Sunday, December 16, 2012

Scope of analysis

Awareness of boundary issues and scope of analysis is essential in critical thinking.

Let’s take a look at energy. We tend to bucket energy sources in buckets like renewable, fossil fuels and nuclear, but what does that really mean?

On the face of it fossil fuels and energy sources like solar, wind and hydro have nothing in common and are seem contradictory.  Solar energy obviously is energy captured from the sun and as wind is also a phenomena caused by solar heat it too is a solar derivative.  With respect to hydro, the sun heats water which, with the help of wind evaporates, forms clouds and then rains down in mountains where we can use the water to run turbines and capture kinetic energy. Therefore hydro is also a solar derivative.

Fossil fuels are the product of organic remnants of primarily plants which lived a long time ago, died and were transformed under heat and pressure into various forms of fuels like coal, oil and natural gas. Those source plants however were powered by the sun, so as we zoom out fossil fuels too are a form of solar energy.

That leaves us with nuclear as a true separate and distinct energy source. Or is it?

The sun is a ball of gas which is so large that the particles on the inside are squeezed together to the point where they fuse. In other words, a nuclear (fusion) reaction. The sun then is a form of nuclear energy.

That leaves us to the inevitable conclusion that at the macro-most level all energy sources that we have access to and are aware of are nuclear at their core. So when we talk about renewables, fossil fuels etcetera keep in mind that these are distinctions which exist only because of a choice in the scope of analysis.

Monday, September 24, 2012

Fed Musings /2

The only way to have a chance at implementing the inflation mandate is to have complete control over either one side or both the demand and supply side of currency. Although the Fed as agent of the department of treasury and in theory is the issuer of currency in the US and therefore should have a supply side monopoly on currency creation, there is a fly in the currency creation ointment. As per MMTs horizontal and vertical currency concept the Fed does not appear have material control, or chooses not to materially control the fractional reserve lending system, let alone the shadow banking system. Government can try to regulate the minimum reserve requirements (although they can be, and are circumvented through a number of pathways) but the government (yet) cannot impose maximum reserve ratios (force banks to lend a certain minimum amount visa viz their reserves). Whether commercial banks use a fractional reserve of 10% of 12% has a very significant impact on the actual number of currency units floating around in the economy and the Fed has no direct control over it although it can has a number of tools which in the short term can increase or decrease the amount of money in the system.

All this puts commercial banks in the de facto position of issuers of the currency. When you go to a bank for a loan the money which the bank puts into your account does not exist until the bank creates it out of thin air and “lent” it you. In other words, that commercial bank created more currency units without a corresponding increase in goods and services to maintain the currency’s value. As long as you don’t use the newly deposited money now sitting in your checking account to buy goods/services you won’t be creating inflation but that is unlikely because one generally does not take an interest bearing loan without the a probability of spending the money of greater than zero. In the meanwhile the banking system charges the borrower interest on money on which in effect it only pays interest on 10% of the balance and the other 90%, which the banking system wished into existence, it pays net zero.  As a numerical example, if you go to the bank and borrow 1000 at 4% the bank does not pay a depositor say 2% on 1000. Because of the magic of fractional reserve banking the banking system pays a depositor 2% on 100 and charges the lender 4% on 1000. The missing 900 was in effect pulled out of thin air at zero cost to the bank. To be clear, one has to look at this on a system basis, not an individual bank basis. Just looking at the interest, for the 1000 loan it receives 40 in interest and pays 2 to the depositor.

Net Interest Margin, or NIM in short then is a deceiving measure because it doesn’t equalize for dollar amounts but for percentages.

As a suggestion then in fractional reserve banking then one theoretically should be able to borrow and lend at the same rate as the fractional 90% at zero cost provides the profit margin.


