Uncharted Territory

July 29, 2008

Biofuels: an Energy Security (and Price) Own Goal?

Filed under: Biofuels, Economics, Global warming, Oil price, Politics — Tim Joslin @ 12:13 pm

Here‘s the written form of the BBC story about the Obama campaign team’s second thoughts about biofuels, which I heard on the radio and wrote about yesterday. I wasn’t dreaming!

The written piece includes a couple of points I don’t recollect hearing in the radio version. Apparently, “[Obama] has also said in the past that the subsidies help with energy security and climate change” and he “has also backed President Bush’s controversial coal-to-liquid fuel programme which benefits coal miners in the south of his home state.”

Obama’s advisor, Professor “Kammen’s paper says that a car will emit more greenhouse gases [GHGs] driving on corn ethanol processed with coal than it will using normal petrol.”

What the BBC report (or Professor Kammen) doesn’t mention is the energy balance (or the energy returned on energy invested, EROEI) for corn ethanol. We established yesterday that biofuel subsidies do not help with climate change, so perhaps Obama should stop saying they do. If they don’t help with energy security either, then that would remove Obama’s entire rationale for supporting them. Not that, given the wonders of the political process, he couldn’t get away with simply falling back on the apparent European (and probably US) historic position that farmers (“ours”, not those in poorer countries, of course) are different to the rest of us and their lifestyle should be subsidised, period. At least we’d then all know where we stand.

What we also have to bear in mind is that, although some forms of energy are more useful for some applications than others, different forms are interchangeable, at the margin. Here in the UK, natural gas and electricity prices are rising steeply in step with the oil price. In fact, you more often here about the “energy crisis” than the “oil crisis”, since whereas the overwhelming priority in the US seems to be to carry on driving, here it’s simply to keep our poorly-insulated homes warm. There is a lot of concern about “fuel poverty” in the coming winter. Indeed, as Bush and Obama realise, over the longer term, coal can be converted to oil (if you don’t care about the GHG emissions).

Oil is the most valuable fuel, and, all else being equal (i.e. if the price at the pump doesn’t change enough to compensate), we may well be able to reduce national consumption by displacing some with biofuels, though, globally, we will likely simply use the oil elsewhere – the Displacement Fallacy (pdf). If every country produces biofuels, though, then the oil price will drop and consumption will rise. The oil price will in turn tend to rise again because of the increased consumption and we’ll simply be back where we started from. Oil will still be expensive, but we’ll simply be consuming biofuel as well, that is, more fuel in total (there’s nothing “closed” about the global warming problem). Clearly, there is a complete lack of clarity as to what we’re collectively trying to achieve even in terms of the oil market. More on this another time.

What I want to stress here is that, because some uses of oil are interchangeable with other forms of energy, there is a basic energy price even though oil is at a premium. So, if producing biofuel does require more energy than the oil it “displaces”, then, sure, we might reduce the premium commanded by oil, at least temporarily, but we’d be likely to increase the basic price of energy by a greater amount. Biofuel may be an energy security, and price, own goal.

Now, we can’t simply say that the EROEI is negative for corn ethanol, just because Professor Kammen has shown that the use of corn ethanol results in more GHG emissions than “normal petrol”. The corn ethanol inputs include coal which produces more emissions per unit energy than oil. But not much more – we’re not talking about the difference between oil and natural gas (i.e. methane) here. The link to their original source is broken, but the Energy Information Administration (EIA) notes that: “According to the United Nations Environment Program, coal emits around 1.7 times as much carbon per unit of energy when burned as does natural gas and 1.25 times as much as oil.”

But, when answering the question as to whether the American taxpayer gets any energy security in return for their corn ethanol subsidies, we need to include all the energy consumed in producing corn ethanol. We need to include the (amortised) energy cost of all the facilities required, from ethanol refineries to improved roads and vehicles. We need to include the energy consumed directly and indirectly by the people receiving the subsidies, compared to what they may have done otherwise. We would have to base “what would have happened otherwise” on the energy consumption of the average American. That is, we need to add in, as an energy cost of biofuel subsidies, all the energy, above that used by the average American, consumed by the owners, employees and contractors of the farms, refineries and distribution infrastructure required for corn ethanol production. We would also need to make an allowance for the extra energy consumption – made possible by the subsidy bonanza – by the communities in corn ethanol production regions. And, as I noticed one wit observe on a blog recently, we might need to allow for all the flights to Washington by corn ethanol lobbyists. I could add that we should also account for all the hot air expended on the campaign trail.

And water is important. We may find that we are reducing river flows by taking water to produce biofuels. Further downstream we may be having to put in energy to get water – either by building salination plants or using energy to import water.

Fully determining the EROEI for corn ethanol is a tricky exercise. I don’t believe it has been or can be done to a high level of accuracy. That’s why subsidies and quotas are evil. If the energy value of all the inputs and outputs was represented by their cash value we would know whether it was “worth” producing ethanol from corn, at least in energy terms. (Don’t forget I’m just talking about energy value here – I’ve already established that biofuels make the global warming problem worse. Once we put a cash value on carbon storage and other ecosystem services – which I advocate – then growing biofuel crops is for Tin Men: you’d only do it if you had straw for brains).

As it is, it is quite likely that we are putting more useful energy into corn ethanol than we are getting out. As the price of oil increases, many countries – not just the US – are instituting quotas and subsidies for biofuels without knowing whether they actually save energy. If they don’t, this will end up pushing up the market cost for all forms of energy. Or reducing energy security, for those who prefer to frame the issue that way. Panicking governments into even more generous incentives for biofuels…


July 28, 2008

The Biofuel Blues, or, it’s the Opportunity Cost, Stupid!

Filed under: Biofuels, Economics, Global warming, Media, Oil price, Politics — Tim Joslin @ 12:32 pm

As I woke up this morning BBC Radio 4 was telling me the very encouraging news that an adviser to Barack Obama has questioned his policy on biofuels. I can find no reference to this story on the Web, but Obama’s website still leads its entire discussion of energy with a speech made in Des Moines, Iowa, capital of the corn belt. For some reason the BBC suggested the policy was to win votes in Illinois. I wonder whether they’ve muddled the two states: won’t Obama win Illinois anyway, being already senator for that state, and isn’t it Iowa that is famous for being corn-country? Though corn does grow in Illinois, too.

Anyway, apparently the adviser is a university professor and has pointed out that ethanol from corn does not reduce greenhouse gas (“GHG”) emissions because of all the inputs to produce the crop. He also noted that it displaces soya-growing from USA which leads to more GHG emissions if it is then grown in areas of virgin forest.

At this point I realised that my arguments about biofuels may be going over people’s heads. Not because it’s such a high-falutin’ line of reasoning. But because, owing to short-comings of the education system (more on this astonishing story in due course), not to mention the political process and processes of public discourse, the average decision-maker or influencer is no better than a drunk lying in the gutter, in terms of the analytical tools they are able to deploy.

Much as I want to get on and discuss the other aspects of my agenda to save the planet, I realised, while waking on a rapidly warming day of a sticky British summer (which, fortunately, inductive reasoning suggests is likely to last only a few days more), that I would have to spell out even more carefully how the issue is not just one of biofuels displacing crops into virgin forests. Such displacement is fairly inevitable, but even if it didn’t happen – let’s say the total global area of land being used for agriculture declines even as we produce more biofuels – then there is still the question of what you could do with the land instead of growing biofuels. A point people seem to find extraordinarily difficult to grasp. Sigh! I have a case of the Biofuel Blues. It’s Too Damn Hot, as someone once sang.

