Category: Economics

Categories
Economics

[1744] Of crude oil prices may not continue to fall for long

Before we get the party going in celebration of falling crude oil prices, beware. This decrease could well be just a pause before prices march to yet another record.

I am suspecting so not because I subscribe to Malthusian logic. Malthusians all over fail to notice that humanity has an amazing capability to adapt. As prices of typical energy rise to a sufficient level, the search and utilization of substitute sources will take place. As a result, the demand for expensive source of energy will fall, bringing along its prices down.

The prices will stay down, given all else being equal, if technological, or rather increase in efficiency in consumption of the energy occurred. Improved efficiency produces a situation where fewer fuel is required for the same amount of production.

I suspect that it is possible that we may be seeing merely a dip in prices of crude oil because I am unconvinced at how the recent fall in prices is caused by structural changes.

On the surface, three factors seem to be causing crude oil prices to fall. They are contracting demand curve probably due to high crude oil prices, appreciating greenback and the slowing down of several world’s major economies. All factors are possibly cyclical and none is structural. When I refer to cyclical changes, I refer to changes in volume and when I refer to structural changes, I refer to changes in efficiency.

The relationship between crude oil price and the health of the global economy is easy to pinpoint.  A slowdown causes demand for crude oil to decrease. While the relationship may well be the reverse, the point is that it is a matter of typical business cycle and has nothing to do with improvement of technology.

The strengthening of the US dollar also has little to do with improvement in technology. To understand how stronger dollar leads to cheaper crude oil, it is important to understand the mechanics that works between trade and exchange rate. Weaker dollar causes cheap export and cheap export causes foreigners purchasing more US product. With weak dollar, the strength of the USD has to return as improvement in net export accumulates capital. If theory does not convince you, then let the number must do the job: the US trade deficit already dropped for the month of June.[1] With stronger dollar and with crude oil priced in riyal or some other currencies, fewer dollars is required to buy the same volume of oil.

Now, the third factor — contracting demand curve — may come closest to encouraging structural changes. The problem is however, I am not convinced that there is a actual improvement in technology. What I see is people using smaller instead of larger vehicles, public transportation, etc. But that is merely temporary lower consumption because once prices become sufficiently low, consumers would abandon small cars and public transportation and anything that only reduce volume of crude oil consumed rather than substituting it.

While there is indeed greater usage of electricity, natural gas and biofuel to replace crude oil, I am unsure how widespread it has been. Besides, the fall in crude oil prices have been too drastic in such a short time that I have trouble accepting the fall is caused by technology.

Why after all the adoption, the decreases in crude oil prices come only now and in such a dramatic pattern? Effects from structural changes should come gradually due to various lags that exist in the real world, not abruptly.

This has led me to speculate that the trend we are seeing is caused by merely and mostly reduction of consumption with little substitution energy consumed as replacement. It is likely that what we are seeing is merely reduction in volume rather than increase in efficiency. If my take is correct, then once prices reached a level somewhere down below, consumption would return to assume its record breaking rise performance which we saw weeks earlier as volume would go up while efficiency level would stay constant. This might be so due to little structural change in the global economy.

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[1] WASHINGTON (AP) — The U.S. trade deficit unexpectedly fell in June as exports advanced to an all-time high, offsetting another big surge in oil imports.

The Commerce Department reported Tuesday the trade imbalance dropped to $56.8 billion in June, down by 4.1 percent from a revised May deficit of $59.2 billion. It was the smallest deficit in three months and much better than the $61.5 billion deficit Wall Street had been expecting.[June trade deficit shrinks as exports climb. Martin Crutsinger. Associated Press. August 12 2008]

Categories
Conflict & disaster Economics

[1740] Of financing Iraqi reconstruction effort is an obligation for the US

US politicians have begun questioning the virtue of the US spending over USD20 billion on Iraq whereas the Iraqi government has merely spent less than USD4 billion on the construction exercise despite having USD70 billion of budget surplus.[1] By comparison, the planned expenditure for the 2008 Malaysian budget was approximately USD55 billion and we are running on deficit.

As reported by the New York Times, security problem in Iraq is discouraging the Iraqi government from spending. Turbulent environment is not conducive for developmental effort, forcing Iraqi institutions to hesitate before even beginning to spend money for new projects. As a result, large Iraqi surplus sits safely idle in banks, earning enormous interest amounting to half a billion to date.[2]

Despite the large surplus and low expenditure, I do not think that would rationalize the call for the US politicians to cut back the US reconstruction expenditure in Iraq, especially when the reason for reconstruction originates from destruction brought upon during the US-led invasion back in 2003.

I am in the opinion that the US has every obligation to finance the reconstruction exercise with its own resources, regardless of the resources available to the Iraqi government. To put it simply, if a person breaks it, the person should pay for it.

This however does not mean that the Iraqi government should not spend anything. It is far more helpful if both governments could simultaneously spend to improve Iraqi public infrastructures like roads and communication lines for example. Restoring old infrastructures and building new ones should take place simultaneously to hasten development of Iraq. In other words, both reconstruction exercise, which is the responsibility of the US, and further developmental exercise, which is the task of the Iraqi side, should happen concurrently.

