Overhead Crush

A concept that’s key to resource depletion is the higher volatility phase, in which both price and supply start to hit ceilings and floors in accelerated fashion. This tends to appear first during the actual peak supply period, or peak plateau period. The pattern has been seen in previous eras in such things as wood, fish, and whale oil. When the post-peak phase gets underway the price amplitude increases even further, playing havoc with supply and demand. As demand gets killed, and then finally collapses, it causes confusion about supply. But then, as demand returns, any questions about supply are soon answered as demand once again bumps up against the supply ceiling.

contracting-triangleVisually, we can think of demand in this phenomenon as being in a kind of contracting triangle. Every time consumption resumes after a previous demand crash, it hits the ceiling at a lower level. This is the point where, if you find yourself living in the age of biomass and wood, you get rescued by coal. For example. This is also the point where, if you are living in the age of oil, it’s less likely you get rescued.

Now, what’s interesting about this pattern in oil is that it appears to have arrived in conjunction with the bursting of an epic sized credit bubble in the West, a quarter century in the making. Leaving aside causality–and yes, there are many who have strong views about causality here–the two forces have now clearly joined. And so what we are dealing with presently is a very nasty ceiling. A unified ceiling, if you will. One made of both interest rates (as an expression of credit availability in a time of depressed economic activity) and energy.

low-ceilingCould this limitation finally resolve the dispute between inflationists and deflationists? I think it could. As I was laying out earlier this winter in Recession vs. Collapse, we are experiencing a deflation that appears to trigger both reflationary policy and reflationary responses in the dollar and commodities–which then leads to more deflation. This is a process that likely began as early as the Summer of 2007. In this deflation-inflation oscillation the metronome ticks first one way, and then the other, causing uproar and loud talk each time among the inflationists, and the deflationists. As I have been suggesting this year, why the need to choose? We have very likely been in an inflationary recession for nearly two years now, with massive deflation in housing and yet stubbornly higher food, energy and health care costs–the latter well above the price levels of just a few years ago. The risk, in my view, is that both trends now accelerate. And, that we experience next something more akin to an inflationary depression.

-Gregor

Graphic: Contracting triangle pattern (typical in technical price analysis).

Photo: clip from the film Being John Malkovich.

  • anonymous

    wages?

  • http://www.marketfolly.com marketfolly

    great stuff Gregor, especially this “we are experiencing a deflation that appears to trigger both reflationary policy and reflationary responses in the dollar and commodities–which then leads to more deflation.”

    So many people are fascinated with the action RIGHT NOW that they're ignoring what could potentially be coming because of it. Waiting with bated breath for this slow motion trainwreck to continue.

  • http://www.competitivefutures.com/blog Eric Garland

    I continually hear, “You know if we keep this up (economic policies, consumer spending, American Idol winners, whatever) the WHOLE THING IS GOING TO COLLAPSE.” I am instead thinking that this is the new face of collapse. Nothing actually (hopefully) blows up, and by and large people don't riot in the streets en masse.

    However, our leaders begin rolling back expectations at an impressive pace: Bob Nardelli calls the Chrysler bankruptcy “a success;” California goes completely broke while Californians prefer to debate the sexual identity of American Idol winners; the Wall Street Journal prints an editorial lionizing Henry Paulson as a “national hero” for “saving us from the bank crisis.” Essentially, most of our leaders and their public relations flacks are reaching “Baghdad Bob” levels of credibility, asserting their total control of the situation while Abrams tanks stream over city borders in the background.

    This is the new face of collapse – not a precipitous, sudden drop, but the insane chattering near the setpoint of inflationary and deflationary trends. Doubling of unemployment and rising stock prices. Rising oil prices and reduction of demand. Dogs and cats, living together, mass hysteria. That's real disruption – upsetting our whole society, while dressed in the camouflage of business as usual.

  • ragnorok

    Good post, Gregor, as usual. My question: so how do we play this? Or maybe just take what we have left of our assets and buy land.

    Response to Eric Garland's comment.
    Back a few decades ago, when in graduate school, my son, then maybe two years old, was playing outside in a common area. He fell and hit his head pretty hard. A Japanese women, wife of a grad student, saw it and said, managing as best she could with limited English: “Baby hit head, if cry, no problem. Baby hit head, no cry. Problem.”
    I would say, about the current scene, that the baby is not crying.

