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A Sequel to the Monetary Story of the Oil Price Collapse

Brendan Brown

There is a big flaw in the now fairly common, optimistic hypothesis that the oil price collapse will fuel a consumer-led blossoming of the U.S. economy in 2015—and maybe even, despite the advanced age of the present business-cycle expansion, develop into a powerful, multi-year upswing. The flaw is that such optimism ignores the recent global spread of asset-price inflation, generated, in its latest episodic outbreak, by quantitative easing policies at the Federal Reserve. Previous epidemics of asset-price inflation—all distinct, but with certain key common characteristics—suggest that the current one will involve an ugly end-phase. The timing of that end-phase is unpredictable, of course. Nevertheless, economic forecasts that fail to include a careful diagnosis and prognosis of the asset-price inflation phenomenon are all but useless.

Speculative temperatures do not rise and fall in synchronized fashion across all asset markets as such inflation progresses—even though in the final crash a wide array of markets are likely to tumble together. Temperature spikes are accompanied by the telling and re-telling of half-plausible stories which rational and sober investors would typically treat with some skepticism, thereby reducing to some extent the possibility that the worst might come to pass. But in a situation of monetary disequilibrium—where the Fed is using various tools, conventional or unconventional, to manipulate rates below neutral level—positive feedback loops tend to develop. Capital gains add to each story’s credibility, and as the crowd expands further, price gains accumulate. This time the famine of interest income induced by quantitative easing and zero rate policy have added to the frenzy.

The plunge in oil prices is itself symptomatic of the asset-price inflation disease having reached at least a dangerous intermediary or even early-late stage. In the beginning years of the Great Monetary Experiment (GME) designed by President Obama’s Federal Reserve Chief, Professor Ben Bernanke, the big rise in speculative temperatures was in commodity markets, including oil, and in several other asset markets characterized by optimism about emerging economies, especially China’s. Commodity-related speculative stories got a circulation boost from the concurrent depreciation of the U.S. dollar triggered by the GME in its early years. In the oil market, the big speculative story was that world demand would outgrow conventional supply by a widening margin as the emerging economies like China continued to power ahead. In the U.S., the shale oil and gas revolution attracted huge volumes of capital on the basis of such views, much of it flowing into enterprises whose capital structure became hugely leveraged in response to sky-high prices for high-yield bonds.

We now know that forecasts of oil demand were wildly exaggerated. And those individuals or institutions who listened to the sales music of investment banks marketing their commodity unit funds as part of a novel diversification strategy are now ruing the day. An unknown but enormous amount of mal-investment has occurred both in the U.S. and globally in the form of then-apparently-sensible capital spending—based on contemporary spot and forward energy prices and facilitated by easy financing—which now looks stupid. This mal-investment has been made not just in energy extraction but also in energy conservation. Yes, there has been economic progress along the way, but how much more would there have been if such large mal-investment had not taken place? For a historical analogy: consider periodic frenzies of railroad construction in previous eras, generally followed d by drastic pull-backs in a reaction to speculative excess.

Keynesian economists tell us that all is nonetheless for the best. Consumers will step up their spending in response to lower energy prices. It’s like a big indirect tax cut. Yet why would consumers act in such an irrational fashion? Economists from Milton Friedman onwards have argued that consumers respond much more to changes in “permanent income” than to transitory fluctuations. Why would—or should—today’s consumers expect oil prices to stay down forever, once investment spending in the oil industry slumps and supply adjustment takes place? Moreover, emerging market economies (including oil exporters) which had been riding the commodity boom will now be cutting their demand for exports from the U.S. and other advanced economies. A downswing in capital spending in the energy extraction industries (and to some extent in related industries like energy conservation) should surely dominate any calculus about whether current spending by the gainers (from oil price reductions) might rise by more or less than does spending by the losers.

