Tuesday, May 25, 2004

Monetary Policy Edition: Being set up for another Oil Crisis?

The Economist notes that while the economic situation of oil is still sustainable (price is only half of 1970's inflated adjusted level and GDP growth less dependent on it) that the price range is again approaching the level of being a threat to the world economy. Remember the price of oil would have to be about $80 pb sweet light crude, but then again if prices reached that level we'd also have oil-crisis style economic stagflation and near 25% unemployment which were also features of the seventies!

That price has been uncomfortably high of late. Last week, the benchmark price for West Texas crude reached a record of $41.85. Of course, adjusted for inflation, this is still only half the level prices reached in the oil-price shock of the 1970s. And western economies are now only half as dependent on oil as they were then. But if current record oil prices are less shocking than the hikes of yesteryear, they are quite upsetting enough to spoil the G7 finance ministers’ dinner. On Sunday May 23rd, they called on all oil producers to pump enough crude to bring prices down to “levels consistent with lasting global economic prosperity and stability”...

At the next official meeting of OPEC, in Beirut on June 3rd, Saudi Arabia will be asked to demonstrate solidarity with its co-conspirators in the cartel. The bargain that holds OPEC together—each member shows restraint in production, so that all can enjoy higher prices—is at stake, they will say. But it is widely assumed that Saudi Arabia must also keep its side of a more fundamental bargain. It must be conscious of American petrol prices, especially in an election year, and, in return, the world’s only superpower will continue to offer the desert kingdom its protection. The other members of the G7 have rather less leverage, but they are promising to flex whatever diplomatic muscles they can find. Nicolas Sarkozy, France’s newish finance minister, in particular, is not one to sit still while others decide the fate of his economy. Those oil-producing nations with which France is most “easily in touch” will be hearing from him soon, he promised in New York.

Mr Sarkozy’s powers of persuasion and America’s promises of protection may be enough, for the moment, to keep the Saudis on side and the rest of OPEC quiescent. Oil prices of $50 per barrel no longer look an immediate prospect. But, by the same token, oil prices of $25 per barrel may, as the Venezuelans insist, belong to a bygone era. If the Chinese economy continues to grow and security fears continue to mount, there may be little anyone, in New Amsterdam or Old, can do.

The oldman has noted before that it would take oil prices of about $90 to reflect a real crisis in oil instead of the current market premium of roughly $5-$7 US pb. That figure is simply based upon the inflated price of oil from the seventies oil crisis with the additional current security premium at it's high end. Can you say "oil-shock to GDP" nine times real fast? Of course other factors were involved such America going off the gold-standard peg rate and seeing an inflation of the dollar value undermining its gold purchase rate.

However contrary to what gut instinct might indicate, we see that actually raising interest rates inaugerated the stagflation era.

By the summer of 1969, Nixon had already applied or was in process of applying fiscal restraints and in July of that year, the Chairman of the Fed announced a hike in interest rates.

At that point, stagflation, though not yet christened, was born. In my book, The Multiple Abyss, I wrote - "In July 1969, six months into the first Nixon Administration and just twelve days before man took his first steps on the Moon, the Federal Reserve Board raised interest rates. In the midst of all the drama of the times, the raising of interest rates seemed a dull, stodgy, inconsequential event. So, not surprisingly, it was received with calm and, initially at least, understanding. The United States had spent enormous amounts of money on the Cold War, on the Vietnam War, on aid to less developed countries and, above all, on President Johnson's welfare society. The resources of even the mighty United States economy were stretched and prices were rising. So the Fed acted "to slow the economy down." Its action was, in the conventional wisdom of the time, "correct." But what happened then?

"One account [in The Indigent Rich, pp.41-2] said that - "...towards the end of 1969, that is, less than six months after the Fed had acted, policies instituted by the Nixon Administration began to push unemployment up. The intention of these policies was to stop inflation by reducing demand. Demand was to be reduced by reducing personal income, which was assumed to be a function of increasing unemployment. But President Nixon had already arranged in his message to Congress that 'if unemployment were to rise' the programme of unemployment insurance 'automatically would act to sustain personal income.' He had therefore undermined in advance his capacity to attack inflation through increasing unemployment and reducing personal incomes.

"But he was more shackled in his capacity to attack inflation by these means than even this contradiction in his policies demonstrates. For his policies, if they did not reduce incomes as much as the increase in unemployment would have done in an earlier period, they did reduce production. The number of unemployed shot up by more than one million in less than a year. The rate of increase in the gross national product dropped sharply. The President's Council of Economic Advisers estimated that the United States economy, in the second quarter of 1970, was operating at about 4 per cent below its potential capacity and that the real rate of growth of GNP in the third quarter was down to 1.4 per cent - or to 2.5 per cent, if the effect of the
General Motors strike were excluded. Growth in the fourth quarter was probably nil. The difference between these estimates and the real rate of growth of 5 per cent or more before the advent of recessive policies was substantial; and was borne out by data showing movements in industrial production. From a peak in July 1969, the index of industrial production dropped steadily to a point 7 per cent lower in October 1970. The decline was sharper as unemployment grew (and as the General Motors strike caused further production losses). The index which stood at 173.1 in October 1969, had fallen to 166.1 in September 1970, and 162.3 in October 1970".

