Inflation and oil price shocks

The conventional wisdom, especially among those who lived through the oil embargo of the 70s, is that higher oil prices will lead to high inflation. But an article by Stephen King, managing director of economics at HSBC, hypothesizes that this may not be the case this time around.

According to King, the worst inflation scenario is that workers (who are presumably unionized) manage to get wage increases in the face of higher prices. Ultimately, this may induce companies to raise prices even higher. This turns out to be especially problematic for retirees, who are on a fixed income. King goes on to argue that since society has changed since the 70s, it's unlikely that such a shift in financial burden is likely to be acceptable.

Society has changed. Western populations have aged. Those people who managed to extract wage increases in the Seventies and early-Eighties are now in their 50s, 60s and 70s. This is the baby-boomer generation, the generation that, because of its numbers, has enjoyed an unusually large influence on political and economic choice.

This is the generation that, in the Seventies, was prepared to tolerate higher inflation but, by the Nineties, was pushing for independent central banks with inflation targets. Now that they have their pension nest eggs, the last thing the baby boomers want is a return of inflation.

King also points out that the workers are less likely to be effective in demanding wage increases now, since there are fewer unions, and factories can always be moved to other countries.
Now, with the collapse of communism in central and Eastern Europe, and with a more open relationship with China and India, capital has become mobile. If workers misbehave, capital goes elsewhere. Workers are, therefore, resigned to the fact that higher energy prices will not be offset by bigger wage increases.
The result, according to King, is that everyone suffers equally—or no one really suffers at all. I'm not sure how to interpret his last paragraph.
Of course, this means that workers suffer as a result of higher oil prices. But that's life. So long as inflation remains low, the arbitrary creation of winners and losers in the light of an oil price shock should be avoided.
In any case, I have a feeling that higher prices due to higher energy cost certainly isn't going to affect us all equally—my guess is that it won't do anything to lower the ever-growing disparity between the rich and poor in the US (and elsewhere in the world).
The employers will also suffer - on one hand they will feel the rising costs on the other they will experience a drop in demand because of lower consumer spenditures.
The total effect in highly competitive market should be more bancrupcies and drop of GDP and investor confidence. This can lead to a total crash if it happens too fast... We are simply living on the edge in fact on many edges at once, but this is not a news.
Too many families have been refinancing their houses to spend more on consumption, including fuel for their big SUV's.  Interest rates are about as low as they're going to get, so the refinancing boom (and the interest-driven appreciation in home prices) is over.

When the stream of cash from refinancing comes to its end, something has to give.  People can't run up other debts indefinitely, so we've either got to see an increase in personal productivity, a decrease in consumption or both.  Unfortunately, productivity in some areas is constrained by our bad investments in energy-inefficient equipment (since 1980, but especially since 2001) which prevent people with e.g. inefficient pickups from taking jobs which require lots of vehicular travel.  This causes some inflexibility, and points to a looming drop in consumption.

People who are caught in a bind between mortgage and credit card bills and fuel costs on one hand and stagnant wages and rising health costs on the other will have to do something.  Many people who live from paycheck to paycheck are now buying gasoline on credit to get to work; when their cards are maxed out, they cannot drive and they lose job, house and possibly their vehicle too (if anyone is willing to even take a repo'ed truck or SUV).  Enough of this and the value of mortgage-backed bonds and credit-driven bank stocks fall.

The alternative is to inflate.  By decreasing the value of debt compared to income, inflation accomplishes the same end without all the bankruptcies and securities defaults.  But something is going to give; we've got to bring things back into balance somehow, and we've already missed the opportunity to start getting efficient soon enough to prevent one of the above two phenomena.

If the FED releases the interest rate gauge on inflation then forget about the US dollar. There are people holding plain papers nominated $4 trillion outside the USA and I'm absolutely sure that most of them are not thinking about the question "whether" but rather the question "when".

It is simply not an option - a currency runnup now will turn USA in a third world country overnight. And given the lack of experience with force majore situations in USA - I'm absolutely sure that millions of people will not be able to survive.

Capital can only flee the dollar if there is some other currency to flee to.  World oil prices affect most everyone to some degree, so inflationary pressures are widespread; we may see worldwide inflation (and devaluation of all debt) for a while.

Of course, the US's debts are denominated in dollars.  Other nations dumping them lets us buy them back for less than face value, and our problem shrinks (messily, but it shrinks).

"Capital can only flee the dollar if there is some other currency to flee to."
There is - euro. There are strong enough economies behind that currency that can accumulate the capital flow. Especially if the EU succeeds in forming energy allience with Russia this will be the best place to put your money in the long term.

I think this is because of the central flaw in the Breton Woods system which requires an international currency and an indebted nation emitting it. The result is a major instability in the world currency markets and of course US hegemony.

"Of course, the US's debts are denominated in dollars.  Other nations dumping them lets us buy them back for less than face value, and our problem shrinks (messily, but it shrinks)."
That's why it has not happened yet. But we've seen that already in the 70s - at some critical point the market realises that a currency is overvalued and the fear of loss becomes stronger then the meager attempts of central banks to handle the situation. In short - you can not pull a string forever.

So would now be a good time to get into some fixed rate debt and buy some Euros? If inflation hits, I can use the Euros to payoff the debt I hold in US dollars.
If everyone starts thinking that we are fucked :)

Basicly it is always a good idea to diversify the financial risk and have different assets in your account. Just don't put all the eggs in one basket - you can buy some euro, maybe energy stock, some would also suggest precious metals (though these already overvalued to my mind).

