share performance, and a campaign of criticism by frustrated investors, Chief Executive Jeff Immelt decided to spin off most of its $500 billion GE Capital arm which, if taken as a stand-alone company, would have been the seventh largest bank in the U.S.

Despite the fact that the unit had contributed some 42 percent to GE’s group profits in 2014, the financial unit had nevertheless become a perceived albatross around the neck of the industrial conglomerate. The move greatly pleased investors, who rewarded the stock with one of its best days in years. The question we should be asking ourselves is why is it so undesirable to be a bank in the United States? What does that say about the underlying strength of the economy?

In the financial crisis of 2008/09, GE Capital, like all the other major financial firms, had to be rescued from insolvency by the government’s TARP or Troubled Asset Relief Program. In the aftermath, GE was branded, as was other large non-banks like AIG, MetLife and Prudential Financial, as a SIFI, or Systematically Important Financial Institution, and thereby ‘too big to fail’.

This categorization exposed GE to a whole new wave of supervision by the Federal Reserve Board and a host of new regulations under the new Dodd-Frank law. This put the firm at a competitive disadvantage against the U.S. markets in general, and other industrial firms in particular. In fact, from its pre-recession highs in May of 2008, GE was off about 20% in the more than six years leading up to this month’s announcement. Over the same time frame, the Dow Jones Industrial Index (of which GE is a part) was up about 36%, with shares of such rivals as United Technologies up much more. This substantial gap caused considerable frustration among GE management and shareholders. GE had performed more like a financial firm (the S&P 500 Financial Sector lost about 12% over that time frame).

Shrewd investors have long believed that ‘core competence’ is key to success. GE’s core competence was as an industrial company building advanced aircraft engines in direct competition with Rolls Royce, power turbines and a whole raft of electrical products including advanced medical devices. Some investors saw GE’s foray into finance, mortgage lending, and credit cards as a dangerous departure. In addition, investors have long seen financial earnings inherently as considerably more risky than industrial earnings. As a result, investors assigned a lower value, or price earnings ratio, to financial companies’ earnings. On the face of it, these factors gave GE good reason to divest its Capital division.

But while those questions are still theoretical, GE shareholders are looking at some tangible benefits. The company has authorized that over the next four years it expects that more than $90 billion that is realized from its asset divestitures will be directed expressly towards shareholders. Some $35 billion in the form of increased dividends, while $50 billion in the form of share buy backs.

In addition, GE’s plan involves repatriating some $36 billion from cash-rich subsidiaries overseas and the payment of an additional $6 billion in U.S. taxes, a tax rate that is significantly higher than what has been the norm at the firm for much of recent history. In the past, high-spending politicians have criticized GE, and many other corporate icons, for their overly efficient tax planning. The move to pay a huge tax bill now may blunt these critiques. But, apparently, optimism about the future of U.S. corporate tax policy is not running high at GE. If it were, planners may not have been so eager to pay such a steep price to move such a large block of cash onshore. GE’s thinking should throw cold water on those who may have thought that a common sense corporate tax reform program is high on Washington’s agenda.

It appears that Immelt was prepared to accept a $6 billion tax bill and the loss of almost half his revenue in order to get out from under the stigma of financial services and the huge weight of supervision and regulations required of a SIFI firm. But sometimes expensive divorces are worth it.

However, lost in the celebration of the return of an American icon to its industrial roots are some troubling factors that may have inspired the decision. If one looks past current narrative of a resurgent U.S. economy, worrying signs of recession have recently come to light. The recent deceleration, combined with the implementation of potentially onerous regulations under Dodd-Frank and signs of increasing stress in the consumer and corporate debt markets, may have helped GE to decide to get out of the lending business while the going was good. In hindsight, the move may look extremely prescient.

But one major question remains. The Fed has given no indication of just how a SIFI company, such as GE, can shed this status once branded. In essence, GE is paying a high price to avoid regulators who may refuse to go away. Once taken, government agencies are loathe to give up regulatory power. Often these fights become completely irrational, with bureaucrats fighting for little more than prestige. Hopefully this will not happen to GE, and the Fed will take the high road and let GE go on its merry way. I wouldn’t be so sure.

