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)