“The problems that exist in the world today cannot be solved by the level of thinking that created them.”
– Albert Einstein
EVERY DAY WE WAKE UP hoping for good economic news: lower unemployment numbers, more jobs created, stronger growth. But we miss the forest for the trees. Our markets, for the past 100 years, have been engulfed in perennial financial crises.
Many of these crises have been associated with major Federal Reserve credit expansions and contractions. Upon examination, these volatile market episodes almost always lead to major moves in non-durable commodities, primarily oil and food.
But first, some historical background.
How do we mark the onset of the age of financial disorder, or, if you will, the Age of Inflation? The starting point was the volcanic eruption in 1914 at the epicenter of the Western world. World War I brought to an end the preeminence of the classical European states system; it decimated the flower of European youth; it destroyed the European continent’s industrial primacy, making Europe a debtor and America a creditor. The classical gold standard was suspended everywhere by the belligerents. The monetary gyroscope of the Industrial Revolution collapsed along with the world trading system into the anarchy of total war.
To interpret the financial events associated with the Great War —and their effect on the ensuing hundred years—let us highlight two crucial occasions of 1913: the establishment of the Federal Reserve system and the publication by the young John Maynard Keynes of his book Indian Currency and Finance. Neither event by itself would probably have created a barrier to resumption of the long period of monetary stability and economic growth under the prewar classical gold standard. But the inauguration of the Federal Reserve and the monetary ideas of Keynes, taken together, created the perfect storm.
As originally conceived, the Federal Reserve system, a government-dominated central bank, was designed to strengthen American participation in the classical international gold standard, even while making the U.S. currency and banking system more “elastic,” so it would be able to deal with crises like the panic of 1907. As the lender of last resort, the Fed was also tasked with issuing Federal Reserve notes and commercial bank deposits against collateral convertible on demand into gold. (By collateral here, we mean things such as the liquid, short-term, high-quality commercial paper of solvent firms used to finance goods in the process of production.)
In Indian Currency and Finance, Keynes had argued that whether a central bank holds its reserves in gold or in foreign exchange “is a matter of comparative indifference…India, in her [use of an informal] Gold-Exchange Standard...far from being anomalous, is in the forefront of monetary progress” heading toward “the ideal currency of the future.” Keynes foresaw the coming interwar official reserve currency roles of sterling and the dollar, which he and other British monetary experts convinced the European great powers to adopt at Genoa in 1922. Keynes hoped thereby to forestall repayment of sterling debt, held by other countries in the form of sterling foreign exchange reserves.
In 1932, months after Britain abandoned gold, Jacques Rueff, the famous French central banker and economist, summarized the basic fact contradicting Keynes’ theory and went on to describe its role in causing the 1930 financial crisis and the Great Depression. Rueff pointed out that when a monetary authority accepts dollar debt for its official reserves, instead of settling balance of payments deficits in gold, purchasing power “has simply been duplicated, and thus [e.g.] the American market is in a position to buy in Europe, and in the United States, at the same time,” which tends to cause inflation. Conversely, the liquidation of those dollar reserves causes deflation. Under the reserve currency system, Rueff argued, total demand is, in fact, divorced from total supply. Thus, disequilibrium in the general price level is inevitable.
The Genoa gold-exchange standard, based as it was on sterling and dollar reserves, was a primary cause of the financial disruptions of the 1920s and 1930s: namely, floating currencies, perennial budget and balance of payments deficits, and central bank money printing, not to mention the trade and currency wars they engendered. A generation later, after World War II, the reserve currency role of the dollar was reestablished in 1944 at the heart of the Bretton Woods gold-exchange system. Though an improvement on the interwar monetary system, Rueff correctly predicted (and tried to prevent) the collapse of Bretton Woods, which, after perennial foreign exchange crises, took place in 1971.
Now, it cannot be overemphasized that the official reserve currency role of the dollar, the so-called exorbitant privilege, continues to this day and is a primary cause of world financial instability. Among legions of recent examples, I shall briefly cite two before we discuss the related issue of money and oil.
First, the recent “Arab Spring” of 2010 and 2011, a revolutionary upheaval of the suppressed Islamic poor and middle class (and celebrated by many Americans as hope and change) was triggered, we were told, by the self-immolation of a heroic Tunisian. But for those who saw beyond New York Times headlines, the systemic fundamental trigger of the North African upheaval was the eruption of vast food and fuel inflation in the Middle East.
The shabby truth is that the inflation of food and fuel prices had been transmitted to the dollarized world commodity markets mostly by the hyper-expansive Federal Reserve monetary policy of 2008–2011—an unprecedented money-printing exercise. The Fed and Treasury’s ostensible purpose was to bail out our reckless, insolvent, cartelized banking system and to rescue the banks by issuing them virtually free money. The authorities were inspired by the conceit, perhaps the sham, that the banker class would then restart the engine of rapid economic growth by lending the free money to small businesses and individuals. But instead, the immense expansion of the Fed balance sheet—that is, the issue of new money unassociated with the production of new goods and services—initiated exchange rate and commodity arbitrage throughout the dollarized world.
This flood of new dollars could not be absorbed by the U.S. economy in recession, but it did ignite huge price increases of basic necessities—especially world-traded food and fuel, about 75 percent of which is bought and paid for in dollars. These price hikes penetrated like a sword into the heart of all subsistence economies—in this particular case, North Africa. In such economies, where food and fuel can consume as much as half of a family’s budget, a doubling of the price of necessities can bring people to desperation, indeed, to the edge of starvation.
In the second example, here at home in the United States, the same rising prices of food and fuel, combined with near-zero interest rates, reduced the real earnings of the middle class and those on fixed incomes—sowing the anger, envy, and bitter political warfare we witness today. For policymakers and investors, it is crucial to understand the subtle market mechanism set in motion by hyperactive Fed monetary policy, joined as it is to the exchange rate and price effects caused by the expansion and contraction of official foreign dollar reserves. Of course, we read everywhere that the absolute dominance of the dollar has gradually diminished since World War II, given the rise of Asia and Europe. Still, the world dollar standard persists because of the scale and liquidity of the dollar markets, despite predictions of its collapse in every bear market I can remember since 1962. There is in fact no equivalent alternative.
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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