It's the money, stupid!

March 17, 2010 | 00:00

It’s the money, stupid!

In the reports and debates on the oil price issue, one explanatory factor seems to be consistenly overlooked. This is the “easy money” policies that have been practised by the US Federal Reserve and most other central banks.

As the Austrian economists Ludwig von Mises and Friedrich Hayek have amply shown, creating money out of thin air, flooding the economy with cheap credit, and keeping interest rates artificially low – as western banking systems have been doing more or less continuously for decades, and particularly so in the years following the dot-com bust and the 9/11 attacks – does not lead to economic growth. On the contrary, it leads to malinvestments – and to inflation. In short: loose monetary policy creates bubbles.

It would go too far here to delve deeply into the capital theory of the “Austrian” school of Mises and Hayek. Suffice it to say that cheap or fiat money that is injected into the economy by banks (on the back of the central banks’ monetary policy) either leads to overinvestment in (more often than not) the capital goods sector, driving up prices of machinery and commodities, or (as is more frequent nowadays) is channeled into speculative activities, in particular investments in stocks, bonds, mortgages and commodities, leading to price bubbles in these sectors. (“Austrian” monetary theory, I should add, is the polar opposite of the Keynesian fantasies that fill the heads of most mainstream economists and commentators in the Anglo-Saxon financial press, who think that wealth is caused by consumption rather than production and that it is possible to generate economic growth by creating fiat money instead of producing goods and services. If only that were true – all economic problems would have been solved long ago! For more on this check out the website of the Mises Institute.)

To what extent commodity prices happen to be affected by the infusion of cheap credit, depends, as Stefan Karlsson writes in an excellent “Austrian” analysis of commodity price booms, ‘on who the early receivers of the money are’ and what they do with it. In recent years, as Chris Cragg’s lucid analysis, published today by European Energy Review, makes clear, most of the newly created money first went into ever more intricate and useless financial products (and of course into stocks and the mortgage and housing markets). Then, when these markets were flooded (“overheated”), the funds flowed into oil futures and other commodities, helping to create the fantastic oil price increase of 2007-2008.

As Karlsson points out, in addition to its relatively straightforward bubble-effect, loose monetary policy has additional effects which tend to drive up commodity prices: ‘If real interest rates fall, then the opportunity cost of holding commodities falls, making them more attractive. And if there is a fear that inflation could get out of hand, commodities could be viewed as good inflation hedges. Moreover, when the Fed inflates more than usual and lowers interest rates, this will drive down the foreign-exchange rate of the dollar, making commodities cheaper for foreigners, a factor that will help push up the dollar price of commodities.’

None of this is to say that there were no genuine “physical” factors behind the recent oil price increase nor that there is no such thing as a (mild) “natural” trade cycle in commodities (both excellently described in Karlsson’s article), but the price rise was made infinitely worse by the infusion of cheap credit and speculative money.

Note that my “Austrian” analysis completely squares with the analysis made by Professor Chevalier in the French report on oil price volatility published last month and other similar analyses, including that of Chris Cragg. That is, recent high oil prices and price volatility were indeed caused to a considerable extent by “speculation”. But the question that is omitted in most analyses is – where did the huge amounts of money of the speculators come from? The answer is: it was created out of nothing – by our monetary system – and deliberately “pumped” into the economy by the monetary authorities.

So how should we look at current oil prices, which are still quite high in relation to “market fundamentals” (as perceived by most market players) and in relation to for example gas prices? I think that the current oil price may well have been inflated again by the huge “stimulus packages” that governments all over the world have adopted to “counter” the crisis. As a lot of the stimulus money finds no outlet in the real economy, it may well be fuelling another oil-price bubble. And the additional effects described by Karlsson are also in play: as continued low interest rates and easy money policies are undermining the strength of most major currencies and fuelling fears of future inflation, investors are led into putting their money into “hard” physical assets, including oil. After all, if in future the dollar or euro ends up being worthless, a barrel of oil will always be worth … a barrel of oil.

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