TJP

A Stable Middle East is Critical for the US Economy

By Byron A. Ellis

March 17, 2008

According to the neoclassical theory, cyclical fluctuations in productivity lead to business cycles. Thus, in neoclassical parlance, business cycles result from exogenous changes in productivity. However, others view business cycles as a result of malfunctioning markets; this latter view requires policy makers to tinker with the economy: government intervention.

Today, it appears that the Federal Reverse (Fed) and the government believe that the sluggish economy is a result of malfunctioning markets. Hence, they have set out to fix the problem by lowering interest rates, monetizing the economy, and providing government transfers. Such policies, however, are inflationary and will lead to high rates of interest and unemployment.

The Fed, the Bush administration, Congress, and some economists believe that the sluggishness of the economy is due to tightening of credit markets. Apparently, the cause of credit constraint is not an important variable in their calculations. However, from neoclassical point of view there is an exogenous variable, or more than one, that is causing a slowdown in productivity.

One variable that comes to mind is crude oil. Crude oil is the world most actively traded commodity. Contracts are traded in the future, where the buyer agrees to take delivery and the seller agrees to provide a fixed amount of oil at a prearranged price and location. Commercial entities use future contracts as hedging tools to manage risk through a variety of options. When used to speculate, price and risk increases. If price moves favorable speculators profit increases.

Instability in the Middle East creates high volatility in the market for crude oil futures. Thus, traders assign risk premiums to future purchases based on supply speculations. It is this risk premium that contributes to the escalating price of crude oil.

The risk premium results from traders observing a signal (s) in the market for crude oil. The signal is either “stability,” st, or “instability,” i. If crude oil traders observe a stable signal then, they conclude that supplies, and hence prices, p_L, will be stable; conversely, if they observe instability, they conclude that disruptions will cause shortages in the future and prices, p_H, will be high.

Traders recognize that the probability (л) of instability in the near future is greater than the probability of stability, or that higher prices are likely to prevail, л(p_H, s) > л(p_L, i). Additionally, they know that consumers, businesses, and the government tend to adjust to the new economic fundamentals of continuous price increases. Moreover, that the new economic fundamentals of rising crude oil prices is profitable to the energy industry.

Tensions between the Bush administration and crude oil producing nations, such as Iran and Venezuela heightens the instability signal and contributes to higher crude oil risk premiums, and hence higher prices at the pump.

In competitive markets, supply and demand determines prices. The market for crude oil, however, is not competitive. The Organization of Petroleum Exporting Countries (OPEC), as a general rule, allocates production quotas for its members. Nonetheless, one would expect that high prices would lead members to cheat by producing more than OPEC production quotas.

Hence, the scarcity arguments run counter to economic theory. And, the Saudis recently confirmed that supply is adequate; they refused the Administration’s request to increase supply. They noted that production would rise only when the market justifies it. Translation, there is enough crude oil on the market and the rise in price is not due to shortages, but rather to war induced risk premium.

The administration and pundits have used the competitive market argument that supply and demand determines prices to justify the rise in crude oil prices. Americans have been conditioned to believe that the current rise in crude oil prices is due to shortages and not to the risk premium associated with the violence in the Middle East.

It is the crude oil risk premium that has adversely affected disposable income in the United States and the rest of the world. Consumers are confronted with a budget equal to their hourly wage (w) times the hours worked (n). They use this budget to cover the costs of housing (h), food (f), transportation (t), daycare (dc), healthcare (hc), education (e), saving (s), and so on, or wn = p_hh + p_ff + p_tt + p_dcdc + p_hchc + p_ee + s + ∑₁ⁿp_nx_n.

Now, lets say that the consumer budget (wn) is $100 and the price that she pays for housing is $20, $10 for food, $10 for transportation, $5 for daycare, $5 for healthcare, $5 for education, $5 for saving, and the remaining $40 for other goods and services (∑₁ⁿp_nx_n). If her wage increases by 3%, from $100 to $103, and transportation price increases (price of gasoline) by 100%, from $10 to $20, there is a deficit of $17 (excluding inflation); so, in order to make up the deficit, she either has to use her saving, borrow, or reduce her allocation to other budgetary components.

It is this chiseling away of the consumers’ income due to the corrosive effect of crude oil prices that has transferred wealth from the consumer to the energy industry and put the United States economy in a tail spin. However, many economists and politicians refused to acknowledge the relationship between increasing crude oil prices and the sluggish economy.

It is understandable that politicians who overwhelmingly voted for a war that destabilized the Middle East are reluctant to acknowledge the linkage between the sluggish economy and crude oil prices. However, in light of research done by Professor James Hamilton on others, it is perplexing to see economists failing to understand this linkage.

Hamilton noted that OPEC’s increases in 1974:1 caused output reduction in 1975:1; gasoline shortages and price increases due to the Iranian revolution in 1979:2 preceded the business cycle peak of 1980:1; and increases due to the Iran-Iraq war 1980:4-1981:1 caused the business cycle peak of 1981:3.

Thus, the policy implication is that the economic fix can only occur by reducing the violence in the Middle East, which would lead to stable or decreasing crude oil prices.

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