The problem with subsidies

There has been much talk lately about whether the United States Government should stop subsidizing domestic oil companies like Exxon, Chevron or ConocoPhilips to name a few. Tax breaks to oil companies are an old time practice in the US and no government, either democrat or republican, has dared to eliminate them. The reason why these tax breaks still exist is not clear for me, as oil has always been a profitable industry, even through energy crisis like the ones in the 70's or the Gulf war crisis in 1990. However, recent talks about the need to eliminate those tax breaks and focus the money on alternate energy have spiked some heated debates across the US, mainly due to the already high prices of gas and the multi-billion benefits of oil companies worldwide. This has put the problem with subsidies back in the spotlight. 

People (and corporations) get used to subsidies really fast and once they are fully integrated in daily life they are just perceived as an acquired privilege, rather than what they really should be: a temporary boost to an ailing or complicated situation/sector. This is a big problem for two main reasons. The first one is that, after their initial effect on containing or lowering prices, the subsidized good or service generally goes up as if nothing had happened, thus rendering the subsidy useless. The second reason is, when government retires said subsidy, prices are expected to go up even more, so people will complain about it. And that people will complain is not an expectation but a true fact.

But despite energy subsidies having a distorting effect on the economy, the clearest and biggest examples of the danger of subsidies I can think of are the homeownership subsidies that caused the Irish and the Spanish housing bubbles. Yes, over-optimistic lending by numerous banks makes them guilty by association,  but they are businesses and they responded to the needs of a market. A market governments artificially created. Governments were the true enablers of said bubbles. I will never understand what (if any) is the noble idea behind subsidizing homeownership through mortgages. If said noble idea was giving access to a decent house to low-income citizens renting subsidies would have worked similarly well, yet they did not appear anywhere. Maybe the reason was that buying a house provides far more tax revenue for a government than renting one does... Whatever the reason was, for me homeownership is not a security but a limiting factor, as discussed in this article.

The only thing these housing subsidies have achieved in both of the examples given is a construction boom together with a price spike, and a quite heavy one. In a normal, not mortgage-subsidized market, even after assuming the natural demand increase caused by higher demographics in the period, the situation would have been very different. A housing and construction boom would have led to lower or stable house prices, never to sky-rocketing ones! Sky-rocketing prices that ended busting the bubble that we can easily trace to the drowning of Ireland and Spain economies in the past two years.

The supply and demand law is at the base of economic liberalism for a reason. It is a force powerful enough to shape any given economic sector with common sense. The market is wise enough to decide on the evolution of a sector. Subsidies should only be used in exceptional cases, or to protect distressed citizens from being excluded from the system (think health for example) but never on a generalized scale or on a long-term basis.

Reasons for an oil producer to go nuclear.

This same week I read at Bloomberg's Businessweek that Abu Dhabi, the 7th country in the world by estimated oil reserves, is building a civilian nuclear reactor to go-live on 2017. The article mainly focused on the assertiveness of the United Arab Emirates (UAE) going forward with their plans despite the ongoing events at Fukushima. Nothing exceptional here from my point of view, as there is nothing in common between the Fukushima plant and and what  the UAE is building in Braka together with Korea Electric Power Corporation (KEPCO).  What I am most interested about is the fact that one of the oil-richest countries in the world is going nuclear.

Illustration of the future, 4-reactor nuclear plant.

Internal energy demand is growing fast in Abu Dhabi, but it is still marginal compared with all the oil the UAE is exporting worldwide. We know Abu Dhabi, as every other producer, can have oil for cheap, so its domestic oil consumption would not justify the huge investment a nuclear energy facility demands. We could also consider Abu Dhabi not a front runner in climate preservation, and because of their small population density they do not have to be much worried about their fossil fuel emissions neither. 

So what could be the reasoning behind this ambitious nuclear plan started in 2008. Are their oil reserve estimates too optimistic? Do they prepare for a sooner-than-expected post-oil era? Or are they simply trying to keep their energy independence? Not being suspicious here, just trying to make some sense of such an expensive and (unfortunately) controversial decision.

The tsunami reach on the global economy

On previous posts we have done a brief analysis on the devastating effects of the earthquake-tsunami combo on the Japanese economy. To have a more general and complete view of the events, one has to look at the other side of the story too, the collateral effects the damage suffered by Japan will have on the global economy. Over the last days we have heard words of relief from Japan's government and from analysts saying that the bite on Japanese GDP will not be as big as thought on first instance. But, no matter how fast the world's third biggest economy can recover from the disaster, the weight of said economy makes it impossible to dismiss the effects it  will have in the coming months (and is having as of now) on the march of the global economy.

