Dave Lewis' best essay, of course it's my view <g>. :
Aug 19: The metastasis of inflation
The whole conventional analysis reproduced in most textbooks proceeds as if a rise in average prices meant that all prices rise at the same time by more or less the same percentage, or that this at least was true of all prices determined currently on the market, leaving out only a few prices fixed by decree or long term contracts, such as public utility rates, rents and various conventional fees. But this is not true or even possible. The crucial point is that so long as the flow of money expenditure continues to grow and prices of commodities and services are driven up, the different prices must rise, not at the same time but in succession, and that in consequence, so long as this process continues, the prices which rise first must all the time move ahead of the others. This distortion of the whole price structure will disappear only sometime after the process of inflation has stopped. F.A. Hayek
A few days ago Bloomberg News ran a story with the following headline, Japanese bonds gain as oil climbs to record, threatening growth. The thesis of the story, that rising oil prices were going to act as a brake on growth, is not new, nor found only in relation to Japan. The growth sapping abilities of a rise on oil prices seems to be an article of faith in the financial press. This notion, it seems to me, is an artifact of a system long gone, i.e. the Gold standard, and inconsistent with the practical effects of the fiat $ standard. One possible inconsistency in the argument might arise when pondering the question, to the extent that a rising price of oil in growth sapping, was not the rising price of financial products during the 80s and 90s equally growth sapping? Indeed, the irony of public officials now claiming that, to quote US Treasury Secretary Snow, I don't think the fundamentals justify the (oil) prices at these levels, seems rich when one considers that the very same arguments were made about equity prices in the late 90s to no avail. Live by credit expansion, die by credit expansion.
From 1981 into 2000 and beyond for the bond markets, prices for financial securities rose dramatically. These prices rose as a result of increased demand for the products, a near 2 decade long persistent shift in the flow of funds, facilitated by substantial increases in the monetary aggregates, then prevailing from tangibles like oil, silver and gold into the financial sector. Towards the latter stages of the boom in financial securities quantities of funds flowed into this sector which were orders of magnitude greater than the amounts required to, for instance, drive up the price of oil to $100. Remember that the daily turnover of the spot foreign exchange market is measured in the trillions of $. To put that number in context, $1Tln will buy you a little under 21B barrels of oil or roughly enough oil to supply the US' needs at current consumption rates for just under 3 years. Alternatively, 21B barrels of oil would fill the strategic petroleum reserve 31 times. The point I'm trying to make is the quantities of money thrown about in the financial sector daily dwarf the flows that are needed to allocate resource in the real sector.
To get a sense of the shift in the flow of funds consider that, according to the Federal Reserve Flow of Funds report, in 1980, US citizens' net acquisitions of financial assets totaled some $320B. By 1998 that figure had almost tripled to $910.7B, and in 2003 net financial acquisitions came to $986.4B. In 1980 some 17M bbl/day (6.2B bbl/year) of petroleum products were supplied to the US. Using the EIA's average annual price of 21.59 for crude oil as proxy multiplier, that comes to $134B. In other words, in 1980 the US net acquisitions of financial assets ran 2.4 times higher than the cost of oil. In 2003, some 20.4M bbls/day (7.4B bbls/year) of petroleum products were supplied to the US. Again, using EIA data, this comes to roughly $205B over the year. Thus, over a period when net annual acquisitions of financial assets tripled the net cost of petroleum products rose by only 50%. That is, by 2003, net acquisitions of financial assets exceeded the net cost of petroleum products by a factor of 7.3.
All of which is to argue that those who are looking for the price of oil to come down due to the "growth sapping" effects of increased oil costs have to explain why a far greater expansion in financial flows towards financial assets didn't lead to a similar slowdown in growth. In my view, what we are seeing here is the metastatis of inflation. At first, during the growth cycle of inflationary finance, as always seems to happen, funds tend to flow towards financial assets. Inflation, that is, is confined in the sectors deemed "benign." Eventually, however, a leak appears in the flow of funds and barring a decision to impose severe credit rationing, all prices eventually begin the shift to a new plateau.
Moving well back in time, the Dutch East India company was formed in 1602. Assisted by the credit creation abilities of the first modern central bank, the Bank of Amsterdam, increasing flows of funds were invested in the colonial/mercantile venture. But by the 1630s a leak developed in the flow of funds. Tulips became the rage with the average price paid for a Viceroy bulb, 2500 florins (from Mackay chapter 3) buying you 21K lbs of cheese or 31 new suits of clothes. As one might expect, other prices soon began to rise, until the exports of gold from Holland eroded the capital base sufficiently to force a collapse of Tulipmania. As gold is no longer used to settle international trade imbalances, we should not, I believe, expect to see a similar deflationary collapse but instead, the Austrian "crack-up boom."
Over the past few decades, oil has tended to be the commodity that attracts leaks in the flow of funds. The 60s boom in financial asset acquisitions, since it was not reversed by credit rationing begged by the increased outflow of US gold, eventually leaked into the oil sector, leading to the inflationary 70s. Something similar appears to be happening now and absent some abrupt shift in Fed strategy, other prices will soon follow suit. The point being that it is the excess credit creation that facilitated increased acquisitions of financial assets which is the culprit behind the jump in oil prices. To use monetary policy to ratio credit sufficiently to bring down the price of oil is to pull the rug out from the financial markets, a policy for which few politicians will campaign.
From the perspective of my role as Gold investor, the table has now been set. Since 2000, the monetary authorities have shown increased unwillingness to ration credit to the financial sector. As tends to happen a leak has now appeared in the flow of funds, with finance losing out to oil. Even if oil falls back to $40, an outcome that is looking less and less likely by the day, inflation will continue to manifest in the US real sector.
Some commentators have noted the change in relative prices of oil and gold of late. Yet, this too seems normal to me. It is the experience of inflation following the first leak in the flow of funds that leads people to shift funds out of the banks and into hard assets. That is, just as night follows day, the oil rally of 2004 will begat the inflation of 2005 and the eventual rally in Gold. As the elder Bush wisely said, albeit in reference to a different course of action, Gold investors need to stay the course. Now that the monetary authorities have lost control of the flow of funds, something noted recently by Martin Wolf of the FT; The US is now on the comfortable path to ruin. It is being driven along a road of ever rising deficits and debt, both external and fiscal, that risk destroying the country's credit and the global role of its currency, the writing is on the wall. |
