Small Cap Pulse Speaks to James Hamilton About Oil Prices and Monetary Policy
Jun 02, 2008
Author: SCP Editor
May 29, 2008 James Hamilton, Economist, Interview
TP: You’ve written persuasively on the topic of oil prices and monetary policy which I think are both really relevant at this point with oil prices jumping to $130 per barrel and on the heels of seven consecutive rate cuts from the Fed which arguably have contributed to inflationary pressures that are becoming more relevant in today’s discussion as well. I wanted to interview you this morning and get your thoughts on these issues as they pertain to a lot of the banter that we are hearing in the media.
Specifically, with respect to oil prices and the factors that are currently influencing the increases that we have seen lately, what factors do you attribute to the current environment?
JH: Well, if we are taking the longer run perspective, the big run up in oil prices since 2001 for example. I think there is no question that strong fundamentals in terms of demand and supply are the biggest part of the story. There has been a real surge in demand from the newly industrialized countries. China in particular, but also the middle east oil producers are consuming more of their own oil and that has run up against stagnating global supply and actually decreasing global exports last year.
So that is by far the most important single factor.
Now, in addition over the last couple months I think we have seen contribution from some other areas. Certainly the declining dollar is something that affects the prices of oil in terms of dollars and I think the very rapid cutting of the Fed Funds Rate that you mentioned has also been a factor that may have aggravated some of the price movements over the last few months.
TP: And a lot of commentary has been revolving around the role of speculation in the prices and we are seeing different proposals by certain members of Congress to ban trading on futures and so forth. To what extent do you think that is really relevant given the other supply demand issues and the related Fed cuts?
JH: I worry about making speculators into a scapegoat here because as I say there is a fundamental issue here that is real and we have to deal with it with some real responses. I am sympathetic to those that say that there has been a contribution from speculation to the latest price movements.
And I think there are some concerns about over the counter derivatives being traded. Not just in terms of commodities but a lot of other areas. Personally I am more worried about things like credit default swaps. I would like to be specific though about what it is that may be the source of concern here.
My source of concern is that if you trade a derivative contract through an organized exchange you set aside some funds as a margin and you increase those funds as the market starts to move against you to make sure that you have the ability to fulfill your side of the contract.
With these over-the-counter derivatives there is nothing playing that same role. And the question is what gives the counter parties the confidence that those contracts are actually going to be fulfilled.
I think part of the confidence is the “too big to fail” idea - for example Bear Stearns at $13 trillion in notional commitments outstanding before they failed. Where in the world are they going to get funds to cover those positions if they needed to? I think people were assuming that if they started to fail the Fed would bail them out.
So I see a potential instability there and I can see some reasons for trying to make the financial system more stable. But again I worry about making speculation into too much of a boogie man here because the real factors are very big and really a more important part of the story.
TP: You have drawn an interesting distinction about the dynamics driving oil prices in the 1970-1997 period as opposed to what has been driving oil prices recently and you have also been insightful about suggesting that it is really tough to compare the time periods on an “apples-to-apples” basis. What do you think is different about today’s climate that we didn’t see in the period of 1970-1997?
JH: In the 1970s there were big disruptions in oil supply from specific locations resulting from specific geopolitical events starting with the OPEC oil embargo in 1973-74, the Iranian revolution in 1978, the Iran/Iraq war soon afterwards.
These were all very big events and those are what produced the oil spike, the spike in oil prices we saw in the 1970s. There isn’t a corresponding supply disruption over the past few years instead it has been sort of this steady thing where if it is another month those prices have probably gone up again.
In this case it is the pressure of demand running up against constraints on the supply side. I think what people who lived through the 1970s sometimes overlook thinking they can apply the lessons of the oil industry then to what is happening today is the real transformation of the world with these newly industrialized countries, China in particular.
This has been a major change in the world. This is the new story. This is what is really unprecedented, the growth in demand from China.
So, they have had their petroleum consumption increase 7% a year for the last 20 years or so and if you project that out by 2020 they would be consuming as much oil as the United States is and by 2030 they would be consuming twice as much as we currently are. Are those projections totally ludicrous? Well, if you look at China today for every 100 people there are 3.3 cars and in the U.S. for every 100 people there are 77 cars.