As an aside, inflation is similar to obesity in that a large pantry does not make you fat, but consuming its contents faster than one uses the energy content does. Money is similar that way; as long it is not used to buy goods/services there won’t be upwards pressure on prices. And that is why the Federal Reserve pays interest on reserves; as long as the money is parked at the Fed not too much money is chasing goods/services, thereby containing the quantity of money available to buy goods/services. It is likely though that at some point those reserves will no longer be parked at the Fed at which point roughly 10 times that amount will be available, although not necessarily used, for investment/consumption.


Zero inflation in a complex economy is difficult to achieve because there are so many different moving parts both on with respect to the demand for goods and services as well as the combined currency supply of the Fed and commercial banks. As the quantity of goods and services changes continually the money supply in an ideal world would change in the same amount at the same time. That is highly unlikely to happen. Take a look at BEAs GDP series – the Q/Q gyrations are significant and it would be impossible to match the quantity of money in real time.

Human activity is by nature deflationary. Whatever we humans do, we will try to do it better/faster the next time we do it. And generally we succeed. The change from one try to the next may not be necessarily significant but even a 1% improvement adds up quickly.

Saturday, August 25, 2012

Fed Musings

I’m going to post a short series on The Federal Reserve, its mandates and some of the consequences.

The stated mandates of the Federal Reserve, an institution which is neither federal nor has reserves, are laid out in section 2A of the Federal Reserve Act (as amended) the triple (not dual as so often is stated) goals are : "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”.

With regard to stable prices note that on February 25th, 2012 Dr. Bernanke announced that the Fed’s inflation target was 2% because it was best aligned with the mandated goals of full employment and price stability.

The first observation is that Dr. Bernanke appears to be doing congress’s job by changing the mandate of stable prices without any apparent instruction to do so from congress.

 An inflation target other than zero by definition means that prices are not stable. If balance in your Certificate of Deposit went down by 2% per year you would not call the balance of your CD “stable”, yet that is exactly what Dr. Bernanke’s announced goal is.

Inflation has not been zero for a long time so one way to interpret Bernanke’s inflation target as acknowledging that the “stable” part of the mandate is not reality. However, as the only time in recent history the US has had negative inflation was in the 1920s and 1930’s and, depending on the horizon of analysis long term inflation seems to have settled out around 3 percent even the non-congressionally mandated target of 2% is problematic and a systemic bias which has socially disturbing consequences.  An inflation rate different from zero causes winners and losers by means other than the actor’s actions, and to the extent the Fed has an effect on inflation the Fed is in the judge’s seat against the specific direction (“Stable prices”) of congress.

Let’s take a look at inflation.

Inflation causes a transfer of wealth from those who save currency to those who borrow currency. Inflation is also a wealth tax on the currency part and the non-currency part of one’s wealth which depreciates and which requires currency to be maintained. An inflation rate other than zero therefore introduces an asymmetry in the financial system at large and in the allocation function between savers and investors/borrowers specifically.

Please note that the US government, with whom the Federal Reserve is closely aligned is a significant borrower in the financial markets. 

Inflation, and perhaps even more importantly, the variability of inflation and inflation expectations over time and the variability in extend to which specific baskets of goods and services are subjected to inflation therefore introduces a temporal bias in the term structure of inflation expectations and biases other than the fundamental value (whatever that is (a topic for another post perhaps)) of specific asset classes and economic sectors.

If one’s net worth is greater than zero cash is not the place to hold your net worth when inflation is greater than zero. Inflation drives wealth out of cash and into non-cash / real assets because generally non-cash assets will keep pace with inflation. One of the consequences of this is that it reduces liquidity because the holder of the asset faces a hurdle in switching asset classes – transaction costs and lack of pricing transparency. Furthermore, viewed purely from a “store of value” perspective, not a business venture approach, the non-income producing real assets most investors have access to have are negative carry assets. The negative carry on a home owner occupied house with zero financing is somewhere around 2% - the same as Bernanke’s inflation goal.  As a private individual even if you own non-income producing assets such as a forest or oil fields you will have negative carry because of property taxes, ongoing expenses and amortized transaction costs. The only holders of real assets who have significantly less negative carry, and perhaps even have positive carry are entities which receive taxes, not pay them – entities with the power to tax. Precious metals come with storage costs, whether implicit such is when one buys an ETF or explicit when one rents storage space.  