Here was the essential cause of stagflation, identified (even before its baptism) in The Indigent Rich as early as 1971. By 1974, the term itself had been coined and in "Inflation: A Study in Stability", published in that year, I wrote - "If it is socially unacceptable to move demand down far enough to balance supply, then the only way of achieving balance in an inflationary situation is to move supply up or, at least, keep it up to meet demand. Our failure to try to do this explains why we have so often had 'stagflation'. When insufficiency of supply started to cause inflation, we have applied - and, indeed, we still do apply - monetary and fiscal policies that curtail certain areas of demand, including investment demand, and that curtail production. This reduction of supply while demand necessarily stays up under the pressure of government as well as of private outlays, achieved those twin evils of more unemployment and higher prices.

"When we have reached that point of ultimate frustration, we have then - just as we did in the 1930s - flailed around desperately for remedies roughly within the confines of our existing economic orthodoxies. Wage levels are said to be too high (that was a favourite in the 1930s too); therefore wages should be frozen or cut. Others say we need an incomes policy and price control. Or we should revalue the currency or cut tariffs.

Most governments have tried some of these; some have tried them all. None really works....."

Thirty years later, we still haven't moved far beyond where we were in 1974.

We now depend almost entirely on hiking or cutting interest rates to solve our problems of inflation - and just about everything else, domestic and external.

Of course as many have argued, the oil-price rise had a lot to do with the rise of staginflation.
While the entire world was affected by what essentially can be equated as a rise in the price of energy, the US economy found the dramatic rise in oil prices - an astounding 184% in just the first six months of 1974 - to be particularly detrimental: it created a unique situation known as stagflation, whereby the rise in oil prices resulted in an overall rise of all prices, or inflation. This in turn increased business expenses and thus decreased profit margins -- thereby setting the stage for a contractionary economy that ushered in an era of higher unemployment. The equation was simple yet devastating: inflation plus unemployment equaled stagflation, which resulted in a weak economy.

Of course if you believe in classical Keynesian economics there was no recession in the seventies because Staglation theoretically can't exist if the Phillip's curve is correct. (Wikipedia)

The Phillips curve, which is associated with Keynesian economics suggests that stagflation is impossible because high unemployment lowers demand for goods and services which lowers prices. This results in low or no inflation. By contrast, monetarism which argues that inflation is due to the money supply rather than to demand predicts that inflation can occur with high unemployment if the government increases the money supply.

Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the United States in the late 1970s. The difficulty in fitting its existence within a Keynesian framework led to a greater acceptance of monetarist theories in the 1970s and 1980s, but some still believe in Keynesian economics, saying that there was no recession at that time.

I propose a synthesis. What if stagflation required three major ingredients? It required the possibility of inflation by a excessively loose monetary supply, but at the same time rising interest rates to set off an initial GDP growth stunting slide, and the price rise of a key commodity such as oil because of supply-shock fundamentals?

Well we know that because of the devaluation of the dollar and the drop in confidence in the US Treasury debt, that the first condition of an excessive monetary supply growth has been met. There are more dollars than demand previously so hence the price has dropped. Furthermore with a potential repositioning of the Chinese Yuan and the Japanese Yen sliding toward the Euro perhap provides the downside for an even further slide: 10-30% by my previous estimates based on reading. That meets the first condition.

The second condition of rising interest rates in order to attempt to quell monetary supply growth and fiscal imprudence is being met because the Federal Reserve is raising interest rates. Granted they wish to be behind the curve admittedly, but the role of raising interest rates is just to provide an initial downturn in GDP to start off the slide. In the seventies interest rates were also raised, it was just that they were not raised enough while the central bank colluded to help Nixon get re-elected by turning a blind-eye toward massive social spending that "broke the bank" of US budgetary discipline. Does that sound deja-vu-ish for some reason?

Well surely we at least do not have the third condition, which is that the oil market isn't as sensitive as it was toward supply shocks because of the addition of more producers outside of OPEC right? Well according to David Ignatius in the Washington Post we have allowed ourselves to become manipulated by the Saudis who have used just in time delivery methods to increase price sensitivity to supply disruptions.

The Saudis were able to do this since only effectively they have spare capacity and so by manipulating their shipment schedules to prevent inventory pileups of oil that would act as price shock buffers from being built up.

Homemade Oil Crisis

By David Ignatius
Tuesday, May 25, 2004; Page A17

The "oil crisis" of 2004 is one more sign that a Bush administration that once hoped to transform the sources of instability in the Middle East is instead retrenching to a messier version of the old status quo...

