– 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.

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

House of Representatives Energy and Commerce Committee Chairman Henry Waxman will this week publish a full text of proposed climate change legislation, including details of a cap-and-trade scheme for regulating and pricing emissions of greenhouse gases.

Press reports suggest the Waxman bill will give away as many as 75 percent of the permits free to power utilities, coal-producers and other industrial users in the first stage of the plan to defuse opposition and buy support from congressional Democrats representing industrial and coal-producing states.

Free allocations would be phased out eventually, but only after a lengthy transition period that could last as long as 10-15 years.

Free allocations will undermine the immediate impact — and demonstrate the depth of opposition — to cap and trade but the real question is whether any transition to full permit auctions is automatic or requires further congressional action.

Commentators have focused on the budgetary implications of giving away permits for free. The president’s own budget plan anticipates revenues of $646 billion from permit auctions over 8 years from fiscal 2012 to fiscal 2019. The White House has already “spent” these revenues on tax breaks for low-income families as well as energy research and development.

Critics allege that giving away permits for free will blow a hole in the budget calculations and lead to even worse deficits over the next decade.

This is wrong. The White House included revenues from permit sales in its budget plan for symbolic reasons — to show it was committed to implementing cap-and-trade; it would spend the political capital needed to get legislation through Congress; to showcase the benefits auctions could bring; and to show how low-income groups could be protected against the impact of rising permit and energy prices by redistributing the proceeds.

But officials have been careful not to rely on the anticipated revenues too heavily. The president’s plan allocates the money to discrete tax breaks and research spending rather than general government revenues. If the permit revenues do not materialize, the tax breaks and research funding will be cancelled, and there will be no implications for the deficit.

SALAMI SLICING

Instead, the decision to give away most permits for free demonstrates that the shallow political consensus surrounding climate change and emissions pricing is forcing even supporters to take a very cautious approach to the issue.

Giving away 75 percent of the permits and phasing in a full auction system over a decade or more will limit the program’s effectiveness early on. But it is probably the only way to build support from Democrats in the industrial Midwest and Appalachian coal states needed for a House of Representatives majority and a 60-vote super-majority in the Senate.

More importantly, the administration wants to get agreement on the principle of cap-and-trade so that it can start building the necessary infrastructure (an inventory of emissions sources, supplementary regulations, and permit exchanges).

Once the infrastructure is in place, free allocations can be gradually reduced and the permit system can be tightened over time. Crucially, once trading starts, it will create vested interests among traders and permit owners, making it almost impossible to reverse or relax the scheme. So even a small-scale limited program will benefit from a ratchet effect.

The administration and its supporters in Congress are employing “salami tactics” — slicing a big controversial decision on which it may not have sufficient support into lots of small steps which are not objectionable in themselves but which, taken together, will eventually accomplish the same goal.

CAP-AND-TRADE NO MORE?

In another sign of increasing political sensitivity, the Wall Street Journal reported the administration is consulting on how to rebrand its cap-and-trade program to lessen opposition from voters and legislators.

Until recently, advocates of emissions control favored cap-and-trade rather than an emissions tax because it was seen as more “market-friendly” and obscured the impact of raising the cost of both permits and energy paid by consumers.

For political reasons, cap-and-trade has been favored even though research by the non-partisan Congressional Budget Office suggested a tax would be a better choice because it is more straightforward and offers the certainty about emissions costs that utilities and other heavy energy users need to make long-term investment plans.

But as voter awareness of how cap-and-trade will work and will increase energy prices has grown, popular support has eroded. According ecoAmerica President Robert Perkowitz, interviewed in the WSJ, less than half the respondents in a voter survey said they would support a cap-and-trade policy. So the administration is keen to rebrand the process.

AUTOMATIC OR NOT?

When the full bill is published, the focus will be on the number of permits given away free in the first stage. The real interest, however, is how quickly the free permit allocations will be replaced with permit sales and whether the transition is automatic or will require further congressional action.

Environmental groups will support a fairly substantial allocation of free permits in the first phase to get the bill through Congress, provided there is a clear timetable for moving to a full auction system and the transition is automatic and not subject to further congressional votes. In contrast, coal producers and power utilities will lobby hard to ensure Congress must vote again before free allocations are reduced and the trading program is tightened further.

Crucial points to watch out for:

(1) Whether the actual text of the legislation sets out a timetable for withdrawing free permit allocations in binding language, or whether a move to full auctions is set out in a non-binding “sense of Congress”.

(2) If the legislation mandates a transition to full auctions in binding language, is it conditional on further congressional approval or automatic?