  • tooearly

    as someone astutely said: the cost of everything you need rises and the things you have falls

  • http://alephblog.com David_Merkel

    I haven't written much about this recently, but this has been a theme of mine:

    http://alephblog.com/2008/01/22/deflation-or-in

    http://alephblog.com/2008/08/02/inflation-for-g

    http://alephblog.com/2007/12/26/depression-stag

    I liked this post, and most of your posts generally.

  • mika2k1

    Q: Inflation?
    A: You betcha!

    In fact, we're ALWAYS in an inflationary situation. It's built-in into the system. I would also add that the US is now facing a Weimar Germany scenario, with a rapid deterioration and collapse of the USD. Regardless of the interest rate route chosen, when currency and savings are devalued to zero, there's no way but to look at this as inflationary.

  • jk

    i can think of 2 mechanisms whereby the supply ceiling is lowered, aside from the “past-the-peak” problem:
    high prices lead to nationalization of producing assets, which then tend to be run less efficiently.
    low prices lead to reduction in investment, which tends to require long lead times.

  • gregor.us

    This post got very good treatment at FT Alphaville on Friday 12 June 2009.

  • gregor.us

    I've been studying some inflations and deflations historically, and I recall the Israeli inflation quite well from my trip there in 1983/1984. It kinda makes sense to me that in American culture especially we would go in the Either/Or direction but frankly it looks to me like price chaos and financial mayhem trigger all sorts of surprising conditions whenever they start to unfold. The deflation in US housing started off the top several years ago and yet food and fuel ramped right over that destruction. I think the US economy has been “in a weird place” actually since 2000.

    I'm feeling more confident that eventually this period will be seen as a failure of central banking. I actually don't take the view that central banking in a paper currency system is doomed to fail. I know that most of them have. But I still think it can be done. However, I have to give some credence to the view that eventually the populace votes itself decreased taxes and increased spending–until the unsurprising conclusion.

    For the moment, I do indeed favor an acceleration of the deflation in housing and the inflation in food and fuel–via the mechanism of the USD. In fact, I have a very bad feeling about California housing very possibly taking a final but very, very nasty leg down.

    G

  • gregor.us

    Eric we should speak at some point. My return trip to 19th C social science literature indicates a continuous phenomenon that's been going on for a long, long time wrt societal reactions to those who address the future.

    G

  • http://www.chartsandcoffee.com chartsandcoffee

    Weekly Market Analysis From Charts and Coffee Blog is up – http://chartsandcoffee.blogspot.com/2009/06/sun

  • Fullcarry

    Austrian economists would probably argue that there can only by one tangible definition of inflation and that is an increase in the supply of money. Given such a definition, we are, of course, in the age of inflation. And inflationary times ultimately entail higher interest rates which should have a depressing effect on interest rate sensitive sectors like housing and autos as you suggest.

    Even beyond the Austrian definition though, higher interest rates will cause CPI to go higher as the monthly cost of housing will increase. This will mostly happen due to higher rents as the monthly cost of purchasing a house gets prohibitive and most people turn to renting. And eventhough CPI is a political index, this increase will be manifesting a real effect as the cost of procuring a shelter is increasing.

  • http://www.competitivefutures.com/blog Eric Garland

    Gregor: “The past isn't dead…it isn't even the past.”

    In some ways, I think we're just now coming to the end of 19th century technologies and ideologies. Coal and colonialism are just now starting to look at the end of the rope as global warming and Chinese-led globalization are turning our assumed outcomes on their head.

    As for me, I'm excited for the return of top hats and steam technology!

  • gregor.us

    SteamPunk reality show coming to a cable station in your area.

    G

  • http://www.competitivefutures.com/blog Eric Garland

    My wife is a physician, and when we're on the town watching drunk people, the scariest sign is when someone can't protect their own airway and doesn't react when they hit their head.

    The current scene: you hear the sickening sound of noggin-on-concrete, and you see no reaction. *Yikes*

  • Moe Gamble

    I always appreciate hearing your thinking, Gregor.

    You realize that the pattern you drew is a continuation pattern.

