– John Kemp is a Reuters columnist. The views expressed are his own –

Resounding defeats for Democratic Party gubernatorial candidates in Virginia and New Jersey on November 3 have killed any lingering hope Congress will enact climate change legislation this year, and may doom the prospect of passing a cap-and-trade bill this side of the 2010 mid-term elections.

Prospects for eventually passing legislation may now depend on winning Republican support with nuclear loan guarantees and more offshore drilling.

While the president remains personally popular, with high approval ratings, and does not need to face the voters again for another three years, 16 Democratic senators and 256 Democratic members of the House of Representatives will be on the ballot in November 2010.

The Virginia and New Jersey off-cycle elections are often idiosyncratic. But crushing defeats for Democrats at the top of the ticket in both states are already sparking a bout of soul-searching over the lessons that need to be learned if the party is to retain firm control of both houses of Congress next year.

What worries many Democrats is that turnout among the young voters who helped propel them to victory last year fell away sharply, self-identified independents broke heavily for the Republican candidates; and voters overwhelmingly cited the economy and jobs rather than healthcare or climate change as their major concern in exit polls.

Democrats face the classic dilemma for any party after a defeat — press ahead trying to enact a difficult agenda or pull back, re-focus on simpler and less controversial measures.

The White House insists both defeats were due to local factors (a poor candidate in Virginia, a souring economy in New Jersey) and will not change the president’s determination to press ahead with an ambitious domestic agenda centered on healthcare reform and climate change.

But the party’s congressional wing is divided. Liberals (mostly from safe seats at little risk next year) argue the administration and party should press ahead; voters will rally behind a record of accomplishment next year. Moderates and conservatives (mostly from swing seats or those carried by John McCain in 2008 or George W Bush in 2004) as well as those from heavy industrial states are pressing to scale-back and refocus on cutting unemployment.

In this context, it seems unlikely the administration can find the 60 predominantly Democratic votes it needs to pass a climate bill on the floor of the Senate; hammer out a compromise between the differing House and Senate versions in conference; then secure simple majorities in both houses to pass the agreed bill into law.

Even before this week’s election results, the prospects for passing climate change legislation this year were dimming rapidly. But the arithmetic, already challenging, has now become very tricky as the administration loses momentum.

60-VOTE DOUBT IN SENATE

In the Senate, only two Democrats are up for re-election in Republican-leaning states carried by John McCain (North Dakota’s Byron Dorgan and Arkansas’s Blanche Lincoln).

Both have already taken a cautious approach to climate legislation. Both broke ranks with the majority of their colleagues earlier this year to vote for a Republican amendment preventing the budget reconciliation process being used to push through cap-and-trade on a 51-vote straight majority rather than the 60-vote super-majority normally needed to end a filibuster.

But the party remains ambivalent over cap-and-trade, split between liberals from coastal states who want a commitment to tough emissions reduction objectives, and senators representing industrial areas or conservative states anxious about supporting anything that could be portrayed as a costly, job-killing energy tax by their opponents at election time.

In theory, the Democratic Party (together with its independent allies) has the 60 votes needed to push a climate bill through despite almost uniform Republican opposition. In practice, the party broke 26-31 in favor of the Republican amendment to the budget resolution earlier this year, in what many saw as a straw poll on cap-and-trade.

Some Democrats have fallen into line since then, and the administration may be able to pick up one or two Republican votes such as South Carolina’s Lindsey Graham with the promise of loan guarantees and other government help for the nuclear power industry.

With several Democrats harbouring concerns, though, there are not yet 60 votes for an ambitious climate bill.

The bill will not be openly defeated on the Senate floor. If it dies or gets delayed it will be in the cloakroom. Majority Leader Harry Reid will not bring it up for a vote unless and until 60 firm votes are in his pocket. So Democrats with doubts will be able to delay the bill indefinitely by holding out and asking for more concessions, without having to come out explicitly against it.

RISK OF REVERSAL IN HOUSE

The arithmetic looks as daunting in the House of Representatives. While the lower chamber has already approved its own climate bill (HR 2454) legislators will have to vote again to pass the consolidated version if and when it is agreed in conference.

There is nothing to stop congressmen changing their minds. As the election draws closer and the already bitter partisanship in the chamber intensifies, some of the bill’s earlier supporters may withdraw.

The original bill passed only by the narrowest of margins (219-212), with 44 Democrats voting “No.”

A total of 84 Democrats represent Republican-leaning districts carried by John McCain or George W Bush in 2004. It will take only a handful of further defections to sink the measure if it returns from conference.

If the consolidated bill has been toughened in line with the Senate version (S 1733), congressmen will have a ready-made excuse to claim it has gone too far.

Parties controlling the White House usually lose seats at the mid-term elections, so pressure on Democrats in Republican-leaning areas will be immense.

The party’s heavy losses in Virginia and New Jersey this week will make them very cautious.

CROWDED AGENDA, LOSING MOMENTUM

Arguably, the president has tried to push through too many ambitious reform proposals and stretched his political capital too thinly.

At the best of times, it would be difficult to get either healthcare reform or climate change through Congress when the president’s majority is an uneasy coalition of liberals and centrists. But when the president is having to deal with a recession, financial regulation, and whether to increase the military commitment to Afghanistan, it has proved impossible to rally support for them both at the same time.

