Sunday, January 23, 2011

Time Preference, Kim Kardashian, Quantitative Easing, Good Black Swan – 2 of 2

Since the beginning of this year, the Financial Times has been all over the case of oil. Its January 5 headline warned:

Oil price ‘enters danger zone’

‘Enters a danger zone’ was in quotes because it came from the chief economist of the “International Energy Agency” who told the FT that “the oil import bills are becoming a threat to the economic recovery.” FT took it from there and surmised that “the warning from the IEA will put pressure on Opec to increase its production.”

Then this past Wednesday, the paper “revealed” that Saudi Arabia had broken ranks with the Opec members and had “increased output quietly in a bid to avoid the impact of price spike”. The Opec secretary general called the rumors of tightness in the oil markets “incorrect”, but no matter. The editorial board of the FT has set its collective mind on doing something about the oil price. To that end, anything would do, whether diffusing disinformation or pumping out a two-man shop with a childishly grandiose name to issue warnings.

Whether the OPEC members will fall for these silly tricks remains to be seen. But the oil price is a serious subject in itself and regardless of who brings it up and under what conditions, it deserves serious consideration. Let us consider it then, starting with the reason for the price rise. Only a criminally insane doctor would prescribe a cure without having diagnosed the disease. We, too, must begin the cause, of which the price rise is a symptom.

Assume oil is $2 a barrel. Here is a picture of this value relation for those who learn visually:

The picture shows that one barrel of oil is worth $1 + $1 = $2.

The FT is saying and hoping that “the warning from the IEA will put pressure on Opec to increase its production.”

What would that achieve, this OPEC increasing its production?

Why, it is elementary. If more oil is produced, the same $2 would correspond to more oil, say, 4 barrels, as shown below.

That is the definition of cheaper oil: the same $2 buying more oil (4 barrels)than before (1 barrel). That is what the FT wants to see.

What happens if instead of more oil, more dollars were produced?

Then, the picture would look like this:

In this situation, confronting the same barrel of oil is more dollars than before. That is another way of saying that oil has become more expensive: more dollars are needed to buy the same barrel of oil.

That's the current situation. Oil supplies have remained constant for the past three years. The reason the oil price has gone up is the Fed's quantitative easing (QE) in the past year that has increased the supply of dollars.

QE is not the same as printing money. The latter increases the quantity of money as means of payment while the former increases it as the medium of exchange (to ease liquidity pressure). But that’s a distinction without a difference in terms of the final result, which is devaluation of the currency.

Because the US dollar is a reserve currency, its devaluation – lowering of its value – translates into an increase in the price of other currencies and commodities, including oil. Just replace the oil on the left side of the last picture with your choice of currency, commodity, mineral, metal, grain, what have you, and you will see this. They all become more “expensive”. Hence, for example, the sharp rise in food prices.

The high price of oil which is becoming a “threat to the economic recovery” of the oil importing countries is not the making of OPEC but the U.S. Federal Reserve.

Does Bernanke know that?

Yes, he does. The entire world, literally, is up in arms against his policy. From the New York Times of November 6, 2010:
The United States confronted growing restiveness with its economic policy on Saturday as leading Asian countries resisted its call to set limits on trade deficits and surpluses while also warning that the decision to pump more money into the American economy would have harmful global repercussions ... Countries like China, Brazil and Germany have warned that the unilateral move devalues an already-weak dollar, and could set off a destabilizing flow of funds into emerging economies that will inflate their own currencies and make their exports more expensive.

On Friday, the German finance minister assailed United States monetary policy as “clueless,” and China suggested that American officials explain their decision so as to calm international anxiety.

Even Japan has been complaining. “First and foremost, one of the biggest reasons for the yen’s rise is the dollar’s weakness, a reflection of American economic policy. We need for there to be a clear understanding of that background,” Prime Minister Kan told Wall Street Journal.

Yet, Bernanke remains resolute, pushing ahead with QE as if he had a vision.

What gives? How did a meek academic whom the Lehman bankruptcy knocked off balance morph into Mr. Resolve? A case of baptism by fire?

The answer is No; that would be an idle conjecture. What is more, the Fed can be very mindful of the “foreigners”. The statistics it released early last December showed that the foreign banking entities benefited as greatly from its various credit and liquidity “enhancement” programs as the U.S. banks and companies.

Wherein, then, lies the explanation?

The newspaper of record to the rescue. Under the heading “Sarkozy Brings Message on Dollar to U.S” it reported on January 11:

President Nicolas Sarkozy on Monday brought his campaign to lessen the dollar’s central role to the White House, where such talk has never found a warm hearing … Mr. Sarkozy has argued that the dollar’s role as the single global reserve currency does not reflect an increasingly multipolar world. Rising economies like China, India, Brazil and Russia are wielding increasing weight and, in China’s case, explicitly calling for a shift away from the dollar’s privileged status.

Mr. Obama did offer general words of support for Mr. Sarkozy’s efforts.

Can you imagine that? Can you imagine a foreign leader coming to the White House with plans for replacing the dollar as the reserve currency and receiving words of support from the U.S. president?

Can you imagine a foreign leader with plans for challenging the U.S. military supremacy being allowed into the White House, never mind receiving words of support from the president?

Yet, there was President Obama, offering support for reducing the role of dollar. That is the official U.S. policy then, with Bernanke aiding and abetting it.

On the face of it, the policy seems “unpatriotic”. Who would want to weaken the U.S. dollar? That is why Sarah Palin and the Tea Party types are against QE. That is also why the German finance minster called the policy “clueless”; he could not for the life of him understand why the U.S. government would undermine its currency.

But it is Herr Schäeuble and the Tea Party types who are clueless. They imagine that the U.S. policy makers would inject trillions of dollars into the international channels of circulation without having thought about the consequences or predicted the obvious immediate effects.

You see how quickly, logically and inevitably we get from finance to politics. They are one and the same subject.

A detailed discussion of QE must await Vol. 4. I merely note in anticipation that the status of the dollar as the reserve currency is a double-edged sword for the purpose of social engineering. In the same way that – and precisely because – it allows for the unchecked expansion of say, military expenditures, it stands in the way of – because it takes away the excuse for – deep budgetary cuts. That is why cuts to the social services in the U.S. have not been nearly as draconian as in Europe.

The dollar as a reserve currency, in other words, is an impediment to a fundamental social restructuring plan that involves replacing the government with private enterprise. So it must lose that status. That is the angle through which we must understand QE: as the bold move in the “Great Game” of finance and politics that is unfolding across the globe. The rest is secondary.