Capitalism Did Not Win the Cold War

This article first appeared at Foreign Affairs.

Why cronyism was the real victor.

When the Soviet Union collapsed 26 years ago, it was generally agreed that the West had won the Cold War. This was affirmed by the prosperity and possibilities awaiting citizens of Western countries, as opposed to the political and economic stagnation experienced by those in Communist states. A natural conclusion, much repeated at the time, was that capitalism had finally defeated communism.

This sweeping statement was only partially true. If one took capitalism and communism as the only two protagonists in the post–World War II struggle, it was easy to see that the latter had suffered a mortal blow. But there was a third, stealthier protagonist situated between them. This was a system best identified today as cronyism. For if capitalism did win over the other two contenders in 1991, its victory was short-lived. And in the years that have followed, it is cronyism that has captured an ever-increasing share of economic activity. A survey of the distribution of power and money around the world makes it clear: cronyism, not capitalism, has ultimately prevailed. Continue reading at Foreign Affairs >>>

The Futility of Annual Top 10 Predictions

In every recent year, a black swan event has made top 10 lists appear quaintly naive and unimaginative. Our list is probably no better.

This time of year, top 10 predictions are all the rage. These lists can be interesting and entertaining but how useful are they really?

This question goes to the heart of forecasting. How futile or how useful is an attempt to forecast the economy, or technology, or world events for the next twelve months? There are three answers. Read more

The Relationship Between Fertility and National Income

We all heard that “demography is destiny”. But how many of us truly believe it? If demography was destiny, the world would look very different today. The two demographic giants China and India would be uncontested economic and military powers. The United States would be a regional power struggling to keep up. Larger European nations such as Britain, France and Germany would barely register on the economic map, while smaller ones such as Switzerland and Finland would be invisible. Nigeria and DR Congo would be African powerhouses. Brazil, Indonesia and the Philippines would be the shining stars of their continents. Read more

Rise of the Rest: A Vision Deferred

Changing demographics and the commodities crash have slowed down the development of poorer countries.

Perhaps it all started with a turn in China’s demographics. Demand growth for commodities has declined sharply from recent years and has resulted in a crash of global prices. Copper is down 54% from its post 2008 peak and down 25% this year alone. Crude oil is down 67% and 39% in the same time spans. In addition to softer demand, prices were negatively impacted by jumps in supply, most notably from shale energy producers in the United States. Read more

When Will Oil Bottom?

Not until the discount of WTI to Brent disappears.

If one of Saudi Arabia’s objectives is to curtail American shale oil production, then it bears to reason that this objective will not be attained until Brent and WTI trade at parity once again. In recent years, the surplus production of American oil coupled with the legal ban on US oil exports has resulted in a discount of WTI vs. Brent. Going forward, there will be no incentive for a domestic oil buyer to replace US oil (WTI) with foreign oil (Brent) as long as the first is at a discount to the second.

Regardless of the prevailing price, US shale oil production will continue to grow through this year; many wells have already incurred their upfront costs and need the cash flow from production to recoup those costs. When oil was flying high near $100, these operating cash flows were expected to widely offset the upfront costs and to generate an attractive total return for the venture. Now with oil near $50, many will not generate a positive return but they still need the cash flows to get as close as possible. Despite a declining price, there is therefore an incentive to keep pumping for as long as possible.

In theory, at current prices, shale production growth will taper off and could even reverse after a few years. This at least is OPEC’s calculation. Markets discount the future and OPEC’s current price war cannot be judged a success until the WTI discount to Brent has disappeared.

It appears on its way to doing so, having fallen from a high of $9 and a 2014 average of about $6 to little over $2 today (see chart).


It is a fair assumption that the discount will continue to shrink if the price of oil continues to fall. At $40 or $30, it may disappear completely, But at those levels, there will be other unforeseen consequences. For example, if the US economy weakens due to job losses in Texas and North Dakota or due to more weakness overseas, there would be less demand for oil, resulting in another domestic oil glut and another widening of the discount. Stay tuned.


Oil Quake 2014

2 December 2014

The consequences of a collapsing oil price will be deep and wide ranging. Brent oil has crashed from $115 per barrel in mid June to around $70 today, and WTI from $107 to $66. Here are the likely ramifications, the obvious and the less obvious:

1- Pressure on US shale oil producers: “Tight” shale oil is more expensive to produce than conventional oil. A lower oil price means lower profits for shale producers, or losses in many cases. OPEC’s alleged strategy and gamble are to put some of these people out of business in order to maintain the cartel’s long-term control on pricing. See next two charts.


On this, four issues should be considered.

First, the breakeven oil price for shale producers is a moving target. It may be $70 today but it will be lower than $70 in the future thanks to new technology and cost cuts.