Hopes that healthcare and climate change legislation could be rammed through early in the year, long before the mid-term elections, while the Republican Party was still consumed by infighting after losing heavily in 2008, have evaporated.

Climate change has become a second-order priority. The political capital needed to assemble winning coalitions for a bill in both chambers is being deployed elsewhere.

The best option for the administration may be seeking to broaden its coalition, buying more Republican support through a combination of nuclear financing guarantees and greater access to offshore drilling.

But if an agreed climate bill does not go through before the year end, its prospects next year, when legislators will be fixated on the looming elections, are no better.

(John Kemp is a Reuters columnist. The views expressed are his own)

Warren Buffett’s acquisition of the remaining 77.4 percent of Burlington Northern Santa Fe (BNSF) railroad his Berkshire Hathaway does not already own looks like a strategic bet that America’s future energy needs will be met, in large part, through a massive expansion in coal-fired power generation coupled with carbon capture and storage (CCS).

Coal is the most important item moved on BNSF’s railroads. It accounted for almost half the tonnage moved by BNSF in the first nine months of the 2009 (214 billion revenue ton miles out of a total of 444 billion) and a quarter of the company’s revenues ($2.7 billion out of a total of $10.4 billion).

BNSF’s track and rights of way are perfectly positioned to benefit from a massive expansion of the country’s coal-fired output in the next 20 years, coupled with CCS technology to curb the carbon-dioxide emissions.

BNSF controls the crucial rails linking the massive domestic reserves of the Powder River Basin, the Northern Great Plains, the Western Interior Basin and the Illinois Basin east to the main industrial centres of the Midwest and west to the major electricity demand centres in southern California.

* http://pubs.usgs.gov/of/1996/of96-092/Comp/main.gif
* http://www.eia.doe.gov/cneaf/coal/reserves/chapter1.html#fig1
* http://www.bnsf.com/tools/reference/division_maps/?menu=5&submenu=0
* http://graphics.thomsonreuters.com/109/US_ENRGY1009.gif

– John Kemp is a Reuters columnist. The views expressed are his own –

The Bank of England’s decision to continue with its asset purchase programme, or quantitative easing (QE), at the rate of 50 billion pounds per quarter in Oct-Dec, unchanged from Jul-Sep, shows bank officials are more worried about ending support for the recovery too soon than about risking inflation by leaving it too late.

The problem with QE is that you have to keep buying the same amount of assets each month to maintain the same monetary stance. With interest rates, the Bank can cut them and they stay cut. If asset prices drop with QE, it represents a tightening of monetary policy.

The Bank initially bought 75 billion pounds in the first 3 months (Apr-Jun) and then tapered this to 50 billion in the second three months (Jul-Sep) as the crisis engulfing the banking system and the rest of the economy eased. A cautious approach might have tapered the QE programme again to 25 billion in the final three months of the year before ending it entirely at the start of 2010. But the Bank opted to stick at 50 billion.

Critics point out that the programme has not achieved its announced objective of increasing bank credit and the amount of money in circulation. The rate of growth in M4, the broadest money supply measure, has risen only marginally. But that ignores the counterfactual of what would have happened to M4 in the absence of the programme — it might have fallen sharply.

Growth in the monetary aggregates is, in any event, mostly endogenous. It depends on demand for credit. In the current environment, where many households and businesses have little or no collateral, credit is impaired, and most are focused on paying down debt rather than adding to it, limited growth in M4 is not surprising. Trying to make it grow faster is like force feeding a duck to make foie gras — possible but unnatural.

QE has always been as much about restoring confidence, dispelling fears about deflation and ensuring a ready market for the safer securities banks hold as much as growing the money supply. On most of these measures it must be considered a qualified, if expensive, success. A full judgement will only be possible when the Bank has proved it can withdraw the excess liquidity in a timely manner to prevent an upsurge in inflation.

In the end, the decision to press on is driven by fears about the fragility of the current recovery, and the risk that if QE ends too soon, effectively tightening policy, whatever green shoots have emerged over the summer will be killed off by an autumn frost.

All recoveries are fragile and weak early on. While the rebuilding of inventories along the supply chain, often provides the initial boost, this must eventually be replaced by a more sustained increase in household and business expenditure.

But with their new focus on the experience of the 1930s, central bank officials worldwide are more worried than normal about doing anything to stall the recovery.

Looming over the debate is the experience of 1937, when the Federal Reserve responded to concerns about the amount of “excess liquidity” in the banking system and sharp rises in the price of some commodities, especially steel, by doubling reserve requirements on banks in the space of nine months. It effectively converted previously “excess” reserves against which the banks could lend into “required” reserves against which they could not.

The four-year old recovery (1933-1937) promptly collapsed amid tightening bank credit, and the United States suffered the second deep recession in a decade, with output not fully recovering until the onset of war in 1940-41 (https://customers.reuters.com/d/graphics/DSTMIRROR.pdf).

Anxious to avoid a repeat, it is no wonder that the Bank of England is in no hurry to tighten policy. While this level of QE must eventually generate inflationary pressures, the Bank judges, probably correctly, that it still has some time before policy needs to move to a more restrictive setting.

-- John Kemp is a Reuters columnist. The views expressed are his own --

Like Archbishop Thomas Cranmer before he was burned at the stake for heresy, the U.S. Commodity Futures Trading Commission (CFTC) seems about to make a dramatic recantation.