Ben Bernanke Now Blogs

Ben Bernanke presided over the Federal Reserve for two terms, from 2006 through 2014. A year and half into his first term, he began driving the Federal Funds Rate down. By the end of his frantic interest episode, this key overnight lending benchmark had been crushed. It hit bottom, and it hasn’t sprung back in over 6 years since.

Everyone is harmed by zero interest policy. Who suffers the most is open to debate, but one obvious candidate is the retiree who lives on a fixed income. These are people who worked and saved their whole lives, and now they depend on interest to buy groceries and heat their homes. For them, zero interest is like breathing air without oxygen. They suffer a slow death by suffocation.

In writing about this class of people, economist John Maynard Keynes used a term he intended to be pejorative—the rentier. In Keynes’ view, those who invest capital to earn a yield are parasites. In The General Theory of Employment, Interest, and Money, he asserted that the rentier is a “functionless investor” (i.e. gets paid for doing nothing). Keynes called for “the euthanasia of the rentier” by government suppression of the interest rate.

Recently, former Federal Reserve Chairman Ben Bernanke has begun blogging at the Brookings Institution. He wrote that legislators said he was “throwing seniors under the bus.” He reassures us that he “was concerned about those seniors as well.”

That is a neat little example of context-switching. These unnamed legislators did not ask Chairman Bernanke how he felt as he was throwing senior citizens under the bus. His feelings are not the issue. The issue is whether zero interest does, in fact, throw seniors and other rentiers under the bus. Bernanke can’t deny that, and he doesn’t try.

Instead, he offers this, “But if the goal was for retirees to enjoy sustainably higher real returns, then the Fed’s raising interest rates prematurely would have been exactly the wrong thing to do.” Got that? We have to keep interest low, so seniors can earn more interest.

Bernanke then unwittingly makes a good point. “Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by ‘the markets.’ The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere.”

This is indeed the whole point of irredeemable paper money and central banking. The decision to extend credit, and at what interest rate, has been taken away from the people. The saver is totally disenfranchised. The power to set rates has been concentrated, and placed into the hands of the committee who runs the central bank. It’s just how irredeemable paper money works.

We free marketers should always keep something in mind. The regime of the dollar centrally planned. Although then planners deserve criticism, we should not focus on them. We should take care not to imply that any other planner would do better.

There is no such thing as a good central planner. There are only central planners that destroy capital less quickly and those who destroy more quickly. Sometimes, people may think that a Fed chairman is not so harmful during his tenure, only to realize the full extent of the destruction later (for example, Alan Greenspan).

Bernanke thinks he is defending himself, when he makes his most damning statement. “A premature increase in interest rates engineered by the Fed would therefore have likely led after a short time to an economic slowdown and, consequently, lower returns on capital investments. The slowing economy in turn would have forced the Fed to capitulate and reduce market interest rates again. This is hardly a hypothetical scenario: In recent years, several major central banks have prematurely raised interest rates, only to be forced by a worsening economy to backpedal and retract the increases.”

So interest rates have to go down when the economy is weakening. Consider the interest rate trend since 1981.

Long Term Treasury Rates
(Courtesy of the Federal Reserve Bank of St. Louis)

Why has the rate been falling for over three decades? Why has the economy been weakening for 34 years? It’s even worse in Japan and Germany, and even worse than that in Switzerland (which sports a negative rate on the 10-year bond).

Bernanke and his colleagues did not see the crisis of 2008 coming, even as they centrally plowed the world into it. Despite his crocodile tears, savers all have bus tire tracks on their backs. When I was in grade school, kids could work a paper route, and with compounded interest, pay for a college degree. No longer. Workers can set aside 10% of their salaries, if they wish, yet they have no hope that it will ever support retirement. Seniors are forced to spend their capital, fearing to outlive their money.

This is the central banking endgame. Have you ever seen one of those humorous signs that says “The beatings will continue until morale improves?” Similarly, the interest rate will keep falling until the economy improves. The Bernanke’s of the world will never find an opportunity to raise rates.

If we don’t change the regime, rates will continue to fall into the black hole of zero—and negative, as in Switzerland and Germany.

Instead of giving us an apologia, Ben Bernanke has a unique opportunity to show the world that central banking has weakened the global economy. Central banking cannot plan us out of the quagmire it has planned us into. Bernanke could give a clear statement, and explain that for all of his intelligence and education, it availed him not. The irredeemable dollar cannot be fixed.

