Think, Invest! by

Thursday, September 27, 2007

It's the currency, stupid!

“Don't worry,” a friend told me this last week. “Bernanke is a very smart man. He's doing a good job. He's a much better economist than Greenspan. He's going to take care of us.”

While my friend is one of the most respected oil analysts in the country, I could not bring myself to feel the same level of confidence as he does. As I lay in bed each night last week, I keep hearing over and over what Ronald Reagan claimed were the 9 most dangerous words in the English: “I'm from the government, and I'm here to help you.”

I'm confident that forthcoming events will cause the public to lose faith in the Fed, but I’m perplexed as to why so many people are still hoping the Fed can save us from a situation they largely created.

What is the situation? Debt. Plain and simple. The U.S. is suffering from excessive debt. Don't believe me? Check out the statistics. Debt-to-GDP levels are at records, debt-to-output is at records, and debt-to-income is dangerously high [What I like about these measures are that they are relative to the size of the economy and therefore take into effect changes in inflation, population, and the like. In other words, with more people and more money, we can support more debt, but we cannot realistically support more debt relative to the size of our economy.] Government debt is reasonable relative to GDP and business balance sheets are strong, but consumer debt is simply too high. The z1 report from the Fed shows the consumer in good shape only because asset values have grown with debt, but if housing prices prove illusory, future z1 reports could reveal a much bleaker reality. The fact that the Fed cannot raise interest rates to 5.25% without slowing the economy indicates clearly that debt is a serious burden.

Furthermore, with all the fancy financial innovations, such as CDOs, CLOs, and
derivatives - not to mention the rise of leveraged hedge funds and private equity firms - our economy might be even more leveraged than stastics show. No wonder the Fed panicked and lowered rates 50 bps - even though major banks reported solid earnings last week.

Why have our debt levels grow so much? While there are undoubtedly many reasons, the simple fact of the matter is that the Fed has kept interest relatively low for 20 years. With the introduction of hedonics and substitution into inflation calculations in the 90s, inflation rates began to come out lower than previous forms of measurement. Measured the same way as in the 1980s, inflation has been way above the Fed Funds rate for a long, long time. To me, that's a clear signal to consumers that it's much better to borrow than save.

If a centralized committee (the Fed) is going to keep short-term rates below inflation rates, it is much smarter financially to borrow and buy assets. Look at housing as one example. Housing prices have gone up over the last nearly two decades while the value of the associated mortgages has gone down. With low real interest rates, it's the savers who are suckers! As John Stewart, who gave one of the best interviews of Alan Greenspan I’ve ever seen, asked “When you lower the interest rate and drive money to the stocks, that lowers the return people get on savings in the bank. So they’ve [the FOMC] made a choice: we would like to favor those who invest in the stock market and not those who invest in a bank…It seems to me that we favor investment but we don’t favor work…there’s this whole other world of hedge funds, short betting – it seems like craps – and they keep saying ‘Don’t worry about it, it’s free markets,”…but it really isn’t. It’s the Fed…It’s about making people believe the system is sound…If the stock market is high, people are confident in spending, and if it lowers, they feel less confident.” Amazing that a comedian came up with one of the better critiques of the Fed I’ve heard in a while.

“But if the economy slows because of the debt burden,” a business associate recently asked, “then wouldn't the economic slowdown reduce aggregate demand and therefore inflation?” That's the theory, and a large basis of Fed policy, but it's misguided. Because it doesn't factor in the currency effect.

In short, the Fed can inject liquidity into the U.S. market and support the U.S. stock market and banks, but it only moves the crisis of confidence from the lower lying banking level to the currency level (as we’ve seen in the past several weeks with the dollar reaching new lows). Bernanke claims that the Fed caused the Great Depression by not flooding the system with liquidity, but few remember that the market was getting ready to make a run on the dollar and the Fed was trying to defend the dollar and faith in the U.S. Back in those days, if you abandoned your currency, there were major consequences. Today, are there no such consequences?