Later today, the Commission will hold the first of three public hearings to discuss whether to impose tougher position limits in energy markets and restrict the availability of hedging exemptions. But it is already preparing to release a report that will accuse speculators of playing a significant role in last year's oil price spike, according to a report in the Wall Street Journal.

While it might seem a minor shift in emphasis, it is a radical reversal of the Commission's previously stated view that there was "no evidence" that investment flows had a material impact on prices. Commission staff have doggedly maintained that physical supply and demand factors could explain all the observed volatility in oil and other commodity prices over the past two years.

The position was stated most forcefully by CFTC Chief Economist Jeffrey Harris in testimony to the House of Representatives' Agriculture Committee in May 2008 (http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/harris-fenton051508.pdf).

It was repeated in September 2008 in the CFTC's "Staff Report on Swap Dealers and Index Traders" and again this year in a joint report with the United Kingdom's Financial Services Authority (FSA) on commodity regulation for the International Organisation of Securities Organisations (IOSCO).

The Commission's view has come under pressure from sceptical legislators as the scale of speculative positions in commodity markets and the number of exemptions the Commission and exchanges have granted have been revealed. Congressional anger threatened to derail Gensler's confirmation. The price of allowing him to take office seems to have been a promise to take a tougher approach.

The CFTC's position had become politically unsustainable. The climbdown was foreshadowed earlier this year when incoming CFTC Chairman Gary Gensler admitted in a pre-confirmation letter that "rapid growth in commodity index funds was a contributing factor to a bubble in commodities prices that peaked in mid-2008" and "the expanding number of hedge funds and other investors who were increasing asset allocations to commodities ... also put upward pressure on prices".

But most observers expected it to announce a shift only after the three public hearings planned for July and August, giving the futures industry an opportunity to water-down the conclusions. The Commission's early move suggests it does not intend to be side-tracked from determined reform by vested interests.

The shift is significant because it changes the question from "whether" to limit the impact of investment money on commodity markets to one of "how". The Commission has issued a set of questions for the hearings that include a strong presumption the outcome will be some form of tougher and more comprehensive position limits (http://www.cftc.gov/newsroom/generalpressreleases/2009/pr5681-09.html).

The move leaves the FSA increasingly exposed. It has not accepted there is a problem in the commodity markets it regulates, let alone agreed that the solution is tougher limits and more stringent regulation. The FSA's line is still that there is "no evidence" speculation has influenced prices. If the CFTC abandons that position, however, the FSA's could become intellectually indefensible, and London's sleepy regulator may come under strong pressure to fall into line.

- John Kemp is a Reuters columnist. The views expressed are his own. -

Reports that China has asked for a discussion about reserve currencies at next week's expanded Group of Eight summit in Italy has added to confusion about whether the country wants to dethrone the dollar from its status as the world's sole reserve currency. But the very fact the issue has been pushed onto the agenda suggests that a fundamental shift is underway.

Given the U.S. government's enormous borrowing requirements over the next decade to cover the bank bailout, fiscal stimulus and deficits in Social Security and Medicare, the dollar's reserve status depends on emerging markets' continued willingness to accumulate U.S. liabilities rather than switching to other stores of value, such as the euro or the IMF's Special Drawing Right (SDR).

As the largest buyer of U.S. Treasury securities, China can break the dollar's reserve currency status any time it wants. But it would risk large losses on the stock of U.S. debt that it has bought already. The resulting unstable stability is the foreign exchange version of the Cold War stalemate based on "mutually assured destruction".

Senior Chinese officials have given off mixed signals about their intentions.

When pressed, officials have indicated China will continue to stand by the dollar in the short term and denied the country has begun to diversify its official holdings. But that has not stopped People's Bank of China (PBOC) Governor Zhou Xiaochuan floating the idea of shifting to a super-sovereign currency based around the SDR.

Zhou's call for diversification was repeated last week in the central bank's annual stability report, which noted that "an international monetary system dominated by a single sovereign currency has intensified the concentration of risk and spread of the crisis". It went on to urge the IMF to exercise closer supervision of the economic and financial policies of major reserve-issuing countries.

Chinese officials have bluntly expressed concern about U.S. fiscal and monetary policies that appear to contemplate inflation and devaluation as a way out of the debt crisis, or at least accept it with weary resignation.

China has started backing a variety of small projects designed to encourage greater "internationalisation" of its currency (such as an active RMB market in Hong Kong and bilateral discussions with Latin American countries on the use of RMB to settle trade transactions).

The question is whether China is preparing to deliver the "coup de grace".

Pressing for a reserve currency discussion at the expanded G8 summit (which will also be attended by India, Brazil, Mexico, South Africa and Egypt) suggests China's leaders are serious. They must have known that just pushing the issue onto the agenda would rekindle market fears about the dollar's value.

But it could also be an attempt to create leverage and seize the initiative as part of wider efforts to shape the international financial agenda.

In the past, G8 summits have been structured as a monologue from the advanced industrial economies to the developing world. But following the debt crisis, the leading emerging markets are in no mood to be lectured.

By putting the dollar into play, China's government may hope to pre-empt pressure from western countries for a revaluation of the RMB, and take exchange rate discussions off the table entirely.
It is also a sign China is ready to begin flexing its financial muscle and will have to be treated as an equal alongside the United States, EU and Japan, shaping as much as responding to the policy debate.