What he should say is that it is now time for the world to consider a four-letter word that has been all but banished for decades. Gold.

Monetary Metals Brief 2015

It’s the start of a new year. The question on everyone’s mind is whither the prices of gold and silver? This Brief presents our answer (and the full Monetary Metals Outlook 2015 report gives our reasoning).

One approach to the question of price is to draw a line, extrapolating the past trend into the future. Here is the graph for gold.

Line Extrapolation Gold

This line would give us a gold price around $1000 at the end of 2015. If we did it for silver (not shown), we would get around $10.

We don’t think that most traders would do something this simple (though some mainstream anti-gold commentators might). Our point is that technical analysis is about looking at the trend. We do not believe that the past trend in the gold price is likely to be a good predictor of the price in the future, because the past drivers of the price won’t be operative in the future.

Another approach is to plot gold against M1 money supply. Here’s what that looks like.

M1 Extrapolation Gold

This implies that the price already ought to be well over $2,000 and unless central banks put down their keyboards and back away, it will be hundreds of dollars higher by the end of 2015.

We don’t believe this approach, or any approach based on the quantity of money, is valid. At best, one can find correlation without causality. For example, some people thought that there was a correlation between the winning conference of the Super Bowl and the presidential election (an NFC win was supposed to forecast a Democratic president). We think this chart proves there is no causal link between money supply and the gold price.

Other analysts attempt to calculate a gold price based on inflation—by which they mean rising consumer prices. They say gold should do well in inflation. And, they say that it should be coming any day now because look at how fast the money supply is growing. We don’t think that the money supply drives consumer prices any more than it drives the gold price. The crashing commodity markets over the past few years—notably oil in the second half of 2014—should once and for all debunk this idea.

Gold is not purchased for consumption. So even if consumer prices were rising, that does not mean that the gold price must rise. Or, vice versa. Consumer prices are influenced by numerous variables such as efficiency of production that have nothing to do with gold.

Many fall back on the fundamental argument for gold and silver. Paper currencies are now being debased recklessly. Every central bank in the world has openly declared its intent to beat down its currency. This is true, paper currencies have been falling for decades. We believe they will all go to their intrinsic value—zero. There’s just one catch, it doesn’t necessarily have to happen tomorrow morning.

So the past gold price doesn’t predict the gold price of the future. Any correlation between the gold price and macroeconomic indicators is temporary. And, we can’t trade gold based on the premise that paper currencies will meet their final fates. So where does this leave us?

We first need a method of measuring current supply and demand fundamentals in the monetary metals. They are quite different from all other commodities, as humanity has been accumulating them for millennia. We discuss our methodology and show our data and reasoning in the full report. In this brief, we will just skip to the bottom line and give our year-end Fundamental Prices for gold and silver.

They are $1,319 for gold and, brace for it, $15.10 for silver. Both of these numbers have come up a little in the first weeks of the year, but not enough to change our view of the market as it stands now.

That’s the key phrase: as it stands now. The supply and demand fundamentals emerge from a dynamic interplay between several kinds of market participants (we describe this in more detail in the full report). At the moment, it’s not showing any signs of major breakouts. There simply is no reason today to back up the truck and load up on gold—much less silver. (If you don’t own any, then our advice is to go buy a little—not for trading but for holding—and don’t worry about the price).

That said, a sea change is coming.

To have any chance of predicting it, we have to understand what drives people to buy gold. We don’t mean what news stories make people hit the buy button on their futures workstation, or buy GLD calls on E-Trade. Speculators, especially those who buy with leverage, cannot create a durable and long-term move higher in price. They are just trying to front-run what they believe will happen, and often end up front-running only each other.

What makes people buy gold coins and bars, and stick them under the mattress for years or decades?

The answer is simple, but a paradigm shift from everything we’ve all been taught in government schools, watched on TV, read in the financial news, and learned in Econ 101. Gold is the only financial asset that is not someone else’s liability. There are plenty of other financial assets; the world is overflowing in paper derived from paper, stacked on top of paper. And every one of them depends on a counterparty servicing the debt and making payments. There are also many tangible assets such as antique cars, real estate, and art work. Every one of them is illiquid in good times, and may be impossible to sell in a crisis.

Gold is unique for these reasons.

