Oil and Gold Jude Wanniski October 9, 2004

Memo To: SSU Students
From: Jude Wanniski
Re: Oil, Gold and the Dollar

Most of you who study here at Supply-Side University are under 40 years of age, I believe. So I will assume you are not aware that the shortages of oil in the world's supply that pushed the dollar price to $53 a barrel this week never occurred prior to the 1970s. That's right, no matter how fast the world increased its consumption of oil, in wars and economic booms, the world oil industry was always ready with enough added supply to keep the cost low. The lesson this week will explain why for most of the past 160 years since oil came into use, one ounce of yellow gold could buy 15 barrels of "black gold," as oil came to be called. And why an ounce of gold today can buy only 8 bbl of oil.

The central reason is that in August 1971 the United States went off the gold standard. As long as the Federal Reserve had kept the dollar/gold exchange rate at $35 per ounce, the world price of oil remained steady at roughly $2.50 per barrel. It was in January 1972 that economist Robert Mundell, observing that the dollar gold price had doubled to $70 since the dollar was floated five months earlier, predicted the price of oil would soon rise dramatically. Indeed, it took another 18 months before the oil price rose above $2.50, because there was a ready reserve of available supply held by the oil-producing countries. When gold doubled to $140 oz in 1973, as the Fed tried to expand the economy with easy money, the Arab oil countries decided to quadruple the oil price to $10 bbl, which they could do because ready reserves had been reduced.

The demand-side economists who advised President Nixon to end the gold standard and float the dollar independently of any commodity price did not anticipate any of these consequences because their models view the primary function of money as a medium of exchange. In classical theory, the primary function of money is as a "unit of account." That is, the mere "concept" of a dollar has its highest utility in serving the vast marketplace of goods and services when it is constant in value. Among the most important service that constancy provides is as a signal to the business community on where and when to invest fresh capital and where and when to hold back such investment.

If an apple could exchange for an orange, or either could exchange for $1, a sudden problem in the orange supply (hurricanes or frosts in Florida) would cause the apple/orange exchange rate to change. It would more apples to buy oranges and if the price of an apple stayed at $1, this meant an orange would be priced somewhere above $1. The higher price would signal orange growers (and their bankers) that it would pay to invest fresh capital in orange groves to repair the damage, and the earliest to do so would get the benefits of selling more expensive oranges. Eventually, the traditional relationship of apples and oranges would be restored, perhaps disrupted the following season with a blight in the apple crop.

When in 1997 the price of gold declined from a level of $385 to $350 oz then to $330 oz, Polyconomics warned that the oil price would decline from $25 bbl and at that other commodity prices would also decline to re-establish trading relationships with gold and with each other. Fed Chairman Alan Greenspan paid no attention to these warnings because he was being celebrated for having presided over falling commodity prices. But this meant the dollar was throwing off confusing signals to the world oil industry. By 1998, oil fell to $10 bbl, a price so low that it discouraged all investment of fresh capital. There are plenty of proven reserves of oil in the ground, but it takes enormous amounts of capital to get the oil from the ground to the consumer. For two years and more, ALL new investment in oil infrastructure stopped around the world. Meanwhile, the big cushion of ready reserves was used up as the world regained its economic footing and asked for oil to fuel industrial operations that were back on line. The oil price climbed dramatically and by 2000 was at $30 a barrel.

This should be enough for you to chew on now in understanding why gold hit $53 last week, as there is still no cushion. The oil industry (and their bankers) are by now wary of investing big time to reap the rewards of $53 oil, knowing the Federal Reserve is now bent on fighting an "inflation" that is mostly the result of the high oil price and climbing gold price. If the Fed errs and induces a recession, the price of oil may fall again. You should now see why I can argue that as long as the dollar remains afloat, the world will continue to experience energy shortages. The alternative would be if another country or countries fixed their currencies to gold and the world began pricing oil in that currency. That would mean a decline in the dominance of the U.S., especially in its global banking reach.

Here is a client letter I wrote for Polyconomics' clients on February 15, 2000, when oil had climbed to $30 bbl from its 1998 low point.

OIL OVER $30/bbl
By Jude Wanniski

The primary reason oil is above $30 a barrel is that our central bank, the Federal Reserve, is not required by law to keep the dollar price of gold constant. From time to time, I have to remind you of the critical importance of gold as a pure signal of monetary error by the Fed. This is because the news media are so filled with second- and third-order impressions of why oil is where it is. When -- after a dozen years of keeping the dollar relatively stable against gold -- the Fed permitted the monetary deflation of 1997-98, gold fell to $280 from $380.

Commodity prices followed, as we predicted in early 1997, but oil's decline was of a far greater magnitude than gold's. This is because the global economic weakness that followed the dollar deflation resulted in a sharp decline in the need for the oil in the pipeline. This is what we have to expect to happen in a world without a reliable unit of account, against which prices of all goods can be reckoned and through which scarce capital can be allocated to fulfill basic human needs. As long as we permit Fed Chairman Alan Greenspan and his colleagues at the Federal Open Market Committee to determine the supply of dollars in the exchange economy -- instead of permitting the market to do so against the standard of gold -- there will be these wider swings in relative prices. In a world of monetary stability, a rising oil price automatically would draw capital into development of new sources. In this environment -- with the memory of oil's price crash so fresh in the collective mind of the oil industry -- there is hesitation about new investment. It is riskier.