A small amount of progress has been made in thinking about how to deal with global warming (henceforth “GW”). A book discussing “Kyoto2” is due out this week. George Monbiot (and I believe Mark Lynas) is enthusiastic so I looked at the web summary of the idea (if the book is out a few days early, as often happens, I’ll buy it today so I can sit under a tree out of the heat and read it!). The idea represents considerable progress. It advocates a supply-side solution, that is, restrictions on the production of fossil fuels rather than just their consumption. Correct. Targeting emissions alone will not in itself keep any oil, coal and gas in the ground. Much better to limit the amounts that are dug up, or pumped out. And, in conjunction with a supply-side solution, Kyoto2 advocates the use of existing market mechanisms – i.e. the price of oil etc. – to try to influence the whole global economy. Good work.

I too have been thinking along these lines. I too would like to treat the world as one global economy. I’ll comment when I’ve read the Kyoto2 book, but one problem is that we can’t do this. Unfortunately, as I’ve outlined, and even revisited once already, states and trading blocks distort the global economy. Massively. This has to be taken into account. I look forward to reading Oliver Tickell’s book to see if he’s done this.

But here’s what really baffles me. Why, oh why, does everyone advocate short-term – often annual targets for emissions? GW is a long-term problem. Any solution must be resilient through booms and busts, even wars. That’s why I’m Abebooks best customer right now for books on financial crises! If we’re going to try to solve GW through the price of commodities, such as oil, then we have to take account of the fact that demand and supply and hence commodity prices naturally fluctuate considerably.

GW is a long-term problem. Hold that thought.

Back to biofuels. Almost everyone analyses the problem in terms of the annual emissions of growing biofuels. So they consider the displacement of food crops onto other land as a short-term problem. This is fundamentally the wrong way of looking at the problem.

The last time I penned this argument I had Winnie the Pooh talking to Piglet about “100 Hectare Wood”. Very witty it was too, and highly topical just now, since the EU has banned the “acre”. (Sad, but maybe one less unit conversion to worry about). But then I got worried about whether or not Disney Corporation would be happy about a lengthy spoof on their “intellectual property” and wimped out of posting it. (I’ll leave it to another time to discuss whether we actually want a world where our rights to reference our cultural heritage actually are or should be allowed to be restricted in such a way).

The point is that if we have an area of land – say 100 hectares – we could use it to grow trees or we could perhaps use it to grow biofuel crops. The one is the opportunity cost of the other. If you do an MBA (and I recommend you do, since they are clearly not actually teaching how our society works in schools), one of the things you will learn is that for any investment project you have to tally up the costs and benefits of doing it and the costs and benefits of not doing it and compare the two. You may want to compare a number of alternatives.

For example, a project to manufacture widgets may make use of a factory already owned by the company you work for. You might mistakenly base your business case for manufacturing widgets on the cost of the factory being zero. If you did that, though, you would be sadly disabused of your opinion by your company accountant. It would be such a howler that he might even verbally abuse you as well.

Even if you weren’t charged for the factory space through internal company cost control processes you would still have to include in your business case a benefit in the alternative project of not manufacturing widgets. For the sake of argument this benefit would be the rental value of the factory through the period over which it is proposed to manufacture widgets. It is quite plausible that once the opportunity cost of renting the space to someone else is taken into account, it would make little business sense to use the factory to manufacture widgets. It might be much better to simply rent it out. This is the way you have to “run the numbers”. It is elementary.

In an MBA of course, costs and benefits are considered in cash terms. But we can do the same thing with carbon.

We could either grow biofuel crops on our land or we could simply leave it alone and trees would grow. Carbon would build up in the soil because it is not being ploughed. There would be other benefits, aesthetic and practical. All these benefits are positive to the project of not growing biofuel crops. Remember, to work out if the project makes carbon business sense we’re going to compare the two projects – growing biofuels and not growing biofuels – in fact, just as in the example of manufacturing widgets, we will have to subtract any benefits of not growing biofuels from the case for the project to grow biofuels.

When we correctly evaluate the case for growing biofuel crops it is a no-brainer. We could either grow crops for 100 years or grow a forest over that time. Even allowing for the possibility of fire, we can, on average, expect a hectare of forest to store at least 100 tonnes of carbon after 100 years. Once we allow for the energy costs of production, fertiliser and so on, it turns out that, in temperate regions, you will not be able to grow enough biofuel crops on a hectare of land to displace a tonne of carbon emissions a year. Nowhere near.

In tropical regions the case for growing biofuel crops also needs to be assessed in this way. I suspect, though, that, once realistic figures are used for the benefits of allowing forest to regrow (my 100 tonnes/hectare is a deliberately low figure, since the argument against growing biofuel crops in temperate regions is so strong there’s no need to make any potentially contentious assumptions), and for the carbon stored in forest soils, compared to the likely depletion of soils used to support annual biofuel crops, and for the value of water retention and maintained biodiversity, once all these figures are put together, the argument for growing biofuel crops will be seen to be remarkably weak.

This argument is developed further in my Biofuel papers.

I’m hoping that Obama doesn’t have straw for brains and won’t follow the yellow brick road being built by the corn ethanol lobby. Like that of the Wizard of Oz, their vision is an illusion. (Oh, sorry about the plot spoiler!).

Damn, I was hoping to end there, but now I remember I wanted to highlight two policies from Obama’s website:

Expand Locally-Owned Biofuel Refineries: Less than 10 percent of new ethanol production today is from farmer-owned refineries. New ethanol refineries help jumpstart rural economies. Obama will create a number of incentives for local communities to invest in their biofuels refineries.” [I won’t digress now – I’ll explain why “rural economy” is a contradiction in terms some other time].

“Confront Deforestation and Promote Carbon Sequestration: Obama will develop domestic incentives that reward forest owners, farmers, and ranchers when they plant trees, restore grasslands, or undertake farming practices that capture carbon dioxide from the atmosphere.”

Here’s a way out, Mr President-in-waiting (careful with the triumphalism, mate, we had a guy called Kinnock over here once, you may have heard of him). I’m not entirely unfamiliar with the political imperative to find ways to allow your constituency to have their cake and eat it. Here’s my advice: make it a no-brainer for land-owners to choose the second set of incentives over the first. That way you may still be able to tell everyone just what they want to hear! Isn’t politics great?

It’s hot – this flat wasn’t built for today’s climate so woe betide the poor wretch who has to live here in 50 years time. I’m going for a swim. Right now.

July 25, 2008

Reflections on Reflections on Oil

Filed under: Economics, Energy policy, Global warming, Markets, Oil price — Tim Joslin @ 6:49 pm

My piece yesterday was never intended to be the finished article.  My goal is to outline a solution to global warming that might prevent the human race destroying the natural world and many members of our own species.  A solution based on how the world is, will, I suggest, be superior to one based on how we would like the world to be.

But I now realise that, lengthy though it was, Reflections on Oil omitted a few points that might be vital to understanding the jigsaw.

Cycles within Cycles

As I write, oil is down 10% from its peak a week or two ago, much to the relief of stock markets around the world.  Is this the turning point marking the end of what I yesterday termed the First Oil Demand Shock?

Who knows?

The trouble is, that, like fleas (which, famously, have little fleas upon their backs to bite them…), markets have long cycles, short cycles, and everything in between.  Each cycle has its own cause, possibly in the “real” world, and may be reinforced or damped by positive and negative feedbacks.  The time element is crucial.  In the UK we see today that, though oil is down, the price to the domestic energy consumer is still going up.  If we’ve seen the oil peak, the price rises yet to be passed on represent more inflation, which could cause higher interest rates, which will reduce economic activity, which could cause the price of oil to overshoot on the way down…

On the other hand, oil might shoot up again.  I wrote a few days ago that the issue of Iran has not gone away.  As I recollect, the talks last weekend gave Iran a couple of weeks to show some movement in its negotiating position.  As many commentators have observed, there’s also a dangerous window between the US presidential election and inauguration.  Particularly if Obama wins.

