The intersection of where supply meets demand is the point where prices get set.
This lesson is the basis of all classes on economics. It was drilled into me at college and graduate school by my professors. The principal is the basis of all economic theory implemented by Wall Street as well as government officials. Without it there would be no way to measure and track prices.
However, given the economic stagnation that has permeated the U.S over the last eight years, the U.S. has gone on a money printing scheme the likes of which the world has never seen. The Federal Reserve, the United States central bank, has “printed” more than $2 trillion since the global economic crisis began in 2008. This has more than tripled the size of its balance sheet. Prior to beginning this paper money creation spree, the Fed held $950 billion in assets; now it holds nearly $3 trillion.” (This number is dated and actually much higher today). Since we had no demand, the U.S decided to print more money (supply) so that people would actually go out and purchase things as well as invest in order to increase demand.
The basis of sound investing is the principle that you earn a good rate of return given sound fundamentals. However when so much money is printed and flooded into the economy, the price of things naturally goes up; and, its at this point that investing becomes quite difficult. At that juncture, you have to decide if the investment looks good on its merits, or looks so because the amount of money that is in circulation is causing the price to go up.
Investors throughout the world grabbed the billions being created by the government and made bets on certain sectors where they thought they could make money. A rising tide lifts all boats; but, as business magnate, investor and philanthropist Warren Buffett said, “when the tide goes out you get to see who’s been swimming naked.”
To understand the consequences of this, take a look at oil.
“Spending on global oil production has increased by around 350% since the early 2000s. Back then, the global oil exploration and production industry was spending around $150 billion a year on capital investments. By 2013, that figure had grown to more than $500 billion a year. In the U.S. alone, the 50 largest oil and gas production companies in 2013 invested nearly $200 billion into new production.”
The U.S discovered so much oil that its now the second largest producer of oil in the world. Drivers in the U.S are ecstatic that they are now paying less at the pump. But these lower prices are a result of the billions of dollars that went into that industry. What about the investors who poured that money into oil?
The industry is in trouble because a lot of the capital used was raised via debt. Since 2007, total debt in the U.S. exploration and production sector has gone from $125 billion to almost $300 billion. Much of this debt is destined to default. These defaults are going to wipe out many companies and many investors.
These defaults are a direct result of too much money chasing too few goods. The investors thought they were making good decisions; but, the influx of all this money tricked them. The investments in oil were made because the price of oil was high and investors could borrow money easily. Most investors in this space had no idea that the price of oil would drop dramatically. But, when you have smart people and $300 billion dollars flooding into the oil sector, the inevitable happened: they found more ways to extract oil from the earth.
The oil sector is not alone in this phenomena. In the end, the flawed decision by policy wonks to create more cash to get the economy going will cause much more capital destruction. Last year along renewable energy attracted $329 billion. I believe much of this money will be destroyed as well. Even as money pours into that sector, defaults are already surfacing. Sun Edison, a solar company valued at $10 billion a year ago is facing a $1.4 billion default.
This money creation has also effected many real estate markets here in the U.S. Major cities, such as Manhattan and San Fransisco, have seen prices skyrocket as the wealthiest people in the world have bought homes in order to make money from the certain price appreciation. The rich know that when the government turns on the printing presses it is time to trade dollars for assets. The poor and middle class do not have this opportunity available to them as they do not have the disposable dollars to invest. Once again those sectors of the population will feel the brunt of this as they get priced out of these markets.
The decision to print money to bolster the economy will not end well. History is replete with examples showing that no country has ever spent its way to prosperity. The same way households have to contract spending and make priority decisions on necessary spending when attempting to wipe out debt, so too nations. After 2008, the U.S had a chance to clear the decks and eliminate many companies that had made bad fiscal decisions and were on the verge of collapse. Instead, the financial sector as well as the auto industry were “rescued (read: “bailed-out”) instead of allowing them to go under. Those bad debts did not disappear. The government just restructured them and printed a boat load of money hoping the problems would go away. They did not. They remain…bigger and worse than before.
We now have a second default wave coming from the oil and renewable energy sectors that, once again, will put us in the same or worse peril than did the housing crisis.
Don’t kill the messenger.