In the short term there is a great probability that you will lose from euro - there is a rising interest rate differential that can cause the dollar to continue to appreciate in the near future. I'd watch the energy situation - if oil gets close or above $100 the risks of sudden dollar depreciation become pretty high. Our energy wastefulness costs the world too much and at some point they can decide to get rid of US demand just by dumping the dollar (maybe systematically and moderately but maybe not).

Also, does anyone know how inflation effects housing prices. If wages increase along with the decline of the dollar, do houses become more affordable or does the value of the house climb along with wage increases? Does anyone know what happened in the 70's inflation?
Housing will go up, along with everything else, but inflation could be a way of softening the bubble pop. People are less comfortable with absolute drops in asset prices than they are in flat asset prices while everything else appreciates.
Not the euro, but gold (and possibly silver as well).

Eurozone countries will also be tempted to inflate away their debts.  Take a look at their

  • public debt/GDP ratios,
  • budget deficit/GDP ratios,
  • prospective dependency ratios (retired vs working folks).

They are as screwed up as the US is, and maybe more, because the US budget deficit was brought about by tax cuts that can just end, and by a war that can also just end (not during this Administration, obviously).  But their budget deficits cannot be pinpointed to similar specific and easily reversable (mis)policies: they have not cut taxes or entered any war recently.  Rather they are structural, and so more difficult to solve.  The difference is that the US debt has been financed mainly by foreigners, so the net gain from inflating it away is greater for the US citizens.

By the above measures, Japan is just a very bad joke.  So, forget the yen.

OK, what about the Swiss franc?  I don't know really what those parameters are for the Swiss economy, and actually don't care, because the case can be dismissed on grounds of volume: if a significant amount of currency reserves are switched to CHFs, that would cause such a CHF overvaluation that would enable the lowest-wage-earning Swiss folks to vacation in five-star resorts anywhere!  Which brings the point: using any currency as reserve currency amounts to giving the issuing country a free lunch.  They give paper and receive goods.

So we are left with precious metals.  BTW, the Bretton Woods system (1944-1971) was a gold standard: the USD was pegged at 35 USD/ounce.  And while it worked the US was a net creditor to the rest of the world.

Interestingly, this viewpoint is not just the realm of gold bugs and pseudo-analysts on the fringes.  It has just been proposed by one of Morgan Stanley economists, Stephen L Jen.  See:

"We argue gold is a good hedge, or, more precisely a `neutraliser', against currency risk.

This favours central banks holding more gold in their reserves to dilute their exposure to foreign currencies.  First, the USD could falter and thus erode the USD value of the Asian central banks' foreign reserve holdings.  Second, the Asian currencies could appreciate leading to a valuation loss on official reserves.  Gold holdings could partly `neutralise' or dilute the first risk but can do little about the latter, especially if the country in question has low gold holdings. For the same reasons, petrodollar holders should also consider buying gold."

Interestingly too, the same issue of MS Global Economic Forum features a comment by another of their economists, Robert Alan Feldman, about the prospect of peak oil.  It is good to see that not all economists are of the flat-earth variety:

"For policymakers, the oil market presents a classic case of decision under uncertainty. There are two axes to consider. First, either the optimists are right or wrong. Second, either the world invests in technology/exploration, or it does not. So there are four combinations. (1) Optimists right/Few investments:  Civilization is safe, with little waste. (2) Optimists right/Big investments:  Civilization is safe, but has wasted some resources. (3) Optimists wrong/Few investments:  Civilization is NOT safe. (4) Optimists wrong/Big investments:  Civilization safe, but not as rich as if oil were unlimited. For a policymaker, it is better to spur the investments, because the worst possible outcome is a bit of waste. This waste can likely be absorbed by economic growth."

I wouldn't be so certain that the Euro is a strong currency in face of a total worldwide collapse.  It, like almost all of the currecy out there, is a fiat currency, and under a massive economic collapse, all fiat currencies will likely collapse, especially since alot of it is intrisically tied to the dollar and we're going to probably crash first, pulling everyone with us.

Others argue gold, and while I'm also a goldbug, if you have anything close to a decent amount of investment monies it just doesn't make sense.  Where are YOU going to keep $200,000 of gold without making yourself a target?  It's better for low investors like myself who have a couple of thousand invested, can carry their money in gold easily, and really are less interested in making that money grow as much as just having a safe investment, although that can be argued with gold.

The best money-making, value-secure investment would be in goods.  It is obviously a large-scale investment, as it requires investment in warehouses and hard security, but post-collapse, the price of necessities like water and tools will skyrocket, and there will be demand.  Further, if you're shrewd, you can always barter for goods that are in low demand in the short-term (construction utilities) but will be heavy demand once we gain our footing again (if we do).  Also, goods are extremely cheap right now, with outsourced production.  Of course, there's alot of ethical delimas in there, including profiting on life necessities and sending more dollars out of the country.

But, overall, that's where the money will be post-collapse.  Just remember, during the gold rushes, it was the merchandisers that struck it rich, not the speculators.  