Then again, I suspect China to have put off any steps to slow its economy until after the Olympics and maybe even to have over-bought oil to avoid any possibility of losing face during the event.

The puzzle deepens because we know that markets know about these factors.  Risks may or may not be fully discounted.

The whole point (as this New Scientist article bleedin’ obviously notes – subscribers only I’m afraid, but it’s worth reading to see that the authors and presumably sub-editors don’t actually know what moral hazard is!) is that any asset is only worth what someone is prepared to pay for it, regardless of its “theoretical” value, so prices are largely determined by the untamed animal that we call the market.

But I don’t believe anything – even the market – is as random as Taleb seems to insist.  Turning points in markets are difficult to predict, but nevertheless we know they will happen.  Prices must, by definition, peak or trough eventually.  Many smart commentators knew the UK housing market was overbought going into 2007, even if the average punter couldn’t detect the signal in all the (often self-interested) noise.

Lumpy oil supply and consumption

The patterns, albeit grossly simplified, that I suggest will (in the event of a lack of or the ineffectiveness of steps to avert global warming) appear in the data of future oil consumption and and hence price, are a result of the effect of nation states on the market.

I never cease to be amazed by the capacity of people’s sense of entitlement.  One might argue that windfall profits (beyond those necessary to incentivise the companies involved) from the extraction of natural resources should accrue not to individual states but be used for the benefit of the whole of humanity.  One would not get very far.  It is the small number of oil-producing countries which allows oil to be rationed to everyone else.  Now that these countries are wealthy, they have little need to compete amongst themselves for the oil market.

I mentioned demand-destruction yesterday, but we should also reflect on how the high profits from oil have led to a global search for new supplies.  But a large proportion of these new suppliers are already oil-producing countries.  Sure, there are pockets of oil and gas being found from Israel/Palestine to Australia, but the new frontier of the Arctic is controlled by Russia, Norway, Denmark and Canada.

Only a few oil-deficit countries, including the US and Brazil, can boost oil-production.  I’m an environmentalist.  I think it should all be left in the ground.  The rest of the world must be wondering, though, why it is only now that the US is prepared to remove restrictions on offshore drilling.  People must be thinking they can’t want it that much if it’s worth less than a few polluted beaches.  Which tends to imply oil could ultimately get a lot more expensive yet.  The US certainly, and likely Brazil too eventually, will soon be able to consume any additional oil they pump.  So, in terms of reducing the long-term oil price increase, it won’t be enough to delay the Second Oil Demand Shock for very long.

As I explained yesterday, this will eventually push up the oil price to extreme levels.

The argument is not changed by the fact that, over time, the population of oil-producing countries will rise, partly because their wealth will permit larger families than otherwise and partly through migration both of the wealthy and of cheap labour, as we see from Dubai to Alberta.  The population increase will simply cause an ever-increasing proportion of oil to be consumed near where it is produced.  George Monbiot laments the fact that:

“The UK’s entire climate change programme is based on a statistical artefact. The only reason our pollution appears to have declined is that we have outsourced our emissions. A fair account of our carbon emissions would include those we import minus those we export: a balance that can only worsen in a post-industrial economy.”

But if some of our highest emitters (F1 racing drivers, say) move to Dubai while we are still able to watch them on TV and British companies continue to profit from their work, then surely that migration also represents an outsourcing of our emissions.

The whole plan is daft.  The idea of rigid emission targets for specific geographical areas (aka countries) is deeply flawed, especially when the rate of reduction of emissions that is proposed is conceivably less than (highly variable) annual rates of migration and changes in trade.  And totally especially when much of the world is outside the trading system!  Doh!

Effect of New Technologies

Today’s Guardian reports on wind power in China.  This is encouraging, but however much wind and solar power is produced it will not in itself keep the fossil-fuel in the ground. We’ll simply use more energy.

And what’s more the price of oil could continue to rise.  There are (at least) two reasons for this:

– cost and price are separate concepts.  The excellent blog post (but where’s the sequel?) I referred to yesterday asked:

“Is there a limit to how high the prices can go? Yes, the price of alternatives. If say solar energy is available for $200 a barrel equivalent of oil, then the price of oil will stabilize at $200 a barrel.”

Just because the cost of production of, say, the production of solar power drops, this will not drive down the price of oil.  If there is not enough energy available in total, then the lucky owners of both the solar power and the oil (as well as those of other sources of energy), will continue to make large profits. (Which will encourage more entrants into the energy market until it once again becomes a buyer’s market – but this could take an indefinite amount of time, impossible to determine in advance).

– oil is a complex product.  Some uses of oil, e.g. to power aircraft cannot easily be replaced with the use of electricity (although this may be possible in the long-run).

There is no real limit to how high the price of oil could rise relative to other goods.  Even if the cost of a plane flight exceeded the median annual salary by many times, some could still afford to fly.  And money is just a way of allocating resources.  We could simply end up with more super-rich people who can afford to fly while the rest of us are stuck on the ground.

Governments distort the economy

Not only do we have a lumpy global economy, we also have huge distortions caused by the bizarre willingness of governments to manipulate prices and engage in all manner of subsidies.  I quoted an FT article yesterday which included the quite staggering statistic that “officials recently estimated [India’s] subsidy bill… at $60bn.”   That’s likely of the same order as they spend on health or defence.  Unbelievable.

Lest anyone think I’m singling out India, I recently came across this FT article which gives some impression of the full horror of China’s currency misalignment.  What this means is that vast resources are being mis-allocated.  That is, millions of jobs have been created which may not be viable in the long-term.  I suspect this will not end prettily.

And in the UK the government now – yes, I’m afraid it’s true – encourages the creation of jobs for which (to maintain a reasonable standard of living) it is necessary to have people pay negative taxation (“tax credits”).  More on that another time.

Against this background we have to deal with the problem of global warming.  Tricky.

July 24, 2008

Reflections on Oil

Filed under: Economics, Energy policy, Global warming, Markets, Oil price — Tim Joslin @ 4:52 pm

I once visited an art installation which consisted of a pool of oil maybe 10m long by 5m wide at about 1.25m high. It was indoors and still, so, at the angle you looked at it, the reflection was near-perfect. Apart from a few dust motes on the surface it was like a supernatural (using the word in the sense made popular by the late Lyall Watson) mirror onto the world.

Let’s see what light reflecting on oil can shed on the current economic turbulence.

My thoughts on the price of oil were prompted by a piece “Welcome to a world with $500 oil” by Willem Buiter at the FT (non-subscribers may not be able to view Buiter’s blog) a week ago. I was away from a computer, made some notes, lost them, and now I’ve found them again. So here goes…

If you’re not living on a desert island you will be aware that we are witnessing “demand-destruction” at current oil prices around $130 a barrel. How, you may wonder, could reputable economists predict a price of $500/barrel?

To answer this question we’ll have to explore the pathologies of the global economy. In short, when it comes to oil, the global economy is being severely distorted. The price you pay at the pump is not simply a result of supply and demand for oil around the world. Yes, we’re all connected in one global economy. But the global economy is as imperfect as the image seen in a fairground distorting mirror. The actual price of oil to consumers in (say) the developed countries is a result of political decisions, exchange rate manipulation and subsidies, in short government interference conducted on a colossal scale.

Now, in trying to prevent global warming, effective solutions will have to rely on market-forces. Perhaps, before proceeding, we need to consider how well our market is actually operating.

We live in a complex world, but let’s consider three classes of nation state:

– the “developed” (I hate this term) countries, in particular the EU and US – those who either are or can be expected (from 2012) to attempt to meet Kyoto-style consumption targets;

– the industrialising countries, such as China and India;

– the oil-producing countries, especially OPEC and Russia.

