The UK Guardian article (January 20, 2015) – Davos 2015: sliding oil price makes chief executives less upbeat than last year – reported that the top-end-of-town are in “a less bullish mood than a year ago” and that “the boost from lower oil prices is being outweighed by a host of negative factors”. The increasing pessimism is being reflected in the growth downgrades by the IMF in its most recent forecasts. A significant proportion of the financial commentators and business interests are now putting their hopes on the ECB to save the world with quantitative easing (QE). That, in itself, is a testament to how lacking in comprehension the majority of people are about monetary economics. QE will not save the Eurozone. But I was interested in this pessimism in the context of falling oil prices given that with costs falling significantly for oil-using sectors (transport, plastics etc) and disposable income rising for consumers (less petrol costs), the falling oil prices should be a stimulating factor. I recall in the 1970s when the two OPEC oil price hikes were the cause of stagflation. So why should the opposite dynamic cause ‘stag-deflation’ (a word I just invented)? There is a common element – fiscal austerity – which explains both situations.
The following graph shows the history of monthly crude oil prices in US dollars per barrel from January 1974 to December 2014. The blue line is the actual (nominal) price and the purple line is the real equivalent where the nominal price has been adjusted by the US Consumer Price Index and expressed in terms of January 2015 prices.
Notable is the size of the real shock in the 1970s. Mostly nominal prices have moved in line with the general movement in prices.
The data is available from the – US Energy Information Administration.
As an explanation of what is going on at present, I think this article by Fairfax economics editor, Peter Martin (January 13, 2015) – Falling petrol price good news for consumers but why didn’t experts see it coming? – was interesting and informative.
Oil price shifts in the 1970s ended the Keynesian era
The OPEC oil price hikes in the 1970s provided the switch point that saw the conservative ideas regain ascendancy despite them being cast into disrepute during the 1930s by the work of Keynes and others.
The world economy and the currency markets were severely disrupted by the outbreak of hostilities in the Middle East in October 1973 (the 1973 Arab-Israeli War).
This was accompanied by the oil embargo imposed by the Organization of the Arab Petroleum Exporting Countries (OAPEC).
A few days later, on October 16, the Arab nations increased the price of oil by 17 per cent and indicated they would cut production by 25 per cent as part of a leveraged retaliation against the US President’s decision to provide arms to Israel.
The price of oil rose by around 3 times within eight months.
The economies of Europe and Japan, which were heavily dependent on oil as the primary energy source were severely impacted by the rising prices. The US economy was less affected owing to its lesser dependence on imported oil.
The result, the US dollar appreciated by 17 per cent in the six months to February 1974, basically taking it back to the December 1971 value at the time of the signing of the Smithsonian Agreement. Further, the European currencies suffered major depreciation, as did the yen.
On January 19, 1974, the French government decided to float and exit the ‘snake’ because it was facing a major strain on its foreign exchange reserves as a result of its dependence on imported oil.
The oil price rises soon fed into the general price level and accelerating inflation became widespread.
The inflation of the 1970s was not the same beast that the deficit terrorists were predicting over the last 6 or 7 years would strike as a result of the rising fiscal deficits.
Economists distinguish between cost-push and demand-pull inflation although the demarcation between the two “states” is not as clear as one might think.
In this blog – Modern monetary theory and inflation – Part 1 – I outlined the demand-side theory of inflation. Essentially, if nominal spending outstrips the capacity of the economy to meet that demand with higher real output, the economy will enter a demand-pull inflationary phase.
The excess demand ‘pulls’ prices up.
The reason the deficit terrorists were wrong is because they didn’t understand the difference between a price-adjusting and quantity-adjusting states.
When there is excess capacity (supply potential) rising nominal aggregate demand growth will typically impact on real output growth first as firms fight for market share and access idle labour resources and unused capacity without facing rising input costs.
Under these conditions, firms will be quantity-adjusters with respect to spending increases.
As the economy nears full capacity the mix between real output growth and price rises becomes more likely to be biased toward price rises (depending on bottlenecks in specific areas of productive activity). At full capacity, GDP can only grow via inflation (that is, nominal values increase only).
Under these conditions, firms will more likely be price-adjusters with respect to spending increases.