King's points are interesting; his comments about labor are on target. In the present environment, because capital is mobile and cheap labor is everywhere, inflation will not occur because of labor demands. In fact, we are living in a period of deflation that is being offset by rising energy prices. Right now, there is a struggle between deflationary forces (cheap labor) and inflation forces (rising prices in energy). There are no winners, only temporary ones: those companies raking in huge profits from cheap labor. Here is the scenario that in all likelihood will occur: In the long run, inflation will win and there will be no way for workers or for retirees to manage the rising costs. None. Rising energy costs are a given. There are a number of points to remember: (1) Rising energy costs affect the transportation/supply chain. While the abundance of cheap labor can provide elasticity, in the long run it cannot. Once that elasticity is gone, prices must rise. (2) As energy costs slowly escalate, workers and retires will expend less and less on those goods provided by cheap labor. Budgets have to accommodate essential needs. Some things will simply not be purchased. Energy is an essential need. (3) Credit is now being extended in every form imaginable to prolong the purchasing life of consumers, driving interest rates down. But even the most generous credit line has a limit. We are drawing very, very close to that limit. (4) Once the credit string has been drawn as tight as it can and once the elasticity provided by cheap labor disappears, companies whose profits have skyrocketed are going to find themselves in the same position as those now going bankrupt. In short, we are entering a period of severe global economic contraction. We may see occasional brief glimpses of blue sky as energy prices fluctuate, but those will be followed by every darker clouds.
As I recall, the last big runup in gold in the late 70s was fueled at least in part by wealthy Arab royalty in Saudi Arabia and elsewhere investing heavily in gold because of their fear of the instability of the US dollar. Dollar worries are happening again and gold is on a significant run up again having moved from the mid $200 range to the mid $400 range in a relatively short period of time. Plus we see calls from various OPEC nations such as Iran and Venezuela wanting to move to Euros or some other currency to denominate oil transactions.

I am not an economist so won't venture to do more than guess but it seems as if similar economic considerations are in place once again that might see a significant dollar devaluation (inflation), a significant flight out of dollars to other "safe havens" like gold, euros, or foreign bonds, and subsequent recession in the US (and by extension in the rest of the world).

As for the article referenced, I suspect that there are many talking heads desperately trying to "jawbone" the economy into some sort of soft landing rather than a harder crash. But hey, it's October again, the month of past historic stock market flops and this one looks shakey against the current economy.

I think the point about the retirees is a critical one since they are a huge voting bloc in this country. Bush is going to look ridiculous urging private accounts after the stock market crashes. Airlines, Steel, Auto are just the first of many industries with large unfunded pension liabilities that will be put onto the public's growing list of additional expenses. Blue collar workers certainly don't have the power either politically or through union actions to drive wages much higher, particularly in a high unemployment world. White collar workers will find their energy intensive lifestyles completely unsupportable and they will hurt the most from the housing bubble collapse / debt refinancing squeezes. Deflation is a major risk in a depression. Our economic/financial structures are not really built for rapid deflation.
There may be some truth to the idea that wages in the US will be held down by the continued possibility of outsourcing for some time to come. However, that's only likely to worsen our trade deficit, which is itself inflationary (as it's got to put downward pressure on the dollar at some point). Also, wages in India and China are rising very rapidly as the demand for skilled people in those economies is great. Even unskilled labor is rising quickly in the cities. That's eventually likely to feed back into rising prices for goods (though perhaps not for some time, as there is still quite a bit of potential for more offshoring).
Stuart, I agree the globalization process is particularly different when viewed through a peak oil lens. I argued for WTO, NAFTA, etc because I always thought that it was big industry that would benefit the most from higher tarriffs. For instance, imagine how little incentive GM & Ford would have to increase production of hybrids if we had huge tarriffs on Japanese hybrid imports.

However, through globalization we are mothballing domestic production capabilities that will be essential as A. The dollar weakens B. Transport becomes ever more expensive C. Each region has to become more self-sufficient in food, energy, goods.

I have to say that I'm now feeling pretty negative about the WTO model of world trade. We should keep some industries capable of ramping up to meet domestic needs in a crisis.

I tend to the view that globalization is going to be more attractive post peak than a lot of people think (unless we experience a major collapse). We need to remember that ship transport is roughly 100 times as energy efficient per ton-mile as road transport. So for example, here in San Francisco we're going to be almost as close to Mumbai or Shanghai or Tokyo as we will be to New York, energetically, and much closer to them than we will be to, say, Denver.
In addition, there are more options for powering ships than
land transport. Ships can run on any solid or liquid fuel,
as well as wind. For land transport only rail approaches the
versatility and efficiency of sea transport.
Lest we forget: really big ships (and submarines) can also run on nuclear power.
Let's hope it leads to political reform if China as well.
This is a very shallow and dim-witted view of the economy in general, and inflation in particular.  Does King think rising prices only affects workers?  Oil prices affect industry, in the form of rising energy prices, and higher transportation costs. Oil is not the only commodity rising these days: inflation in virtually all commodities is creating rising costs for industry.  Profit margins are disappearing very quickly.

With steeply increasing fuel costs, corporations will find that it is not so easy to move to a different country if a local labor force demands higher wages.

blog on peak oil and peak dollars:

What King forgets is that US consumption is at record high levels (over 70 percent of the economy) and is currently the linchpin for the global economy. Stephen Roach at Morgan Stanley has been stressing these facts for the past few years. King says we won't have inflation because workers are too weak to press for higher pay, and makes a good argument (Richard Freeman of Harvad Economics writes a little more sympathetically:
But King doesn't push the implications beyond that smarmy remark about tough luck for the little guy and gal getting shafted by capital's greatly increased ability to vote with its feet.  He forgets that central bankers are acting as if they think we will have inflation, in increasing interest rates. That's putting a damper on the economy. Another problem is that without inflation where is the US middle class going to get the purchasing power to continue buying? The refi boom seems to be ending in declining house prices, so that door to extra income is probably closed (and may slam hard enough to take down the house if house prices plunge). In the midst of this unpleasant mix, oil price increases and their effects on other prices come as a big tax increase. And there's a good reason why you don't impose a massive tax increase when an economy's beset by lots of problems.

