Oil prices, trade deficits, interest rates, and inflation - facts and fictions
As the article puts it:
Based on my own reading of the Yukos
situation and overall oil supply situation over the last few months it
appears that the situation is both exaggerated by the analysts and
reporters - who are far from disinterested parties - and exacerbated by
national political policies and actions. Neither the US
is a wholly owned subsidiary of the oil industry under the Bush regime,
nor the Russian government, which is (and has been for many years)
dependent on oil export income for a major part of its revenues have
any inherent interest in actions which would lower oil prices.
In the case of Russia, one could make a
case for high oil prices being in the national interest. In the
US, it is harder to make a that case - the argument is contaminated by
the disproportionate benefits to major oil companies and the ties of
the Bush regime to those companies.
When oil analysts such as Mr. Flynn assert
that "the health of the world economy hangs in the balance" because of
Russian oil policies and Yukos's tax problems, I lose patience.
This statement is based on an implied, and nowhere demonstrated,
presumption that the Yukos production alone is both required and
sufficient to prevent oil
price increases which would endanger the world economy - which is
First, the oil involved, though
significant, is not so great a part of the total needed that its loss
would increase prices a great deal - all of the price increase which
would result from loss of Yukos supply has likely
already been incorporated into the "uncertainty premium" currently
Second, the sensitivity of
prices to supply is exaggerated in the short term by the statements of
oil speculators and analysts who have an interest in those prices, and
whose version of reality is uncritically reported by an unsophisticated
press. In fact, energy consumption does decrease as prices rise,
and that decrease
reduces demand and stabilizes prices.
If it were not for the influence of
political uncertainties produced by the Iraq War and the diversion of
large quantities of oil into the US's Strategic Petroleum Reserve, even
over wrought hand wringing by the analysts and speculators about the
Yukos flap would not justify the uncertainty premium currently added to
rational prices for oil.
$50.00 Crude. But the CBS
MarketWatch article goes beyond
that, to assert a spector of $50.00 oil and
Quoting the article:
While it would have a significant
psychological impact on public impressions, $50 oil would not be the
disaster implied by the people quoted. That price very well
may be reached, and it won't be the end of
the world economy if it is.
Which is apparently an obvious enough
truth, that there are those who think the possibility of that price is
not sufficiently alarming. These people are led to describe even
dramatic scenarios -- dollar devaluation accompanied by
hyperinflation. The anticipated public and political reaction
to these scenarios, predictably enough, fit the interests of the
oil companies quite well.
Over the last 18 months or so the dollar
has declined in value, slightly, with respect to other
currencies. One analyst wants to blow this up into a real crisis,
with implications for the price of oil itself. Quoting from the
CBS MarketWatch article again:
There actually may be no limit to how high prices can go if the U.S. dollar continues its decline, said Peter Schiff, the president of Newport Beach, Calif.-based investment firm Euro Pacific Capital.
Now I am scared!
In fact, Mr. Schiff
has a considerable ax to grind - an unacknowledged agenda - in
proposing such an unrealistic interpretation of recent history and
prospective changes in the value of the dollar. Though his
language is extreme, the much
more temperately expressed concerns of Alan Greenspan and the Federal
Reserve Board lead those august representatives of our political
establishment to the same, questionable, policy
Mr. Schiff is straightforward in his opposition to decreasing the value of the dollar. Instead, he would strengthen it by raising interest rates. Raising interest rates would in fact have several effects, and one would be to strengthen the dollar relative to other currencies. In addition:
On the other hand, keeping interest rates
low would largely have the opposite effects:
dollar should be at a value that
permits US exports come into balance with US imports, and we achieve a
or positive balance of trade. Monetary
policy should be designed to support US
exports, and bring the balance of trade into balance. However,
due to economically
extraneous factors, including the perception of economic, financial,
and political stability in the US, the desirability of storing value in
US dollars may be so high that cash inflows to the US will continue
even in circumstances where trade comes into balance, which would
result in a positive balance of payments. Equilibrium at a
slightly negative balance of trade, and neutral balance of payments
might be a more desirable goal.
Mr. Schiff is not content with generalities
in blaming his
vision of impending disaster on a "falling" valuation of the dollar, he
gets into some pretty far fetched detail on the topic:
He's in the camp that sees oil prices of $50 by year's end. But "oil prices next year are going to head north of $60 a barrel and just continue on up," he said, adding that he even sees $80 to $100 oil over the next few years.