The drama on the oil spot market has masked the fact that the recent price squeeze has been building for several years -- and is largely a result of conflicting policy decisions made in Washington and Riyadh. A rapidly growing Chinese economy meant that upward pressure on prices was inevitable. But neither the Saudis nor the Americans took appropriate steps to defuse the problem before it became a crisis.

The Bush administration contributed to the oil price squeeze in several ways, according to industry experts. First, it failed to address the fact that demand for gasoline in the United States was increasing sharply, thanks to ever more gas guzzlers on the road and longer commutes. The administration also continued pumping 120,000 barrels a day of crude into the Strategic Petroleum Reserve, making a tight market even tighter. And by letting the value of the dollar fall sharply over the past year, the White House all but forced the Saudis to raise dollar-denominated oil prices to compensate.

The administration's more serious mistake was that as energy supplies tightened, it did nothing to reduce U.S. demand. A year when the United States was fighting a war in Iraq would have been an ideal time to ask the country to sacrifice a bit, to reduce its dependence on oil from the Middle East. Instead, the Bush administration let SUV Nation roll on.

Meanwhile, as Americans burned their energy, the Saudis subtly fiddled with the oil market. By keeping inventories low and encouraging a policy of "just in time" deliveries to refiners, they kept spot prices on a knife edge. The result was that OPEC, after years of powerlessness, became in effect a central bank for oil.

"U.S. policymakers are guilty of denial," says Roger Diwan, a managing director of PFC Energy, a Washington-based consulting firm. "Tighter specifications for refiners, runaway demand and supply bottlenecks have indeed created market tightness. Blaming the producers doesn't solve the problems created by contradictory U.S. energy policies over the last two decades."

Bush administration officials who talked blithely in the run-up to the Iraq war about replacing Saudi Arabia as the locus of the oil market should be forced to drink a barrel of crude. As things have turned out, events have underlined the inevitability of Saudi Arabia as the supplier of last resort. An administration that set out to transform the Saudi-dependent status quo has ended up reinforcing it -- at the very time that terrorist attacks are showing the kingdom's vulnerability.

Conspiracy theorists will see these developments in oil markets as further evidence of a plot between the House of Saud and the House of Bush. That's nonsense. What we are seeing in the market is a result of clever policies in Saudi Arabia and dumb ones in the United States. This "crisis" is man-made, and the more it resembles the oil-crisis frenzy of the 1970s, the more nervous we should all be.


So according to David Ignatius we are again approaching a situation where we are vulnerable to oil supply shocks. This satisfied the third condition that the supply side of the oil market has to have business fundamentals conducive to a supply-shock setting off an oil-crisis.

With the three conditions having been met, we can suddenly see ourselves being very vulnerable economically to any untoward political or military events that would constrain the oil supply at least for the next several years until more capacity comes on line. The vulnerability of the US to an oil-crisis and attendant stagflation has never been more similar to the seventies than today. The depression in manufacturing and basic industrial production as well as price increases in other key commodities due to the growth of China is also fueling the possibility of a stagflation wave.

Nationally the economy was having a bad week:

WEEKLY MARKET COMMENTARY
Tuesday, May 25, 2004 10:59 GMT
Weekly Commentary
By: Cornelius Luca
http://www.gftforex.com


The dollar gave way broadly during the past week
The dollar gave way broadly during the past week, particularly versus the yen and the pound. Traders realized profits as the dollar had been increasingly overbought. It should see further weakness, but the dollar seems to have only a limited downside at this point. Perception that the Saudi Arabia will help trim by unilaterally increasing its oil supply to temper the exorbitant prices of gasoline should buffer dollar’s decline.

Past Week's Data and Events
United States


The dollar fell across the board last week amid mixed economic data.

Manufacturing in New York State declined to 30.2 in May from 34 in April. It had peaked at 42.05 in February.

In the same vein, the Fed Bank of Philadelphia's general economic index collapsed to 23.8 in May from April’s 32.5. Still, the dollar showed only a brief pullback following the weak reading.

Housing starts fell 2.1 percent in April to 1.969 million homes, down from a revised 2.011 million in March. Building permits, however, rose 1.2 percent to a 1.999 million rate.

The index of leading economic indicators rose 0.1 percent in April after a revised March increase of 0.8 percent, the biggest gain since May 2003.

The number of Americans filing initial claims for unemployment insurance rose to 345,000 last week from an upwardly revised 333,000.


If the "recovery" has peaked already then the hypothesis of a double-dip recession is gaining strength. Add to that a potential stagflation or just ordinary inflation (10%?) scenario and the news from here on out will likely be bad. The secondary real estate market deflation however would at last create a capital asset liquidation phase that might put the economy on firmer footing for a real recovery in mid-2005. That's just about the only real good news out there right now! Of course if stagflation hits, we could be entering truly difficult times economically.

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