Supply-Side University Lesson #13
Memo To: SSU Students
From: Jude Wanniski
Re: Gold & Oil
The deep slump in the dollar price of oil is causing grief to oil producing companies and countries around the world. The prospective mega-merger between Exxon and Mobil would not have been contemplated if oil was above $207 bbl., where it was before gold began its slide from $385/oz. two years ago — eventually dragging oil along with it in a global dollar deflation. I wrote the following article for Hart's Oil and Gas World on September 28 and it appears in its December issue. I think it will be useful for you to see how I address an industry that has little understanding of monetary economics, yet is being brought to its knees by monetary errors. For those of you who still have difficulty grasping the connections between the dollar and gold and the rest of the price universe, it always helps to hear the same story told in a different way from a different perspective.
BLACK GOLD, YELLOW GOLD
By Jude Wanniski
It is safe to say very few people in the oil and gas industry realize that the dollar price of oil is now largely determined by the Federal Reserve Board. Which is to say that as the nation's central bank manages the supply of dollars relative to the demand for dollars, its accumulated daily and weekly mistakes have much more to do with the dollar price of oil than the supply and demand for the oil itself. In a world of floating currency exchange rates, the price of oil in each country's currency is largely determined by its central bank.
By this reasoning, the price of oil has dropped over the last 18 months to a level that makes life miserable for oil producers almost entirely because of deflationary monetary errors by the Fed. That is, the central bank's fight against earlier errors it made in an inflationary direction — by supplying the world with more dollars than it wanted — turned into an enormous error in the opposite direction.
When the United States was on a gold standard, this could not happen. When the price of gold began to rise from the official dollar rate of exchange, the Federal Reserve had to restrain the creation of monetary liquidity, i.e., currency and bank reserves. If it didn't, holders of the excess dollars could demand gold from Treasury's holdings at the agreed upon price. When the price of gold began to fall from that official rate, even by pennies, the Fed was obliged to add liquidity.
Under that kind of monetary discipline, the price of oil fluctuated with all other prices around the gold dollar, rising and falling in narrower ranges within business cycles and national and international expansions and contractions. Prices in the Great Depression fell not because of insufficient monetary liquidity, for example, but because the Smoot-Hawley Tariff Act of 1930 and the Hoover tax increase of 1932 caused a worldwide decline in economic activity and surplus of oil and gas.
Gold is of course obsolete as a medium of exchange. Nobody wants to go back to using gold coins or gold dust to buy horses or houses. But it remains the market's truest measure of scarcity or excess money in the financial system, even after Richard Nixon in 1971 suspended the dollar/gold link in 1971. Nixon did so thinking the Fed's ability to increase the money supply would help the economy and his re-election chances. Instead, in the next two years gold quadrupled in price to $140 from $35 as the Fed supplied liquidity to a market that wanted less, not more.
It was a Canadian, Robert Mundell, who alone among academic economists predicted in January 1972 that "We will soon see a dramatic increase in the price of oil, and thence all other commodities." For two years, the OPEC nations continued selling oil at the old price level, about $2.50 a barrel, but in increasing volumes. When the dollars lost 75% of their value against gold, OPEC quadrupled the price of oil. Americans blamed the sheiks when they should have blamed President Nixon and the economists who advised him.
When the gold price began its decline from a plateau around $385 in December of 1996 to as low as $272 earlier this year, it was inevitable that the price of oil would have to tumble by roughly the same amount. Other commodities have followed in train, causing similar problems to fanners and miners. This also means that unless the Fed supplies more liquidity than the market is demanding in the future, neither gold nor oil will recover and prices of all other goods and services as well as the nominal price of wages and real property will come down as well. The Commodity Research Bureau index of prices has been following gold down almost in lockstep over the past year.
Why did this happen as it did? For several years, from 1985 until 1993, the Federal Reserve had more or less kept the gold price stable at around $350 an ounce. When it shot up to $415 in August 1990 in response to Iraq's invasion of Kuwait, as the market guessed the Federal Reserve would inject dollar liquidity to offset an expected oil shortage, as oil futures showed a climb from $20 to more than $35. The Fed did nothing, the gold price soon crept back to $350, and oil came back too.
In this period of relative dollar stability against gold, the world in general and Asia in particular became comfortable in the dollar realm. Their central banks could take their guidance from the Federal Reserve by keying their own liquidity demands to the price of the dollar. The problems began with President Clinton's tax increase of 1993. The higher tax rates caused a decline in the demand for dollar liquidity. Because the Fed did not drain the liquidity be selling bonds from its portfolio to its member banks, the surplus pushed up the gold price. From its $350 plateau, it began to rise at year's end and by February 1994 settled at $385, a 10% increase. At that point, the dollar price of oil recovered from its lows of the previous year and followed gold up. Fed Chairman Alan Greenspan worried that the gold price increase would be inflationary and tried to bring it down by raising interest rates. He should have been selling bonds, to take liquidity out of the system, but he feared that would lead to recession. Gold hovered at $383 or a few dollars above.
For the Asian banks to keep their currencies as good as the dollar, their central banks had to add liquidity in order to prevent their currencies from appreciating against the dollar. Thailand was especially anxious to keep the baht linked to the dollar. Its banks were soon flush with reserves that they really did not need, but became available to borrowers who had only cross-your-fingers collateral.