Developed Countries

With oil at $130 we are seeing demand destruction in the developed countries. Probably enough demand destruction to cause a cyclical downturn in the price of oil. As such cycles always overshoot, my bet is that we will see $50 oil again at some point in the next few years. Of course, once we have made efficiency improvements (in particular more mpg), consumption will increase again, since driving will be good value once more.

But this demand-destruction is only happening because governments are (by and large) making sure consumers pay the true supply and demand price of oil. In fact, they are even prepared to make consumers pick up the cost of some of the externalities of oil use by imposing fuel duty. Carbon-trading, where it is applied, represents an attempt to ensure consumers pay for the global warming externality.

Oil well and good.

Industrialising Countries

These countries do not, in general, pass on the full cost of oil to consumers. In India, for example, heating oil is subsidised. The price of oil doesn’t increase only far enough for consumers to change their habits. The government has to feel the pain and then impose a price rise on an unhappy population.

Not only that, but the currency of many countries is artificially pegged to the dollar.

Digression: Trade Imbalances Cause Credit Crisis AND Oil Spike

Here’s some food for thought. For years the Jeremiahs* have been warning us about trade imbalances. Now I just wonder if this isn’t an underlying cause of both the credit crisis – since the real problem was the cheap loans, partly made possible by the need to invest trade surpluses, which drove house prices up in the first place – and the oil price rise (and commodity inflation). What is happening in the world today, I suggest, is that – looking for gold at the end of the development rainbow – many people are doing work for much less than its true economic value. Many are being exploited and living in appalling conditions on low wages. But for other occupations in the same economy – say IT work in India, white-collar jobs carried out by the burgeoning Chinese middle class – consumption patterns are approaching those in developed countries. Such workers cost much less in dollar terms not because they are more efficient than the developed country competition (likely they are less efficient) but because they are in a “developing” country. In short, they benefit from the vast army of cheap labour.

Cheap Labour and the Cause of Trade Imbalances

Here’s my proposition:

1. Exploitation lowers costs indirectly for developing country exporters. It’s not that the IT worker in Bangalore is directly exploited. It’s the exploitation of the guy living on a few dollars a day who brings the lunch to the IT worker’s desk which allows the IT worker in Bangalore to undercut the IT worker in Basingstoke.

2. The inefficiency in labour terms of making the IT worker redundant in Basingstoke in order to employ two in Bangalore to do the same job allows the developing country to build up a trade surplus.

3. The problem would be much reduced if the IT worker in Bangalore had to pay the UK price for petrol. If it’s subsidised (or even if there is less duty and/or carbon tax included in the retail price) he will be able to consume more relative to the value of what he produces. The trade surplus allows more oil to be consumed than would otherwise be possible. [Actually India wisely allows the rupee to float, so doesn’t have an overall trade surplus. The argument applies insofar as India has a massive trade surplus in IT services].

How Developing Countries Will Cause the Next Oil Price Spike

I mentioned that many developing country currencies are pinned to the dollar allowing trade surpluses to be maintained, albeit at the cost of some inflation. Surely if the currencies were allowed to appreciate then developing countries could afford even more oil? Well, yes, they could as long as they were able to maintain their trade surpluses.

Here’s the problem for developed country consumers. If developing countries (China, you know who you are!) break the dollar peg (i.e. allow their currencies to appreciate) they will be able to push up the price of oil (at the expense of some loss of exports).

If they maintain their trade surplus (by keeping their currency low) they will be able to push up the price of oil, until the trade imbalances becomes unsustainable. Without currency movement this will happen in the worst case when developed countries are unable or unwilling to service their debts, but before then when they are unable to borrow or borrowing becomes too expensive. Recognise anything yet?

One problem is that the developed countries such as the UK and US seem to be happy to nationalise private debt either directly (Northern Rock, Fannie and Freddie) or indirectly by tax-giveaways and budget deficits. The wrong policy in my opinion, but let’s not digress too much.

The conclusion is that because of their trade surpluses and unwillingness to pass the true supply and demand cost of oil onto consumers, the developing countries will be able to push the price of oil up well beyond today’s levels. Many scenarios are possible, but here’s a likely one. Once demand-destruction in the US in particular pushes the cost of oil down to around $50, it will bounce because of demand from China and India, in particular, which will continue to increase even as the developed countries move away from oil. Until…

All this is a colossal mistake of course, because, in a short-termist rush to develop, economies are being created that are not only highly inefficient (in labour terms) but also reliant on limited supplies of energy. If we continue on this path, then somewhere along the line this inefficiency will be exposed, and there will be economic meltdown on the scale of the fall of the Soviet Union or the Great Depression.

Maybe the developing countries could push oil to $500/barrel, but there are other players in the market.

It gets even worse.

The Oil Producers

Now, here we have a real problem.

Oil producers get free money.

It’s only in the last half-century or so that countries have not had to work for resources. The security guarantees of the present world order, coupled with the voracious global appetite to consume, provide unparalleled riches without the burden of corresponding military expense.

Oil producers get free money.

They give oil (and money) away to keep their population happy. This raises the price of oil by reducing the amount available for export, that is, the supply to consumers in importing countries.

They have built up huge sovereign wealth funds (SWFs). They practically have more money than they know what to do with. More to the point, the larger the SWF, the more the oil-producing country can afford to consume each year. The process is cumulative.

Venezuela is giving away oil for political influence.

The Gulf states are building colossal cities. Building these consumes oil. The cities are unlikely to promote efficient use of oil, because it’s cheap in these countries. And worst, these projects, even if they could not be justified without the surplus capital from oil revenues, create industries and put money in the hands of their populations, leading to still more oil consumption.

Now, the oil producers only judge they need so much money from exports.

Here’s the screamer: the higher the oil price, the lower proportion of their oil the oil-producing countries will tend to export.

I see I should have written this blog post a week ago, since a comment on Willem Buiter’s blog makes a similar point, referring to a blog from India (hi over there!).

So over a period of decades there is a massive positive feedback in the system.

I suggest we’re witnessing only the First Oil Demand Shock, as consumers in “developed” economies are forced to cut back on their use. I suggest the most destructive in human terms will be the Second Oil Demand Shock when those countries who are currently building economies reliant on affordable oil are forced to cut back their consumption. If I had to guess I’d expect this Shock in about 2020. The Third Oil Demand Shock will be a long drawn-out affair when one by one the oil-producers are unable to maintain the profligate lifestyles of their populations and are afflicted by the Curse of Oil.

Unless of course we think in the meantime of some way of keeping the stuff in the ground.

* I wonder whether the language police have ruled this usage (“doleful prophet or denouncer of the present age”, Concise Oxford Dictionary 7th edition, 1982) ideologically unsound for some reason, since it doesn’t appear in Wikipedia, the Wiktionary or dictionary.com. Sorry if anyone’s offended.

July 23, 2008

Fannie and Freddie Get Naked: Update

Filed under: Economics, Housing market — Tim Joslin @ 3:16 pm

It’s important to be accurate so here are a couple of corrections to my previous post:

First, I now see from the Battlestar Galactica subtitles that the past participle of “frak” is “fracked”, not “frakked” as I said last time. Future students of early 21st century English are going to be extremely puzzled not just by the irregular conjugation of the verb (cf. whack, whacked), but also by its usage. Rather than a euphemism, it is apparently a direct substitute in all circumstances for the overused vernacular term for what a naked Fannie and Freddie might indeed get up to. It’s bizarre when you think about it that the rules for pre-watershed TV are so strict when no such restrictions apply to the stack of DVDs families might choose to watch instead. At least Red Dwarf’s “smeg” had its own independent usage, and in many cases must have been more vulgar than the word it replaced!