King might be writing nostalgically about the merits of inflation in a while...

There is a key point about inflation that is not being addressed here. Inflation is a general rise in price levels, i.e. virtually all prices are going up, including the price of labor, wages.

For inflation to happen, there MUST be a growth in the money supply relative to the supply of goods.

The central bank (the Fed, in the U.S.) largely regulates the growth of the money supply. If they do not expand the money supply through lowering interest rates and other means, the money supply will not grow, and there will not be inflation.

Rising oil prices cannot cause inflation. They do not cause more money to be created, and without more money there is nothing that can cause general prices to rise.

A more likely sequence is that an increase in oil prices threatens to send the economy into recession, so the Fed decides to stimulate the economy by lowering interest rates and adding to the money supply. This increase in money in circulation can cause inflation. But it is the Fed's decision and action which causes the inflation. By itself, a price rise cannot cause inflation.

Presently, the Fed is on a trend of increasing, not decreasing, interest rates. Most observers expect this to continue at least until early next year. Therefore we will not see significant inflation at least in this time frame. Only if the Fed changes its policy and starts reducing interest rates is inflation a possibility.

(Yes, there have been localized price hikes due to increased energy costs, but without an increase in the money supply, the impact of these will be to reduce demand and curtail general spending, causing other kinds of goods to have to lower their prices because consumers have less to spend. We will probably see significant price-cutting this holiday season as consumers and businesses see more of their income going to energy related expenses.)

Not quite.
If the real economy slows down the money velocity also slows down. This is equivelent to expanding money supply and you get your inflation. That's why the FED is fighting the inflation preemptively until it's not gone out of control yet (inflation -> recession -> more inflation etc.)

The real economy is long due to slow down because you can not feed growth with stock and RE bubbles forever. We can only hope that the process can be controlled.

If the real economy slows down the money velocity also slows down. This is equivelent to expanding money supply and you get your inflation.

No, you've got it backward. A fall in the velocity of money is equivalent to people hoarding money (and you're right that people do this when the economy slows down) but this reduces inflation rather than increasing it. Inflation is an increase in the money supply, but if people are hoarding it (equivalently, slowing down its velocity of circulation) that has the same effect as decreasing the money supply. This is another reason why energy price increases will tend not to be inflationary.

See for example

Sorry, bad memory from my economic courses abouth the definition of velocity of money. Here it is:

M*V = P*Q

M -> money supply
V -> money velocity (number of times a dollar is spent per month)
P -> price level
Q -> GDP

so, P = M*V / Q
If Q drops in constant M and V prices rise. The way to contradict that is to decrease V by raising interest rates and keeping money in the banks (this relation has always been quite vague to me, how do you make people addicted to(and locked in) spending save? you have to be really aggressive).

Q drops if energy prices rise for an energy importing economy because businesses and individuals offset their spenditures to foreign economies (the energy exporters).

So, price stability can be achieved only by means of quite severe recession (at least in theory). The original article somehow assumed that we'll have price stability whilst keeping the currrent pro-growth status quo which I can not agree. Of course for the US exists a third option - to expand borrowing abroad to offset rising energy costs. Whether it is a good idea I don't know.

thanks for reminding me of this. Good formula to have in your back pocket.
Aside from these points, what about the pressures caused by the scarcity of commodities?  If prices don't rise, people will simply refuse to sell high-demand items (except maybe on the black market, or something like the 'hard currency' markets of the Soviet bloc.).  This may not be inflationary, per se, but prices will rise.  
Halfin makes an important point about the likelihood of inflation. My working assumption for the last several years has been that we are heading towards a rerun of the 1930s, not the 1970s and that it is deflation we should be concerned about. The Fed has already engineered a huge increase in the money supply, extending the credit bubble to unprecedented heights. The real estate bubble is starting to burst and the implosion of the debt bubble can't be far behind. The Fed can increase interest rates and force us into a deflationary spiral immediately or it can leave them where they are and watch the dollar fall off a cliff in the next few months. Either way there's no avoiding a crash, even before factoring in peak oil.

I suspect there's a liquidity crunch in our future. Ironically that might cause enough demand destruction to obscure the fossil fuel production peak. I would expect energy prices to fall, although people's ability to afford access to energy supplies may fall even more quickly, amountng to a price rise in real terms.

You make an interesting point about the possibility of deflation. I am not too familiar with this term, so I wandered on over to Wikipedia. They have an interesting section on the japanese deflation. This particularly interested me:
Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.
I know how to guard against inflation. But what are steps to guard against deflation besides getting out of consumer debt, which is always a good idea?
The best investments in the event of deflation are cash, and long-term government bonds. During deflation, asset and stock prices fall and businesses fail, so commodities and stocks are not good investments. Bonds will increase in value when interest rates go down, but you want strong bonds because of the many defaults which occur in a deflationary era. Those would be U.S. government bonds, or those of another stable government. Long-term bonds will show the best appreciation because they will lock in the high interest rates for the longest period.