    Your recent comments on societal reaction to discussion of big problems have been interesting as well.

    My take is that it's crucial to keep the band playing until first class has boarded the life boats.

  • Pfalk

    I agree with your point about housing deflating while food and energy is inflating. But that really is only another way of saying that “While housing has been unfairly gaining in value over the last X years, there is now a changing (restoring?) of the relative values of these commodities”.

    This is not unusual, we've seen the relative cost of electronics drop for decades now (and we've previously seen the relative cost of oil and food steadily drop for decades, before that.

    The most likely reason for this rebalancing is that 3rd world countries are becoming integrated into the world economy, and their needs are for food and gas, not housing in California.

    I don't actually share your bad feeling about housing in California (as I understand your comment). Housing prices are fundamentally driven by 3 things:
    1. cost of fund (=interest)
    2. The ability of buyers to pay (i.e. are there lots of well-paying jobs)
    3. Population growth
    I am comfortable with the long term job market in California, as well as with its desirability as a immigration destination (both within the US and internationally). I also think that the current mortgage interest rates (about 6%) are reasonable, and I don't see any huge changes in the near future.
    The big unknown here is: Will we keep on exporting jobs to China/India?

    Peter

  • gregor.us

    Thanks Peter. When I talk to people about a state like California, I often find myself saying something like this: “Oh no actually I am very positive on California culture, innovation, and some of its resources. Just not at current price-levels or population.”

    If you take the view that I do that California got leveraged up both financially and infrastructurally, way past what the State could support, then it's easier to see the good things–and the good traditions–but also see that California's physical growth has peaked.

    Let me give some examples: no more net additions to the state's highway system. No more net additions to the state's housing stock. No more net additions to the state's commercial real estate square footage.

    I do forecast some buildout of rail, and possibly more agricultural expansion. However, the latter too has reached certain limits via water. Of course, if the state wanted to spend the billions and billions needs to make current water infra more efficient in the central valley, then, yes one could raise yields I would think.

    The size of the government grew beyond the state's economy. The state's economy, like the US as a whole, grew out past sustainable levels because of debt creation as well. Infrastructure in CA–especially the system of freeways–now looks like a drag rather than an enhancement for either productivity or the economy.

    One has to remember a basic theme: the bulk of California, Southern CA, was built to a cheap liquid fuels standard. Southern CA no longer “works”. And it will just get worse from here. Oil is at 72 with unemployment in CA at very high levels.

    There is no return to the normal for CA. Something new, yes I hope so.

    CA housing looks to me like it wants to trace out some of the most terrible declines we have seen elsewhere. Many areas have now given up everything back to 1989 levels. Of course, it is a huge State with lots of different housing markets. So I am reluctant to make a blanket statement. That said, I see the disease coming into SF Bay and LA proper. I don't think this ends until the upper middle class get hurt badly in prime LA and prime SF. (BTW that is a demographic statement, not a political statement. :-) Just trying to locate the focus).

    Here is what I see next in CA: Higher taxes, lower economic activity, a massive hole in State Govt spending and payroll (normally would be a good thing from a free market perspective), decaying infrastructure, ongoing pension losses or reduced payout from CALPERS, city and town bankruptices (more Vallejos), more layoffs in City and Town govt payrolls. And so on.

    Meanwhile, innovators in Silicon Valley and Filmakers in LA will continue doing great stuff, along with many other globally oriented businesses in CA. But it won't be enough to support what the state had become.

    G

  • http://twitter.com/mika2k1 mika2k1

    Greger, this cannot be stressed enough, as long as we're using the calculus of printing money — with currency and savings eventually devalued to zero — this talk of deflation is little more than muddled thinking. It doesn't matter how much RE prices have come down, it's irrelevant, money has/is losing its value at even greater pace.

  • Pfalk

    Gregor – we are for the most part in agreement. Let me summarize what I think you said:
    1. California has structural problems – I agree
    2. Cal. real Estate has is facing additional declines, even in the Bay Area and LA

    Item 1: its' important to remember that most of the problems (as I see them) are related not to the California economy, but rather to the State of California (ie. the government).
    The biggest issue is that it's almost impossible to gorvern the state with the current rules:
    * 66% majority for a budget
    * 66% mojorty to raise taxes
    * Huge and growing committments to State workers (especially Police, Prison and teachers unions)
    * Revenue sources are very cyclical, i.e. income taxes and sales taxes are very dependent on the boom-bust exconomy, while property taxes (which are fairly stable) comprise a shrinking source of revenu.

