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Essays 10
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May 10, 2008
Possible Oil crunch, "Oil Vigilantes", and the 1970-80 Experience
Yesterday a short report was posted concerning the alarming non-stop surge of Oil prices in the past week (see: Rising Oil Prices: Crunch Time May be Here ). In April, a long term monthly chart of Oil was posted in which a potential oil price of$130 was indicated at the top of a multi-year up-sloping price channel ( see: Panoramic Oil Chart ). An update of this chart is presented below with the indicated price of $130-135 at the top of the channel.
Even on cursory inspection, the chart reveals a striking similarity between the trajectories of Oil prices during two periods, each about 9 years in duration: 1971-80 and 1999-2008. From this observation, it is appropriate to ask the following questions. First, what were the conditions that caused the rise of Oil prices in the 70s and, as a corollary, are similar factors identifiable in the more recent nine-year period?. Second, what are the circumstances that put an abrupt end to the surging Oil prices in early 1980?.
Causes and remedies for the surge of energy prices in the 70s.
Two conditions were principally responsible for the energy crisis of the 70s:
1. First, the US' persistence in keeping price controls on Oil and Natural Gas at levels (about $2.0/barrel for Oil) way below the economic value of these commodities. With the help of the emotions engendered by the Arab-Israel conflict, Middle Eastern Oil producers eventually refused to accept such controls any longer and nationalized their Oil resources, thereby allowing prices to surge to their more natural level.
2. Second, the control of interest rates imposed by Regulation Q in the US, prevented the implementation of monetary policies that could have counteracted the resulting inflationary pressures. One of the consequences of negative Real interest rates was a significant depreciation of the US dollar and associated run up of Gold.
Both sets of controls were relics left over after the end of Wold War II. By 1979, as the situation became unsustainable (Oil reached a price close to $40, inflation galloped to over 12%), President Carter, in concert with Congress, decided the time had finally arrived to take the measures needed to reverse an economically very damaging trend.
Legislation was debated and prepared for decontrolling Oil and Natural Gas prices. The provisions were to be implemented soon thereafter by President Reagan, Mr. Carter's successor in the White House. At the same time, Mr. Carter appointed Fed Chairman Volker to preside over the repeal of Regulation Q and the decontrol of interest rates, a task that Mr. Volker undertook with a vengeance. The effects of these policies were dramatic, almost immediate, and long lasting. From 1980 onward, a dis-inflationary era was inaugurated that lasted till recently. Oil prices fell to about $10/barrel three times since then and were not to see $40/barrel again for 24 years(or the equivalent inflation-adjusted price of about $80/barrel for 2 more years). Initially, however, the cost turned out be burdensome indeed. Two years of teeth-grinding economic recession of which a frustrated new President could hardly see the end.
Admittedly, in the interest of brevity, the above account oversimplifies what were very complex events and omits several important factors that contributed to the success of the policies implemented in those years (end of Union Power, trade liberalization, relief from excessive taxation, removal of constraints to capital flows etc.); but in terms of relevancy to current conditions, it covers the most essential points.
One additional aspect should be mentioned at this point. It concerns the glorification of Mr. Volker as the Hero Slayer of the Inflation Dragon. The ability and skill demonstrated by Mr. Volker in steering the US financial ship through the turbulent waters of deregulation, particularly in the early years, is undoubtedly deserving of high praise. However, what should be firmly kept in mind is that, in the end, all Fed Chairmen are political appointees called to implement policies consistent with the goals of their bosses in the Executive and Legislative Branches of Government. Mr. Volker was no exception. He was called by the President and Congress to administer whatever bitter medicine was required to cure the ills of an economy in serious trouble. To this end, he had a clear mandate and a blank check. He carried out the task well, but without those explicit combined Presidential and Congressional mandates, he could have hardly begun his difficult mission. This is a fact of crucial importance when considering the role of current Fed Chairman Bernanke and the actions that can reasonably be expected of him in dealing with our current financial and economic exigencies.