Schiff's argument that declines in the foreign exchange value of the
dollar are responsible for oil price increases depends on an absolute
relationship between the value of the dollar and the price of oil,
implied by the second of the three paragraphs, which simply does not
exist. Since oil is bought and sold with dollars it is equally
true, and and more plausible, to assert that a "depreciating value of
the U.S. dollar" dollar always would make oil cheaper to non dollar
economies (less expensive dollars equate to less expensive oil).
And Mr Schiff does make that assertion in the very next
paragraph! (Problems interpreting Mr. Schiff's reported
comments may be with the reporting, more than the comments. His
July 30 essay on
this topic is coherent, and worth reading.)
The point there that "as the dollar becomes
less valuable, oil becomes cheaper and cheaper for everybody outside of
America", is unarguable. Though he
seems to regards this as a
negative outcome, and I regard it as a positive outcome, my argument is
not with that point. Rather, it is whether the scenario he
describes has begun to
happen at all. The slight decrease in the value of the dollar
relative to other currencies which has occurred over the past year or
so is just not significant enough to have had, or to have the effect he
describes in the future.
The US is not really flooding the world
dollars, at least not enough to drive the dollar down
effectively. Flows of money back into the US are
still compensating to some degree for outflows needed to pay for the
goods and services we are importing. The value of the dollar is
still so high that we are running a massive trade deficit, importing
far more than we export. Only when the value of the dollar
achieves parity with other currencies will we pay enough for imported
goods, and earn enough from exported goods, to bring our trade account
In fact, the price of oil will continue to
be determined by the demand for oil relative to
supply, plus whatever "uncertainty premium" is added by the market. Of
course, as the dollar declines in value and becomes cheaper for non
dollar economies, their demand for oil will increase - and the value of
the dollars obtained by sellers of oil will decrease.
Economic theory says that these two facts together might affect overall
supply and demand and prices.
But the recent increases in oil prices are
not driven by the dollar's slight decline in exchange rate. It is
economic expansion in
developing countries, not a decrease in the value of the dollar, that
is driving their demand for oil. And it is the war in Iraq, and
political uncertainties in Russia and Venezuala, that undercut the
perceived reliability of oil supplies and add that very high
"uncertainty premium" to the price.
But Mr. Schiff goes even further, according
to the article:
And it won't end there. "We have the chance for hyperinflation in the U.S. if the government doesn't get its act together, if the Federal Reserve stays behind the curve and doesn't dramatically increase interest rates above the rate of inflation substantially," said Schiff. If the Fed doesn't take action, then hyperinflation could send oil to $100 or more and "everything will be getting more expensive -- food, anything that we consume," he said.Here he is calling overtly for a very large PRRR, ostensibly to avoid hyperinflation. Already, the Feral Reserve Board (intended) has raised interest rates for a second time in 6 weeks, in the face of a very low rate of job growth and continuing losses of wage income. This is, in fact, a recipe for another round of Nixonian stagflation, and possibly even deflation and depression of the US economy. The degree to which Mr. Schiff's comments and thinking are wandering out of orbit is apparent in the last sentence, which simply has no logical structure to analyze.
But after all - he is an oil investment analyst. Let's give him a break.
Addendum - Notes, Disclosure and Reservations:
Its fair to note that an article in the August 11, 2004, Chicago Tribune quotes a Chicago investement banking economist's assertion that holding the Fed's benchmark rate below the rate of inflation for an extended period would be a "recipe for stagflation [a stagnant economy with high inflation] and disaster." This is not my view, and I think that a careful look at precursors to the "Nixon round" of stagflation would support me - but I am relying on memory and have not checked the numbers.
Peter Schiff has a quote - typically dramatic and gloomy - in the same article.
