Monday, May 08, 2006


Will rising oil prices bring stagflation? Stagflation is the combination of high inflation and high unemployment/recession, a phenomenon that Keynesian economists long thought to be impossible—until it happened in the UK and the US in the ‘60s and ‘70s. According to Wikipedia, it is caused by a shock to a nation’s aggregate supply curve—such as what happens when oil prices rise significantly, although in reality nothing in macroeconomics is quite that simple. It’s particularly problematic because central banks can only address either the inflation or the unemployment, and which ever they work to reduce, they must do so by exacerbating the other. Not pretty.

So will the current spike in oil prices bring about another bout of stagflation? It is certainly possible. First, we must answer two questions: is the current oil price rise inflationary, and is it a drain on our economy that will cause recession and the accompanying unemployment? If both answers are yes, then a continuing rise in oil will bring stagflation.

Is the current rise in the price of oil inflationary? Simply put, inflation is a rise in the general price level. If oil is more expensive, then everything that is made from oil also becomes more expensive. And everything that is transported using oil. And that has any constituent component or process that utilizes oil. So everything becomes more expensive. So yes, a rise in the price of oil does cause inflation. It may take some time to trickle down to the end consumer across all processes, but it will happen. Back up…now it gets more complicated. A rise in general price level is measured in currency, and that currency’s relative purchasing power (its price) fluctuates with its supply and demand. So an oil price rise is not inflationary as long as the rise in the price of oil is paced by a gain in the value of the dollar. But, that’s not happening, with the US dollar on a dive lately—the Canadian Loonie is at $0.90! So, in the end, the answer is still YES: this rise in the price of oil IS inflationary.

Is the rise in the price of oil a drain on the economy that will cause a recession and increase unemployment? That may seem obvious, but let’s work through it. You pay more for oil, but someone gets that money. What do they do with it? Do they spend it back in the economy, buying goods and services that drive economic growth? If so, then it isn’t a drain, just an inflationary re-distribution that has some loss due to inefficiency of unplanned transition—that is, investments made in the past in reliance on low oil prices don’t pay off so well. This can still be recessionary if it is a sufficiently sharp shock caused by enough of an increase in oil prices. What if the money isn’t cycled back into the economy in the classic petrodollar recycling scheme? What if it is spent in the economy of an overseas exporter of oil—say to build the world’s tallest building in Dubai. That is definitely a drain on the domestic economy, but on the international scale it is really still just a re-distribution among nations that has some loss due to transaction cost inefficiency. So, in the end, the answer to “is the rise in oil price recessionary” is simply that IF the rise is sharp enough to cause re-distribution inefficiency losses, then YES. It’s anyone’s call whether or not we are at that point yet, but I think that we are already well on the recession path.

So does that mean that Stagflation is on the horizon? I think it’s quite possible. When the Fed (US central bank) is faced with this problem, how will they react? They can stimulate the economy (combat recession and unemployment) by lowering interest rates—and in the process spur further inflation, or they can try to combat inflation by raising interest rates—and in the process hurt economic growth by making credit more expensive. Today’s economy is largely financed by home-equity loans that provide money to consumers as their house values “rise” (which is itself a function of how low interest rates are because it makes more people qualified for larger mortgages). Higher rates will make people’s adjustable rate mortgage payments go up, and will hurt their ability to earn money to make these higher payments. Lower rates will stimulate inflation, which will actually make our housing payments lower (especially if wage growth paces inflation—though that’s not likely), and will keep inflating the property bubble, increasing our ability to borrow against our home “value” and spend, spend, spend. This has the added benefit of “inflating away” our debt (both personal and national). It is a dangerous game—and it is exactly what we have played to “recover” from 9/11. So what path will the Fed choose? It is stuck between a rock and a hard place, forced to choose between keeping the party going a little longer (at the risk of a sharp hangover) and imposing harsh austerity measures. What will Bernanke do on May 10th when the Fed next meets? I think he’s smart enough to know that he should raise rates. And I think he will actually do that this time—although timidly. A quarter point, maybe. If he "takes a pause" in the rate hikes, then it's a virtual confirmation that the Fed has chosen to try to not think about the coming hangover. As soon as it starts to “hurt,” which is exactly the POINT of raising rates, they will start to come back down. I don’t think that problems will boil over this summer, but we might just have a Weimar Winter.


Dale said...

so, slightly off topic. and you may've seen it before, but this piece seemed right up your alley (as far as global energy infrastructure warfare goes) and i felt complelled to share.

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