The dollar's reserve status has become highly conditional, one of a number of items to be bargained over as part of the international financial agenda. Past experience suggests that when reserve currencies become highly contingent in this way, it marks the beginning of the end.

The dollar will not lose its reserve status completely. But it is set to become less "special". In future it will have to share its reserve status with the euro, the yen and perhaps even in time the yuan.

– John Kemp is a Reuters columnist. The opinions expressed are his own —

Perhaps the most frustrating aspect of much western comment on the unfolding crisis in Iran has been its over-simplification and lack of historical awareness. Perspectives are shaped by a single issue (western concerns about whether Iran is pursuing a nuclear weapons program) and the desire to draw a simple Manichean distinction between good guys (liberal-democrats) and bad ones (clerical-authoritarians).

The reality is far more complicated.

Part of the problem is a truncated sense of history. For most western commentators, the history of Iran’s troubled relations with the west starts in 1979 with the triumphant return of the glowering Ayatollah Ruhollah Khomeini at the head of the revolution which swept away Shah Reza Pahlavi’s western-backed regime and replaced it with a new Islamic Republic.

Western anxiety was compounded by the 444-day American hostage crisis that helped destroy the presidency of Jimmy Carter, and humiliated a United States still reeling from defeat in Vietnam and the Watergate crisis. Iran and the United States soon became embroiled in a series of proxy conflicts fought in Iraq, Lebanon, and via terrorist attacks on U.S. targets.

But for many Iranians the country’s troubled relations with the west can be dated further back — to at least the CIA-backed coup against Prime Minister Mohammed Mossadegh in 1953.

It marked a crucial turning point in Iranian history, something a bit like the Prague Spring, in which a popular, reforming and democratizing but also nationalist prime minister, who believed Iran should control the exploitation of its own petroleum resources, was removed by western intelligence agencies anxious to protect their countries’ interest in the oilfields.

The Pahlavist regime which replaced Mossadegh may have been modernizing and reforming, but it was also absolutist, dissolute and corrupt, and the Shah’s secret police, the SAVAK, ruthlessly hunted down and murdered opponents at home and abroad. While Pahlavist exiles abroad promote the memory of a modernizing golden age, there is no enthusiasm for monarchist restoration at home, and the Shah went into exile largely unmourned.

Criticism of the Shah’s regime was never confined just to religious conservatives. Even liberals were critical of the excesses of the Peacock Throne.

Iran therefore has no reason to love the western powers.

Subsequent events have deepened the mutual suspicion. When Iraqi President Saddam Hussein launched an unprovoked aerial attack on Tehran in 1980 and sent the Iraqi army across the Shatt al-Arab in a brutal war of aggression designed to exploit the turmoil and internal weakness of the fledgling Islamic Republic, the western powers stood aside.

Iraqi forces occupied the oil-rich and strategically vital province of Khuzestan, Iran’s cultural cradle, and captured the half-million strong city of Khorramshahr — and the west did nothing.

When Iran’s regular army and the volunteer forces of the Revolutionary Guard and the basij (the same groups now being used to suppress the protests) drove Iraqi forces back across the border and then moved into the al-Faw peninsula and began to threaten Iraq’s second city of Basra, Iraq resorted to chemical weapons — first the nerve gas sarin and then, when Iranian soldiers were given atropine-filled syringes as an antidote, switching to mustard gas.

Still the west did nothing. In fact, western companies were busy supplying the precursors Iraq needed to make its chemical arsenal and breach the Geneva Protocol. Meanwhile, western intelligence agencies were supplying Iraq with satellite reconnaissance photographs to aid the war effort.  Funding was catalyzed from friendly regional regimes to support Iraq’s faltering war effort and avert the risk of an outright Iranian victory.

To counter Iran’s successes on the ground, Iraq’s air force began strategic bombing of Iran’s cities, then switched to missile attacks on Tehran using Scuds, as Iran suffered its own version of the blitz.

None of this is to suggest Iran did not commit atrocities of its own, or to take Iran’s side over Iraq.

But when western leaders condemn Iran’s alleged quest for “weapons of mass destruction” and fulminate against Iran’s missile program, they betray a startling lack of perspective.

Some estimates put the number of Iranian soldiers who fell victim to chemical weapons as high as 100,000. Total casualties (killed or wounded) are put as high as 1 million. When Iran accepted a UN-mediated ceasefire proposal in 1988, Khomeini not unreasonably likened it to drinking a cup of poison.

Given this history, western leaders are in no position to deliver credible moral lectures, and it is hardly surprising that Iran’s leaders and media mutter darkly about western interference. Nor is it surprising that the Obama administration, seeking to improve relations, has been anxious to avoid the impression of meddling.

– John Kemp is a Reuters columnist. The views expressed are his own –

Economic history is the only field of human endeavor where the past changes as much if not more than the present and the future. Policymakers and practitioners struggle to define and write a “narrative” of the past as a means to control how policy responds to current and future problems.

The debate now over financial reform is a case in point. Even though the banking system has only just emerged from the most severe shock since the 1930s, the battle over how to define the events of the last 18 months, and what they should mean for investors and regulators in future, is already well underway.

Contrasting speeches last week by Federal Reserve Governor Kevin Warsh and Bank of England Governor Mervyn King illustrate the two extremes around which the debate is polarizing:

* Warsh speech

* King speech PDF

The financial sector will exploit these differences to derail any fundamental overhaul of regulation.

