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Countdown to 100$ oil (11) - it's Greenspan's fault!

by Jerome a Paris Sat Aug 27th, 2005 at 06:27:09 AM EST

When you have new record highs for "nominal" (see below some commentary on that word) oil prices almost on a daily basis (see for instance Saboteurs and storm warnings push oil to highs, FT, 26 August), it becomes hard to choose a date for a new "countdown" diary...

Today I have a great excuse as the Economist has come up with an article which pretty directly puts the blame for highr oil prices on Greenspan and his lax monetary policies. This came as a pleasant surprise after a week of atrociously slanted (and fawning) coverage on Greenspan by the Financial Times (as diaried in loving detail in this piece which sadly did not generate a lot of comments: Greenspan gets TWO blowjobs in the FT this week). Usually, I trust the less ideological FT more than the Economist, but in that case the Economist is certainly closer that what I think is the reality of the markets.

Nominal oil prices
First of all, have you noticed how most commentary about oil prices now inserts this seemingly innocuous adjective to describe oil prices, "nominal"? "Nominal" suggests that oil price are not really that high and thus not such a casue to worry. While technically correct, I find it interesting that so many people in the markets and media find the need to reassure the public (and themselves?) that increasing oil prices are not such a big deal.

The Economist, in one of its articles this week on oil prices (Oil and the global economy: Counting the cost) provides the following illuminating graphic which shows that depending on which estimate for inflation over the past 25 years you use, you are getting damn close - or even well above - the highest "real" prices of 1980.

Moreover, a calculation of real prices depends on the deflator used. Relative to American producer output prices, the appropriate measure for businesses, real oil prices are already close to their 1980 peak. For an oil-importing economy as a whole, however, the relevant deflator is arguably export prices, since the main way that dearer oil causes pain is through the terms of trade. Relative to global export prices, oil prices are at an all-time high (see chart).

Why high oil prices are here to stay

As the cover of the economist makes clear, the current high oil prices are caused by strong demand and not by a temporary oil showk like in the 70s. The two biggest consumers (the Economist's "oiloholics") are the USA and China and their thirst for oil is still growing, despite almost tripling since late 2001.

Last year's increase in global oil consumption was the biggest for almost 30 years. The old rules of thumb based on supply shocks do not work for price increases driven by rising demand. If oil prices rise because of a shortfall in supply, they will unambiguously cause GDP growth to fall. However, if higher oil prices instead reflect strong demand, then they are the product of healthy global growth. They will therefore be less damaging.

The downside is that, if prices are high because of strong demand rather than a supply shock, they are likely to stay high for longer. In past oil shocks, a rise in price as a result of a temporary supply disruption caused oil consumption to decline, so that when supply returned to normal prices promptly fell. But if oil prices are being pushed higher largely by rising demand in China and other emerging economies, a sudden collapse is less likely.

A the Economist explains in another article (The oiloholics behind subscription wall):

The main reason why high oil prices have so far not kiboshed the world economy is that cheap money has supported spending sprees and housing bubbles in many countries, notably America, which have offset the impact of dearer oil. The two main engines for the world, the United States and China (also the two biggest oil consumers), have both had their growth boosted by lax monetary conditions in the past couple of years. Indeed high oil prices can partly be seen as a consequence of low interest rates. The two most important prices in the world economy are the price of oil and the price of money, and they are linked. If interest rates are abnormally low (in bond yields as well as short-term rates), then as global demand increases in response, oil prices should rise--especially if production capacity is tight, as it is today.

So referring to the recent climb in oil prices as a "shock" is misleading. The market is simply responding to stronger oil demand on the back of a strong world economy. The increases in both global GDP and global oil consumption last year were the biggest for almost 30 years.

