The oil price has doubled in the past year because the US Federal Reserve
panicked over risks to the over-leveraged financial system and flooded markets
with excess liquidity. The world is willing to pay arbitrarily high prices to
hedge against inflation, but the cost of inflation hedges drags down the world
economy. Last week's spike in commodity prices and swoon in global stock
markets points the way to a deep and prolonged fall in economic activity.
Breaking out of the death spiral still is possible. With mixed emotions, I
propose a simple solution. In fact, a crash would not be an altogether bad
thing for the United States. At least it would
exorcise the something-for-nothing culture of the past two decades.
The baby boomers would not be able to retire, to be sure, but in America
retirement means watching an additional 40 hours of television per week. For
all I care they can keep working. For the world's poorest, though, the
consequences would be deadly (see
Rice, death, and the dollar, Asia Times Online, April 22, 2008). My
proposal draws on the experience of 1979-1984 under similar circumstances,
although the parallel is far from complete.
By catastrophic breakdown, I mean a well-defined chain reaction:
Markets expect economic growth to decline as oil prices rise.
American financial institutions, whose market capitalization has fallen by
almost half in the past year, sustain higher default rates from households and
firms, leading to some failures.
Credit availability shrinks as banks come under pressure, raising the default
The price of household assets (real estate and stocks) continues to decline,
destroying their creditworthiness.
Markets expect the Fed to continue to ease monetary policy and offer unlimited
liquidity to all comers, as it did with the mid-March bailout of Bear, Stearns.
Investors turn away from falling equity markets and buy inflation hedges,
pushing oil and commodity prices up further.
Monetary ease is a medicine whose side-effects have become worse than the
disease. Blaming "speculators" for rising oil prices is cheap demagoguery.
Pension funds have invested hundreds of billions of dollars in commodity index
funds during the past two years to hedge against inflation. The more the Fed
debases the dollar, the more money shifts away from the stock market into
inflation hedges. The data leave no doubt of this.
There is a visible long-term relationship between oil and the dollar
US$ trade-weighted index vs oil price, 1973 to present
The dollar collapse and oil price spike of today mimics the dollar's fall and
the oil price surge at the end of the feckless administration of Jimmy Carter,
and stopped when the Fed tightened monetary policy between 1979 and 1982.
Therein lies a lesson.
Recently, though, the correlation of daily returns to oil and the
trade-weighted dollar index has reached a new low, that is the oil price is
more likely than ever to rise on days that the dollar index falls.
Three-month rolling correlation of daily returns to the US$ trade-weighted index
and spot oil: the relationship is stronger than ever before
The position of American households is so fragile that major institutions might
fail. Washington Mutual, America's largest thrift institution, is now trading
at a tenth of its 2007 stock price. It is not clear whether any other
institution is willing, or indeed able, to take it over.
Federal Reserve chairman Ben Bernanke knows that something has gone dreadfully
wrong. He spent the month of June threatening to do something about the sagging
dollar and soaring commodity prices, until the market concluded last week that
he was bluffing. Bernanke simply doesn't have the nerve to raise interest rates
into a weakening economy.
Under parallel circumstances, then Fed chairman Paul Volcker did precisely that
in 1979, bringing the central bank's lending rate up to 20% over two years of
tightening. Inflation under the Carter regime had run out of control, the
dollar collapsed, and the price of oil rose to a then menacing $40 per barrel.
After Volcker tightened monetary policy the dollar's trade-weighted exchange
rate doubled and the price of oil fell sharply.
At the same time, the Ronald Reagan administration cut marginal tax rates
sharply, and the American economy began a quarter-century growth cycle. Lax
monetary policy had produced stagflation instead of growth, but tax cuts
succeeded. The costs, to be sure, were painful - 1,600 American banks and a
similar number of savings and loans failed between 1980 and 1994, at a cost of
$160 billion to taxpayers. America sustained its worst economic downturn since
the Great Depression, with an unemployment rate of 11% in 1980.
The present crisis, sadly, is far less tractable. Top marginal income tax rates
of 70% in 1981 were the equivalent of banging your head against the wall. It
felt good when you stopped. With the top federal rate at roughly half the 1981
level, it is hard to argue that lower tax rates will buoy economic activity.