The Fed claims that if inflation rises, they will raise interest rates, thereby reducing aggregate demand, slowing the economy, and eliminating the excesses that are causing capacity constraints and inflation. If the economy slows, the Fed will lower rates, which will have the opposite effect. This Fed model, however, is flawed, because what happens if there is a crisis of confidence, and people start moving money away from the dollar?

If the U.S. experiences a falling currency, the effect can slow the economy AND cause inflation. Just ask anyone who has lived in Argentina, Zimbabwe, or numerous other countries whose governments created more and more money supply to try to rescue their economies. If a country acquires too much debt, other nations (as well as the country's own citizens) can begin to lose faith in the strength of the currency. As the currency begins to sell off, the economy begins to slow. In an attempt to rescue the economy, the government prints more money, but that only causes a further fall in the currency, slower economic growth, and more inflation. While not Argentina, the U.S. is showing similar characteristics, which should - if the inflation of the 1970s is any lesson - be addressed immediately, even if that means a deep but temporary recession.

The risk the Fed is running is that if the world begins to lose faith in the dollar then the Fed is useless. The dollar, and their ability to print more dollars, is the source of the Fed's power. Without that, they will just be a bunch of useless academics. The great market thinker Peter Schiff was on CNBC this weak and he suggested that the Fed should have raised interest rates not lowered them. He made a similar argument as I’m making. He was literally laughed at – by his fellow panelists and by the interviewers. We’ll see who laughs last.

“But no one really knows the cause of inflation from the 1970s,” said my business contact, “There were many psychological components.” My oil analyst friend said something similar: “There is a psychological risk of panic. The Fed was right to lower 50 bps.” While it would be foolish to deny a psychological element to movements in markets, these “moods” are temporary in nature and are only caused by underlying fundamentals. The crash of 1929 could not have occurred without massive debt growth throughout the 1920s. Was it the panic that caused the Great Depression, or the euphoria that led to the excessive debt build up that caused the panic? By 1929, the fundamentals in the economy were weak and prone to collapse. Conversely, with nearly $1 trillion in currency reserves, China is looking very strong. I can't imagine a run on the Chinese currency for “psychological reasons!” It’s almost preposterous to say that. Sure, there could be a run on the dollar for psychological reasons, because people around the world could wake up and see the fundamentals for what they are! So we should focus not on trying to prevent the “psychological panic,” but we should focus on the root sources of weakness in our economy, what caused them, and how we can fix them.

A final point I'd like to make is what I'm calling the debt productivity theory. The theory is quite simple, but if proven to be true, it would have tremendous consequences in terms of how the Fed conducts its monetary policy. The theory surmises that low interest rates are highly beneficial in the short run. They encourage the acquisition of low-cost debt, which provides extra growth and seemingly increases productivity, because more low-cost debt actually reduces a company's or a consumer’s costs. However, when debt levels become too high, and rates must be raised to continue to attract capital, the opposite effect is true. Debt costs go up, and productivity goes down. The implication is that lowering rates might help the economy in the short-term, but it has a strong hangover effect, especially when debt levels are allowed to get too high relative to GDP, output and input.

So when inflation comes, don't buy the “surprise” that officials express. There have been many people warning of the consequences of higher debt for years. It's like the CEO of Countrywide, who claimed the market for housing was great, great, great. He did so for years. Finally when the bubble went pop, he expressed total and utter surprise. Surprise?

According to the New York Times, “In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. ‘There is room,’ he wrote, ‘for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing.’ As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst. Now the question is what can replace the housing bubble.”

Wednesday, September 26, 2007

More Oily Thoughts

My oil post drove record traffic on my blog! Thanks to everyone who visited.

I wanted to follow up with some brief additional thoughts that have been inspired by discussions on my FAVORITE investor board, the FAX board at

On that board, there has been a lot of talk about whether oil is experiencing an unsustainable price boom similar to housing, internet stocks, and other past bubbles.

