Guest post by Kurt Cobb of Resource Insights

Those who are incompetent require our correction. The incompetent need to know how to succeed. Maybe this takes education. Maybe it takes better judgement. Maybe it takes a thoroughgoing review of their errors. While the incompetent may elicit our scorn, they do not merit our moral indignation.

That is reserved for the unscrupulous. The unscrupulous are sometimes incompetent. But often they are quite competent at taking our money under false pretenses.

What the recent MF Global bankruptcy–the eighth largest in U.S. history–tells us is that the world’s financial system may be moving headlong into a collision of incompetence with unscrupulousness. (Full disclosure: I had a small account with MF Global and so have had a ringside seat, so to speak, in the bankruptcy proceedings.) I do not mean to say that before now there was no unscrupulous behavior in the financial system. What I mean to say is that it does not matter how competent someone believes a firm is at investing or handling money; if the firm is perceived as dishonest, that’s it!

So far the revival of stock and commodity markets around the globe via enormously stimulative budget and monetary policy has assured most people with invested money that the authorities are, in fact, competent to manage downturns, even severe ones. Markets may not be back to their previous highs, but they are a far cry from the devastation of late 2008 and early 2009.

Now the competence of those authorities is being questioned as Europe appears mired in a long battle to save the euro as the currency of its 17-country Eurozone. The question is: Should the average investor–the buy-and-hold investor–stick it out once more and trust in the authorities to make things all better? That is a monumental question.

But soon that question will be competing with an even uglier one? Can I count on the institutions which hold my money and investments–primarily brokerages and banks–to deal honestly and fairly with me? Can I count of them not to steal my money?

As the questions of competence and trust converge, the financial system seems increasingly imperilled. If authorities do everything right, but investors believe they can no longer trust their brokers and banks not to steal their assets, the competence of the authorities in monetary and fiscal policy will simply not matter. And, if investors should simultaneously lose faith in the ability of authorities to handle the roiling financial crisis in Europe and lose trust in their brokers and banks to safeguard their money, we should be prepared for a wipeout that will make 2008 look like a day in the park.

This is the scenario lurking behind the MF Global collapse. Clearly, MF Global was incompetent at managing its risks including the risk that its lenders such as banks and hedge funds would withdraw funding for its positions. (Firms such as MF Global borrow money short-term to buy long-term assets and profit from the difference between the interest payments on short-term funding and the stream of revenues from long-term assets. The short-term funding must be periodically renewed. If this seems risky, it is.) The lenders stopped lending not necessarily because they believed MF Global to be unscrupulous, but because they believed the firm was no longer competent to manage the risks associated with its portfolio of highly leveraged investments. Fearing losses on their loans, they didn’t roll over their financing.

Then came act two. MF Global misappropriated protected customer funds to support its precarious positions, especially those in European government bonds which seemed increasingly dicey this fall. Perhaps the firm felt it would be able to pay customers back once the fuss died down, and no one would be the wiser. But the fact that MF Global managers carefully covered their tracks in making the transfers tells us what we need to know. They believed what they were doing was illegal.

Here is the problem that regulators face. Prior to the MF Global collapse they had been able to say that no holder of a regulated futures account had ever suffered a loss of deposits (collateral or cash). Naturally, people lose money on futures positions every day. But that’s a far cry from having money which has been deposited to support those positions simply stolen. That makes it impossible to collect money even if you win your bets, since the money that is supposed to be transferred to you from the people on the losing side of the trade just isn’t there.

Futures accounts are not insured for such losses for the simple reason that the regulators wisely decreed that customer money and firm money have to be separated, and customer money simply cannot be used for the firm’s own trading without customer consent. There was no consent, and there would have had to have been collateral posted or contractual obligations agreed to had there been any consent.

Worse still, the CME Group, owner of many U.S. futures exchanges, was the auditor for MF Global and thereby responsible for making sure customer money was properly segregated and actually in the right accounts every day. One would think that the owner of the exchanges would have a special interest in making sure one of the world’s largest futures brokerages–with which the exchanges do business every day in huge volume–is handling customer money properly.