(3) If the phase out of free permits is conditional, does it require positive action by Congress (legislators would have to vote in favor of reducing free allocations, something which could be hard to achieve) or negative approval (free allocations reduce automatically unless Congress specifically votes to block the reduction, which would be equally difficult)? Positive approval would make a full auction system hard to achieve. Negative approval would make it hard to block.

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

The financial crisis and wild gyrations in commodity prices have exposed deep conceptual flaws in the way academics and regulators think about commodity markets that will force a fundamental re-think.

In particular, they have demolished three key main planks on which the laissez-faire approach to regulation has rested:

* Fundamentals linked to physical production and consumption of commodities are the principal drivers of prices. Speculators or investors provide an important source of market liquidity, smoothing out temporary imbalances. Their activity may accelerate the adjustment, or even cause the market to overshoot. But speculative influences cannot force prices away from fundamentally determined equilibria for any sustained period.

* Commodity markets are highly competitive, with many buyers and sellers, each accounting for a small share of the overall market, unable to influence the prices set to any great extent.

* Regulators can draw a meaningful distinction between attempts to “manipulate” prices (which are illegal) and the impact of “dominant” positions (which are not).

Each of these assumptions has proved incorrect, forcing a fundamental reappraisal.

(1) FUNDAMENTALS AND SPECULATION
Traditional theories about commodity markets assume there are two basic types of participant: producers and consumers using the market to hedge away existing price risks (”commercials”) and investors or speculators using the market to take exposure to price risk (”non-commercials”).

Prices are assumed to converge on an equilibrium based on supply-demand fundamentals, with commercial players acting as the main drivers of pricing behaviour and speculators playing a subsidiary role balancing the market and providing liquidity.

But as the scale of investment in commodity markets has grown, speculation has emerged a factor in its own right, a new “fundamental” alongside traditional physical supply and demand.

It raises the difficult question of what happens if the weight of investment money moves prices away from their fundamentally determined equilibrium value for a prolonged period?

Most analysts insist this is not possible. But the widely acknowledged housing bubble and mispricing of risk in credit markets have shown markets can deviate from fundamental valuations for years at a time. If credit and housing markets can misprice assets, there is no reason commodity markets should be any more “accurate”.

(2) MANIPULATION AND DOMINANCE
The idea commodity markets are characterised by lots of small buyers and sellers unable to influence prices is clearly not true in practice:

* Hedge fund Amaranth had positions amounting to more than half the open interest in certain natural gas contracts when it collapsed in 2006.

* One market participant was revealed to be running positions in the NYMEX crude oil contract amounting to more than 300 million barrels of oil in the first half of 2008 when the Commodity Futures Trading Commission (CFTC) corrected an error in its commitment of traders reports.

* Investigations by the Energy and Commerce Committee of the U.S. House of Representatives revealed NYMEX had issued 117 exemptions to the normal position limits in the NYMEX crude contract alone since 1991.

Positions on this scale clearly have the potential to disturb prices. Until now, regulators have generally tolerated them provided there is no attempt at active manipulation. But the difference between manipulation and dominance is mainly one of intent. If the practical consequences are the same, should regulators try to limit dominant positions as aggressively as they pursue outright manipulation?

(3) LIQUIDITY IN THIN, SEGMENTED MARKETS

Most commentators assume global markets, such as oil, are too large to be manipulated successfully. But most commodity markets are in fact quite small. Even in the U.S. government bond market, supposedly the largest and most liquid market in the world, a string of “settlement failures” has highlighted the limits of liquidity, prompting warnings from the U.S. Treasury about the behaviour of participants with dominant positions.

If liquidity and large positions can become a problem even here, the risks in smaller markets such as crude oil let alone niche markets such as carbon are far greater.

Market segmentation compounds these risks. Most futures contracts are in fact for very specific grades of material delivered in specific locations, restricting them to only a very small fraction of worldwide production and consumption.

Markets are also segmented into individual contracts which are not (completely) fungible: the market for Jun 2009 natural gas is not (quite) the same thing as Jul 2009 natural gas. Given this segmentation, it makes no sense to talk about the “bond market” or the “WTI market”. Individual market segments are much smaller and more vulnerable to distortions.

(4) MORE REGULATION, BUT HOW?

Excessive volatility undermines the function of price signals by making it harder for producers and consumers to differentiate real long-term signals from the mass of short-term movements (”noise”). It imposes real costs in terms of resource misallocation when producers and consumers get it wrong, and these costs are non-trivial.

The damage bubbles do to the economy and the planning-investment process by producers and consumers provides a strong intellectual justification for some form of regulatory intervention. But what?

