Private Equity & Dividing By Zero

I’ve been pulled from a period of post-nuptial dissolution and lassitude by an astonishing article in yesterday’s Wall Street Journal on private equity buyouts. It describes a simple game. Private equity firms persude creditors fund highly leveraged buyouts. The bought-out firm then takes on more debt to quickly pay large sums to the private equity firm, its new owner and manager, in the form of management fees and dividends.

Consider Intelsat. According the the WSJ article, private equity investors put up $515 million, while creditors footed the remaining $5.5 billion to purchase the communications satellite business. Within two years, the private equity investors had extracted more than $576 million in fees and dividends, while still retaining full ownership of the firm. Now that’s a good position to be in. After two years, while the underlying firm was struggling, renegging on promised employee benefits, and showing a negative net worth, it’s owners had already earned 5.75% annual returns on their stake and recovered their capital in full, while still retaining control of the company and claim to any future profits it might earn! Alluding to a previous post, this is a deal right on the dotted line. For zero net investment, the private equity firm gets to gamble taking all the profit and growth a 3 billion dollar firm can generate, or walking away from the table with a bit of bad publicity and the unwinding of some legal entities.

It’s easy, as is apparently the German custom, the think of private equity firms as “locusts”. But this is capitalism, and people are supposed to figure out ways to exploit unusual opportunities. It’s not the sharks who are feeding, but the rare, bloody meat floating in the water that’s the problem here.

There’s an old math cliché that you can prove any proposition so long as division by zero is permitted. I think a finance version of this cliché would be that anything is possible if there’s a mispricing in any market that can’t undone by its exploitation. Credit markets for the past half-decade have matched this description. Central banks have held money cheap, despite unprecedented and every growing use of borrowed funds by everyone from strapped consumers to eager-to-please businesses to multibillion dollar investment funds. In unmanipulated markets, the orgy of borrowing that has characterized the last few years would have led naturally to tighter rates. Thanks to the US Fed, the People’s Bank of China, the freewheeling dollar lending of petrostates, and of course the Bank of Japan, that hasn’t happened. Money has been nearly free. Banks have had to compete mercilessly for the privilege of lending for any interest at all. Risk has been so sliced and diced and sold and apparently “managed” by the derivatives boom that many creditors have been made comfortable with positions that in the past would have looked like laughably bad deals for them. Global interest rates have been fixed by the behavior of central banks collectively and state-affiliated investment funds at absurdly low levels.

The current private equity boom is largely a means of exploiting that mispricing. The underlying businesses that are bought and sold are means to ends. It is not what they do, what new efficiencies or synergies or what not that can be introduced that matters. It is how well their assets can be used to justify continual leveraging, how cheaply they can be bought, how good a story can be told to keep the terms of borrowing from becoming too onerous even while cash is sucked from the firms by equityholders, that matters most. The underlying business then becomes a lottery ticket. If a firm can, in the course of doing a deal, build a really great company, put together several firms and take advantage of synergies, improve underlying efficiencies, then the value of all those improvements is pure profit for the private equity fund. Leveraged buyers have every incentive to try to build and improve the companies they float through. But in a world of artificially cheap credit, taking underperforming companies and turning them into great ones becomes secondary, gravy. An arbitrage opportunity is better than any risky investement. The first order of business for a rational private equity fund would be to find target investments through which to exploit mispricings in credit and risk can be efficiently exploited.

Of course this will all come apart, rather soon I hope. If collective state behavior does change (a very big if) and the era of absurdly cheap money ends, many of these heavily leveraged deals will go south, and we’ll have a predicatable wave of Enron-like scandals, as firms go bust, private equity funds write off their investments, and creditors sue them for fees and dividends they extracted from retrospectiovely insolvent companies. If central banks around the world are determined to keep money cheap, if China keeps ramping its exports and lending away all the proceeds for next to nothing, if the petrostates keep buying up dollar debt with all their oil proceeds, if the Bank of Japan and US Fed get spooked by the prospect of recession and hold rates low, we can put off much of this unpleasantness, but with much worse eventual consequences.