So there is a lot of potential for further growth there. There has been tremendous growth already. And that is why it is just a different ballgame, so those people thinking that we will again see the collapse of oil prices because it has happened before aren’t taking that into account.
TP: Last July, I remember Arthur Laffer making an argument that oil prices would pull back to $40, basically on that argument – that it has done it before. Against this backdrop that you characterize with substantial room for growth in terms of demand it seems wild that you can think that oil prices could ever drop back to $40 per barrel.
JH: Yeah, I don’t think we will see that again. Now I don’t rule out a big drop. Certainly from $130 there is a lot of room below. But we are never going back to $40. Maybe we will see $60 in a real calamitous downturn but even that if it happened would be short lived.
Even if there were substantial increases in production in the next few years you don’t have to project those trends from China and other countries very far into the future before they are going to eat up all of that and then some.
On top of which you have the oil producing countries that are accumulating tremendous wealth and one of the places that wealth is going is into their own consumption of energy. And that is eating a lot into what could be available for export.
So I think we are in a new world and sometimes it takes some time for people to recognize that things have changed.
TP: I agree. You have also spoken about, and have some interesting insight into Peak Oil theory. What is your general take on how that factors into the overall perception at this point?
JH: I worry when people use just two words “Peak Oil” to kind of summarize the whole things as if you are either in the camp or against it. I see the issue as more complicated.
What I think is unambiguously true is that a given oil field shows a history over time of initial production and eventual decline as you get the oil out of that area and that is not a theory that is just an absolute fact. There is no question that if you want to keep on maintaining oil production you have got to find a new field, and if you want to increase production every year you have got to find more and more new fields.
So that is not a theory that is just the way the business works. The question in my mind then is not whether eventually we are going to run are of new fields, it is a question of when. If you are looking for example within the United States, U.S. production of petroleum has been declining pretty steadily for about 40 years. So I think it is very hard to argue that it is something other than that we have run into some geological constraints and those wonderful fields in Texas and Alaska are way into decline at this point. I think we are seeing a decline in production from the North Sea, Mexico’s Conterral, possibly also the Kuwait Burgan field and some even speculate the wonderful Saudi Ghawar field.
So to me that isn’t really controversial. We have also wonderful new discoveries, the offshore African field, Central Asia, Brazil…I think there is an open question which reasonable people should look at with an open mind as to how long those new discoveries are going to keep us going. But again I come back to this point - you don’t have to project those Chinese demand figures over too long until it is going to eat up whatever optimistic assessment you have on the supply side.
So in those terms I guess I am with the Peak Oil community, I think this is an issue. I think we will be dealing with it within this next generation. Maybe some aspects of it are indeed what we are dealing with right now. It is an interaction though of these supply constraints and the very, very strong demand that we have been seeing.
TP: And it seems that even the experts have no idea what to expect. If you look at Boone Pickens who announced on Squawk Box back in February that he was shorting oil at $98 and today he thinks it is going to $150. I think you have written in the past that the more we understand oil prices the less we are able to predict it. Can you elaborate on what that really means?
JH: Well you might draw an analogy with stock prices where I think a lot of people are familiar with the basic theory. If I knew for sure the price of stock was going to go up next month I should be buying it right now and the price today is going to jump up in response to whatever news anybody has about what is coming down the road for that company later.
That is known as the efficient theory of stock prices which says that the current price would reflect all available news and any change from here is something that is very hard to predict. Now, there are lots of refinements to that theory and there are lots of investigations of it in terms of stock prices and we can talk about it at great length.
But there is no question that is a good approximation to stock prices. They are very, very hard to predict. And the basic theory says yes, they should be. If they were something that you could predict there is somebody doing something wrong and that would be what is hard to explain.
Now why are oil prices like that? Well, for a couple of reasons. One is that you can store oil and you can put it into inventory. And so the same thing, if everyone anticipates the price of oil is going to be higher next month, they shouldn’t be selling it now, they should be putting it into inventory so that they can sell it next month.