Second, I see an informative article in the NYT today about Fannie and Freddie provides a “multimedia” graph comparing “jumbo” and F&F compliant mortgage rates since 2001. It’s only since the start of the credit crisis that the spread has been as much as the 1% I mentioned: previously it’s been around 0.2%. Nevertheless, a very generous subsidy that only served to inflate the housing bubble. Of course, it’s not really the amount of the subsidy which inflated the housing market – this just reflects the risk the taxpayer has taken on. The fact that F&F’s debt was sold like US Treasuries paying a generous rate and $100 billions are owned by safety-first investors such as China and other states allowed more money to flow into the US housing market than would otherwise have been the case.

Some interesting comments on the effect of F&F on the US housing market are collected here.

It doesn’t look pretty.

July 22, 2008

Global Warming and the Nature of Science, or, The Ofcom has Spoken!

Yes, finally the Ofcom has spoken. Not very loudly, it seems. It’s really just a rap on the knuckles for “The Great Global Warming Swindle”, largely because:

“…whilst Ofcom is required by the 2003 Act to set standards to ensure that news programmes are reported with ‘due accuracy’ there is no such requirement for other types of programming, including factual programmes of this type.”

Unbelievable. What planet are they (or rather the legislators responsible for this insanity) on? One that is going to get a hell of a lot warmer, it seems, if we can’t work out how to make rational, science-based decisions. How can the category “factual programmes” even exist without “standards [of] due accuracy”? Has anyone thought about what the word “factual” actually means??

Remind me if I don’t return to this argument later on, but to state the thesis briefly, in complex domains, problems – whether big ones (like GW itself), or small ones, like “Swindle” – almost always have many causes. Dealing just with the immediate cause may be futile. In the case of “Swindle” it may be most effective putting effort into changing the rules of the media game, rather than engaging in trench warfare. Because, if the ultimate arbiter of truth is not factual accuracy then we just end up with a popularity contest. Hey, why not incorporate audience votes in science programmes? Phone-in to vote for your favourite theory of gravity!

Luckily, in the case of “The Great Global Warming Swindle”, the programme:

“…broke rules on impartiality and misrepresented the views of the government’s former chief scientist…” even though it “was ‘on balance’ cleared of ‘materially misleading the audience so as to cause harm or offence'”. (Quotes from the Guardian’s news story on the findings).

But what if they hadn’t broken any rules?

And at least in this case George Monbiot got his retaliation in first, with a comment (and CiF) piece in today’s Guardian, as well as an essay in G2. [Illustrated with the usual photographs, incidentally: someone should devise a market instrument for investors in pictures of power stations, melting ice and – my personal tip – pictures of solar panels and photogenic children in Africa. Oh, sorry, it slipped my mind for the minute that markets are in the dog-house right now.]

George does an excellent job, as usual, in his forensic G2 piece (though there’s a touch of conspiracy theory in his analysis of Channel 4) but in the very last column it all falls to pieces. [See yesterday’s post for my views on conspiracy theories and the need to read the detail – in this case right to the end – to avoid Taleb’s randomness illusion]. Even so, I urge you to read George’s dissection of “Swindle”: you may be surprised. I recollect that I had moreorless bought into the idea (which Monbiot debunks) that Thatcher’s espousal of GW science was partly due to her search for weapons to use against the UK’s coal-mining industry.

Remember, though, that, as well as the particular pathology – in this case the way “Swindle” was given a platform – we also need to look at the underlying causes.

This is where a major problem lies in George’s piece:

“[Channel 4] says [its scheduling of “Swindle” and other programmes] ‘is against the background of the IPCC [Intergovernmental Panel on Climate Change] stating that there is a 90% certainty that the causes of global warming are man-made, it follows that there is a 10% uncertainty. Yet this 10% uncertainty receives a disproportionately small amount of airtime.’ I [George continues] find this argument extraordinary. A 90% level of confidence does not mean that 10% of the evidence suggests that an effect is not occurring — in fact, there is no reliable evidence showing that man-made global warming is not taking place. It is expressed in this way because there is no absolute certainty in science. The ‘very high confidence’ the IPCC expresses in the global warming thesis is the strongest statement any reputable scientist would make about his area of study. It is legitimate and right to stress that there can be no absolute certainty about global warming.” [my italics stress].

90% is not in fact a very high probability when we are discussing scientific findings. In my opinion, it would be more than justified to say that we’re “virtually certain” that “man-made global warming is […] taking place”, and by virtually certain I mean at least 99%. A 99.9% claim would be perfectly reasonable. So why does the IPCC not say this? Saying 90% gives the green light to people like Martin Durkin (the maker of “Swindle”).

I’ve just done a bit of weight-training and consulted the IPCC’s latest massive report (The Fourth Assessment Report, or “AR4”). If we look at Table 1 on pages 120-1 of the Scientific Basis (there are 3 parts to the overall report) we see that, although the IPCC is happy to use the words “virtually certain”, it only does this when a result “can be estimated probabilistically”. For example, a particular set of data may have a definable probability of indicating a trend.

[Note that our ability to calculate such statistics requires us to make assumptions about randomness – i.e. a bell-shaped curve or Gaussian distribution. This implies that we have a theory about the causes of variation in the data in the first place! For example, if we say we’re 99% certain that the glaciers are melting this finding must have been calculated against a null hypothesis that changes in glacier volume are subject to random fluctuations. This may not be true. There could be reasons we are entirely unaware of for all the world’s glaciers to either melt or grow at the same time (on top of reasons for correlation between glaciers in the same region which have presumably already been taken into account). Such “unknown unknown” correlation would invalidate the null hypothesis and hence the 99% “virtual certainty”. If we’re 99% sure what the data tells us, then surely we must be at least 99% sure of our theoretical understanding. I’m sure Taleb would agree with me! It’s entirely illogical to have more faith in data-driven findings than in any aspect of the underlying theory explaining them! But this is not my main point today.].

No, what baffles me is why the IPCC restricts itself to a maximum of “very high”, that is, 90%, confidence when it comes to “scientific understanding”.

Politics may have played a part in the IPCC process. Some governments may have lobbied for 90% rather than 99% as the maximum possible confidence. But let’s put that to one side. I want to argue that a critical factor is widespread misunderstanding of the scientific process.

Practising scientists often cite the philosopher Karl Popper. They understand that theories can be “falsified”. Some may even have heard of Thomas Kuhn and appreciate that such “falsification” takes place in “scientific revolutions”.

But what happens in such revolutions? In fact, scientific theories are superseded rather than “falsified”. Let’s consider one or two examples very briefly. When Einstein “overturned” Newton’s theory of gravity he didn’t demonstrate that Newton’s equations were wrong. Rather, he showed the limitations of Newton’s theory. Crucial experiments (where the difference was large enough to be measurable) showed that Einstein’s theory made more accurate predictions than Newton’s. In effect, Einstein incorporated Newton’s findings in his own theory of gravity. Albert never said: “Silly old Isaac’s made a mistake there.”

A case closer to the topic in question is the oft-cited theory of the 1970s that we were about to enter a new ice age. Now this theory hasn’t gone away. The Earth would be cooling (though there is debate as to when the next ice age would occur), if it weren’t for global warming. The current theory of global warming includes the ice age cycle as well as all other prior theories for the variation in the Earth’s climate, such as the effect of volcanic eruptions. Quantitative statements about man-made global warming take into account numerous other causes of climate variation.

Now, it’s possible to imagine reasons why the Earth might not warm as much as projected. For example, the solar system could enter some as yet undetected dust cloud. But any quantitative estimates of the effect of such a dust cloud would have to include the effects of man-made GW. And if the planet cooled dramatically as we entered the dust cloud we’d still have to worry about its temperature rising beyond today’s level because of our greenhouse gas emissions when we came out again. Just the same as, if we solve the problem of global warming and get the climate back to something resembling its pre-industrial state, we will – over the longer timescale of millennia rather than decades – need to take account of the Earth’s ice age cycle which was apparently of such concern in the 1970s.