After all, it is not liquidity or interest rates or equity deals that matter in the enterprise of human wealth. It is the business of producing real goods and services. A world in which nominal wealth becomes detached from real production, and bound instead to cleverness in manipulating the machinery of high finance, is a world in which financiers will have an ever larger share of a progressively smaller pie.

Blame Avoidance: Understanding the Bernanke Fed

I think it’s very simple.

They know something bad is going to happen. It could be a deflationary recession, it could be out of control inflation. In a world awash in liquidity and debt, in which the US Fed has limited effective control over the quantity of money and the quality of claims, either possibility is plausible.

The Fed doesn’t want to be blamed. Feds are historically blamed first for pushing interest rates too high (causing a deflationary recession), and second for letting inflation get out of hand. So, the Fed’s first priority is not being blamed for acting too aggressively and causing a recession. They can avoid blame by pausing the rate hike cycle, if it seems decent to do so, or by moving 25 bp per meeting, if inflation numbers run high. That “measured pace” is now a kind of default, not a blame magnet, and anyway, it’s a Greenspan Fed strategy, so if contiguous 25 bp moves precede a recession, most of the blame goes to Bernanke’s predecessor. But the Fed also doesn’t want to be blamed for failing at its core mission of keeping inflation under control. So, in “jaw-jaw” mode — speeches, informal comments, etc. — Fed officials come off as hawkish, hoping to maintain their credibility as inflation fighters, and thereby reduce self-fulfilling expectations of increased inflation.

This is a fairly optimal strategy for avoiding blame. If a recession hits, blaming the Fed for being too aggressive will have limited traction. After all, the Fed only continued its predecessors policy of gently tightening, and only when inflation numbers clearly forced continued tightening. Blaming the Fed because Bernanke talked about inflation numbers exceeding his comfort levels in some speech is not going to take. The formal record will be one of very measured interest rate rises, and very moderate statements and minutes. If there’s a recession, it won’t be the Fed’s fault. If inflation continues to pick-up, the Fed can try to maintain its credibility by talking tough and continuing the 25 bp hikes. If the Fed really is “behind the curve” on inflation, and prices accelerate, eventually they might be blamed. But that involves incremental and subtle attributions of blame. They can always, actually “shock the market”, if things get out of hand and the blame for inflationary pressires gets palpable. But much better to threaten to do something radical (deniably, through third parties and rumors) than to take the risk of actually doing something, until something absolutely must be done, and the risk of serious blame can no longer be avoided.

I do think some kind of bad economic period is inevitable, though whether it looks like recession or stagflation or just modest inflation and sluggish real growth is uncertain. I’m not sure that I blame the Fed for avoiding blame. But I do blame the Greenspan Fed, and current administration, and the ossification of economic ideas into stale ideologies over a longer period of time, for getting the US economy into an obvious, big mess, while the best and brightest debated whether a garbage dump wasn’t the optimal outcome if something resembling a market happened to produce it.

Leveraged fund optionality and the “least cost bearer of risk”

Traded financial derivatives, it is often claimed, permit markets to find the “least cost bearer of risk”. But if this is true, what exactly does it mean? Who are the least cost bearers of risk? Highly diversified investors with very strong balance sheets? It’d be natural to think so. But think again. Perhaps the least cost bearers of risk are aggressivley speculative investment funds intentionally leveraged to the point where the potential upside is very large, and the corresponding downside triggers bankruptcy.

Recall that any leveraged, limited-liability entity can be understood as a call option. If a business owes the bank $1M, but its assets — including the present value of expected future profits — are worth less than that $1M, it can declare bankruptcy. Its owners hand over all assets to the bank, and walk away without paying off the loan. On the other hand, if equityholders believe the business is worth more than a million, they pay off the bank, or rollover the loan, depending on the operation’s current liquidity and available investment opportunities. Thus, the value of this entity to equityholders can be described by the red curve below.