If the concept of a unique supply-demand equilibrium based on fundamentals is abandoned in favour of one that allows other factors (including speculation) to play a role, does that make the regulator irrelevant (if there is no natural equilibrium, how can speculation be said to distort it)?  Or does it mean the regulator should step in to curb “excessive” volatility and ensure prices bear some resemblance to the physical supply-demand balance?

And if regulators do have a role, how should it be enforced?

Past practice in the United States has favoured position limits, what might be termed a “structural” solution.

But practice in the United Kingdom has favoured a more “behavioural” approach, allowing large positions but imposing additional burdens on those running them to do so in a way that minimises market distortions. Neither approach has proved effective.

In practice, any new regulation is bound to be more intrusive and will be strongly opposed by many market participants. But before regulators pick that fight, they need to forge a new consensus around how these markets work in reality.

Regulators are under pressure to consider whether some of the smaller, less liquid markets need special oversight, especially where they are linked to larger ones and there is a risk that a dominant position in the smaller market can be used to manipulate prices in the larger one.

The recent report on commodity market regulation by the International Organisation of Securities Commissions (IOSCO) admitted positions in unregulated over-the-counter (OTC) markets could, in principle, influence prices on regulated public exchanges, and called for greater information and oversight on positions in these markets.

So far the focus has been on soliciting greater information about OTC trading on larger markets such as oil and natural gas. But a case could be made that regulators should also concentrate on smaller markets (such as carbon) many of which are traded OTC and where linkages to larger markets such as power may make them more important than their size suggests.

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

The bond market’s adverse reaction after the Fed announced no new asset purchase facilities or bond buyback programs highlights the fundamental difference between interest rates and quantitative easing (QE).

Rate cuts provide ongoing support for an indefinite period until the Federal Open Market Committee chooses to reverse them. In contrast, QE programs provide a one-off, time-limited boost that has to be continually reapplied to have the same effect.

With interest rates a decision to leave rates alone represents “no change” in policy; with QE, a decision to leave the scale and duration of the buyback program unchanged is a “tightening”.

QE is time-limited because it drives up bond prices and cuts yields only as long as buybacks continue, or are expected to do so. Once planned buybacks have been completed, or are not expected to be extended, the market will revert to its natural clearing equilibrium. Repeated doses of QE are needed just to keep yields unchanged.

This creates something of a dilemma for policymakers in both the United States and the United Kingdom. The Bank of England’s program to buy 75 billion pounds worth of government and corporate bonds will be completed in mid-June. The Fed’s program to buy $300 billion of medium and long-term U.S. Treasury securities finishes in September.

Once the current round of purchases are complete, both central banks will have to decide whether to embark on another one (intensifying criticism about inflationary financing of public debt) or end it (triggering a sharp yield increase).

In fact, yields will start rising well ahead of the formal end of the programs, unless the Bank and the Fed give a clear signal they will undertake further purchases.

The dilemma is especially pressing for the Bank of England given the imminent expiry of the current round. Officials will come under pressure to clarify their intentions at next week’s Monetary Policy Committee meeting. But the Fed too will face growing pressure over the summer to signal whether the existing programme will be extended beyond September.

It was the Fed’s failure to announce new and larger QE programs yesterday, and the implication that current support might expire in a few months, that caused the bond sell off overnight. Yields on 10-year U.S. Treasuries jumped to 3.16 percent, the highest since Nov. 2008 on Thursday, undoing all of the gains since the Fed announced its QE programme last month.

Terminating QE programs and not replacing them would amount to a sharp tightening of policy and trigger a large, destabilising rise in yields. So the central banks might opt to scale them back instead — continuing to buy debt, but in progressively smaller quantities — as a smoother way to withdraw exceptional support.

The problem is that if QE programs are not withdrawn fairly soon, they risk breaking down anyway under the weight of their own internal contradictions. Because the longer programs run, the more debt central banks will monetize, and the more fears of an eventual inflationary breakout will grow.

Eventually upward pressure on yields caused by increased fears about inflation will offset the downward pressure from QE purchases, neutering the programs’ effectiveness. At that point, ever larger quantities of QE will be needed to achieve the same degree of yield reduction or stabilization.

QE may have bought the central banks a little time but returns will diminish later in the year. The sooner they can articulate a managed retreat the more likely they are to retain some influence over the back end of the yield curve.

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

Senator Arlen Specter’s decision to cross the aisle and join the Democratic Party hastens the extinction of moderate Republicans in the north-east and symbolizes their deep problems.

But it does not change the legislative landscape.

On the most contentious parts of the president’s program — cap-and-trade emissions program, healthcare and Social Security — the key divisions are among Democrats rather than between the parties. Specter’s defection numerically swells the party’s ranks but in practice brings the administration no closer to the magic 60 votes it needs to push through ambitious reform proposals.