Warsh’s speech characterized the crisis as the “panic of 2008″ and set it in the context of the previous two decades of rapid non-inflationary growth, implying the crisis was an irrational aberration in an otherwise well-functioning economic and financial system.

In effect, Warsh reprised a philosophy associated with former Fed Chairman Alan Greenspan: occasional, wrenching crises are a price worth paying for an innovative, dynamic and wealth-generating form of capitalism. Policy should focus on ameliorating the after-effects rather than risk stifling growth by aiming to prevent crises altogether.

In contrast, King made the case for fundamental reform. He highlighted the real costs which a crisis that originated in the financial system is imposing on the real economy, as well as the more intangible but no less profound impact on attitudes towards wealth-creation, reward and regulation.

While noting there was no support for “excessively bureaucratic regulation”, King made clear “change to the structure, regulation and indeed culture of the banking system is necessary. Blaming individuals is no substitute for acknowledging the failure of a system, of a certain type of banking.”

STABILITY VERSUS GROWTH

King’s speech echoes the famous analysis set out in Hyman Minsky’s “Stabilising the Unstable Economy”. Minsky made a compelling case that periodic crises were an essential part of a financial-capitalist system in which massive long-term investment projects were financed by issuing large volumes of debt. By breeding over-confidence and increasingly risky capital structures, periods of stability laid the seeds of their own destruction.

But unlike Greenspan, Minsky argued such crises were not a “price worth paying”. Appropriate regulation was both necessary and desirable to constrain risk-taking to an acceptable level, and could be achieved without sacrificing growth. King’s speech appears to be advocating something similar.

Warsh is re-fighting an old debate between “stability-first” and “growth-first”. It is a false choice, as a closer look at the historical record suggests.

The problem with his speech is its truncated view of history. He notes U.S. output (measured by real GDP) grew at an average rate of more than 3 percent a year between the mid-1980s and 2007, and was significantly less volatile than in earlier periods. Unemployment averaged less than 5.75 percent, a full percentage point lower than in the previous 15 years.

But this is a tendentious use of dates. Warsh has picked the start and ends points to support a pre-determined conclusion. It specifically excludes the last two years of underperformance (2008 and 2009) from the period of the Great Moderation (as if the current problems had nothing to do with the policies pursued in the preceding years).

And by choosing the start point as the mid-1980s, then going back 15 years, it lumps both the Volcker recession of 1980-1982 and the oil shock of 1973 into the same base period for adverse comparison. With a selective use of statistics like this, it is possible to prove anything.

It is worth looking further back, in a more neutral manner. The attached PDF chart shows annual GDP growth since 1930 and the average rates for 20-year periods (1930-1949, 1950-1969, 1970-89 and 1990-2009).

While annual GDP growth was certainly less volatile during the most recent period, the average growth rate (2.5 percent) was not especially high compared with the previous 20 years (3.2 percent) or the two decades of the 1950s and 1960s (4.3 percent).

Warsh focuses on the undoubted benefits that openness to trade and rapid financial innovation delivered during the 1990s and the first part of the current decade, describing them as the principal achievement of the Great Moderation. Minsky’s own golden era was the 1950s and 1960s, when relatively conservative bank balance sheets and strict regulation appeared to tame the violent boom-bust cycle of the pre-war years while still enabling brisk growth and unprecedented prosperity.

But it is not obvious from the historical record whether macroeconomic management has been superior over the last 20 years to the 1950s and 1960s. Nor is it obvious policymakers have to choose between financial stability and economic growth. It is possible to have respectable growth and stronger financial supervision.

KEEPING OPTIONS OPEN

Minsky attributed the stability of the 1950s and 1960s to the impact of wartime finance, which had swapped a large part of the private securities on bank balance sheets for government debt, increasingly their liquidity, coupled with the development of a more extensive system of lender-of-last-resort, deposit protection and bank regulation.

Much of that framework of prudential oversight and conservative balance-sheet management has been swept away in the last 20 years as policymakers have relied more heavily on “market discipline”. The debate is how far to go in trying to recreate it.

Bank of England Deputy Governor Paul Tucker has already suggested banks should be forced to hold a greater cushion of highly liquid assets (for which read government debt) to reduce liquidity risks. In his speech, King reiterated the point.

He went on to suggest it was unsustainable that banks could take highly risky investment strategies while backed by an implicit (and free) state guarantee. Either regulation must be tightened, banks must pay for the guarantee, or it must be restricted to a range of “narrow banks” performing utility-like payments and basic lending services.

Rather than a set of detailed and perhaps politically unrealistic policy prescriptions, King’s speech should be seen as a plea to keep the debate and options open, not close them down prematurely and revert to business as usual.

King is right to try to encourage a deeper examination of the origins of the crisis. But radical reform seems unlikely. Wall Street and the City of London are already fielding an army of well-paid, silver-tongued lobbyists to deflect it. And as the divisions between King and Warsh reveal, regulators are too ham-strung by disagreements among themselves to force fundamental restructuring on a reluctant the industry.

– John Kemp is a Reuters columnist. The views expressed are his own –

Steady improvement in manufacturing surveys, payroll data and freight movements all indicate the U.S. economy is approaching the low point in the business cycle and should hit the bottom within the next one to four months. But that does not necessarily imply a strong and sustained expansion is about to get underway.

