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One hundred years of monetary disorder.
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Almost two-thirds of world trade, not including the international trade of the United States, is still transacted in dollars. U.S. dollar financial markets are the repositories for as much as $6 trillion of foreign reserves, not easily invested elsewhere.
AS WE CONTEMPLATE THE WRECKAGE left behind by a century of financial disorder, we must be mindful that we can only play the cards we are dealt. Having wandered the oil patch in North America from 1990 to 2005, and the Russian oil sector after 2000, I do have some conviction about the future price of oil, the most important price in world markets other than the dollar exchange rate.
You will have noticed, if you have studied the oil market, that oil equities are highly correlated to variations in the oil price. If that relationship continues to hold, the oil sector should outperform the market and the overall economy in 2013. And depending on the scale of Federal Reserve credit expansion (QE3) and the dollar’s direction, the oil price should, with fits and starts, head upward until the end of 2015.
Why? Major moves in the oil price are subject to econometric analysis. The prices of non-durable goods, primarily oil and food, change systematically with variations in what my partner, John Mueller, and I call the world dollar base: the sum of the U.S. monetary base and official foreign dollar reserves (a large part of which is held in the custody account at the Federal Reserve). There’s an interval of approximately 30 months between the rapid expansion of the world dollar base and a big move in the oil price.
We’ve seen several foreseeable mutations in the oil price since the end of convertibility in 1971, opportunities for concentrated, successful investment in the oil sector. During the recession of 1970, President Nixon and his chairman of the Fed, Arthur Burns, decided (not least to boost Nixon’s chances for re-election) upon a vast expansion of Federal Reserve Credit, which under fixed exchange rates intensified the expansion of foreign dollar reserves. Nixon’s landslide victory in 1972 was followed by an enormous move in world oil prices during 1973 and 1974.
In almost every case of a big oil price move, there is a political event that the press reports as the plausible cause. In the 1972–1974 case it was an Arab embargo, for example. But without the previous vast expansion of central bank liquidity, the oil move, under conditions of a more stable money stock, would have been far less dramatic.
In 1978, the Fed, under G. William Miller, a Carter appointee, repeated the Nixon-Burns credit experiment in a stagnant economy, rapidly expanding the Fed balance sheet. The dollar exchange rate fell swiftly and there was a huge accumulation abroad of official dollar reserves. By 1980 the oil price peaked at $40, up more than fivefold from 1975.
Similarly, the world dollar base expansion resulting from the Treasury’s effort to sink the dollar from 1985–88 led to the commodity inflation of 1989–90, followed by recession.
The final case is, of course, the Greenspan-Bernanke Fed, which, after the recession of 2000–2002, went into overdrive. Quantitative easing in the early years of the new century brought the Fed funds rate down to historic lows. The dollar fell sharply on the foreign exchanges, leading to a massive expansion of official foreign holdings of dollar reserves, to which the oil price is very sensitive. We measure the rate of gain of the world dollar base expansion in order to gauge the future pace of the oil price rise. In this case, the oil price peaked at $150 in 2008, exceeding our 2005 forecast of a doubling to $100 a barrel.
Using our world dollar base model, what can we say about next year? Remember, our forecast is based on the regular interval between rapid expansion of the world dollar base and the move in the oil price. The unprecedented Fed balance sheet expansion of late 2008 through the summer of 2011 was associated, as in the previous cases, with a fall in the dollar and the accumulation of official dollar reserves abroad.
So considering the previous intervals between world dollar base expansion and the oil price move, we should anticipate and plan for a steady rise, with intermittent downdrafts, in oil prices from early 2013 through 2015.
For a more thorough look at the relationship between the world dollar base and the oil price, consult my new book, The True Gold Standard: A Monetary Reform Plan Without Official Reserve Currencies and the book of my partner, John Mueller, Redeeming Economics.
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