Senate tradition allows even a single senator to block passage of legislation by filibustering it. Since time is precious, even the threat of a filibuster is usually enough to stop legislation in its tracks.

Rule XXIII (cloture) curtails the right of unlimited debate and caps further debate at 30 hours. But it can only be invoked with agreement of 60 senators (three-fifths of the chamber’s total membership).

So the real majority required to pass contentious legislation is 60 rather than 51 (50 assuming the vice-president uses his casting vote).

Such 60-vote majorities are rare. The last was in 1978. But the Democratic Party has been inching close. The party has support from 58 senators (56 elected as Democrats, 2 as independents). Specter’s defection will give it 59. If Democrat Al Franken is confirmed as the winner of the Minnesota’s disputed election by the state Supreme Court, the party will get the 60th vote it needs for a super-majority.

But American political parties are not homogenous. Legislators do not necessarily do the president’s bidding, even for one as popular as Barack Obama.

Until now, the threat of a filibuster sustained by the 41 Republicans in the chamber has masked divisions among Democrats themselves. If the Republicans are reduced to 40 votes and unable to block legislation, Democrats will find themselves in an uncomfortable spotlight.

Party divisions were on display earlier this month when 26 Democratic senators from industrial and Midwest states broke with colleagues from the coasts to bar the use of the expedited budget reconciliation process to pass climate change legislation using a cap-and-trade program.

On financial regulation, healthcare, and Social Security, the party is deeply split between liberals anxious to push ambitious reform, and centrists who favor a less radical approach. Given these divisions the president may not have 50 votes, let alone 60, with or without the support of Specter and Franken.

While the president may not be forced to negotiate with Republicans, the administration will still have to craft compromises between liberal and centrist Democrats.

Specter’s change of party makes little difference. Together with Maine Republicans Olympia Snowe and Susan Collins, Specter was already one of the most liberal Republicans in the Senate. In many areas, the administration could already count on his support to assemble ad hoc 60-vote majorities even as a Republican. Nothing will change.

In others, especially climate change, Specter is likely to be anything but a reliable vote. Pennsylvania is a coal and industrial state. Like other senators, both Democrats and Republicans, sitting for these states, Specter has been wary of any cap-and-trade programme that would not include generous grandfather rights and free permit allocations for heavy industry.

The price of securing 60 votes for cap-and-trade — a long transition period coupled with generous exclusions or free permit allocations for heavy industry and coal producers — remains unchanged. A program can pass this year, but the number of votes that need to be bought from within the Democratic Party means it will be heavily watered down.

The cost of bank rescues and fiscal stimulus is the largest financial disaster to befall the federal government in peacetime history of the United States.

Only World Wars One and Two, and the American Civil War, caused larger deteriorations in the budget. Bank rescues, stimulus and tax cuts will bequeath a massive legacy of government debt, on course to reach a level not seen since 1947.

Stabilising government finances will require deep cuts in spending and sharp tax rises in the years ahead.

The need to refund the huge stock of maturing debt and issue new securities to cover deficits will also make it hard for the Federal Reserve to raise interest rates in a timely manner once the crisis has passed. Officials will face a protracted conflict between raising rates to head off inflation and keeping them low to stabilise the government debt market and contain government borrowing costs.

LESSONS FROM THE WAR

All the challenges now facing the Fed, Congress and President Barack Obama were prefigured by President Franklin Roosevelt in his annual budget message to Congress in January 1942, when the president outlined the enduring financial consequences of mobilising the government and the nation to fight a “total war”. Click here for pdf.

Roosevelt promised to finance as much as possible of the cost through increased taxes. But the president recognised as much as two-thirds of the burden would have to be met by borrowing on an unprecedented scale.

He warned federal debt would rise from $43 billion in 1940 to 110 billion in 1943. In fact it rose six-fold from $43 billion in 1940 to peak at $269 billion in 1946. He also warned taxpayers would still be paying for the conflict long after the fighting was over: “an increase in interest requirements will prevent us for some time after the war from lowering taxes to the extent otherwise possible”.

How the government handled the challenge provides useful lessons for policymakers handling the legacy of debt from the current crisis.

BUDGET DISASTER

The attached chartbook puts the bank rescues and fiscal stimulus in context. It shows the government’s annual borrowing, debt stock and interest payments since the 1930s, together with projections based on the budget plan submitted to Congress by the Obama administration and evaluated by the non-partisan Congressional Budget Office (CBO).

The budget deterioration between 2007 (when the government was running a deficit of 2.4 percent of GDP) and 2009 (when the deficit is forecast to hit 13.1 percent of GDP) is only half the size of the deterioration between 1940 (1.6 percent deficit) and 1942 (21.8 percent deficit) but far greater than anything experienced in peacetime.