Countries affected

The first wave to affect the global economy was a logic fund repatriation, specially from Japanese banks and insurance companies in need of liquidity to begin with reconstruction tasks at home. This initial repatriation made the yen go higher instead of immediately falling as expected, but this is not something to fear specially for the rest of the world. What some people are fearing is that Japanese mutual funds, hedge funds and instruments alike began to massively withdraw their positions over the rest of the world to take their money back home. If this movement is done gradually no significant damage would be done, Japanese money would simply be substituted by somebody else's money. But if this repatriation was to be done massively it would pose an important threat, specially for emerging markets. Emerging markets usually rely on bigger economies' capital to fund their growth, to the point where a runaway of Japanese money could partly derail short-term growth expectations for some emerging markets. I am not talking China, Russia or Brazil here which are exposed but big enough to not notice a heavy change. I am talking about smaller markets like South Korea, Singapore, Hong Kong, Taiwan, Malaysia, Thailand, South Africa or Chile.

Japan's earthquake biggest replica: the economic one

First of all, my thoughts are with the Japanese people in these difficult moments. I am sure being such a hard-working, disciplined and respectful country they will have no (unmanageable) problems getting over it very soon. 

Earthquakes as big as the one that hit Japan last night are always followed by numerous replicas of different strength. These replicas can last for several days until the tectonic plates 'settle down' again. Well, we have begun to see what can be the biggest and more widespread replicas of said earthquake: the economic one. Few hours have passed since the disaster and we can already see the effects on the markets: oil prices, gold and stocks go steeply down and the german bond and the US dollar go up. Pure textbook reaction.

ECB raising interest rates. Damage control?

Take a quick look at the news an see how many times the expression 'raising tensions' appears on articles lately when talking about the situation in the Middle East. I am sure you do not have enough fingers to count them... Now take this same expression but exchange the word 'tensions' by 'interest rates' and see everybody panic and run for their lives. Although we have lived (and we are still living) one of history's longest period of low interest rates, people keep asking for more. Governments and enterprises around the world have grown so accustomed to debt issuing and uncontrolled spending thanks to cheap money that mentioning the slightest interest rate hike makes them shiver.

The key factors to justify a (slight) interest rates raise are all there though: we have growing core inflation, uncontrolled energy prices, excessive debt and severely depreciated currencies. On the other side we have a weak, mostly artificial recovery (already mentioned), that depends heavily on the availability of cheap money. Which side has a more important impact on the future status of the economy? It is clearly the first one, no hesitation. The Middle East turmoil is not coming to an end soon, and until it does the oil barrel price will keep rising, putting even more pressure on inflation control measures.

More inflation in the actual scenario we are facing would kill all recovery aspirations on the medium and long-term, even if it now seems detrimental for the short-term.

Do not get me wrong, as of now, a raise in interest rates will be hard to handle, specially for debt-burdened countries like Greece, Ireland or Portugal. It would be bad for Spain too even if its debt situation is marginally better, because all the semi-public savings banks (called 'Cajas de Ahorros') are now undergoing reforms to transform themselves into normal banks. A process that needs, and will need, a lot of funding and bond issuing on their part. For these troubled countries higher interest rates mean only one thing: more expensive financing, that is all they can think of when they hear these words.

The US Dollar not-so-free fall

When talking about international trading and investing everybody has grown accustomed to the same face, the US Dollar. It was at the core of any transaction, it denominated almost all the financial instruments you could think of and it was the shelter everybody looked for when things got ugly (this last one was shared with gold obviously). But this familiar face seems to be aging quickly for a number of reasons and, most importantly, it does not seem to care about it.

This omnipresence of the USD has always been key for the US economy, as it has allowed for the US to issue more and more debt at quite low prices independently of the markets situation. The perceived-risk of the US debt had always been very low (notice the past tense here). The US government of course knew this, and used it on its favor but they have been using the strategy for too long and too hard. As it happens with everything, if you overuse and stress something for long enough, it breaks...

EUR-USD exchange rate. Credit: Yahoo!

 

Peak-oil? More like Peak-gas

Everybody talks every once in a while about the much feared Peak-oil, but what we are suffering right now is a different phenomenon. We are seeing gas prices go through the roof worldwide, matching or even exceeding the record prices posted on the summer of 2008 when the Brent crude hit the 145$/barrel mark. 

Since then we have grown accustomed to high gas prices, fueled (pun not intended) by consecutive cuts in production from the OPEC and political conflicts around the world. However, even if we take these factors into account, the demand has fallen so abruptly due to the economic crisis than the barrel price is steady at 85-91$/barrel. The problem is that actual gas prices are not following the price of the oil they come from. But a picture is worth a thousand words:

$/barrel VS $/gallon from 01.01.2008 to 12.27.2010 (All data from US Energy Information Administration)