In fact, we should view the oil market collapse—together with simultaneous setbacks in emerging-market asset classes and commodity currencies—as typical of a mid-late phase in the asset-price inflation cycle. History is full of suggestive examples. Global asset prices soared in the early to mid-1920s, fueled to a great extent by the low-interest policies of the Federal Reserve under Benjamin Strong. Then came the first bubble-burstings: the 1926 Florida land bust, the 1927 Berlin stock market crisis, and the nationwide decline of U.S. real estate prices beginning in 1928. And then came the final-stage disaster: the Wall Street Crash of 1929, and the total collapse of Germany’s banking system in 1931.

Or consider much more recent experience: Late in the great asset-price boom of the 1990s, a succession of “minor” emergencies took place—the Asian debt crisis of 1997, and the LTCM hedge-fund collapse and “Ruble Flu” and Russian Central Bank default of 1998—before Wall Street and other major stock markets finally crashed in 2000. And during the global credit bubble that followed those crashes, signs that the U.S. economy was entering a growth-cycle downturn began to emerge as early as 2006—when key residential real estate markets perceptibly cooled—even though there would be another two years of temperature spikes before this latest epidemic of global asset-price inflation reached its deadly end phase.

How will the market irrationality of current asset-price inflation evolve from its mid-phase to its end-phase? That is a question to which no answer can be found in those expert macro-economic forecasts that now make such rosy holiday reading in the United States. We might parody Bill Clinton and say “It’s the financial markets, stupid!”

Areas of mal-investment and episodes of financial excess are always more clearly perceived through the rear window than through the front. Yet surely there are signs of vulnerability to be seen. A U.S. motor-vehicle sales boom that’s drawn its power from a sub-prime auto-finance boom—which is itself dependent on a private-equity and high-yield debt boom. Or an aircraft industry boom driven by the same private-equity and high-yield credit environment, which delivers record-low leasing terms to airlines all over the world—especially to quasi-government carriers in Asia. Or a general transportation-equipment boom spurred by the shale oil and gas revolution in the U.S. Or an American rental-apartment construction boom, again made possible by high-yield debt and speculative private equity. Or a global financial-services boom based on the sale of high-yield, high-risk credits to investors hoping to arrange the next big mega-merger or Silicon Valley IPO or international carry-trade coup. Or an unusually profitable U.S. non-financial corporate sector, now being propped up (to a great if ultimately unknowable degree) by the kind of securities and foreign-exchange investment betting known as zaitek in Japan during that country’s great bubble of the late 1980s.

The list of troubling phenomena is long. And any number of developments might—sooner rather than later—upset the apple cart. First there are the idiosyncratic factors, including the possibility of a sudden wave of profit taking in one or more of the aforementioned asset classes as present holders seek to lock in their gains. Second, it may become apparent (during the first half of 2015, for example) that the U.S. economy has not taken off on a higher flight path, but rather sunk back into 2-percent-per-annum growth—or less. Third, the recent plunge in oil and other commodity prices might produce a wave of financial distress extending beyond just directly exposed banks (like those in Australia and Canada) to highly leveraged non-financial corporations all across the world. Fourth, Europe’s skies in particular might darken again, perhaps with violent swings of the political pendulum in France or Italy—or Spain, whose economic and financial interdependence with Latin America places both in peril should something go seriously wrong.

Or it might be something else altogether. CONTAGION! That is the final word of caution. We live in a world where monetary disequilibrium—originating in the U.S., duplicated or amplified in Japan, and soon to be magnified in Europe—has caused such widespread distortion of financial market prices as to hopelessly confuse the invisible hand. So we should prepare ourselves—even expect—a correspondingly widespread short-circuiting in the global economy at some stage. The first fuse to blow will involve financial contagion. A plunge in the U.S. equity market would be the “Big One,” rapidly if not simultaneously prompting a steep decline in the market for high-yield credit and most European sovereign debt. As carry trades in currency and credit thus unwound, the yen would jump as the horde of speculators on a “weak yen” frantically sought to cut their risks and losses. An alternative scenario might involve a sharp drop in one sector of the credit market—perhaps related to shock emanating from non-financial corporate retrenchment—spilling over into the equity markets as a whole.

The infernal possibilities are endless. But they are real.

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