Relevance of the 70s experience to the current situation
Easy monetary policies and negative Real interest rates have prevailed in the US for most of the time since the year 2000, very much as in the early 70s, and this time even without Regulation Q as an excuse. A consequent depreciation of the US dollar likewise has occurred during this period. In the global arena, low interest rates policies combined with heavily subsidized energy prices to consumers in several countries, most importantly China, constitute a faithful reproduction of the conditions prevailing in the US in the 70s. The inflationary effects now seen in these countries are likewise reminiscent of the consequences seen in the 70s in the US.
Assuming the surge of oil prices continues unabated, are there any actions that can be envisaged to curb or at least stabilize Oil prices as in 1979?. Of course the differences between now and then are immense, most notably the new situation of near equilibrium between supply and demand of Oil. Nevertheless some conjectures can be articulated even if the probability of their being realized is very low at the present time.
Thus, it is not unreasonable to think that, if Oil prices rise to levels much above the present one, policy makers in the US and elsewhere may be forced to consider measures that now appear unthinkable. For instance, could Mr. Bernanke be empowered to announce a rapid re-normalisation of interest rates by increasing the Fund rate to the calculated neutral level of 4.0% and thereby causing a rapid 10-15% appreciation of the US Dollar?. Could any additional fiscal stimulus be formally excluded by Congress and the Administration?. Could enlightened energy policies be finally devised and implemented here and abroad?. Could the Chinese Government explicitly declare that energy subsidies to consumers will be drastically curtailed or ended soon after the Olympics?. Could these subsidies be ended as well in other countries?.
None of this is impossible, although no one should hold his/her breath waiting for such decisions. The reasons are simple. Just like in the 70', any effective measure to remedy the current situation will come at the same cost: a severe and prolonged economic contraction. It takes leaders with character, fortitude, and a strong stomach to take actions carrying this kind of economic collateral damage.
Unfortunately, short of such actions, the field will be left free to a new breed of vigilantes, the Oil Vigilantes, who are smart and opportunistic enough to exploit price as the sole mechanism to curb consumption by pushing it to the limits of economic endurance.
Possible Oil crunch, "Oil Vigilantes", and the 1970-80 Experience
Yesterday a short report was posted concerning the alarming non-stop surge of Oil prices in the past week (see: Rising Oil Prices: Crunch Time May be Here ). In April, a long term monthly chart of Oil was posted in which a potential oil price of$130 was indicated at the top of a multi-year up-sloping price channel ( see: Panoramic Oil Chart ). An update of this chart is presented below with the indicated price of $130-135 at the top of the channel.
Even on cursory inspection, the chart reveals a striking similarity between the trajectories of Oil prices during two periods, each about 9 years in duration: 1971-80 and 1999-2008. From this observation, it is appropriate to ask the following questions. First, what were the conditions that caused the rise of Oil prices in the 70s and, as a corollary, are similar factors identifiable in the more recent nine-year period?. Second, what are the circumstances that put an abrupt end to the surging Oil prices in early 1980?.
Causes and remedies for the surge of energy prices in the 70s.
Two conditions were principally responsible for the energy crisis of the 70s:
1. First, the US' persistence in keeping price controls on Oil and Natural Gas at levels (about $2.0/barrel for Oil) way below the economic value of these commodities. With the help of the emotions engendered by the Arab-Israel conflict, Middle Eastern Oil producers eventually refused to accept such controls any longer and nationalized their Oil resources, thereby allowing prices to surge to their more natural level.
2. Second, the control of interest rates imposed by Regulation Q in the US, prevented the implementation of monetary policies that could have counteracted the resulting inflationary pressures. One of the consequences of negative Real interest rates was a significant depreciation of the US dollar and associated run up of Gold.
Both sets of controls were relics left over after the end of Wold War II. By 1979, as the situation became unsustainable (Oil reached a price close to $40, inflation galloped to over 12%), President Carter, in concert with Congress, decided the time had finally arrived to take the measures needed to reverse an economically very damaging trend.
