Reply #63: Oil – Inflation – Silver & Gold [View All]

[54anickel]

http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=45891

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A tax raises some prices, but depresses others

Higher crude oil prices selectively increase the costs of energy, food, transportation, medical, and many other essential sectors, but at the expense of the consumer having fewer remaining funds for other purchases. Consumers who are near their maximum tolerance for debt will react to higher costs for essential commuting travel to work by making fewer discretionary trips to the mall and by purchasing fewer luxuries. Although travel by automobile is essential in most parts of the USA, consumers stressed by high energy prices will tend to keep their old car longer or to replace it with a used car and to significantly delay the optional purchase of a new car. Everyone needs a place to live, but high energy prices will discourage potential home buyers from looking at new homes with a long commute to the office, and will focus their attention on the positives of renting an apartment closer to work instead. By increasing the prices of essentials, and thereby separating the consumer from a surplus of spending funds, high crude oil prices indirectly reduce the demand for non-essentials such as luxury items, new cars and houses. Just as a tax removes potential spending funds from the economy and transfers those funds to the tax agency, high crude oil prices absorb funds that the consumer would otherwise have available to spend on other purchases.

It should be obvious that a very high tax rate focused on a few essential sectors will depress the overall level of economic activity, and that the slowdown will exert downward pressure on the prices of non-essential sectors. Similarly, high crude oil prices raise the cost of essential transportation, utility, food, and comparable items, but also have a depressing effect on consumers who are left with no surplus of spending funds. The net result is that the prices of essential energy-impacted areas increase, but the slowing economy depresses the prices of non-essential areas.

Inflation adjusted crude oil prices are much higher than average

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A slowing economy will moderate energy prices


While pessimists may see a glass full of inflation as the inevitable price increases caused by high energy costs work their way through the economy, the Optimist sees the glass of economic activity being drained dry by high energy costs. As consumers reduce their spending for non-essentials, discretionary sectors will lose jobs, will have falling stock prices, and will be reinforced with an array of negative news. All of those negatives will combine to persuade consumers to reduce unessential spending. The cumulative result of high real oil prices will be an economy which slips and slides toward recession. A slowing economy in the USA will reduce energy consumption both at home and in key Asian nations which will encounter a decrease in the level of their exports to us. A global reduction in the demand for energy will significantly reduce the price of crude oil in international markets. The Optimist is happy he can provide the welcome news that the inflation adjusted price of crude oil will be lower in the future, even if the reason for that good news is a world wide reduction in the rate of energy consumption due to the traumatic recession that high priced energy would impose on the USA.

The Fed will fight the deflation devil

So, do you think that maybe a brief recession would lower energy costs enough to put the USA back on track to a high level of growth and another decade of endlessly rising stock and real estate investments? If so, then you get my vote for the most optimistic person in the nation! As yet another example of This Time It Really Is Different, the Optimist concludes that the USA will not again have another simple recession which proceeds to clean out the excesses of the prior expansion, and sets the stage for solid economic growth in the future. The unimaginable levels of debt and leverage in the USA makes the economy unstable and incapable of supporting the type of normal recessionary slowdown that the nation has gone though so many times before. What would have been a simple and mild slowdown in the past would now be magnified to intense proportions by the debt and leverage. If not given a lifeline, a slowing economy would fall relentlessly into a deflationary depression much deeper that the 1930s.

Fortunately, our friendly Fed is ever alert to that danger, and they keep a lifeline always at the ready. That is the same lifeline which the Fed used to rescue the economy when stocks crashed in 1987, when LTCM defaulted in 1998, in the months preceding Y2K, and when stocks again crashed in March of 2000. That lifeline is a substantial increase in the money supply. So long as the Fed is able to sufficiently ramp up the amount of money in circulation, they can be sure to reverse a potentially disastrous slowdown into a new illusion of growth. That would be a perfect solution for the American economy, except for two small problems. First, the amount of money supply increase needed to positively affect the economy increases with each intervention cycle. Secondly, the liquidity can only be added, but it can never be removed because removing the stimulus of the added money supply would cause the very deflationary depression that the money was injected to prevent. For each crisis that is solved by increasing the money supply, there must be a correspondingly higher inflation caused by an increase in the amount of fiat paper which is chasing the same amount of purchasing opportunities.

Inflation is a rising tide that lifts all price boats

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