Crucially however, wartime deficits were quickly reversed. The deficit shrank from 23 percent of GDP in 1945 to 2.8 percent of GDP in 1946, and by 1947 the federal government was actually running a small surplus of 1.7 percent of GDP. By reducing borrowing requirements and even running surpluses the Roosevelt and Truman administrations helped limit the build up in debt and maintain confidence in the government bond market.

In contrast, the Obama budget plan assumes the government will still be running deficits throughout the forecast horizon. The president’s outline has no plan to stabilise the long-term financing requirement, let alone run surpluses to pay down debt. Projected deficits in 2011 (6.4 percent of GDP), 2013 (4.1 percent of GDP) and 2019 (5.7 percent of GDP) are all much larger than before the crisis began and the budget position will be deteriorating again.

By failing to give investors a credible horizon for stabilising then reducing borrowing, the administration may struggle to place the securities it needs and risks triggering a sharp rise in yields once the immediate crisis has passed.

The Treasury is already running into resistance. Almost all the new debt issued so far has been short term (maturing in less than two years). The government has found it impossible to place longer-dated notes and bonds at acceptable yields; most medium and long-term securities have in effect been bought by the Federal Reserve (”monetised”) under the quantitative easing programme.

TAX EFFORT

The Roosevelt-Truman administrations were able to turn deficits into surpluses because the wartime emergency was accompanied by a massive expansion in the tax base — and many of those taxes were maintained at or near emergency levels for several years after the conflict ended. The war was accompanied by a massive increase in “tax effort” (tax collections rose much faster than GDP as a whole).

In fact, the federal government was able to fund about a third of the cost of the war effort ($90 billion per year by 1944) through increased taxation ($32 billion) with remainder raised by borrowing ($62 billion). Once the fighting ended, extra revenues could be used to fund an expansion of social programmes as well as reducing government borrowing needs.

The problem with the Obama outline is that it is not accompanied by any increase in “tax effort” and fails to identify new sources of funding to rebalance the budget in the longer term. Officials argue that dealing with the crisis is a one-off expense which should be funded by borrowing rather than (deferred) tax rises. But the CBO projections show much of the deterioration is in fact structural and will not be reversed by current tax and spending policies.

The president’s budget will still require massive tax increases, spending cuts or some mixture of the two to bring the budget back to a more stable trajectory. It is silent on where these will be found. But the scale is reasonably clear. Even after current emergency programmes expire, the government will need to find tax rises or spending cuts amounting to around 2-3 percent of GDP by 2015-2019, which would represent one of the largest fiscal “consolidations” on record.

INTEREST BURDEN

The debt build up will not be costless. Even assuming the government can hold costs to low levels, interest payments are set to climb from $237 billion per year in 2007 (1.7 percent of GDP) to $733 billion per year in 2019 (3.8 percent of GDP).

Interest payments were already the sixth-largest item in federal spending in 2007, absorbing 9 percent of all outlays. By 2019, interest payments will have risen to 11 percent and become the third or fourth-largest item. If debt cannot be stabilised, or borrowing costs rise, there is a real risk that rising interest charges will start to crowd out the money available for other programmes.

This will also create a severe problem for monetary policy. As in the late 1940s, the Federal Reserve will come under intense pressure to keep rates low and stable to avoid destabilising the bond market and triggering a damaging rise in yields that would drive up the borrowing burden significantly.

The Fed’s role as the government’s debt manager (assumed during the war and again during the recent crisis through the quantitative easing programme) will make it hard to raise rates.

After the war ended in 1945, the Fed found itself trapped, obliged to continue supporting the government bond market throughout the rest of the decade to avoid a damaging escalation of yields. Support was not withdrawn until the Fed-Treasury Accord in 1951 and not fully until 1953.

For all their promises that liquidity will be reduced and interest rates normalised in a timely fashion this time around, the debt overhang inherited from the crisis will pose the same dilemmas, and Fed officials will struggle to control liquidity and raise rates in a bond market characterised by massive (over-) supply.

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

Comparisons between the current downturn and the Great Contraction of 1929-33 have multiplied as commentators and investors have tried to forecast the recession’s likely depth and duration. But as the U.S. economy shows signs of stabilising and attention switches to future inflation the more useful comparison is actually with the 1940s.

The massive build up of highly liquid assets (cash and bank balances) during the Second World War is the closest parallel to the current escalation of bank reserves as a result of quantitative easing programmes in the United States and elsewhere around the world. The relatively modest pick up in consumer prices after the war ended may hold lessons for the outlook for inflation over the next five years.

There is a risk the commodity markets may have over-estimated the speed with which excess liquidity will be transformed into higher inflation and higher prices.