Ignoring the speculators, who only buy gold to sell it for a quick gain when the price rises, or to cut losses when the price falls, who buys gold to hold for the long term? What are their motivations?

Anyone in the world buys gold when they don’t like the interest rate offered on paper, and especially when they don’t like the rising risks.

Based on the price and supply and demand moves so far, it is likely that the price of gold will end the year higher than it ended 2014. However, silver will fall if the speculators currently holding it up give up.

In this annual report, we’re not just trying to look at whether the metals are over- or under-priced. We are trying to predict a change in attitudes. It is not a matter of if, but of when.

We think the sea change is more likely than not to begin in 2015. We don’t use the term “sea change” lightly. The crisis of 2008 was the beginning of a credit collapse. Most market observers believe that the central banks fixed the problem, and have been talking of the “green shoots” and “nascent recovery” and “GDP growth” for years.

It is noteworthy that even the skeptics have accepted that the system will hold together. Most of them have given little thought beyond how to make more dollars. Even gold is just a vehicle to speculate to make dollars. In other words, few have been worrying about default risk. They have focused on inflation, and trading to get a higher rate of return than that.

This means they have not focused on counterparty risk or credit quality. We think this will change in a big way.

At the moment, we see little reason to put a lot of capital in harm’s way betting on a rise in the gold price, much less on silver. But that’s why we reassess the supply and demand fundamentals every week in our Supply and Demand Report. We will report on changes as they occur.

 

This Monetary Metals Brief 2015 is based on the full Monetary Metals Outlook 2015 report. The full report contains graphs of the monetary metals’ Fundamental Prices for 2014, a fuller discussion of gold, our macroeconomic views including the resent crisis in Switzerland, and our supply and demand theory.

 

© 2015 Monetary Metals LLC. All Rights Reserved.

The Hidden Perils of Low Interest Rates

Late last year, with the U.S. economy experiencing falling unemployment and seemingly low inflation, observers were extremely confident that the Federal Reserve would move judiciously in 2015 to restore ‘normal’ interest rates sooner rather than later. However, in light of the recent fall in both stocks and oil, that conviction has softened considerably.

Many, such as the very influential Bill Gross, now believe that our current Zero Interest Rate Policy (ZIRP), which has been in place for six years, will remain in place throughout the year. While this likelihood is a disappointment to many, who would have preferred to see the economy move along without Fed-supplied training wheels, few really understand the pernicious effects these policies are inflicting on the economy the longer they are held in place. In short, ZIRP is slowly transforming the world economy into a dysfunctional basket case.

Historically, it has been estimated that a ‘normal’ fair rate of return on short to medium-term high quality debt is between 2 and 2.5 percent, net of inflation. Recently, the Fed published year-on-year U.S. CPI inflation for mid November 2014 at 1.3 percent. This would suggest normal short-term rates at around 3.5 percent at present.

However, using the government’s methodology that was in place prior to 1990, John Williams’ Shadow Government Statistics (SGS) newsletter calculates inflation to be currently some 5 percent. Using methods in place prior to 1980, it is a staggering 9 percent. At that level, current interest rates should be somewhere around 11.0%. Even if we estimate that real inflation is currently 3%, then our “normal” rate of interest should be around 5%. This is some 50 times the rate paid currently on most bank deposits. This gap is distorting the economy in untold ways.

In early December 2014, the U.S. Congress approved further Government spending of some $1.1 trillion. This came just as the U.S. Treasury’s debt broke through a total of $18 trillion. It wasn’t that many months ago that the $17 trillion barrier was first breached.

Currently, the U.S. Treasury can borrow for 10 years at around a rate of 2 percent. But if long term rates rose to 5 percent, which would be in line with the historic range of “normal,” the 3 percent difference would cost the Treasury an additional $540 billion in annual interest payments (based on the current $18 trillion in debt). This would considerably undermine the government’s fiscal position, and necessitate an upheaval in federal budgeting.

The financial repercussions of a tripling or quadrupling of interest rates truly are horrific. They lead to a sense of foreboding that the Fed, aware acutely that the U.S. Treasury simply cannot afford a return to normal interest rates, will not restore normal rates unless forced to do so by international bond or currency markets. It appears, therefore, likely that ZIRP will continue for years to come. This feeling is underpinned by a view that low interest rates are simply a benign stimulant that fails to appreciate the actual harm they impose, particularly in the fixed income markets.

