Michael Hudson talks on oil and housing

How do you explain the soaring price of oil? Is it mainly a supply/demand issue or are speculators driving the prices up?

MH: It’s true that enormous amounts of speculative credit are going into commodity index funds. Forward purchases increase the demand for deliveries of oil and other raw materials. But bear in mind also that as the dollar depreciates, OPEC countries have sought to stabilize their receipts in euros, and to offset their losses they are suffering on the dollar-denominated securities they have bought with past export proceeds. For over 30 years they have been pressured to recycle their oil earnings into the U.S. stock market and make loans to U.S. financial institutions. They have taken large losses on these investments (such as last year’s contributions to bail out Citibank), and are trying to recoup them via the oil market.

OPEC officials also point to a political motive: They resent America’s military intrusion in the Middle East, especially in view of how much it contributes to the nation’s balance-of-payments deficit and federal budget deficit.

Look at it from their point of view. They see that the U.S. invasion of Iraq was a win-win situation as far as the oil industry is concerned. If America conquers Iraq and forces the Oil Agreement through, U.S. companies will be able to grab the world’s largest available pool of oil for a generation, and U.S. officials can use the oil weapon against oil-deficit countries. Last week the U.S. oil firms managed to bump Russia’s oil industry out of the Iraq picture, reversing the trend that had been developing under Saddam.

And if the war continues to be a military and economic disaster, the price of oil will skyrocket, providing a price umbrella for domestic U.S. producers – as you can see from how the stock market is raising its valuation of Exxon and other oil majors. So the question is by no means just an economic one.

The U.S. press prefers to blame Chinese, Indian and other foreign growth in demand for oil and raw materials. This demand has contributed to the price rise, no doubt about it. But the U.S. oil majors are receiving a windfall “economic rent” on the price run-up, and are not at all unhappy to see it continue. By not building more refining and shipping capacity, they have created bottlenecks so that even if foreign countries did supply more crude oil, it would not be reflected in refined gasoline, kerosene or other downstream product prices.

The Fed has traded over $200 billion in US Treasuries with the big investment banks for a wide variety of dodgy collateral (mostly mortgage-backed securities). How can the banks hope to repay the Fed when their main sources of revenue (structured investments) have been cut off? Are the banks secretly using the money they borrow via repos from the Fed to dabble in the carry trade or speculate in the futures markets?

MH: The Fed’s idea was to buy enough time for the banks to sell their junk mortgages to the proverbial “greater fool.” But foreign investors no longer are playing this role, nor are domestic U.S. pension funds. So the most likely result will be for the Fed simply to roll over its loans – as if the problem can be cured by yet more time.

When a bubble bursts, time makes things worse. The financial sector has been living in the short run for quite a while now, and I suspect that a lot of money managers are planning to get out or be fired now that the game is over. And it really is over. The Treasury’s attempt to reflate the real estate market can’t work, but can only cut losses for the financial institutions who have become the nation’s major political campaign contributors. Mortgage arrears, defaults and foreclosures are rising, and much property has become unsaleable except at distress prices that leave homeowners with negative equity.

This prompts them to do what Donald Trump would do in such a situation: to walk away from their property. The banks will be left holding the bag, just as they were in Japan after 1990. In Japan’s case, real estate prices declined steadily every quarter for 17 years! That should give you a flavor of how serious the U.S. problem is today.

The banks are trying to win back their losses by arbitrage operations, borrowing from the Fed at a low interest rate and lending at a higher one, and gambling on options and derivatives. But this is a zero-sum game: one party’s gain is another’s loss. So the banks collectively are simply painting themselves into a deeper corner. They hope they can tell the Fed and Treasury that if it doesn’t keep bailing them out, they’ll fail and cost the FDIC even more money to make good on insuring the “bad savings” that have been steered into these bad debts and bad gambles.

The Fed and Treasury are following the traditional “Big fish eat little fish” principle of favoring the vested interests. They are more willing to bail out the big financial institutions than to bail out savers, pensioners, Social Security recipients and other small fry.

--Many of the TV financial gurus --as well as Henry Paulson--keep assuring us that the worst is behind us, but I don't see it. Foreclosures are increasing, the dollar is falling, unemployment is rising, manufacturing is sluggish, food and fuel are soaring, and consumers are backed up on their credit cards, student loans and house payments. Where would you say we are in the present cycle? What will it take to rebound from the current slump? Will the stock market take a beating before all this is over? What do you think the greatest problem facing the economy is; inflation or deflation?

MH: The idea that we’re even in a business “cycle” is whistling in the dark. To think of the economy being in a cycle is to imply an automatic recovery is in store. This free-market idea was developed at the National Bureau of Economic Research by opponents of government regulatory policy. The fantasy is that the economy oscillates in a fairly smooth and regular sine curve. But this always has been a fiction. 19th-century writers didn’t speak of economic cycles, but rather of periodic financial crises. There is a slow buildup, and a sudden plunge, so the shape is ratchet-shaped.

Today’s plunging real estate and stock market prices are not a self-correcting ebb and flow in which downturns set in motion automatic stabilizers that produce recovery. Each U.S. recovery since World War II has started out from a higher level of debt. The result is like driving a car with the brakes pressed more and more tightly. Alan Greenspan at the Federal Reserve flooded the banking system with enough credit to enable debts to be carried by borrowing against the rising price of homes and office buildings, corporate stocks and bonds. In effect, the interest charge was simply added onto the debt balance. But now prices are falling, leaving families, companies and many Wall Street firms with negative equity. Asset-price inflation fueled by the Federal Reserve – is giving way to debt deflation.

Today, the prospects are dim for paying off debts out of further price gains for homes and real estate. Speculators have pulled out of the market – and as late as 2006 they accounted for about a sixth of new purchases. The United States and other countries have reached the point where interest and amortization payments are absorbing the entire economic surplus of so many individuals, so many companies and so many government bodies that new construction, investment and employment are grinding to a halt. Families, real estate investors and companies are obliged to use their disposable income to pay their creditors. This leaves them without enough money to sustain the living standards of recent years – and they no longer can wipe out their debts by declaring bankruptcy as in times past, because Congress has passed the harsh bankruptcy law that credit-card and bank lobbies paid them to pass.

This means that there won’t be a rebound, and it will take longer than 2009 to recover.

Michael Hudson is a former Wall Street economist specializing in the balance of payments and real estate at the Chase Manhattan Bank (now JPMorgan Chase & Co.), Arthur Anderson, and later at the Hudson Institute (no relation). In 1990 he helped established the world’s first sovereign debt fund for Scudder Stevens & Clark. Dr. Hudson was Dennis Kucinich’s Chief Economic Advisor in the recent Democratic primary presidential campaign, and has advised the U.S., Canadian, Mexican and Latvian governments, as well as the United Nations Institute for Training and Research (UNITAR). A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002)