The outbreak of war was accompanied by an unprecedented build up of liquidity in the U.S. financial system. Deficit-financed spending on armaments and the war effort finally eliminated the persistent under-employment of the previous decade and ensured strong growth in corporate revenues and household incomes.

At the same time, households and firms had little opportunity to spend the money. The Federal Reserve imposed strict limits on consumer credit from September 1941 onwards. Consumer durables disappeared from the shops as the government first restricted then banned production of motor vehicles, refrigerators, washing machines and other electrical appliances for civilian use to conserve output capacity for the war effort.

The result was a massive increase in cash and bank balances. After having been flat for the previous 20 years, the amount of cash in circulation quadrupled from $6 billion to $25 billion between 1939 and 1945. Bank deposits more than doubled from $43 billion to $101 billion (Click here for PDF).But while inflation rose when wartime price controls were lifted, the increase was nowhere near as much as expected given the massive overhang of liquidity which had built up.

To paraphrase Arthur Conan Doyle about the dog that did not bark at night time, the surprise was not that inflation rose so much after the war, but that it rose so little.

Consumer prices rose just 8 percent in 1946, 14 percent in 1947 and 8 percent in 1948, and actually declined in 1949 — and this was after the removal of extensive price controls that had limited increases for 5 years. There was no inflation outbreak.

LIQUIDITY DEMAND

In terms of the standard monetary equation (MV=PT), where changes in the money stock (M) and demand for liquid balances (cash and bank deposits) (V) are related to changes in output (T) and the price level (P), the increase in currency and bank deposits (M) was largely absorbed by an increased desire to hold liquid balances (a fall in V) by firms and households even after the war was over.

In non-technical terms, increased demand for liquid balances persisted for several years after the conflict had ended and helped mop up the increased amount of cash and bank deposits.

Increased demand for liquid balances ensured most of the extra liquidity created during the conflict remained safely bottled up within the banking system.

In their seminal “Monetary History of the United States”, Milton Friedman and Anna Jacobson Schwartz attributed increased demand for savings in the form of currency and bank deposits to widespread fear about a resumption of the depression and mass unemployment once wartime spending ended.

Even though the economy continued to grow strongly, households behaved as if another slump was imminent, and chose to save rather than spend accordingly.

Experience after the Civil War and World War One had taught them to fear the war’s end would be accompanied by a sharp recovery driven by speculation and inventory building, promptly followed by an equally sharp downturn.

Worries about a return of unemployment caused households and firms to hold far more cash than had been the case in the 1930s. As a result, much of the “excess liquidity” which caused policymakers to fear a surge in inflation was not, in fact, “excess” at all.

Only when the outbreak of the Korean War (1950) removed the spectre of unemployment and deflation did the liquidity overhang become a severe problem for inflation and monetary policy, forcing the Fed to begin a sustained campaign of interest rate increases and other measures to mop up excess liquidity.

The Friedman-Schwartz interpretation highlights the importance of household and corporate expectations when deciding how much liquidity in cash and bank balances the private sector wants to maintain, and whether increases in the money supply will have an impact on inflation.

So long as households and firms fear recession and unemployment, high demand for liquid balances and a cautious approach to spending and borrowing will prevent even sharp increases in the money supply from becoming inflationary. Only once the threat of renewed slump and unemployment has receded will money supply growth start to show in spending and prices.

INFLATION POSTPONED

The current build up of huge amounts of liquidity in the banking system as a result of quantitative easing, and soon from the monetisation of a substantial proportion of the government’s budget deficit, is resulting in a similar liquidity overhang.

But the experience of the 1940s suggests the market may be over-estimating the inflationary potential.

Everything depends on how far the searing experience of the past 18 months produces a lasting shift in saving and borrowing behaviour, or is quickly forgotten.

But over the next 18 months, fear of unemployment and the risk of a double-dip recession are likely to restrain corporate and individual spending, as well as bank lending, keeping many of those apparently excess bank reserves safely bottled up in the banking system.

Even beyond that, the need to rebuild devastated portfolios and a more cautious approach to spending and saving could result in a one-off increase in demand for currency and bank balances that will soak up some if not all of the recent rise in money supply.

The medium-term (3-5 year) outlook is still for faster rate of inflation than the advanced economies have been used to over the past decade (perhaps 3-4 percent per year). But expectations of a huge inflationary breakout may prove wide of the mark.

If true, corporate bonds at good spreads over benchmark government rates could provide unexpectedly attractive returns to investors. But investors betting on a resurgence of commodity prices could face a longer wait than anticipated, with contango payments in the meantime eroding the advantage of any eventual rise in the flat price.