Savings are the prime source of real long-term investment. Today, savers are being crushed by the Fed’s manipulation of interest rates to below a real return. To find even small real returns, investors have had to scour the financial landscape for sources of yield. In doing so, they have ventured into risky territory and have, for instance, flooded into the high yield market, pushing junk yields to record low territory. The repercussions of providing excess capital to risky businesses have yet to be experienced, but the energy industry should provide us with a hint of things to come. Over the last few years small and midsized energy firms were able to borrow cheaply and lavishly to fund drilling projects, thereby greatly increasing production. But in retrospect, these efforts look like they helped create an oversupply of energy that has depressed the price of crude and has exposed the energy sector to long-term financial stress. Bankruptcies and creditor losses may be inevitable.

Another concern of the Fed is that despite an unprecedented increase in liquidity and part-time employment, real job creation is still sluggish at best. Furthermore, the Manhattan Institute’s Power & Growth Initiative Report of February 2014 notes that the U.S. oil and gas boom has created some one million jobs with a further ten million in associated occupations. The oil boom has improved net employment and kept the economy out of recession. But oil prices have fallen dramatically, threatening these economic bonuses and high-yield bond defaults. It’s hard to see what other distortions and hidden pitfalls have been created by negative real rates. The traps often become visible only after they have been sprung.

But with major economies such as the European Union, Japan and Russia flirting with recession (and China slowing down considerably), there is growing fear that normal interest rates would be dangerous at present. This fear likely will encourage the maintenance of ZIRP, possibly for years, with financial markets disconnected increasingly from the real economy.

Therefore, investors may continue to benefit for some time from the consistent boosting of financial markets by central banks. However, the longer a major correction or even a crash takes to develop, the more sudden, deep and devastating it may be.

Black Gold Loses Glitter

The stunning 40% drop in the price of oil over the past few months has scrambled global economic forecasts, changed the geo-political landscape, and has severely pressured many energy sector investments. Economists are scratching their heads to determine if the drop is good or bad for the economy or whether cheap oil will add to or decrease unemployment, or complicate the global effort to “defeat” deflation. While all of these issues merit detailed discussions, the first question to address is if the steep drop is here to stay and whether energy prices will stay low enough, for long enough, to seriously reshuffle the economic deck. Based on a variety of factors, this is not likely to happen. I believe a series of technical, industrial, and monetary factors will combine to push oil back up to, and potentially beyond, the levels that it has seen over the last few years.

The dominant narrative explaining the current situation is that oil has collapsed largely because the growing mismatch between surging supply and diminishing demand. But there is little evidence to suggest that such conditions exist on the global stage.

According to the data available this month from the International Energy Agency (IEA), global demand for crude oil has increased by .74%. from 2013 to 2014, and is 3.6% higher than the average demand seen over the past five years (2009-2013). The same trend holds true for the United States, where 2014 demand is expected to come in 1.3% higher than 2013 and essentially the same as the average demand over the previous five years. (As an aside, the relative stagnation of U.S. oil demand provides a strong counterpoint to the current belief that the U.S. economy is stronger in 2014 than it has been in recent years).

So if the low prices are a function of supply and demand, but demand has not collapsed, then the difference has to be supply. The theory here is that the fracking and shale boom in North America has flooded the world market with unexpected supply, thereby pushing down the price. While it is true that the new drilling techniques have revolutionized energy production in the U.S. and Canada, the increase in production has been mostly negligible on the global stage.

Oil production in North America increased a hefty 8.8% from 2013 to 2014, and 17.7% over two years from 2012 to 2014. But outside of North America the story has been quite different. In fact, total global production increased by just .55% between 2012 and 2013 (2014 global data is not yet available). In 2012, North America accounted for just 17.4% of global production, but over the following year contributed 59% to the total increase of global production. So the fracking miracle is, at present, primarily a local phenomenon that has made limited impact on the global stage. In fact, in its most recent data, the IEA estimated that in 3rd Quarter 2014 total world demand exceeded total world supply by only .6%, hardly a figure that suggests an historic glut.

