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Triage in the Upcoming War for (Energy) Independence
(Paul Tolnai, June 9, 2008)
I want to take issue with where (I think) you are going with Can the Market Solve the Energy Shortage/Peak Oil Crisis? You state "I think it is safe to say there won't be enough private money generated over the next 20 years to lend the U.S." Do you mean "capital" when you say "money"? Capital is savings, actual resources. If I have a whole silo full of stored wheat, which can only come about by me consuming less than I produced, I have capital.
This capital can be put to use in many different ways, e.g. a nice year long vacation, or utilize it to invest in a technological venture. ‘Dem engineers gotta eat while they’re inventin’ the next big thing. This saving can be denominated in a unit of account – a monetary numeraire, if you will, but it is important to keep one’s focus on the physical resource. Because there are many different resources that can be saved, that is not consumed right away, we tend to normalize them all to a unit of account. So forget how this wealth, this capital, these savings are enumerated or accounted for, it’s the resource that can be utilized that is important.
Because one of the attributes of money is "a unit of account" we tend to think of money as wealth. But it isn’t. Using the term money in a very general way can lead to fallacious reasoning.
Those engineers can use my wheat while they are inventing; however, just printing more “money” doesn’t provide any actual resources for the productive activity that requires savings to continue to fruition. That only capital – savings – can do. Printing more money DOES provide more resources, but in a sinister sort of way.
That silo of wheat you bought from me for $12,000 so I can summer in Paris, well after you print up a whole bunch more money, I’m going to find out that I’m going to run out of resources in 10 weeks instead of 12. Basically you stole some of my resources, savings, by cheapening the value of the monetary numeraire. This attacks another attribute of money - as a store of value.
This is why hyperinflation is so destructive: it hijacks all the savings of a society in a consumption binge. Afterwards the society is broke. Not because it doesn’t have any money – money is all over the place, but because all the savings are gone. Wealth is savings, not “money”. Bringing new alternative energy resources into being via innovation requires capital, that is savings, not money per se.
The government doesn’t really have any savings, so when you state "there won't be enough private money" i.e. (capital/savings), I would ask "what other kind of savings are there?" Sure, there may be some government budget surplus tucked away somewhere, but most folks aren’t aware of it. You must have some pretty good inside connections if you know of such, as I’m under the delusion that the government is deeply in debt. Yes, the government does have land holdings, and mineral rights thereon as well as offshore, and those do constitute savings as they haven’t been spent or squandered (yet). But that’s about it.
Now these actual physical resources can be compared to other things via our handy dandy unit of account measure, but again that is for comparative purposes only. And yes by being able to normalize disparate things via our unit of account, another attribute of money becomes manifest: it serves as a medium of exchange. However if we were to redefine the measure of weight, kilograms, then I can weigh anywhere from 50 kg to 1,000 kg, but it’s my actual physical body mass that ultimately matters and not the label you assign it. So it is with money.
The entire investment cycle is all about the concept of time preference. Do I prefer to pig out and consume everything NOW, or do I prefer to consume some later. My decision to lend my savings to a group of engineers depends on my assessment on the utility that I might derive from the fruit of their labors, versus the utility of just consuming my savings next Tuesday. The greater the prospective return I expect on deferring consumption, the more I will save.
But, hopefully, we have in the discussion above put money into its proper perspective, that is it is not wealth per se, only a measure of it. So let us insert it into this discussion. The prospective return that I expect to receive on my invested savings is just an interest rate because most likely I will not invest directly but rather use an intermediary who will pay me for the use of my savings.
If you fear that "there won't be enough" savings, one must logically ask "What then is to be done?" Answer: raise the level of savings! How? Change the time preference so that folks would rather consume less now. How? The price for savings is just the interest rate and as that price goes up the amount supplied goes up. No, that dynamic has NOTHING to do with "money". We need physical resources to invest in the future and that means consuming less now. Yes, it’s the old saw of not having your cake and eating it too.
Then you come to the crux of the matter. You ask: "Guess what happens to housing . . . when global interest rates double or triple." Well, I’ll guess: plummet. A house can be bought from past savings, that is all cash, or from the promise of future savings, debt service. Since we have established that there are insufficient current savings to bring badly needed alternative energy sources into being, we are talking about not only raising the level of savings but also where to invest those savings.
Do we continue to put these savings towards past housing mistakes via debt service, or towards new technology. Because the genius participants of the housing bubble assumed variable debt versus fixed debt – so they can borrow more – the market will make this decision for us. The market will decide that this old debt is not worth consuming any more precious savings and will liquidate this malinvestment. Yes, not only will folks lose their home, but indeed it is absolutely necessary, as those homes will parasitically squander the future savings that are better utilized elsewhere in the economy.
Price is not just some arbitrary thing. It has a purpose. It distributes scarce resources – here the resource is future savings and the relevant price is the interest rate. To recognize something as being necessary doesn’t mean that one’s recognition of such is joyful. A battlefield surgeon may well triage a wounded soldier as beyond hope not out of joy, but out of practical necessity.
We simply cannot continue to dump precious resources into these overpriced McStuccoBoxes and the only way to do that is to liquidate these ridiculous mortgages which have the same utility as ransom payments. As interest rates rise, these dumb debts, promises for future savings, will be liquidated automatically. We simply do not have enough savings to fund alternative energy and service the McMansion mcstakes.
When you find yourself in a hole, quit digging. It’s time to quit pouring resources into past mistakes and focus on the future! A free market will distribute resources, more or less, efficiently, and that means that future savings are not going to continue to pour for the next 23 to 29 years into past mistakes. Only government intervention can save the "flip this house" home debtors, and for that all of us will be poorer, as a scarce resource is simply forcibly misallocated.