All went well until the November elections in the U.S. in 1996. It was good news for Americans as the re-elected President Clinton and the returned Republican Congress vowed to work together to produce a satisfactory budget. As the markets began to smell the tax cuts which eventually appeared — the capital gains tax cut, the Roth IRA, and the higher exemptions on estate tax — the demand for liquidity increased. The real economy was gearing up for faster non-inflationary growth.
Unhappily, the Fed not only did not respond to the increased demand for liquidity with fresh supply, it actually raised the overnight interest rate it controls early in 1998. The gold price plunged through the $350 plateau and by midyear was at $325. Remember the folks in Thailand? In valiantly trying to keep the baht equal to the appreciating dollar, the Bank of Thailand was forced to starve it own economy of liquidity. When it could no longer handle the stress, in July 1997 it devalued the baht. In the months that followed, the chain reaction spread through the rest of South Asia.
Why is the yellow metal so important as a signal of the Fed's monetary errors? Why is black gold among the first commodities after gold to follow its lead, up and down? The reason is that gold remains the most monetary of all commodities and that oil has many of the same monetary properties.
Even after all currencies floated free of a gold link in the 1970s, the central banks continued to hold gold as monetary assets. There are only about 120,000 metric tons of gold in the world. Because we know how much there is and where it is — almost a third held by central banks — is one of the most important reasons it has such utility as a monetary commodity. It is why Alan Greenspan told Congress he puts it at the top of his personal list as an inflation signal — saying its stock is so great relative to its flow. Less than 2500 tons are added to the total amount each year. Oil also has a relatively high stock — a 40-year inventory of proved reserves — relative to its annual flow. The value of a "money" has to remain as steady as possible because it must serve as a unit of account for long-term contracts.
It also has to be portable and "fungible," which means each unit must be identical to every other unit. Gold refined a specific purity meets that requirement to perfection while oil comes close. The least fungible "commodity" is land, in that each square foot is different than every other square foot merely by its place on earth. For that reason alone there could never be a "land standard" for money. A monetary asset also has to be easily divisible — which leaves out diamonds, and immune to the elements — which leaves out anything that oxidizes.
For thousands of years, gold and silver were the elements used by civilized people as "big money," with the base metals used for small transactions. When France and the United States demonetized silver in 1873, its monetary functions declined and its industrial uses expanded. Almost the same amount of silver is produced each year as gold, but it is consumed by industry while gold goes into public inventories as a monetary asset and into jewelry as a private monetary asset. Silver's stock is now fairly low relative to its flow.
When there is a productive demand for dollars that is not being satisfied by the Fed, the dollar becomes relatively scarce relative to real things. The first real thing that signals the dollar's scarcity is the most monetary of commodities, the dollar price of which will decline (the beginning of deflation). When the Fed supplies more dollars than are productively demanded — or fails to withdraw dollars suddenly in surplus for some reason, the dollar gold price will rise (the first breath of inflation).
As the gold price rises or falls, prices of other goods and services may move in the opposite direction for a while. This is because in the first instance they are priced in terms of their supply and demand. The most monetary commodities first rise or fall with gold and eventually all prices in the galaxy of prices readjust to the new price level established by the dollar/gold rate.
If you look at a chart of the gold price relative to a generic oil price, you will see that they also diverge, but eventually come back into balance. In the last two years, because the markets have become more sensitive to the gold/oil nexus, the two commodities have had less divergence.
There is nothing mystical about these relationships. If the U.S. government decided to manage the supply and demand for dollars on an Apple Standard, fixing a generic apple at $1 each by adding or subtracting from liquidity as the generic apple fell below $1 or above, the galaxy of all other prices would eventually adjust, but it would take much, much longer. Because of the uncertainties surrounding apple crops, the Apple Standard would be much less efficient than a Gold Standard, but oranges, for example, could not get much out of line by selling for a nickel or for $10 each.
It was this insight shared with me by Robert Mundell that led me 20 years ago to conclude that the world was not running out of liquid oil and natural gas.
Where does the oil and gas industry go from here? Of course that depends in the short run on what the Fed does. If it supplies enough liquidity to make gold scarcer than dollars, the gold price will rise and carry up oil and the prices of other things that come out of the earth along with it. In the longer run, oil's future is dependent not on nominal prices but on economic growth around the world.
Jack Kemp, for example, says that if he runs for President in 2000 and wins he could fix the gold price between $325 and $350. If that were to happen, the rest of the world would be able to fix their currencies to a dollar as good as gold, and the world economy and demand for oil would expand accordingly. A barrel of oil might not rise much above $23-$25, but a lot more of it would be demanded, produced and sold. Steve Forbes has in the past made the same arguments.
In that scenario, independent oil entrepreneurs would once again win or lose because of their own skills in finding black gold, not because of errors one way or the other by the Federal Reserve.
Next week, the last before the holiday break, will feature a guest lecture by Robert Mundell on international monetary policy. It was originally delivered in 1983 at a conference in Washington, D.C., co-sponsored by Mundell and Rep. Jack Kemp, in advance of an international economic summit meeting by world leaders in Williamsburg, Virginia. It is still so clearly developed that it reads as if it could have been delivered in the last year or two. Make sure you come to class for it!