Sunday, September 18, 2005


Check out the Cunning Realist's piece on the effect of oil on our economy. As he mentions, it's a long post, but well worth a read.
For those of us who work in the financial industry, these are interesting times. But even those who have nothing to do with Wall Street have a stake in what's happening below the surface of our economy. This is particularly true in light of the government's response to Katrina, which will impact all of us. This post will focus primarily on oil. As I'll explain, I believe oil is the most important issue facing us right now, but not for commonly accepted reasons. This is a long post, but I don't think you can fully understand major geopolitical issues including Iraq, Iran, and China without also understanding some seemingly unrelated issues that are coming to a head right now. I'll try to keep the wonkishness to a minimum and make this accessible to most readers.

First, we need to dispense with some of the myths about oil that have gained acceptance recently through sheer repetition. One of these is that the relentless rise in the price of oil "acts like a tax on the consumer." This is nonsense. Taxes, as painful as they are, at least have some domestic benefit for those who pay them. Taxes build roads, maintain the military, and pay for public education. The majority of money we fork over at the gas pump simply leaves the country. It builds roads in Riyadh, Tehran, and Caracas. Another chestnut is that "oil is doing the Federal Reserve's job for it", which I heard yesterday on a business news show---the implication being that Alan Greenspan and the Fed don't need to raise interest rates since higher oil acts to slow the economy just as higher rates do. More nonsense. Oil does not do the Fed's job; it reflects the job the Fed is doing. All else being equal, the more money the government prints, the higher oil goes. And indeed, over the past year all else has been equal. Despite the constant media hype about Chinese demand, last week Morgan Stanley analyst Andy Xie noted that oil's demand-supply relationship has not changed this year---but oil prices are up about 70%.

You can thank easy money. Although the Fed continues to raise interest rates at a snail's pace from historic lows, the financial system is flush with liquidity. In real terms, monetary policy is easier now than at any time since the early 1970's when the U.S. was paying off the debts from another expensive war, and Federal Reserve chief Arthur Burns kept rates too low to help Nixon get re-elected. (By the way, you can listen to Nixon and Burns on the Oval Office tapes secretly discussing manipulating the economy and government statistics to boost Nixon's 1972 re-election chances at this link. It's fascinating, and a must-listen for anyone who naively believes the Federal Reserve is immune from political pressure as it is supposed to be. It's also relevant, as records indicate that current Fed chairman Alan Greenspan has been visiting the White House far more often than any other of his predecessors.) This leads to yet another oft-spoken absurdity about oil: even though it is near an all-time high, "it's still well below its inflation-adjusted high" of the 1970's. In other words, the price of oil is rising due to inflation, but we've printed so much money over the past 25 years that we've made oil cheap! So goes that line of reasoning, which is cognitive dissonance, denial, and circular logic all wrapped into one. Want a good prediction on where oil will be trading a year from now? Tell me exactly what the Fed's monetary policy will be and how much liquidity will be created or drained over the next twelve months, and I'll give you a pretty good guess on where oil will be trading.


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