The result of the CME’s poor supervision was a huge seize-up in futures trading as a significant portion of the world’s largest players in the futures markets found their money frozen, waiting for someone to sort out the mess. Nearly six weeks after the collapse customers are only now getting a portion of their cash back, around two-thirds of it. The rest will have to wait for a claims process, and there is currently no guarantee that the remaining third will be paid back.

Now, if you are a futures trader and especially if you trade on behalf of clients, would you want to continue to trust the current U.S. regulatory system to safeguard your money? Why not go to say, Canada, where regulators appear to take their jobs more seriously and trade there? After all, Canadian customers of MF Global didn’t lose a penny.

That’s what the domestic futures exchanges and brokerage firms are facing. A gradual and perhaps persistent loss of business to someplace where traders feel assured about the safety of their funds. And, many small traders are simply giving up trading futures at all, believing the regulatory authorities are incompetent and the brokerages too crooked to deal with.

Now, I’m imagining such an outlook migrating to people holding stocks, bonds, and mutual funds at brokerages and mutual fund companies. I’m even imagining that outlook infecting regular checking and savings account holders at banks. It may already be happening in Europe in countries such as Italy and Greece where wealthy people seem to be shifting their money to safer banks in Germany or even outside of the Eurozone altogether.

These types of fears have a way of taking on a life of their own and spreading all of a sudden across the globe. I’ve mentioned before that Nicole Foss, writer for the financial commentary site The Automatic Earth, has said that liquidity and confidence are the same thing. If I lose confidence that my investments and cash in brokerage accounts and bank accounts are safe for whatever reason, then I will sell my holdings and withdraw my funds moving them to where I think they will be safe. If enough people do this, liquidity dries up as everyone heads for the exits at the same time. There are not nearly enough buyers to handle the sell orders in various markets. And, if people withdraw money from banks, the banks must quickly find some other source of liquidity than customer deposits. Such liquidity problems are already appearing at banks in Europe. And through it all, it will not matter whether investor fears are actually justified.

As the prosecutions of financial malfeasance rise, as the revelations of double dealing and outright theft abound, as the ability of European, American and Asian authorities to calm markets is eroded, the intersection of incompetence and unscrupulousness is poised to fling the global financial system into the dark unknown. These kinds of complete meltdowns have occurred in individual countries with disastrous results; Argentina comes to mind. But a grand failure of this sort on a global scale was only really hinted at in 2008. That’s how bad it could be next time.

Kurt Cobb is the author of the peak-oil-themed thriller, Prelude, and a columnist for the Paris-based science news site Scitizen. His work has also been featured on Energy Bulletin, The Oil Drum, 321energy, Common Dreams, Le Monde Diplomatique, EV World, and many other sites. He maintains a blog called Resource Insights.

Guest post by Gail Tverberg of Our Finite World

The world has many ideas for solving our energy shortfall, but they all seem to involve investment:

• Drill for more oil and gas;
• Develop alternative energy sources;
• Build more efficient gas-powered cars or electric cars;
• Fix homes and offices so they are more energy efficient.

I thought I would check through government data to see if we really have a chance of being able to invest enough money to solve our problems.

What I found was more than a little disturbing. United States’ “Net Savings,” as a percentage of Gross National Income has dropped greatly and is now below zero. This is a situation one website described as implying an “unsustainable path”.

Figure 1. US Net Savings as a Percentage of Gross National Income, based on Bureau of Economic Analysis Data (Table 5.1)

Back in the 1950s and 1960s, when the Interstate Expressway System was built and the electric grid that we are still using today was built, Net Savings averaged close to 10% of Gross National Income. It has dropped since then, and is now negative.

Let me explain “Net Savings” by showing a second graph.

Figure 2. US Savings and Investment Ratios, based on US Bureau of Economic Analysis Data.