There is plenty of liquid petroleum out there. There is scarcely any need at the moment to explore for more proven reserves. There already is a 40-year supply at projected demand levels and if the world grows faster than projected, there is plenty more oil to be found. There is really no such unit of measure as a "cubic mile," there being no need to measure anything that large. But to put oil in perspective, it helps to note that the volume of Earth is 260 billion cubic miles. That is 260,000,000,000 mi³. The amount of oil withdrawn from the earth, refined and consumed so far would occupy a mere 6 mi³. Proven reserves would occupy another 25 mi³, more or less. I made the calculations over the weekend to make a point about how little mankind has contributed to the oxidization of carbon, but they are also useful reminders about the connections of the financial markets to the real world.

Because petroleum still is critical to the workings of the world economy, short-term shortages that result from the Fed's monetary errors cause real economic problems at the margin. We have a bit of petroleum in the Strategic Petroleum Reserve, but the government is always reluctant to use reserves even when they are needed. Those who are enjoying high oil prices do not want the government to "solve" the problem by selling off its inventory, which would then remove the threat of government sales. President Nixon ended the gold standard in 1971 to protect the nation's gold reserves, which then comprised 8% of all the bullion mined in the history of the world. Except for a bit sold in the Carter administration, it still is under guard at Fort Knox, waiting for Goldfinger.

The world economy actually is doing quite well, now that it has for the most part adjusted to the monetary deflation of 1997-98. The temporary weakness due to market confusion over prices ended in most parts of the world. New growth is drawing down inventories that had been misjudged as higher than they turned out to be by the International Energy Association. When you are paying $2 a gallon this summer, remember it is not because of greedy OPEC oil sheiks, but because the Establishment does not want to give up its ability to manipulate the currency. (We note our Treasury Department is trying to derail the nomination of a German candidate to head the International Monetary Fund, on the grounds that he has little experience in "managing currencies." The big boys who run the multinationals need someone they can trust for bailouts, when they guess wrong.)

Even with oil above $30, things do not look so bad at the top of the world, Wall Street. Yes, the Dow Jones Industrials are down 10% from their peak, but that makes Alan Greenspan happy, and gold remains perched above $300, well above its lows in the $250 range last year. This makes sense to us, as the higher equity prices and lower gold prices coincided with expectations that there would be some kind of compromise on tax cuts this year, particularly on estate taxes and individual retirement accounts. There now seems little chance of progress there and the DJIA fell off accordingly. Gold ran up a bit as the surplus liquidity remained in the system, a higher fed funds rate having no noticeable effect on liquidity levels.

We observe an unusually high level of economic nonsense being spouted lately, because of the demands of the presidential candidates. Vice President Al Gore, who invented demand-side economics, has opined that we cannot promise to cut tax rates, because if there is a recession, we might have to raise taxes to re-balance the budget. We could picture John Maynard Keynes turning in his grave. Indeed, Robert Solow of MIT, an old-fashioned Keynesian who normally loves high taxes, said Gore should "have his mouth washed out with soap." Our Treasury Secretary, Larry Summers, was almost as bad, though. A tax cut now, he opined, would cause a recession, because it would force Greenspan to raise interest rates to prevent an inflationary boooom!! In his Monday "Outlook" column, the WSJournal's Washington Bureau Chief Alan Murray noted that Arizona Sen. John McCain says we should not lower the capgains tax or marginal rates NOW, but should do so if there were a recession. Murray said no, cutting capgains and marginal rates are meant to increase investment leading to future growth. To combat a here-and-now recession requires spending or tax cuts that put money into people's pockets immediately, if not sooner. Take the cash from the lockbox and drop it out of airplanes?

Meanwhile, the yield curve remains oddly inverted, suggesting a beached whale. The betting at the long end is that Greenspan will not raise interest rates two or three more times, but how do we get the curve back where it belongs -- with long rates higher than short rates? (At least the gyrations in the long bond have ended arguments that it is in short supply.) Greenspan has painted himself into a theoretical corner, from which there is no logical escape route. Driven by his overriding commitment to paying off the national debt, a political bug that has infected both parties; the national discussion about our public finances has become surreal. The good news is that it can only get better as we move toward the November elections. I did notice on Sunday's Meet the Press that Texas Governor George W. Bush made the first supply-side argument of his campaign. He must be getting desperate.