    These are all TRUE, but we shouldn't forget that they are essentially consequences of rules we've made – and they could be unmade – they are not intracible like: Lack of water, bad climate or traffic jams. The electorate has choosen to enact term limits, guaranteeing that polititians have no interest in getting along across the isle. We, the people have also enacted all the laws that underlie the issues I outlined above (2/3 majority….)

    This brings us to the other issue you raised: Real Estate.
    There I do see a fundamental issue that you mentioned: There is limited possibility to build new housing. This, coupled with your (and mine) assertion that ultimately the High tech, agribusiness and Music/film industries are sound and will grow, in spite of government funding issues – will yield a situation where more and more folks will bid for a static supply of housing – thus putting a floor under housing prices.

    I *do* share your view that in the short run the Silicon Valley upscale properties, too, are in for a loss in value. It is, however important to remember that there are 2 or more different real estate markets in California.
    1. The Los Altos Hills/Beverly Hills market (very upscale and expensive)
    2. The Upper Middle class proffessional market (let's call that the Cupertino market), populated by e.g. successful engineers.
    and lastly
    3. The rest of the market. This will be represented here by Soledad, but it could be any city in Riverside or Central Valley

    This “Soledad” market was real estate speculation at its best. They were bult up, not because lots of folks was moving there for the well paying jobs, but because it was cheap to build there. Soledad's main industry is the Prison and some vineyards, emplying farmworkers. The commute to Silicon Valley takes 90 minutes or so.

    The “Soledad” market has been whiped out. It was almost pure bubble.
    The “Cupertino” market has barely been touched – yet – but as you imply it will be. But you shouldn't expect the 40% – 60% drop that you've seen already in the Soledad market. I think that we'll bottom out at around 20% from peak, which will put us well above 1989 (and above 1999) levels.
    The Beverley Hills market, I don't know about, but I think the rich will do well, it's sort of the definition of being rich – If you need to, you can just sell the yacht to keep your house, or take one less vacation per year.

    Does that mesh vith your views too?

    Peter

  • Ben

    Mr. McDonald-
    Just caught latest thoughts from your hero-cum-sparring partner, Hugh Hendry. Any thoughts and reactions would be welcome…
    http://zerohedge.blogspot.com/2009/06/hugh-hend

  • http://twitter.com/dvolatility DistressedVolatility

    Nice post Gregor, I'll be watching that inflation wedge for a breakout..

    -DV

  • RJ

    Great analogy, and frightening if you suffer from claustrophobia. Above the drop ceiling, must exist what can only be referred to as “superfluous economic activity”. Incredibly, that now includes housing (as well as associated commercial development).

    Many would consider allowing market forces to define the parameters of powerdown as unnecessarily dogmatic or even cruel. Dimitry Orlov posits that at this point, it's out of our hands. I really don't know.

  • kgw

    “However, the latter too has reached certain limits via water. “

    Via population. I remember cursing a politician between jobs (he was a commentator on KCET in Los Angeles). He was saying that California was going to grow by 15-20 million people so we had to divert water resources to allow development. . .A la Pete Wilson and his crew. We cannot allow California to grow the population by that much, unless we want to explode, in oh so many, different ways.

  • kgw

    “However, the latter too has reached certain limits via water. “

    Via population. I remember cursing a politician between jobs (he was a commentator on KCET in Los Angeles). He was saying that California was going to grow by 15-20 million people so we had to divert water resources to allow development. . .A la Pete Wilson and his crew. We cannot allow California to grow the population by that much, unless we want to explode, in oh so many, different ways.

  • kgw

    “However, the latter too has reached certain limits via water. “

    Via population. I remember cursing a politician between jobs (he was a commentator on KCET in Los Angeles). He was saying that California was going to grow by 15-20 million people so we had to divert water resources to allow development. . .A la Pete Wilson and his crew. We cannot allow California to grow the population by that much, unless we want to explode, in oh so many, different ways.