It is possible to be optimistic that the worst of the downturn is now over (or nearly so), while remaining cautious about prospects for strong and sustained recovery once the cyclical turning point is passed.

The slow and fitful recovery from the last recession is one reason to be careful. The National Bureau of Economic Research (NBER), the traditional arbiter of the U.S. business cycle, dates the last trough to November 2001 (eight months after the expansion peaked in March 2001 and just two months after the attack on the World Trade Centre). But signs of a strong and sustained recovery did not emerge for more than two years.

Fitful expansion in 2002 and 2003 is one reason the Fed kept interest rates so low for so long. While many commentators now see this is a significant error that contributed to subsequent bubbles in the bond and real estate markets, at the time the slow recovery caused officials, led by then-Governor Ben Bernanke, to worry more about the risk of deflation taking hold.

The Fed was still cutting interest rates to 1.00 percent as late as June 2003, an insurance policy against falling prices. It did not feel emboldened to begin raising them from this ultra-low level until June 2004.

Uncertainty caused by impending war between the United States and Iraq was certainly one factor overshadowing the recovery, but not the only one. Widespread pessimism and a cautious approach to new investment and hiring all helped ensure recovery was very slow. It failed to become clearly self-sustaining for almost three years.

The same could easily happen again.

RESTOCKING AND FINAL DEMAND

Headline increases in gross domestic product (GDP) can be separated into growth from final demand (consumption, business investment, government spending and exports); and increases in the level of inventories held by manufacturers, distributors and retailers along the supply chain (including raw materials, work in progress and stocks of finished but unsold items).

Sustainable increases come from final demand. Inventories are more volatile. Large changes in either direction tend to be quickly reversed within a quarter or two. A large build up in one quarter is usually followed by an equally large reduction in the following one.

The attached chartbook shows quarterly growth rates for GDP, final sales and inventories since 1948, and how the U.S. economy behaved in the first four quarters after each recession ended. Click here for PDF.

Headline GDP and final sales have proved much more stable than inventories. GDP and final sales have been negative in 37 and 35 quarters respectively out of a total of 245 since 1948. In contrast, inventory changes subtracted from GDP about half the time (119 quarters) and added to it roughly as often (126 quarters).

Recessions since 1948 can be divided into two very distinct groups:

(1) Severe recessions characterised by declines in final demand for at least two consecutive quarters. There have been four of these severe recessions (ending in 1954, 1974, 1982 and 1991).

(2) Other, inventory-driven recessions where final demand remained positive (most of the time) but the attempt to liquidate excess inventories by cutting production below final consumption pushed the economy into recession (defined as two quarters of negative overall GDP growth). There have been five of these “other recessions” or “inventory recessions” (ending in 1949, 1958, 1960, 1970 and 2001).

Past experience suggests the early stages of recovery are very different depending on whether the economy is emerging from a severe recession or an inventory-driven one.

In the case of deep recessions, recovery has been led by final demand. Inventory changes continued to subtract from GDP growth in the first quarter after recession ended and did not begin to make a substantial positive contribution until the third quarter (six to nine months later).

The pattern after inventory-driven recessions has been very different. Growth in final demand was much less important, with inventory rebuilding supplying most of the initial impetus for expansion.

In four of the five inventory recessions since 1948 inventories made a positive contribution to GDP from the first quarter after the downturn ended. The exception was the anaemic recovery after the 2001 recession. The lack of a stronger inventory response in this instance may have contributed to the failure to achieve a self-sustaining recovery in this case. But in every case, the inventory-driven recovery fell away somewhat in the second quarter after the recession ended before surging again in the fourth.

From the charts, it is clear that the current downturn looks much more like a severe recession than an inventory de-stocking one (with sharp falls in final demand in both Q4 2008 and Q1 2009).

If this is the correct characterisation, inventory rebuilding may play only a limited role in the early months of the recovery. Assuming the cyclical trough occurs during Q3 (between July and September) re-stocking might not make a significant positive contribution to growth until Q1 or even Q2 2010.

Analysts hoping for inventory rebuilding to provide much of the impetus for recovery in the second half of 2009 may be disappointed. Any expansion in the final months of 2009 is likely to be much slower and more uncertain.

– John Kemp is a Reuters columnist. The views expressed are his own –

The current contango structure in crude oil futures and most other commodity markets — with future prices significantly above the spot market — is providing a strong incentive to buy and store record quantities of raw materials, with most of the cost borne by retail investors in exchange-traded funds and institutional investors in long-only commodity indices.

This “cash-and-carry” strategy rewards market participants with access to storage or finance at the lowest cost. It is providing huge profits for physical commodity merchants, investment banks, and the owners and operators of warehouses and tank farms during the downturn, and helps explain the record profitability from commodity operations reported recently by some of the largest banking and trading groups.

In the current market, the cash-and-carry strategy rewards well-connected “insiders” such as investment and commercial banks able to secure almost unlimited financing at zero-cost as a result of quantitative easing programmes.