There are examples in science of theories that are (or could be) flat wrong. But these are theories for which there is no evidence or for which the evidence has been misinterpreted due to problems inherent in the data-gathering process. This is most likely when observations are difficult, such as at the frontiers of physics. For example, the infamous string theory could be wrong because it makes no new predictions.

Any replacement for a theory with lots of firm data, such as global warming, would have to provide explanations for all that data. Clearly this is easiest if the new theory explains the old theory as a special case, rather than by invalidating it entirely.  In the history of science theories are almost always shown to be incomplete rather than “wrong”.  In my opinion, Imre Lakatos understands this process most clearly, even though this aspect of his ideas is rarely stressed.

The probability of the theory of global warming actually being wrong is therefore vanishingly small.  Our level of certainty is, in fact, far more than 99%.

So one of the underlying causes of programmes like “Swindle” is that even the scientific establishment is unclear as to the nature of its theory. Even if there are unknown unknowns and the planet does not end up warming over the 21st century and beyond this would not in itself invalidate the theory of global warming.

July 21, 2008

Pricking the Oil Bubble?: Bush, Fannie and the Ayatollahs

Filed under: Economics, Markets, Politics — Tim Joslin @ 8:41 pm

It sure is tough trying to explain events in our complicated, modern world. Now that divine intervention is out of fashion, we only have reason to guide us. And there is so much that simply seems irrational!

The Guardian’s Comment is Free (CiF) community is in a lather on the topic of conspiracy theories. I understood that any self-respecting conspiracy theory should be characterised by a complete lack of any evidence whatsoever. I’m therefore a little bemused by some of the discussion. Surely, if we consider speculation about the machinations at the heart of power structures to be conspiracy theories, as Dan Hind appears to, then we should consider ourselves all to be paranoid.

I’m currently reading “The Black Swan”, and I have to say that, if, like the book’s author Nassim Nicholas Taleb, you shun newspapers, then events are indeed likely to appear even more random than to the rest of us! I prefer to believe that all events do have explanations, even if we’re not clever enough to work them all out in advance. Or rather, since most events are predicted in some way by someone somewhere (for example, I recollect watching at least one movie in the 90s with attacks similar to those that later occurred on 9/11), the majority of us aren’t able to work out who is in fact right. The problem is how to distinguish the signal from the noise. The world is not random – even Taleb admits that “Black Swan” events can be explained after the fact. “Conspiracy theorists” are therefore, I suggest, obligated to provide verifiable facts in support of their case.

Last week saw astonishing movements in the markets, as the FT notes. Can we concoct any sort of rational explanation or do we have to put the whole thing down to randomness?

If we cast our minds back to the weekend before last, there was an air of crisis in the markets, centred around Fannie Mae and Freddie Mac, whose share prices were falling by around 20% a day. The authorities in the US took the unusual step of making an announcement on the Sunday (13th July), of what has been called a “rescue” of the two companies. I suggest it was nothing of the sort. Rather it was a statement of willingness to conduct a rescue. Sure, a little flesh was put on the bones, but in essence all that happened was a bit of expectation management. The markets were merely told what they knew already, that is, that the US government implicitly backs Fannie and Freddie.

If I recollect correctly, Fannie and Freddie’s share prices started rising by double-digit daily amounts immediately after the “rescue”. But the broader markets were not soothed. On Wednesday, though, relentless buying of oil gave way to a spectacular drop in the price. Panic-selling of stocks suddenly turned into panic-buying. Soon the bear-hunting season was in full swing. Further measures to counter destructive short-selling were a factor in the turnaround, but these won’t have affected the key factor, the price of oil. The problem with oil is those evil long-buyers!

No, the panic only really subsided on news of apparent reductions in tension in the Middle East. First, the US decided to start talking to Iran. And second, as discussed in one of the most depressing opinion pieces I’ve ever read, Israel exchanged prisoners for bodies with Hizbullah.

Now, it seems to me that decision time at the heart of power is a commodity in very short supply. Decisions on bailing out Fannie and on foreign policy have something in common. Both, I suggest, have to be taken at the heart of the executive, maybe even by George W. Bush, MBA, himself. So, given the intensity of the financial crisis a week ago, the most effective way to open doors in the White House would have been to provide ways of calming the traders.

The markets seemed to be terrified by the never-ending rise in the price of oil. What better way to progress your own agenda than by providing a solution to this aspect of the problem? I therefore wonder whether what we’ve seen is really “a long-overdue shift in American policy”. Instead it may have been more of a tactical move to give the appearance of defusing tensions in the Middle East, with the primary goal of reducing pressure on the price of oil and relieving the crisis in the financial markets (and, I should note, perhaps a secondary objective of taking the wind out of the Obama’s sails as he prepared a week of foreign visits, speeches and policy announcements). The diplomatic moves may have little bearing on the US’s long-term intentions, or the reasoning may have even been, cynically, that, if the US does decide to take more forceful action against Iran (or give Israel the nod), they can say they tried everything. Likely the reasons are complex, and it’s quite possible that different factions within the US administration interpret the move quite differently. I’d guess that the panic on Wall Street at least affected the timing of the diplomatic initiative.

I can’t let a CiF piece from a Charles Harb pass without comment. Many who added comments to the piece itself considered the author to be arguing in favour of terrorist tactics. It’s hard to argue with such an interpretation when Harb writes that: “Hizbullah fulfilled yet another pledge, and successfully ended another chapter in its longstanding battle with Israel”, and that “Hizbullah’s success can be added to its already long list of achievements” [my stress in both quotes] but sneers at “‘Arab moderates'” [he used quotes] and talks of the “now barren ‘peace process’ [which] keeps edging ‘forward’ through road maps, countless summits, visits, and vague ‘visions’ of a Palestinian state that fails to materialise…”. Harb’s piece is so extreme that it wouldn’t surprise me if the Guardian received complaints about it. Perhaps that explains why it was closed to comments between about 7:19pm on Friday 18th July and 10:27am on Saturday 19th.

Reading a piece like Harb’s certainly leads me to the conclusion that, as far as Israel and the Palestinians are concerned, the two sides are not even on the same page. In fact, the two sides do not even agree on who the two sides are. Hizbullah, believe it or not, is not a party in the conflict between Israel and the Palestinians. They crossed a border that was not in dispute to provoke the 2006 war in Lebanon. It seems parts of the Moslem world do not yet accept the right of Israel to exist whereas the rest of us frame the issue as one about the borders of a Palestinian state. And, as was pointed out in comments on Harb’s piece, you can’t follow two policies at once – negotiation cannot succeed when it is being undermined by violence. Harb only reinforced my agreement with the analysis I heard in a public meeting a while back when my MP predicted no substantive change in the Israeli-Palestinian situation by the end of the next US President’s term in office.

Rather than gloat about a Hizbullah “victory” we should perhaps ask ourselves about the motives of the other participants. I can only explain why other Lebanese politicians associated themselves with celebrations of the release of Samir Kuntar by assuming their judgement is clouded by a yearning for the inter-religious harmony that persisted in Lebanon for centuries, which is described by Taleb in Black Swan (see what you can find out by hoovering up information!). OK, I write from afar, but it seems to me that the harmonious Lebanon of the past is gone forever.

Even more interesting may be the motives of the Israelis. I understand the prisoner exchange was mediated by Merkel (and, I assume, OK’d by the Americans, perhaps for reasons similar to those behind their Iranian diplomatic initiative), but the Israelis didn’t have to do it and they didn’t have to do it now. Here’s my “conspiracy theory”. Let’s first remember that Israel “lost” the 2006 war in Lebanon partly because of Western public opinion, not Moslem public opinion. Bush and Blair were forced to demand a halt to the bombing of Lebanon and the Israeli incursion across the border. Now, Israel will have learnt from that experience. They will also have had a fair idea of what would happen when Kuntar was released. The prisoner exchange may have been “good” PR for Hizbullah in the Arab world, but I’m afraid it was also “good” PR for Israel in the West. Especially “good” PR if they are contemplating military action.