The primary reason oil is above $30 a barrel is that our central bank, the Federal Reserve, is not required by law to keep the dollar price of gold constant. From time to time, I have to remind you of the critical importance of gold as a pure signal of monetary error by the Fed. This is because the news media are so filled with second- and third-order impressions of why oil is where it is. When -- after a dozen years of keeping the dollar relatively stable against gold -- the Fed permitted the monetary deflation of 1997-98, gold fell to $280 from $380. Commodity prices followed, as we predicted in early 1997, but oil's decline was of a far greater magnitude than gold's. This is because the global economic weakness that followed the dollar deflation resulted in a sharp decline in the need for the oil in the pipeline. This is what we have to expect to happen in a world without a reliable unit of account, against which prices of all goods can be reckoned and through which scarce capital can be allocated to fulfill basic human needs. As long as we permit Fed Chairman Alan Greenspan and his colleagues at the Federal Open Market Committee to determine the supply of dollars in the exchange economy -- instead of permitting the market to do so against the standard of gold -- there will be these wider swings in relative prices. In a world of monetary stability, a rising oil price automatically would draw capital into development of new sources. In this environment -- with the memory of oil's price crash so fresh in the collective mind of the oil industry -- there is hesitation about new investment. It is riskier.

There is plenty of liquid petroleum out there. There is scarcely any need at the moment to explore for more proven reserves. There already is a 40-year supply at projected demand levels and if the world grows faster than projected, there is plenty more oil to be found. There is really no such unit of measure as a "cubic mile," there being no need to measure anything that large. But to put oil in perspective, it helps to note that the volume of Earth is 260 billion cubic miles. That is 260,000,000,000 mi³. The amount of oil withdrawn from the earth, refined and consumed so far would occupy a mere 6 mi³. Proven reserves would occupy another 25 mi³, more or less. I made the calculations over the weekend to make a point about how little mankind has contributed to the oxidization of carbon, but they are also useful reminders about the connections of the financial markets to the real world.

Because petroleum still is critical to the workings of the world economy, short-term shortages that result from the Fed's monetary errors cause real economic problems at the margin. We have a bit of petroleum in the Strategic Petroleum Reserve, but the government is always reluctant to use reserves even when they are needed. Those who are enjoying high oil prices do not want the government to "solve" the problem by selling off its inventory, which would then remove the threat of government sales. President Nixon ended the gold standard in 1971 to protect the nation's gold reserves, which then comprised 8% of all the bullion mined in the history of the world. Except for a bit sold in the Carter administration, it still is under guard at Fort Knox, waiting for Goldfinger.

The world economy actually is doing quite well, now that it has for the most part adjusted to the monetary deflation of 1997-98. The temporary weakness due to market confusion over prices ended in most parts of the world. New growth is drawing down inventories that had been misjudged as higher than they turned out to be by the International Energy Association. When you are paying $2 a gallon this summer, remember it is not because of greedy OPEC oil sheiks, but because the Establishment does not want to give up its ability to manipulate the currency. (We note our Treasury Department is trying to derail the nomination of a German candidate to head the International Monetary Fund, on the grounds that he has little experience in "managing currencies." The big boys who run the multinationals need someone they can trust for bailouts, when they guess wrong.)

Even with oil above $30, things do not look so bad at the top of the world, Wall Street. Yes, the Dow Jones Industrials are down 10% from their peak, but that makes Alan Greenspan happy, and gold remains perched above $300, well above its lows in the $250 range last year. This makes sense to us, as the higher equity prices and lower gold prices coincided with expectations that there would be some kind of compromise on tax cuts this year, particularly on estate taxes and individual retirement accounts. There now seems little chance of progress there and the DJIA fell off accordingly. Gold ran up a bit as the surplus liquidity remained in the system, a higher fed funds rate having no noticeable effect on liquidity levels.

We observe an unusually high level of economic nonsense being spouted lately, because of the demands of the presidential candidates. Vice President Al Gore, who invented demand-side economics, has opined that we cannot promise to cut tax rates, because if there is a recession, we might have to raise taxes to re-balance the budget. We could picture John Maynard Keynes turning in his grave. Indeed, Robert Solow of MIT, an old-fashioned Keynesian who normally loves high taxes, said Gore should "have his mouth washed out with soap." Our Treasury Secretary, Larry Summers, was almost as bad, though. A tax cut now, he opined, would cause a recession, because it would force Greenspan to raise interest rates to prevent an inflationary boooom!! In his Monday "Outlook" column, the WSJournal's Washington Bureau Chief Alan Murray noted that Arizona Sen. John McCain says we should not lower the capgains tax or marginal rates NOW, but should do so if there were a recession. Murray said no, cutting capgains and marginal rates are meant to increase investment leading to future growth. To combat a here-and-now recession requires spending or tax cuts that put money into people's pockets immediately, if not sooner. Take the cash from the lockbox and drop it out of airplanes?

Meanwhile, the yield curve remains oddly inverted, suggesting a beached whale. The betting at the long end is that Greenspan will not raise interest rates two or three more times, but how do we get the curve back where it belongs -- with long rates higher than short rates? (At least the gyrations in the long bond have ended arguments that it is in short supply.) Greenspan has painted himself into a theoretical corner, from which there is no logical escape route. Driven by his overriding commitment to paying off the national debt, a political bug that has infected both parties; the national discussion about our public finances has become surreal. The good news is that it can only get better as we move toward the November elections. I did notice on Sunday's "Meet the Press" that Texas Governor George W. Bush made the first supply-side argument of his campaign. He must be getting desperate.