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

Institutions often outlive their usefulness. Since the end of the Cold War, NATO has often looked like an organization in search of a mission. Lately, the International Monetary Fund (IMF) has also seemed like one lost without a contemporary role.

The IMF is trying to reinvent itself as a global financial regulator or as a forum in which member states can hold mutual discussions about their banking, monetary and fiscal policies — a sort of World Trade Organisation (WTO) for finance.

Getting agreement to set up a major new international institution is difficult since sovereign states jealously guard their prerogatives and are reluctant to concede any authority to a supra-national body. But dismantling them when their original rationale has passed is almost as difficult:

• International institutions are so hard to set up there is a temptation not to waste the effort and keep them around to solve other, emerging problems, without having to start from scratch again. Not so much mission-creep and mission transition.
• Officials are good at coming up with new reasons for organizations to exist.
• In most cases there is no vocal constituency calling for obsolete institutions to be dismantled.
• Perhaps most important, institutions become a familiar and comfortable part of the international landscape, handy to keep around just in case they are ever needed again sometime in the next few decades.

Last year a number of European Bank for Reconstruction and Development (EBRD) shareholders questioned the future of the bank and asked for a review of its direction. In recent months it has reinvented itself as a crisis lender.

In many ways the IMF is a relic of a vanished world. Originally set up by the Bretton Woods Conference to promote orderly balance of payments adjustment between countries in a world of fixed exchange rates, the IMF and its members could not make the system work and it collapsed acrimoniously in the late 1960s and early 1970s.

So the IMF reinvented itself as a crisis-lending institution for developing countries and promoter of the laissez-faire, pro-trade and pro-privatization policies of the “Washington Consensus” across Latin America, Eastern Europe and Asia through the 1980s and 1990s.

Unfortunately, the Fund’s limited financial help came with such unpalatable conditions attached many of its best middle-income clients in Asia and Latin America vowed “never again” and decided to operate large balance of payments surpluses and accumulate sufficient foreign exchange reserves they would never again be forced to go cap in hand to it.

In some ways, fear of IMF conditionality contributed to the accumulation of global imbalances that lies at the heart of the current crisis.

BADGE OF DISHONOR

In fact, IMF conditionality became such a “badge of dishonor” that no self-respecting country wanted to be seen asking for advice, let alone taking the Fund’s money. With almost no takers for its services, the IMF’s income from lending dried up. The institution was been forced to lay off staff, and become little more than a prestigious think tank.

Not to be discouraged, the IMF is trying to get back into the game. The much-criticized conditions have been (largely) abandoned and the Fund is increasingly talking up its condition-free new lending facilities — which are generally available to those countries which don’t actually have a crisis, but might experience an irrational one in future, so this is a prophylactic.

Like an over-cautious banker, the Fund now prefers to lend large amounts of money to people who don’t actually need it.

WANTING MORE

But the Fund wants much more. In particular, it wants to become the premier venue for countries to discuss and coordinate their fiscal, monetary and exchange rate policies so that they take into account the external impact on other members and avoid the build up of destabilizing imbalances.

In the same way the WTO is a standing forum for negotiations and consultations among its members on trade, the IMF would like to do the same for fiscal, monetary and exchange rate policies.

The Fund wants to promote an exchange of ideas and the adoption of best practice (though who will define best practice remains unclear — until a year ago, financial deregulation was considered best practice).

Whisper it quietly, but in the same way WTO rules impose formal, treaty-based disciplines on what members can do affecting trade, the IMF might in the end have formal treaty-based disciplines on what members can do in finance.

In some ways, this would take the IMF back to its roots.

But the Fund never managed to impose significant disciplines on the policies of members. The problem is that it has never had leverage over the policies of surplus countries.

At Bretton Woods and after, the United States, the largest surplus country during WWII and in the aftermath, carefully ensured there were no binding disciplines (requiring currency appreciation or fiscal and monetary expansion) on the freedom of action of surplus countries.

Now circumstances have changed and the United States is the largest deficit country. U.S. policymakers have suddenly discovered an enthusiasm for regulating countries with surpluses.

But the basic problem remains: control over fiscal, monetary and financial regulatory policies is so central to the purposes of the modern state that no sovereign government, other than in circumstances of dire need, will willingly give them up or accept binding disciplines. Surplus countries are rarely placed in this position.

Unless the Fund can develop a compelling case for both surplus and deficit countries to accept compulsory adjustment, and tough multilateral surveillance with real disciplines, all the grand talk is set to remain just that.

The Environmental Protection Agency (EPA)’s proposed findings on greenhouse gas emissions were a carefully worded attempt to appease climate-change activists while containing hostility from business and energy organizations or Congress.