DOING THE CONTANGO

In a contango market, the Futures Price = Spot Price + Finance (interest rate on the money borrowed to own the physical commodity) + Storage (cost of hiring tanks, tankers or warehouses) + Insurance (premiums for insuring the commodity against loss, sinking, damage, theft etc). Click here for PDF. More generally, the equation can be re-written to cover any market (whether contango or backwardation, when the futures price is below spot) so the Futures Price = Spot + Finance + Storage + Insurance - Scarcity/Prompt/Convenience Premium. The prompt premium is the additional price a consumer is prepared to have spare material on hand “just in case” rather than risk having to go out into the market and buy it at an uncertain price or even find it is unavailable.

When commodity inventories are low, the convenience/scarcity/prompt premium can become very large and dominates all the other terms in the equation, ensuring the futures price is below the spot, and the market is in backwardation. But otherwise the term is small and the cost of finance and storage exceeds the convenience/prompt premium and the market is in contango.

In practice, we can ignore the insurance term because (a) it tends to be quite small and (b) does not change very much. For this analysis, we will also ignore the prompt/convenience premium since markets are well supplied at present and expected to remain so for the foreseeable future, with high stocks of crude oil, aluminium and other commodities.

In this simplified world, Futures Price = Spot + Finance + Storage. In some sense, the futures price is above spot because by buying forward the purchaser avoids the finance and storage cost. Conversely, the spot price is at a discount because buying now and holding into the future incurs finance and storage charges.

So far, we have assumed the finance and storage costs are the same for all market players. But in practice the cost of finance varies over time and among market participants. On the storage side, the cost depends on whether you own tanks/vessels/warehouses; whether you have leased them on a long-term deal; and whether a special discount is available.

In principle, the Future Price = Spot + Finance + Storage relationship should hold for the marginal market participant doing the storage and reflects the marginal players financing and storage charges.

But for everyone else with lower financing and storage costs the actual cost of storage should be below the cost reflected by the contango. For these players, it pays to buy physical commodities, put them in storage, and then hedge the long physical position with a short futures position, pay the smaller storage and finance charges on the physical and receive the larger yield from the contango.

REWARDS FOR INSIDERS

Market participants with access to cheap finance (banks) or cheap storage (tank farm and warehouse owners, or those with long term deals) can make money on the physical deals.

This is one reason many commodity firms run a physical trading house and a warehousing company in tandem together with a futures brokerage. The point is to exploit synergies and run a balanced business that is somewhat insulated from the cycle.

The physical trading business directs metal to the warehousing company and tries to ensure they are full (and therefore earning rental income from the metal). Whether the company takes the income as rent (accruing to the warehousing arm) or as a cheap rent deal (with extra contango income accruing to the physical trading desk) is a matter for the tax accountants.

But it creates an attractive synergy. When the economy is booming, warehouse stocks will be low, so earnings on the warehousing company are poor, but futures turnover is usually high in a bull market, so the futures brokerage and speculative book make money. When the economy is in recession, futures turnover drops and commission earnings fall, but the warehouses will be full earning plentiful rental income.

Only a small number of metals trading companies are fully integrated (comprising a customer-oriented broker, a physical trading business, and a warehouse). But most others will have special arrangements with one or more warehousing companies. There are similar systems in oil — with banks taking leases on tank farm space or floating vessels to play the same strategy.

BACKWARDATION RISK

So far we have assumed that the physical and financial parts of the store and hedge game mature at the same time (ie the lease on the storage space and the futures positions mature on the same date). In this trade, there are no risks.

But it may be possible to spice up the returns by accepting some risk by mismatching the two legs of the deal. A close look at the shape of the futures curve reveals that the steepest contango is usually for the first day or month, with progressively smaller contangos thereafter.

Instead of taking a 3-month lease on some storage space and putting on a short position 3 months forward to hedge it, some physical traders will take a 3-month lease and put on a short position 1 month forward (earning the biggest bit of the contango) with the assumption they can roll the short forward by another month and then another when the correct time comes.

The risk here is the market flips into backwardation at some point before the 3 months is up. In which case rolling short positions forward will incur a cost not generate revenue.

Either the backwardation has to be paid (reducing total returns on the strategy) or the metal/oil has to be delivered before the 3 months are fully up against the maturing short position, in which case the player is paying storage costs on empty tanks/warehouses.

Long-term storage plays popular with many banks and trading houses at the moment, where shorts are repeatedly rolled, are a bet that the market will not flip into backwardation, and no one will organise a squeeze, before the storage deal matures.

This seems a fairly safe bet in the current environment of cheap money and plentiful inventories.

– John Kemp is a Reuters columnist. The views expressed are his own –

Power generation from renewable sources such as wind turbines, solar cells and biomass plays a small but important part in satisfying total electricity demand around the world, and is growing at an exponential rate thanks to generous public subsidies and government support.

Renewable sources have increased their share of worldwide generation from just 0.4 percent in 1980 and 1.1 percent to 2.3 percent in 2006. In its “World Energy Outlook 2008″, The International Energy Agency (IEA) projects their share will double to 4.9 percent by 2015, and then almost double again to 8.7 percent by 2030. Click here for PDF.

Policymakers are relying heavily on renewable generation to meet projected growth in the electricity demand over the next 20 years while limiting growth in the emission of greenhouse gases.

Unlike reserves of oil and gas, which may be exhausted within the next 70 years, renewables will remain a source of power indefinitely. Much the same could be said of coal, but renewables do not contribute to increased carbon dioxin concentrations in the atmosphere.