Now all you need is a good crystal ball so you can predict deflation before it happens, and you're all set.

Long term bonds may well become illiquid during a deflation. They represent a long term vote of confidence in the finances of a particular government. In the case of the US in particular I would suggest that confidence is misplaced. If enough potential creditors take the same position regarding the risk associated with the US government debt, they will require a higher interest rates in order to continue to invest. As interest rates rise, the price of older long term bonds carrying a lower rate of interest should fall substantially. If interest rates rise far enough, older bonds may become very difficult to sell even at a discounted price.

Short term debt instruments do not carry the same risk, at least for the time being. Eventually the US government may copy Argentina and convert all short term debt to long term and subsequently default on it, but we are a very long way from that point in my opinion.

Bonds other than government issued are likely to fare much worse as deflation should precipitate a flight to quality that sees credit spreads widen to an unprecedented level. Interest rates even on high grade debt should increase to relect higher levels of risk, but the rates on lower grade bonds are likely to climb far higher and many bonds are likely to be defaulted on. Higher interest rates would worsen the domestic economic situation drastically, but the government is unlikely to have a choice if it can't attract the new foreign investment it needs in order to continue servicing its obligations without raising rates.

Personally, I think deflation is right around the corner (ie within the next year) and preparing for it should be a matter of priority.

My personal opinion is that this is nuts.

An overdebted economy would never take a restricted / deflationary course to avoid (hyper)inflation. This will cause such a bankrupcy level that 1929 will look like a pinic. Besides in a contracting economy you will need to constantly raise interest rates because you will have more and more derivative assets against contracting real sector. Unless these assets suddenly lose their value (debtors go bancrupt). Since the biggest debtor is the government I am  hard to believe that it would desire its own bankrupcy; no, it would rather try to devalue its debt by permitting a moderate inflation - but not such that would cause currency devaluation. We are simply walking on thin ice with this, and it is getting thinner over time.

This is in fact what US has been doing with the rest of the world all the time since 1949 - emitting fiat assets, providing a shelter for the world's hot capital. These assets though, get devalued with time and this helps keep debt under control.

You imply that the US government may have a choice as to whether or not its economy follows a deflationary course. I don't believe it has any choice in the matter at all as I don't believe governments have any control over major trends, although they think they do. People will be expecting the Fed to engineer a soft landing and when it fails to do so its reputation will be in tatters (as will the reputation of whatever politicians are in power at the time - as happened to Herbert Hoover in the 1930s).

I agree with you that a deflationary spiral will be a financial disaster and will make 1929 look like a picnic. Indebtedness is much worse now than it was in 1929 and asset classes are arguably more overvalued than they were then. Positive feedback has taken us further up than it had then (the virtuous circle), and when it kicks into reverse will take us further down as well (the vicious circle). On the bright side, if there can be said to be one, it will take the pressure off a tight energy supply market through demand destruction.

Of course the government can - or at least it can try to - influence the economy. This's what the monetary policy is for. If they simply start printing dollars in case of recession we can see very unpleasant things happening.

Deflation happens spontaniously in case of overproduction or drop in consumer demand whichever comes first... Well I intuitivly rule out overproduction because the rising energy costs should act like an added friction to scaling out production. Indeed the drop of consumer demand is there because of the sticky wages and higher personal spenditures on energy. So the companies are stuck between dropping demand and rising costs. But if they lower the prices to boost demand in this highly competitive market they will certainly go bankrupt.

My scenario is that most of them will try to raise prices and scale back to smaller units and to markets that are not that price sensitive. Thus they will also cut the growing transportation costs. Not surprisingly WalMarts, KMarts etc. will be the first to disappear.

This is more like a stagnflation scenario - and this is what the history of the 70s is telling us will happen.

The government doesn't set trends - it follows them. It's actions are the ultimate expression of the herd instinct and therefore a lagging indicator. Governments are always fighting yesterday's war, so to speak, which in this case means inflation. Expect them to go on fighting 'inflation' well into a deflationary spiral, thereby making a bad situation worse as expensively as possible.

They'll have to raise interest rates in order to attract foreign capital into the bond market under conditions of increased risk, which will result in an even more severe economic contraction. It really won't be a question of the government having a choice in the matter, but merely responding to external pressures. The same thing happened in the 1930s and cost Herbert Hoover his reputation, but it was no more a matter of choice then than it will be this time.

The Japanese government spent over a decade desperately trying to stimulate their economy, but the population wouldn't spend. In a deflation, why would you spend? If you wait the price will be lower. Money is withdrawn from circulation by those saving for a rainy day or to buy something when the price has fallen much further. The perpetual growth machine grinds to a halt and the accumulated leverage crucifies the economy on the way down.

We have a great deal of excess production capacity (for things other than fossil fuels) in our system, constructed with virtually free credit during the great credit binge we've just lived through. We will probably have a shortage of demand in the near future, once the markets crash and precipitate a depression. The setup for a deflation of historic proportions is clear.

Japan is several years ahead of us as they began their deflationary spiral in 1989 as you point out. The Japanese stock index has fallen approximately 75% since then and isn't finished yet. As the US moves into deflation, the Japanese export market will largely dry up and the remaining bad debt on the books of Japanese banks will no longer be able to be covered up. They are undercapitalized since the real estate crash there and may well collapse as the credit bubble implodes in the US.