So that is going to introduce some of this same feature of whatever news there is about future oil supply and demand is going to show up in today’s price. On top of which you have a long-term calculation in terms of suppliers of ‘should we produce now or five years from now’ and that is related to these issues that we are talking about – what Chinese demand is going to be at that point, what are the prospects of supply. And again that same calculation would suggest if it is totally predictable for example, if oil prices are going to double over the next few years, the producers are crazy to be pumping the stuff now they should slow down and produce more later.
So the basic economic theory of the oil price, like the basic economic theory of the stock prices would suggest that the price change should be very hard to predict. Again the empirical evidence would support me on that as well as looking at the track records of the people that you mentioned. It is hard for anybody to predict the price of oil.
TP: Even predicting inventory seems to be getting tougher and tougher. Today this is the second week in a row that expectations as far as inventories have just been way off.
JH: Well yeah, there is a question in terms of what is going on with inventories. Of course the numbers we have are the refiners’ inventory – that is where we collect the data. But there are lots of other parts of the process that we don’t have good data on storage from the production tankers to retail and so on so those numbers aren’t as perfect or as all encompassing as some people sometimes think.
TP: If we can turn to a second to, the Fed has been brought up earlier in our conversation - current fiscal policy and Fed policy – there is a lot of debate about how important is a strong dollar policy. People like Robert Rubin think it is extremely critical as a policy here in the U.S. and other apologists for the weaker dollar think it is not so important and in fact a weaker dollar is helping exports and so they will spin the benefits of a weaker dollar. What is your overall perception on the importance of a strong dollar policy for the economy?
JH: Well it certainly true that a weaker dollar can encourage exports and that may be one of the things helping us keep our nose above water and avoid a recession at the moment. But in general I don’t think I would want to promote a target for the value of the dollar as a specific goal of policy. Instead I think what is important is the stability of the purchasing power of a dollar – namely inflation. And that makes a lot of sense to try and keep that low and stable and predictable.
And there is no question for example that the United States has enjoyed tremendous benefits over the years from having the world’s reserve currency – that so many transactions are conducted in dollars. That is very helpful to us and it is not something that we would want to lose. And if we do get to a point where the dollar is perceived to be an unstable store of value – and here I am talking about inflation uncertainty, that could well be something that would erode that position. If that is what you mean by a strong dollar – trying to have stable and low inflation, I am all in favor of it.
But I don’t think we should be targeting a particular exchange rate of the dollar against the euro. And there is a longer run problem that the trade deficit the United States is running is not sustainable. What is going to change that? Well a lower value for the dollar is one very logical candidate.
TP: If you look at a tradeoff – talking about the benefits of a weaker dollar on exports it just seems that -I have heard number attributed to exports as a percentage of GDP being about 12 percent whereas
I have heard numbers that consumer spending is about 70 percent of GDP and it just seems that the implications of a weaker dollar to the consumer and inflationary pressures on the consumer it just seems it isn’t a good tradeoff to say that ‘well, it is helping our export business.’
JH: Well, there are lots of factors that are going to influence what the value of the dollar should be. How much we are exporting how much we are importing, our growth rate of the real economy, opportunities for investment in this country and abroad. And to think you know for sure what the value of the dollar should be as a result of some kind of policy evaluation of those issues is assuming more knowledge than I certainly possess.
I would worry about a claim that we know what the value of the dollar should be and if the market says that it is anything else we would want to change that. I think flexible exchange rates have proven themselves to be very workable and effective strategy for dealing with that.
But again, I think you can separate the question of inflation. I think there has been some erosion of the Federal Reserve’s commitment to keeping inflation low. I think that has been perceived by the international community that has contributed to a movement away from the dollar and ultimately does threaten our role as the world’s reserve currency and as I said I think that is something that we should be concerned about.
TP: To what extent do you see the Fed’s lack of commitment to the strong dollar policy if at all, as being supportive to the administration’s clear decision to use debt as a catalyst for driving growth?