The “endangerment” and “contribute” findings, that greenhouse gases posed a danger to human health, were designed to provide clear signs of progress on a signature issue for the administration while preserving maximum flexibility.

The Obama administration is struggling to reconcile high hopes of ambitious action with the need to formulate a policy that can be sold to the Democratic Party’s working-class base in the industrial Midwest and coal-producing states of Appalachia.

Senior officials have tailoring their message depending on the audience. In briefings to climate groups, the administration has stressed it has enough authority under the Clean Air Act to regulate emissions and is prepared to press ahead unilaterally if Congress fails to approve comprehensive legislation.

But in remarks aimed at legislators and business organizations, officials have stressed they prefer a legislative solution, that any regulation is subject to consultation and would not take effect for years, would be limited in scope, and would be pre-empted if Congress enacted a comprehensive scheme.

For climate groups, the endangerment and cause-and-contribute findings have been presented as a major step forward. For business lobbies and legislators, as a minor regulatory change required in response to the 2007 Supreme Court decision in “Massachusetts versus EPA”.

VEHICLES, BUT NOT POWER OR INDUSTRY

The problem is the complicated nature of EPA’s authority under the Clean Air Act. In fact the act is not a single piece of legislation but a series of laws passed over more than three decades conferring separate authorities on the EPA.

The basic division is between Title I of the Act (Air Pollution Prevention and Control) and Title II (Emission Standards for Moving Sources).

* Title I gives EPA authority to publish national ambient air quality standards (NAAQS), including limits on specified pollutants, and require state governments to submit implementation plans to enforce them. Title I covers all sources of pollution, including stationary ones such as power plants and industrial facilities as well as mobile sources such as motor vehicles and aircraft.

* Title II gives EPA specific authority to impose regulations limiting emissions from new motor vehicles sold in the United States. Title II is much narrower in scope and applies only to motor vehicles (there are some limited provisions for aircraft emissions, not relevant here).

The trigger language under both titles is similar: emissions “cause or contribute to air pollution that may reasonably be anticipated to endanger public health or welfare”. But the language is incorporated in two separate places in the law, one under each title.

What EPA did on Friday was to publish a determination that found that emissions of CO2 and five other gases contributed to climate change and a threat to public health and welfare in the context of new motor vehicles (Title II). But it was silent on the question of whether emissions of the same gases from other sources such as power plants and industry were also a threat to public health and welfare (under Title I).

In fact, in its formal announcement, the agency was careful to note “EPA is not proposing or taking action under any other provision of the Clean Air Act”. In the accompanying press statement, EPA went further and said “An endangerment finding under one provision of the Clean Air Act would not by itself automatically trigger regulation under the entire Act”.

This is clearly illogical. Either emissions from vehicle tailpipes and from stationary installations such as power plants and industrial facilities both endanger public health and welfare, or neither do.

In fact, the agency’s finding noted transportation sector sources (subject to regulation under Title II) were only the “second largest greenhouse gas-emitting sector” (accounting for 24 percent of the total). The largest source is electricity generation (contributing 34 percent of the total) with the industrial sector not far behind (contributing 19 percent); both are subject to regulation under Title I.

In another twist, the agency cited six gases as contributing to climate change but only four of these are emitted by motor vehicles; the other two come from other sources.

EPA claims its narrow decision was required to comply with the Supreme Court ruling in “Massachusetts” — which required the agency to issue a finding under Title II but was silent on its responsibilities under Title I. But there was nothing to preclude it reaching a broader decision if the EPA had wished, and it would have been more logical to do so.

IT’S POLITICAL

The real reason for these regulatory contortions is political. The administration and EPA are wary about trying to launch a nationwide CO2 emissions regulation scheme under the existing Clean Air Act:

*It is far from clear the Act was intended for this purpose; the Supreme Court is divided and this approach to regulation depends on the continuing support of a narrow base of five justices, including swing-voter Justice Anthony Kennedy.

*It would turn the EPA into one of the country’s top economic and business regulators (a task for which it is not well suited).

*It would provoke howls of rage from Congress about by-passing the normal legislative process, a criticism to which Democrats are sensitive having accused the Bush administration of much the same thing during its eight years in office. The party is wary of being blamed for raising energy costs for ordinary businesses and consumers without some political cover.

For these reasons, EPA reached the narrowest possible finding. But the Title II ruling on motor vehicle emissions means it would be relatively easy for EPA to make a broader ruling under Title I if comprehensive emissions legislation stalls for lack of 60 votes in the Senate.

The EPA and the Obama administration may find it hard to control the process from here. If anyone files a petition to the agency asking it to consider regulating emissions under Title I, the agency may not be able to refuse without appearing irrational and vulnerable to a court challenge.