I have argued that the run up in price for oil has been driven by real demand, a demand which is necessitating the addition of supply in the near and immediate terms. Because it is not easy to create additional oil supply quickly, the market is driving prices higher and rewarding those who risk their capital on new, expensive oil projects. The fear is that eventually these high prices will lead to too much euphoria and too much investment in new supply. However, I don't think we're there yet, as the forecast for new mega-projects shows only marginal supply additions coming online over the next several years.

From my point of view, the real issue is demand. Until the central bankers of the world get serious and raise interest rates to reduce demand, high prices should continue to exist, especially given the potential for price spikes because of the limited amount of excess spare capacity. Therefore, I would expect high price to remain in place until we see evidence of inflation in the U.S. CPI numbers and a willingness on the part of the Fed to address this inflation.

Of course, this forecast assumes that the Fed will act aggressively in the event the U.S. economy begins to slow. My belief is that the economy is already slowing significantly and that the Fed will continue to lower rates. Remember, the Fed is a political organization (despite their claims at independence). They are under tremendous pressure to keep the economy out of recession in the short term. During a recession, the pressures to lower rates are enormous, even if inflation is beginning to increase.

Looking a year or two out, sustained high prices might lead to a plethora of new supply projects just as the Fed is being forced by higher inflation to end its 20+ year policy of consistently lower average rates. That would indicate a good time for investors to begin cashing in on their oil investments. Until then, I think oil and natural gas continue to be the best investment to protect against the irresponsible policies of the Fed.

Finally, here is a good piece on the Apache website about how this upcycle in oil is being demand driven:

"During the past 20 years, each region of the world, except Africa, has experienced declines in oil demand. However, there have been only two minor decreases in worldwide oil demand in the same time period: 19,000 barrels per day (Bpd) in 1991 and 141,000 Bpd in 1993.

"Nominal oil prices rose dramatically in the 1970s and early 1980s, contributing to high inflation rates. The chart below shows a spike in oil prices associated with U.S. economic recessions. Those spikes were generally caused by supply disruptions. On an inflation-adjusted basis, current oil prices are still not at the level reached in the early 1980s. The recent rise in prices has been caused by a strong growth in demand rather a supply disruption. Despite a dramatic rise in oil prices, no recession has yet occurred and inflation has remained in check.

"During the past four years, the U.S. dollar has fallen over 30 percent against major currencies. Because oil is priced in U.S. dollars, the rise in oil prices has had a lesser impact on foreign buyers of oil."

Monday, September 24, 2007

On Oil and Natural Gas

In many previous posts, I have talked about the negative consequences of Federal Reserve policy and the seemingly imminent threat of inflation.

In this post, I'd like to talk about something positive: how to make money from what’s happening in financial markets.

In the world economy, competition for labor and resources is heating up. So far, this competition has been most evident in the price of oil - in large part because oil is so easily transportable and because it is so important to every economy. Oil is not only important for transportation but also for the manufacturing of petrochemicals, which are used for so many purposes.

However, with oil prices having risen from $12 in the late 90s to around $85 today, it is fair to ask: is this just another bubble waiting to pop?

In investing, my preference is always to ignore the "psychology" of the market, to try to understand the fundamentals, and then to set a long-term horizon for my investments (by not being leveraged or overcommitted in any way – in case my trades move against me even as the fundamentals stay in my favor). I believe that over the long term markets are rational (even though they can be highly irrational in the short run, cough,

So, what are the fundamentals for oil and natural gas?

Today, according to the International Energy Agency ("IEA"), oil consumption is currently slightly ahead of production. IEA figures estimate demand at 85.9 million barrels a day ("mb/d") and production at 84.6 mb/d.