Another bearish statement came from Peter Schiff, president of Euro Pacific Capital Inc., a California investment firm, who claimed the U.S. economy is beset with many deep problems, including heavy consumer debt, a housing market "bubble" and too many heavily indebted corporations. He said a deep recession is inevitable, and the Fed should bring it on more quickly to "purge all the mistakes of the boom."Mr. Schiff has a rep. He "bears" watching, methinks. A comment at the (most excellent and very highly recommended) "Capital Spectator" blog (comment) notes about one of his essays "As a piece of financial commentary, Schiff's piece about as rhetorically unhedged as you can get." Here, true to form, he has written (July 9, 2004) :
"Today, the only reason the U.S. remains the world's leading economy, is because the dollar still serves as the reserve currency. However, if market fundamentals can ever manage to re-assert themselves, this is a reality that can, and indeed must, change."Despite my lack of agreement with Mr. Schiff on many points, he has a distinctive, fact based and value driven point of view which is worth becoming familiar with. It leads him to present information that is not given enough attention in normal financial and economic news reporting, or, in his judgement, in policy formation. His critique of current policy is especially useful, as it strips the basic tendencies of Federal Reserve policy bare of their cloak of moderation, and exposes the direction in which the Fed is moving and the potential consequences. (Neither fast enough, nor with draconian enough vigor and clarity, according to Mr. Schiff.) See his July 20, 2004, essay for more.
I must note that his observations about inflation, and they way it is understated and misreported, both in the press and by official Washington, concern me. His observations fit with my own, and lead to a conflict between my objective of reducing the valuation of the dollar and the need to do so without producing a cycle of extreme inflation.
The goal of limiting the rate of inflation is assisted, in the case of oil price driven inflation, by the fact that increasing oil prices suppress economic activity in much the same way that increases in the cost of money, that is interest rates, do. Quoting an August 16, 2004 New York Times newsletter by Jonathan Fuerbringer:
Mr. Schiff wants to avoid the inflationary cycle, and hopefully hold down the price of oil, by increasing interest rates. I have noted above the highly negative effects of such an increase, including the perpetuation of undesirably high valuation of the dollar. At the same time, holding interest rates down, while having the desirable effect of reducing the value of the dollar, is in effect walking on a knife edge. If Mr. Schiff were correct the amount of inflation he predicts would be a disaster for Americans on fixed incomes. But Mr. Schiff is not an unbiased observer, he has dogs in the fight, and reasons to advocate high interest rates.
And higher oil prices may be an acceptable stand in for higher interest rates in their effect on inflation, while offering long term advantages to US employment and export activity.
The same "Capital Spectator" Blog (here) notes Bill Gross's "latest missive". I have a very high regard for Mr Gross's analysis and recommend reading all the way to the 'Goldilocks yield' reference, w which addresses that troublesome "knife edge". Note especially two startling charts: "Total Credit Market Debt (all sectors) as % of U.S. GDP" -1915 to 2005; and "Financial Sector Profits as a % of All Domestic Corporate Profits" - March 1977 to September 2004.
August 11, 2004
Rev: August 16, 2004
|June Trade Deficit
Shock. August 13, 2004, the US trade deficit was headlined
as "US trade gap explodes to record in June". The reported
deficit "exploded to a record 55.8 billion
dollars in June, the sharpest deterioration in more than five years". This
"shattered the previous record deficit in
April of 48.2 billion dollars." Quotes from people with
special interests in the topic include
"The trade deficit soared to simply incomprehensible heights in June,"
said Naroff Economic Advisors president Joel Naroff. And "It is just a phenomenal deterioration
for one month in the trade balance," said BMO Financial Group senior
economist Sal Guatieri.
The causes of this sharp decline assigned by the commentators do not hold up to examination - one noted that higher energy prices may have resulted in a softening of the world economy, but that runs counter to both statistics available on other than US economic performance, the fact that the oil price runup is largely in futures, not current or "spot" prices, and that the price runup is in dollars, not local currencies. What does happen is that paying for oil uses dollars that might otherwise be used to buy US products.
And in fact, US exports declined, not because of a softening of the global economy, but because the need to pay for oil used dollars that might otherwise have purchased our exports. Of course, the US had no such problem - as the "reserve currency", pushed to the boiling point by a flood of dollars from oil transactions, a huge government budget deficit, and consumer spending driven by refinancing of the US housing stock, dollars were in plentiful supply. And overvalued relative to other currencies.
As a result, US imports climbed 3.3%, to $148.6 billion.
Appropriately, the dollar lost some value on this news. But no where nearly enough. The Fed foolishly projected its intention to continue supporting the dollar's value by raising interest rates. This will perpetuate and worsen the imbalance, reducing the relative price of oil to the US and increasing it to other countries - who might otherwise use those dollars to buy US product.
Discouragingly enough, the Kerry campaign response has not addressed the problem, but issued a statement implying that it could be solved by "enforcing trade agreements" and "fighting for jobs here at home" - whatever that means. Sorry fellas, that just won't make it - not in economics and not in politics.