To protect oneself from deflation, getting out of debt is the highest priority. It is advisible to have reserves of liquidity (cash or cash equivalents - short term treasuries for instance) in an extremely safe banking environment. US banks have been playing Russian roulette in the derivatives market for far too long and do not represent a safe banking environment. They constitute a house the leverage built, and leverage is not kind to the banking system during a credit contraction.

Suitably protected liquidity allows you to take advantage of a deflationary scenario, in that the value of all asset classes falls in relation to the value of cash. This is a result of people trying to cash out all at once in order to cover their debts once a crash has begun. If you still have cash when there are many sellers and few buyers, there should be tremendous bargains to be had. The key is to cash out in advance. Unfortunately, what is rational for the individual becomes one more nail in the coffin for the collective, but failing to cash out doesn't save the collective anyway. The damage is already done as the mountain of leveraged debt already exists.

A measure of self sufficiency is also a good idea, whether as a hedge against inflation or deflation. Either can disrupt the brittle lifesupport system globalization has created. A deflationary scenario would suggest sitting on the cash and purchasing the means to be self sufficient once prices fall, but to do that means forgoing the opportunity to learn the skills necessary for modest self reliance. It takes time to install renewable energy equipment for instance, and to adjust your lifestyle in order to accommodate it. Other self sufficiency measures also take time to learn. I regard it as an insurance policy and therefore didn't wait for prices to fall first.

It depends on the rate of depreciation - in case of a market panic interest rates are a very little help. Raising them higher now may even worsen the problem and simply postpone the settlement date by attracting short term capital. Besides you will have to pay this interest somehow, and if you do not produce anything you will have to go further in debt.

I'm also afraid that significantly higher IR can throw us in a severe depression. If you compare it with the Reagan's 80-s it will be a whole lot worse, because 1) higher energy prices 2) much higher indebtment (higher interest due).

You state this with great certainty, but actually it's a theory, and one that does not seem to be in very good accord with the facts. Empirically, it seems to be the case that oil shocks are very often associated with stagflation - which has just started to rear it's head for the first time in a very long time now that we are having our first (so far very mild) energy shock in a very long time. Yes, interest rates control the cost of borrowing. But people's desire to borrow can change for other reasons than interest rates alone; such as that everything is getting more expensive, because everything involves a certain amount of highly inelastic and rapidly price-increasing oil, and people choose to increase their borrowing rather than accept a reduction in their lifestyle.
I meant to comment on this before. I think you are getting a little ahead of the facts here. We are not in a situation of stagflation right now. Yes, we've had a couple of months of slightly higher prices in certain sectors, and some signs that economic growth may be cooling. But "a single swallow does not make a spring". We are a far cry from the classic Jimmy Carter stagflation where the "misery index", the sum of the inflation and unemployment rates, reached 22 percent. At present, core inflation is still moderate, and the economy is still growing. It is way premature to be talking about stagflation, based on the current economic situation.
I agree with this. I headlined my piece "A Touch of Stagflation" the other day, because that's all it is. We've only had a very mild energy shock from the hurricanes (something around 0.3% of global oil supply, and around 3% of North American NG supply), by historical standards (eg compared to losing 7% of the world's oil supply in the 1980 shock), and it hasn't fully worked its way through the economy yet.
Well, Mr. King is right that the Reagan Revolution and corporate run globalization have stripped labor of the ability to increase wages, at the same time COLAs have basically been stripped from those on "fixed" incomes.

However, Mr. Greenspan is a monetary fanatic and he's wetting his pants right now with the commodity and a few other inflation numbers. Good probablity of a half-point rise and you can count on quarter point rises until Greenspan leaves, which will most likely induce a recession into a situation that has great global financial instability. History never repeats itself quite exactly.

And this instability was caused in part as Mr. King says "by the Nineties, was pushing for independent central banks with inflation targets." That's close to the funniest thing I've read in awhile, I remember people being in the street demanding "independent" central banks.

We could have a bit more nuanced picture of the oil prices and inflation by adding some factors here.

The share of oil in world energy mix has diminished from 39.3% in 1999 to 36.8% in 2004 (BP). This has mitigated a little the oil impact. Besides all oil prices have not risen. Many oil producing countries have heavily subsidized or regulated prices that show in the price of exported goods. The diminishing share of oil means that if we had today the -99 share the oil consumption would be about 7% higher - this would mean almost 5 million barrels. Here we see that substitution happens - this time mostly by coal.

The imports from China (with its 94% energy self-sufficiency) dampen inflationary tendencies in the US and Europe. Note that we have here not only cheap labor but cheap energy, too. This effect is quite significant.

The share of oil in the US GDP is about 4%. The oil prices are still relatively low compared to the GDP level (deflate oil price in constant dollars with real GDP). The relative impact of oil is not so high yet.

The commodity prices have decreased markedly lately as the Chinese demand growth has slowed a bit. This has offset part of the oil price effect.

The energy-intensive industry has left or shut down in the US. Its share in the manufacturing is smaller now than at the time of the previous oil crises. This mitigates also the impact of the natural gas prices.

And there is always the lag. Oil prices rise has been very sharp so the effects of $60 oil will be seen a little later. The wages and other prices may follow but they have not had time yet to really do that. We will see.  

TI makes his usual insightful comments!

There are two kinds of oil price increases.  During the '70s, OPEC increased oil prices because they could.  They had monopoly power.  Our response was fight monopoly with monopoly.  We have a monopoly on printing dollars so we just readjusted the price levels so that their oil was worth what it was worth pre-1973.