Despite alternative sources of energy and energy efficiency initiatives, demand for oil has grown tremendously over the last 30 years. In 1980, demand for oil was a little over 60 mb/d. After the 1981 recession, demand sunk just below 60 mb/d, but has since climbed to over 85 mb/d. With emerging economies growing quickly, demand is estimated to continue to grow. According to the U.S. Department of Energy, worldwide production is expected to increase to 98 mb/d by 2015 and 118 mb/d by 2030.

Growth in oil consumption is being driven by strong demand from Latin America, the Middle East & Africa, and Asia. In the early 80s, Latin America consumed around 3 mb/d. Today they are consuming over 5 mb/d. In the early 80s, the Middle East & Africa consumed around 3.5 mb/d. Today they are consuming around 9 mb/d. In the early 80s, Asia consumed around 9 mb/d. Today they are consuming over 18 mb/d.

India's demand alone has grown from under 1 mb/d in the 80s to nearly 3 mb/d today. China's demand has gone from around 1.5 mb/d in the early 90s to around 6 mb/d today. No wonder the U.S. Energy Information Administration expects China's demand to triple by 2030. India and China have over 2 billion citizens combined, versus 300 million for the U.S., yet their combined oil consumption is around 9 mb/d vs 21 mb/d for the U.S.

Another factor driving consumption growth is central bank policy. Money supply worldwide is growing extremely quickly, meaning more consumers have more money to spend, even in spite of higher oil prices. Until central banks launch a serious campaign to raise worldwide interest rates and reduce aggregate demand, oil consumption growth should continue at a rapid pace. Money supply in China is growing around 15% a year. The same is true in India. Even M3 in Europe is growing around 10% a year, and reconstructed M3 in the U.S. is likely growing by similar amounts. Oil-rich countries in the Middle East are experiencing even faster money supply growth.

Although some central banks are starting to show slight concern about inflation, few of them have taken serious steps to reduce their money supply. In the 1970s, it took nearly a decade of inflation for the U.S. Federal Reserve to become serious about fighting inflation. Many pundits and economists expressed surprise at the cause of inflation, despite the conclusion by Milton Friedman that: "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output."

Despite the rapid growth of money supply worldwide, central bankers are hesitant to take the tough and unpopular step of raising interest rates, as evidenced by Bernanke's testimony last week. Ron Paul was lambasting Bernanke, claiming a weak dollar would lead to more imbalances and difficult times. Bernanke essentially responded that as long as core inflation remained contained, a weaker dollar was not a problem. The implication: even if oil prices are high, the Fed will keep interest rates low. Only if workers start demanding higher wages in the U.S. will the Fed take any action.

Although the supply of new oil has just managed to keep up with consumption, excess capacity has fallen. Oil production is very difficult. There are often outages, due to storms, due to technical problems, such as pipeline or refinery issues, and due to political conflicts. Outages are normal for the oil industry and lead to quick, large, yet temporary spikes in price. Because it is known that outages occur so often, the oil industry relies on excess capacity, which is production that can be brought online quickly but which is not currently producing.

During the oil embargo of 1973, excess capacity shrunk to 3 mb/d. During the Iranian revolution of 1979, excess capacity was down to 4 mb/d. During the 1980s, excess capacity climbed up to nearly 11 mb/d. Where is it today? It is estimated to have sunk to around 1 mb/d a couple of years ago, and to be around a little under 3 mb/d today. Given the growth in consumption from 60 mb/d to 85 mb/d, excess capacity is extremely low, even as China, India and others consume more and more. If a political event disrupts the flow of oil now, there is hardly any cushion.

Oil rigs are used to drill for more oil and establish new, producing wells. Rigs counts went from 2,000 in the early 70s to over 6,000 in the late 70s. Following the oil bust of the early 80s, rig counts declined to nearly 1,000 by the late 90s. With the rise in consumption, rig counts have since climbed back to 3,000, but with production declining in many major oil fields around the world (the North Sea, Mexico, and even Saudi Arabia according to some estimates), rig counts may need to go even higher to meet growing demand.

