Successive meetings on oil at the American Enterprise Institute Wednesday and on the world’s monetary system at the Cato Institute Thursday brought the current problems with the world economy sharply into focus. There’s far too much money currently sloshing around the world, and not nearly enough oil. The combination of the two will make for interesting times ahead, in the sense of the ancient Chinese curse.
The surge in oil prices since 2002 has been largely driven by demand. Whereas the rise in prices in 1973 was driven by the OPEC oil embargo, and that in 1979-81 by the interruption in supplies first from Iran and then from Iraq (due to the Iran/Iraq war of 1980-88) the rise since 2002 has had no major supply-side cause, although depletion of North Sea oil fields and the brief interruption of Iraqi production in 2003 have played minor roles. Instead, the rise has been caused by a steady rise in demand from the United States, accompanied by a very rapid rise in demand from China and to a lesser extent India – more than 60 percent of the rise in oil demand in 2002-04 was from the Third World, 36 percent of it from China alone.
The surge in money, on the other hand, has been largely driven by supply. China, a huge new participant in the world economy, has a very high savings rate, which savings are largely trapped by exchange controls, and are recycled through the Chinese banking system to prop up state owned dinosaur companies. In the United States, money supply has increased much faster than Gross Domestic Product for a full decade, causing asset bubbles in the stock and housing markets. In Europe, the new European Central Bank, beset by long term sclerosis in growth and desperate to increase the political legitimacy of the euro project, has erred consistently on the side of easy money, keeping its discount rate at 2 percent, below the Eurozone rate of inflation, for more than 2 years now. In Japan, the remnants of a prolonged period of asset deflation are now wearing off, but interest rates remain around zero even as the economy begins to recover at a substantial rate.
The result of all these differing factors, almost all of them due to political control of the money supply, has been an orgy of world money creation on a scale never before seen. Previous inflationists, such the corrupt politicians of Weimar Germany (who were attempting to make French postwar reparations worthless) affected only one medium sized country, but today’s money flood is worldwide.
The two trends are linked, but only loosely. Money supply creation inevitably feeds into asset prices, and into the prices of the goods most dependent on a freely functioning world market, and whose supply cannot readily be increased. The problem can be disguised by such statistical sleight of hand as “core” inflation – strip out all the things whose price rises — and “hedonic” pricing – knock off an arbitrary factor for quality improvement, to make the numbers look lower – but eventually, as we saw in the 1970s, reality catches up.
In balanced markets, capital investment and increased consumption mop up much of the excess liquidity that has been created. In today’s market, capital investment is depressed by the overhang of foolish investment from the 1997-2000 bubble, while Chinese and to a lesser extent other Asian consumers are artificially constrained from consuming what they produce, forcing the profits instead into ever higher mountains of Chinese and Asian central bank holdings of U.S. Treasury securities.
The effects of easy money stretch far beyond the oil and housing markets, and are much less benign than is popularly believed. Consider, for example, the U.S. balance of payments deficit, and the weakness in U.S. employment statistics, which on Friday showed an increase of only 56,000 for October, far below the 150,000 thought to be needed to absorb new entrants to the workforce. Both are affected by easy money, through the mechanism of the international bond markets. In current markets, not only are real interest rates low (2.08 percent on the 10 year US Treasury TIPS, equivalent to about 1.3 percent when the hedonic “fudge factor” in the price index is stripped out) but risk premiums are exceptionally low, with emerging market borrowers such as the defaulted Argentina able to return to the market on attractive terms.
In a market where poor credits can borrow almost as cheaply as good ones, and private equity and hedge funds are aggressively seeking investment opportunities in exotic stock markets, the cost of capital for an investment in say China is very little higher than for an equivalent investment in the United States or Europe. However, since the cost of producing a product is the sum of its raw material costs (generally similar for everybody), labor costs and capital costs, if capital costs in the Third World are exceptionally low, products produced in the Third World become exceptionally competitive compared to US products.
With the capital cost advantage of U.S. producers of many goods negated by an ocean of sloppy money, the labor cost advantage of their Third World competitors becomes relatively more important. Consequently, factories in the United States are closed down, jobs are outsourced and the U.S. balance of payments lurches into ever greater deficit. In such a world, cheap money, far from benefiting U.S. workers as one might expect, in reality damages them, exposing their jobs to unnatural blasts of icy Third World competition.