But with renewable sources still costing more per kilowatt hour than conventional power from nuclear or fossil fuel plants burning gas and coal, renewables have not yet reached “grid parity” with other power producers and are struggling to penetrate the power market.

Market penetration depends on subsidies, price support and quota schemes mandating power suppliers buy a minimum share of their electricity from renewable. But widespread variations between countries and even within them suggest uptake is sensitive to the form in which support is offered. In particular, guaranteed prices for renewable producers have been more effective than quota systems in encouraging widespread development of wind and solar power.

RENEWABLES PENETRATION

Since all OECD governments are committed to increasing the share of renewables in total output, it makes sense to rank policy effectiveness in terms of market share rather than absolute watt hours generated.

On this measure, penetration ranges from 25 percent in Iceland, 20 percent in Denmark and 9 percent in both Germany and Spain, to 1.6 percent in the United Kingdom, 1.3 percent in Sweden and 0.6 percent in Japan.

In absolute terms, the United States is the world’s largest producer of renewable energy with 72,000 gigwatt hours (GWh) last year. Only Germany (60,000 GWh) and Spain (27,000 GWh) are comparable. But it is also by far the world’s largest producer and consumer of non-renewable power (more than 3.7 million GWh). The share of renewable generation in the total was actually rather small (just 1.7 percent) and puts it in the middle of the international spectrum.

Some country-to-country variability can be explained as the result of past policy choices and natural resource endowments. Iceland’s high share is based on its abundant geothermal resources. France’s low one the fact nuclear plants provide three quarters of the country’s total power output, leaving little demand for renewables or power from any other source.

But historic policies and natural resources cannot explain why Denmark, Germany and Spain generate six times more renewable power (proportionately) than the United Kingdom, the United States and Sweden.

PRICE GUARANTEES OR QUOTAS

The main factor determining policy success is the structure of the program. Price-support systems (used in Denmark, Germany and Spain) have been more effective than quota-based systems (used in the United Kingdom, Sweden and parts of the United States):

(1) Price-based feed-in-tariffs (FITs) guarantee renewable power producers the right to sell electricity into the grid at a fixed rate set by law, or in some variants at a premium over the peak market price or some average of the prices in a previous period:

* FITs guarantee priority access to the network (grid managers must buy power offered by renewable producers first at the agreed price, even when competing conventional generators offer power more cheaply).

* The grid pays a premium for renewable power (allowing renewable generators to recover the higher costs associated with their generation).

* In the most successful schemes this price is reasonably predictable (it is either fixed in cents per kilowatt or linked to an annual average) to make it easier for renewable producers to obtain project financing.

(2) In contrast, renewable obligation certificates (ROCs) and renewable portfolio standards (RPS) are quota systems. They require power sellers to buy a minimum number of megawatt hours (MWh) or a minimum percentage of total sales from renewable sources. Power sellers receive credits for every MW of renewable power they buy and must acquire a set number of credits by the end of the compliance period, buy surplus credits from others, or pay a financial penalty.

Quotas have been adopted by the United Kingdom, Sweden and most state-level governments in the United States that have set renewable targets. Favored by economists as the most efficient way to produce a given volume of renewable energy, since they encourage lowest-cost options to be developed first, they are seen as “market friendly”, technology neutral, and more compatible with integrating renewable output into the wider power system. In theory, the target volume of renewable power is guaranteed because tradable creditable prices will rise until enough renewable generation is incentivised.

Because quota systems do not guarantee a price for the power being sold to the grid, prices remain highly variable, determined by supply and demand in the wider power market, which can make it hard to obtain project financing.

Uncertainty can prove fatal to projects involving with high upfront capital costs (such as solar and offshore wind farms), long payback times (7-10 years), or where developers are small technology-driven companies relying on bank-based lending rather than established power utilities which can finance projects on their balance sheets. Quota systems have not tended to encourage innovation.

In contrast, price-based FITs have proved extremely successful in encouraging widespread installation of wind turbines (Denmark and Germany) and solar cells (Germany and Spain). Because they guarantee prices and revenues for an extended period, up to 20 years in some cases, loan finance is readily available, even for projects on a fairly small scale. In Germany and Spain, banks will provide loans for solar cells at household level.

TILTING THE PLAYING FIELD

The most common objection is that FITs may not be efficient because they do not promote the sequential uptake of lowest-cost options first. Most FITs are designed so higher-cost forms of renewable generation receive higher guaranteed prices to encourage the uptake of a diverse range of technologies. But there is a risk that power consumers can be forced to pay high prices for extended periods even if the generation cost eventually declines.

Most FITs have some flexibility built into them. While prices for existing producers of renewable energy are guaranteed for the lifetime of the FIT, the terms on which new FITs are offered to new projects can be adjusted periodically in response to changes in uptake rates and costs. In Germany, increases in uptake and cost reductions result in “degression” — a cut in the guaranteed price offered to new producers once certain target levels are met (previous guaranteed tariffs are not altered).

The objection remains that FITs involve the government picking winners rather than allowing technologies to emerge through market-based competition. But the need to recover high upfront capital costs over long timescales in volatile power markets means that large-scale renewable power generation may not be consistent with private financing unless some form of price support is forthcoming.

If policymakers want to encourage it, with all the associated costs, recent experience suggests feed in tariffs and price guarantees will prove far more effective than the quota systems favored so far in the United States and United Kingdom.