Meanwhile, natural gas prices have diverged significantly from the price of oil. Historically, the price of oil has averaged around 6.2 times the price of natural gas. In other words, if oil is $80 a barrel, natural gas would normally trade at $12.90 per mmcf. Why? Because there is an energy equivalency of 6.2 times between a barrel of oil and a mmcf of natural gas. However, natural gas is not $12.90 per mmcf. Rather it ranges from $6.30 for the forward month contract up to $9.12 for natural gas delivered in the winter of 2009. In other words, natural gas is extremely inexpensive relative to oil by historical standards.

Why? For starters, natural gas is not as easily transporable as oil. Therefore, its price is driven by supply and demand in regional markets. Since Hurricane Katrina, there have been no major outages of natural gas supply in the U.S., there has been increased production (as a result of the high prices after Katrina), and the summer and winters have been mild, resulting in reduced consumption. As a result, natural gas inventory levels are about 13% above their historical averages. If natural gas exceeds storage capacity, producers have no other option than to burn the natural gas. These burn-offs are extremely costly and wasteful.

While the threat of burn-offs is real, especially if this winter is mild, for long term investors natural gas represents a great value. Natural gas is domestically produced in large quantities and doesn't have to be shipped from the Middle East, Venezuela, Nigerian, and other politically sensitive parts of the world. It burns more cleanly than oil and therefore is better for the environment. And now it is significantly less expensive. That's why industry tycoons like T. Boone Pickens have started companies like Clean Energy Fuels, which is producing natural gas to be used to power buses and cars. It may take a long time, but eventually more natural gas and less oil will be used in the United States, until the price ratios come back to around 6.2.

So how can we make money given what is outlined above?

My idea has been to invest mostly in domestic oil and gas producers. They are U.S. companies, with all the transparency and legal protection that comes from owning U.S. companies. Many also have debt in U.S. dollars, which benefits as the dollar falls and oil prices go up.

My favorite stock is Devon Energy (symbol DVN). DVN has first rate management that understands the financial and macro elements of the oil and gas industry, but they are also showing how effectively they can manage their assets by growing production through the drill bit. Production at DVN is increasing around 10% a year, which produces excellent results in times of rising prices. They also get about 60% of their production from natural gas, which means they can benefit if natural gas prices return to their historical ratio with oil. DVN also does a great job of managing their risk. Most of their assets are in steadily producing wells, while a small portion of their assets is in high-risk exploration. DVN recently was upgraded by Moody's because of improvements in the company's leverage and production.

Another company I have bought is Compton Petroleum (symbol CMZ). They have not done well with what has happened to the price of natural gas. CMZ is a Canadian natural gas producer. They have grown their company in a fast, strategic manner. They want to continue to grow in a way where they can manage costs and leverage the development of their highly-effective, efficient production team. While natural gas has performed worse than oil, especially in Canada, I believe this company will do well over the long term, whenever natural gas prices rebound. The only downside is that they are Canadian (no offense to our Canadian brethren, but Canadian companies can oftentimes be less investor friendly and subject to a government that is less business-oriented).

Another company I am considering buying is EOG Resources (symbol EOG). EOG is very conservative and smart. They are not leveraging their company, leaving their options open. They have proven themselves to be very effective in terms of increasing production organically (without acquisitions). Currently they are increasing production by 10 to 12 percent a year. As a conservative, domestic producer with exposure to natural gas, they are well positioned should natural gas prices rise.

I also own Exxon (symbol XOM) because of how well managed they are, and how diligent they are about using their capital only in projects that have compelling returns.

I recently add ConocoPhillips (symbol COP) because of their valuable refining assets, their investment in Lukoil, and because the company seems to be taking steps to restructure and improve their operations. COP has traded at a discount to other majors over the last several years, but their restructuring efforts may provide an extra boost soon.