The recycling of Petrodollars occurred.  What OPEC got was a transfer of ownership but the world economy moved along once the adjustments and accomodations were made.

The second type of oil price increase occurs when its EROEI increases.  More resources have to be allocated to achieve the same energy inputs.

We're beginning to see this as the easy oil is extracted and the best fields deplete.  Deep water oil is hard to get.  

Looking at the Hirsch Report, I've estimated that we could deal, for a while, with a switch to substitutes at a 3% depletion rate on a 100 mbpd economy by about doubling our investment in oil E&P or $100 billion a year.  But that's a very rough calc.

When we have to make big shifts in capital and resources to keep energy flowing in, then other uses of capital will have to surrender.  That means lower growth and inflation - "stagflation" will return, as Stuart has mentioned.

This stagflation will affect different economies differently, largely due to their ability to adjust and to their energy productivity.  Highly productive, highly adaptive economies like the US will do better than, say, China, since the Chinese need access to foreign energy (especially oil) to upgrade their productivity to help make the most of their human capital.

A well-handled transistion to peak oil can be made.  The result will be an economy that grows more slowly and devotes more of its productive surplus to infrastructure.  We'll see more people working in energy businesses and hopefully fewer people pursuing frivilous, wasteful careers as lawyers or journalists.

I am not ready to declare stagflation yet. There is not enough evidence. So far we have had rising oil prices, relatively good growth and moderate inflation. This is not stagflation.
I didn't say we were IN stagflation yet.  I only described it as one mode of energy-related inflation.  I see the market price of oil being imposed by low cost producers, until late.  The balance of the providers have "air cover" for the market price above their production costs.  Once production costs drive prices, then we'll see stagflation.
This doesn't mean that we will have stagflation in the US this time. The petrodollars are not necessarily coming back and the share of domestic producers is smaller and hence their rising incomes will have less impact on the economy.

Rising oil prices are having a strong impact on the trade balance. But it is not necessary that the dollar will crash because it will not help much. There is no way to boost exports or imports-substituting domestic production based on very expensive imported oil and non-available natural gas. The alternative is to cut imports drastically (to reach balance now would mean cutting it to half!). So the result is most likely a strong recession and deflation, not stagflation.

The US has now a double energy crisis and the natural gas situation is worse. No additional gas is physically available for some time (LNG terminals are not there). No significant nuclear capacity is being added. Coal could help a little but it is very difficult to boost production enough to compensate all this. This will hit the economy.

I define stagflation on a global scale based on increasing EROEI of critical energy forms.

We're working feverishly on new nukes here at VBM - really!  We've got several RFPs on the table and engineering can't get enough talent to work on the new design.  Expect ramp rates to be less than demanded of the industry for maybe a decade given lack of experienced people and global fabrication bottlenecks.

There are some power uprates still to be performed in the US but not many.  Otherwise capacity factors are about max'ed out.

Coal plants are coming more expensive than nukes!  Two data points art 600 MW in Omaha at $1800/kW and 500 MW in Virginia (SE anyway) at $2000/kW.  We can do a 1500 MWe plant for maybe $1600.  A comparable output coal plant would see economies of scale but I doubt it could catchup especially with higher fuel costs.

To nuance a bit further:

Chinese imports into the developed world have more than dampened inflation in the past--they have been deflationary. But that is in the base period. Now, we've seen shipping costs roughly triple, price of steel and plastic and other inputs sharply up, US dollar declines and the yuan (very slightly) up. So import prices rise.

If you substitute a cheap import for an expensive local good, there is a one-time cut in inflation. But once we depend on buying that import, if its price rises, it contributes to inflation.

Commodities-yes, steel dropped from $650ish to $550ish, but it's headed up again. And it was $350 2 years ago.

I will grant that workers are weak, and their pay rises will fall behind other costs. But with rises in the costs of energy of all types, transport, interest rates and a lot of other inputs, I'm betting on a period of higher inflation with lower growth.

I'm currious about the future begavior of countries with their own oil reserves.  At what point will the price of oil on the world market become almost irrelevent because the need to supply (read: subsidize) domestic consumption will trump the desire to export?
The handwriting is already on the wall. Go look at gold and silver over the last 24-36 months. Then compare that with your basic 401-K or mutual fund return.

In the last few months it has been up and down, but precious metals are definitely on a trend up...  so, who puts their money into that type investment and why?

see above posted worries for possible answers...

This is an interesting article, shows relationship between gold, oil, real estate, etc.

from Reuters:

"An analyst for the U.S. Energy Information Administration (EIA) told Reuters Monday that the government would likely drop its U.S. and global energy demand estimates in a report to be released Thursday. "

does anyone know why?  the US & global energy demand estimates are in every weekly EIA report.  why all of a sudden drop it in this week's report?

I think it's just poor wording.  Change the "drop" to "lower" and read the sentence again.
i see.  so the US IEA will further lower its demand estimates.  right?
so they will resort to manipulation
Anyone notice this gem today?

Yea.. That's exactly what we need at this point in time.  One of the major manufacturers left in the states going bankrupt.  A massive government bailout of a company with 300 BILLION dollars of debt.  That's more than the cost of the Iraqi War and the total spending on Hurricane Katrina so far COMBINED.  