In the United States, investment is made in many kinds of long-lasting goods, including everything from buildings, to roads, to oil and gas drilling, to pipelines, to wind turbines, to equipment for factories. Gross Domestic Investment (blue) is the total of such investment made in a given year, shown as a percentage of Gross National Income.

Some of this Gross Domestic Investment comes from an increase in debt; some of it comes from savings. Gross Savings (red) is the portion that comes from savings (foregone consumption), rather than an increase in debt.

Each year, some long-term assets wear out or are destroyed. Net Savings (green) is what is left, after subtracting the portion that relates to these assets which are lost (“Consumption of Fixed Assets”). So basically Net Savings is the amount of investment during a given year in long-lasting goods that was not financed by an increase in debt, and is not simply a replacement for something that has worn out. If Net Savings is negative (as it is today), we are not even replacing things that wear out, except through the use of more borrowed money.

Quarterly data shows that Net Savings is still negative in 2011.

Figure 3. US Net Savings as a Percentage of Gross National Income on a Quarterly Basis, based on BEA Data.

When Does High Net Savings Occur?

High Net Savings occurs when companies in general are quite profitable–in other words, when invested capital can be expected to yield a high rate of return. In such an environment, most companies will be earning enough profit that they can invest in additional plant and equipment, if desired. In such an environment, real wages are likely to rise. Governments will have little difficulty obtaining enough taxes for schools and roads, and other governmental investment.

The term “bankable project” is sometimes used to describe a project with an expected high rate of return, since this is something that a bank might be willing to lend money on, if  asked. An economy with high Net Savings will have many bankable projects.

Why would Net Savings Decline?

I can think of four reasons for the decline:

1. Declining EROI. Much of the infrastructure of the United States was built in the day when oil was cheap because the Energy Return on Energy Invested (EROI) was very high. Over time, EROI has dropped, and as a result, the price of oil has risen. When the price of oil was inexpensive, new infrastructure could be added cheaply. Oil and gas companies made good returns, even with low oil prices. Now oil costs have risen but wages have not risen correspondingly, creating a mis-match. With the relatively lower wages now, it is harder for workers to afford oil-based products and goods manufacturers make.

2. Human Labor Has Been Mostly Replaced. At one point, it was possible to create substantial efficiency gains simply by replacing human labor by fossil fuel labor. For example, a ditch digger could be replaced by a machine that dug ditches, and the cost of digging ditches would go down quickly, creating a profit for the entrepreneur buying the machines and the company making the ditch digging machines. The biggest opportunities for efficiency gains have already been taken.

3. Decline in Protectionism / Rise of World Market. In the early days, domestic industries were protected with tariffs. As tariffs were lifted and world trade increased, there was increased competition from areas with lower wages.  Capital was attracted to parts of the world where returns on capital appeared to be better, leading to a loss of investment in the US.

4. Limits to Growth. As we reach Limits to Growth (of the type described in the 1972 book by that name), completing claims for limited resources can be expected to raise costs for basic materials relative to wages. As a result, bankable investment projects can be expected to become less numerous. Herman Daly talks about a lack of bankable projects, not only in the US, but around the world,  in this recent post. In his view, the low returns on projects today may be related to ecological limits to growth.

Will There be Enough Funds for the Investments that will be Required to Solve our Energy Shortfall?

It is difficult to see that there will be enough funds available for such investment.

At this point, we need increasing debt just to stay even in terms of replacing infrastructure. We cannot expect ever rising debt to continue, however.  Instead, we should expect reduced debt, as I described in my post The Link Between Peak Oil and Peak Debt – Part 1. Private debt is already declining and is under further pressure, because of  European banking problems and Basel III rules reducing the amounts European banks are able to lend. The US Government keeps increasing its debt level, but this continued growth in debt is unsustainable, and is the reason behind threatened governmental shut-downs.