JH: Well, we could talk about what aspects of debt are in fact directly a choice of public policy. I guess I would start first there with the federal debt – the result of government budget deficits and I certainly am amongst those that think it has been unwise for the U.S. government to have been borrowing as much as it has been over the last five years. I am among those that think it has been a contributing factor to our trade deficit and so that would be the first place to start I think in terms of trying to deal with the issue and I guess I would agree with you I would prefer to see deficits from Washington reduced as a strategy for dealing with that first rather than a monetary stimulus that brings the value of the dollar down.
Now in terms of other government policies that are relevant for debt I think the next place I would look are government sponsored enterprises (“GSEs”), Freddie Mae and Freddie Mac which as you know were part of a real explosion in their participation in housing markets over the last 20 years and then as the private sector started to replicate what they did with the subprime loans in particular, that is where we got into the problems that we are in now. There is a question for the point of view of public policy is did it make sense for organizations that are that closely allied with the government - the GSEs are not part of the government but there is a perception there is an implicit government backing to their liabilities that is part of what fuels their growth.
The question is whether that is really desirable from the point of view public policy. And I guess the traditional answer to that is something like ‘home ownership is a social good and it has been a good thing that we have encouraged people to own more homes and Fannie and Freddie participating in the mortgage market helped contribute to that.’ On the other hand I think financial instability is extremely undesirable and the explosion of debt has certainly played a role in that so again I guess I would be sympathetic to the suggestion that this is part a public policy that was encouraging the accumulation of debt that was maybe unwise and uncalled for.
And then finally you might point to the very low interest rates in 2003 and 2004 coming out of the Federal Reserve. I think in retrospect we would all agree that was a mistake – too much stimulus. I am of the opinion that again the Fed let interest rates get too low in the current round of loosening. So I could agree with those issues.
Now maybe there is also a role about regulation and the question about regulation in the financial sector. Again I think a lot of us would be agreeing at the moment that there is some more need for regulation. There were a lot of lapses. Exactly where in terms of a public policy or philosophy about debt that springs from I am not too sure. I do think there is a case to be made for, let’s re-evaluate some of the things that happened over the last decade and try to put everything on a little more solid footing.
TP: So with the advantage of hindsight, looking back on the past 5 to 6 years, and what seem to be some questionable decisions being made in terms of policy, what do you see as being the biggest risk to the economy today looking forward? There is a lot of uncertainty out there. Debates are still taking place about whether the economy is in a recession. Unarguably, everyone acknowledges that there is a lot of uncertainty out there and the economy has definitely slowed down.
JH: Well a recession by itself is not a scary thing. We have had plenty of them and come out the far end just fine. But I remain very concerned about housing and what it will end up doing to the financial system. And this has been sort of like watching a train wreck in slow motion. But the big danger is that a lot of these loans are not going to be repaid and if there are substantial losses on the part of major financial institutions which put some of them into insolvencies we have a risk of a risk of really an unprecedented kind of challenge to our financial system. That has been the big worry for a year now and it remains the big worry.
We are not out from under that at all.
The biggest risk factor in that in my opinion is how far house prices decline. The more house prices go down the more people are underwater with negative equity, owing more than their home is worth, the more those loans end up in foreclosures and the bigger the losses to come. That is still the big danger, the number one concern at the moment and that hasn’t gone away at all, at least in my mind.
TP: It just seems to be exacerbated by the fact that personal savings remain negative and credit debt is accelerating.
JH: Well, to me a big issue is something was going terribly wrong with our financial system. As I say I think there were loans made that just should not have been extended. It is a fundamental failure of the system that they were made in the first place. And I think you want to be looking at that and addressing that. So if we were looking at details of what might be done along those lines, my first concern is a question of accounting transparency.
If you look at the income and asset statements of some of these financial institutions you can come away very frustrated in that you don’t get a clear sense of exactly what their exposures are, exactly what their strategy has been. You will find these ‘boiler-plate’ kind of statements that the lawyers seem to put in that they are exposed to this risk or that risk, some kind of qualitative statement but you can’t get any quantitative understanding of just what they are exposed to or just what their risks are.