If the automotive parts manufacturer Delphi cannot afford to manufacture in the United States except at wage rates below $10 per hour, as its Chairman recently claimed, its workers and potential workers are getting no benefit whatever from the advances of modern technology and the glories of globalization. Politically, they will blame the party in power; in reality they should blame the Fed and its international partners in money creation.
Ben Bernanke’s solution to deflation, of dropping money from helicopters, is precisely the wrong one for this situation. In reality the world’s central banks should be scouring the world with giant vacuum cleaners, sucking up the surplus liquidity that has distorted the world’s economic system so badly. The welfare of the U.S. working man, not inflation alone, should be the primary concern of the Fed going forward.
Fortunately, Fed Vice Chairman Roger Ferguson at the Cato meeting made it pretty clear that inflation targeting, as far as the Federal Open Market Committee was concerned, would take second place to maintaining the Fed’s credibility and fighting the scourge of inflation, of which he sees the reawakening. By fighting inflation, the Fed will slow the world economy, but as if by magic it will slow it most in the Chinese and Third World export sectors, while competitive conditions for U.S. manufacturers will unexpectedly improve.
The decline in the U.S. balance of payments deficit will bring a rebalancing of the world economy that in the long run will be highly beneficial, even to those Third World countries whose export sectors have recently surged far beyond their equilibrium level. Existing Third World exports will be relatively little affected, because their capital costs have mostly already been incurred, but new Third World capital investment will fall off, as the potential profitability of new projects disappears. Third World domestic consumption will increase and domestic saving fall, so Third World consumers will enjoy more of the economic benefits that their diligence and industry have earned.
In China in particular, a revaluation of the renminbi by perhaps 15 percent, (less than the 25 percent that is apparently needed in today’s distorted world economy) would bring Chinese trade fully into balance, and enrich Chinese consumers. In a period of tight money, with a revalued renminbi, the Chinese state sector and the banks will find it much more difficult to borrow money. This will result in an acceleration of foreign penetration of Chinese banking system, as happened in Japan in 1997-2000, but also a sharp fall in “white elephant” Chinese real estate construction and, if Chinese government policy is well advised, a diversion of resources towards rural areas and their inhabitants. This will reverse the excessive urbanization, increasing inequality and wasteful heavy industry and real estate investment that have characterized the Chinese economy in the last decade.
As for oil, the recession that tight money will bring will allow the world oil market to catch its breath, and new production to be brought on stream. Canadian tar sands production in particular is highly profitable at current prices and, once brought fully on-stream, would allow the United States to reduce significantly its dependence on unstable Middle Eastern and African oil producers. In the long run, world oil production must peak and begin to decline, so the price mechanism must be allowed to provide the signals necessary for the world economy to adapt accordingly. Politically dictated government regulation has the potential to distort the market, providing harmful subsidies or producing unexpected and counterproductive results such as the switch in the United States to SUVs that was caused by the Corporate Average Fuel Economy legislation of the 1970s and 1980s.
To ensure that adaptation takes place as quickly as possible, and that the U.S. economy is not overwhelmed by a sudden oil supply crisis, government can help mainly by eliminating existing subsidies and obstacles to a sound energy policy. Environmental regulations must be streamlined to permit the construction of new nuclear power plants. Excrescences such as last summer’s Transportation Bill, which provided road construction that was free to users and funded by taxpayers, must be eliminated. Petrol taxes must be increased to ensure that U.S. consumers are left in no doubt of the tough choices that have to be made.
Kevin Hassett of AEI pointed out that if U.S. use of public transportation was increased from its current 1 percent of total mileage to the European average of around 10 percent, U.S. oil imports from Saudi Arabia would no longer be necessary. The Federal government could achieve this by increasing taxes on petrol until it cost the European average of $7 per gallon, while remitting other taxes, sharply cutting Federal spending on new roads and correspondingly increasing spending on public transport. Of course, like most desirable political initiatives, such legislation would be hugely unpopular and opposed by a myriad of angry lobbyists.
Higher interest rates, more expensive oil and a recession are all thoroughly unpleasant medicines that the U.S. public is going to have to swallow. Not for nothing do they call economics the Dismal Science!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.