August 19, 2004

As you may remember for a certain course you took, Nobel Laureate Milton Friedman explained to us long ago why this not always the case.  Remember Friedman’s famous quote “inflation is always and everywhere a monetary phenomena.”  There is nothing in that quote about oil prices!

What actually happened in the 1970’s is the Fed increased the growth rate of the money supply in response to economic slowdowns caused by the disruption of the flow of oil.  Thus, it was the increase in the growth rate of the money supply that “caused,” if you will the inflation of the 1970’s not the increase in oil prices.  This same problem occurred around the world:  central banks increased the money supply to deal with their weak economies.  And as Friedman predicted the result was inflation.

So what’s going on this time around?  The popular and business press is wringing their hands over the increase in oil prices.  The price for a barrel of oil today is over $48 while just a few years ago it was only $12.  “Oh no!!”  The pundits scream, “We are headed for the 1970’s stagflation again…”  Maybe, maybe not.

What is actually happening?  Why are oil prices going up?  There are a number of reasons: 

1) High demand.  As the U.S., European, and Japanese economies are growing and expanding they use more oil.  On top of this we have China and India growing rapidly and also demanding more oil.  As demand increase, ceteris paribus, price will go up.

2) Low inventories.  Those of you in the Northern U.S. know that we had a cold winter.  Cold winters means more oil has to be used to make home heating oil and thus draws down reserves.

3)  Supply Chain Problems.  Venezuela is run by a nutcase Hugo Chavez, the Russian oil industry is in turmoil, and we the “problems” in the Middle East.

4)  Stupid U.S. regulation.  In the U.S. gasoline is not just gasoline.  Different regions of the country are “required” to use different types of gasoline.  For example, in my old home town of Racine, Wisconsin, they use one type of gasoline.  But if you drive 10 minutes outside of Racine the gas stations sell a different type of gasoline. This happens is many regions across the U.S.   Remember what happens to price when you have heterogeneous products:  prices go up.  You loose economies of scale.

5)  Weak dollar.  Since oil is priced in dollars as the value of the dollar falls in the foreign exchange market sellers demand higher oil prices just to stay even.

On top of all of this, the price of oil today is really not that high….relatively speaking.  That is, the price of oil over the past several years has not increased as fast as the price of other goods and services.  So yes, $48 a barrel for oil seems expensive compared to 3 years ago but consider the following:

In 1980 oil was $21.59 a barrel which in today’s prices would be $49.63

In 1981 oil was $31.77 a barrel which in today’s prices would be $66.20

In 1982 oil was $28.52 a barrel which in today’s prices would be $55.98

M3 Money Stock

This is not to say high oil prices don’t matter.  They do.  A lot of individuals and a lot of firms are being hit hard by these higher oil prices.  But the Saudi’s want to keep us addicted to their oil.  It has more to do with politics, foreign policy and repressing one’s own people than it does the income that the oil generates…but that’s an entirely different topic.

In the long run, oil prices probably won’t drop much, and as long as the Fed does its job, inflation probably won’t be a problem.  The pundits will find something else to worry about and most Americans will shake their hands and say “see…this economics stuff never makes any sense...I always thought higher oil prices caused inflation…”

All the best,

MB