The Downside of Cheaper Oil - Part II

I had a reader send me an email the other day referencing the oil price declines that I outlined. I wanted to bring up a possible scenario about the drop in the price of oil at a rapid pace. I'm not entirely sure that I got that point across. In the posting, I mentioned how a decline in the price of oil, along with real estate prices, could affect our economy here in the U.S., and abroad. Too much of a decline too fast could be problematic for the world economies. A nicely paced decline might not be a problem at all. I don't know if that tone of the posting made it in there, as the emailer pointed out that although oil was priced $15.00 lower than four weeks ago, it's still at $65.00. I think the exact quote he used for me to get my bearings was to "step back from my deep economic thinking and get with the real world".

I like these kinds of emails.

As I mentioned, I was hoping to instill a thinking scenario whereas the price of oil drops too quickly. Yes, the price of oil is still high when compared with five years ago. But, as the emailer mentioned, even OPEC has keyed in on the fact that the world is over-supplied. There again kind of reiterates what I was driving at. If we are in fact oversupplied, then the potential for a sharp decline is there.

So, why is a sharp decline a problem?

Let's first look at the overall increase in prices that we've seen. Oil has gone up slowly over the past few years from the lows of 2001 of $11.00 to the most recent highs of about $78.00. Unlike the 1980's sharp increase, the increase in oil prices this time around was modest in tempo happening over the course of the entire five years. In the 1980's, the move took an almost a 1908 San Francisco Richter Scale approach and ended up being a "shock" to the system. That shock to the system spread quickly all over the economy. The trickle through ramifications of the shock pushed our economy into a hyper-inflated era that is still studied and referenced to this day.

In our modern economic history here in America, there are a few events that have molded us. The Great Depression is one of them. The second is the 1980's inflation era. Ben Bernanke, in his book, The Great Depression, mentions that in order to really understand an economy, you must first study the biggest economic event that ever happened and see how our economy has been formed or guided since then. The two other major economic events were the inflation eras of both the 1980's and what would be the present day economic landscape we are in. At some point, perhaps five years from now, we'll look back at our economy today and learn how to better manage events such as what we saw over the recent years. For now, however, we can't really grasp where we are until we've finished going through it.

And as for a sharp drop in the price of oil and real estate and its affects on the economy here in the United States? A sharp drop could be disastrous for our economy. If we were to enter into a price deflationary period, the Federal Reserve would be forced to act aggressively to contain this decline. The recipe for this, as the Japanese have shown us, is twofold. First, you drop interest rates all the way down to nothing. Second, you turn on the printing presses at full blast and hope that everyone and their mother borrows and spends. Regrettably for the Japanese, that's not what happened. Hopefully, we'll be able to maneuver through this differently. As for the dollar in a scenario like this, if the Federal Reserve does have to drop interest rates all the way down like that, The dollar will follow along with interest rates. You can bet that the price of goods bought overseas will go up. Way up. Think double in value. That will certainly fix the trade balance. But, it will cook everything else in the process.

Thanks for the email, Al.