Oil Debate Series - Part 2

Today is the second part of the series regarding oil. We hope you enjoy our debate, and again, if there are any questions that you would like to see debated relating to oil, please post a comment for us.

Question #3: Can oil prices lead to stagflation? Will they?

BB: Let me put it simply: they can, and they will. Unless something occurs which halts the rise of oil prices, it is very likely for the dreaded situation of simultaneous high inflation and stagnant growth to occur. Of all the terms in economics, there are few as feared as ‘stagflation.’ The last time that stagflation was prominent was in the 1970’s, which also just so happened to have been a time of sky-high oil prices (see where I’m going with this?). Those oil shocks were widely blamed for the stagflation’s onset, and though silly policies by the Federal Government and the Federal Reserve played their part in making the situation worse, it was oil prices that created the situation. That historical lesson does not leave me with an optimistic outlook. In theory, we should learn from the mistakes of our predecessors, yet in this case, that may not be enough. Unless something is done to stop the rise of oil prices, the trends that have already been establish (rising inflation, decreasing growth) are likely to continue until we enter a period of stagflation. Uh-oh.

JK: It depends; the fact oil contributed to stagflation is undeniable. However the assumption that oil shocks bring about stagflation is false. Stagflation is simply rising unemployment and inflation, an oxymoron but possible. The stagflation of the 1970’s was brought about by a variety of factors namely, because central bankers didn’t do their jobs correctly. Inflationary expectations rose, because the initial response to the rise in oil prices was to cut interest rates (sound familiar). Almost all Central banks pursued this pro-growth, pro-cyclical policy, which lead inflationary expectations to rise. If you listen to the press conference from ECB President Trichet one thing you can conclude is that he is terrified about inflation. He highlights the dangers of short-term policies that can alter long term inflationary expectations. When they set in then the domino effect of a wage price spiral can be initiated which will only make a bad situation worse. Oil can be considered a necessary but not a sufficient condition for stagflation. However the given the current situation stagflation will most likely occur, due to the prolonged period of time that oil has been at its current price. The spill over effect can be seen in every countries PPI. The wage increase can be observed in China and India. As for the OECD, a lot of pain awaits because imports which that have contained inflation will become very costly. Let us only hope that Central Bankers choose the prudent course of containing long term inflationary expectations, not promoting short term growth.

Question #4: Will the price of oil lead to the USD losing its premier status in the FOREX world?

JK: No, these types of responses are typical from Mahmoud Ahmadinejad and Hugo Chavez. Both stand up individuals, but both with little or no trade ties to the United States besides oil. Yes, Chavez does export millions of barrels to the U.S. but these countries need to export just as much if not more than U.S. needs to import. One of the reasons that oil is above $140 is because the U.S. dollar has depreciated. The reason for this depreciation is our current account deficit, excess government spending, etc. The rise of oil did not crush the dollar; the depreciation of the dollar gave the price of oil a shot of steroids. The dollar is king because the domestic economy creates 13 trillion dollars annually. As long as the risk premium associated with U.S. investments continues to be low and the U.S. stays on the forefront of technological innovation the premier status will not change. The dollar will lose its premier status when China can build a 747 or provide financial consulting. Currently China fills container ships with of knick-knacks, not very inelastic, and definitely not reserve currency export.

BB: As much as I hate to do this, I agree with John. The critics of the USD have been howling for decades, and I don’t expect this current recession to alter much. The only way that the USD could be knocked off its pedestal is if it becomes so weak that it can no longer function in its many roles, such as the reserve currency for the world, the currency for commodities, or the currency involved in the bulk of FX trades. In the end, it would be too monumental of a project to shift away from the USD, and even if the “powers that be” decided to, which currency would take its place? The only truly viable candidate would be the EUR, yet that has only been around for about a decade, so it lacks the historical track record of the greenback. So while it is possible that the USD might eventually lose its spot as top dog, that time is many years down the road. Even if the price of oil is shifted to another currency in the next few years (also unlikely), I do not anticipate the USD losing much prominence.

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