The global economy reminds me of a sardonic phrase I would hear in Vietnam 44 years go. If someone said, “The AO (area of operations) is in a dynamic state,” it meant that something important seemed to be going on, but nobody really knew what the heck it was.
Indeed, the “dynamic state” in the present day is truly something important. Now let’s try to figure out what’s going on.
Oil prices are falling, and Russia is in a classic foreign exchange crisis that may become a full-blown economic crisis. OPEC is pursuing policies that will throw its weakest members into recession, if not financial collapse. Europe is on the edge of deflation and recession in many of its countries.
There are some common threads in all of this. One is oil prices; the other is economic mismanagement.
First there is the relationship between a change in price of a specific essential good, such as crude oil, and inflation or deflation. Do rising oil prices spur inflation, and will falling prices bring on deflation? If so, does cheaper oil mean the Federal Reserve has more breathing space before raising interest rates from historic lows to avert inflation?
Any introductory econ text emphasizes that inflation and deflation are changes in “the general price level.” Fluctuations in the price of any specific product like oil — no matter how essential — are not the same as inflation or deflation.
People may react to this by asking, “Didn’t high oil prices cause inflation in the 1970s?” Some economists, including me, would say no, and cite Nobel economist Milton Friedman that “inflation is always and everywhere a monetary phenomenon.” Inflations only occur when the money supply has grown too fast. If energy prices rise but the money supply is constrained, that will force households to buy less of other things if they want to heat homes and drive cars as before. This lower demand for other goods will drive their prices lower and the weighted average of prices won’t rise.
That is generally true in the long run. But in the short run, falling prices of specific goods like oil do ease visible inflation. Since energy is an important fraction of the “market basket” of goods on which price indexes like the Consumer Price Index are tabulated, any fall in its price can counterbalance increases for some other goods.
Since oil is a raw material in making many goods, the savings cascade forward and eventually reach consumers buying finished products.
Usually, that is good news for a central bank like the Fed. Now, however, some fret that falling consumer and producer prices could push economies like the European Union or even the U.S. into deflationary mindsets that lead both consumers and businesses to curtail spending and slow the economy.
Perhaps, but I think Fed Chair Janet Yellen was right to downplay the price level effects of falling oil prices in her news conference after Tuesday’s Fed meeting.
Despite the dissent of Minneapolis Fed President Narayana Kocherlakota, who voted for his last time Wednesday, the Fed probably will continue to tighten very gradually with short-term interest rates lifting off the bottom sometime next year.
The news has entirely ignored the fact that the “monetary base,” the measure of currency and bank reserves that underlies the money supply, has already fallen by 9 percent since September. This shows that some tightening effectively is already underway.
So the effects of falling oil prices on inflation or deflation in our country are probably not as important as many think.
They are, however, good for the general economy. Households will have more money to buy other things after paying for heating and driving.
Production costs will fall for farmers, miners and many businesses. The slump in spending on oil and gas drilling and processing will offset some of this, but the net effect is to promote growth of output.
That isn’t true in countries for which oil income is the center post of their economies. Iran, Nigeria and Venezuela are particularly vulnerable, and they will be in extreme economic distress in coming months. In all three, the fall in oil prices is the straw on a camel’s back of stupid policies for their general economy over many years. Cheaper crude is a “precipitating event,” in any economic collapse there, but the root causes are far deeper.
That is true in spades for Russia, which is a case by itself. That country’s current crisis is the manifestation of a triple witching hour of factors.
First is the fact that the “nationalistic authoritarian kleptocracy” economic model of Vladimir Putin is a terribly inefficient one. High oil prices obscured that for years, but, to use a Marxist phrase, falling oil reveals the “internal contradictions” of a cancer-riddled Russian economy.
Effects of economic sanctions imposed in reaction to bellicose Russian policies toward Ukraine and other former soviet nations or satellites are the second negative factor. These hurt Russian trade and inward foreign investment as well as financing and refinancing of loans Russian firms have from abroad. Overall economic and political insecurity drives both domestic Russian plutocrats and foreign investors to pull their money out of Russia. That, rather than falling oil prices, is the principal cause of the foreign exchange crisis.
Thirdly, oil has been the mainstay of Russian exports and a fall in the supply of dollars and Euros derived from less-valuable oil exports would have forced the value of the ruble down against these currencies even if the rest of the Russian economy were healthy and there were no geopolitical tensions. But it would have been nothing like recent plunges.
Exports are short-term flows and show up in the “current account” of the balance of payments. But investments flowing out of the country in the long-term “capital account” are central to the crisis. Once started, it is not likely that a recovery in oil prices would correct this.
The economy of Russia could get very bad very soon. Given the mercurial and autocratic nature of Putin’s regime, this is dangerous for the world as a whole. The West should set aside “schadenfreude,” or joy at someone else’s problems — the world is better off with Russia on at least an even keel than with it in crisis.
The foreign exchange interactions in all of this, for the United States, Europe, Russia, Japan, China and nearly everyone else are hugely important, but these issues must wait for another column.