Oil and the economy: a primer

As Alan Greenspan muddles further into obscurantism and partisan irrelevance (seriously, he's against deficits, and yet in favor of tax cuts for the rich, and trillions in debt to pay for Social Security privatization? Jeez.) the nation yearns for clear-eyed economic wisdom. And so I, despite the personal sacrifice, as well as my utter lack of qualifications, yet offer my humble services.

Sure my formal economic training is limited to macro and micro courses at San Diego State back in the day. But perhaps that will suffice.

To begin.

Oil prices 101
Perhaps the most basic of economic ideas is that of supply and demand, that is: if supply is greater than demand, prices go down, if supply is less than demand, prices go up.

A corollary: If supply is fixed, but demand rises, prices go up.

This last is relevant to the world's current oil-price situation.

The oil producing nations are currently producing oil at or near capacity, and there will be no increases of capacity available in the foreseeable future. And yes that includes the Alaska National Wildlife Refuge, which may provide at most 3-6% of US daily consumption. A relative drop in the bucket.

Meanwhile, in addition to the always thirsty US oil market, two burgeoning economies, India, and most dramatically China have significantly increased their demand for oil, and will continue to do so, again into the foreseeable future.

So, classic economics: oil supply is static, demand is rising, and prices are going up. Easy.

Take the dollar, please.
Supply and demand also applies to international currency valuation. Currently the US is flooding the world market with dollars. And it is doing so in two ways.

The first way is through the US government's massive operating deficit. That is, the government is spending more money than it is taking in, currently at the rate of about $2.27 billion per day.

So where does the money come from? Well, unlike individuals, or even the several states of the union, the US government has a unique ability, if it needs more money, it can just print more. Now the US doesn't just print regular old dollar bills, it prints special kinds of currency like bonds and Treasury bills (T-bills). The main difference between a dollar bill and a T-bill is time. That is, a dollar is worth its full face value right now, while a T-bill is only worth its full value at some specified point in the future. And that, though vastly over-simplified, is about it, T-bills, treasury bonds, even US savings bonds are just a type of money.

So when the US government operates at a deficit, it finances that spending by issuing Treasury bills and the like. The current US deficit stands at about $7.7 trillion, ($7,791,779,810,738.91). Which means that $7.7 trillion in T-bills and such are out there on the market, held by individuals, companies, and especially countries. That's one part of the dollar supply.

The second source of dollars on the open market is the US trade deficit, that is, the difference between what we in the US spend on foreign goods and services, and what people in foreign countries spend on US goods and services.

In 2004 the US trade deficit was a record $665.9 billion, a 25% increase over the 2003 deficit. That is, the US (you and I) spent almost $666 billion more buying stuff from overseas than folks overseas spent buying stuff from us.

In essence we're shipping boxcar loads of cash overseas in exchange for boxcar loads of fuel-efficient cars, home electronics and all the crap they sell at Walmart.

So, is this a problem?
Maybe, maybe not. Here's the deal:
In the past, moderate outflows of US dollars have been essentially beneficial both to the US as well as our trading partners around the globe. Historically the dollar has been one of, if not the most stable currency in the history of human trade. As such it has been a boon to international trade and has become the base currency for the majority of international business transactions. Good for us, good for everybody.

But as the Bush administration continues profligate borrowing to finance its tax-cuts and wars, countries holding large numbers of US dollars can begin to wonder whether the dollar's value will maintain its stability. Even the barest hint of such a doubt can send global markets into a tizzy. In short, if the perception grows that there are too many dollars on the market (that is, to use the classic economic paradigm, the supply of dollars exceeds the demand for them), the value of the dollar will fall.

In fact, international markets have begun to recognize exactly that, and the value of the dollar has begun to slowly drop relative to other currencies, most notably the Euro, which is increasingly becoming the alternative to the dollar in international trade.

I have always depended on the kindness of strangers.
How'd that work out for you Blanche?

Currently the main bar to a radical decline in the dollar's value and resulting inflation, (quick primer on inflation: if dollars are worth less, it takes more of them to buy stuff) is the self interest of the other economies which are inextricably entwined with that of the US. All it would take to precipitate disaster would be for one of the major US donor states to decide to get rid of its dollar holdings. If say, China, for reasons either economic (worries about the dollar's declining value) or political (US support for Taiwanese independence) decides to dump dollars, the results would be devastating. (Good article on the dollar dump potentialhere.)

Now here's where it gets scary
Remember those oil prices?

Another interesting thing about oil is that it is one of those commodities whose trade is done in US dollars.

So now there are actually two things at work driving oil prices: the laws of supply and demand for oil, and the laws of supply and demand for US dollars.

So even as increasing demand for a limited supply of oil drives prices higher, it also takes an increased number of devalued US dollars to purchase that oil.

And given continued US demand, those same oil purchases will drive increasing US trade deficits, leading to further devaluation of the dollar and increasing costs for oil ad infinitum.

Good news/Bad news
There is a way to stop or at least slow this death spiral: conservation. Even small gains in energy conservation can have important effects. Reducing consumption:
1. reduces our trade deficit, reducing downward pressure on the dollar; and
2. reduces our portion of global demand, easing our significant contribution to oil price pressure

Conservation has, of course, some other benefits as well, reducing pollution and decreasing our dependence for our oil fix from countries like Saudi Arabia and Venezuela. As I've argued before, US energy policy should be an inherent part of US Security planning.

So, that's the good news, the solution is simple, conserve. The devil is, as always, in the details: how do we implement a meaningful conservation regimen?

A gas tax of course.

And of course, there may be a few implementation problems, such as the conservatives screaming that it'll be bad for business, and whose money is it anyway? Liberals ranting at a gas tax's regressive, disproportionate affect on the poor. That sort of thing.

Both of which are, of course, true.

But consider, it takes neither a crystal ball, nor a Ph.D. in economics to foresee a time in the very near future where, as a consequence of the aforementioned factors, the price of oil will be much higher anyway. Does anyone seriously doubt that?

When that happens (next year, the year after?) GM indeed won't be selling any Hummers, the poor will be crowding what little public transportation exists, and those dollars spent ($4, $5, $6 per gallon?) will go to stuff the silk-lined pockets of some of the most regressive regimes in human existence, that's whose money it'll be.

Instead why don't we pay ourselves first by taxing gas at the pump to encourage conservation?

Why don't we pay ourselves first and pay down the inflationary and destabilizing Federal deficit?

Why don't we pay ourselves first and invest in conservation , alternative fuel and transportation technologies?

Why don't we pay ourselves first and establish US dominance over the only technologies absolutely certain to become vital over the next century as fossil fuel reserves are depleted?

We're going to be paying anyway. Why don't we pay ourselves first?

A would-be economic demiurge can dream can't he?

Now that global economic forces are combining to push oil prices so high even the plutocrats of BushCorp™ might notice them, perhaps we'll see some movement towards policies that might actually impact our energy consumption.

My fear though, is that the economic purists will win yet another ideology versus reality battle within the walls of the West Wing, and that BushCorp™ will let the holy market decide. And certainly the invisible hand of the market will eventually bring the death spiral to an end, though that end will not be much to our liking.