Granted, they won't pay that much of the debt off and much will be liquidated, but to who?  Which auto companies in the world have enough capital to purchase entire auto plants?  I guarantee that none of them are domestic.  Even if they don't liquidate the plants, all the rest of the assests are still going to go foreign. Even if it's a very light bailout, giving them enough to survive for a few more years, the budget will be expanded, finainced through foreign investors.  Why are we at a point that we cannot save an American company by our own means?  Why do we have to save an American company by prostituting it out to foreign competitors?  It's just pure bullshit.

Maybe, the one positive thing that could happen because of this, based on current energy prices, is a stipulation of the bailout being extremely heavy investment in hybrids, electrics, and maybe hydrogen.  That would be an extremely forward looking investment strategy and if pulled off would solve alot of our current crises.

Of course, since the powers that be don't like government interference, even while we give them billions of dollars, I doubt anything like that would happen.

I don't understand the supposition of a bailout.  Are you saying that because the govt. keeps passing legislation to help the most profitable companies on the planet (the recent 'encourage new refineries bill' for one) so they must also help everyone?

Bankruptcty will allow them to restructure the company; in my view they will try and renegotiate labor contracts.  According to the same article they have a 'healthy balance sheet' so bankruptcy may not even be necessary.  I see this as a red flag they are tossing up to say they are going to make some drastic changes.

GM Chairman and CEO Rick Wagoner has said repeatedly this year that the automaker needs to negotiate lower health-care costs for active and retired union members and their families but has so far not won an agreement in negotiations.

The message I hear from him to Labor is: 'If you don't negotiate, we'll declare bankruptcy, and the courts will negotiate for you.'

But then, S&P moved their bonds from "junk" to "junkier," which won't help matters much.  

To quote the guy from Airplane! : "They bought their ticket, they knew the risks, I say let 'em crash."  

My supposition for bailout is just a sampling of recent history.  If you look at the airline industries, who are bankrupting left and right, we bail them out because 1) they provide a service that is absolutely critical to our economic livelihood and 2) the drain on our economy because of a collapse is greater then the drain of a bailout.  

If you think the government will do this for even the most modest of airline companies, and not a manufacturing and economic giant like GM (I mean.. they generate more revenue than alot of countries do), I think you're greatly mistaken.  And, you can't use the excuse of the political capital gains that caused alot of the bailouts post 9/11.  Airline bailouts were happening along time before that.  

One way of looking at the Delphi debacle...and its effect on precisely through deflationary forces--cheap labor abroad.  

GM is setting up shop in China; expect Delphi to follow.  Entire manufacturing chains are moving to China.  Some multinationals are insisting on their suppliers being in East Asia.

In the states, people overextended through credit are going to be hard pressed to repay those loans and credit cards as they find their salaries cut again and again.  And the price of energy will drive in exactly in the opposite direction.  This is not the 1970's.  It's far worse.

Well, at least some public officials are making appropriate gestures of practicing what they preach about energy. Maybe not much more than gestures, but I'll take it. Governors Bill Richardson (D-NM) and Jeb Bush (R-FL) are parking their gas guzzline SUVs and making a show of driving, hybird SUVS.;_ylt=Asi0z5BgECTt9.bFAgekDJO s0NUE;_ylu=X3oDMTA3OXIzMDMzBHNlYwM3MDM-


Let the Feds bail out GM, and then Delta and all the rest of the stupidly-run corporations. The whole concept of "bailing them out" is fradulent, because the Federal government we have today exists on BORROWED MONEY. This is the house that must inevitably crash, or that we taxpayers will be indentured to finally pay off. The sooner it corrects, the better, because no matter what anyone here wishes, it will correct itself and it will be painfull in the extreme. As I have posted earlier, there are many crows coming home to roost in the near economic future.


You can have a look around Texas and find lots of hybrids being used by various municipalities. They began quickly phasing out pickup trucks in favor of hybrids when gas started to rise. You can see lots of them in Houston and Austin.

But a politician driving a hybrid is just a PR-show - you have to look at their voting record to determine if they are what they wish you to believe. Most are not.

Politicos rely on soundbites and videosnippets to convey positions they do not actually endorse or believe in.


And, you will notice, one of my points is that it doesn't matter who bailouts the bailouts the corporation, be it government money or by liquidated assets.  The point is, it will ALL be paid for by foreign investors, driving even more money into the foreign market.  We're saturating the gd thing with our cheaply produced, easy-money, Wal-Buck dollars, and the only result is hyperinflation.

Come on.. don't you really think that somewhere in the PRC there is some upper-management person running around telling the elites that they have to start seriously devesting their dollar assets?  How long will it take for them to listen?

Descolada -

Until we begin to sink on our own, it's in PRC's best interest not to rock the boat. As soon as any country begins divestiture of dollars, the dollar will be worthless. And that will happen instantly in todays electronic trading markets. I think the piling on would happen at light speed.

When we sink, so does the dollar hegemony, and with it, the world as we know it. Something new will have to be birthed or rebirthed at that point.

Actually, I have a thesis on this.  The devaluation wouldn't happen at light speed, but would make a general westward progress.  Futures would go through the roof, of course, but as you work your weight westard from the epoch point, markets don't open.  Of course, this doesn't take into account investment into foreign markets. But, overall, I think you'd see a trend as people start waking up towards the west, realizing the shithole day they've woken into, of economic collapse.

Isn't it interesting, even in our light-speed globilization, things would still be limited by natural sleep cycles?

Anyway, as far as diversification out of the dollar market, I think if it were done at a slow enough pace no one would notice until it were too late to stop it.  Hell, maybe PRC is doing that right now.