As an aside, don’t confuse commodity futures with real assets – for every long position there is a short position and the net of both is always zero.  Even if one were to buy a physical commodity and put it in storage, because of the negative carry nature of storage at some point the commodity will be sold back into the market so the net effect on quantity supplied is zero. However, it is possible that speculation increases the volatility of the commodity price and that very well may have knock-on effects on longer term supply and demand decisions.

Inflation then drives holders of cash to relative illiquidity with the attendant lack of price discovery and thereby interferes with capital formation because it hinders capital movement.

Note that this is in direct conflict with what the Fed and other central banks have been doing in recent times by attempting to “create liquidity” in a greater than zero inflation environment.

The medicine then is partially responsible for the disease.
To be continued.

Friday, July 6, 2012


Energy Return On Energy Invested and its variations is a metric frequently used to look at our efficiency in harvesting energy with respect to the energy input.

As an aside, regarding fossil fuels in day to day use we talk about energy production when strictly speaking we don’t produce coal/oil/gas but extract it and sometimes convert it.  Strictly technically speaking fossil fuels as well as renewables are solar energy; one is previously accumulated stock and the other is flow. Think balance sheet versus income statement.

EROEI is an attractive concept but has a number of issues which can reduce its utility significantly.  The main issue with EROEI is that it suffers from boundary issues along a number of vectors.

1.       The first boundary issue is that although it is relatively easy to measure the energy produced it is significantly more difficult to determine the energy consumed in producing the energy. Should only direct energy inputs be counted (for example the energy to turn the drill on an oil rig), or should second order inputs (the energy the workers on the rig used going to work) or even third order inputs (the energy used to make the car which the worker uses to go to the rig) count?

2.       Another boundary issue is that of the input fuel source. If the Input energy is fossil fuel based the EROEI analysis will tell you how efficient the energy extraction process is with respect to energy use, and therefore how much energy ultimately can be extracted. If, however, the input energy is renewable even if the energy conversion process is seemingly inefficient in at the end of the process one has in total more energy than one started, which is quite the opposite from when the input was fossil fuel based.

3.       Another consideration is that of the energy density of the fuel produced/ extracted. Generally the higher the energy density of a fuel the higher its utility is. Methanol and gasoline are both liquid fuels but one has a higher utility because of its higher energy density. Specifically, in mobile applications the energy density of the fuel you carry has a very direct impact on the end user utility.

Aside from boundary issues EROEI does not take into account the different utility associated with different energy carriers. Instead there is an implicit assumption that all BTUs are created equal. In real life though some BTUs are more equal than others.

Once you move from an entropic system (where energy flows from a highly concentrated state to a less concentrated state) to a negative entropy system (where you capture some form of diffuse solar energy and concentrate it) everything changes. Instead of running down finite energy sources you are now adding to the quantity of energy available. There will be other limits, but not energy per se. In a system relying on non-renewable energy, no matter what your EROEI is eventually you'll run out of fuel. In an open system therefore EROEI is interesting as a conversion efficiency measure, but irrelevant with respect to sustainability of the energy input of energy production.

If humanity wants to continue to exist in a form recognizable to us making the switch from an entropic energy supply to a negative entropy energy supply is unavoidable. Without making that switch the game will be over at some point.  We are starting to feel the first hints of limits to growth along a number of vectors, both on the input side as well as the output side of economic activity. Specifically, what you're seeing now is that there is a tension between a financial system which requires growth to exist and a natural system (resources) which naturally deplete and which have an extraction rate which at some point can no longer be increased. Switching to a negative entropy energy system would be an important step towards dealing with this problem.