Second, the breakeven oil price, for example $70 for a given shale well, includes upfront investments which means that the marginal cost of production is lower. In many cases, this marginal cost is below $40 at wells which are already up and running. After the crash, producers will treat upfront investments as sunk costs and will continue to operate these wells for their attractive cash flows.


Third, US law does not allow oil exports from the lower 48 states which means that the shale oil produced in the US ex-Alaska must today be processed domestically. OPEC’s calculation may be that the price of Brent will go low enough to displace domestic US producers, but this looks unlikely as long as there is a discount between WTI and Brent prices. If shale oil production slows down, one would expect the discount to narrow and disappear. In fact, factoring in the cost of transport, Brent would have to trade at a discount to WTI, instead of the current premium, before OPEC’s strategy could be considered a success. WTI is still trading at a $4 discount to Brent today, essentially unchanged in the last two months, albeit lower than it was in the earlier part of the year.

WTI Brent

WTIBrentDiscount 20141201

Fourth, there is some risk of financial turmoil. Several US shale oil producers are highly indebted and will suffer from declining cash flows. Marketwatch has compiled a list of companies that “are in big trouble if oil prices remain low”.

In addition, this article in The Telegraph (which appeared before the latest decline in oil) states that:

“Based on recent stress tests of subprime borrowers in the energy sector in the US produced by Deutsche Bank, should the price of US crude fall by a further 20pc to $60 per barrel, it could result in up to a 30pc default rate among B and CCC rated high-yield US borrowers in the industry. West Texas Intermediate crude is currently trading at multi-year lows of around $75 per barrel, down from $107 per barrel in June.

A shock of that magnitude could be sufficient to trigger a broader high-yield market default cycle, if materialised,” warn Deutsche strategists Oleg Melentyev and Daniel Sorid in their report.”

In 2010, energy and materials companies made up just 18pc of the US high-yield index – which tracks sub-investment grade borrowers – but today they account for 29pc of the measure after drilling firms spent the past five years borrowing heavily to underwrite the operations.

In the end, a lower oil price may deter some new shale investments, but it will not, or not yet, shutter existing wells. It is difficult to make a case that $70 per barrel is low enough to significantly alter the shale oil dynamic, unless a large number of companies run into financial distress.

2- Pressure on oil-dependent governments: The outcome here may be the difference between a manageable shock for some, and a much more challenging situation for others. Stratfor has compiled the table below which shows the energy dependence of several government budgets. Countries such as Iran, Venezuela and Nigeria need an oil price well in excess of $100.

In the right column are each country’s financial reserves which are a measure of each government’s firepower to withstand the shock. Budgets with a high breakeven and low reserves relative to their populations will experience greater strain than others. Venezuela and Nigeria appear vulnerable. Russia will also feel pressure but it has larger financial reserves and a falling currency which will dampen the shock internally.


3- Relief for US consumers and manufacturers: The fall in oil and slower fall in gasoline prices are a clear positive for US consumers. Deutsche Bank analysts estimate that every cent decline in the price of gasoline results in $1 billion of annual energy savings in the United States. A one dollar decline would free up $100 billion every year for investing or spending. The Wall Street Journal estimates that, since 2007, Americans have underspent on apparel, household textiles, appliances and real estate, all sectors which stand to benefit from years of pent-up demand.

WSJ chart

More broadly, the US economy will experience a new stimulus from lower commodity prices. All sectors (ex-energy) are beneficiaries but transport and manufacturing companies could enjoy significant windfalls.

It’s the Demography, Stupid

11 November 2014

(See also the post Demography Charts – 1)

America’s anemic recovery can be explained by its slowing demographics.

Politicians tend to overstate the positive impact of their policies on the economy and to also exaggerate the negative impact of their opponents’ policies. In all likelihood, there are other more potent factors at work.

Instead of GDP, we look at wealth creation as the main measure of the economy. GDP measures economic activity which means that building roads to nowhere is a positive contributor to GDP in the near term because of the jobs provided and the material and services purchased. But building roads to nowhere is a waste of money. By contrast, wealth creation accounts for the return on invested capital and differentiates between good and bad projects.

And wealth creation has three main drivers: innovation, demographics and the economy’s institutional framework.

To illustrate the importance of innovation, consider a country where there is little innovation and therefore little creation of intellectual property assets. The main assets in such an economy are hard assets, such as real estate, natural resources and the like. Unless there is strong demand for these assets from foreign markets, the economy of that country would stagnate or grow slowly with its population. Good examples of such countries today are commodity economies like the leading oil producers, industrial metal producers etc.

Now consider a country where there is innovation but where the population is small. Here the amount of wealth created by innovation would be quite small unless there is strong foreign demand for the products and services brought about by that innovation. A new iPhone that can only be marketed to a small population would create a lot less wealth than one marketed to a large population. Good examples are Switzerland and Finland which are quite innovative, have relatively small populations but export their products in large quantities.