Investments whose returns are like options have an unusual property. Usually, investors hope to minimize risk and maximize returns in their investment choices. But the expected return of an option increases with the risk (or volatility) of the underlying asset. Consider the case of an idealized entity operating entirely on borrowed cash. It holds $1M in assets, all borrowed, no owners equity. On the graph above, it sits at the point where the dotted line intersects with the red line. Suppose equityholders had a choice, hold the million dollars cash, or flip a coin in a bet that either doubles their money or loses it all. An unleveraged, risk-averse investor always prefers sure cash to a fair coin-flip. But a very leveraged investor who has the option of shifting costs to the lender, takes the coin-flip. If she loses the flip, she loses nothing, the lender takes the cost. If she wins, she’s turned other peoples’ money into a cool million for herself.

A 100% leveraged entity is a zero-cost bearer of risk. The downside of any potential investment is immaterial. Only the probability-weighted magnitude of the expected upside matters. A 100% leveraged entity prefers volatility to safety, even if the “average” outcome of a gamble is not particularly good. Even if the coin in the previous example were rigged so that the fund loses 2 out of 3 flips, equityholders still prefer to play than to hold cash. Since creditors bear the losses, the only cost to a bad gamble is the opportunity cost of better gambles that might otherwise have been undertaken.

In the real world, very few entities get to borrow all their assets, hold all gains, but walk away from any losses by defaulting. It’s a great deal for the borrowers, but a crappy one for lenders, who strive to prevent these kinds of perverse incentives from arising. Lenders typically require borrowers to hold significant equity. A typical borrower sits at the intersection of the red and green lines. At this point on the curve, equityholders absorb most losses, as well as any gains on their investments, and the possibility that some of their losses will be borne by lenders if they lose absolutely everything is unlikely to be particularly relevant. Also, business bankruptcy often exacts nonmonetary costs that mitigate predatory behavior by borrowers. Controlling equityholders of failing businesses lose reputation, their jobs, see their friends lose jobs and retirement security, face lawsuits, etc. Finally, lenders often protect themselves with “covenants” that remove control from equityholders as the degree of business leverage increases, to prevent borrowers from taking big chances after they’ve borne great losses.

But, nevertheless, the world is a diverse place, with lots of different kinds of businesses and creditors. While very few entities enjoy 100% leverage, some businesses fall much closer than others to the dotted line on the graph above, some businesses have more non-monetary costs associated with bankruptcy than others, some businesses have more restrictive covenants than others. Leverage is no longer as simple a concept as funds borrowed from a diligent local bank. Bonds can be sold to the public, to naive foreign investors, to foreign central banks. In markets awash with liquidity, borrower reputation may substitute for balance sheet due-diligence in the decision to extend credit.

The trading of financial derivatives is supposed to transfer risk exposure to its least cost bearer. In light of the foregoing discussion, what might a least cost bearer look like? As we’ve seen, entities that are nearly completely leveraged, that fall near the dotted line on the graph above, face a low, or even negative, cost to bearing risk! This is counterintuitive, since these are the sorts of entities that face the greatest likelihood of bankruptcy. But that is exactly the point. Bankruptcy transfers the cost of risk gone bad to others. The least cost bearer of risk is an entity with few nonmonetary costs associated with failure, and a reputational or strategic capacity to take on leverage without surrending its ability to take risk. It should be no surprise to anyone following financial markets that this sounds a lot like a highly regarded hedge fund. Think Long-Term Capital Management.

The point of this essay is that LTCM-style meltdowns are not aberrations, but are a rational, structural consequences of a financial system in which the returns of some entities have high optionality, offering the possibility of high-returns for a low sums put at risk of total loss. LTCM should not be regarded as a failure or lapse of judgement on the part of its managers or investors. Its failure was a “normal accident”. Assuming independence of returns across investments, the rational investor should diversify her holdings among a very large number of funds with LTCM-style leverage and high appetites for risk, as these offer far superior return to risk than traditional investments. Many, perhaps most, of these investments would go south, and end up worthless. But the returns on the high-leverage, high-risk funds that succeed will much more than make up for these setbacks. On average, lenders bear most of the risks and equityholders enjoy most of the gains. It’s a good deal for investors.