Why Greenspan is to blame

So Greenspan is to blame. Easy money, by fuelling debt,  asset prices and the "wealth effect" that comes from increased valuations of homes (directly via house equity withdrawals or indirectly as a simple psychological effect) fuels growth artificially - and oil demand. The important thing to remember is that current growth is unsustainable, and is in effect "stolen" from the future, when we will have to restrain our consumption to repay the debts incurred. But the oil demand growth, in the meanwhile, is very real, and is a serious problem as it bumps against the very real constraints from the supply side, caused by the combination of approaching peak oil and insufficient investment in the past few years. Even if growths stalls, as is likely, we have entered an age with limited spare capacity and thus very high oil price volatility.

Excessive growth in demand in America and China is, in effect, imposing a tax on others by pushing world prices higher than they would otherwise be. Even more serious, with little spare capacity in the oil industry, such rapid growth in consumption leaves the market vulnerable to any supply disruption, like those that initiated previous oil shocks.

This effect is exacerbated by the fact that the economies that are currently growing the fastest tend also to be the least efficient users of oil. To produce one dollar of GDP, emerging economies use more than twice as much oil as developed economies. Many emerging economies, including China and India, subsidise oil. Insulated from the reality of rising world prices, consumers guzzle more oil than if they had to pay full market prices. This, in turn, pushes global oil prices higher

Btw, the last point, while focusing on emerging economies, reminds us that the oil industry benefits from tons of direct and indirect subsidies and thus that "market forces" apply to heavily distorted markets...

But back to Greenspan: The Economist notes that financial markets would normally have reacted to such a situation, with its riskes of higher inflation, through the bond markets:

Rising oil prices may even be read as a signal that global economic growth has been more rapid than existing output capacity can sustain. Normally, bond yields would perform that role. But the bond market has been behaving mighty oddly, with yields falling over the past year. The rising oil price is thus taking some of the job of constraining the world economy away from higher interest rates. From this point of view, a high oil price is quite healthy, a way of helping to prevent the global economy from overheating. A much more efficient solution would be tighter global monetary conditions. But tighter money now risks pushing the housing and borrowing booms into reverse, tipping economies into recession.

I have discussed on various occasions the indeed strange facts that long term interest rates are a record lows, despite the recent increases by the Fed of short term interest rates, and despite the inflationary pressures from more expensive oil. This is usually sold as a sign of the world's confidence in the US economy and its non-inflationary prospects. My conviction - and that of the Economist, is that long term bonds are low because there has been so much liquidity injected in the world economy by the Fed in the past few years that all assety prices (and that includes bonds), are simply over-priced (bond yields go down as their prices go up). Inflation on consumer goods has been mostly kept in check by the emergence of China as a cheap global producer, but this may not last.

This morning, the FT has yet another egregiously fawning piece on Greenspan (following the two embarrasingly uncritical pieces earlier this week), with this quote, which I think hits the mark accidentally:

A hard act to follow in Fed's one-man show
A drawback of Alan Greenspan's highly successful 18 years at the Federal Reserve is that US monetary policy has become too personalised around the chairman, potentially leading to market trauma after a mere mortal takes over the job, it was suggested on Friday.

The most ironic part is that the next article has Greenspan pointing out himself what his successor will have to live with:

Greenspan warns on impact of asset prices
Alan Greenspan, Federal Reserve chairman, warned on Friday that movements of stocks, bonds and house prices are having a far greater impact on US and global growth than in the past.
Mr Greenspan, who is due to retire from the US central bank in January, said the Fed was paying increased attention to these issues and implied that his successor might have to cope with a sharp drop in asset prices, complicating monetary policymaking.

Yes. The policies of the Bush times. Find every way to push problems to later so that they have to be solved (much worsened) by someone else.

I will let the Economist conclude with a link back to the oil prices:

The fact that America's economy has been able to shrug off higher oil prices mainly as a result of a housing and mortgage bubble is hardly a comforting thought. What happens when house prices flatten, or even fall? Consumers will then feel the full force of dearer oil. Come to think of it, a further spike in oil prices could even be what pops the housing bubble, if it unsettles consumers enough. So far, the rising oil price has done little harm; but worse may well be on the way.

So Greenspan has helped cause the situation we have today, with debt-fuelled unsustainable growth. It seems that the hard reality of the oil market is what will cause the collapse of this bubble. Pretty ironic for a hack working in cahoots with a bunch of Texas oilmen.

