oil futures

This article is based on highlights from a lecture by George Soros, at the London School of Economics to launch his new book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means (PublicAffairs, May 2008). Early in this lecture, Soros situated the beginning of current problems down to deregulation as practised by Thatcher and Reagan from 1980. He gave four reasons why he believed the US economy (and the world economy as it is impacted) will go into recession: 1. The decline in housing prices is still accelerating and is going to overshoot on the downside the same way as it overshot on the upside. We are not yet half way in the decline in housing prices. We will have at least 12 more months of increasing foreclosures and so on. 2. The consumers who have been relying on the double digit rise in housing prices for their ‘piggy-bank’ have withdrawn equity from their mortgages at a rate in excess of the current account deficit. This peaked at around between 8-900 billion USD in 2006. Now the outlook has changed and they are facing declining housing prices where at least 15% of regular mortgage-holders will be 'underwater' in their mortgages. Savings will therefore have to increase. The American consumer will cease to be the motor of the world economy which they were for the last 25 years. 3. The banking system is severely impacted, despite its 'quite impressive ability to raise capital'. The willingness of banks to lend to finance business is also going to impact capital and spending etc. 4. The situation now carries simultaneously the threat of inflation and recession. This is partly because the dollar has ceased to be the unquestioned accepted reserve currency, which up until recently allowed the American consumer to become the economic motor of the world and permitted the US to consume over 6% more than it produced. When asked if 'we' [the world] are heading for recession, Soros said, “Yes”. Asked about Europe, it was obvious that Soros saw the European economy as different from that of the US. He anticipated, for instance, problems for Spain, but not for Germany, because Spain has had a housing bubble but Germany has not. He expressed the opinion that these kinds of different outcomes will give rise to 'serious tensions' in the EU, because up until now the EU has been characterised by convergence rather than divergence'. Now there will be divergence. Also, the ECB (European Central Bank) has an 'asymmetric directive'. Its job is 'to prevent inflation, not to maintain growth'. As a result it is keeping interest rates steady rather than reducing them. That and, most importantly, the exchange rate, because lowering interest rates quite radically has led to a decline in the value of the dollar and that 'decline in the dollar has effectively exported the recession to Europe'. But 'the UK and the US will probably be more affected'. On the possibility that hope of continued growth might lie in the developing world "decoupling" from developed world: Might it be true to say that if the US consumer stops dragging the world along, the world will still be dragged along by China and India whose growth will mitigate the recession?. “There is a very substantial difference between the developing and the developed world which has positive and negative aspects. It may lead to avoiding a world wide recession but on the other hand it could be responsible for inflationary pressures which can make problems bigger for the developing world. There is a difference but there is no decoupling. We are Siamese twins tied together." Soros said that there is a "Need to improve the quality of regulation. It is not enough to regulate the money supply; you also have to regulate credit. This is because credit conditions do not always correspond to the money supply. Markets tend towards extremes of optimism and panic. Therefore you have to have minimum reserve requirements and optimum reserve requirements. They need to be made variable. That is the way to prevent asset bubbles from developing. Greenspan is right to say it is difficult to identify a bubble and to know when to interfere. It may be difficult but you cannot escape the duty. Keeping the economy on an even keel is an art, not a science. Regulators have to accept this additional duty … It is not enough to bail the system out when it collapses." Markets can behave faster and regulators are slower and more bureaucratic; you need both. Soros stated that he thinks that "market fundamentalism is a very convenient belief for the 'haves' because it justifies their having it. In other words, they prosper (that includes me, [he added] by the way, among the haves but I don't share this view on market fundamentalism). It's a wonderful excuse for pursuing your self-interest to the detriment of the common interest because there is a theory which says says that the common interest is best served by everyone pursuing their own interests. So its a very convenient belief and that is why it has such great currency and that's why you find that it is generally people with lots of money who are supporting and propagating this belief. There is a connection. The impact of the price of oil at $130 on US inflation... "I have given this a lot of thought because it is really quite disturbing, the price of oil. And I would say that there are four factors involved. One, the increasing difficulty and cost of finding and extracting oil. People talk about "Peak Oil, but that is a misnomer for increasingly expensive oil. So that is number one. "Secondly because of the decline of the dollar you now have a backward- sloping supply curve, that is to say, the more the price goes up the less incentive the oil-rich countries have to convert their oil reserves underground, which appreciate in value, into dollar reserves above ground, which depreciate in value so you have a backwards sloping supply curve. There are also other factors involved, namely that many of the oil reserve countries are in the hands of desperates who mismanage the economy ... Iran or Venezuela and so on... You know it's easy to be a Bolivarian revolutionary when you have oil at over $100. That's the second factor. "Thirdly the main areas of demand growth are in China and in the oil producing regions of the Gulf and Russia. And in those countries the price of oil is subsidised and therefore the rising prices don't have an effect on demand. In the US, yes. But in those countries and that's where the real growth is... the price does not influence demand. "And fourthly there is a trend following speculation and it is now having a major effect on the price of oil and you see that in the rise of far out delivery ... the real big move has not been in the cash price of oil but in the futures price several years out. And that does affect the cash price as well ... so there is now a bubble aspect also. So those four factors are responsible for the rise in oil. Again there is this sort of Greek tragedy aspect of it. Yes, if you have a serious recession in the developed world, it means that demand does go down and the the price will be affected, but first you have to have the recession for that to happen, and the rise in the price of oil actually hastens the outset of the recession and that is part of my argument why this crisis is different from the previous ones." You can download the entire lecture from the London School of Economics site at www.lse.ac.uk/resources/podcasts/publicLecturesAndEvents.htm.