If highly leveraged funds are good deals for investors, than hedge-fund managers ought to be competing to create them. (We’ve not touched on the much maligned “2 & 20” fee structure of many hedge funds. That adds additional optionality to hedge fund incentives, but it is only icing on the cake.) Funds should be competing to maximize their leverage without compromising their capacity to take-on risk, leap-frogging one another down the slope of a graph towards that dotted line. Speculative derivative positions often offer both risk and leverage in convenient packages whose “rocket-scienceness” helps to obscure both aspects, and make it possible for a fund to take on yet more.

Of course there is a problem here. Somebody ends up bearing all the risk that leveraged funds can write off via defaults. What is rational behavior for each individual fund or investor may turn out not to be so rational, if failures turn out to be correlated rather than mostly independent. If several funds default away large losses, the funds’ creditors may in turn default, wiping out other funds’ gains and increasing the likelihood of futher defaults. In a typical “tragedy of the commons”, rational behavior by investors and managers can lead to a systemic crisis.

Update History:
  • 12-Jun-2006, 10:am p.m. EET: Changed “tragedy” to “crisis” in last sentence to avoid double-use, and removed the overdone word “grave”. Fixed two spelling errors.

Free trade, or the first few hits are free?

What was that famous Adam Smith quote, the one that made the case for free trade better and more concisely than ever before, or ever since?

It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor.

What is prudence in the conduct of every private family, can scarcely be a folly in that of a kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.

But, you know, the “prudent master of a family” does not engage his tailor and buy his shoes on credit, for prolonged periods of time and with no forseeable means of repayment. Debt securities do not represent the produce of our industry. Sometimes the wisdom of crowds is not found in central-bank manipulated markets, but in the messy kinds of preferences expressed by voters in elections.

I’m all for free trade. But what many businesses and economists refer to as free trade, in this real world circa 2006, is not trade at all. Trade implies two parties exchanging value. I’m a long-time, knee-jerk anti-protectionist. But at this moment, I don’t know who to be more afraid of: US politicians catering to paleolithic economic xenophobia, or economists who’d describe as “free trade” the United States’ growing addiction to goods and services it cannot pay for and the nation’s ongoing, humiliating “soft default” on debts public and private via real depreciation of the dollar.

A man standing in line at a soup kitchen is involved in a voluntary transaction between two parties. He may think he’s outsmarted the guy with the ladle, working the system, getting something for nothing. But that man in line at the soup kitchen is neither admirable nor prudent, and it is that guy with the ladle who holds the power. The problem with a free lunch is that it may not be there tomorrow. And a free lunch, however long it lasts, is not free trade.


This rant was inspred by a post by the very excellent Mark Thoma.

Risk Management Monocultures

Via Brad Setser, Steve Johnson describes the recent sell-off in world markets:

The selling was largely driven by a sharp rise in volatility, with the Vix index, often referred to as Wall Street’s “fear gauge” hitting a two-year high.

This increased the “value at risk” of leveraged investors such as hedge funds, forcing them to cut long positions. Many of the assets that had made the strongest gains this year, such as emerging markets, fell most sharply as a result.

This issue of VAR-driven sales on increasing volatility bring up a very general point about risk mitigation in financial markets: Any single risk-mitigation scheme widely adopted to reduce the risk of individual participants increases systemic risks to the market. Runs on banks, programmed stop-loss sales, and now sales at VAR thresholds are some examples of this that we’ve seen. All are dangers of risk management monocultures.

Dangers of derivative-based risk control are more subtle, because derivatives allow the party that would otherwise bear risk to hold their “insured” positions rather than scrambling for the doors. But if the bearers of transferred risk manage their exposures very similarly, then their collective behavior creates systemic risks that come back to bite holders of the underlying. For example, if bearers of credit risk in swap arrangements mechanically short the credit market to hedge risk as credit spreads grow, bond prices will fall and credit spreads widen just as surely as if uninsured bondholders had sold-off themselves. Derivatives allow for greater diversification and dispersion of risk, ideally to those who best placed to bear it. This probably does push back the thresholds at which dangerous risk-mitigation herd behavior kicks in.