So if it’s not supply and demand, what could it be? First, there are technical factors. There was a widespread concern going into 2014 that the recovery would bring with it higher oil prices. This may explain the surge in speculative “long” contracts in crude oil futures seen in 2014. These positions, in which investors sought to make a levered bet on rising oil prices, peaked around July at 4 million contracts, nearly four times as high as 2010. With so much money anticipating an increase, a small pullback in crude could have caused a wave of selling to close out losing positions. If that is the case, in an over-levered market, this could lead to a domino effect that pushes prices far lower than market levels. But as these positions get unwound, markets eventually return to normal. If that happens, we could see a significant rally in oil.

The surging dollar is another factor that has pushed down prices. Oil is globally priced in dollars so any increase in the dollar translates directly into a decrease in the price of crude. Over the past few months the dollar has seen a major rally that I suspect has been caused by the widespread, but unfounded, belief that the Federal Reserve will begin to tighten policy in 2015 just as the other major central banks shift into prolonged easing campaigns. When traders realize that this is unlikely to occur, the dollar should sell off and oil should rise.

Industrial forces will also come to bear soon. Much of the new North American shale production has been characterized by relatively high extraction costs, large production volumes, and fast depletions. A high amount of capital expenditure is needed to maintain production volumes. If the price of crude stays low, we can expect to see a decrease in capex expenditures from the companies most closely aligned with horizontal drilling and fracking. In fact, such evidence has already come to light. This means that volume decreases will start to bite far sooner than they would in the case of traditional oil extraction.

Ordinarily, falling energy prices are a great economic development. Lowering the cost of heating, power, and transportation means consumers and businesses have more money to spend on everything else. But the U.S. economy is now far more vulnerable to energy sector weakness. A substantial portion of high paying jobs that have been created in the last few years have been in energy production. Already the capex slowdown in the Dakotas and Texas is beginning to be felt by energy workers in those areas (12/2/14, The Globe and Mail). If these trends continue, the employment reports that currently drive so much of the economic confidence, will begin to look decidedly weaker.

But falling energy will also help hold down consumer prices. And while this may sound like a good thing to anyone with a standard amount of common sense, it is not seen as a good thing by economists who believe that higher inflation is a prerequisite for economic growth. Weakening employment and slowing inflation could quickly entice the Federal Reserve to launch the next round of QE far sooner than anyone currently predicts. This could turn the table on the current dollar rally and help push oil back up.

If oil stays low, it may turn out that entire U.S. oil boom was just another Federal Reserve inflated bubble. If it pops, the job losses and debt defaults that would ensue could have a far greater impact on the economy and the credit markets than did the bursting of the Internet bubble back in 2000. For those who think that cheap oil prices will provide a strong enough shock absorber, think again. When the housing bubble burst in 2008, $35 oil did not spare the U.S. economy from recession. Nor did $20 oil keep us out of recession in 2001. Oil producers have raised hundreds of billions of “junk bond” financing that may become vulnerable if oil prices stay low for an extended period. I do not believe the Fed will allow debt defaults that would result to impact the broader economy. They will be inclined to support oil prices just as they have been willing to support other strategically important asset classes.

If oil investors overbuilt capacity based overly optimistic price assumptions, which were created by artificially low interest rates and QE, why would similar mistakes made by investors in stocks, real estate, and bonds not be similarly exposed? This could mean that the popping of the oil bubble may be just one of many bubbles that are ready to burst. But given the difficulty of dealing with such a situation, QE 4 may ultimately need to be larger than QE1, 2, and 3 combined!

As a major player in oil production, the U.S. stands to gain far less from the current price slump than many of our trading rivals. Saudi Arabia, the dominant producer, has notoriously low production costs and should likely withstand the current slump with little need for structural reform (Saudi Arabia’s geopolitical strategy for cheaper oil was recently examined by John Browne in his recent Euro Pacific column).

The primary beneficiaries of the current oil dip are the Asian countries that use lots of oil but produce very little. Thailand, Taiwan, South Korea, India, China and Indonesia all import oil and, therefore, will benefit by varying degrees. Many governments (India, Indonesia, Malaysia) are removing high cost subsidies – so the immediate benefit is not to the consumer, but to government fiscal balances, which will improve greatly.

So every silver lining usually comes with a cloud or two. Although the dip in oil prices is currently the biggest thing on the street and the cause for optimism, good times come with a cost, and they are likely to be short-lived. Energy stocks have been unfairly beaten down and could offer long-term value at current price levels.