What bearing does all this have on the markets? Well, I’m not convinced that Fannie is any safer than before, nor that Israeli action against Iran’s nuclear installations is any less likely than it was 10 days ago. Nothing substantial has happened. No bad news has been got out of the way. My experience may be a little limited, but I recollect the markets plummeting practically until the day of the Iraq invasion in 2003. With markets, it’s all about anticipation. Until the issue of Iran’s nuclear ambitions is resolved unambiguously I suspect the oil price will not retreat decisively and, irrespective of whether the worst effects of the credit crunch have yet been seen (I suspect not, but that’s another story), we won’t reach the bottom in the equity markets.

I’m not raiding my piggy-bank to buy shares just yet!

July 20, 2008

Moronic Mortgage Moment at Money Guardian

Filed under: Economics, Housing market — Tim Joslin @ 4:05 pm

An article appropriately titled “Three-quarters of the answer” in yesterday’s Guardian Money section appears to have been written and edited by people with three-quarters of a brain. Between them.

Any readers who may have spent the last year on an expedition to the deepest, darkest, most off-grid areas of the Amazon rainforest may be shocked to hear that mortgages for more than 90% of a property’s value are now expensive and difficult to obtain in the UK.* Clearly the Guardian Money team have been wrestling with anacondas, because they suggest that lenders are happy to write 100% mortgages on 75% of a property!

The Guardian have decided this week to give free advertising to schemes whereby developers provide buyers with a soft loan for 25% of a property’s value so that the buyer only needs a mortgage for the remaining 75%. The rationale? A gimmick to avoid simply marking down the headline price, perhaps? No, the Guardian identify another “advantage” of these schemes:

“One plus point is that mortgage rates for people borrowing 75% of their property’s value tend to be more attractive and easier to get hold of, says Philip Hogg at Miller Homes.”

Well, that would be the case if you paid the other 25% of the property’s value as a deposit. But in this case you don’t own that 25%. The article is clear that:

“…you can sell the property at any time and retain your share of the selling price, while the developer will be entitled to 25% (or whatever its share is at that point) of the open market value at that time.”

“[B]orrowing 75% of [a] property’s value” in these circumstances is a 100% mortgage for three-quarters of a property. Not likely to be on “attractive [terms] and eas[y] to get hold of”, methinks.

I suppose there may be ways round this problem. Perhaps the developers are prepared to take on the risk of the buyer defaulting on the mortgage. They may be prepared to indemnify the mortgage lender for the first 25% of a loan in the event of a default. This would allow a buyer to obtain preferential terms for a 75% LTV (loan to value) mortgage.

If, though, a buyer were to take out a 75% loan claiming it is secured on the whole property when the developer still owns 25%, then, of course, they and/or their professional advisers would be committing what many would term mortgage fraud.

And surely that can’t be what the Guardian is suggesting its readers should take part in?

Anyone not missing 25% of their brain would be best advised not to buy at all until sellers have faced reality and simply marked their prices down a great deal more than they have so far. The sooner and faster they drop their prices, the better it is for everybody, except those misled by “reporting” such as in this week’s Guardian Money section. Daft schemes such as the ones to which the Guardian freely donates the oxygen of publicity seem to have been dreamed up simply to avoid developers having to take a loss.

* This week’s Guardian Money Best Buy tables list only one mortgage above 90% LTV (loan to value) and that’s misleading because there is a HLC (Higher Lending Charge) for borrowers of over 90% (so for LTVs above 90% it’s really a different mortgage). If you don’t know what a HLC is have a look at this article titled Mortgage Lenders Are Still Ripping You Off.

July 16, 2008

Fannie and Freddie Get Naked

Filed under: Economics, Housing market — Tim Joslin @ 4:51 pm

I was going to use the title “Fannie and Freddie are Frakked (as they say on Battlestar Galactica)” but the one I’ve finally chosen summarises what I want to say even better. And is likely to get more hits! 😉

The essential underlying problem with the US mortgage market should be obvious to anyone who uses Yahoo!’s US Finance pages. I have to say Yahoo! provide an excellent service though it’s a shame that their UK site has so many broken share price graphs, and lacks some of the facilities available across the Pond. I often think Yahoo!’s offerings have a certain nostalgic 1990s clunkiness that would make their business a good fit with (say) Microsoft. 😉

Perhaps I jest overmuch. I must be punch-drunk. Back to the serious business.

If you scroll down a little on Yahoo!’s US Finance home page, you’ll see a table of average mortgage rates. The average price today for a “30 Year Fixed”, for example, is 6.14%, whereas for a “30 Year Fixed Jumbo” it is 7.16%. What’s the difference? You may well ask. The point is that in the US smaller mortgages are cheaper because they can be sold to Fannie Mae and Freddie Mac – they are effectively underwritten by these institutions.

Alarm bells ringing yet? The difference between the cost of different mortgages should (on average) reflect (mainly) the risk (and costs) of default. Now, it seems to me that the risk of default is not higher simply because a mortgage is larger. In fact the whole sub-prime disaster suggests that the risk of default in the US mortgage market is higher the lower the amount of the mortgage. I would have thought buyers of larger mortgages are also more likely not to be first-timers, so are not only likely to have successfully paid a previous mortgage, but may also be borrowing less than the full value of the house they are buying. I don’t know if the Yahoo! data takes these factors into account by correcting for the credit rating of the mortgagees and comparing like mortgages (e.g. 90%). Nevertheless, there’s no reason for larger mortgages to be riskier and therefore more expensive than smaller ones. It must also be cheaper to administer $1bn worth of large mortgages than $1bn worth of smaller ones.

Now, the approximately 1% difference between the pure market rate of Jumbo mortgages and the distorted rate of regular mortgages is a lot. That is, Fannie and Freddie are in effect subsidising regular mortgages by charging too little for the risk. Clearly they have not put enough aside for a rainy day. I daren’t even calculate the value of the subsidy (it’s not 1% of the $5 trillion plus of outstanding loans, which would be a mere $50 billion, since the monthly payments are not 1% lower than what they should be, they’re 6/7ths of what they should be, and that’s before subtracting F&F’s funding costs). Obviously it depends on how much of the risk F&F have been able to pass on. But as far as I understand it, the whole caboodle (less any remaining shareholder capital) is underwritten by Uncle Sam.

The Empress and Emperor, Fannie and Freddie, are wearing no clothes!

No wonder the markets are spooked. There’s a lot I admire about the US. But I do not include in that category the effectively nationalised mortgage market – rather incongruous in the land of free enterprise, don’t ya think? – and the lack of effective gun control laws. But I suppose when the Yanks head for the hills at least they’ll be able to shoot rabbits.

I mentioned the “shareholder capital” in F&F a couple of paragraphs ago. I should say at this point that I do not agree with my new best blogging buddy (thanks to his views on biofuels) Professor Willem Buiter of the FT, when he writes that:

“Outright nationalisation, with the existing shareholders getting nothing… would be [a] fair and efficient option.”

though it’s clear that:

“Fannie and Freddie… are not viable as private institutions without a government guarantee for their liabilities.”

IMHO, the shareholders have been mis-sold and should be compensated.

Buiter is quite correct when he argues that the liabilities represented by F&F belong to the US Government. But fudging is their only policy option. Because the next focus of the crisis may be the US fiscal deficit and hence the dollar (it’s surely hardly the time to be thinking about increasing the deficit). Which could simply push up the dollar price of oil (particularly as “black gold” is taking over some of the safe-haven role traditionally filled by the metal itself) increasing the pain for consumers and indirectly depressing house prices further…

Time to clean the shotgun?