With reduced debt levels in the future, Gross Domestic Investment will drop below Gross Savings in Figure 2, above, leaving even a smaller amount of funds available for investment than we have today. We may very well, in the aggregate, reach the point where we are not able to maintain current infrastructure with the funds that are available for investment. This means that will need to make choices on which things we maintain–schools or roads or oil distribution pipelines or electric grid or our housing stock. If we suddenly want to spend a lot more on new oil and gas drilling, or on an upgraded electrical grid and more wind turbines, this would seem to reduce funds available for investment in other things, which are also quite necessary.

If we think of investment as requiring the use of resources such as oil, steel,  copper, and fresh water, it would stand to reason that there is an upper limit on how much we can invest each year. If we are in fact reaching “Limits to Growth,” or even “Peak Oil,” the total amount of these resources available in world markets will be declining. Even if the amount of resources extracted each year does not decline, but stays close to flat, the share of these resources that the US is able to obtain and use for infrastructure building is likely to decline, because of more-rapid growth of emerging market nations.

The Way Forward

The only way around this difficulty that I can see is adding high EROI, quick payback, energy projects such as oil wells from the 1930s. Unfortunately, there aren’t any of these left (and of course, they have environmental issues as well).

We have deluded ourselves into thinking that projects that require government subsidies and that theoretically will produce an adequate return over a long period (20 to 60 years) are an acceptable way of replacing high EROI, fast payback projects. This might be true, if we still lived in a world in which fossil fuels would provide enough of a  subsidy to the system that we could live without favorable cash flow returns from other investments.

The problem is that now, even fossil fuel investments require a lot of up front funding (think oil sands extraction in Canada, and fracking of oil and gas wells in the US), and don’t necessarily have all that good a long-term return, regardless. This is especially the case if the government needs to take an increasingly large share of this return, in order to fund its infrastructure requirements.

And increased debt is less and less of a solution.

Somehow, we need to be looking at the overall picture. How can we get enough profitable cash flow to get the cash we need to buy the resources needed to maintain essential parts of infrastructure? If we are looking at energy-related investments, what do they really provide in terms of cash flow? They may supposedly have a high EROI, if viewed over a long enough period, but this in itself is not all that helpful, if cash flow is not positive in a fairly short time-period–probably seven years or less.

My expectation is that the majority of energy investments will be terrible in terms of cash flow, and thus make our “Net Savings” (and Gross Domestic Investment) even lower over time. Installation of wind turbines and solar panels is likely to fail in terms of providing quick cash returns.

In fact, anything that requires a subsidy is likely to have serious cash flow issues. But even new nuclear power plants and new coal-fired power plants will have such issues. Adding scrubbers to coal-fired power plants without them is a great idea from an environmental point of view, but further adds to the need for additional infrastructure investment, without ever generating additional cash.

Perhaps we need to be figuring out which infrastructure investments we can eliminate, that won’t bring down the whole system. Which roads do we turn from asphalt to gravel? Can we eliminate purchase of military jets? Do we stop building and upgrading schools and universities? Do we stop building new homes and office parks?

I will admit I do not fully understand this whole issue. If we could suddenly convince the world that US has more opportunities for profitable investments than anywhere else in the world, theoretically our problem could be solved. But I don’t see this happening. Some have claimed that the recent improvements in oil and gas drilling make the US a more attractive place for investment, but I am doubtful that this is a true solution. Many of the assessments seem to be based on very optimistic estimates of future oil and gas production from “fracked” wells. And the amount of the effect is likely small.

I am afraid that the lack of cash flow funding for investment in infrastructure is what will eventually bring the system down. This is not an issue that researchers have looked at much, to my knowledge. This connection has the potential to pull the whole system down quite quickly–I would guess in 20 years or less.

Perhaps we need to be thinking more about what infrastructure investments can truly last beyond the system itself. The names “Renewables” were given to our current high-tech wind turbines and solar PV to give us the impression that they can last beyond the system themselves, but I  am doubtful that this is really the case, since they depend on the availability of the electric grid and other support systems. Perhaps we need to be focusing more on lower tech applications that can be repaired with local materials and will truly provide lasting benefit.