The solution is for us to consume less, save more, and pour these saved resources into bringing alternative energy online. The consumption binge has to end in order to increase the savings rate, currently at a nice even number, 0 (I know, I know, our Commander-in-Chief has asked us to support the war effort by "going shopping". Well, here’s another reason to end this misbegotten war), and to stop pouring future savings into past mistakes.
All of this can and will
be accomplished simply by allowing the interest rate to rise. Yes, the consequences
will be devastating, but sometimes things have to get worse before they can get
Exactly! But how much is the monthly consumption cost of the purchased shelter? Well, there is a ready answer for that, it's the monthly equivalent rent. If the house across the street is equivalent to yours and is renting for $2,000 and you are paying $4,200 PITI, the obvious question is: What is the extra $2,200 for? When I grew up, mortgage payments were, by and large, equivalent to the neighborhood rent. The barrier to ownership was coming up with the 20% down. Also, one may not be inclined, or able to, establish roots and simply prefer to rent. But there was not great disparity.
OK, so we know that the financial institutions are pocketing the extra $2,200 and they will recycle it back into the marketplace, and perhaps they might very well invest it (both equity and long term loans are considered capital) in alternative energy. What's wrong with that? Well, firstly it disconnects the one doing the savings from the potential gain. Recall that there once was an alternative energy investor, back in the 19th century called John D. Rockefeller. There have been many articles about how home debtors are simply becoming the equivalent to tenant farmers (working for "the man", whose avatar this century is the money center finance capitalist. Incredibly, the "money" that was lent to the dumb home flipper was simply created out of thin air).
This is an inefficient model. Moreover, as the market cries out for more (more?, we're at zero) savings, this cry is transferred through the medium of the interest rate, and the home debtor quickly finds that his excess "pass thru" climbs to $2,500, $2,800...until he can no longer provide the savings that the institutions are demanding. Since the market sees that this home debtor cannot provide the capital thru debt service, it merely liquidates this unserviceable debt and moves on. So who now is going to provide the savings that the market is calling for? Well, it is a fact of life that investment comes from those with wealth (recall wealth is savings) who will reallocate their investments to where the potential return is greatest and who have sufficient discretionary income to consume less (switch from Johnnie Walker Black to Red) and save more. Our original home debtor wasn't the guy. He buckled. After his belt was at the last hole, he had nothing left to give. Yes, the market is heartless, if the capital (source of savings) is out there, it will find it - the savings it craves.
What if it's not out there you fearfully ask? Well, this is why Chad or Bangladesh isn’t leading the charge into alternative energy. They don't have the capital. If the US, or the OECD countries together, can't come up with sufficient savings now, then we do without. If you can't come up with the capital for a Maybach, you do with a Lexus. It's as simple as that, As the Stones use to sing "You can't always get what you want". Notice that I embedded the word "now" into the 2nd previous sentence. It may simply take a bit longer to raise the necessary capital than we want. And indeed, the time lag implied may well engender secular changes in society in order to bring about the desired change sooner. That is, the Suburbans and Explorers will be retired a bit earlier than before and sales of Minis and Priuses may begin to pick up, folks may begin to forsake more expensive convenience food, etc. etc. All of this will tend to shorten the time for the necessary capital to be accumulated. Yes, it’s the “Invisible Hand” at work.
I am not advocating debt forgiveness here in any way. Those who foolishly took on too much debt should not be rewarded. Let the debt revert to a true market value and assumed by a new responsible borrower who will service the debt at the lower debt service level. Moreover, providing relief via fixing the payment amounts to nothing more than pegging the interest rate at an arbitrary value. It pegs the interest rate to the needs of the home debtor, not the needs of the market.
Yes, the market is telling us that petroleum is at $140 a barrel, and heading higher, that it wants to (anthropomorphizing here) bring new alternative sources of energy online. What’s wrong with that? Any other ideas? Magic wands maybe? Santa? The market wants to serve the general society (that is what the term “market” refers to) and not a particular class, e.g. irresponsible home debtors. This pegging of the interest rate to an arbitrary value is nothing more than a form of price controls, and we know how well that works.
Yes, the interest rate is just a price – the price for savings. If the price of soybeans rises, it tells farmers to plant less tomatoes and more soybeans.. If the price of savings rises, it means consume less, save more. If one puts a cap on the price of soybeans or savings here, one will get less, versus more of them.. That solves nothing. It leads to shortages, specifically, a shortage of savings/capital and hence less alternative energy and more overpriced housing will still be ‘in the fields”.
Someone please explain to me exactly what this solves. It is not as though the home debtors will be left homeless. They will simply have to move across the street, so to speak, into rental housing and only pay the $2,000 market equivalent rent. The extra $2,200 is now theirs to do as they wish. They might even see some attractive alternative energy investments opportunities in which to invest their $2,200, (they broke at some level above $2,200, $2,200 was doable). They are living in equivalent homes and have an opportunity to get some investment returns**, whereas before, the extra $2,200 got them exactly what?
It seems to me that everyone is better off with liquidating the bad investment and moving on, looking towards the future. And the market looks at this dispassionately and sees that it merely guided the home debtor away from an investment with little potential, the overpriced home, and into something with promise. It pats itself on the back, tearfully not understanding the insults and invective being hurled at it.
** On the investment side of the ledger, the interest rate is the hurdle rate, that
is the prospective rate of return that an investment opportunity must minimally
present to the marketplace. That is, if borrowed money costs 8%, then I am unlikely
to invest in a venture which looks to return 7%. The prospective return is usually
significantly higher. Note that even if you invest your own money, 8% is still the
hurdle rate because that is the opportunity cost to you – you could lend out for
8%. Because alternative energy looks to displacing $75, $85, or $100+ oil, its
prospective returns look good. They weren’t so good with $35 oil. The problem
confronting us today is called “reality”.
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