The rising costs ‘push’ prices up.
Cost-push inflation is an easy concept to understand and is generally explained in the context of ‘product markets’ (where goods a sold) where firms have price setting power. That is, the perfectly competitive model that pervades the mainstream economics textbooks where firms have no market power and take the price set in the market, is abandoned and instead firms set prices by applying some form of profit mark-up to costs.
Please read my blogs – Modern monetary theory and inflation – Part 2 – for more discussion on this point.
The OPEC cartel knew that the oil-dependent economies had little choice, at least in the short-run, but to pay the higher oil prices.
This represented a real cost shock to all the economies – that is, a new claim on real output. The reality is that some group or groups (workers, capital) had to take a real cut in living standards in the short-run to accommodate this new claim on real output.
At that time, neither labour or capital chose to concede and there were limited institutional mechanisms available to distribute the real losses fairly between all distributional claimants.
The resulting wage-price spiral came directly out of the distributional conflict that occurred. Another way of saying this is that there were too many nominal claims (specified in monetary terms) on the existing real output.
This explanation of inflation is variously referred to as the battle of the mark-ups’, the ‘conflict theory of inflation’ or the ‘incompatible claims’ theory of inflation.
The inflation dynamic is a ‘cost push’ because its initial source is a rise in costs that are then transmitted via mark-ups into price level acceleration especially if workers resist the real wage cuts that capital tries to impose on them – to force the real costs of the resource price rise onto labour.
Ultimately, the government can choose to ratify the inflation by not reducing the nominal pressure or it can break into the wage-price spiral by raising taxes and/or cutting its own spending to force a product and labour market discipline onto the ‘margin setters’.
The weaker demand forces firms to abandon their margin push and the weakening labour markets cause workers to re-assess their real wage resistance. That is ultimately what happened in the 1970s.
In the 1970s, the high inflation that followed the OPEC oil price hikes was accompanied by high unemployment as governments tried to suppress economic activity to control the inflation.
This era of stagflation (‘stag’ referring to the recession and rising unemployment and ‘flation’ to the price level acceleration) provoked a major shift in economic thinking.
The Keynesian macroeconomic orthodoxy, that dominated the post World War II period, was predicated on the view that the total spending in the economy determined the level of unemployment. Firms employed people if they had sales orders.
After the cessation of WW2 and with the mass unemployment of the Great Depression of the 1930s still firmly etched in the minds of policy makers and the population, governments generally committed to using fiscal and monetary policy to maintain states of full employment where everybody who wanted a job could find one. This led to an acceleration of prosperity across the advanced world.
Accompanying this approach was a view that inflation would only result if the spending outstripped the capacity of the firms to produce goods and services, leaving them no option but to increase prices.
Accordingly, high unemployment should be associated with low inflation and vice-versa. Stagflation thus presented a new situation.
Most economists understood that inflation could also emerge as a result of sudden cost pressures (for example, imported oil price rises) which then squeezed existing profit margins and the real value of the workers wages, and under certain circumstances, could trigger a struggle between labour and capital over who would bear this loss
Inflation would result if workers gained wage rises and firms responded by pushing up prices or vice versa. The correct policy response was to address the incompatible demands for more national income from labour and capital by seeking some sort of consensual approach to sharing the costs of the imported raw material price rise.
However, this understanding was lost on policy makers when responding to the OPEC oil price hikes and they sought to stifle the accelerating inflation by suppressing spending using policy measures we now refer to as fiscal austerity (public spending cuts and/or tax increases) and tight monetary policy (increasing interest rates).
The resulting stagflation created a perception that Keynesian policies had failed and bestowed a sense of legitimacy on the free market approach, which had claimed that inflation was the result of lax government policy. This view had been wholly discredited during the Great Depression by the work of John Maynard Keynes and others, but remained alive and well in the more conservative academic departments.
The long-standing dominance of Keynesian policy was thus abandoned by a large number of economists in the 1970s. The US economist Alan Blinder noted in 1987 that by:
… about 1980, it was hard to find an American macroeconomist under the age of 40 who professed to be a Keynesian. That was an astonishing turnabout in less than a decade, an intellectual revolution for sure.