Earlier "Countdown Diaries":

Countdown to 100$ oil (10) - Simmons says 300$ soon - and more
Countdown to 100$ oil (9) - I am taking bets
Countdown to 100$ oil (8) - just raw data
Countdown to 100$ oil (7) - a smart solution: the bike
Countdown to 100$ oil (6) - and the loser is ... Africa
Countdown to 100$ oil (5) - OPEC inexorably raises floor price
Countdown to 100$ oil (4) - WSJ wingnuts vs China
Countdown to 100$ oil (3) - industry is beginning to suffer
Countdown to 100$ oil (2) - the views of the elites on peak oil
Countdown to 100$ oil (1)

Crossposted on dKos for your recommendations:


In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sat Aug 27th, 2005 at 06:28:45 AM EST
There is no need to worry.  After all, "


My goodness, this is true. By the way, Citgo, owned by a Venezuelan state ownedcompany has 14,000 gas stations in the USA.

Where do I get in line?

by ilg37c on Sat Aug 27th, 2005 at 06:59:07 AM EST
The blog you keep pimping for is stupid, reactionary, and unfunny.
by afew (afew(a in a circle)eurotrib_dot_com) on Sat Aug 27th, 2005 at 10:09:10 AM EST
[ Parent ]
Thanks Jerome for keeping us informed about this crucial issue. Oil prices, that is. The image that comes to my mind after reading your diary is that of a House of Cards. It won't take much for it to come tumbling down.

I continually remind myself when filling up with premium at $2.77 a gallon (very roughly $.70 a liter) that you folks across the pond are still paying more than double that price. I saw gas at $2.95 in Denver yesterday, $3 is the new barrier here, but I think $4 is when people will go bananas.

PS- For you guys across the pond- Alan Greenspan is married to a woman named Andrea Mitchell, a TV newscaster who has for many years covered White House politics. When Jerome writes about him getting BJ's from the Financial Times, I can't help but think to myself "well, he ain't getting them from the Mrs."  ;-)

by US Blues on Sat Aug 27th, 2005 at 10:56:58 AM EST
Since the mid-90's the Fed has been consistently increasing M3 by around 5%/year.  For most of this decade the Cost of Capital was negative -- the Fed was paying selected borrowers to haul dollars away.  

These monies fueled the Internet Overinvestment Boom and now, since that bubble popped, the Housing Bubble.  The Housing Bubble, in its turn, is fueling overconsumption in the US feeding back into China.  The Illusion of Wealth created Moral Hazards in the two countries on many different levels one of which, but only one - alas, is the unwillingness of either country to acknowledge their idiotic oil policies.  

The US Oil Policy seems to be: Let the Oil Companies make as much money as the market will bear while never, ever, investing in research and development of alternatives.  Concurrently, the US domestic demand for oil is inelastic due to dependency on the automobile for Public Transportation [sic].  As Oil prices rise the Oil companies will, no doubt, do very well but any shift of consumer demand for shiny trinkets made in China must shrink.  

This, in turn, will lower economic activity in China and eventually reduce China's ability to purchase US Treasury and Corporate Debt instruments ... and the whole system will come under stress.  

The Good News is a lower demand in China will lower oil consumption as their addiction is somewhat elastic as they use oil for production of goods relieving some of the stress.  Potentially buying time for the US to shift to different automobile technologies with less reliance on gasoline (petrol.)

If, of course, the US consumer has the Purchasing Power to buy the new technologies.  Given the lousy Cash Statement of most Americans (in the Red) this is a huge whopping 'if.'

Even a meandering post some wind to some conclusion so:

China and the US are screwed and the EU gets to 'share the experience.'  Norway (the oil-drenched sods) should do OK -- We can all move to Bergen and Sirocco can put us up in his flat.  