Legislation was debated and prepared for decontrolling Oil and Natural Gas prices. The provisions were to be implemented soon thereafter by President Reagan, Mr. Carter's successor in the White House. At the same time, Mr. Carter appointed Fed Chairman Volker to preside over the repeal of Regulation Q and the decontrol of interest rates, a task that Mr. Volker undertook with a vengeance. The effects of these policies were dramatic, almost immediate, and long lasting. From 1980 onward, a dis-inflationary era was inaugurated that lasted till recently. Oil prices fell to about $10/barrel three times since then and were not to see $40/barrel again for 24 years(or the equivalent inflation-adjusted price of about $80/barrel for 2 more years). Initially, however, the cost turned out be burdensome indeed. Two years of teeth-grinding economic recession of which a frustrated new President could hardly see the end.
Admittedly, in the interest of brevity, the above account oversimplifies what were very complex events and omits several important factors that contributed to the success of the policies implemented in those years (end of Union Power, trade liberalization, relief from excessive taxation, removal of constraints to capital flows etc.); but in terms of relevancy to current conditions, it covers the most essential points.
One additional aspect should be mentioned at this point. It concerns the glorification of Mr. Volker as the Hero Slayer of the Inflation Dragon. The ability and skill demonstrated by Mr. Volker in steering the US financial ship through the turbulent waters of deregulation, particularly in the early years, is undoubtedly deserving of high praise. However, what should be firmly kept in mind is that, in the end, all Fed Chairmen are political appointees called to implement policies consistent with the goals of their bosses in the Executive and Legislative Branches of Government. Mr. Volker was no exception. He was called by the President and Congress to administer whatever bitter medicine was required to cure the ills of an economy in serious trouble. To this end, he had a clear mandate and a blank check. He carried out the task well, but without those explicit combined Presidential and Congressional mandates, he could have hardly begun his difficult mission. This is a fact of crucial importance when considering the role of current Fed Chairman Bernanke and the actions that can reasonably be expected of him in dealing with our current financial and economic exigencies.
Relevance of the 70s experience to the current situation
Easy monetary policies and negative Real interest rates have prevailed in the US for most of the time since the year 2000, very much as in the early 70s, and this time even without Regulation Q as an excuse. A consequent depreciation of the US dollar likewise has occurred during this period. In the global arena, low interest rates policies combined with heavily subsidized energy prices to consumers in several countries, most importantly China, constitute a faithful reproduction of the conditions prevailing in the US in the 70s. The inflationary effects now seen in these countries are likewise reminiscent of the consequences seen in the 70s in the US.
Assuming the surge of oil prices continues unabated, are there any actions that can be envisaged to curb or at least stabilize Oil prices as in 1979?. Of course the differences between now and then are immense, most notably the new situation of near equilibrium between supply and demand of Oil. Nevertheless some conjectures can be articulated even if the probability of their being realized is very low at the present time.
Thus, it is not unreasonable to think that, if Oil prices rise to levels much above the present one, policy makers in the US and elsewhere may be forced to consider measures that now appear unthinkable. For instance, could Mr. Bernanke be empowered to announce a rapid re-normalisation of interest rates by increasing the Fund rate to the calculated neutral level of 4.0% and thereby causing a rapid 10-15% appreciation of the US Dollar?. Could any additional fiscal stimulus be formally excluded by Congress and the Administration?. Could enlightened energy policies be finally devised and implemented here and abroad?. Could the Chinese Government explicitly declare that energy subsidies to consumers will be drastically curtailed or ended soon after the Olympics?. Could these subsidies be ended as well in other countries?.
None of this is impossible, although no one should hold his/her breath waiting for such decisions. The reasons are simple. Just like in the 70', any effective measure to remedy the current situation will come at the same cost: a severe and prolonged economic contraction. It takes leaders with character, fortitude, and a strong stomach to take actions carrying this kind of economic collateral damage.
Unfortunately, short of such actions, the field will be left free to a new breed of vigilantes, the Oil Vigilantes, who are smart and opportunistic enough to exploit price as the sole mechanism to curb consumption by pushing it to the limits of economic endurance.
| Panoramic monthly Oil chart with price channel |
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| Data as of May 9, 2008 |
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