The resurgence of the free market approach, which we now rather roughly refer to as neo-liberalism manifested initially as Monetarism, and Milton Friedman and his University of Chicago colleagues championed the entry of these ideas back into the mainstream policy debate.
The rise of Monetarism was not based on an empirical rejection of the Keynesian orthodoxy, but was according to Alan Blinder:
… instead a triumph of a priori theorising over empiricism, of intellectual aesthetics over observation and, in some measure, of conservative ideology over liberalism.
It represented a shift from those who consider that state intervention, regulation and spending is crucial for the achievement of a balanced and equitable economy, to those who eschew state involvement and believe, with religious passion, that a self-regulating free market can provide increasing wealth and opportunity for all.
The core Monetarist idea was that excessive growth in the money supply associated with excessive government spending and lax monetary discipline by the central banks (interest rates too low) caused inflation.
Further, price stability required the imposition of deflationary policies, which involved tighter credit policies and cutbacks in fiscal deficits.
The Monetarists introduced the concept of the natural rate of unemployment, to combat the view that the austerity would generate higher unemployment.
Put simply, they argued that a free market would deliver a unique unemployment rate that was associated with price stability and that government attempts to manipulate that rate using fiscal and/or monetary policy would only lead to accelerating inflation.
The prescription was for policy makers to concentrate on price stability and let unemployment settle at this ‘natural’ rate, ignoring popular concerns that it might be too high.
By this time, any Keynesian remedies proposed to reduce unemployment (such as, increasing the fiscal deficit) were met with derision from the bulk of the economics profession who had wholeheartedly embraced Monetarism.
Despite the predominance of Monetarist thought at the time, there was very little factual evidence presented to substantiate their policy approach.
In fact, it flew in the face of all reasonable logic. It was a triumph of free market ideology over the facts.
But with policy makers increasingly loathe to use discretionary fiscal and monetary policy to stimulate the economy, unemployment rose and persisted at high levels.
The battle against high unemployment was abandoned in order to keep inflation at low levels.
So it was clear why recession ensued and unemployment rose quickly – fiscal austerity was imposed which killed off spending growth and damaged sales. Firms responded by laying off workers.
Why should firms be pessimistic when oil prices are falling so sharply?
During the GFC, oil prices fell sharply as you can see from the graph at the outset of this blog. But the relief was short-lived and as fiscal stimulus led to the early stages of recovery, the prices rose again.
The more recent price cuts are not of the same ilk. The Saudis are clearly engaged in a strategic exercise to drive the higher cost oil explorers in North America and Russia broke and are prepared to accept lower margins in order to achieve that objective.
The falling prices are what economists would call a reverse supply-side (cost) shock – a favourable one. Consumers will have more disposable income and firms will have lower unit costs.
So why wouldn’t that invoke optimism?
The answer is obvious. Any beneficial impacts from the supply-side of the world economy are being offset by the demand-side contractions brought about by on-going fiscal austerity.
Even with deflation, firms will not hire and expand production if they do not expect the sales environment to be favourable in the immediate future.
Firms hire workers to produce goods and services for sale. They will not employ to produce unsold inventories no matter how cheap labour or other essential raw material inputs becomes.
The on-going mainstream obsession about fiscal surpluses and the operation of the fiscal rules in the Eurozone are clearly creating a negative future outlook about the state of expected demand.
So in the 1970s, we had stagnation with accelerating prices because of fiscal austerity (demand-side response) responding to a major supply-shock (oil price rise).
Now we are facing on-going stagnation with decelerating prices and even deflation (falling price levels) because of because of fiscal austerity (demand-side response) even though the global economy has enjoyed a major beneficial supply-shock (oil price fall).
There is no mystery as to what is going on at present. One might expect that a fiscal stimulus now would be more effective than before the oil price fall because firms might are facing cost reductions and consumers have more disposable income available as a result of the energy price falls.
But the dominant dynamic is not coming from the supply-side (the oil price cuts) but from the on-going suppression of spending as a result of the ill-considered imposition of fiscal austerity.
The deficit terrorists really have a lot to answer for.
That is enough for today!
(c) Copyright 2015 Bill Mitchell. All Rights Reserved.