Another new favorite is InterOil Corporation (symbol IOC). IOC is engaged in the exploration of natural gas and oil in Papua New Guinea. The company is a fully integrated, with upstream, midstream, and downstream assets. Exports should benefit from Asia’s growing appetite for oil and gas. Of note, T. Boone Pickens recently made a large investment in the company.

Why isn’t Clean Energy (symbol CLNE) on the list? Valuation. If it comes down in price dramatically, I’ll definitely add some. I think Pickens is a genius, and I love the idea of using natural gas to power buses and cars. Even with CLNE’s growth prospects, though, it seems overvalued.

Other oil and natural gas companies aren’t as highly priced as CLNE, but they aren’t exactly cheap. By historical standards, oil and natural gas companies are highly valued relative to their book values. However, given the irresponsible actions of the worlds' central bankers, the increasing demand/supply imbalance in oil, and the divergence in the price of natural gas, I will continue to buy high quality oil and gas companies on dips in their stock prices. I'm not buying today, but if prices pull back 10% or so, I'll start adding more to my already significant positions.

Wednesday, September 19, 2007

The Zentay Cycle

Having been born in the early 1970s, I remember coming of age politically to two important lessons. We will never forget, I heard pundits, politicians, and academics sayings, that:

1) The U.S. should not engage in any military action that is not definable and achievable;
2) Inflation should be contained at an early stage, no matter what the cost.

As such, it is with great disappointment that the two unforgettable lessons of my early childhood have seemingly been forgotten, and I haven’t even turned 35. Sidestepping the politics of the war, I’d like to focus on inflation. I’d like to explore why we have abandoned our previous caution and why the later part of this decade threatens to look a lot like the late 1970s.

As my good friend, Michael Nystrom, and I were discussing today, one of the biggest problems – and most frustrating problems – that America faces is that so few people see or care about how credit & money supply growth are creating imbalances in our economy. Because so few people care about monetary policy and economics, pundits, politicians, and academics take advantage of peoples’ ignorance to point them at the wrong causes of the problem (except, of course, Ron Paul, who’s a brave politician who points out the importance of strong money). Backing up and taking a more generalized view, we can see the cycle of money supply growth and inflation in action. The model I have developed for this purpose is the Zentay Cycle (a very modest name indeed). As many readers may recognize, this cycle owns a great debt to the Kondratieff Cycle, after which it is modeled. The difference, or rather extension of the Kondratieff Cycle, is that the Zentay Cycle seeks to bring in politicians and bankers and explain their participation and reactions within the various seasons of the cycle.

Spring of the Cycle – This is the season in which I came of age, from around 1984 to 1992. The Spring is the most intellectually pure stage of the cycle. The harsh Winter of higher interest rates and economic recession has passed (Volcker raising interest rates and forcing the 1980-81 recession), but society remembers the lessons from persistently high inflation. Central bankers are conservative and are supported in their calls for interest rates high enough to fight off inflation. Bankers and investors agree with central bankers. Bond vigilantes sell long-term bonds at any hint of inflation or whenever central bankers appear to be less conservative than is necessary. High interest rates from the Winter have left the consumer landscape with low levels of debt. Politicians may try to raise taxes or increase spending, but they only have limited success, as central bankers and pundits claim that higher taxes will slow economic growth and increased spending will cause inflationary deficits. Gradually, the high government debt levels from the Winter come down somewhat. At the start of the Spring, businesses have high debt levels and low price-earnings ratios. They begin to reduce their debt levels over time. Average interest rates begin to move lower, as the fear of hyperinflation recedes. Shockwaves of fear appear from time to time (such as 1987 and 1991), but in general the Spring is an improvement from the Winter. Central bankers are respected and increasingly well regarded. Politicians are neither popular nor unpopular. Bankers are moderately successful. Average citizens do okay, not great.