Skepticism is the first step on the road to truth. -- Denis Diderot

by ATinNM on Sat Aug 27th, 2005 at 11:14:48 AM EST
Dean Baker is one of my favorite US economists. He agrees with Jerome that Greenspan is guilty of recklessly blowing bubbles:

The Federal Reserve Board is having its annual retreat at Jackson Hole, Wyoming and the agenda this year is devoted to a retrospective of Greenspan's 18-year tenure as Fed chairman. The world has not seen a greater display of obsequiousness since the death of Leonid Brezhnev. An economist whom I used to respect even called him the greatest central banker in history . . .

Let's get a few facts on record:

1) Mr. Greenspan ignored the stock bubble. . . . decided that it wasn't his job to do anything about the creation of $10 trillion in bubble wealth and the resulting economic distortions. . . . The tens of millions of people who saw much of their retirement savings disappear in the crash are just out of luck, as are the pension funds that are now insolvent . . .

. . .

2) Mr. Greenspan promoted the housing bubble. . . . like the alcoholic who gets over one hangover by starting on the next, Greenspan's tool for getting out of the recession created by the collapse of the stock bubble was to promote a bubble in the housing market. . . .

When the housing bubble bursts, we will see the loss of $5 trillion in housing bubble wealth. . . . Tens of millions of people will be in for a rude shock . . . this will destroy their plans for a comfortable retirement.

The economic fallout will also be enormous. . . . You will see a huge falloff in consumption . . . The resulting recession may well be worse than the 1981-82 slump.

For extra fun, watch for the collapse of the secondary mortgage market . . . think S&L bailout, think $400-$600 billion in federal spending.

But Baker also agrees with FT that:

In 1995 and 1996 he lowered interest rates and kept them low. This allowed the unemployment rate to fall below the 6.0 percent level that the vast majority of economists considered a floor. . . .

The decision . . .  gave millions of people jobs. . . . disproportionately benefits those who are most disadvantaged, especially African American and Hispanic workers. . . . allowed for the first sustained growth in real wages for most of the country's workers since the early seventies. . . .

There is a bit of a contradiction here, I think, since, as Jerome argues, the low interest rates helped to make the stock bubble possible in the first place, and the bubble itself contributed to faster growth and low unemployment, making the 1990s boom unsustainable in the long run.

Baker argues, though, that Greenspan had an option other than raising interest rates:

The proper remedy for the bubble was actually very simple - talk. If Greenspan used his Congressional testimony and other public speaking opportunities to lay out the case for the bubble, there is little doubt that it would have deflated long before it reached such outlandish proportions.

Is this true? Is it possible to jawbone our way out of financial bubbles?

If not, is there any hope of creating a sustainable full employment economy without blowing bubbles? How do we square this circle?

by TGeraghty on Sun Aug 28th, 2005 at 07:18:18 AM EST
Well, maybe to clarify, I don't want to let it be believed that I think that everything Greenspan did was bad. One can argue that he did indeed a pretty good job until 1998-99. The response in 1987 was probably the right thing to do (although it also brought in a few heady years followed by a nasty recession), and his calls in 1994-96 were indeed pretty good (and in 1994 he did buck the markets by increasing the Fed rates somewhat unexpectedly).

Where he erred, and is all the more inexcusable after his "irrational exuberance" speech in 1996, is when he decided to encourage the dotcom bubble (all the talk about a "new economy" and increased productivity) - and then when he compounded that by creating a bigger bubble, which he has so far managed to keep alive until beyond his retirement.

He has not solved problems in the past 7 years, he has just pushed them under the rug, while making them a lot bigger. He has also been a hack in encouraging Bush's insane tax cuts and in encouraging his Social Security plans - when he was the guy that raised the payroll tax in 1983 to fill up the SS reserve fund (the "lockbox") to make SS fully solvent. In effect, he made the middle classes overpay for 20 years, and then he helps give out the surpluses to the very rich. Hack, hack, hack.

He could have spoken out against the bubble in 1996/7/8/9. He had the credibility to stop the worst excesses. He chose not to, and he is fully responsible for that, and all the consequences of that, and the snowballing he also chose to go for.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sun Aug 28th, 2005 at 05:33:32 PM EST
[ Parent ]
While the US job creation might have been a good thing for USAmericans, the rest of the world didn't fare as good.