Home ownership, moreover, offered a hedge against inflation, and rising home
prices sustained household net worth.
Today's crisis, by contrast, threatens the solvency of households. After a
quarter-century of taking on debt, home prices are collapsing. Americans,
moreover, have saved nothing during the past decade, borrowing an annual sum
from foreigners that amounted to $1 trillion in 2007. The crisis of household
solvency became a banking crisis through the collapse of the market for
lower-quality (subprime) mortgages, and threatens to metastasize into something
much broader. That is the message the markets delivered during June.
There is no way to avoid some economic pain. America is in a recession and will
stay in a recession for a while. The only question is whether it will come out
of the recession in one piece.
The most urgent task is to restore the financial standing of households.
1. Allow individuals to contribute up to $100,000 a year of pre-tax dollars into
individual retirement accounts.
Americans need a tax cut on savings, not on consumption. Shovelling liquidity
into the system has made matters worse. But a shift from consumption to savings
will increase the supply of long-term capital, bringing down the cost of equity
to firms and long-term interest rates, including mortgage rates. Let the middle
class save in pre-tax dollars.
That will increase the budget deficit, but no matter; in a world of financial
pain, it is easy to find buyers for Treasury securities. Former governor of
Arkansas Mike Huckabee's "fair tax" proposal goes even further, and in the
right direction, eliminating all taxation of income, including income on
capital, and substituting for it taxation of consumption. That's good medicine,
but the patient probably is too weak to take it at the moment.
2. Eliminate capital gains tax on all single-family residences, and preferably,
on all capital assets.
What the housing market requires now is speculators, bottom-fishers, predators
- investors who can make cash bids for homes. The best way to get
bottom-fishers into the market is through tax incentives. Using taxpayers'
money to keep people in their homes is pointless. Americans will be on the move
looking for different jobs in any case as employment shifts away from retail,
financial services and real estate. The trick is to make homes saleable.
Eliminating capital gains tax altogether would not be a bad idea. Here is why:
S&P 500 since 1997, nominal and adjusted for the consumer price index
American equity markets show no real capital gains since 1997. That is, an
American who bought the equivalent of the Standard and Poor's 500 Index at $954
in January 1997 and sold today at $1,278 would have exactly the same number of
inflation-adjusted dollars (not taking dividends into account). Long-term
capital gains would remove $64 of the nominal profit of $324. Because the
capital gain was illusory to begin with, this investor would have lost money on
an 11-year holding period. If eliminating capital gains tax seems too much like
a giveaway to the rich, at least index capital gains for inflation.
3. Raise short-term interest rates to stabilize the dollar.
With inflation running at 3-4% today rather than at 12% in the aftermath of the
Carter administration, an increase in the central bank's short-term rate, say,
to 4%, probably would have a big impact on the dollar exchange rate as well as
commodity prices. Today's 2% rate helps no one and hurts everyone except
4. Allow sovereign funds to buy American banks.
American banks don't have enough capital, and the unraveling of the leverage
pyramid as well as the weakening economy conspire to reduce the capital they
have. With their stock prices falling, they have difficulty raising more
capital from their existing shareholders. Someone has to recapitalize the
banks, and the market will not do so until excruciating levels of distress have
There is no shortage of capital, though; the Fed's liquidity binge has put
trillions of dollars into the hands of sovereign wealth funds maintained by
exporting nations. It is painful to allow the crown jewels to fall into foreign
hands. Ask Thailand, which kept foreign investors out of its banking system
until the 1997 collapse, and afterward welcomed them in. Americans either can
swallow their pride, or tighten their belts.
This brief list does not cover such weighty matters as energy policy, bank
regulatory policy, and so forth, but it indicates the sort of turnabout that
America requires. Americans have to change their lives. There are two ways to
do this. The federal government can provide incentives to do so, or the market
can compel a change in behavior using the instruments of torture at its
With the above presentation I have discharged my civic duty. The likelihood
that the present administration and Congress will do anything remotely like
this, of course, is vanishingly small. My advice to individual investors?
Invest in some popcorn, because the next six months will be something to watch.