Summer of the Cycle – This is the happiest time of the cycle, from around 1993 to early 2000. The shockwaves of fear dissipate. Average interest rates come down more, government debt levels are contained, and economic growth accelerates, creating a wealth effect throughout many levels of society. The more wealth is created, the less conservative participants become. With economic growth, consumer and businesses are more willing to add debt. The debt and credit creation adds more growth and the perception of productivity gains. These productivity gains allow central bankers to relax their conservative stance towards interest rates. Lower interest rates lead to lower costs of capital, the perception of even more productivity gains, and more debt and credit creation, with all the ensuing short-term benefits. Faster economic growth leads to government surpluses. Businesses do very well, keep debt levels reduced, and see their price-earnings ratios expand. Central bankers and politicians are wildly popular. Bankers are successful. Average citizens do well. Class tensions ease. Everyone is generally happy.

Fall of the Cycle – This is the time when problems in the cycle begin to emerge, from around mid-2000 until 2007. A recession or market crash creates a slowdown in economic growth and aggregate demand. Central bankers, less conservative because of their success and popularity in the Summer, lower interest rates to “save” the economy. Debt, credit, and money supply increase even more dramatically, which temporarily leads to a mini-summer and the perception that nothing is wrong. However, productivity levels begin to decline as the burden of debt leads to systemic imbalances. Mild hints of capacity constraints and inflation appear from time to time. As the mini-summer begins to fade, more serious problems emerge. Politicians are increasingly unpopular. Businesses add more leverage, oftentimes through innovative and off-balance-sheet mechanisms. Bankers continue to be successful through increased leverage, but average citizens struggle. Class tensions begin to escalate towards the end of the cycle. Skepticism towards leaders and centralized institutions is rampant.

Winter of the Cycle – In an effort to prevent the onset of Winter, central bankers try to lower rates dramatically, and begin to do whatever they can to create more credit and money supply, but economic problems remain. Politicians, unsatisfied with the results from the central bankers’ actions, call for more government spending and government-induced demand-side solutions. Central bankers continue to call for restrained spending by politicians, but central bankers are less and less popular and lose credibility. Taxes are increased to cover the expenses of government programs. Productivity falls. Inflation begins to increase persistently as capacity constraints spread and demand-side solutions exacerbate these constraints. Pundits wonder at the cause of inflation and many short-term solutions are proposed with little success. Economic growth flounders and unemployment increases. Bankers lose money as confidence in the financial sector falls and long-term interest rates rise. Businesses and banks suffer from lower economic growth and the higher leverage incurred during the Fall. Bankers, too, turn on central bankers. Class tensions are high as different parts of society fight over the validity of different government-sponsored solutions. The Winter is long and hard. Exhausted by the duration of the Winter and already wildly unpopular, central bankers come to the realization that the only way to end the Winter is the opposite of their past solutions. Rather than creating more credit and money supply, they seek to dramatically reduce credit and money supply. Interest rates go up significantly, economic recession is harsh, citizens suffer, businesses and banks are hurt, but the end of inflation and Winter is achieved.

If the Zentay Cycle is in fact correct, I believe we are at the cusp of generating higher inflation. Productivity gains from the Summer are fading, credit and debt levels are too high, central bankers are beginning to try very hard to increase liquidity, and politicians are starting to talk about demand-side solutions. However, employment levels are already high, capacity utilization is high, and other parts of the economy show little excess capacity. Certainly housing is in decline and has excess capacity, but housing seems to be the exception rather than the rule. For example, more oil is being consumed worldwide than produced. Fertilizer companies are reporting significant demand and an inability to meet some customers’ orders. Hotels are often full and prices are going up. Airlines are operating near full capacity and starting to raise rates for the first time in many, many years. The important core-driver of unit labor costs is now increasing 5% a year. In other words, economic volatility is NOT reducing costs.

Unfortunately, those in power have not seemed to have learned the lessons of the past. The late 2000s is unlikely to be identical to the late 1970s. “History,” Mark Twain said, “doesn’t repeat itself, but it does rhyme.”