Innovation is back.
Innovation is back.

Finally, consider a country that has lots of smart innovators and a large population but that suffers from a poor institutional framework. It is a country where the government and citizens are corrupt, where contract law is nonexistent, where capital markets are small, where property rights are not protected. There would be little wealth creation in such a country because the innovators would emigrate to another country where they could more readily prosper from their innovations.

Since 1945, the United States has been blessed by all three major contributors to wealth creation: strong innovation, strong demographics and a stable and supportive institutional framework. The same has been true for Europe, albeit with slower innovation and slightly worse demographics. The same has been true for Japan, with still worse demographics.

So where do we stand today? Of the three main engines in the US, innovation and the framework are still going strong. But demographics have weakened in several ways. First, after declining for several decades, the dependency ratio (number of dependents per worker) has been rising since 2005. Second, the number of Americans aged 30-60, arguably the most economically active age bracket, has stagnated at a little over 120 million people. Previously, the 30-60 group had grown steadily in every year from 1978 to 2005.

Presidents Reagan and Clinton are credited with a successful economy but their years in office also benefited greatly from a falling dependency ratio. The same is true for the second President Bush until mid-decade when the dependency ratio bottomed out and started to rise.

The anemic recovery since 2008 can largely be explained by our deteriorating demographics. The US population used  to grow by 1 to 2% every year, which meant that companies could count on real growth of 1 to 2% and another 2 to 4% of inflation. But since 2007, annual population growth has fallen below 1% and inflation has also fallen. So what used to be safe annual domestic revenue growth of 3 to 6% is now looking more like 1 to 3%.


In Europe too, the dependency ratio bottomed and started to rise in the middle of the 2000s decade. In addition, Europe has been less innovative than the US in the past ten years, which explains its stock market lagging the US market. The rise of Google, Facebook and others and the resurgence of Apple have all taken place in the new millennium. Europe has had no such large success stories. Worse, one of its former superstars, Nokia, has nearly disappeared. So Europe still has a strong institutional framework but its other two engines of wealth creation are sputtering.

Japan’s dependency ratio bottomed in the early 1990s which may explain the country’s stagnation since then. It remains highly innovative but perhaps not sufficiently so in new focused companies with higher returns on capital.

The lesson of recent years is that US innovation may be strong enough to counter the effect of weakening demographics, but not strong enough to produce strong GDP growth. In addition, revenue growth in several industries has become highly dependent on exports to emerging markets. The economy and markets will do well if export demand continues to grow. But if emerging economies experience an important slowdown, our worsening demographics means that there will not be sufficient demand at home to pick up the slack.

For more data on US and world demographics, please refer to these previous posts:

The Economy’s New Boss: Demographics

Is America Heading Towards Zero Population Growth?

European GDP: What Went Wrong

Demographic Megatrends of the 21st Century

US Demographics and Housing

Oil Spread: Fourth Decline in Six Months

Since our last post, and much as predicted by three previous declines in the last six months, the WTI-Brent has collapsed again from $9 to $4.50. There is increasing talk of removing the ban on US oil exports. In particular, there was a study conducted by the Brookings Institution which argues in favor of lifting the ban. The authors are unequivocal [their emphasis]:

Based on our analysis we recommend that the U.S. reconsider and modernize its energy policy by lifting the ban on crude oil exports entirely and immediately. It is evident to us — based on our policy deliberations, the extensive macroeconomic modeling of the U.S. economy and the global oil market research we have commissioned — that the greater U.S. exports of crude oil, the greater the economic and energy security benefit to the country.

There were also comments by former Treasury Secretary Lawrence Summers:

The merits [of lifting the ban] are as clear as the merits with respect to any significant public policy issue that I have ever encountered. And it is an important test of the efficacy of the functioning of our democracy whether within the next nine months we will get to that correct solution.

There is therefore increasing momentum in favor of lifting the export ban. This would probably require a vote in Congress and is unlikely before the November midterms.







Oil Price: WTI – Brent Spread Scaling $9 Again

This is the fourth time in the last six months that the WTI – Brent spread has exceeded $9 per barrel. In the previous three instances, the spread then quickly narrowed to $4, $5.50 and $3. The spread opened up a few years ago with the large increase in oil production in the United States. Because the US does not allow the export of crude oil, a chronic glut in certain grades has resulted in a discount of the US price (WTI) to the global price (Brent).

The instability of Middle Eastern oil supply (notably from Libya and Iraq) and the current spat with Russia over Ukraine have created new pressures on the US to allow oil exports. Until then, the large spread creates a competitive advantage for the US economy, and lower costs for manufacturers, utilities, refiners and transport industries.