But if the buyers of risk all turn out to look alike and act alike, if their tolerance for bearing risk is limited, if they have underpriced risk in tranquil times, then everybody had better watch out. Even for those who have trimmed exposure rather than assuming risk, derivative-based risk management, like diversification, can only protect against security or sector-specific risks, not against systemic risk. If everyone bearing any important category of risk has similar (“industry best practice”) ideas about how to cut incipient losses, that’s a source of systemic risk. Beware risk management monocultures.

Global Imbalances — Warren Buffett’s Cap & Trade

In a conversation about a recent post of Michael Shedlock’s, Eugene Linden likened financial risk to environmental toxins. His very astute observation was that the use of derivatives to disperse risk is much like the strategy of managing toxic chemicals by flushing them to the sea. At first blush, this is eminently sensible, because poisons when sufficiently diluted are not poisonous at all, and may be harmlessly absorbed by the environment. But in fact, the strategy is fraught with peril. Some toxins don’t stay dispersed, particular agents accumulate them, and become poisoned and poisonous. In a bay, shellfish might accumulate dangerous levels of heavy metal, and become unfit for human consumption. In the financial world, we know that lots of risk has been created and “dispersed” via derivatives, but we don’t have good information on whether all this financial risk is harmlessly diversified, or has concentrated dangerously in the hands of some speculative agents. The accumulation of metals by seabed mollusks does harm not only to the mollusk. Similarly, ill-advised accumulation of risk by hedge funds or investment banks could lead to consequences extending far beyond the risk-accumulator.

I thought this was a particularly good analogy, and have been thinking of other pollution metaphors in finance. “Global imbalance” is a shorthand commonly given for the situation in which some countries — in particular the United States — are spending more than they collectively earn, while others (China, Saudi Arabia, Russia) are selling their goods and services for debt. These habits have become embedded structural facts of various economies, implying changing the pattern — the US builds up debt, China and the oil states — will require “economic adjustment”. Economic adjustment is a euphemism for hard times, and this arrangement is not just a private matter between a few countries. In today’s interlinked global economy, US consumers provide a great deal of world demand and the US dollar is the global “reserve currency”. China’s population represents nearly one quarter of the world population, and its political stability depends upon economic growth. If “adjustment” doesn’t occur smoothly, there could be a global economic downturn, political instability, resource wars, you name it. These are all improbable events, but they are risks borne by the entire world, and risks that grow with continued unbalanced world growth.

So, in a sense, “global imbalance” is also a lot like pollution. The United States, China, the elites who run the petrostates, are all “getting something” out of the present arrangement. (The US gets to consume inexpensive goods paid for with low-interest IOUs that may never be fully paid; China gets export-led rapid-fire development; and the petrostates get high oil prices without crimping demand, since the US is buying with debt and China is taxing and subsidizing oil consumption.) But, at the same time, they are poluting their own economic and political environment, and that of the rest of the world, with risk. Like polluters generally, “global imbalancers” continue to do what they’re doing because in the short-term it’s profitable, long-term costs are uncertain and won’t be borne solely by the polluter. In economist-speak, global imbalance, like pollution, is an “externality”.

Of course, with respect to pollution, industrial societies have been dealing with these problems for a long time. There’s no formula for preventing pollution, but one approach that’s worked very well both environmentally and politically are so-called “cap and trade” programs. I got to thinking about how we might “cap and trade” global imbalances.

I’m not the brightest bulb on the tree, but Warren Buffett just may be. He proposed a scheme called “import certificates”, way back in October 2003. Revisiting it, what does it amount to? It is precisely a cap and trade scheme for global imbalance. I read this way back when, and thought it was kind of loopy. Rereading it now, it seems kind of brilliant. This Buffett guy, he’s not so shabby. Why did this proposal get so little notice? It’s remarkable in that it permits markets to determine who can most efficiently bear the cost of global rebalancing, and permits gradual application, as the initial “cap” on the US trade imbalance could be set at something like the present level, with a commitment reduce US overspending only gradually. It’s financial innovation at its very best. Why hasn’t this been done? Why don’t we do it now?

