Tuesday, April 18, 2006

Elevated Crude Prices and Other Pressures May Burst the Forming Credit Bubble
Joe El Rady

Today’s record Crude Oil closing price of $70 per barrel may not usher economic chaos, but the trend forebodes crisis. Elevated oil prices cause significant inflationary pressure which erodes GDP. The recessions that followed every shock in oil prices from 1974 to 1991 cost the US economy 4 trillion dollars.

While most inflation is a benign and correctable product of economic growth, the “cost-push” inflation caused by high oil prices dispossesses government officials and central bankers of the levers they use to control the economy. Thus, a sustained elevation of crude oil prices threatens to cause uncontrollable inflation.

During economic expansion, inflation naturally occurs from the increase in wages caused by high demand for labor. High wages increase consumption, leading to higher wages, starting a cycle that leads to higher prices and higher demand for liquidity. This type of “wage-pull” or “demand-pull” inflation is easily controlled and corrected by either monetary or fiscal policy.

The Federal Reserve can control the money supply by buying and selling securities on the open market, easing or tightening bank reserve rates and setting discount rates. Government can control the money supply by increasing or decreasing taxes or spending or both. Regardless of action by central bankers or government officials, American fiscal policy autonomously and automatically impedes inflationary pressure by moving employees who earn higher salaries into higher tax brackets and, thus, limiting the disposability of their increased income. Finally, if neither monetary nor fiscal policy can control inflationary pressure, the economy exerts its own control when prices finally outstrip wages and capacity begins to outpace demand—leading to a recession, which decreases demand for production, labor and capital and thus re-equilibrates prices. The “cost push” inflation caused by increases in the prices of commodities and production factors like crude oil, however, casts the horror of rendering these tools useless.

When producers experience an increase in one of their inputs, they must raise the prices of their outputs. Since this “cost push” inflation is neither the product of nor the movement in concert with high employment and wages, it outpaces them, burdening consumers, who respond by curtailing spending. Curtailed spending leads businesses to cut labor and capital expenditures. This cycle causes an atypical recession: one accompanied by inflation. Economists named this phenomenon “stagflation” when they first encountered it in the 1970s.

Neither the Federal Reserve nor the government possesses affective tools to ameliorate stagflation. Tightening the money supply only leads to further economic contraction. Increased government spending on infrastructure, while costly, can help to absorb excess labor; however, the Bush tax cuts have left a budget deficit so huge as to castrate government’s ability to increase spending. On the contrary, the record budget deficit will fuel further government borrowing which raises interest rates due to the “crowding effect” of government’s competing with creditors in the financial markets. Empirically, every 1 percent increase in the debt to GDP ratio causes a 0.4 percent increase in long term interest rates.

Furthermore, since crude oil is priced and purchased in US Dollars, European and Asian countries may find it helpful to devalue the dollar in order to cushion their purchases. Moreover, the need for petroleum producers to recycle their increasing inflows of petrodollars may clog financial markets with a glut of US currency, further devaluing it.

This situation would prompt the Federal Reserve to intercede on behalf of the dollar and to implement levers that invariably result in yet higher interest rates that would only slow the economy further. Moreover, with the rising unemployment and declining real incomes that the oil shock induced recession would usher, Americans may demand higher levels of consumer debt at the new higher interest rates.

Adding to this wicked mix, the tax cuts and stimulus package of the first Bush Term, for better or worse, responded to economic contraction by attempting to spur both increased consumer consumption and business investment—at a time when the business community was already finding it difficult to implement the capital investments of the late 1990’s and was compiling high levels of inventory. All of this occurred while the Federal Reserve lowered interest rates. The continual injection of M1 into the economy has created excess liquidity in global capital markets—as evidenced by sharp increases in the price of Gold and Silver.

More alarmingly, the global wash of liquidity has compressed credit spreads. The compression of credit spreads has created an array of soft-spots. It has allowed inefficient companies to float on cheap capital. When these companies finally fail, the excess inventories will be impossible for the economy to absorb. Even more alarmingly, the global wash of liquidity has spurred an unprecedented growth in the high-yield asset market and its derivatives and synthetic securities shadows. The level of credit derivatives outstanding currently exceeds 19 times the value of the underlying paper. Underlying interest rate volatility being a main factor in the pricing of these synthetics, should interests rates rise there may be no way settle these trades at their strike prices. With the explosion in derivatives outstanding, there will be no way to unwind the trades. This may force cash auctions. Currently, no cash market exists for instruments like credit default swaps.

None of these predictions has yet occurred since in real terms today’s oil prices have yet to match the prices of the 1970’s and other shock periods. Furthermore, the stagflation triggering price level is much higher today since oil is not as large a factor in production processes and since the US economy has evolved to a service base. However, as hedge fund speculation, geopolitical uncertainty, lack of refining capacity and emerging market demand squeeze prices higher and higher, America finds itself closer and closer to economic perils unfelt since the 1970’s.