Dean Baker mentions tens of millions of people who saw much of their retirement savings disappear in the crash, he doesn't mention investors from all around the world who also saw their capital, thrown into the supposedly most profitable national economy by the trillions, go up in smoke. A capital flow 'helped' by FED (and other US economic governance) policies in wide-ranging fields, and distorting and hurting the economies this money left.

*Lunatic*, n.
One whose delusions are out of fashion.

by DoDo on Mon Aug 29th, 2005 at 03:36:30 PM EST
[ Parent ]
I've always wondered if one of the reasons the German (and other European) economy(ies) fared poorly after 2000 is that a lot of individual investors from Europe joined the dotcom fun pretty late in the game, and they were the ones that were left holding the bag. American investors, except for the few most extreme cases, if they invested earlier in the 90S would stille come out in positive territory. Europeans (starting with the Deutsche Telekoms, Alcatels and the like) that bought assets at inflated prices in 1999-2000 had to support real losses. I remember seeing that German foreign investments reached records in these years (to the tune of 150 billion euros, I think), and a good chunk of it was probably lost altogether. Quite a nasty shock for the economy.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Mon Aug 29th, 2005 at 05:51:51 PM EST
[ Parent ]
I think you're definitely onto something there. The question is, will internationals get burnt by this new bubble? Will the Chinese investment method (mostly US Treasury Bonds) insulate them from a similar scenario?

Also, an interesting question is how much did Japanese companies lose in the dot com bubble and what effect did it have?

by Metatone (metatone [a|t] gmail (dot) com) on Mon Aug 29th, 2005 at 06:30:26 PM EST
[ Parent ]
Here's what The Economist said about blowing bubbles, August 5, 2000:

ALAN GREENSPAN, chairman of the Federal Reserve, says that when he changes interest rates, share prices are not his target. But that is not how it seems on Wall Street, where it has long been an article of faith that you "don't fight the Fed." In recent years, this rule has repaid its followers handsomely. When the Fed is raising rates, as it has been this year, America's stockmarket performance tends to be poor. But when Mr Greenspan's monetary policy has been looser, as in late 1998, after the collapse of Long-Term Capital Management, and late last year to ease millennium-bug fears, share prices have soared (see chart).

(Sorry, I found this among old archives on CD, and can't provide a link to the article).

by afew (afew(a in a circle)eurotrib_dot_com) on Sun Aug 28th, 2005 at 04:03:15 PM EST
Predictably (?), Paul Krugman weighs in against Greenspan in a NYT op-ed here.


The U.S. economy is currently suffering from twin imbalances. On one side, domestic spending is swollen by the housing bubble, which has led both to a huge surge in construction and to high consumer spending, as people extract equity from their homes. On the other side, we have a huge trade deficit, which we cover by selling bonds to foreigners. As I like to say, these days Americans make a living by selling each other houses, paid for with money borrowed from China.

One way or another, the economy will eventually eliminate both imbalances. But if the process doesn't go smoothly - if, in particular, the housing bubble bursts before the trade deficit shrinks - we're going to have an economic slowdown, and possibly a recession. In fact, a growing number of economists are using the "R" word for 2006.

And here's where Mr. Greenspan is still saying foolish things. In his closing remarks he suggested that "an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports and a corresponding improvement in the current account deficit." Translation, I think: the end of the housing bubble will automatically cure the trade deficit, too.

Sorry, but no. A housing slowdown will lead to the loss of many jobs in construction and service industries but won't have much direct effect on the trade deficit. So those jobs won't be replaced by new jobs elsewhere until and unless something else, like a plunge in the value of the dollar, makes U.S. goods more competitive on world markets, leading to higher exports and lower imports.

So there's a rough ride ahead for the U.S. economy. And it's partly Mr. Greenspan's fault.

by afew (afew(a in a circle)eurotrib_dot_com) on Mon Aug 29th, 2005 at 06:12:37 AM EST

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