Capitalism can’t function if the players don’t know what is going on. And I think we have kind of reached that point. With this opaqueness of the system and all of these derivatives that nobody has a handle on I think there is no excuse at all for these structured investment vehicles being off-balance sheet entities.
That in my mind is a big concern.
TP: Continuing to look forward as we head into this next presidential cycle – clearly fiscal policy is going to matter with the next administration in terms of its philosophy about the deficit and some of these issues that we have talked about. Have you had a chance to look at McCain and/or Obama’s economic platform and form any opinions about that at this stage?
JH: Well, a bit. I have to tell you that I am not terribly impressed with either man individually in terms of their understanding of economic issues. I do know some of the advisors to both of them and I am impressed with some of their advisors. The question is to what extent they are going to be following that advice. So, for example, in McCain’s platform, there is a big emphasis on cutting taxes which is kind of surprising I think given – he did have sort of a solid record on some of the spending issues. But there seems to have been a political step he took.
In particular this gasoline tax holiday, I think it is something that didn’t come out of any of his economic advisors but it was a political calculation that it may sound good to people this summer. That is one concern I have.
If I can be a little skeptical about politics I think the best performance of the American system has come when we have had the president and congress from two different parties. That seems to be what really gives us fiscal discipline. Whether it’s Bill Clinton with the Republican Congress or maybe McCain with a Democrat Congress. I think the checks of the two would probably be more effective than either party alone with their current plans.
TP: That is interesting, with respect to Obama, there has been a lot of criticism in the media about the lack of clarity in terms of what Obama’s economic platform is. I don’t know whether that has been fair criticism when you juxtapose that against McCain’s but have you had a chance to look at what Obama, or at least his advisors have been suggesting he put out there as a platform?
JH: Again he is mentioning tax credits, but to his credit he was not jumping on this gasoline tax bandwagon the last few weeks. If you look at the statement on his webpage, it is sort of some generic ideas. He seems to share this idea that we really have got to help the people who are running into problems with mortgage payments. I am concerned that may be a little simplistic. So the simple story were telling on that was people took out adjustable rate hybrid mortgages with the reset on those they get into trouble and that is what we need a policy to deal with.
Whereas my interpretation has been the biggest risk factor has been the house price itself. And that it is the house price decreases that are causing the problem and if you just try to prevent the group of people from moving out of their homes but those price decreases continued I think you risk pushing this into a bigger problem. For me the biggest fear, the ultimate financial meltdown would be a situation where Fannie and Freddie go into financial insolvency. That is a problem we cannot solve. I don’t think it is feasible for the government to say that ‘we will back up this group or that group to make sure their loans are solid.’ That may work for awhile but it doesn’t really address the bigger insolvency issue.
So I am not terribly impressed with the set of proposals that either candidate has come out with at this point. But I do think highly of their specific advisors and if either or both of them listen to their advisors I think we will do ok.
TP: You think there is a chance that Fannie and Freddie can actually go into insolvency?
JH: Absolutely, they have a huge volume of outstanding debt and it is just a question of how bad those loans end up performing. That is the big issue, the big concern.
TP: In light of all of this and knowing that we are also a stock-focused media publication we would be interested to know if you are invested in the stock market or if there are any particular directions that you are inclined towards as an investor.
JH: Well, what I do myself and what I recommend for others is broad based domestic and international equity index funds, I also have some inflation index treasuries, and short run treasuries and as a resident of San Diego I am afraid I have a lot of participation in the real estate market as well.
TP: I am sorry about that.
JH: Well no, really it can go down a whole lot and we are still way ahead. I am thinking of it as a consumption good. But to be honest I have a lot of money in that.
TP: Well professor Hamilton, I want to thank you for your time this morning and we appreciate your insight into oil prices, the economy and other relevant issues that our readers and are listeners are paying attention to.
Interview by Todd M. Pitcher
About James Hamilton
Professor Hamilton is Chairman of the Economics Department at UCSD, has served as visiting scholar to the Board of Governors of the Federal Reserve System, the Federal Reserve Bank, and the Bank of Portugal. He is the Associate Editor of the Journal of Business and Economics Statistics and the Journal of Money, Credit and Banking.