It would be far more acceptable for US politicians to call for the Iraqi government to match the US developmental expenditure instead. Nevertheless, the inability of the Iraqi government to spend has to be addressed first before the call could be earnestly made and that means securing peace in the war torn country. After all, the low figure for expenditure is about inability to spend rather than refusal to spend.

With greater security, those projects could bring economic returns to the Iraqi society. With insufficient security in place, those projects would just be another targets for the insurgents.

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[1] “The Iraqi government now has tens of billions of dollars at its disposal to fund large-scale reconstruction projects,” Mr. Levin, who is chairman of the Senate Armed Services Committee, said in a joint statement with Mr. Warner. “It is inexcusable for U.S. taxpayers to continue to foot the bill for projects the Iraqis are fully capable of funding themselves. We should not be paying for Iraqi projects, while Iraqi oil revenues continue to pile up in the bank.” [As Iraq Surplus Rises, Little Goes Into Rebuilding. James Glanz, Campbell Robertson. New York Times. August 5 2008]

[2] The deposit at the Federal Reserve Bank is so large that the United States has been obliged to make $435.6 million in interest payments to Iraq through the end of last year, according to the new report. [As Iraq Surplus Rises, Little Goes Into Rebuilding . James Glanz, Campbell Robertson. New York Times. August 5 2008].

Categories
Economics

[1736] Of temporary inflation could be a reason for unchanged rate

Malaysian central bankers have become victims of a running joke lately: if you are divided between maintaining a low unemployment rate and containing inflation, pray and do nothing.

On Friday last week, Bank Negara made known its decision to maintain the Overnight Policy Rate at 3.5% even as the local real interest rate is negative.

The recently published monetary policy statement is too hilarious for me to read quietly. It reminds me of what US President Harry Truman once famously said: “Give me a one-handed economist… All my economists say, ‘On the one hand… on the other’.” For sure, Truman would not find a one-handed economist on Jalan Dato’ Onn either.

The statement opens with a pessimistic tone by making references to the wage-price spiral and persistent inflation. It is all doom and gloom but then Bank Negara vows to take the “appropriate monetary policy response” to “maintain medium-term price stability and ensure that the high inflation does not undermine the longer growth prospects of the Malaysian economy.”

After comforting the public that the bank is prepared to do whatever is necessary to fight inflation, the bank says “while both the risks to higher inflation and the risks to slower growth have increased, the immediate concern is to avoid a fundamental economic slowdown that would involve higher unemployment”.

The statement ends with “based on this assessment, the Monetary Policy Committee has decided to keep the Overnight Policy Rate unchanged at 3.50%.”

Smooth.

To be fair, however, the bank did indicate that projected slower economic growth is expected to keep inflation in check. The statement also seems to suggest, or at least I interpret it as such, that the inflation rate we are experiencing is likely only a one-time spike.

The fact that there are lags between wages and prices would discourage a wage-price spiral, further providing the case that this high rate of inflation is unsustainable. All those control mechanisms over prices, though lamentable, do a good job at delaying the catch-up game between wages and prices. In other words, it helps keep inflation tamer than what it could have been.

I think the possibility that this is a one-time hike in inflation is important in understanding why the bank did not increase the OPR last week.

Ben Benarke in a speech last year said: “”¦With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices.”

This is probably what is happening at the moment, fuelling the rationale for Bank Negara to maintain the OPR.

But how confident are we that this is merely a one-off hike?

Well, the 7.7% inflation rate is mainly due to the June 5 hike in local retail fuel prices. It is fair to assume, especially with all the control regimes the state has put in place, that if there is another hike in inflation rate, it would probably be caused by another hike in retail fuel prices.

Within that context, world crude oil prices at the moment have taken a dive and the fall is nothing less dramatic. From close to US$150 per barrel, a record even in real price, it now hovers below US$125 per barrel.

Now, the jury may still be out but the demand curve has to contract sooner or later as market participants adapt to a new reality which calls for less reliance on fossil fuel. Just as how the 1970s taught us about our amazing versatility in solving crises, there is little reason for us to embrace the Malthusian logic now and throw in the towel.

If indeed the demand curve has shifted, then Bank Negara has all the more reason to expect that the current high rate of inflation is temporary in nature despite the expressed concern about persistent inflation. And the bank did indicate how temporary is temporary in the statement: by mid-2009, we should be able to party on and laugh all this off.

Perhaps more importantly, the government has little reason to increase prices at the pump if prices stabilize at the current level. With current global crude oil prices being so favorable to the state’s coffers, there has been talk within the Barisan Nasional government about reducing local retail fuel prices.

Apart from politically undercutting the Pakatan Rakyat, reduction of prices has the potential to bring down the inflation rate without the need to raise interest rate, thus providing the bank some room to do something about the unemployment rate.

But damn, negative real interest rate!

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A version of this article was first published in The Malaysian Insider.