Bad control systems and margins of error

Today I’m into nutshells.

Asset markets and central banks are control systems, intended to provide incentives that encourage the effecient use of human and economic resources. I believe these “macro” control systems are malfunctioning, badly. Structural weaknesses in these institutions have permitted some classes of agents to profit from the misallocation and expropriation of resources, creating strong constituencies for the continuation and exacerbation of those structural weaknesses.

Why has nothing really obviously bad happened, if the world’s macroeconomic control systems are so out of whack? Economies are big, slow things. They have a lot of intertia — they like to keep doing whatever it is they do. They can be tortured a good bit and bounce back. They have a great diversity of control systems, much more fine-grained, local, and efficient than the large scale capital markets and games played by central banker finance ministers. There are margins for error. But those margins are not infinite. Self-correcting control system failures are okay. Autocatalytic failures, where ineffeciencies promote even greater ineffeciencies, are not. That’s where I think we are now.

When describing the problems, they sound very big, central, “macro”: currency manipulation, artificial liquidity, leverage, asset bubbles, commodity inflation. But central banks are not the answer to the problems they’ve helped to create. Reform, when it comes, won’t be with a Plaza Accord, an IMF/G-7/OECD initiative. The solution, eventually, will involve changing the definitions of money, corporate stock, and other financial assets, and the structure of the markets on which they trade, to be less prone to self-reinforcing malfunctions, and far more grounded in specific, local, and concrete knowledge. These will be fairly radical changes, though there may be incremental paths to get there. Understanding what more robust and effective market-based control systems would look like, and developing a rich, quantitative theory relating information-work to efficient decision-making, are perhaps the crucial challenges of our time.

Existing Home Sales, okay or bad?

Existing home sales (seasonally adjusted) were flat in March, after a jump in February that seemed counter to notion of a popping housing bubble. Rising to flat existing home sales are definitely better news than plummeting values. But, the news is not really as okay as it seems.

Houses differ from many commodities in that sales should be affected by inventory, even at constant prices. Why? Because an inventory of houses is not like an inventory of identical widgets. No two homes are exactly alike. Cautious buyers seek homes that must match very idiosynchratic criteria. Holding “pickiness” constant, the likelihood that any buyer finds a suitable home will corelate positively with the number, and therefore “selection”, of homes is target neighborhoods. Therefore, all else being equal, existing home sales should be expected (as an absolute number) with increasing inventory.

Even with February’s “jump”, existing home sales didn’t keep up with rising inventory. Flat sales in the face of rising inventory this month is suggestive of a weakening home market.

Here’s a graph of existing home sales in absolute numbers (seasonally adjusted):

And here’s existing home sales as a fraction of inventory:

In the context of rising inventories, the graph of sales in absolute terms would be expected to “better” than reality, because sales should rise with inventory. The graph as a fraction of inventory looks “worse” than market reality, because even in a healthy housing market, the increase in sales attributable to higher inventories would not keep up with the increase in inventory when there is already a fairly reasonable selection of homes available.

Hat tip: Calculated Risk

Update: Commenter tryuj notes, correctly, that I’m off by a year on the months graphed. I’ll try to redo these graphics soon… Okay, they’re fixed now. Thanks to tryuj and qwerty.

Parsimony

The one thing that the current leadership of the United States and the current leadership of Iran have in common is an interest in high oil prices. Iran’s government and ruling elite live off of oil revenue. At present, macroeconomic conditions are such that high oil prices lead to a redistrubution of wealth in the US towards the Bush administration’s personal and political friends without (so far, so good) damaging the broader economy in any obvious way.

A gentlemanly game of saber-rattling seems to be in the interest of both parties. Perhaps that is why we have one.

A nuclearizing Iran may be a real issue. The world is full of real issues. The current crisis might have come up any time in the past decade, and might have been delayed five years with the smallest amount of fudging and dissembing and rhetorical moderation on Iran’s part. Why now?

