Friday, March 11, 2011

Baum: $100 Oil Kills Brain Cells

Caroline Baum, over at Bloomberg, makes a number of key points about the current increase in the price of oil and its relation to inflation, or more precisely its lack of relation to overall price inflation. Among the key points she makes are:

1. Inflation is a monetary phenomenon: too much money chasing too few goods and services.  
2. Higher oil prices don’t cause inflation. They aren’t synonymous with inflation. Higher oil prices represent a relative price increase until proven differently...When oil prices rise [because of an oil supply shock], consumers have to allocate more of their household budget to filling the tank and heating the house, leaving less for discretionary purchases. The composition of their spending may change, but nominal spending shouldn’t be affected.

3. The recent increase in oil prices qualifies as a supply shock -- a decline in Libyan oil production and expectations of further disruptions in Middle East supply -- on top of what was already a demand-driven rise as the world economy recovered. Crude oil had already breached the $90 a barrel mark at the end of last year, well before Egyptians took to Tahrir Square in January to demand that President Hosni Mubarak step down. (Note in my view the climb to $90 was also the result of monetary inflation, since the Fed was increasing the money supply at that time-RW)

4.The Fed needs to respond to higher oil prices, high oil price syndrome victims say.
Bad idea, especially if “respond” means print more money. That was the medicine applied in the 1970s. The result was higher inflation and slower growth, which created a problem for those who thought there was a trade-off between the two.
There are really three things going on in the economy right now on the price front. There is a supply shock pushing up the price of oil because of disruptions of oil coming out of the Middle East, as Baum correctly points out this has nothing to do with overall price inflation. There is also stronger demand for some commodities as emerging countries become wealthier. This is pushing certain commodities up, but should also not be considered overall price inflation. As Baum correctly points out, overall price inflation is a monetary phenomena. This factor is, indeed, currently resulting in a broad increase in price inflation as a result of Federal Reserve money printing.

It is this third factor, central bank money printing which can be the most damaging to an economy. The first two factors tend to be one time shocks to the system that result in the economy adjusting. The third factor can destroy the very structure of an economy, destroying a currency and making economic planning extremely difficult, if not impossible. Such price inflation, if it would reach a hyper stage, would be most damaging if it took place in a highly industrialized, interdependent economy such as the one we have in the United States.  And this is the type of dangerous price inflation that the Federal Reserve continuously flirts with.

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