Categories
Economics

[1733] Of follow-up to lag and inflation article

I somewhat take exception to a comment[1] I received at The Malaysian Insider. I just want to refute the live in a dream world, wet behind the ears and textbook accusation. Here, I just want to show how “textbook” the idea I conveyed really is:

Various factors might account for these changes in the Phillips curve, but, as Mishkin pointed out, better-anchored inflation expectations–themselves, of course, the product of monetary policies that brought inflation down and have kept it relatively stable–certainly play some role. If people set prices and wages with reference to the rate of inflation they expect in the long run and if inflation expectations respond less than previously to variations in economic activity, then inflation itself will become relatively more insensitive to the level of activity–that is, the conventional Phillips curve will be flatter. [Inflation Expectations and Inflation Forecasting. Ben S. Bernanke. July 10 2007]

I stress, “if people set prices and wages with reference to the rate of inflation they expect in the long run and if inflation expectations respond less than previously to variations in economic activity, then inflation itself will become relatively more insensitive to the level of activity”

What author of that comment failed to realize is the idea of the neutrality of money in the long run but I suppose when one live down in the mud, it is hard to see the general trend.

Sometimes, we need to fly 20,000 feet above the ground to make sense of the bigger picture and I take comfort in that.

Mohd Hafiz Noor Shams. Some rights reserved Mohd Hafiz Noor Shams. Some rights reserved Mohd Hafiz Noor Shams. Some rights reserved

[1] Reproduced for reference:

Agreed with the last 2 comments. you have only touched on the surfaces of the problem and live in a dream world…and still wet behind the ears too.

“..an escalator clause is a must if preservation of real wages is a goal” this is a great line but who gets this but CEO’s. The average joe on the street don’t even have a contract and the average joe is the one who is going to be doing the rioting and some politician is going to ride on this ticket and he will be in power after the next election only to find that he is NOT able to stop the problem…. you know the rest, its been happening around you. Your economic books may be great but this is the real world. [July 23 2008]

Categories
Economics

[1732] Of inflation is not really that bad, if there is no lag

It is fashionable these days to reminisce about the days when a penny could buy a fancy candy. I have no recollection of such times and I strongly suspect they are but a myth, especially when the not so old retell a story that should only be in the vague memory of the dead. I cannot help but roll my eyes whenever a conversation which touches on once-upon-a-time-a-penny-could-buy-a-fancy-candy slowly turns into a lament against inflation. Talk of inflation in the public sphere almost always takes a pessimistic tone but the inflation that we suffer is really misunderstood possibly due the lag that exists while wages and prices chase each other.

It is typical for many modern economies to see a rise in the general level of prices over time since the 1970s. There were some cases of deflation but we mostly live in an inflationary world. In Malaysia where inflation has been around for the longest time, many in the public complain about how inflation reduces  individual purchasing power.

What many do not realize is that the general rise of price levels is as much as about the general rise of wage levels. As both factors try to catch up with each other, inflation really matters little in the long run.

Due to this, it really does not matter if a penny could buy a fancy candy in a time long forgotten but not now. We can still afford to consume that candy anyway. In fact, it is very likely that with all the real improvements we have seen in our standards of living, we can afford to buy more candies than we ever could when candy was priced at only a penny.

But however many candies we can afford nowadays, what makes inflation hurt in the short run is the lag between price increases and upward adjustments to wages. This lag is usually associated with a phenomenon known as price stickiness: individuals and entities take time to change prices. Sometimes, the act of changing prices itself incurs cost and further forces prices and wages to be inflexible.

For instance, one transportation company that I am familiar with took two weeks to revise its prices upwards after the June 5 price hike. Why two weeks? Internal approvals, negotiations with customers, costing modeling, simulation, etc. The company was adversely affected by the lag but after that, higher fuel expenditure is met with higher service prices while the service level remains the same.

This is the actual meaning of inflation. It is not about erosion of a person’s real purchasing power per se but rather, it is about erosion of purchasing power of a unit of a currency.

It is important to note that the phenomenon does not exclusively happen to businesses. Individuals too undergo the same path. In the long run, the wages and prices tend to approximately equalize each other. And just like what happened to the transportation company, it is the lag of wages vis-à-vis prices that hurts individuals. Inflation adversely affect real wages by depressing temporarily, until nominal wages catch up with higher level of nominal prices.

So, how do we reduce the pain?

There are a number of things but my favorite revolves around management of expectation.

The idea is that if individuals or entities successfully anticipate a rise in prices, wages would quickly match the other. That would come close to eliminating any lag that might exist otherwise.

To do that, wages have to be defined in real terms, i.e. having wages adjusted to inflation. In employment contracts especially, an escalator clause is a must if preservation of real wages is a goal. At the moment, too many people out there have their wages defined in nominal terms, i.e. unadjusted to inflation. For businesses, well, they could just increase their prices and pay their own wages.

If we manage to considerably eliminate this lag, then perhaps it would finally dawn on many that inflation really does not matter as much as many make it out to. More importantly, the story of a penny candy would finally be buried and forgotten.

Mohd Hafiz Noor Shams. Some rights reserved Mohd Hafiz Noor Shams. Some rights reserved Mohd Hafiz Noor Shams. Some rights reserved

A version of this article was first published in The Malaysian Insider.