I’m not alleging a conspiracy here. In a game of two players with a mutual interest, there need be no secret handshake to seal a deal. Nor am I alleging that everything is fabricated. Perhaps the new Iranian President really is driven by domestic power considerations in his boastful cretinism. The Bush Administration probably does want to see regime change in Iran and an end to its nuclear program, and Sy-Hersh-style deniable brinkmanship may be a defensible strategy to get there. But it can’t hurt, from either perspective, that the athletes in this little game of nuclear chicken are very, very well paid.

Are high oil prices a net stimulus to the US economy?

Commenter “jm” to a Brad Setser post remarks…

Because such a large fraction of any rise in the prices we pay the oil producers is immediately lent back to us — and in dollar-denominated loans — the effective drag on the US economy of higher oil prices is less by that fraction.

If we pay $10 more per barrel for oil, but $8 of that is immediately recycled back to us through purchases of US securities…

His analysis is right on, but perhaps it doesn’t go far enough. As a thought experiment, let’s make a bunch of assumptions, and see what happens:

  1. Following JM, we posit that 80% of oil revenue is neither consumed nor used to fund domestic investment by oil producing countries, and is instead used to purchase debt securities on international markets.
  2. We presume that the US has an 80% market share in the international debt securities market, and that this will remain constant over the short term. (Even if Iran, for example, buys only Euro debt, we assume that indirectly 80% of all international lending finds its way to the US.)
  3. We guesstimate that the US accounts for 25% of the world’s petroleum consumption, and that oil demand is perfectly inelastic (short term).
  4. We assume that US current economic activity is cash constrained. That is, US agents will consume or invest all the cash that they borrow, without regard to the total debt load they are racking up in the process.1
  5. We assume for simplicitly that cashflows are instantaneous, that effects are not at all lagged.

Now, when a US consumer purchases that a dollar’s worth of oil, the US economy sees an outward cashflow of $1. Oil producers see an incoming cash flow of $4 (since the US represents 25% of the world market by assumption). Oil producers lend $3.20 of that revenue to international markets. US borrowers take on $2.56 worth of debt. What’s the net cashflow to the US economy associated with a purchase of oil? For ever dollar spent on oil, Americans get their dollar right back in lendings, plus an extra $1.56 of new lending to purchase homes, vacations, and SUVs with. In other words, an increase in the price of fuel is cash flow positive to the US economy! By assumption 4, this means that despite the reduction of net exports represented by high fuel prices, an increase in the price of oil leads to an increase in US GDP! It’s a great deal, until something changes.

The assumptions above are not quite right. Probably something less that 64% of every dollar in the world spent on oil ends up repackaged as loans to the US. World oil demand is likely to be price elastic, especially outside of the US where funds spent on oil are not offset by incoming debt-driven cash flows. But I think the overall point stands. So long as the US collectively is not worried about its increasing debt load to the rest of the world, high oil prices may well be a current stimulus, and not a drag at all, on the US economy.

(For more on this topic, see Brad’s post, the Nouriel Roubini post Brad was responding to, this post by “Calculated Risk” on his own blog, another post by CR on Angry Bear.)

Update: I think I should add that my personal opinion is that there is some truth to this story, in describing the recent past, but that the world is changing, the US is getting skittish about taking on more debt and the world is getting skittish about lending so cheaply, so that relying on high oil prices as a “stimulus” going forward would be a bad idea.


1 Assumptions 4 and 2 are all mixed up, as the US “market share” of debt sales, which I’ve assumed constant, has something to do with Americans’ willingness to increase their indebtedness, and with the price Americans can get for securitized debt, that is with the low yield Americans pay. For the past while, US long-term debt prices have been nearly constant, and the US share of sales to international debt markets has been consistently high. But as the price of Americans can command for taking on long-term debt is finally beginning to subside, assumptions 4 and 2 lose even the very modest contact with reality that they may once have had.

Update History:
  • 17-Apr-2006, 8:11 p.m. EET: Lots of small clean-ups, added update with my opinion on whether this story applies going forward.
  • 21-Apr-2006, 10:45 a.m. EET: More small clean-ups.