There are a lot of positive feedbacks in the housing market, so clear thinking is called for. The critical consideration is who carries the risk. Effectively concentrating the risk and assuming the state can bear the burden seems to me to be one of the worst options. At least the UK is trying to run down its Northern Rock mortgage book, though it would have been far preferable to allow this risk to remain private, as I pointed out at the time.

I vaguely understand why Fannie was created in the first place. But, once they’d stabilised the mortgage market, why on Earth did they underwrite new loans (and create Freddie in 1968)? Surely the correct policy was to run down the mortgage book and try to prevent another Depression? Keeping the cost of mortgages artificially low just inflates house prices.

11 months ago I thought the credit crisis would be “over by Christmas”. Now I fear years of trench warfare. A bursting asset bubble (created by a failure to take the pain of the previous one, the dotcom bust) has collided with an inflationary shock. The incorrect policies (it’s not just me – Ricardo Caballero at the FT also “gets it”) to address the first problem have exacerbated the second.

As Alan Partidge might say, the markets wanted the “bread” of liquidity, but were fed the “cake” of lower interest rates. They couldn’t digest the cake, so it’s being eaten by the breeding rats we call inflation! (As I said, punch-drunk!).

The correct historical parallel is not the 1930s or the 1970s. Our present difficulties embody elements of both crises. Every sign is that we’re going into a tailspin and have failed to meet the challenge. Now it’s just a question of how bad it gets. Everything depends on when the oil price peaks. Talk about eggs and baskets.

July 15, 2008

How to save a billion pounds

Filed under: Rail, Transport — Tim Joslin @ 10:24 am

A tad belatedly, the UK recently completed its high-speed rail link to the Channel tunnel – the French had theirs ready in 1994 when the tunnel opened, of course. Ours cost £5.8 billion and cuts “journey times to Paris by 20 minutes to two hours and 15 minutes and to Brussels by 25 minutes to one hour and 51 minutes”, according to the BBC. Here’s a plan to save a third of those numbers of minutes (why the saving on trains to/from Paris is less than to/from Brussels is beyond me, since the track in question is common to both routes – arcane timetabling issues presumably come into it).

Yesterday afternoon I was told the train from Brussels would get me to St Pancras at 13:03. It didn’t. This might sound like one of those conundrums in the paper, but, as far as I could tell, on this occasion the service ran bang on time. The train to Cambridge left King’s Cross at 13:15 on the dot. I know – I was running for it. King’s Cross is next door to St P and, even more favourably, the first platform you come to is number 8, where the Cambridge train left from. It’s 3 minute walk, tops. To say I (rather then the train) will arrive at “St Pancras” or worse “King’s Cross/St Pancras” at 13:03 is spin to the point of lying.

What happened to the other 9 minutes? Let’s be reasonable and just try to save 5 of them. Even if this cost us, say £160 million, the saving would be worth a net £1 billion at the rate of the high-speed link (if £5.8 billion saves 25 minutes, then to find the cost of saving 5 minutes we divide by 5 and get £1.16 billion).

First, it can take several minutes just to escape the carriage. These things were not designed by the iPod team, I can tell you. Let’s put to one side the arm-rests on the seats – clearly the carriage requirement specification did not include any provision for people to actually move around the train. The arm-rests are carefully positioned to manage to catch the average adult in the upper thigh or worse. But, although avoiding catching the arm-rests with your leg generally only results in one on the other side of the aisle tripping up the suitcase you are wheeling, the arm-rests are a problem mainly when the train is moving, and not the limiting factor when queuing in the aisle to get off.

No, what I noticed while standing in the aisle swearing yesterday was that there are doors at one end of the carriage only. 80 people, many with large items of luggage, trying to go through one small exit. Now, I presume train doors are expensive, but I suggest a false economy has been made. It clearly never occurred to anyone that these trains are point to point. (Or maybe it did, and they don’t care). (Practically) everyone gets on at Brussels (also a tedious process) and everyone gets off at St Pancras. They don’t drop off a few passengers at every station. I recollect that the previous train I caught, from den Haag to Brussels, did have rather more door provision, even though at most stations only a few people got on or off.

So, the whole point of investing £5.8bn in this train service was to shade a few minutes off the journey time to compete with air travel, yet a design decision has been made which adds several minutes to the average journey time. But I’m not finished yet. The whole problem is compounded by the luggage pantomime. For the benefit of anyone who hasn’t used the Eurostar service, although even medium-sized suitcases fit above the seats, racks have helpfully been provided for large items of luggage next to the door. Not quite enough racks, though, mind – suitcases blocking the aisle and exit are a regular problem. Yesterday I watched in horrified fascination as those lucky enough to be leaving the train each held up dozens of other people as they slowly collected their heavy bags. Often they had to move other people’s bags first.

Clearly the luggage pantomime would take half the time if there were an exit at each end of the carriage, but there may be other options. Large bags could be checked. People could – like on the trans-Canadian – collect them on the platform. A luggage carriage would be a more efficient way of providing the space used for luggage racks throughout the train, since in general some will be full (or overflowing) and some less than full. The luggage carriage could be the first on the train (where it might also provide a crumple-zone if they ever crash the thing!), since that’s the way you have to exit both in Brussels and London (though a problem to solve is that the luggage carriage would then be at the back on the return journey).

This brings us neatly to the second problem. When you finally manage to get off the train you find yourself on a narrow, crowded platform, full of hundreds of people, many wheeling large suitcases. This is where a few more minutes go. Remember, the £5.8 billion investment implies that each minute is worth about £200 million. The problem I’ve already alluded to is that you have to walk to the front of the train – I’d guess something approaching 400m from carriage 17 where I was. And when you finally get to the front of the train, you simply go down to another station level on an escalator (after queuing for it, of course). Although fairly cluttered – for some reason a shopping mall has been included in St Pancras – this other level is the main station service level, where you find the ticket office and, in my case the passage leading to the road where (I kid you not) you have to dodge taxis in order to cross to the King’s Cross part of Europe’s busiest (non-airport?) transport interchange.

Particularly frustrating if you’re in a hurry is that the Eurostar platform has entrances along it, but no other exits. This is simply poor station design. Though it may also have something to do with the obsession with “illegal immigration” – despite French and UK border checks at Brussels, you get to walk past a UK passport checkpoint. Although the booths are unstaffed, you get stared at by several “spotters” as I think they are termed – they could be immigration, police or a bunch of guys having a laugh, for all you can tell. (What a welcome! Couldn’t these guys be hidden behind screens, or watching us on CCTV?). Presumably, this checkpoint is deemed necessary, but it could nevertheless be duplicated at least once. Even if there was only one more checkpoint bottleneck at the rear of the train, further exits could be provided along the platform to move people to more space on the lower level. And how much value was put on each metre of width of the platform? Since a few metres more width would allow the crowd to move much faster – and a minute is worth £200 million, remember – the value of a platform-metre should have been tens of millions of pounds. I bet it wasn’t. Or rather I bet no-one even did this calculation.

So, to save a billion pounds – or rather £1.16 billion pounds worth of time for £160 million investment – I suggest we spend a few million on experiments on alternative carriage designs with doors at each end so that people can exit a bit more quickly. Implementaion will have to wait until the fleet is renewed, though. More practical would be to spend the rest of the money on (1) additional exits from St Pancras (and Brussels) so that people can get away from the train more quickly coupled with (2) carriages for the storage of large items of luggage at either end of the train.

As someone who once started a blog purely to report on the state of UK public transport, I know to stop here. The problem is that there are so many issues that I could write a tome after every journey, since passenger interests are barely taken into account, which is surely what government should be doing.

Next time I’ll tell you how to save tens of billions of pounds. Or, to put it another way, improve the service with no engineering at all so that I for one would never consider taking the plane to large areas of Europe.

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