The mathematics of debt growth in excess of underlying economic growth are inescapable. Taken to its logical extreme, every asset would be collateralized and debt service would stifle economic activity. Before that point is reached, however, debt becomes an unbearable economic burden—its costs exceed its benefits—which throws debt formation into reverse. The reversal in a system whereby fiat money, governmental borrowing, and central banking have divorced debt growth from the real economy is swift, dramatic, and inevitably contractive and deflationary. (Straight Line Logic, “A Skyscraper of Cards,” 10/19/14)
When “magic” economic nostrums can no longer keep an economy running in place, it falls backwards, painfully. In “non-magic” economics, debt growth well in excess of economic growth for an extended period, rising taxes, and increased regulatory sand in the gears and government rent-seeking eventually produces an economy that not only stops growing, but contracts. Almost immediately, debt in the most leveraged sectors of the economy starts unravelling, and in a debt-saturated economy that unravelling spreads quickly, because virtually every financial asset is someone else’s debt (or equity, which occupies an even lower rung on the priority-of-payback ladder). In 2008, it started with mortgages and mortgage-backed securities and engulfed the world’s financial system with frightening speed. (Straight Line Logic, “The Economics of Debt, Deterioration, Deflation, Depression, and Disorder,” 11/17/14)
The future is now. The carnage in the oil sector, where a glut has knocked over a third off its price in less than five months, is not an aberration, but a harbinger—the shape of things to come across sectors and around the world. It kicks off the depression, or more accurately, the resumption of the depression that started in either 2000 or 2007 (let the statisticians quibble about that determination).
The oil industry is a perfect example of the analyses in the two articles cited above. The only wrinkle is that so many of the major participants are governments, but that does not change the conclusion. All of the oil-producing nations’ governments had assumed a much higher oil price, and budgeted accordingly. Of those governments, Saudi Arabia and the Gulf states have the lowest costs of production. Even at the current price, their production is break-even or profitable, but their total revenues are falling far short of budget projections. For other nations, the situation is much more dire. Not only are revenues coming up short, but they are losing money with every barrel they pump; their costs of production are higher than the current price.
Their spending plans are an implicit lien on their future oil production. That is in addition to their explicit liens; many of the governments have incurred heavy debts. The plunging price of oil is a margin call, and the governments have no choice but to curtail spending, raise taxes, and sell assets, which in many cases means selling more oil for the cash flow—even if it results in economic loss—adding to the glut. Next up: debt defaults. Eventually uneconomic oil production will have to stop, adding to unemployment and economic contraction.
Venezuela, a major oil producer, is on the cutting edge. Social spending has been the only thing keeping President Nicolas Maduro in power. However, things have gotten so bad that he recently had to seek an emergency loan from China. Venezuela is burning through its foreign exchange reserves and when the Chinese loan is gone, default on foreign-currency-denominated debt will be inevitable. On Bolivar-denominated debt, Maduro will further crank up the printing presses to inflate away the liability. Inflation, already running at more than 60 percent per annum, will skyrocket. The situation is not quite as grim in other large oil-producing nations, including Russian, Mexico, and Nigeria, but without a quick recovery in the price of oil (a low-odds bet), they will soon be sharing Venezuela’s pain.
In the US, it is a matter of debate concerning the break-even price for oil production in various producing areas, and how leveraged producers are. However, some of them are losing money at sub-$70 per barrel oil, and cheap money and compressed credit spreads have led some of them to take on too much debt. So the US oil industry, lately touted as the greatest American economic miracle since Silicon Valley, is sharing the pain, too, as a glance at oil company stock and bond price charts the last few months will confirm. Even Silicon Valley has its ups and downs.
If, as the media keep repeating, the oil price drop is a “tax cut” in the US, we should get ready for more such tax cuts as the price of many goods and services falls. The oil industry is a large enough component of the global economy that its looming contraction, coupled with weakening economies (some are already in recession) throughout the developed and developing world, should get the snowball rolling on the debt contraction-deflation-depression progression mentioned above. Unfortunately, our tax cuts are going to be pretty puny compared to the costs of rising unemployment, widespread defaults, falling asset prices, and contracting economies.
Batten down the hatches.
A HISTORICAL NOVEL THAT’S A PERFECT ANTIDOTE TO TODAY’S BLEAK SCENE, AND A PERFECT HOLIDAY GIFT!!!